Financing Terrorism Risks a Backstop, Not Bailout

Canada must deal swiftly and carefully with the global insurance repercussions of the September 11 terrorist attacks in the U.S. Canadian insurers will very likely be asked to take bigger retentions and pay more for catastrophe coverage. And, just when primary insurers want more coverage, there will likely be less reinsurance capacity.

Reinsurance protection for most insurers in Canada expires on December 31, 2001. Once the deadline has come and gone, reinsurers are suggesting strongly that terrorism coverage may be limited severely. If reinsurance against terrorism is not available, Canadian insurers will likely have little choice other than to exclude terrorism to the extent that they can, and to limit their capacity to the level of the exposure that they themselves can absorb.

Pool complexities

An Insurance Bureau of Canada (IBC) special task force on terrorism and insurance coverage has reviewed the experience of Britain’s Pool Re along with recent developments and proposals in the U.S. These were found to be too complex, too costly, and too dependent on government. Instead, the task force is proposing a short-term back-up measure.

The mechanism is predicated on the likelihood that reinsurance capacity will return in the regular market. If it does not, however, long-term pool mechanisms may need to be considered, depending on developments over the next few months.

Temporary mechanism

Simply put, the proposal placed on the table by members of the IBC is a temporary mechanism that does not otherwise upset market equilibrium. In short, it is merely a “back stop” until capacity returns. The design provides a response that can be quickly put in place so as to avoid disrupting the market. Reinsurance premiums would be remitted to the Canadian government. Primary risk exposures are assumed to be downtown Toronto, Montreal and Vancouver. Some believe that business interruption losses could far exceed all property losses. Coverage would include U.S. locations written on policies issued in Canada.

Impact on covers

Instability associated with terrorism may adversely affect the pricing of catastrophe reinsurance coverage in general. This could put many primary insurers in the position of writing coverage with potentially large losses that cannot be reinsured. Another catastrophe (not necessarily an act of terrorism) such as another ice storm or an earthquake could financially cripple much of the primary insurance and reinsurance industry.

In a special report from A.M. Best Canada, there is a suggestion that if reinsurers either elect or are instructed by their head offices to exclude “fire-following” acts of terrorism cover, the result will be another serious gap. The reason: although primary companies may exclude terrorism, by law, it is less certain that they can effectively exclude fire-following coverage. That same restriction does not apply to reinsurers.

Furthermore, in a preliminary study of the attack on the World Trade Center, IBC member Munich Re notes that events previously considered highly improbable have become probable. It comments that “the WTC loss event shows that insurers’ and reinsurers’ overall commitment can only be clarified if their liabilities for losses due to terrorism are transparent”. Without transparency, it is impossible to calculate risk and set premiums appropriately.

Proposal outline

The underlying principles of the industry proposal as put to the federal government includes:

Stability for insurance consumers;

Simple, low-cost administration;

Minimal government involvement;

Transparency;

Residual market pricing;

Maintenance of market equilibrium;

Immediate implementation;

Economic stability and preservation of existing financial structures;

Short-term solution pending assessment of long-term needs;

Balancing interests of consumers, government and industry;

Policyholder costs related to exposure.

The government has indicated that its prime objectives in the creation of a back stop plan include least government intervention, incentive for the normal market to return, and comparability with the emerging program in the U.S.

IBC proposed endorsement

“There is great concern within the p&c insurance industry regarding its ability to continue to offer coverage against terrorist acts to Canadians as from the beginning of next year. Accordingly, the IBC special task force has developed model policy wordings for insurers who may decide to exclude this risk. “Terrorism” for the purposes of the proposed IBC policy endorsement wordings, would be defined as: “an ideologically motivated unlawful act or acts of violence or force or threat of violence or force committed by or on behalf of any group(s), organization(s) or government(s) for the purpose of influencing any government and/or instilling fear in the public or a section of the public.” However, with timely adoption of the IBC’s proposal, current wordings would more than suffice, making exclusions unnecessary.

The next few weeks will be critical for the reinsurance market as the uncertainty surrounding the availability issue looms. A remedy to the potential lack of terrorism catastrophe reinsurance coverage must be provided as soon as possible. The IBC believes the industry proposal provides that remedy.