Disasters, Politics, and Insurance: Theory and Practice

1. Disasters, Politics, and Insurance:Theory and Practice Michael G. McCarter, FCAS, MAAA October 7, 2002 CAS Catastrophe Risk Management Seminar

2. Disasters, Politics, and Insurance • Theory: AAA Monograph on Insurance Industry Catastrophe Management Practices • Practice: Congress and the debate on a Federal Terrorism Backstop • Theory Vs. Practice: Issues for actuaries to consider • Society and Risk: Constraints on Actuarial Models

3. AAA Catastrophe Management Monograph • Presented to NAIC and Federal Reserve in June, 2001 • An overview of theory and practice of insurers in managing catastrophe exposures • Designed to help the Federal Reserve Board better understand insurers given its role as the umbrella financial services regulator under Gramm-Leach-Bliley

4. AAA Catastrophe Management Monograph (cont.) • Definition of catastrophes • Insurer capital considerations • Insurer management of catastrophe exposures (5 iterative steps) • Reinsurance and risk transfer • Public policy implications

5. AAA Catastrophe Management Monograph (cont.) • Emphasized challenge to insurer capital caused by lack of independence of catastrophe exposures • Discussed exposures to natural disasters and methods of modeling, controlling and financing such exposures • No mention of exposure to catastrophes caused by terrorism • Public policy discussion included the implications of various possible capital and reserve requirements

6. The World Before September 11, 2001 • Pool Re established in the UK in 1993 as a result of IRA bomb attacks • Compulsory government scheme in Spain covers Basque terrorist attacks • But we never thought serious terrorism could happen here, even though it already had begun

7. The World Before September 11, 2001 (cont.) • 1993 First World Trade Center Bombing: 6 Killed, Insured Loss $725 Million • 1995 Oklahoma City Bombing: 166 Killed, Insured Loss $145 Million • Terrorist attacks on US lives and property in a number of foreign countries

8. The World Before September 11, 2001 (cont.) • Each event was regarded as unique, a subject for Tom Clancy or Hollywood, but not as a precursor of more to come • AAA Catastrophe Risk Management Committee presented its paper to the NAIC and Federal Reserve Bank staff in June 2001 • It provided a good conceptual overview and primer on catastrophe risk management for insurers, but there was no serious discussion of terrorism risk (I served on that committee)

9. The World Before September 11, 2001 (cont.) • So, in that far away world, we can see why: • Most insurance policies were silent on terrorism exposure, and by implication covered it • Most reinsurance policies were silent on terrorism exposure, and by implication covered it • There was no significant push to evaluate or do anything about US terrorism exposure

10. September 11, 2001 • A stunning, coordinated attack by foreign terrorists on US soil • 3,014 victims killed • Insured losses estimated to exceed $40 billion • A sudden sea change in our assumptions: it can happen here

11. Insurance Industry Reaction to September 11, 2002 • Announced that claims would be paid without invoking war risk exclusions • Insured loss estimates have been as high as $70 Billion • A majority of those losses will fall to the relatively small reinsurance industry due to the prevalence of excess of loss reinsurance • An already hardening market hardened more

12. Ins. Industry Reaction to September 11, 2002 (cont.) • Reinsurers realized they could not withstand another such event and saw terrorism exclusions as the only short-term solution that could protect their solvency • Insurers realized that their solvency could be threatened by terrorism exposure, especially with reinsurance coverage vanishing, but terrorism exclusions weren’t going to be the complete answer • Many exclusions would require regulatory approvals, and workers compensation and the standard fire policy did not permit such exclusions

13. Ins. Industry Reaction to September 11, 2002 (cont.) • But the “exclusion solution” is unsatisfactory because it transfers the terrorism risk back to insurer customers without giving them any tool to deal with it • Private insurers did step up to develop facilities to provide some terrorism coverage, e.g., for aviation where insurers thought they could understand and quantify the terrorism risk • To enable insurers to provide more generally the coverage their customers need, US insurers outlined a “Pool Re” type proposal within a month of 9/11

14. The US “Pool Re” Proposal • A nationally chartered mutual insurance company that would offer reinsurance to member companies. • In turn, it would buy reinsurance from the Federal government to cover losses in excess of its aggregate retention • The proposal existed in outline form, with many issues left for resolution during the debate • Potentially, this was the most market-oriented proposal

15. The US “Pool Re” Proposal (cont.) • Possibly would have required some anti-trust exemptions for the rate and coverage determination process • Many other issues had not been resolved, including the tax treatment, who would be the principal regulator, or even whether membership would be voluntary or mandatory • However, insurers might have been able ultimately to choose to compete against Pool Re’s prices and coverages, re-introducing competition into the terrorism insurance market

16. The US “Pool Re” Proposal (cont.) • Pool Re was a tested concept. It had worked in the UK • However, there were a lot of details to resolve, and it entailed creating a permanent entity • Politicians quickly concluded that what was needed was an “interim” solution, one which gave the private insurance market time to recover, adjust, and begin providing terrorism coverage • The first proposal to emerge became the first proposal to die politically

