Terrorism Exclusions Walking a Thin Line

In the late afternoon on the first Saturday of January, a light aircraft controlled by a 15-year old pilot student crashed into the 20-floor of a skyscraper situated in downtown Tampa, Florida. The aircraft had been tracked by the Coast Guard shortly after its unauthorized takeoff from an airport located outside of St. Petersburg, Florida. While there were no reports of casualties or losses at the time of going to press, and it was unclear to whether the impact of the plane had been accidental or a deliberate act, this latest incident serves as an uncomfortable reminder of the events that took place on September 11 of last year. Specifically, insurers and reinsurers worldwide scrabbled after the September 11 terrorist attacks to identify their potential exposures to potential catastrophic terrorism losses, with aircraft and high-rise buildings located in dense urban centers seen as offering the greatest risks.

Following the September 11 attacks against the World Trade Center (WTC), New York, global reinsurers made it known that they would not provide coverage for terrorism-related losses beginning with the 2002 treaty renewals. As a result, insurer representative groups in both the U.S. and Canada began pursuing their respective federal governments to provide temporary financial coverage to primary companies until the full impact of September 11 and the real exposure of the industry to future risks could be determined.

Subject to political vagaries, the U.S. Congress closed 2001 without passing legislation that would have enabled the creation of a government-backed reinsurance facility for large terrorism losses. The Canadian government also remained silent, presumably waiting for leadership from the Americans. And, as the bells celebrating the New Year rang out across Canada and the U.S., millions of insureds across the commercial and personal lines of business began a year without coverage against terrorism.

U.S. exclusions

Just before the U.S. Congress closed for the end of the year festivities, the National Association of Insurance Commissioners (NAIC) issued a statement saying that its members would be left with little choice but to approve insurer-submitted policy exclusions for acts of terrorism unless the government stepped in with an alternative reinsurance facility before the end of the year. “There is strong consensus among NAIC members that if Congress doesn’t act, state insurance regulators will be left with no choice but to begin approving some exclusions for commercial lines,” says Terri Vaughan, president of NAIC.

In the face of the government’s apathy to the situation, many such exclusions have since been approved by regulators across the country. The Insurance Services Office (ISO), which deals with policy standards and filing issues for over 200 insurers, released policy terrorism exclusion wordings just before the yearend deadline. These wordings, which apply to commercial property and liability business, were approved by 50 states, Guam, Puerto Rico, The U.S. Virgin Islands and Washington D.C. The exclusions were accepted on the basis that they will only kick in when an insured loss exceeds US$25 million. This threshold does not apply to terrorism relating to nuclear, chemical or biological materials. The ISO has offered on a limited license basis the use of its terrorism exclusion wordings to non-members free of charge.

At the time of going to press, it was unclear what the impact of the exclusions would have on the U.S. commercial sector, as well as the potential capacity disruption this may inflict on the insurance sector. Shortly after it became clear that the government would not act in time, The Council of Insurance Agents & Brokers (CIAB) called on insurers to act with restraint in applying exclusions and re-pricing of risks. “Significant premium increases in the current renewal season could hurt the underlying solvency of commercial enterprises throughout the nation and world. We urge restraint on the part of members [insurers] of the industry as we continue to push for an appropriate and responsible federal response [to the terrorism issue],” says CIAB president Ken Crerar. Despite this uncertainty, hopes were still high that the U.S. government, following the opening of Congress, would act swiftly in the beginning of the year to address this shortfall in capacity.

Canadian exclusions

“The deadline we were working to came and went,” observes Stan Griffin, vice president of regional operations at the Insurance Bureau of Canada (IBC). Griffin heads up a special IBC task group established to identify the risk facing insurers as a result of terrorism acts, as well as negotiate with the federal government on the implementation of a temporary reinsurance facility to cover such risks.

