Since 9/11, Howard Kunreuther and his colleagues at the Wharton School’s Center for Risk Management and Decision Processes have been examining the thorny issue of how to protect society from the economic effects of the next terrorist attack.

By Jon Hurdle | Photography by Jacques-Jean Tiziou

Ever since he joined the Wharton faculty in 1972, Dr. Howard Kunreuther, the Cecilia Yen Koo Professor of Decision Science and Public Policy and co-director of the Center for Risk Management and Decision Processes, has been biking to work from his home on Philadelphia’s Main Line. But on the morning of September 11, 2001, Kunreuther was following a different route, riding up the Hudson River bike path on the west side of Manhattan on his way to Columbia University—where, as it happened, he was working on a study of catastrophic risk.

Hearing on the radio at 8:48 a.m. that a “small plane” had hit the World Trade Center, he stopped at the 69th Street pier, where he could see one of the towers in flames. He left the pier at 9:01, a minute before the second plane hit the other tower, and only learned of the second plane, and of the disaster in general, at about 10 a.m. when he took a call from his wife Gail, who told him what had happened. The event became a turning point in Kunreuther’s career, a catastrophe that dwarfed all previous events—floods, earthquakes, hurricanes, chemical accidents, and other disasters—for which he had developed his risk theories. “The ultimate low-probability event,” he calls it.

Terrorist events differ from natural disasters in many ways, but they share one characteristic with them—having happened once, they are likely to happen again. For the past several years, Kunreuther and his colleagues at the Wharton Risk Center have been examining the thorny issue of how to protect society from the economic effects of such an attack. Since early 2003, the center has hosted three one-day roundtable discussions in an effort to provoke thinking in industry, government, and academe about how to ensure social and economic continuity after another major terrorist event.

This past February, at the latest meeting in the series, Kunreuther held court in a Huntsman Hall lecture room before an audience of some of the top minds in the insurance industry. With an urgency that befit his subject, he crisply framed the topic, introduced the speakers, and invited participants to consider the big questions: Can the insurance industry alone provide meaningful coverage against the next terrorist attack? What role, if any, should government play? What’s the best way of motivating business and industry to protect themselves from an attack on the scale of 9/11?

These issues will be examined in a report to be completed later this summer coauthored by Kunreuther and Wharton colleagues Dr. Neil Doherty (Frederick H. Ecker Professor of Insurance and Risk Management and chair of the department), Dr. Scott Harrington (professor of health care systems), Dr. Paul Kleindorfer (Anheuser-Busch Professor of Management Science and professor of decision sciences, economics, and business and public policy), Dr. Erwann Michel-Kerjan (research fellow), Dr. Mark Pauly (Bendheim Professor and professor of health care systems, business and public policy, insurance and risk management, and economics), Dr. Isadore (Irv) Rosenthal (senior fellow), and Peter Schmeidler (senior consultant).

The purpose of the report is to inform congressional deliberations on whether to renew the Terrorism Risk Insurance Act (TRIA), a temporary law enacted in the wake of 9/11 that established the federal government as a backup reinsurer against catastrophic losses from foreign acts of terrorism on U.S. soil. Commercial reinsurers, hit by billions of dollars in claims from 9/11, effectively withdrew from the market shortly after, leaving primary insurers with no way of spreading the extremely high risk of covering their clients against another such event.

With the government protecting the insurers—who are now required to offer terrorism coverage to their clients—more businesses have since purchased coverage against terrorist attack, but face the prospect of much higher premiums or even no coverage if the government withdraws from the market by allowing TRIA to expire at the end of this year.

Many insurance industry professionals argue that TRIA has achieved its goals since being enacted in November 2002, and so should be extended for at least a couple of years while a more permanent solution is found.

The act’s supporters also contend that government is just as responsible for aiding recovery from such an attack as it is for attempting to prevent one because it is a matter of national security that is arguably related to the conduct of U.S. foreign policy.

“Some say this problem is directly related to U.S. foreign policy and so should be dumped right in the lap of the government,” says Dennis Kuzak, senior vice president at EQECAT Inc., one of the three leading U.S. firms that model catastrophic risk.

