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Report n°3: Financial protection of critical infrastructure

Financial protection

As is the case for banking and financial services, however, large-scale infrastructures are not simply major technical networks; they would be better described as the supporting structures of the economic and social continuity of a country. In this respect, one particular network has a special role to play to guarantee the continuity of a country in the grip of disaster, and that is insurance because it provides for the financial protection of victims. For that matter, this is probably a clearer point of convergence between European and American approaches for the protection of large vital networks.

In fact, in most industrialized countries, insurance is one of the principal instruments for risk management(6). Without this possibility of transferring the risk to insurance companies (they themselves transfer all or part of their exposure to reinsurance companies or to financial markets operating on an even larger scale at global level), many activities would certainly not have reached their existing level of development.

The price of insurance can therefore be viewed as a good indicator of the level of risk of certain activities. For instance, it would seem fair that a young inexperienced driver should pay a higher insurance premium - other things being equal - than a motorist who has been driving his car regularly for ten years without ever having the slightest accident. In the same way, smokers or those who practice so-called high-risk sports (rock climbing for example) pay a higher life-insurance premium than other people, since their level of risk a priori is higher than average. In both cases, the principle of risk-sharing ex ante in exchange for the payment of a pre-determined premium is based on sound knowledge of the risk associated to such activities (car insurance, life insurance) for which there is a great deal of historical data as regards claims.

For many actuaries, an important limitation for the creation of an insurance market to cover a particular risk, is the non-applicability of the law of large numbers which guarantees that insurers can count on an almost certain level of compensation to be paid out(7). This law, in its present form as applicable to insurance, can be stated as follows: for a sequence of random variables the correlation of which is not above certain limits, the variance of the average becomes as small as is required, provided the number of variables is sufficiently large. Thus for insurance purposes, the greater the number of aggregated policies, the more it authorizes, other things being equal, a prospect of sure prediction on average (8).

One of the central issues at stake in the financing of catastrophic risk is to determine a similar risk-sharing approach, but for events with extreme potentialities and relatively less frequency. Those are precisely the two factors which are a source of great difficulty for insurers.

To simplify, two conditions must be verified for a risk to be considered insurable. Firstly, the capacity to identify and quantify (or at least to evaluate partially) the probability of an event occurring, and the amount of associated loss incurred if it does occur. The second is the capacity to establish a premium scale which is a reflection of the level of risk (thereby limiting the incidence of selection). If both these conditions are verified, the risk may be considered insurable. This does not, however, signify that it is a profitable activity for an insurance company, and it may well decide that it will not cover the risk. This is the case in particular if it turns out that it is impossible to establish a insurance price level for which the insurer will have sufficient demand and income to cover the costs incurred by the activity (development, marketing, collecting premiums, compensation on claims) therefore adding up to a level of profit viewed as sufficient. In such a case, insurers may prefer not to cover certain risks, individual or corporate, unless obliged to do so by law.

This may seem rather obvious, but it is one of the fundamentals of insurance : the sector guarantees continuity of economic and social activity, but requires minimum profitability for those involved.

(6) Described in simple terms, insurance guarantees as a counterpart for the ex ante payment of a relatively small sum (premium), protection against substantial loss in terms of the policyholder's capacity to pay. By the transfer of all or part of his exposure to more broadly based financial structures with greater capacity for diversification (therefore less vulnerable to that risk; an insurer for instance) an agent (individual or business entity ) is relieved of a risk that he would have difficulty in coping with on his own if it ever materialized.

(7) The notion underlying this law (meaning physical law, rule) was first introduced by the works of Pascal, Bernoulli, and Laplace, later by those of Poisson.

(8) This effect of large numbers is very useful but nevertheless is not strictly necessary to the act of insuring. Paul Samuelson demonstrated that risk sharing (taking on a certain proportion of a given risk for each of the parties) can be more fundamental for reducing risk than the repetition of identical and independent risks. See P. Samuelson (1963). Several recent publications discuss Samuelson's work; see for example S.A. Ross (1999) or E. Peköz (2002).