1 Dealing with Extreme Events: New Challenges for Terrorism Risk Coverage in the U.S.

The terrorist attacks on September 11, 2001 (9/11) against the United States revealed that the nature of international terrorism had changed. These attacks raised the fundamental question as to what are the responsibilities of the public and private sectors in reducing the risks of terrorist attacks and who should pay for future losses should the terrorists be successful? This paper focuses on the potential role of insurance in providing future protection against terrorism and the challenges facing the private sector in offering this type of coverage alone. Given the developments since September 11th, we contend that government needs to play an important role in concert with the private sector in providing insurance against losses from this type of extreme event. Catastrophic events present special challenges for economics and risk management since they can have severe long-term economic and social consequences and are difficult to assess quantitatively. As these events normally have a low probability of occurrence, there are limited historical data on which to base estimates of the risks and there is considerable uncertainty associated with experts ’ risk assessment estimates. An aversion to ambiguity leads insurers to set premiums much higher than they otherwise would be if there was agreement among experts as to the likelihood and consequences of future events (Kunreuther, Hogarth, and Meszaros, 1993). On the demand side, it is well known that if insurance i