But others say the government’s presence in the market discourages private-sector mitigation of the terrorist threat such as strengthening buildings or increasing airline security, impedes the development of a private market, and shifts the costs of a future attack to taxpayers rather than to the owners of targeted businesses or buildings.

The Wharton report is expected to coincide with an assessment of TRIA from the U.S. Treasury. But the non-partisan Congressional Budget Office (CBO) is already on record as opposing the extension of the act, arguing that the private sector will ultimately do a better job without government playing a role.

At the February roundtable, the CBO’s David Torregrosa argued that expiration of the act would increase businesses’ incentive to mitigate their own risk by shoring up buildings or by moving their operations to locations that are seen as less-likely targets for terrorists. TRIA may result in higher overall costs because it is a disincentive to taking such actions, Torregrosa argued. “In general, private investors are better off bearing the risk.”

The CBO’s report, published in January 2005, argued that insurance rates should be increased to reflect higher anticipated costs, and it rejected the view that TRIA should be extended because terrorism is assumed to be a long-term problem.

Those higher premiums following its termination, critics of the act add, would encourage businesses to build or reinforce structures to withstand terrorist attacks and would spur the development of risk-spreading mechanisms such as catastrophe bonds, which pay high rates of interest to the holder who runs the risk of losing both interest and principal in the event of a terrorist attack.

The conclusions of the Wharton roundtables have fed into the Wharton Risk Center report, which Kunreuther hopes will play an important role in congressional deliberations later this year on whether to renew the act and, if so, how it might be modified. But in his role as moderator of the discussions, Kunreuther has been careful to remain neutral in the debate. Taking sides, he believes, would immediately reduce the Risk Center’s effectiveness in presenting and analyzing the problem. “Once you get into the politics, you’ve lost your credibility in evaluating the pros and cons,” he says. Accordingly, the report will not be making recommendations but rather will evaluate policy alternatives and provide arguments on both sides so that government and industry can make an informed decision.

In his role as facilitator, Kunreuther often succeeds in identifying common ground among an audience whose members have diverse agendas and competing points of view to represent, says Frank Nutter, president of the Reinsurance Association of America and a participant in the roundtables. “He brings an intellectual capacity to the discussion.”

The independent stance of Kunreuther and the Risk Center in articulating the debate over terrorism insurance also adds credibility in the eyes of the Bush administration, which is likely to be sympathetic toward Wharton’s work because of the school’s traditionally pro-market stance, Nutter adds. “The value of the Wharton Risk Center is to step back from the fray and help us recognize what would seem to be in the best interests of both the government and the private sector. It’s an independent voice.”

While Kunreuther has spent much of his professional life studying people’s attitude to risk, his personal life includes activities such as skiing, motorcycle riding, and white-water canoeing, reflecting a belief that risks are worth taking. His motorcycling has included trips from Texas to Mexico City and Chicago to Washington and a trip with friends from Salt Lake City, Utah, through Idaho to Jackson Hole, Wyoming, with his wife Gail riding on the back of a Harley Softail. He describes motorcycling as “a sport you do with all the five senses—it makes you totally aware.”

He’s an even greater fan of the bicycle, both as a means of transport and of recreation. In addition to more than 30 years of commuting to Wharton by bicycle, he has taken long trips, such as a 500-mile journey from Philadelphia to Vermont to raise money for research into Parkinson’s disease, from which his father died. For the first half of that trip, he was accompanied by his son, a professional jazz guitarist and then joined by his daughter, an anthropology professor at Bard College in New York State.

Kunreuther’s appetite for adventure has had tragic consequences. While snorkeling in Jamaica on a trip celebrating 19 years of marriage to his first wife, the couple was hit by a motorboat, killing his wife and almost killing Kunreuther. The incident has led him to campaign for propeller guards to be fitted on such vessels. He has been married to his second wife, Gail Loeb, a social worker, since 1990, and their family now includes four adult children.

Kunreuther’s current focus on terrorism is the extension of studies that go back some 40 years into ways of managing the risk of natural disasters such as floods, hurricanes, and earthquakes. On a trip to Alaska after a major earthquake there in 1964, he discovered that many people weren’t insuring themselves against quake damage—despite the region’s vulnerability to such events—because they didn’t believe it would happen to them. After the earthquake, residents lobbied for and received federal disaster assistance, and some ended up better off than before the quake because they obtained forgiveness for past debts.

