Quantitative Terrorism Risk Assessment

Abstract

Traditionally, terrorism risk has been priced based exclusively on the relationship between supply and demand in the insurance market, with no basis in actuarial principles. This article discusses how the tragic events of September 11, 2001, have irrevocably changed the market for terrorism insurance, since terrorism has become a U.S. catastrophe risk. The author states that since insurers seek to quantify risk distributed over several months (versus a period of only a few days), quantitative assessment of terrorism risk may be achievable. The article proceeds to address the challenge of quantifying terrorism risk, and ultimately suggests that developing quantitative terrorism risk models may provide a foundation for securitizing and trading terrorism risk. The author introduces three examples of potential alternative risk transfer instruments for terrorism risk: 1) a catastrophe bond triggered by workers' compensation claims from extreme terrorism‐related events; 2) a catastrophe bond to cover life insurers from losses related to an attack employing a weapon of mass destruction; and 3) a contingent financing instrument triggered by a terrorism event whose natural buyers are financial short‐sellers.