Griffin’s comment is made in response to the yearend deadline the government, represented by the Ministry of Finance, missed in bringing about a terrorism risk solution. As such, the IBC issued policy exclusion wordings to member insurers, many of whom had notified brokers just prior to the end of 2001, that non-statute terrorism covers on both commercial and personal lines would be implemented. “Most companies are using the exclusion wordings, there are only a few gaps where insurers are exposed.”

In addition, a significant breakthrough for insurers came through in the eleventh-hour when many reinsurers agreed to provide temporary terrorism cover for statutorily-mandated risks such as “fire-following”. This had been of prime concern to insurers as a significant portion of potential losses arising from a catastrophic terrorist attack would fall under this category (reinsurers can withdraw cover without regulatory approval, while insurers have to gain regulatory approval before acting with regard to certain types of cover such as fire-following or auto insurance). Furthermore, local insurers face an even greater exposure through “fire-following” in that Canadian written policies (inclusive of fire-following) are applicable in non-Canadian jurisdictions, thereby creating an international exposure to a risk that would not normally be covered. “Reinsurers positions in Canada have also evolved to the point where it would appear that they will offer coverage as required by statute, with the exception of U.S. exposures and ‘target risks’. The gaps in coverage, therefore, are likely reduced to statutory coverage requirements for these two areas,” Griffin observes. The recently introduced terrorism exclusions are inclusive of bio-chemical and nuclear contamination-related exposures.

Like their U.S. cousins, insurers in Canada remain hopeful that a government reinsurance solution to terrorism risks will be presented in the near future. However, as Griffin notes, the course of discussions have moved more toward “high risk target” covers. Initial government reaction had been to restrict cover to commercial property, while pushing for an unacceptably high level of industry participation in the risk at an exceedingly high premium level. “The revised [government] proposal would have received little industry support,” says Griffin.

As such, The IBC is now pushing for a temporary government plan to cover high-risk terrorism areas. Firstly, this includes Canadian businesses with incidental U.S. exposures of over Cdn$2 million, but do not exceed 15% of total insured values or more than Cdn$25 million per location. Secondly, government coverage for “target risks” in Canada, namely high-rise buildings in major cities. The IBC’s revamped plan describes these as “having insured values exceeding Cdn$500 million to a maximum value of Cdn$2 billion for any one risk”. Certain target risks, falling below the minimum value described above, but deemed to be at greater risk to a terrorist attack, would also be covered by the government facility. Specifically, a future government plan is unlikely to provide general terrorism coverage for commercial and personal lines. In this respect, Griffin says the exclusions implemented by insurers at the beginning of this year will likely remain in place. Furthermore, even i f a broad government plan were to be brought into place, “it will be interesting to see if insurers will be prepared to “unscramble the egg'”.

Insurer approaches

Peter Borst, chief agent for Employers Reinsurance Corp., and chairman of the Reinsurance Research Council (RRC), confirms that some reinsurers are providing coverage on both commercial and personal lines subject to loss limits. “As far as target risks, or larger commercial risks are concerned, the emphasis continues to be on exclusions,” he adds. As such, Borst emphasis that, until a government “back-stop” plan is introduced, there will continue to be a lack of terrorism coverage available in the market.

George Cooke, president of The Dominion of Canada General Insurance Co., wryly observes, “with many reinsurance treaties not yet put to bed, there are going to be a lot of industry executives staying close to home over the [yearend] holidays”. In this respect, he notes, many companies had waited until the last moment before the festive break with the hope that the federal government would step in to fill the reinsurance gap on terrorism covers. This did not happen, he observes, and companies such as Dominion began issuing policy exclusions for terrorism on both commercial and personal lines. “Looking at the marketplace, we are seeing some large insurers placing terrorism exclusions in both commercial and personal lines. Since reinsurers are starting to see exclusions being applied at the primary level, they are starting to come back to the table, and they’re being a lot more rational in their expectations.”