Kunreuther discovered that people were more likely to insure themselves against relatively likely  events—even though those events had a limited impact—than they were against much rarer events, like an earthquake, that had devastating consequences. “People were not making decisions in a rational way,” says Kunreuther, an economist by training. “It got me thinking about how to deal with low-probability events.”

He developed his behavioral theories with a study of the reaction to Tropical Storm Agnes in the northeastern United States in 1972, which caused some $2 billion in damage. Few homeowners had flood insurance, despite its being heavily subsidized, and the Small Business Administration ended up giving $5,000 grants and 1 percent loans to uninsured victims.

“Our conclusions … suggest that individuals have a difficult time dealing with the concept of probability and tend to rely on salient data (e.g. past experience) and easily accessible sources (e.g. friends and neighbors) rather than utilizing
statistical data and making tradeoffs between benefits and costs,” Kunreuther wrote in “A Conceptual Framework for Managing Low-Probability Events,” a chapter in Social Theories of Risk, a 1992 book edited by Sheldon Krimsky and Dominic Golding.

In Pakistan, during a one-year stay at the Institute of Development Economics in 1970-1971, Kunreuther did further research into behavioral influences over economic decision-making, and discovered that rationality sometimes underlies apparently irrational acts.

He conducted a study of farmers to see who was more inclined to grow rice, a food crop, or jute, a cash crop. Expectations were that poor farmers would grow more rice because they needed the food, while richer farmers would devote more land to jute. But he found that the very poor farmers gambled by growing more jute than all but the richest ones.

The explanation, he found, was that the poor farmers were prepared to take the risk in an effort to get out of debt while their rich counterparts could afford to take a chance on boosting their income. “It was quite rational on one level but looked irrational,” he says.

Kunreuther’s conclusions about economic behavior often went against prevailing models that assumed rationality, says Paul Slovic, a psychology professor at the University of Oregon who has worked with him since the early 1970s. “It’s a hallmark of Howard’s work,” Slovic says. “He’s not afraid to depart from many models.”

In his work on floods, Kunreuther discovered that people were not only failing to cover themselves against catastrophic risk but were becoming a drain on the public purse when disaster struck.

By drawing on behavioral psychology to explain decision-making on insurance, the Alaska experience also illustrated Kunreuther’s willingness to take an interdisciplinary approach to his work, Slovic adds. “He’s very open to ideas that may just lead to better policy. He’s not wedded to any ideology.”

Kunreuther himself makes the point in his Conceptual Framework essay, noting that sociological and psychological factors are an important influence on economic behavior and must be considered by policymakers. The implication is that government must have some involvement in the market in order to counteract the irrational behavior of many consumers towards disaster protection, and to avoid paying billions of dollars in disaster relief.

In the case of flood insurance, the government’s response was the Flood Insurance Act of 1968, a law that Kunreuther’s research influenced, requiring homeowners with federally linked mortgages to buy flood insurance.

Foreshadowing the current debate—and the likely resolution—over terrorism coverage, he concluded almost 40 years ago that the management of low-probability, high-risk events was legitimately a matter for a public-private partnership. “There is an inability for the private sector alone to deal with low-probability events,” he says.

The failure of market-based mechanisms to spread the risk of terrorist attack supports this point. Reinsurers are unlikely to return to the market with any significant capacity because of the uncertainties of the risk, and catastrophe bonds have not been issued in any meaningful quantity.

“Neither of those risk-transfer mechanisms seems especially promising today,” Kunreuther and Erwann Michel-Kerjan wrote in a Spring 2005 article in Regulation magazine. “A sustainable market to cover losses from terrorist attacks has not emerged in the wake of September 11.”

Another possible private-sector solution is a mutual insurance pool, where the risk of terrorism coverage would be spread among a large number of insurers who join the pool. But the idea was undermined by a 2004 Towers Perrin study of 14 U.S. workers’ compensation insurers, which found that while the pool would create some additional capacity, it would be nowhere near enough to offset losses from a major terrorist attack. Such an attack could inflict workers’ compensation losses of $90 billion, three times the industry’s capacity for covering terrorism, the study found.

