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New study by UC Berkeley, Santa Clara University experts explores terrorist insurance market
28 October 2002

By Ute Frey, Haas School of Business

Berkeley - The collapse of the U.S. terrorist insurance market after Sept. 11, 2001, was the result of insurance firms' aversion to covering large-scale catastrophies, according to a new joint study by professors at the University of California, Berkeley's Haas School of Business and Santa Clara University's Leavey School of Business.

The study, "Extreme Events and the Market for Terrorist Insurance," says that temporary government intervention would help revive the terrorist insurance market after an event as extreme as the Sept. 11 attacks and help stabilize affected industries. Real estate and airline industries were hurt significantly by the insurance market turmoil.

Insurance premiums skyrocketed after Sept. 11, while coverage was severely limited or cancelled, leaving "trophy" office buildings without required coverage and potentially disrupting new construction projects. Yet, the insurance industry had sufficient reserves to cover the insured losses -in excess of $50 billion- incurred on the day of the attacks, according to study co-authors Dwight Jaffee, UC Berkeley's Willis Booth Professor of Banking, Finance and Real Estate, and Thomas Russell, professor of economics at Santa Clara University.

"Insurance firms," Jaffee says, "shy away from large risks if the size of the risks are uncertain. But insurance firms are willing to provide auto insurance, since the size of the risks are well known."

Jaffee and Russell conclude that aversion to providing catastrophic event insurance has also been observed following natural disasters such as Hurricane Andrew in 1992 and the Northridge earthquake in 1994. This tends to dissipate over time if no further events occur, the authors say.

"Government support of the market for terrorist insurance could help bridge such disruptions, both currently and in the future," says Jaffee, who also is co-chair of the Fisher Center for Real Estate & Urban Economics at the Haas School of Business.

Jaffee says such intervention could come in the form of direct government insurance, having the government be the insurer of last resort (offering guaranteed catastrophe bonds, for example), or having government be the lender of last resort. The U.S. Senate and House of Representatives have now passed separate bills to support the market for terrorist insurance, he said, and a compromise bill is expected shortly.

"The goal of government should be not to replace the market, but rather to calm the market until it restores itself," the report concludes. "Generally speaking, the less government intervention the better, but the key is to make sure that capital continues to flow into these lines."