17. The White House / Treasury Plan • Designed to reassure markets that terrorism insurance was available in the short run and provide time for markets or government to develop a more permanent solution • A three-year plan, paying 80 to 90 percent of claims from the ground up to $100 billion in payments each year • Many limits on the types of claims eligible for compensation (no claims for punitive damages)

18. The White House / Treasury Plan (cont.) • Insurers would not pay premiums for the plan or repay plan payments • Those features seemed too generous to Congress, and the White House Plan was never actually introduced. • Some of its ideas were incorporated in the Sarbanes-Gramm-Dodd “Senate Compromise” plan

19. Sarbanes-Gramm-Dodd Senate Bill • Similar to the White House Plan (no insurer payments for the plan)except: • One year plan, with an option for an additional year • Industry deductible ($10 billion first year, $15 billion second year) apportioned to insurers based on gross written premium market share • Federal aid capped at $100 billion a year, but insurers freed from liabilities exceeding that amount

20. Sarbanes-Gramm-Dodd Senate Bill (cont.) • State law pre-empted on definition of terrorism and on prior approval of rates and forms • Probably less agreement on tort limitations, although it’s hard to tell since the bill did not reach final form in 2001 • Terrorism defined as acts by foreign entities • This is the bill the Senate didn’t pass at year-end 2001

21. H.R. 3210 - Oxley Bill • Passed the US House of Representatives on November 29, 2001 • Political advantage: not a taxpayer “bailout” of the insurance industry, since the federal assistance was characterized as a loan rather than direct aid • The facility would pay (as a “loan”) 90% of aggregate terrorism losses exceeding an industry or individual company trigger • However, the “loans” are not repaid by the insurers receiving them, but by assessments on all insurers based on market share

22. H.R. 3210 - Oxley Bill (cont.) • If the total “loans” exceed $20 billion, surcharges could be imposed on policies to repay the federal government. • Total “loans” could not exceed $100 billion, and the program would be for two years with an option to extend for another two years • Terrorism defined as an act by a foreign entity • Includes a number of restrictions on the damages covered and partially preempts state laws

23. H.R. 3210 - Oxley Bill (cont.) • Some concerns with H.R. 3210: • The “loan program” appears unlikely to attract capital to providing terrorism coverage • It also provides little incentive for good underwriting of the terrorism exposure. Like guaranty funds, it leaves strong companies to pick up the pieces of weak ones. • It doesn’t deal with domestic or “unknown” terrorists, or losses greater than $100 billion

24. At the end of 2001 • The perception was that a federal terrorism backstop needed to be passed, or the sky would fall in January, 2002 • Oxley’s bill, H.R. 3210, passed, but the Senate could not agree on any bill, apparently due to opposing positions on tort reform language • Congress adjourned before Christmas, and in January 2002 the sky did not fall • The perception of the chances of Senate action on a Federal Terrorism Backstop became very negative

25. 2002: The Sky may be Falling, only Slowly • Although there appeared to be no enthusiasm in the Senate for action on Terrorism insurance, there appeared a slow drumbeat of studies building a case for action • February 26, 2002: GAO releases report on terrorism insurance • “Rising uninsured exposure to attacks heightens potential economic vulnerabilities” • Contained some anecdotal evidence of the impact of lack of terrorism insurance on commercial property transactions

26. 2002: The Sky may be Falling, only Slowly (cont.) • April 15, 2002: ISO and NAII release property/casualty industry results showing first ever net loss ($7.9 billion) for a full year. Including unrealized losses, industry surplus fell $27.7 billion, or 8.7%, to $289.6 billion compared to $317.4 billion a year earlier • And these numbers included only about $10 billion of 9/11 losses on a net basis. There could be another $15 billion to come on that basis • Financial results like these provided incentive for a hardening market

27. 2002: The Sky may be Falling, only Slowly (cont.) • April 17, 2002: AAA Extreme Events Committee releases statement entitled Terrorism Insurance Coverage in the Aftermath of September 11th • It reports on the significant acceleration of the market price firming post 9/11, and on exposure and coverage issues facing insurers and reinsurers. • It points out that Workers Compensation and other coverages can pose a serious solvency threat due to terrorism exposure

28. 2002: The Sky may be Falling, only Slowly (cont.) • May 1, 2002: JEC releases a study, “The Economic Costs of Terrorism” • This study discusses how the costs of terrorism impose a drag on the economy through increased transaction costs and other inefficiencies • Effectively functioning insurance markets are needed to reduce those inefficiencies

29. 2002: The Sky may be Falling, only Slowly (cont.) • May 23, 2002: JEC releases second study entitled “Economic Perspectives on Terrorism Insurance” • It concludes that the market for terrorism insurance remains limited, and very expensive where available • The problems associated with terrorism insurance “pose a significant threat to sustained economic growth”

