Using models in catastrophe risk management
It was a bright, sunny morning when four airplanes
departed from airports in Boston, New Jersey and
Washington, DC. No one could have imagined that a few
men in each of these aircraft were hijackers on a suicide
mission. They demanded neither money, nor the release
of prisoners or safe passage, but steered the aircraft into
buildings in New York City and Washington, DC -buildings that symbolize American economic, military
and political power. Two of the world’s tallest buildings,
the twin towers of the World Trade Center, collapsed
and were reduced to rubble. The Pentagon sustained
serious damage, and four large commercial aircraft were
lost. More than 3,000 people were killed and 2,500
injured in fewer than 100 minutes.
The terrorist attacks of September 11, 2001 produced
insured losses larger than any natural or man-made
disaster in history. To give some perspective, the
insured loss from Hurricane Hugo (1989) was more than
$1 billion with total economic damages exceeding $7
billion. Hurricane Andrew (1992) cost the insurance
industry over $15 billion, while the Northridge
earthquake (1994) generated over $12 billion in insured
losses. The current estimate of insured loss from the
September 11 attacks is on the order of $40 billion and
may grow further as more information is compiled. The
sheer size of the loss coming from an entirely
unforeseen peril, combined with the uncertainty arising
from the United States’ rapid military response,
produced financial shockwaves that shook insurance
markets worldwide. What might be the next attack? In
what form might it come? At what cost? How often might
future attacks occur? To restore stability to the market,
insurance and reinsurance companies urgently needed
answers to these issues if they were to develop rational
underwriting and pricing policies related to terrorism risk.
To cope with such an unprecedented situation, a basic
language for terrorism exclusions was developed by
Insurance Services Office, Inc. (ISO). More recently,
models have been introduced by leading catastrophe
modeling companies to help insurers and reinsurers
quantify their risks, assess coverage, estimate the
financial impact of future attacks, support pricing
decisions and improve overall portfolio management.
The greatest challenge facing the modelers is estimating
the likely frequency and severity of future terrorist
activity. Unlike natural catastrophes, terrorist attacks are
a function of highly variable human behavior. No purely
quantitative technique can precisely foresee human
action. To have a better understanding of the probability
and nature of future terrorist activity, it is critical to tap
the judgment and experience of renowned experts on
terrorism. Thus in developing the models, the modelers
work closely with counterterrorism specialists who have
high-level operational and analytic expertise and
experience in government agencies, such as the FBI,
CIA and the Department of Defense. The models need
to be robust and capable of analyzing various threats
posed by a variety of groups, including domestic
extremists, formal international and state-sponsored
terrorist organizations and loosely affiliated networks.
They also need to examine the full range of potential
conventional attacks, including air crash and bomb blast,
as well as non-conventional weapons, including
chemical, biological, radiological and nuclear and their
impact on insurers' and reinsurers' books of business.
Terrorism models will continue to evolve as more
information becomes available. According to Karen M.
Clark, President and CEO of AIR Worldwide Corporation
(AIR), a subsidiary of ISO, “There is going to be a much
greater margin of error in estimating the probability of a
terrorist attack versus a hurricane strike. So much more
data is available on hurricanes and we have a much
better understanding of the physical forces that cause
them and determine their severity. The new terrorism
models, however, will provide a sound basis for
insurance and reinsurance companies to establish
effective underwriting and pricing guidelines for terrorism
coverage. It’s not precise, but it’s better than anything
else our clients currently have available. And the
methodology is going to evolve.” Using these tools,
insurance companies will now be able to reasonably
estimate the full range of possible attack scenarios for a
large database of landmark properties, including highprofile "trophy" targets having greater-than-average risk
of attack due to their symbolic value.
AIR released its Terrorism Loss Estimation Model in
early September 2002, the first commercially available
probabilistic model to estimate the financial impact of
insured property and workers’ compensation losses from
potential terrorist attacks. The model considers over
300,000 possible terrorist targets in the United States.
Estimates of the frequency of occurrence and severity of
attack are generated using the Delphi Method, which
was developed by the RAND Corporation after World
War II as a way to statistically combine expert opinion
and eliminate, to the extent possible, individual
subjectivity. The model then calculates the effect of
various weapon types on potential targets, taking into
account the construction type of the target building and
those of the surrounding structures. The model also
estimates the number of injuries and fatalities based on
building damage and occupancy, and considers
coverage provisions to calculate total insured loss.
AIR’s Terrorism Loss Estimation Model was used to
support Silent Vector, an executive level terrorism
preparedness exercise held on October 17 and 18,
2002, at Andrews Air Force Base near Washington, DC.
The model was used to provide detailed exposure data
for possible terrorist targets used in the exercise.
Organized by the Center for Strategic and International
Studies (CSIS) and the ANSER Institute for Homeland
Security, the purpose of the exercise was to assist the
Administration and Congress in their effort to increase
the effectiveness of response to specific and credible
threats of a major terrorist incident. Since its release, the
AIR terrorism Model has received a great deal of interest
from entities within the insurance, financial services and
real estate industries, as well as several branches of
government.
--------x-------Author: Shibabrata Ghosh
Data Analyst,
AIR Information Technology.
www.air-worldwide.com
About ISO and AIR
Insurance Services Office, Inc. (ISO),is the premier source of information, products, and services related to property and
liability risk. For a broad spectrum of commercial and personal lines of insurance, ISO provides statistical, actuarial,
underwriting, and claims information and analyses; consulting and technical services; policy language; information about
specific locations; fraud-identification tools; and data processing. In the United States and around the world, ISO serves
insurers, reinsurers, agents, brokers, self-insureds, risk managers, and insurance regulators and other government
agencies.
AIR Worldwide Corporation (AIR),a subsidiary of ISO, is the world's premier risk modeling and technology firm
specializing in risks associated with natural and man-made catastrophes, weather and climate. Founded in 1987, AIR
pioneered the probabilistic catastrophe modeling technology had revolutionized the way insurers, reinsurers and financial
institutions manage their catastrophe risk. AIR’s leading edge models of global natural hazards, which form the basis of its
software systems, enable companies to identify, quantify, and plan for the financial consequences of catastrophic events.
AIR has developed models covering all major natural hazards, including hurricanes, earthquakes, winter storms,
tornadoes, hailstorms and flood, for more than 40 countries throughout North America, the Caribbean, South America,
Europe and the Asia-Pacific region.
AIR also models man-made perils. Managing risk from terrorism has, unfortunately, become an essential part of today’s
business decision-making process. In the wake of the tragic events of September 11, 2001, and at the urgent request of
several clients, AIR developed and introduced the first fully probabilistic terrorism model capable of quantifying the risk
from this emerging threat.
References
www.boston.com
www.cnn.com
Race to predict terror’s cost, The New York Times (September 1, 2002)
Predicting extreme event for businesses in her business, The Economic Time (November 3, 2002)
Insurance Information Institute (http://www.iii.org)
Insurance Services Office (http://www.iso.com)
AIR Worldwide Corporation (www.air-worldwide.com)