The Risk Of Terror

Terrorism, and the cost of terror, has taken the forefront of catastrophic loss concerns of the global insurance industry. Until September 11 of this year, when acts of terrorism perpetuated in New York City and Washington D.C. brought about destruction of unprecedented magnitude and horror, the concept of such a loss was unimaginable in North America. While the sheer travesty of these inhuman acts continues to occupy our minds, the broader financial implications for insurers and reinsurers of these events is beginning to take hold. Just as importantly, those within the property and casualty insurance industry are questioning the future risk of terror acts and their potential exposures to them. As many of the financial rating agencies tracking the insurance industry observe, the September 11 events will no doubt cause several casualties on the global stage. Specifically, all agree that the fateful day in question will forever change the outlook and possibly the structure of the global insurance industry.

While insurers and reinsurers exposed to losses resulting from the terrorist attacks carried out in the U.S. on September 11 were among the first in public to emphasize their sympathy for the loss of life caused by the destruction – with over 5,000 expected dead with many of those employed within the insurance industry – the financial reality and consequences of the events are beginning to take hold on the industry. To date, early loss estimates reported by insurers and reinsurers relating primarily to property, aviation, life, business interruption and workers’ compensation covers have been wide in range, with many of the figures adjusted on an almost daily basis. At the time of going to print, total loss estimates projected by the insurance industry, as well as several rating agencies and actuarial consultants, suggest that insurers/reinsurers could be looking at an insured cost ranging from US$30 billion to up to a staggering US$200 billion (including long-tail liability losses).

The uncertainty shown in the early loss estimates relate to the magnitude of the terrorist event, or rather “events”, the legal interpretation of which could have significant bearing on the final insured cost. On the morning of September 11, terrorists hijacked four commercial jetliners which were used as “flying bombs” to crash into the World Trade Center (WTC), located at the heart of New York City’s financial district, as well as an attack against the Pentagon complex in Washington D.C. Two of the planes crashed into the twin towers of the WTC, causing their total collapse as well as a third 47-level building forming part of the complex. The third plane smashed into the Pentagon while the fourth crash-landed into an open field after an apparent struggle ensued between the hijackers and passengers aboard.

Although insurers have begun payment of claims, particularly life covers, as yet an accurate assessment of the insured property losses has not been carried out as claims adjustment teams have not been allowed by the authorities into the disaster recovery zone surrounding the WTC site. Direct aviation losses have been easier to identify, although liability exposures will likely take several years to be fully revealed. As Don Callahan, a vice president at the Canadian office of reinsurance brokers Guy Carpenter & Co. Inc. observes, “the impact on aviation covers, including ‘downtime’ of airlines, will be staggering” – see article in this issue of CU on “aviation consequences” for further details.

Rating agencies

Despite reassurances by insurers/ reinsurers of their ability to pay claims resulting from the September 11 terrorist attacks, a number of international financial rating agencies and actuarial consultants have issued media statements raising concern. Most of the rating agencies have indicated that they will be downgrading the security ratings of several insurance groups. They, plus some of the actuarial consultants, have also expressed concern over the financial stability of the insurance industry overall in its ability to deal with the losses and remain solvent.

Notably, Standard & Poor’s has downgraded its long and short-term ratings of the Germany-based Gerling group, specifically its Gerling Global Re operation, due to the significant shift in the company’s latest loss estimate of up to about US$300 million compared with the first estimate of around US$80 million. The rating agency has also downgraded several of the Lloyd’s of London syndicates, which face heavy exposure on both the WTC property and aviation side. Lloyd’s has issued a statement pegging its total anticipated loss at around US$1.9 billion. Many other insurers and reinsurers have posted subsequently higher loss estimates than had been originally anticipated. Standard & Poor’s has indicated that it will be keeping a close watch on events across the board.

