Terrorism: The New 21st Century CAT

The same cannot be said for terrorism, however. This man-made threat, which is limited only by the imagination of a terrorist, is one that insurers simply cannot forecast.

Natural catastrophes are somewhat predictable, and in many cases come with some degree of warning. Insurers can track when and where hurricanes are likely to strike, the type of damage they will cause, and which areas are most vulnerable.

Along with their expertise on behavior of natural catastrophes, insurers also have developed sophisticated tools for projecting what kind and the amount of damage these events may cause.

Terrorism is different. It is not a fortuitous event. It is premeditated, planned and executed with a specific purpose. The principal objective of terrorism is to injure a society, religion or culture.

Terrorism is not a peril?it is based on motive, not chance. The perils that occurred at the World Trade Center were aircraft collision, explosion, fire and collapse; the motivation behind them was terrorism.

Terrorism is not insurable for the same reasons war is not insurable?it is impossible for insurers to say whether New York is more at risk of a terrorist attack than Seattle. In fact, terrorists could just as well strike at a rural power plant as Times Square.

Insurance policies are not designed to address this type of societal risk. None of the methods insurers use to determine premiums or rates on exposures apply in the context of terrorism. From a traditional underwriting standpoint, even the best insured could be a bad risk for terrorism.

For insureds, normal loss control and mitigation measures do not reduce the threat of terrorism, only the impact it has on their operations. Office towers can be built or retrofitted to withstand earthquakes in Los Angeles or hurricanes in Miami, but few businesses would want to turn their offices into hardened bunkers. As an example, businesses can plan for a terrorist attack as they would for a fire or explosion.

Such measures include improving building security and planning for evacuation and disaster recovery, such as setting up an alternate location in the event a building is damaged or destroyed. Businesses that are heavily reliant on electronic data need to have back-up systems.

Concentration of risk is also a major concern. A company with most of its employees in one location has a serious problem from both a human capital and an insurance standpoint. Considering corporate governance requirements, a company could find itself hard-pressed after an attack has occurred to explain why it had not purchased terrorism coverage.

One thing is clear: In the next attack?which most governmental officials, including the president of the United States, warn is a certainty?we must assume that the terrorists will aim to match or exceed the carnage wrought in the Sept. 11 attack.

That attack produced estimated insured losses of about $40 billion and was the largest insured loss ever, easily surpassing the $20.5 billion caused by Hurricane Andrew in 1992, the $17 billion due to the California Northridge earthquake in 1994, and the $6.7 billion in estimated losses for Hurricane Charley, which occurred just last month.

Another attack on that scale or larger could erase much, if not all, of the property-casualty industry?s estimated $150 billion in capital available to pay commercial losses. In addition, many carriers could be mortally wounded before they could claim federal reimbursement under the Terrorism Risk Insurance Act, better known as TRIA.

Other nations with a longer history of terrorism have set up industry-funded reinsurance pools backed by the government. Britain?s Pool Re, for example, was set up when insurers balked at providing terrorism coverage after a bombing by the Irish Republican Army in London in 1993.

More recently, France set up its own pool in 2002, with the government acting as reinsurer of last resort. Germany, Israel and Australia also have similar plans. While terrorist attacks in Europe have not yet been on the scale of Sept. 11, the March 11 train bombings in Madrid that killed 190 people may signal a change.

Although TRIA provides essential financial assistance to the commercial lines insurance industry against a catastrophic terrorism loss, it has some shortcomings. Insurers are required to take on significant retentions?10 percent of the previous year?s direct earned premium for 2004 and 15 percent in 2005. These retentions will add up to financially destabilizing numbers for individual insurers in the event of a catastrophic attack, and it is only above those retention levels where the federal government would pay 90 percent of the remaining losses up to a maximum of $100 billion.

There are other shortcomings, as well. While TRIA requires insurers to make terrorism insurance available to the same extent they provide commercial insurance for other types of losses, insureds are free to decline the coverage, except for workers' compensation policies and certain property policies.

By making insured participation voluntary, TRIA increases the potential for adverse selection?only those with a significant exposure will buy terrorism insurance?and compromises the industry?s ability to spread terrorism risk across a large number of insureds. Also, the state and federal views about TRIA are inconsistent. To ascertain even an estimate of exposure, an insurance company must have some idea whether it will be required to cover a loss or not.

Lastly, TRIA is only temporary, expiring at the end of 2005. Congress and the Treasury Department have only very recently considered the impact TRIA?s expiration will have on the availability and affordability of commercial insurance for terrorism losses, the financial integrity of the property and casualty insurance industry, and the stability of the U.S. economy.

The effect of TRIA?s pending expiration, however, will begin to be felt in the fall of 2004, as the renewal process for policies extending into 2006 begins. As indicated by reinsurer representatives at the May 18, 2004 Senate Banking Committee Hearings on TRIA oversight, reinsurers are unlikely to provide sufficient capacity to replace the federal backstop. In the event insurers are unable to transfer risk to reinsurers or the federal government, they will have no choice but to take a hard look at their exposures and scale back.

Terrorism is a national security issue; one that can jeopardize the country?s entire financial system. Another attack on the scale of Sept. 11 or larger is likely to cripple the p-c industry.

The burden of safeguarding our economic infrastructure cannot be borne by the insurance industry alone. A stronger, permanent federal terrorism backstop would not only reduce the risk to the insurance industry?s survival, but also safeguard the entire economy from the effects of a terrorist attack.

Steven R. Pozzi, managing director and senior vice president, Chubb & Son, and chief underwriting officer for Chubb's Commercial Insurance business unit, is based in the company's Whitehouse Station, N.J., office. He can be reached at spozzi@chubb.com.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 3, 2004. Copyright 2004 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.