Terrorism Risk and Insurance
Prior to September 11, 2001, insurers provided terrorism coverage to their com- mercial insurance customers essentially free of charge because the chance of property damage from terrorist acts was considered remote. After September 11, which costs insurers about $31.6 billion, insurers began to reassess the risk. For a while terrorism coverage was scarce. Reinsurers were unwilling to reinsure pol- icies in urban areas perceived to be vulnerable to attack. Primary insurers filed requests with their state insurance departments for permission to exclude terror- ism coverage from their commercial policies.
Concerned about the limited availability of terrorism coverage in high- risk areas and its impact on the economy, Congress passed the Terrorism Risk Insurance Act (TRIA). The Act provides a temporary program that, in the event of major terrorist attack, allows the insurance industry and federal government to share losses according to a specific formula. TRIA was signed into law on
November 26, 2002 and renewed again for two years in December 2005. Passage of TRIA enabled a market for terrorism insurance to begin to develop because the federal backstop effectively limits insurers’ losses, greatly simplifying the underwriting process. TRIA was extended for another seven years to 2014 in December 2007. The new law is known as the Terrorism Risk Insurance Program Reauthorization Act (TRIPRA) of 2007.
The Difficulty of Insuring Terrorism Risk: From an insurance viewpoint, terrorism risk is very different from the kind of risks typically insured. To be readily insurable, risks have to have certain characteristics.
The risk must be measurable. Insurers must be able to determine the pos- sible or probable number of events (frequency) likely to result in claims and the maximum size or cost (severity) of these events. For example, insurers know from experience about how many car crashes to expect per 100,000 miles driven for any geographic area and what these crashes are likely to cost. As a result they can charge a premium equal to the risk they are assuming in issuing an auto insurance policy.
A large number of people or businesses must be exposed to the risk of loss but only a few must actually experience one so that the premiums of those that do not file claims can fund the losses of those who do. Losses must be random as regards time, location and magnitude.
Insofar as acts of terrorism are intentional, terrorism risk does not have these characteristics. In addition, no one knows what the worst case scenario might be. There have been very few terrorist attacks, so there is little data on which to base estimates of future losses, either in terms of frequency or severity. Terrorism losses are also likely to be concentrated geographically, since terrorism is usually targeted to produce a significant economic or psychological impact.
This leads to a situation known in the insurance industry as adverse selection, where only the people most at risk purchase coverage, the same people who are likely to file claims. Moreover, terrorism losses are never random. They are care- fully planned and often coordinated.
Assessing Risk: To underwrite terrorism insurance—to decide whether to offer coverage and what price to charge—insurers must be able to quantify the risk: the likelihood of an event and the amount of damage it would cause. Increas- ingly, they are using sophisticated modeling tools to assess this risk. According to the modeling firm, AIR Worldwide, the way terrorism risk is measured is not much different from assessments of natural disaster risk, except that the data used for terrorism are more subject to uncertainty. It is easier to project the risk of damage in a particular location from an earthquake of a given intensity or a Category 5 hurricane than a terrorist attack because insurers have had so much more experience with natural disasters than with terrorist attacks and therefore the data to incorporate into models are readily available.
One problem insurers face is the accumulation of risk. They need to know not only the likelihood and extent of damage to a particular building but also the company’s accumulated risk from insuring multiple buildings within a given geographical area, including the implications of fire following a terrorist attack. In addition, in the United States, workers compensation insurers face concentra- tions of risk from injuries to workers caused by terrorism attacks. Workers com- pensation policies provide coverage for loss of income and medical and rehabili- tation treatment from “first dollar,” that is without deductibles.
Extending the Terrorism Risk Insurance Act (TRIA): There is general agreement that TRIA has helped insurance companies provide terrorism cover- age because the federal government’s involvement offers a measure of certainty as to the maximum size of losses insurers would have to pay and allows them to plan for the future. However, when the Act came up for renewal in 2005 and in 2007, there were some who believed that market forces should be allowed to deal with the problem.
Both the U.S. Government Accountability Office and the President’s Working Group on Financial Markets published reports on terrorism insurance in September 2006. The two reports essentially supported the insurance indus- try in its evaluation of nuclear, biological, chemical and radiological (NBCR) risk—that it is uninsurable—but unlike the insurance industry, the President’s Working Group said that the existence of TRIA has negatively affected the development of a more robust market for terrorism insurance, a point on which the industry disagrees. TRIA is the reason that coverage is available, insurers say. The structure of the program has encouraged the development of reinsurance for the layers of risk that insurers must bear themselves—deductible amounts and coinsurance—which in turn allows primary insurers to provide coverage.
TRIA and its extensions authorized the creation of a federal reinsurance plan, which is triggered when insured terrorism losses exceed a predetermined amount. The program, a sharing of losses between the insurance industry and the federal government according to a preset formula—a type of reinsurance— has enabled the commercial insurance market to function, even though the threat of terrorism remains.
The law defines an act of terrorism under the 2007 amendment. To be cov- ered by the federal program, an act of terrorism must be committed by individu- als acting as part of an effort to influence the policy or conduct of the United States. The law also requires that the act be certified by the Secretary of the Treasury in concurrence with the Secretary of State and the Attorney General.
Insurers do not pay the federal government for this reinsurance coverage.
Only commercial insurers and causes of losses specified in the underlying policies are covered. In addition to commercial lines insurers, insurers eligible for coverage include residual market entities such as workers compensation pools, state-licensed captive insurers and risk retention groups, see report on captives. Personal lines insurance companies—those that sell auto and home insurance—and reinsurers are not covered. Neither are group life insurance losses.
Most types of commercial insurance losses were covered under the origi- nal legislation, except some specialty coverages such as medical malpractice and crop insurance. Some commercial insurance coverages were deleted under the 2005 extension including commercial auto insurance, professional liabil- ity except for directors and officers liability, surety, burglary and theft and farmowners multiperil, a coverage similar to homeowners.
In return for the federal backstop, commercial insurers must make terrorism coverage available and conspicuously state the premium charges; policyhold- ers can reject the offer and choose to mitigate this class of risk in other ways.
In offering terrorism coverage to their policyholders, commercial insurers must make it available on the same terms and conditions as they offer in their non- TRIA coverage.
After September 11, to minimize the likelihood of a wave of liability claims, Congress established the Federal Victims Compensation Act, which provided nearly $7 billion in payments to families of September 11 victims. In return, vic- tims’ families were required to give up the right to sue those they perceived as responsible parties. This provision is not part of TRIA or its extension.
Mandated Coverages/Exclusions: In some states a doctrine know as “fire following” applies. This means that in the event of a terrorist-caused explosion followed by fire, insurers could be liable to pay out losses attributable to the fire (but not the explosion) even if a commercial property owner had not purchased terrorism coverage. A number of states have amended their standard fire policy laws to exclude such coverage for acts of terrorism.
Injuries in the workplace resulting from terrorist attacks are covered under state workers compensation laws. Workers compensation insurance is a manda- tory coverage in all states but Texas.