30. Have the terrorists gone away? • USA Today Headline (June 11, 2002) “U.S.: ‘Dirty bomb’ plot foiled” • Other headlines: “U.S. won’t dismiss possible July 4 plot” • “U.S. Fears Use of Belt Bombs” • “U.S. Alters Estimate of Threats” - The new National Intelligence Estimate says that the U.S. is more likely to suffer a terrorist attack using weapons of mass destruction than an attack by a foreign country using long range missiles

31. Even Bankers are starting to understand • Well, not all of them: “Insurance Gap Has Little Effect According to Fed Poll”. But: • “Terror-Insurance Flap Ensnares Opryland Deal” • “Moody’s Real-Estate Review Puts Terrorism Insurance in Spotlight” • “Terror Insurance Cost Pits Lenders, Owners”

32. The Senate Acts • A version of the Sarbanes-Gramm-Dodd bill was introduced as S. 2600 and was passed on June 18, 2002 • However, tort liability issues appear to be separating people as much as ever • Congress is scheduled to adjourn on Friday, October 11 for the elections, and it needs to get the appropriations bills done • The Conference Committee has not yet produced a compromise bill

33. But will Congress Act? • The Conference Committee would have to agree on a compromise between the House and Senate versions. • Then both Houses of Congress would have to pass the compromise version to send it to President Bush for his signature • Could it happen? Yes • Will it happen? Possibly in a “lame duck” session

34. Workers Compensation Issues • A coalition of business leaders has asked Washington to consider action on a Federal Backstop for Workers Compensation • No terrorism policy exclusions are permitted for Workers Compensation, so the risk to solvency of a terrorism catastrophe is particularly great • WC is a “no-fault” type coverage, so the tort liability issues holding up action on other proposals can be finessed here • This proposal is in its early days, and no bill draft is yet available

35. Assume Congress Acts: Actuarial Issues • The Federal Terrorism Backstop proposals are temporary - one or two years with possible extensions for a similar period • The terrorism threat is not temporary • The CIA National Intelligence Estimate evaluates major terrorist attacks as more likely than long-range missile attacks • Actuaries and insurers must consider how to deal with the “sunset clause” of the Federal Backstop proposals

36. Assume Congress Acts: Actuarial Issues (cont.) • The Federal Terrorism Backstop proposals have limitations on coverage in terms of deductibles, limits, and definitions of covered events • The NAIC has indicated it wants to reconsider the issue of terrorism exclusions in the event Congress passes Federal Backstop legislation • Actuaries and insurers need to consider how to pay for insurers’ residual terrorism exposure, and the exposure that might be returned to them if state regulators disapprove terrorism exclusions

37. Assume Congress Acts: Actuarial Issues (cont.) • Are manmade and terrorist-caused insurance catastrophes an entirely new thing? • No - even natural disasters have a manmade component, as it is manmade things that are insured and paid for • No - aviation coverage and ocean marine coverage have often included war risk coverages for a price • Yes - modern complexity and interconnection gives the terrorist a broader selection of bigger potential targets

38. Society and Risk: Constraints on Models • Do we model and attempt to cost all possibly conceivable manmade events, even the most unlikely? • No - some events are too big to finance. Consider the dinosaur-killer asteroid. Insurers don’t need to charge for it, because they won’t be around to pay for it. • No - some events are too rare to finance. The 1-in-10,000 year asteroid (or hurricane, or earthquake, or volcano) may do significant insured damage, but policyholders aren’t willing to pay for such coverage (unless such an event has just happened).

39. Society and Risk: Constraints on Models (cont.) • Is risk financing the only issue in considering how to deal with manmade and terrorist caused catastrophe risks? • No - Consider the risk mitigation efforts undertaken by our government in Homeland Security, air transport security, and in the war against terrorism • It should be harder today than it was pre-September 11 for a terrorist to cause a large loss

40. Society and Risk: Constraints on Models (cont.) • Is the tradeoff between risk financing and public risk mitigation a new concept? • No - Remember “Millions for defense but not one cent for tribute”. The United States Navy was founded as a risk mitigation device. Even 200 years ago marine insurance premiums reflected the cost of the depredations of the Barbary Coast pirates.

41. Other Manmade Catastrophe Modeling Issues • Severity modeling is key for controlling accumulations of exposure. This is a natural outgrowth of similar modeling for natural hazards. • Frequency modeling is in its infancy, and may be difficult to make credible in a numerical sense. Given responsive risk mitigation efforts, the standard modeling assumption of independent events is unlikely to hold for terrorism.

42. Summary: Disasters, Politics, and Insurance • There’s been a rapid and deep change in the U.S. insurance industry’s consideration of its exposure to manmade catastrophes • Congressional action, assuming it occurs, will allow management of aggregate exposure, but will not remove the need for insurer consideration of and action on terrorism issues • Society as a whole will focus on mitigating the risk of manmade and terrorist catastrophes • Actuaries will focus on how to finance the residual catastrophe risk, considering the bounds of what society is willing to pay for

43. Thank you! Any questions?