By DR. ANDREW COBURN, vice president of catastrophe research and director of terrorism research, and DR. GORDON WOO, a catastrophe risk consultant, for Risk Management Solutions Inc.
The Terrorism Risk Insurance Program Reauthorization, signed into law on Dec. 17, 2007, provides a seven-year extension of a federal backstop for terrorism losses. Previously, TRIA had only been extended by two years at a time, so many insurers were unable to plan for anything more than a temporary involvement in terrorism coverage. Now they can decide the capital they want to commit to terrorism insurance, the products to offer, and the shape of the portfolio they wish to build over at least a seven-year business cycle.
Fundamental to their planning is the expected shape of terrorism risk over this time horizon. In the previous installment of this two-part series we examined how the insurance industry has used terrorism models since 2001 to manage terrorism portfolios and how these views of risk compared with reality. In this part, we consider how terrorism risk might change over the next seven years and how it can be most effectively managed.
Terrorism risk has been surprisingly stable over the past seven years, which is largely an achievement by the Western security forces in suppressing terrorist activity in the face of rising threat. But despite all the investment and political will expended, the risk has not significantly diminished--attempted attacks in the United States have continued at an annual rate of between two and seven since 2001.
The threat persists and cannot easily be extinguished by Western action. It is a stand-off between jihadist terrorists and counterterrorism teams--a dynamic equilibrium--that is likely to carry on unless the stalemate is broken in some way.
Any shift in the balance of risk will depend on geopolitical developments. The al-Qaida military strategist, Muhammad Ibrahim Makkawi, has framed al-Qaida's strategy until 2020 in terms of the relationships among four different groups: al-Qaida (a term which includes the broader jihadist movement); the coalition nations (the United States and its allies); the Muslim nations; and the Umma--Muslim populations worldwide.
The war on terror is defined by the relationships between these four protagonists, not just the direct confrontation between the coalition nations and al-Qaida. Six pair-wise relationships exist among these four protagonists. Over the next seven years, the changing status of these six relationships will define the landscape for terrorist operations, and will dictate the level and shape of terrorism risk.
The current pattern represents a relatively stable balance, where terrorist adversaries are kept in check by well-resourced but finite counterterrorism operations, and the underlying geopolitical relationships among the four power blocs is held in a stalemate. It is possible that this equilibrium could last for most of the next seven years.
At their latest annual convention, RMS' terrorism risk advisors placed the highest probabilities on the current equilibrium lasting for a number of years. But the further into the future the projections go, the more likely a major change or breakthrough is to occur.
The scenarios that could break the stalemate and dramatically reduce terrorism risk include deflation of conflicts in political hotspots like Palestine, Iraq and Afghanistan where sympathizers are radicalized and recruited; a reduction in support for the extremists by the moderate Muslim community, perhaps in response to a specific atrocity or more active hearts-and-minds campaigns by Western liberals; the emergence of a Muslim Ghandi-type figure to encourage the rejection of political violence; the death of bin Laden and a collective failure of succession and replacement of leadership within the radical organizations; and the transformation of terrorist organizations like al-Qaida into legitimate political movements that eschew violence.
These kinds of changes would likely result in less frequent attack attempts and higher rates of interdiction by security services.
The terrorist support networks would be less organized and resourced, so the attacks would be on a smaller scale, possibly focused on disruption and terror rather than destruction. They would also probably be made against softer targets and result in lower losses.
However, these scenarios would come about from longer-term changes related to political situations and public opinion. Overall the likelihood of lower risk trajectories is quite small in the short term but could be seen to increase over the longer term if efforts are consistently applied toward those ends.
LOSING THE STALEMATE
Alternative scenarios provide a tipping point for the coalition to lose the stalemate and enter a new trajectory of significantly increased terrorism risk.
These could include a United States or Israeli attack on Iran, which could cause Iran to release senior al-Qaida leaders currently in detention, also unleashing Hezbollah, or funding other terrorist groups to attack targets within the United States; instability in Pakistan leading to a failed state, or an extremist government, providing sanctuary and a homeland for jihadist groups, potentially even providing jihadist groups with nuclear weapons; breakthrough developments and use of chemical, biological radiological or nuclear (CBRN) weapons by a terrorist group, causing others to emulate those groups, changing the nature of the conflict.