Moody’s Investors Service adds, “Moody’s believes that the cost of these attacks will be ‘exceptionally severe’ for insurers, and that many of the initial estimates made by some companies will prove to be insufficient, perhaps by a substantial amount”. The rating agency also raises concern over the fact that all of the loss figures released by insurers have been on a net of reinsurance basis, and that this will likely spark disputes over responsibility between the two parties. Ultimately, in the event an insurer may find itself facing a greater exposure than initially calculated according to reinsurance protection, the insurer will still be liable for the difference. Moody’s believes that the financial impact of the events on insurers will be broader than just cost, namely causing a “flight” by insureds to “size and quality of insurance carrier”, resulting in further industry consolidation.

A.M. Best Co. believes that U.S. and international insurers, although “challenged” by the terrorist attack, will by and large be capable of meeting their claim commitments. A.M. Best expects the final insured loss tally relating to September 11 will exceed US$30 billion. The rating agency adds, “while individual ratings [of companies] may be affected, the financial strength of the insurance industry will not be impaired”.

Fundamental changes

Research consultants Tillinghast-Towers Perrin expects the events of September 11 will have “profound effects on the insurance world”. In a detailed analysis of potential industry exposures, the consultants suggest that the total insured loss culminating from the terrorist attacks will likely be in the range of US$30-US$58 billion.

Tillinghast notes that determining loss estimates at this stage is “more an art than a science”. However, the company adds that the total insured loss likely to arise from September 11 will considerably supercede that of Hurricane Andrew, which on an inflation adjusted basis cost the industry about US$20 billion. “This is the largest single-event loss in history…only the insured cost of asbestos liabilities exceeds the cost of the terrorist attack.”

Notably, the consultants point out, while losses relating to asbestosis and environmental covers have taken years to develop, the recent terrorist attack occurred abruptly, perhaps as a “single event”, and claims settlement will have to be rapidly handled. Already, they note, the market is showing signs of reduced reinsurance capacity, which could leave insurers with inadequate coverage in coming months. Tillinghast also predicts that policy conditions will tighten with increased use of terrorist exclusions built into reinsurance covers. “Coverage terms may also be a major concern, as reinsurers can much more easily insist on terrorist exclusions than can primary insurers, who often must obtain regulatory approval of changes in policy language.”

Prior to the September 11 terrorist attack, insurers and reinsurers had not included terrorist exclusions in covers, as is fairly common in mainland Europe and the U.K. Tillinghast believes that greater action will be taken by insurers/reinsurers operating in North America to introduce such exclusions. “It goes without saying that the imp
act of the incurred loss from September 11 will be felt in terms of higher reinsurance premiums, fewer prepaid reinstatements and more restrictive coverage.”

A significant issue which will determine the financial impact on insurers is the definition under reinsurance covers regarding “occurrence”. At this point, Tillinghast says, “it is uncertain whether the September 11 events constitute one or more occurrences. The answer will affect the primary company’s net retention [of reinsurance]”.

With roughly 60 insurers having publicly reported losses totaling about US$20 billion, the consultants expect that the final insured loss will greatly exceed current estimates. “Historically, early estimates of catastrophic losses have been low…early estimates of industry losses from Hurricane Andrew and the Northridge earthquake were less than one half of their final tallies. We expect that the terrorist attack will be no different.”

Tillinghast says the manner in which the international insurance industry reacted to losses arising from Hurricane Andrew provides a valuable “outlook” on what may occur in the market following the terrorist attacks. Notably, following Andrew, the amount of property catastrophe coverage available in the market was “cut in half”, the consultants observe, which sparked a dramatic rise in traditional insurance prices and subsequent withdrawal of premium from the marketplace. “…expect that these capacity shortages will become pronounced at the upcoming January 1 [reinsurance] renewals”.

As such, Tillinghast expects that, as both insurer and reinsurer pricing begins to rise, new players may enter some risk markets. “After Andrew, a half dozen new catastrophe reinsurers were born in Bermuda. Product innovation also occurred, in the form of securitization and catastrophe coverage bonds.”

