Using the right analytic tools to analyze and manage terrorism risk is paramount, according to a review of methodologies available for insurers and reinsurers published by Boston-based AIR Worldwide Corp., a risk management division of ISO, Jersey City, N.J.

In its white paper titled "Terrorism Risk Assessment: Best Practices for Insurers and Reinsurers," AIR Worldwide reviews three approaches for terrorism risk management and addresses best practices for exposure data collection and risk control. Techniques are presented to help insurers determine the impact on their portfolios of changes that may be made to TRIA by Congress.

Quantifying risk is particularly challenging when the risk is dynamic, notes the paper, which cites the events of September 11, the changing terrorism risk climate, coupled with nationwide efforts to prepare for and mitigate that risk, as creating an environment of considerable uncertainty.

Adding to the uncertainty, the Terrorism Risk Insurance Act (TRIA)-enacted in response to the events of September 11, 2001-is due to expire at the end of 2005.

"With the likely passage of a two-year TRIA extension, the private market for terrorism insurance should remain viable," said Jack Seaquist, a senior manager at AIR, in a statement. "While the exact terms of the extension have not yet been determined, it is clear that the risk born by insurers will increase. Therefore it is more important than ever for insurers and reinsurers to re-evaluate their current terrorism risk assessment strategies with respect to industry best practices."

The paper reviews the strengths and weaknesses of three major approaches for effectively managing terrorism risk: risk within a defined geographic area, risk in relation to known landmarks or trophy targets, and probability distributions of loss that account for the likelihood of attack.

Analyses of risk within a defined geographic area provide insurers with worst-case scenarios of a terrorist attack. These types of analyses can be run for individual buildings or for all buildings of interest within a defined geographic area.

Risk can also be analyzed in relation to known landmarks or trophy targets. Exposure accumulations can be determined within a specified distance to a particular landmark or a set of landmarks such as transportation hubs. Catastrophe models can be used to simulate an attack on a particular target of interest. Estimates of the potential losses from property damage, injuries, and fatalities can be obtained for each location affected by the event.

Probability distributions of loss that account for the estimated likelihood of various attacks can provide insurers with a comprehensive view of terrorism risk in terms of probabilities of various levels of loss. Results can be used to make underwriting decisions, perform portfolio optimization exercises, and negotiate reinsurance terms.

Source: AIR Worldwide Corp.

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