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Game theory in the popular press.

Game theory helps insurers to judge the risks of terror

Financial Times
Jenny Wiggins
September 8, 2004
text is a cache of ADDRESS

Sophisticated analytical tools predict targets and methods of attack, but their accuracy is open to question, writes Jenny Wiggins. The Bush Administration has waged its war against terror on several fronts: it has created a new Department of Homeland Security, established a Terrorist Threat Integration Center and passed the USA Patriot Act.

But despite those measures some companies fear the terrorist will always get through. They have turned to the private sector for help on gauging the potential impact of future attacks.

Shortly after September 11 2001, a small group of companies that specialise in assessing risk for the insurance industry launched US terrorism risk models.

These combine technology and data to predict likely terrorist targets and methods of attack, and possible losses to life and property.

They are aimed at the insurance and reinsurance industry, which already uses similar models to assess potential losses from natural catastrophes such as hurricanes and earthquakes.

"Most major commercial insurers and reinsurers are using terrorism modelling today," says Robert Hartwig, chief economist at the Insurance Information Institute.

Risk Management Solutions, one of the companies that sells the models, says its models identified the Citigroup building in New York and Prudential Financial's building in New Jersey as possible targets ahead of the US government's code-orange threat alert for the financial sector last month.

Andrew Coburn, director of terrorism research at RMS, says the company can pinpoint possible targets because it believes terrorists make rational decisions.

"Their methods and targeting are very systematic," he says.

RMS uses game theory - analytical tools designed to observe interactions among people - in its models. It argues that, as security increases around prime targets, rational terrorists will seek out softer targets.

Industry participants, however, say the predictive abilities of the models are limited, given the difficulty of foreshadowing human behaviour.

"The probability side can't be relied on as it is with natural hazards," says Ryan Ogaard, global practice leader of the modelling unit at Guy Carpenter, a reinsurance specialist.

Still, the information the models contain is considered valuable for assessing the impact of any attack, in part because modelling com- panies have collated extensive data for their catastrophe risk models.

"We've already built databases of commercial buildings and residences and the people in them for the whole country," says Jack Seaquist, terrorism product manager at AIR Worldwide.

The development of the models has attracted the interest of the US government, which is using some of them in its Department of Homeland Security, according to Dennis Kuzak, senior vice-president at Eqecat.

"We are in fact helping the US government get a better handle on potential risks," he says, adding that this is an "unexpected" use of the model.

How extensively the models will be used in the future remains unclear.

Much depends on the fate of the Terrorism Risk Insurance Act, which was passed in 2002 to provide federal help for any insurance losses sustained as a result of a terrorism attack.

Under the act, the Treasury Department is obliged to cap insurers' liability and reimburse them for some losses.

The act has enabled insurers comfortably to extend coverage to businesses, which are increasingly demanding terrorism insurance.

More than 46 per cent of US businesses bought insurance to cover terrorism risks in the second quarter - nearly double the rate during the same period a year before, according to Marsh, an insurance services group.

The government has not yet decided whether it will extend the act. If it does not, some market participants believe the terrorism risk models could become an increasingly valuable means of underwriting terrorism insurance.

But trade associations for the insurance industry say the inability of the models accurately to assess the frequency of terrorist attacks means they are not a reliable indicator of pricing the risk of catastrophic attacks.

"From a severity standpoint, the total loss from a terrorist event . . . could well exceed the capacity available in the insurance industry," the associations said in a submission to a congressional hearing on the act earlier this year.

Others argue that, if the terror risk act is not extended, interest in the models might diminish because insurance com-panies could be reluctant to provide terrorism coverage at all.

Meanwhile, the accuracy of the models' predictions remains in doubt.

"But hopefully we'll never see them tested," says the Insurance Information Institute's Mr Hartwig.

(c) 2004 The Financial Times Limited. All rights reserved