Terrorism Leaves WC Insurers Exposed

Terrorism Leaves WC Insurers Exposed

With the first anniversary of the Sept. 11 terrorist attacks just around the corner, it is safe to say that the past year has borne witness to one of the most rapid and radical transformations in the history of the insurance industry.

From Ground Zero, the economic shockwaves from that tragic event were transmitted in an instant through many different channels to businesses and governments around the world. Insurance was among the principle mechanisms by which the death and destruction of Sept. 11 were translated into the cold calculus of dollars and cents.

The grim task of assigning values to lives and livelihoods fell squarely on insurers–workers' compensation carriers in particular. This macabre but necessary accounting exercise produced an estimate of privately-insured workers' comp losses of $1.3-to-$2.0 billion out of an estimated $40 billion in total insured losses (see pie chart), exposing the need for a radical overhaul in the way workers' comp insurers think about catastrophic loss.

For workers' comp carriers and commercial insurers in general, the unprecedented nature and magnitude of the Sept. 11 attack and the possibility of future attacks forced insurers to make a number of swift, certain and severe changes in their underwriting practices to prevent their own possible mass extinction. In most property-casualty lines, terrorism exclusions proliferated, prices rose, coverage limits fell, and policies were nonrenewed.

But as a practical matter, workers' comp is more resistant to change than most commercial lines.

Workers' comp defies a simple fix for a variety of reasons. The line remains the most highly regulated of all commercial coverages, and has always been offered on a no-fault basis. (Even losses due to acts of war are not excluded from workers' comp policies.)

Changes in terms and conditions that require nothing more than a few weeks notice to the policyholder in most lines could require an act of a states legislature in workers' comp. Rate change requests can take months even in ordinary times. Moreover, as of this writing, no federal backstop for terrorism risks has been put into place, and the private reinsurance market has all but dried up.

So how are workers' comp insurers protecting themselves against catastrophic loss given regulatory resistance to exclusions and big rate hikes, the lack of a federal terrorism reinsurance backstop, and a severe shortage of reinsurance?

Theyre using the only tools left at their disposal–taking the price increases they can get, increasing their nonrenewal rates, and avoiding the aggregation of risk.

The price of workers' comp coverage is rising by 20-to-25 percent for most employers. While these increases are significant, they can be justified almost solely on factors unrelated to terrorism, including accelerating medical cost trends (up 11 percent in 2001, according to the National Council on Compensation Insurance in Boca Raton, Fla.), the higher cost of reinsurance, guaranty fund assessments, the elimination of unsustainable deviations and discounts, and depressed investment returns.

In short, little of the current increase in price is linked to the possibility of future terrorist attacks.

Nonrenewal of workers' comp policies is an option that insurers are reluctantly forced to pursue. Characteristics that lead to rejection by one insurer will often lead to rejection by other insurers as well, forcing the employer into the states residual market plan.

Growth in these plans is rising for the first time in many years, in large part due to fear of catastrophic loss. Of course, pushing employers into residual market plans is only a partial solution to insurers problems, as companies operating in the states voluntary market must make up losses in the plan.

Perhaps the most intriguing development in workers' comp since Sept. 11 has been the innovative use of catastrophe modeling. Historically, the possibility of catastrophic workers' comp losses were all but ignored by insurers. Even if insurers had tried to push the idea of a catastrophe contingency in their rates, the idea would assuredly have been rejected by regulators based on the lack of actual precedent. But then came Sept. 11.

The primary lesson for workers' comp insurers is that aggregation of risk needs to be considered in the underwriting process, as it is when property risks are underwritten. At least three risk modelers–Risk Management Solutions, Applied Insurance Research, and Eqecat–are working on models that will help insurers understand their exposure to terrorism risks.

Terrorism modeling, unlike modeling for natural disasters, is not exclusively focused on property losses. Because such models also attempt to estimate the number and severity of injuries and deaths under a wide variety of attack scenarios, they are of direct interest to workers' comp insurers. Modelers are also looking at scenarios involving nuclear, biological or chemical attacks.

Terrorism modeling is far more difficult and complex than modeling for natural disasters because it must extend well beyond the identification and quantification of aggregated risks. Modeling for terrorism requires the modeler to “think like a terrorist,” so to speak. The modeler has to gain some understanding of how the terrorist mind works.

To that end, modelers must gather information from unconventional sources and apply what is learned in new ways.

For example, modelers have studied al Qaeda training manuals, as well as interviewed counter-terrorism and national security experts. Information gleaned from this process can be applied in new game-theoretic models of terrorist behavior. These behavioral aspects of terrorism modeling have no analogy in the modeling natural disasters.

Workers' comp insurers today find themselves in the grips of a vise. On the one side, insurer finances are pressured by traditional pricing factors such as rising medical claim severity, falling investment income, and the glacial pace of rate approval.

But the big squeeze–along with a big boost in uncertainty–is coming from nontraditional sources, including the threat of terrorism, the inability to spread or reduce risk efficiently due to lack of reinsurance or pooling facilities, and unacceptably high levels of aggregated risk. The inability to exclude terrorism as a covered cause of loss puts workers' comp insurers in a far more difficult situation than property insurers.

When the first anniversary of the Sept. 11 attack passes next month, workers' comp will arguably earn the distinction as the most exposed of the major “target” commercial lines. Consequently, major changes are ahead as workers' comp insurers adapt to the challenges of insuring the well-being of workers in an uncertain world.

Robert P. Hartwig is senior vice president and chief economist at the Insurance Information Institute in New York. He can be reached at bobh@iii.org.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, August 19, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.