U.K.-based actuarial consultants Milliman note that Lloyd’s had previously assessed a “potential worst case scenario” of a man-made catastrophic event which had been based on two jetliners colliding over New York City. “The events of September 11 are potentially significantly worse than this scenario. The present thinking is that the losses to the insurance market [from September 11] will range from US$40 billion to US$200 billion,” the consultants say. The extreme figure takes into account life insurance, which based on the large number of high net worth individuals who lost their lives during the WTC tragic event could well boost the insured cost to astronomical levels. “This is the first time that we have had a significant number of insured deaths, including many of the key personnel of international organizations.”

Milliman says that “business interruption” will be the hardest of lines to determine an accurate loss estimate. However, the consultants believe that this line alone will likely cost insurers between US$15-20 billion. It will likely take up to 10 years before the true cost of the terrorist attacks can be fully assessed, Milliman adds. “Payment of aviation losses take many years to be actually made, as witnessed by the Lockerbie claim…The insurance market will change substantially as a result of the events of September 11, in players, in coverages, and in the costs.”

Investment bankers Morgan Stanley Dean Witter & Co. expect the WTC insured losses will approach the US$30 billion mark. However, the bank’s prime concern lies with potential insolvencies in the mid to lower reinsurance ranks, and the impact this will have on the insurance market as a whole in terms of “uncollectable reinsurance”. Morgan Stanley also believes that Lloyd’s faces financial jeopardy, with some syndicates likely to fold while the market’s “central cash fund” is likely to be depleted as well as its potential to underwrite coverage.

The investment banker notes that early Northridge insured loss estimates released by the industry were less than a fifth of the final cost. “Northridge was a straightforward, simple, and small event compared to the WTC attack.” As such, Morgan Stanley expect that the final financial impact on insurers/reinsurers will be far greater than many currently expect.

Specifically, insurers are not expected to report “gross losses” but only the figure net of reinsurance. “…they are allowed to offset anticipated recoveries from reinsurers against their loss payments, reporting the expected net liability. In reality, there is no right of offset against reinsurance. The insurer is primarily liable to its customers, and must pay even if its reinsurer does not pay.”

In this respect, Morgan Stanley believes that Lloyd’s syndicates are particularly vulnerable to inadequate reinsurance protection. The Lloyd’s market has partially reinsured internally, the investment banker notes, which creates situations where reinsurers have reinsured each other. “Inevitably, some of the reinsurers in this chain will be over-leveraged.”

And, while the insurance industry globally has been over-capitalized, much of this excess has been among personal insurers and the top reinsurers, Morgan Stanley say. As such, insurers with large commercial exposures may find themselves over-exposed, while the latest events will likely lead to a shakeup within the reinsurance community. Morgan Stanley believe that the current US$120 billion in annual capacity within the global reinsurance sector could be reduced by about a third as a result of the terrorist attacks and potential for future terror exposures. The shift of the market will also likely favor the “top end” reinsurers who will benefit from increased marketshare. “The result is likely to be a winner-take-all scenario in which the largest reinsurers grab significant marketshare at much higher rates. We aren’t sure yet exactly where the cutoff is for the ‘largest reinsurers’. There is no question that Berkshire Hathaway, Swiss Re and Munich Re fall into this category. We believe that Employers Re, owned by General Electric, should also qualify.”

U.S./Canadian insurers respond

The U.S. National Association of Insurance Commissioners (NAIC) reported to the congress House Financial Services Committee in the final week of September that its own investigations of U.S. and international insurers suggest that the insurance industry will be financially capable of dealing with the losses arising from September 11. President Kathleen Sebelius says NAIC will continue to monitor the potential impact the events may have on the global insurance industry, as well as identify certain companies that may require regulatory surveillance or intervention.

Meanwhile, a group of insurance industry representatives led by Chubb Corp. chairman Dean O’Hare also addressed the committee members, warning that insurers can ill afford another catastrophic event such as the terrorist attacks. “The industry has a specific amount of capital, we cannot insure risks that are infinite and impossible to price,” O’Hare says.

