The aftermath of Hurricane Katrina presents valuable lessons for terrorism preparedness and insurance issues. The need for improved post-loss preparedness is fairly obvious, but insurance coverage lessons are less clear.

Consider this scenario: It's 10 a.m., Monday morning. A large American city is starting its work week. On the outskirts of the city, a large truck bomb explodes next to a field of chemical tanks. Five minutes later, on the opposite side of the city, a second truck bomb explodes next to a chlorine gas tank. Two huge toxic plumes are released, enveloping the city.

Panic erupts. A million office workers flood into narrow streets. Hundreds are crushed. Within three days, the toxic releases have killed tens of thousands and permanently injured many more.

The contamination makes the city uninhabitable for years, if not decades. Very much like the Madrid and London bombings, the perpetrators are identified as local citizens sympathetic to Al Qaeda. There is no evidence these citizens were acting at the specific direction of any foreign person or interest.

Sound implausible? Not according to counterterrorism experts Steven Simon and David Benjamin. In their recent book–”The Next Attack: The Failure of the War on Terror and a Strategy for Getting It Right”–the former National Security Council employees in the Clinton administration suggest an attack like the one described above is actually one of the more likely scenarios we need to anticipate. Two important insurance coverage questions are unavoidable:

o Would the so-called NBCR (nuclear, biological, chemical or radiological) exclusion preclude liability, property and business income coverage?

o Under the Terrorism Risk Insurance Act, would this attack be certified as an “act of terrorism”?

The first question echoes the main coverage query being asked in the aftermath of Katrina: “Was the cause of loss wind or flood?” Insurers and risk managers tend to disagree emphatically on the right answer.

At an insurance industry event I attended recently, when asked this question, one senior underwriting officer replied: “A loss like this would absolutely, positively be subject to the NBCR exclusion!” Other insurers asked the same question consistently provide the same response.

Risk managers, on the other hand, express the exact opposite view, sometimes wondering why the question even needs to be asked. “Of course it would be covered,” they tell me. “It clearly was the truck bombs that were the proximate cause of the loss.”

The June 2005 report issued by the Treasury Department on TRIA confirms the confusion over what would or would not be subject to the NBCR exclusion. Remarkably, only 3 percent of the surveyed commercial property and liability insurance buyers reported that they elected to buy NBCR coverage.

This statistic is often cited by industry critics. It is a sobering qualifier to the otherwise positive improvements to 2004 insurance take-up rates for buying terrorism coverage (which rose to around 50 percent).

Equally striking (but almost entirely ignored), surveyed insurers told Treasury that 30 percent of their property and liability policyholders bought this coverage. This 10-to-1 disparity is a serious disconnect. The root cause is the fact the TRIA law itself states that all of the standard terms and conditions of commercial policies will apply, even if a loss is clearly a “certified” act of terrorism under the law.

This means that, even if you pay an additional premium for TRIA coverage, it is possible for the insurer to invoke any number of standard terms and conditions to deny coverage–including the pollution, war, nuclear and contamination exclusions found in most commercial policies.

The second question is as important to captives and traditional insurers as the first is to risk managers. Commercial insurers underwriting in major urban centers might be making a “bet the company” assumption that the federal backstop will apply.

The central problem is that our TRIA law is static, but the terrorist threat is constantly changing. As Mr. Simon and Mr. Benjamin explain, unlike the attacks of Sept. 11, 2001, recent attacks in London, Madrid, Bali and elsewhere were performed by home-grown and Internet-trained terrorist cells acting entirely or almost entirely on their own (based on the unclassified information on these attacks).

Unfortunately, the TRIA law states that an “act of terrorism” will only be subject to the law if the perpetrators are acting “on behalf of a foreign person or foreign interest.” This makes it entirely possible that insurers could find they have no federal backstop.

In many cases–as detailed in a report last summer by the Risk Management and Decision Processes Center of the Wharton School at the University of Pennsylvania, “TRIA and Beyond: Terrorism Risk Financing in the U.S.”–this could equate to a loss of more than 30 percent of the capital bases of even some of our largest insurers.

In most cases, this would mean a probable death spiral, transferring the problem to already-strained state guaranty funds (and then to other insurers–ultimately, to taxpayers).

The two-year extension of TRIA, through 2007, although a positive development, does not address the issues discussed here. We need a new coverage approach making it clear whether a loss involving a weapon of mass destruction is covered or not. We also need a program that is more flexible to address the changing nature of the threat itself.

The new legislation empowers a White House working group to develop recommendations for a long-term solution by September. This is a unique and possibly a final opportunity to mold a proactive alternative to TRIA that addresses the needs of both the private and public sectors.

Special Reports /

Caveat Emptor When Buying Terror Cover

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