Some US companies have been slow to take advantage of the terrorism coverage that is now available to them, says Ronald Gift Mullins.

Bewitched, bothered and bewildered are lyrics from a song lamenting the pain of unrequited love, but they may well describe the feelings re/insurance companies and risk managers have toward terrorism insurance.

Never before has the re/insurance industry summarily been ordered to insure a risk that could produce astronomical losses and for which there is scant loss experience to determine the likelihood of future losses, or what a reasonable rate may be for that coverage. Risk managers must grapple with making a decision to accept terrorism coverage at what could be a hefty premium, or take a chance and go bare.

Granted, this is not the first time the re/insurance industry has been confronted with complex new risks. At the turn of the 20th century, automobiles began bumping into each other, people and things, which quickly brought about the need for auto insurance. A few years later, aircraft required extensive coverages, and in the 1960s, satellite insurance emerged. A recent example is cyber risk, which exploded in the 1990s as rapid expansion of the internet brought increased illegal and fraudulent practices. Like terrorism risks, identifying potential severity and frequency of losses for cyber risk is difficult as well as where and when an invasion may occur. Cyber risk hazard, however, is measurable and in some cases preventable. And cyber attacks haven't yet resulted in catastrophic losses to real property and life.

However, those untested risks were finite and accumulation of values and losses eventually established underwriting guidelines for pricing and exclusions. In the strictest definition of insurance, providing coverage for damages caused by terrorism is an uninsurable risk. Yet, insurers are now mandated to write it with a backup arrangement, some say an inadequate one, from the US government. Businesses may face insolvency if they are hit with a terrorist attack and have no coverage.

TRIA to the rescue?
Before September 11, terrorism coverage was largely included at no extra cost in US re/insurance property and liability policies, including workers' compensation. Following September 11, re/insurers at first attempted to exclude it, but regulatory and political pressure swayed them to provide some coverage. Now, with passage of the Terrorism Risk Insurance Act (TRIA) of 2002, insurers are required to offer to their insureds full terrorism coverage on all commercial lines of business, including property, casualty and workers' compensation. The act, however, does not require businesses to buy terrorism coverage.

TRIA provides for the US government to pay for losses from a foreign-origin act of terror if those losses exceed $5m from a single event. After this threshold is reached, insurance companies must retain a certain portion of the losses, the deductible. For each year of the three years TRIA remains in force, this deductible rises. For 2003, the first full year, the deductible is 7% of a company's direct earned premiums of only those lines covered by TRIA; 10% in 2004 and 15% in 2005. Once the deductible is met for each insurer, the government pays 90% of the losses and the industry 10%, up to a maximum of $100bn annually. If this cap is pierced, Congress may recommend further payouts. The Secretary of Treasury has the main responsibility for certifying that an attack qualifies to be covered by TRIA.

While these retentions may seem high, as estimated by the Insurance Information Institute, if September 11 had occurred while the act was in force, the insurance industry's losses under the terms of TRIA could have been limited to about $11bn in 2003, $14bn in 2004 and less than $20bn in 2005. These figures assume $30bn in commercial property and workers' compensation losses. Total re/insurance industry loss estimates from September 11 now range from $30bn to $40bn.

The government may elect to recoup some of its outlay. It is entitled to surcharge up to a maximum of 3% on commercial policies if the industry's loss is below $10bn in the first year, $12.5bn in the second year and $15bn in the third. All policies providing the type of commercial property/casualty (p/c) insurance covered by TRIA will be subject to the surcharge.

Under the terms of the act, insurers had until 24 February 2003 to notify policyholders of the terms and price of the terrorism coverage offered. The policyholders then had 30 days to accept or reject the insurers' offers. Throughout the three months prior to 24 February, with almost no underwriting information or data to guide them, insurance companies rushed to comply with the notifications and pricing requirements under the law. Once they got the offer, risk managers struggled to determine if their companies, first, needed terrorism coverage; and second, could afford it.

