The question that comes to mind of psychology theorists is whether this phenomenon is a variation of “hindsight bias”–the tendency for people to revise the probability of future events when given information about a past event or experiencing one themselves.

Regardless of how theorists explain the rearview thinking of insurers, the critical question for markets and policymakers is whether this apparently inevitable negative market reaction to the terrorism risk will decrease over time, leading to the possibility of a more widespread private market for the transfer of the terrorism exposure.

There are factors on both sides of this issue. Some factors suggest that the perception of the terrorism risk will increase over time, while others indicate that the fear of the risk will decrease.

Factors on the increase side of the argument include:

The most likely factor to reinforce the market's reluctance to write terrorism risk would be another incident. This need not be a major event. It could be just an attempt like the Richard Reid exploding shoe attempt aboard an airplane.

A second factor is the release of information by government authorities, indicating plans for further attacks by terrorists, particularly those of a catastrophic nature–for example, a suitcase nuclear device, or bio/chemical/nuclear contamination.

A third factor would be the belief by insurers that over time vigilance and security decreased, thereby increasing the likelihood of a successful terror event.

Factors suggesting that the perception of the terrorism risk will decrease over time include:

The history of mega-events tells us that perceptions on probabilities tend to decrease as time passes. For example, following Hurricane Andrew, catastrophe reinsurance rates tripled on average, then in a few years dropped back to about the level of where they had been prior to the event.

The war on terror is viewed as successful. The ability of Al-Qaeda or similar terrorist organizations to conduct a major operation is viewed as being greatly diminished. In this eventuality, insurers are likely to lower their estimates of loss from terrorism events.

Al-Qaeda or other terrorist organizations change tactics. They turn to less catastrophic acts. They turn more towards symbolic events, causing little or no loss of life or property damage. For example, they could move to self-immolation on the U.S. Capitol steps, or other acts in a manner not too dissimilar to the anti-government Buddhist campaign in the early 1960s in South Vietnam.

A final factor would be the belief that the federal government through its action in creating the victims compensation fund, providing an estimated average of $1.6 million per victim, and through its inaction in not passing a federal terrorism reinsurance fund, was in effect saying that it would be a “post-event insurer” of last resort.

If a major terrorism event occurred, there is a strong likelihood that the federal government would feel morally obligated to step in and pay for property damage and bodily injury, since its failure to create a backup terrorism reinsurance pool left the market without coverage.

If such a perception gains credence among policyholders, the demand for the terrorism coverage is likely to decrease. Such a decrease in demand would tend to reduce the price of terrorism coverage and make it a less attractive market in term of pricing for insurers.

It is probably too early to judge how these factors will play out over the next year or so. Since history is often our best guide, the better bet at this point would appear to favor a diminution in the insurance markets fear of terrorism.

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, February 25, 2002. Copyright 2002 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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