Do you need terror insurance, and can you get it?

Catastrophe insurance has two major ironies. One is that buyers tend to be least concerned about a risk just before an uninsured loss and most concerned just afterward. The other is that sellers offer lowest prices and most cover before, and highest prices and least cover after.

The anti-terror market is no exception. Until the attacks of 11 September 2001, cover in the US under property policies was standard and cheap. As 2002 renewals started, however, most reinsurers and primary insurers began to exclude terror from property policies. Stand-alone and bespoke coverage was still available, but in relatively limited quantities and high prices.

Lack of cover a threat to economy

Most companies responded by simply going naked, i.e. with little or no cover, but as the year wore on, public officials grew more and more nervous. Another major attack could have crippled key industries as well as insurers (who already were paying out the lion's share of the 11 September losses). Moreover, said several studies commissioned by the US Congress, the lack of cover began to stall out construction projects and real-estate deals, which posed a serious threat to the recovering economy.

The origins of TRIA

So, by the end of 2002, the US federal government (and its counterparts in France and Germany) stepped in with state-sponsored reinsurance. They followed a path already trodden by Israel, South Africa, Spain and the UK, which had earlier experience with large-scale terrorism. Unlike France or Germany, the US solution was meant to be temporary. Now, as its Terrorism Risk Insurance Act (TRIA) heads towards expiry at the end of 2005, a debate continues - mostly in the US - as to whether and how government should offer terror insurance.

There are three major talking points:

• How strong is the terrorist threat?
• Is it insurable?
• Can special solutions provide the financing?

What terrorists want

Throughout their long and infamous history, terrorists always have been faced with a fundamental trade-off. They want to create enough threat - imagined or real - that the terrorized will give in, say, release prisoners, grant autonomy or stop animal testing. On the other hand, they don't want to create so much threat that governments respond full-force to crush them. (It can be argued that Al-Qaeda went too far with 11 September, which triggered the invasion of Afghanistan and helped build support for the Iraq war in 2003.)

However in recent years, as Swiss Re points out in a mid-2003 report¹, two other aspects of terrorism have changed. One is its cold-blooded murderousness, as shown in the Beslan siege that killed 156 schoolchildren (see article) or the use of airline passengers as human bombs. "Even if we had extrapolated our statistical experience from previous years," says Swiss Re, "we would not have arrived at [such cold-bloodedness]."

Weaponry power is the other change. The classic risk here is a city or region held hostage to a nuclear attack, which is no longer just a James Bond plot, but a genuine possibility. Presumably it was on the minds of the terrorists whose work near the Georgian city of Tblisi was interrupted by police in mid-2003. Some 80 kilograms of radioactive isotopes were seized, which experts say is enough to arm one to three nuclear bombs. But would a terrorist really gain by putting such a mighty weapon to use? This is the main barrier to such a strike, says Swiss Re, not technology or logistics.

Meanwhile, expert opinion is relatively unified when it comes to the likelihood of another 11 September: terrorists probably will choose different targets and methods, but as the report from the US 9/11 Commission puts it: "Americans have been told to expect the worst. An attack is probably coming; [compared to that of 11 September] it may be more devastating still."

But is it insurable?

After the 11 September attacks, the insurance industry admitted it had been caught off guard. Legendary investor Warren Buffett wrote in early 2002: "All of us in the industry made a fundamental underwriting mistake by focusing on experience, rather than exposure, thereby assuming a huge terrorism risk for which we received no premium." He went on to argue that a "close-to-worst-case" terror scenario could cause USD one trillion in losses, which would bankrupt the entire insurance industry.

"Only the U.S. Government has the resources to absorb such a blow," he continued. "If it is unwilling to do so on a prospective basis, the general citizenry must bear its own risks and count on the Government to come to its rescue after a disaster occurs."

Critics greeted this as at best an admission that terror is uninsurable and at worst as a blatant cry for subsidies, yet Buffett's case was probably more subtle. It was about sharing and capping risk, not running from it. It was also about urging the insurance industry to work harder at understanding terrorism.

Sophisticated risk modeling evolves

Clearly, this has happened. Gordon Woo, a catastrophe consultant for Risk Management Solutions, likens the situation in terrorism insurance to that for severe windstorms after Hurricane Andrew in 1992 and for earthquakes after the Northridge experience in California in 1994. By applying game theory, powerful computers and expert judgement, "the methods for quantifying terrorism risk for insured portfolios will continue to evolve with increasing mathematical and computational sophistication, in the same way that the methods for quantifying windstorm and earthquake risk have systematically advanced over the past decade."

New and improved models for underwriting terror risk continue to be unveiled, including Zurich's Global Underwriting Accumulation Repository of Data (GUARD). This identifies terrorism maximum loss (TML) areas, based on locations of businesses covered and numbers of people working in those buildings. These facts are converted into precise maps showing the immediate area around target buildings that would sustain the largest insured loss. GUARD then calculates the total exposure within each TML in terms of property and workers' compensation.

High awareness but limited activity

Meanwhile, companies and organizations continue to look for new ways to capitalize terror cover. For instance in 2003 the International Federation of Football Associations (FIFA) issued the world's first terrorism catastrophe bond, to cover its investment in next year's World Cup. Other options include raising fresh capital or pooling risk (as the UK government does for terror, under Pool Re).

Source of the first anti-terror cat bond

Still, a recent study by Bruce Deal of Analysis Group and Glenn Hubbard, a former Chairman of the US Economic Council of Advisors, concludes that these financing options will not contribute enough to make up for government reinsurance, at least not in the next three to five years. Since 11 September 2001, "we have seen very limited activity on these fronts, despite the high levels of awareness and potential for financial returns."

It comes down to solidarity

As TRIA in the US heads toward expiry - or perhaps reauthorization - debate of these issues will heat up. A key milestone will come in June, when the US Treasury Department is to deliver its assessment of the programme.

But in the end, perhaps the most powerful argument for government intervention will not be about commercial insurance decisions. Instead, it will be about something personal, i.e. fighting the inner terror that causes ordinary people to act selfishly or even cowardly in the face of terrorism, to be terrorized by terror.

As Darius Lakdawalla and George Zanjani of the RAND Center for Terrorism Risk Management and Policy explain in a paper published in July 2004, self-protection by individuals can lead to less protection for society at large. "For example, the cancellation of a building project in a high-profile downtown area might hurt national prestige or morale by appearing to capitulate to terrorists," they write. "It might be individually rational for a firm to self-protect by moving away from a high-profile downtown area, but this might be viewed by the public (or policymakers) as contrary to national objectives. From the national point of view, there may be too much caution and too few social incentives to encourage risk-taking."

A question of national resolve

There are analogies to this. One is mandatory insurance for bank deposits, which is meant to prevent runs on banks, and ultimately, the liquidation of unrelated businesses. Another is the strict rules for front-line soldiers against desertion. In either case, it is recognized that although it might be attractive for a given individual to run in the face of danger, it will invite disaster if everyone runs.

John Kerry, the US Senator who later ran for President in 2004, put it more positively only one day after the Al-Qaeda attacks, saying: "One of the first things we should commit to ... is to rebuild the towers of the World Trade Center and show the world we are not afraid - we are defiant ... It is a question of strength and our national resolve to show our strength."