And there's the rub
TRIA is silent on how coverage for terrorism should be priced. Thus, with almost a total lack of data to compute a premium, insurers had to either just make an educated guess or use a first-generation terrorism risk model developed by one of the three big risk modeling companies - AIR Worldwide, Eqecat and Risk Management Solutions (RMS). Catastrophe models are the closest to terrorism models. But while the early catastrophe models - based on losses from Hurricane Andrew - have been greatly refined using data from subsequent hurricanes and earthquakes, since there has been only one terrorist attack, the terrorism models remain untested.

Basically, the models are based on game theory, which is the standard mathematical basis for modeling conflict, according to Dr Gordon Woo, chief architect of the RMS model. "The greatest challenge in modeling terrorism risk is estimating the frequency of attacks," said Dr. Woo. "We have worked with the world's leading experts on al-Qaeda in developing this component of the model."

The various models approximate the losses that could result from a variety of terrorist attacks using explosives, chemical, biological, radiological and nuclear weapons. Some models can identify potential losses down to a specific ZIP code or even to a finer degree. The frequency of such attacks, however, remains an unknown and eclipses any assurance that these models reflect the degree of loss inherent in this elusive peril.

No, No ISO
The Insurance Services Office (ISO), an organisation that recommends pricing for many lines of p/c insurance in the US, suggested initially that for commercial properties in cities, particularly in New York and Washington DC that are deemed most likely to be at the highest risk for terrorist acts, the price should be 10 cents per $100 of insured value.

As insurance companies began sending out offers for terrorism risk coverage to their insureds, horror tales began circulating through the market. Some owners of landmark or `trophy' buildings were asked to pay as much for terrorism cover alone as they were already paying for their property policy.

However, following strong criticism from insurance regulators in New York and Washington DC that such a rate would increase premiums by 150% for some high risk properties, ISO issued a new agreement that provided for terrorism coverage to be priced at 3 cents per $100 of coverage for the highest risk properties, with a cap of 25%. Lower rates of 1.8 cents for properties outside the cities' downtown areas were granted, with exclusions for apartment complexes and other residential buildings. Washington was divided into three zones, with the downtown area paying a three-cent increase, a second tier that includes Georgetown paying 1.8 cents, and the outlying areas paying less than half a cent for $100 of building value. Rates for Chicago and San Francisco were also refigured, along with other cities considered less likely to suffer terrorist attacks.

Greed and exploitation
Chris Mandel, the president of the Risk and Insurance Management Society (RIMS), said that all in all, the market response was better than it could have been and noted that it would have been a huge mistake if insurers had responded "with greed or exploitation." There was some confusion "over certified versus non certified losses and coverage," said Mr. Mandel. Some insurance companies were "charging separately for each," others were not, he added.

"I firmly believe that both the admitted and voluntary markets are reacting better every day with reasonable and appropriate pricing," said Wayne L Salen, the vice chairman of RIMS external affairs team. But he added that a risk manager he knew had been provided a quote for terrorism coverage that was over five times the basic premium. The quote was provided by Lloyd's. "This Lloyd's quote and other odd variations continue to surface," said Mr. Salen, who is director of risk management for Niagara County, New York. "My terrorism renewal came in, ultimately, at 2% of the standard premium. That is acceptable, though I'd have preferred 0%."

The biggest problem, according to Mr. Salen, was finding coverage through the `miasma' of insurers. The aggregation issue and proximity to New York City created problems and "many carriers have imposed what I would call unrealistic expectations on data needs and their perception of risk terrorism."

There was high stress on risk managers to evaluate the proposal once it was received from the insurance company and then prepare a response in the short time frame allowed, said Mr. Mandel, who is also the assistant vice president of enterprise risk management at USAA, San Antonio, Texas. But the pricing was "generally controlled in most cases, though high risk property profiles are still expensive."

Under-whelming response
Sean Mooney, the chief economist at Guy Carpenter in New York, said: "What we are hearing anecdotally is that take up has been low. We are not surprised. There are a number of reasons. It is not a question of just how high or low the price is. Generally, companies don't like paying for insurance if they don't have to. We have found that a number of big insureds have gone bare for the past year because terror insurance was so expensive and hard to get. Now, they seem quite comfortable and are reluctant to buy it."

A study by Marsh showed that there are as many building owners in the US who are buying the coverage as there are rejecting it.

