How Does the Corporate World Cope with Mega-Terrorism? Puzzling Evidence from Terrorism Insurance Markets

Terrorist attacks that have succeeded abroad since 2001, as well as others that were prevented, indicate that the threat of a large-scale attack is real and will be with us for a long time. Focusing on the United States, the United Kingdom, and Germany, this article analyzes the role that insurance can play in providing commercial enterprises with financial protection against the economic consequences of major terrorist attacks.The article begins by explaining the design and key features of terrorism insurance programs operating today in each of the three countries (TRIA in the U.S., Pool Re in the U.K., and Extremus in Germany). The authors then provide a detailed comparative analysis of the evolution of prices and take-up rates (based on as yet unpublished data), with particular attention to financial institutions. For those who think the U.S. is the most likely target for mega-terrorism, the findings are somewhat puzzling. On average, for example, companies in the U.S. do not pay even half as much for comparable coverage under TRIA as companies pay in Germany under Extremus. This raises important questions. Is terrorism coverage under the U.S. insurance program now drastically underpriced? If so, what would be the likely consequences of another large-scale attack in the U.S.? On the demand side, the authors observe a dramatic increase in take-up rates in the U.S. since 2003, revealing increased corporate concern. By contrast, the market penetration in Germany remains remarkably low.The article also discusses the concept of pricing by contrasting two possible measures of price: premium over total insured value (measure commonly used today) versus premium over maximum annual compensation (real quantity of insurance purchased). Empirical evaluation of these two measures using data on these markets reveals a significant contrast.As the new Congress studies the future of terrorism risk financing after 2007, a better understanding of these programs in the U.S. and Europe and of the recent evolution of these markets will be critical. The analysis provided in this paper shall help corporate and government decision makers develop more effective protection programs against the economic consequences of mega-terrorism to ensure national security and economic growth.