However, once he gets to the market he finds that customers value his sweet, fresh apples very highly and are willing to pay $1 each.

So what is the market price? Obviously $1, and he pockets the 80 cents as an unexpected but welcome profit windfall.

Turning then to the terrorist risk, let us look first at supply.

For an insurance company, the supply price tends to mean the actuarial price–that is, the minimal price based on projected losses that should be charged for this risk.

Ones first instinct is to say that such an actuarial price is impossible to determine in such an amorphous area as terrorism.

But, of course, insurers for centuries have been setting prices for many other risks where there is little or no actuarial analysis.

For example, war risks are routinely insured in the ocean marine line. There is insurance for being hit on the head by a falling satellite. And, of course, there is the well-known example of Betty Grables legs, which were insured via Lloyds of London.

In terms of terrorism, one can be a little more analytical than the above examples.

Thus, the actuarial brains at Guy Carpenters quantitative service unit–Instrat–have suggested some approaches to this question.

Dealing with frequency for the moment, it is believed that the federal government has data on attempted terrorist events over a long period. Given such data and informed guesses on the probability of a successful terror attack, one could make some estimation of the probability of a terror event.

In terms of severity, one can look at the losses of various terrorist events around the world, restate the losses in current U.S. dollars, and calculate an average.

One could be even more creative and fit a statistical distribution to the losses, which could provide a sense not just of the average size of event, but of the relative probability of large versus small events.

Given frequency and severity numbers, one could then calculate expected losses, and add an appropriate expense and profit load to come up with a minimum price.

Turning now to the demand side, the question is: What price would a customer be willing to pay for the transfer of the stand-alone terrorism risk?

The answer would appear to be a fair amount.

Based on congressional testimony and media stories on the need for terror insurance to prevent significant sectors of the U.S. economy–such as real estate and construction–from grinding to a halt, one could safely assume that commercial policyholders would be willing to pay significant amounts for the terrorism coverage.

To see the issue in more concrete terms, let us assume that the federal government decides to supply the terrorism coverage on a full 100 percent basis, just as flood coverage is provided today.

How should they price the product? I would argue that they need mainly to consider the demand side.

They could set a price that is affordable to businesses, so that the wheels of commerce can continue to turn.

They could, for example, add a surcharge to every commercial insurance policy. Such a surcharge should be affordable.

Many businesses in the past two years have experienced increases in insurance premiums, which they have absorbed without undue hardship. So a reasonable surcharge would appear to be an affordable option.

However, the federal “terror insurance” czars would need to take a peek at the supply side. They should want to make sure that the price they charge is sufficient to attract private capacity back into the market once the panic subsides and there is a clearer sense of the state of domestic security.

In fact, by setting a fair price they would encourage the development of a private terrorism insurance market, leading hopefully to the eventual demise of the federal role.

As the debate continues in the halls of Congress and elsewhere, one can expect that many more approaches will be developed to address the pricing issues.

However, one principle should be kept paramount: Demand is the key consideration in setting prices, not supply.

Sean F. Mooney, CPCU, is senior vice president, research director and economist at Guy Carpenter & Company in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 26, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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