Gordon Feller looks at how the terrorism threat has affected the US industry.

Under current estimates, September 11 will cost the insurance industry $40bn. Of this, business interruption coverage will be the largest component of the ultimate total loss, and reinsurers will bear the biggest share of the overall burden. The insurance industry as a whole will pay this time, but it doesn't have the capital to survive another event of this magnitude.

Claims for contingent business interruption from September 11 have raised some very complex coverage issues. Some of the claims being filed by businesses hundreds and thousands of miles from New York City raise troubling questions about the conflict between the underwriters' intent and premium charged, and the customer's alleged understanding of the policy's coverages and reasonable expectations. Given the billions of dollars at stake and the complexity of some of the issues, it is a foregone conclusion that many of these claims and coverage questions will be decided in the courts.

Since so many people felt so completely safe and secure inside their national borders, the industry never added much to premium calculations to cover for this type of loss. Insurers charged their customers what many thought the cover was worth, which was just about nothing. Instead, what is now being asked is: can companies afford to write any form of terrorism cover based on the absolute uncertainties and unpredictability of the shape, form, magnitude, location and intensity that future terrorist acts might take?

For their part, the European insurance companies have become multinational groups with decentralised management over recent years, but they still have difficulties in taking the form of global players. They manage their risks at the level of each business and in each market segment in a non-correlated way. September 11 abruptly illustrated the instantaneous and unexpected conjunction of different insurance categories, leading the European insurance industry to re-examine its underwriting practices.

Unknown exposures
Business interruption losses following September 11 are enormous and could reach 25% of all insured losses. Exposures to that class still remain, however, largely unknown. Risk assessment for business interruption, though very difficult, should be able to quantify loss potentials not only for manufacturing risks, but also for the service industry. Even so, currently it appears that many loss potentials cannot be properly assessed, and the bottom line is that if risks cannot be assessed, they are basically uninsurable.

The events of September 11 indicated to property insurers and reinsurers the levels of potential losses they had unknowingly been accepting, without being able to calculate a premium commensurate with the risk. It was soon apparent after the event that a change in behaviour was urgently needed.

If limits of insurability are already reached for single fire or explosion scenarios, then they are most probably exceeded in the case of natural catastrophes and for terrorism. In addition, terrorism thrives on the shock effect, and it is precisely this facet of the exposure that makes the risk so difficult to manage. The insurance and reinsurance of industrial and commercial property risks is generally based on the probable maximum loss (PML), which is understood to mean the maximum claims burden that could arise from a loss event under unfavourable but not extreme circumstances. Megatowers have so far always been classified as highly protected risks because of the particularly strict building requirements applicable to them, in combination with other safety measures. It is clear that what happened on September 11 will form a quite new empirical basis for determining the PML for a high-rise complex in future. At the same time, it is clear that the ability of insurers to cover terrorism risks is crucially dependent on how much reinsurance capacity is available, and at what price and conditions. At the end of the day, in view of the dynamics and the international nature of the terrorism risk, the basis for any planned spread of risks is lacking, both geographically and over time.

Airline exposures
Another question arising out of the events of September 11 is whether airlines should be held responsible for the effects of terrorism or whether they should be granted immunity. The decision rests with government. The September 11 incidents were most certainly an attack against the US government, and it is the recognition of this fact that has brought about a sense of partnership between governments and commercial insurers. Governments have always been unwilling participants in the insurance business, but if more attacks of this nature take place, governments will once again be in the front line of the insurance business.

Argument has centred on whether the events of September 11 were too large to be exclusively the concern of the market or whether the new threat was one better borne by society. For as long as the terrorism threat exists, it is hard to imagine a clear and final exit strategy for governments; government ultimately is the insurer of last resort.

A further revelation prompted by the WTC loss is that there is a stronger correlation between underwriting and investment risks than previously presumed. The tragedy's impact on the investment side for the insurance industry (property and casualty reinsurers and insurers) is threefold:

  • the investment risk absorption capacity is diminished;
  • a more elaborated asset-liability-management (ALM) based counterparty risk controlling is required; and
  • the general risk appetite of insurers must be reviewed.
  • All in all, a deeper knowledge and better understanding of the underwritten risk structure is necessary to derive an optimal investment policy. The unprecedented simultaneous shock on both the asset and liability sides has shown a degree of correlation between investment and underwriting risks that was previously unrecognised. What's more, many insurance investment portfolios had financial holdings in airlines and other insurance companies, thereby creating even more pronounced cumulative risk positions.