During an earnings conference call in early February 2003, Maurice "Hank" Greenberg, the CEO of American International Group, noted that companies buying AIG's terrorism cover were in many cases those considered legitimate terrorist targets, which raises questions of whether federal measures have made terrorism insurance affordable to average US businesses. He further noted that it was doubtful, depending on the frequency and severity of losses, if p/c insurers could collect enough premiums to cover losses, even with the backing of TRIA.

The difficulty of building adequate reserves for terrorism losses was addressed at a conference on terrorism insurance by Richard Thomas, the chief underwriting officer for AIG. "At present, there are no reserves for terrorist losses," he said. Until the premiums begin accumulating for AIG, if there are claims from a terrorist attack, "they will have to be paid from the capital of the company."

Michael J Mitchell, the vice president of the Graham Co, Philadelphia, said as terrorism cover had become more affordable, more companies were taking it. "Mostly companies that have high-value properties and can pay a few extra dollars to protect property have done so."

Considering the future, Mr Mitchell wondered if the developers who were proposing constructing towers even taller than the ones at the World Trade Center that were demolished on September 11, had considered how they would rent the upper floors of the towers once they were built. The rate for terrorism coverage could certainly be as sky-high as the towers.

Another reason risk managers may be reluctant to buy terrorism coverage is the 1943 New York property insurance policy, according to Mr Mooney. This convention, which is accepted in 28 states, requires insurers to cover damages from fire regardless of the source, which would include losses from terror attacks if a property collapsed because of fire. "There are other forces that could bring down a building without causing a fire," Mr. Mooney said, "but it would be very rare."

Room for reinsurers
Since the federal government was "temporarily in the terrorism risk reinsurance business," according to Peter R Fisher, the under secretary of the Treasury for domestic finance, addressing a conference on terrorism insurance in January 2003, private reinsurers were not covered by the Act.

Insurers, however, can reinsure for deductibles and their 10% share of losses above the deductible. Federal assistance to primary insurers will not be reduced based on any reinsurance provided. An insurer, however, cannot receive payments from other sources, including its share under TRIA, that exceed the amount of an insurer's covered losses. Any excess may have to be returned to the federal government.

Reinsurers also face the same challenges as primary insurers in trying to price the risk. There is little data available and so reinsurers, like their primary counterparts, may resort to guesswork.

Mark Lescault, the head of Swiss Re Americas' Divisional Underwriting Office, New York, said: "The devil is in the details, and many details are not yet resolved. At this time pricing is more of an art than a science.

"Since reinsurers are not covered by TRIA," he continued, "we have to be very diligent in making sure our accumulations are in sync with our balance sheet. Most reinsures are providing a limited amount of reinsurance cover. For both certified and non-certified, the pricing and underwriting are similar." He said the industry was in the early stage of terrorism risk models, and there were lots of unknowns, but some techniques were very promising. "But we have only one data point to use so being able to predict severity and frequency is very limited," Mr. Lescault said.

TRIA after 2005
Inherent in TRIA is a provision for its demise at the end of 2005. That the federal government is not keen on continuing to provide a back stop for terrorism losses was reinforced by under secretary Fisher at the conference on terrorism. He stressed that "an overarching goal of TRIA is the need for insurers to develop aggressively their own resources and mechanisms for terrorism risk coverage when the program expires." "I think TRIA is a good first step," Swiss Re's Mr Lescault said. "The dialogue between the federal government and the industry will continue as we grow in knowledge about this new and precarious issue."

Mr. Mooney of Guy Carpenter observed that the Bush Administration's goal in passing TRIA was strictly for economic reasons. "They wanted to be sure contractors, builders and developers could go ahead with their projects," he said, "and that banks would provide loans for these projects without being hammered by lack of terror cover. And it is being bought in critical urban areas where there is the highest risk of another terrorist attack."

But thanks to TRIA if there is another terrorist attack, the re/insurance industry won't endure a scenario similar to a stanza in that sad love song from Rodgers and Hart's Pal Joey:

Burned a lot

But learned a lot

And now you are broke...

By Ronald Gift Mulllins
Ronald Gift Mullins is an insurance journalist based in New York City.