The attacks of 9/11 showed vividly that terrorism posed a series of challenges that set it apart from the natural and technological disasters Kunreuther had previously studied. It defied the models of probability since it was impossible to know when, where, and how the next attack would occur; it was much more difficult to protect against than, for example, a hurricane, because terrorists could react to mitigation measures; and it showed that a terrorist target can be made vulnerable by weaknesses in connected components of the system in which it operates—a theory he called interdependent security.

Kunreuther developed this theory with Dr. Geoffrey Heal of Columbia University while he was there on sabbatical during the 2001-2002 academic year, having arrived one week before 9/11. The World Trade Towers collapsed partly because of weaknesses in security-screening at Boston’s Logan Airport, where the 9/11 hijackers boarded the planes. Similarly, the bag containing the bomb that downed PanAm Flight 103 in 1988 was first loaded onto another airline in Malta and then transferred to the PanAm plane without further screening. These events illustrated that a system is only as secure as its weakest link.

“Even an airline with an infallible screening system is at risk, since only bags checked by passengers who initiate their trip with that airline are inspected,” he wrote in an article with Heal and Peter Orszag that appeared as a Brookings Policy Brief in October 2002. “The knowledge that investing in screening still leaves an airline vulnerable unless others do likewise reduces the attractiveness of investing in screening.”

The theory of interdependent security implies that insurers cannot offer lower rates to clients who attempt to mitigate their risk because those actions may be negated by a connected, if distant, entity.

Insurers attempting to estimate terrorism risk are hampered by a series of challenges that don’t apply to natural catastrophes such as earthquakes or hurricanes. Enough is known about the nature and timing of natural events to allow credible models to be developed and insurers to gauge their risk. But terrorism is unpredictable in terms of its motivation, impact, timing, and location, and whatever knowledge is possessed about the activities of terrorist groups is closely guarded by government, rather than being available to the computer-modeling companies on which insurers normally rely.

In an effort to assess the risk of terrorist attack, modeling companies have taken several different approaches that are described in Catastrophe Modeling: A New Approach to Managing Risk, a 2005 book edited by Kunreuther and Patricia Grossi, with contributions by the three major modeling companies: EQECAT, Risk Management Solutions, and AIR Worldwide Corporation.

But even the modelers acknowledge the shortcomings of their craft when it comes to terrorism. “There’s a healthy skepticism by the insurance companies toward models of terrorism,” says Kuzak of EQECAT. “There’s a substantially greater uncertainty for terrorism than there is for natural hazards—the models for insured losses are not so good.”

If TRIA is allowed to expire and no similar program is put in its place, premiums will soar, and many firms are unlikely to protect themselves with insurance because of the high cost of coverage and fading memories of 9/11, many industry participants believe. That situation would persist until after the next terrorist attack, when the federal government will come under pressure to compensate uninsured victims, as it did after the Alaska earthquake in 1964 and many other natural disasters since then. Many insurers will withdraw from the market, as they did immediately after 9/11, because of uncertainties over risk and fear of future ruinous losses.

But a purely government program would also have limitations because it would exclude the expertise, the financial resources, and the operational capacity of the insurance industry.

A public-private partnership appears to offer the best chance of working, Kunreuther believes. “For those who recognize terrorism risk coverage as an important tile in the mosaic of national security, the specific characteristics of terrorism risk call for federal participation,” he has written.

The essential challenge is to spread the risk appropriately among the insured parties, the industry, the capital markets, and the government. And given the unique nature of the challenge, the government has capabilities that the private sector lacks, Kunreuther argues. The public sector can diversify the risks through the tax system to the entire population and even spread losses to future generations of taxpayers.

Concerned parties need to examine ways for the public sector to form a sustainable partnership with the insurance industry to provide terrorism insurance, perhaps by offering reinsurance, as it does now, or by covering certain losses from terrorism that are beyond the capacity of the industry, he says. Government may also be able to encourage better risk-mitigation efforts by linking terrorism insurance to protective measures through well-enforced standards and regulations.

Whatever the eventual solution, failure to create the right conditions for a viable terrorism insurance market could have dire consequences, Kunreuther warns. “If nothing coherent is done should TRIA expire, another large terrorist attack could have a much greater financial and social impact than what the nation experienced after September 11.”

Jon Hurdle is a freelance journalist based in Ambler, Pennsylvania.

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