INSURABILITY OF (MEGA)-TERRORISM RISK: CHALLENGES AND PERSPECTIVES

Report prepared for
The OECD Task Force on Terrorism Insurance
Organization for Economic Co-operation and Development, Paris

Howard KUNREUTHER and Erwann MICHEL-KERJAN

March 25, 2004
(20,628 words)

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Four additional elements may explain the lack of interest in new financial 
instruments for covering the terrorist risk. Unlike investments in 
traditional high yield debt, money invested in a natural or terrorist 
catastrophe bond can disappear instantly and with no warning. Those 
marketing these new financial instruments may be concerned that if they 
suffer a large loss on the catastrophe bond, they will receive a lower 
annual bonus from their firm and have a harder time generating business in 
the future.

More specifically, investment managers may fear the repercussions on their 
reputation of losing money by investing in an unusual and newly developed 
asset or making money based on loss of human life. The short-term incentives 
facing investment managers differ from the long-term incentives facing their 
employers. If this is a major problem in marketing catastrophe bonds, then 
there is a need to develop strategies for bringing the principal (employer 
and its shareholders) and its agents (investment managers) into alignment.

Second, there may be a moral hazard problem associated with issuing such 
bonds if terrorist groups are connected with financial institutions having 
an interest in the U.S. For example, the recent aborted DARPA terrorism 
futures market experimented by the Pentagon, suffered from moral hazard: a 
terrorist group supported by specific investors might have an obvious 
financial interest to perpetrate and benefit from a terrorist attack against 
a public figure on whose life odds were placed. (Woo, 2004).

A third reason why there has been no market for terrorist catastrophe bonds 
was the reluctance of reinsurers to provide protection against this risk 
following the World Trade Center attacks of September 11th. Financial 
investors perceive reinsurers as experts in this market. Upon learning that 
the reinsurance industry required high premiums to provide protection 
against terrorism, investors were only willing to provide funds to cover 
losses from terrorism if they received a sufficiently high interest rate. 
(Kunreuther, 2002).

Finally most investors and rating agencies consider terrorism models 
recently developed (see Section E) as too new and untested to be used in 
conjunction with a catastrophe bond covering risks. The models are viewed as 
providing useful information on the potential severity of the attacks but 
not on their frequency. Without the acceptance of these models by major 
rating agencies, the development of a large market for terrorist catastrophe 
bonds are unlikely (U.S. General Accounting Office, 2003).

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