If CBRN weapons were unleashed, the entire nature of the conflict would escalate; failure to prevent escalating violence in Iraq, United States and allies hurriedly withdrawing, enabling insurgents to declare victory, leading to escalation of violent uprisings in many other countries in the Middle East, spreading terrorism to Europe, and on to the U.S. mainland; and assassination of a key Western leader, influencing Western elections, provoking a major backlash and escalation of political violence in many locations.
These negative trajectories would result in an increase in the terrorist groups' capabilities, which would outweigh those of the counter-terrorism teams. Consequently, terrorist groups would be better organized, use a broader network of skills and experience and could potentially have access to more destructive weaponry and greater numbers of operatives.
Improved capabilities might not increase the frequency of attack attempts; centralized terrorist planning would try to avoid mounting attacks too close together in time, as the high counterterrorism alert that follows an attack could compromise a subsequent operation mounted too soon.
But better resourced terrorist groups are more likely to evade detection and could carry out larger scale attacks. Additional simultaneous attacks could be achieved and harder targets--high priority targets which are currently heavily protected--might be attempted. More ambitious attack modes would result in an even stronger risk gradient between cities and a greater concentration of risk at the highest priority targets.
A step-change in the magnitude of loss would also occur if terrorist groups obtained and used CBRN weapons. The first successful CBRN attack to cause a large loss in a Western country would result in a massive response, politically against any state sponsor, militarily against any identifiable perpetrator and socially.
Budgets and resources for counter-terrorism activities to prevent future CBRN attacks would be greatly increased. It would probably unify the Western world and bind a new cohesion among nations across the world. It could potentially turn moderate Muslim opinion against the al-Qaida movement, and paradoxically it might prompt the beginning of the end of the jihadist terrorist movement.
A CBRN attack, if it were a large-scale weapon of mass destruction, would probably be deployed against a city center rather than any one specific target, and unless the new weapons were plentiful, would be prioritized for the very highest tier cities. These negative scenarios are sudden step changes in situations, in contrast to the gradual, positive ones. They could be triggered by a sudden flashpoint of events at any time, so although the negative trajectories are also remote, they may be slightly more likely to occur earlier in the timescale.
The pattern of terrorism risk seen over the last seven years is likely to continue for the next seven, reflecting a dynamic equilibrium between terrorist plotting and active counter-terrorism response. The chance of a major shift to a higher risk trajectory is small but significant, but such a shift has the potential to occur earlier in the seven-year window than many of the positive potential outcomes.
Insurers reviewing their terrorism coverage provision can make plans for the next seven years based on the current risk picture and be assured that current models form a reasonably conservative view of the risk. However they should also allow for the possibility of a major change in the equilibrium of terrorism during this period. If it dramatically moves to a new trajectory of lower risk, insurers will benefit. However, if the status quo undergoes a significant change, it may well be for the worse. Insurers need to allow for a small chance of significantly increased terrorism risk during the next seven years.
As insurers' confidence increases, with more experience and data about the types and scales of terrorist attacks, the aggregation scenarios and limits they use will become more realistic. The very significant safety margins they currently add will be reduced to be more in line with those used for other perils. Probable maximum losses will reflect realistic loss scenarios, take into account the vulnerability of different buildings and reflect observed patterns of terrorism risk, attack modes, targeting and multiplicity of attacks.
Terrorism risk modeling will help insurers derive comparable benchmarks to ensure that capital allocation is efficient and spread more equally across the range of perils covered. Aggregation controls are likely to be rigorously analyzed and enforced in a lot more cities and countries worldwide as international coverage grows, geocoding in major cities improves and the global threat drives corporate demand. Insurers will use views of modeled risk specific to each country to support their risk management and underwriting decisions. Models will also be used more in risk transfer decisions.
Portfolios of exposure will be analyzed and the diversification benefits of widespread exposure will be quantified. Reinsurance, swaps and pools will continue to be provided creatively. At some point, alternative risk transfer instruments will be used to package and transfer terrorism risk from insurers to the capital markets, overcoming the objections of rating agencies who currently remain agnostic on terrorism modeling.
As terrorism risk shifts over the next seven years, modeling will continue to incorporate new views of that risk, as it has done fairly successfully in the past. Being aware of how terrorism risk can change provides the foundation for managing the new risk landscape when evidence of a new trajectory emerges.
September 15, 2008
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