    September 11 added a new dimension of uncertainty to an already financially shaky world economy. Governments, central banks and financial regulators came together very effectively in dealing with the shock of those tragic events. Their strong co-operation augurs well for the way these constituencies will deal with the mounting risks to financial stability, some of which - such as falls in stock value and credit-risk transfer instruments - concern the insurance industry.

    An area that is raising concern in the current climate is that of credit-risk transfer instruments, default swaps and collateralised debt obligations, specifically those that would enable banks to transfer credit risks to other entities, with insurance companies playing a leading role as buyers of these instruments. According to the International Monetary Fund (IMF), between 1997 and 2001, the amount of outstanding obligations of these instruments increased by about nine-fold to an estimated $1.6trn. Nevertheless, the problems in the insurance sector currently centre principally on the behaviour of the stock market, with the biggest risk being a further slump in stock market values (apart, of course, from renewed terrorist attacks).

    After September 11, US insurers and reinsurers have concluded that terrorism is not an insurable risk, at least for the moment. The existing alternative risk management tool is spread mechanisms, but these must respect several key principles, ensuring both consumer access to terrorism insurance and an appropriate level of government involvement. Policymakers need to decide how to spread losses across the insurance industry, and whether to spread them across an even wider base - taxpayers. The primary driving force behind the government's decision to enter the terrorism insurance marketplace should be to safeguard the economy's access to necessary insurance protection.

    In June 2002, the US Senate passed S 2600, a bill establishing a largely taxpayer-funded model. This program does not create a direct reinsurance program, but rather substitutes the US Treasury Department as the risk-bearer. A second principle to consider when designing a risk-sharing program is to protect the government - and, therefore, taxpayers - from excessive costs and inefficiency.

    September 11 forced the insurance industry to rethink the way it functions and reacts. Insurance can only operate within the limits of insurability, but the world is not insurable. Only parts are. The composition of the insurability framework can be altered and consequently open a conduit for more available insurance capacity. The co-operation between public and private entities can provide a solution in circumstances where pure market solutions reach their limits.

    The essence of insurance is to transfer risk in society, and sharing risk is one strategy which fulfils this basic function. Risk sharing is essential for entrepreneurship. It is well known that without risk sharing it would have been impossible to build skyscrapers or engage in other large projects. Who could have borne such risks?

    But if risks reside outside the framework, they have to be considered as uninsurable. The intervention of the state as insurer of last resort helps to make the market possible or to extend the amount of capacity available in the private sector.

    Media intervention
    September 11 was the biggest media event - of an unprecedented nature - in insurance history. How that industry is viewed in times of great crisis is central to its overall public standing. Whatever happens in the world will be perceived and processed by the media. Insurers have to be concerned how it will affect the industry's public image in the coming years.

    Since the news media is always among the first on the scene, crisis communications work must begin immediately and continue long after the initial drama. It is encouraging that during the first month following the September 11 event, 75% of the stories written relative to the insurance industry were either balanced or positive.

    The mass media's portrayal of insurance in a major crisis is the biggest single factor in the industry's public standing. It is the industry as a whole that is judged by the general public, not simply individual companies. Problems also arise from not listening closely enough to critics and failing to communicate what is being done clearly enough and long enough.

    One important consequence of discussing the insurability of terrorism risk is an assessment of the (potential) need for public-sector intervention in this field. The task of the state in a market economy is undoubtedly to provide internal and external stability. Therefore, protection against the risks associated with global terrorism should at least to some extent be organised by the state.

    So far, it has been established that (full) protection against the threats of terrorism will not be available in the private insurance markets. Terrorism risk clearly does not comply with most insurability criteria. In order to generate sufficient capacity in the insurance markets against the risks of global terrorism, risks need to be spread between the insurance industry and the state.

  • Gordon Feller is an independent researcher and journalist, who has also acted as advisor to multinational corporations such as Chevron, Bechtel and IBM, and worked with non-profit think tanks such as the World Policy Institute.