O’Hare called on the federal government to establish an insurance pool for terrorism coverage, similar to the scheme that operates in the U.K. under “Pool Re”. He adds, “it is becoming apparent that as current reinsurance agreements expire, they will be renewed only with a terrorism exclusion, and therefore it will be impossible to provide customers with terrorism coverage.”

A spokesperson from the American Insurance Association (AIA) confirms that work has already begun on a possible structure for a terrorism pool fund. Although at very early stages of development, the pool is likely to be called “Freedom Re”. The U.K. government enabled legislation in 1993 for the creation of Pool Re, which is a registered company owned by its member insurers. The pool covers only damage caused by terrorist acts throughout England, Wales and Scotland. The British government serves as the “reinsurer of last resort” should the pool’s funds become fully tapped. The need for Pool Re arose in 1992 following widespread losses relating to the conflict between the British government and the Irish Republic Army (IRA), resulting in a severe reduction in reinsurance capacity.

While the U.S. market appears to be moving toward
a terrorist pool fund, no plans are underway to do the same in Canada, confirms Andre Fredette, senior vice president at CCR. Fredette also sits on one of the technical committees of the Reinsurance Research Council (RRC). Such a decision could be taken, he adds, but the industry has had little time to investigate its options.

However, Fredette is adamant that action will have to be taken soon to limit the potential risk exposure Canadian insurers/reinsurers face through terrorism. Terrorism exclusions are an obvious and expected reaction to the problem, he notes, but in order for such changes to occur, the industry will have to achieve a consensus in whatever direction it takes. “I think developments in the U.S. will drive actions taken in the Canadian market.”

The Insurance Bureau of Canada (IBC) has established a special task force to investigate the potential risk of terrorism Canadian insurers could face. The task force will hold meetings with senior insurer management to determine their reactions to a possible terrorism attack in Canada. “There are many companies in the U.S. that are going to pay claims as a result of this tragedy [September 11] in spite of the fact that they be holding policies that have exclusions that would exclude acts of terrorism, or acts of war. We are interested here in Canada to know how we would respond,” says IBC representative Don Forgeron.

Allianz Canada president Christian Cassebaum says, “it’s fair to say that the events of September 11 have wakened the insurance industry to the risk of terrorism in North America”. As such, the manner in which insurers assess risk will have to be re-addressed, he says. The terrorist attacks will undoubtedly cause a price reaction in the Canadian marketplace, Cassebaum predicts, with much of the pricing pressure coming to bear from a global level. Insurers could face significantly higher reinsurance pricing and limits of cover as early as the upcoming January renewals, he adds.

Allianz senior vice president of insurance, Michel Trudeau, also expects cover restrictions and reduced capacity will impact Canada. “This is the biggest catastrophic disaster facing reinsurers. I think we will see policy wording restrictions.” Furthermore, Trudeau says it is possible that the terrorist attack losses could spark a similar dramatic reduction in market capacity as brought about during the “liability crisis” of the mid-1980s. “But, I hope not.”

Steve Hammond, leader of commercial underwriting at Royal & SunAlliance Canada, notes that it is still “early days” in the process of evaluating the risk factor presented by terrorism acts. “We’re assessing our situation, what exposures we face in terrorism in general.” Notably, Hammond points out, the events which occurred on September 11 were of a catastrophic nature that has never happened before. In this respect, the potential risks involved go beyond what would normally be expected of terrorist attack related losses. Hammond believes that the most viable approach to dealing with such risk in the U.S. and Canada would be government-backed insurance pool funds.

Chubb Insurance Co. of Canada president Janice Tomlinson says how insurers respond to the risk of terrorism will largely depend on the reaction of reinsurers at the upcoming treaty renewals. “Regardless of how the treaties are negotiated, the events which have happened will add momentum to price firming,” she predicts. The only effective alternative to terrorism exclusions in dealing with the risk involved lies in a pool fund similar to the U.K. model, Tomlinson believes.

U.S. MAJOR MAN-MADE DISASTERS

Los Angeles riots (1992)

US$775 million

World Trade Center bombing (1993)

US$510 million

Oklahoma City bombing (1995)

US$125 million

Source: NAII