Wholesale withdrawal from terrorism coverage is shielding the U.S. insurance industry from widespread rating actions following the September attacks, but it leaves U.S. commerce highly vulnerable to any future acts of a similar magnitude, Standard & Poor’s stated.
“In the current environment, insurers offering terrorism provisions would unduly expose their capital bases and invite ratings downgrades, unless policies were written with some form of government protection,” said Steve Dreyer, head of Insurance Ratings at S&P. Such support, he added, could come from a federally backed reinsurance pool, as now proposed by several industry bodies, or from the Bush administration’s alternative plan for federal payouts that would be triggered by any other major terrorism event.
Virtually all insurers have either already rewritten existing policies to exclude terrorism coverage or have announced their intention to do so with the next round of premium renewals due in 2002. Absence of coverage could have a chilling effect on the economy if businesses from airlines to sports teams to shopping centers curtail or even shut down activity, and if banks prove unwilling to make loans to companies without terrorism insurance. Recently, the French insurance group AXA (financial strength rating ‘AA’) announced it was withdrawing coverage for the 2002 World Cup soccer event, scheduled for June in Japan and South Korea.
Although it has $150 billion in statutory capital, backed by a global reinsurance base of about $250 billion, the U.S. commercial property/casualty industry can ill afford another payout of the kind incurred on Sept. 11. Even natural disasters, such as hurricanes and earthquakes, can generally be underwritten with a reasonably good understanding of risk characteristics and appropriate pricing, and safeguards to curtail losses can be put in place through payment limits or reinsurance, but to maintain terrorism coverage in the existing framework would take the entire industry into uncharted and chaotic territory.
The creation of a federally backed capital resource to underpin terrorism-related payouts would provide a mechanism in which terrorism coverage is conceivable without an automatic ratings consequence. Current proposals call for a mechanism akin to the model now operating in the U.K., in which insurers pool resources to establish a reserve, but rely on the government to cover any losses that exceed it, although this last resort has never been invoked. This is viewed as the means to facilitate coverage, reduce uncertainty, and dampen premium-rate increases. The California Earthquake Authority operates in a similar manner.
Variations on the theme have emerged from such bodies as the American Insurance Association, the Reinsurance Association of America, the National Association of Independent Insurers, and the National Association of Mutual Insurance Companies. They generally envisage a privately run and financed reinsurance pool for terrorism risks, which would purchase its own reinsurance from the U.S. government in return for a premium. Governmental coverage would be enacted whenever the pool’s surplus is reduced to a certain percentage, perhaps 20 percent, of its level at the end of the previous calendar year.
The Bush administration has rejected such a scheme, however, on the grounds of complexity, reluctance to get the U.S. Treasury involved in regulatory activity, and a desire for private market forces to drive improvements in security. Instead, the White House looks for only a temporary government commitment and proposes a three-year plan for government payouts on a gradually decreasing percentage of any future terrorism-related losses, with a maximum disbursement of $100 billion. This short-term approach has been endorsed by the National Association of Insurance Commissioners.
Whichever plan goes ahead, insurers ultimately need to establish an appropriate degree of actuarial predictability and loss protection in order to preserve their financial strength. Until then, the current environment prevents insurers from appropriately underwriting or pricing the extremely unpredictable exposure of terrorism risks. Although the Bush administration proposal would likely provide adequate protection for insurers in the early years to protect their financial strength, the envisaged withdrawal by federal government after 2004 raises questions about the future strength of commercial-lines carriers.
If the insurance industry is asked to accept an increasing proportion of terrorism risk, S&P will evaluate this for individual companies in much the same way it analyzes their assumption of other catastrophe risks. Insurers will need to demonstrate that their ultimate loss exposures are limited in a manner appropriate to their capital strength. Such underwriting discipline and loss protection exists at most insurers for naturally occurring catastrophe events, but the industry will need to develop these skills to meet new man-made risks, in order to protect its capital base. To the extent that an individual carrier has exposure to terrorism events without the ability to underwrite these risks appropriately, its financial strength rating is likely to suffer.
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