Terrorism Insurance Market Post 9/11

Terrorism Insurance

Summarize the situation regarding terrorism insurance for private companies before 9/11/01 and since that time; what has been the trend of the insurance industry regarding terrorism insurance; what impacts or potential consequences does this current trend have on private businesses and our national economy; what is the role and responsibility of the federal government in this regard; and are there any viable alternatives, recommendations or long-term concerns that you can articulate?

Author: Jonathan B. Smith

Michigan State University 's School of Criminal Justice
Foundations of Homeland Security
Professor Phillip D. Schertzing, Ph.D.
Module 7: Private Sector Role and Impacts in Homeland Security
Case Study 11: Terrorism Insurance

Market Pre & Post 9/11

Prior to 9/11 insurance companies considered the risk of terrorism to be so low that they bundled the related coverage into their general property and casualty policies (Hillman, p. 3). There was no additional rider, like many homeowners have for their jewelry or other valuables, required to obtain terrorism insurance. Before 9/11 the market for this coverage could be generally described as liquid and readily available at highly competitive premiums.

Post 9/11 the "tide went out" on the terrorism insurance market. The estimates for 9/11 insurance related losses are as high as $50 billion with two thirds of this cost being covered by the reinsurance market (Hillman, p. 8). Needless to say, the reinsurance market participants were eager to exit the market following 9/11. The reinsurers were able to parachute out of the market, within less then a year because of the structure of their contracts. Reinsurers' policies are typically written for a period of one year with the majority scheduled for renewal on either January 1 or July 1 (Hillman, p. 4). Thus, by August 1, 2002 the reinusurers had drastically reduced their exposure and many had fled the market for this type of risk all together. The key to their expeditious and orderly exit was the fact that their contracts with the primary insurers are not subjected to federal or state regulation. Their relationships with the primary insurers are viewed as transactions among sophisticated parties eliminating the requirement for federal or state regulations (Hillman, p. 3). Reinsurance provides a critical sea anchor like function in the insurance markets. Their retreat from the market has adversely impacted coverage availability, pricing and the overall financial condition and risk exposures of the primary insurers.

The primary insurers were also quick move to reduce their portfolios sensitivity to acts of terror. However, the insurers were not able to capitate their risk as readily as their reinsurance counterparts. The insurance industry is one of the most highly regulated in the nation. Due to individual state regulation the insurance companies needed approval of any proposed policy modifications on a state-by-state basis. The industry in conjunction with the Insurance Services Office (ISO) (an industry resource that works to create standardized contracts for the Property and Casualty Industry) worked with all 50 states to modify their contract language (Hillman, p. 5). By February 22, 2002, 45 states, the District of Columbia and Puerto Rico had all approved the new verbiage. However, the other five states representing 35% of the US commercial insurance market were still unresolved in their position on the contract modifications (Hillman, p. 5).

The industry and ISO made enormous strides to reduce exposure, but industry still remains precariously vulnerable to another attack. In cases where the primary insurer still has to provide terrorism coverage, insurers are forced to shoulder 100% of the capital risk, prior to 9/11 they were exposed to roughly a third of the total risk.

The market for terrorism insurance almost completely eroded following 9/11. Insurance products are fundamentally priced upon actuarial models that are based upon historical data. Historical data is sparse and the losses have been staggering. It is virtually impossibile to actuarially price the coverage. Today, a large portion of the insurance market considers terrorist acts to be an uninsurable risk, who can blame them?

Insurance Industry Trend

The general trend in the industry is to:

Exclude terrorist coverage,
Dramatically reduce coverage, if available at all,
Drastically increase deductibles,
Geometrically increase premiums.

The insurance market is sending a message loud and clear to property and casualty buyers - "INSURERS DO NOT WANT TO INSURE AGAINST TERRORISM." They find the risks related to terrorism to be untenable and uninsurable based upon sound underwriting practices.

Impact on Business and Economy

The impact on business and the economy has been manageable to date because there have been no serious incident on U.S. soil since 9/11. Many companies today do not have adequate insurance to cover them in the result of a terror related loss. The effects of the shift in the insurance market have generally been seen through higher insurance premiums and financing complications because of the inability to find coverage for traditionally insurable risks. The higher premiums represent the market mechanism at work. However, the lack of insurance coverage has put a serious damper on lenders' appetite to lend and potentially to the economy as a whole. Lenders are in the business of assuming credit and market risk, not property and casualty risk. Their loan prices do not factor in historically insurable risks and they are exceedingly uncomfortable with any of these exposures, rightfully so.

The true test of the impact of the terrorism insurance market will only be realized if another terror attack occurs. As a result of the insurance companies' exodus from the market, the brunt of the exposure is being shouldered by the owners of property. This situation truly represents a recipe for disaster.

Role and Responsibility of Federal Government

The federal government plays a critical role in maintaining the integrity of the financial markets. This is apparent on almost a monthly basis as the popular press discusses speculation of whether or not Alan Greenspan, Federal Reserve Chairman, is going to raise interest rates during his regularly scheduled Federal Open Market Committee meetings. When crises occur that dramatically shift the financial markets, it is important that the federal government takes an active role in ensuring their stability. Following the Long Term Capital Crisis (LTCC) of 1998, the Federal Reserve actively met with key institutions and structured a bail out of the fund that helped avert a major financial crisis.

The Federal Reserve or other governing bodies need to ensure the sustainability and integrity of the terrorism insurance markets. The federal government's role is often best served when they provide short term stability, rather than acting as a long term solutions provider.

Alternatives, Recommendations, & Long Term Concerns

The federal government needs to be involved in helping to shape the terrorism risk insurance markets in the future. The reinsurers have abandoned the market because they do not want to take on unprofitable business. The primary insurers have exited the markets for the same reason. The availability of affordable insurance coverage is a basic tenet of a successful modern capital economy and its financial infrastructure. There is a significant interdependency between the insurance business and the other financial markets including: real estate, securities, and lending.

There are a vast number of examples of cases and methodologies for helping to support and maintain insurance challenged risks. Governments of industrialized nations across the globe have taken an active role in helping to maintain, regulate and promote a healthy insurance sector through subsidies, legislation and financial commitments; including programs for: nuclear accidents; political insurance risk; national flood; bank failure; crop devastation; pension guaranty; & vaccine injury (McCool, p. 19). Without government intervention in the terrorism risk insurance sector, the concentrated economic impact of a major terrorist event to a city or region could literally bankrupt its economic future.