Security and the economy: The insurance question

Page 10 

The losses from the September terrorist attacks for the insurance industry (including reinsurance) are estimated at US$30-$58 billion. There is some uncertainty about payments on liability insurance, but even if the final cost is close to the lower estimate, insured losses in 2001 are likely to have been the highest ever, even outstripping the US$21 billion incurred when Hurricane Andrew hit Florida in 1992. The 1992 Los Angeles riots were the most expensive man-induced disaster to date, with claims of US$0.8 billion, almost entirely for property claims. In contrast, the 11 September attacks have led to claims on a variety of types of policies: life, property, auto, airplane, workers compensation and business interruption insurance.

Yet, despite the cost, no major bankruptcies have occurred in the insurance industry, in part because the risk was spread over a number of companies and countries. It is estimated that reinsurers, most of them European, will bear over half of the losses. The capital base of many insurance and re-insurance companies has been hit, though, and it is likely that several companies would not be able to withstand another similar shock.

Following the attacks, primary insurers and reinsurers have curtailed or dropped coverage for terrorism-related risk because of pricing difficulties. They have raised insurance premiums in several industries, particularly aviation and other transportation. Construction, tourism and energy have also been affected. Commercial property and liability insurance rates have jumped by 30% on average, with vulnerable “targets” like chemical plants and high office buildings seeing steeper increases.

These rises should be seen in the context of a sharp decline of premium rates in the 1990s, and even with projected hikes, reinsurance rates should remain well below the peaks reached in 1993, thanks especially to strong enhanced competition in the industry. The reduction in coverage, on the other hand, could squeeze growth if it curtails certain types of investment, such as in property.

Insurance firms may one day be able to price terrorism risk, though not for the foreseeable future. The risk of a large-scale catastrophe of the type that occurred on 11 September was previously considered low (and may still be low) and was seldom formally incorporated into premium rates. With time, this may change. After all, however great the surprise, terrorist attacks do not occur with perfect randomness, nor is there any particular technical impediment for incorporating them within a risk-management model, although such is the uncertainty attached to these events that the predictive accuracy of risk models would be on trial for some time. Nevertheless, a group of European insurance and reinsurance companies has recently announced their intention to set up a pool to cover against limited terrorism risk. In the United States, airlines are in the process of creating a mutual company, Equitime, with a similar purpose, although proposing the government as reinsurer of last resort.

Financial markets could play a key role too in increasing coverage. The market for “catastrophe” bonds has been thin since its launch in 1996, but efforts to repackage such bonds in forms more familiar to financial markets may increase liquidity and lead to a larger role for capital markets in providing alternative risk transfer mechanisms in the future.

The insurance industry is likely to take a few years to adjust. In the meantime, government intervention may be justified.

Indeed, some OECD governments have long had schemes in place to cover terrorism risk, for example, the UK’s Pool Re scheme established in view of terrorist threats from the IRA, and Spain’s state insurance fund, the Consorcio de Compensación de Seguros. Many of these schemes were thought to be temporary responses to market failure. In time, it was argued, the insurance industry’s capacity would develop and efficient risk-sharing arrangements would be established. The fact that many of these schemes have endured is an indication that either the market failure persisted, or that in some cases government intervention crowded out private sector opportunities. No major bankruptcies have occurred in the insurance industry. The capital base has been hit, though, and it is likely that several companies would not be able to withstand another similar shock.

The design of support schemes is necessarily dependent on the particularities of domestic judicial processes. For instance, the UK’s Pool Re scheme does not provide reinsurance for liability coverage and so would be less applicable in the United States where third-party liability is a major issue.

In sum, if government involvement proves necessary, it should be limited in scope, be conceived in partnership with the private sector and be accompanied by the introduction of some type of user fee. In that regard, it is possible that governments will need to act as an insurer of last resort, perhaps involving some international co-operation.

The attacks of 11 September reminded everyone of the importance of government. These partnerships would be vital for the insurance industry under what is known as a mega-terrorism scenario, for instance, even a small nuclear attack. No doubt experts in the industry are examining this possibility closely, for however imponderable such a scenario may be to most of us, 11 September proved that even improbable events have to be factored in.

©OECD Observer No 231/232, May 2002 

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