Cooke says the intent of the exclusions is to negate, or “take out”, what he refers to as “aggregate costs” associated with terrorist risks on either commercial and/or personal lines. In this respect, he points to “business interruption” on the commercial side, and “relocation living expenses” on personal lines. “From Dominion’s perspective, we’ve notified brokers that exclusions will apply to both commercial and personal lines of business.”

One area which insurers cannot exclude terrorism cover from is auto insurance. However, there is limited risk in this respect, says Cooke, “the potential losses on auto would be spread between 50 companies, it’s the aggregation of loss that is deadly for us”. In this respect, the one area of auto the industry is pushing for change from the Ontario regulator is “transfer of loss”. For instance, should a commercial vehicle be used in a terrorist attack, and it can be identified to be the cause of broader losses, the insurer of the commercial vehicle could be held liable for the aggregate of claims through “transfer of loss”.

Steve Hammond, leader of commercial underwriting practices at Royal & SunAlliance Canada, concurs that auto presents limited risk exposure to insurers in Canada. “Based on limited [auto] coverages in Canada, which other countries like the U.K. don’t apply, I think the exposure is limited.” However, he also feels that the potential exposure facing insurers through personal lines’ “living expenses” is a real concern. As such, Royal has also applied terrorism exclusions across-the-board.

While some reinsurers have stepped forward to provide cover for “fire following” and for limited commercial lines, Hammond notes that the terms and level of market support are not consistent. “Part of the reinsurance market has come forward to offer ‘fire-following” terrorism coverage, this has mostly been local companies, it’s not clear where Lloyd’s and the Bermuda companies stand.” Overall, Hammond point out that terrorism as a risk is not unlike “acts of war” which have long been excluded from insurance coverage, and in that respect fall under the domain of the government. “The ball is still in the government’s hands [on terrorism reinsurance],” he adds, “and at the present time the situation is not satisfactory as far as we are concerned. We’ve had to move to protect ourselves through exclusions.”

Bill Breckles, an executive vice president at The Citadel General Assurance Co., confirms that the level of reinsurance available in the market on terrorism is “inconsistent”. He adds, “the terms from reinsurers have been like a ‘scatter-gun’. Just trying to get a group of reinsurers together [under a treaty] offering the same terms has been extremely difficult.”

That said, he says some reinsurers have accepted taking on terrorism risk until policies issued by primary companies come up for review — others, he adds, “have been absolute”. As such, Breckles expects that the current round of reinsurance treaty renewals will produce a significant shake up of where, and with whom business within the industry will be placed. “This is the latest the reinsurance treaties have not been concluded.”

As The Citadel’s portfolio is focussed on small to medium-size commercial accounts, Breckles says the company will not be applying terrorism exclusions across-the-board. The insurer plans to evaluate each account on a “per risk basis”, he adds. But, in the long-run, he believes that the only solution open to the industry is to apply a cap to the potential losses that may arise from terrorism acts, “similar to the earthquake situation”.

Other participants

Whether the government ends up playing a role as the “reinsurer of last resort” with regard to terrorism risks has far broader implications than simply the availability and pricing of insurance.

Notably, should the government not step in, the exposure of insurers regardless of exclusions will have a bearing on the credit rating of companies, says Joel Baker, general manager of A.M. Best Canada. Furthermore, he adds, with the reduction in reinsurance capacity as well as steeper prices, some insurers may opt to reduce their reinsurance expense by retaining risks. With some of the more marginally capitalized companies, A.M. Best has a concern where there may be concentrated exposures to specific regions, like British Columbia, or specific risks, he notes.

The banking sector is also expected to be greatly affected in terms of lending policies should the government not afford general insurance protection against terrorism. However, while the issue is being closed watched, the Canadian Banking Association (CBA) says it has no plans to actively lobby Ottawa to provide protection for assets — commercial or personal. Shaun Murray, a director at the CBA, says discussions have been held at a high level within Ottawa, but at this stage the association is simply observing developments. He notes that the major banks are able to apply their own “risk diversification” methods due to the size of their lending and investment portfolios. One of the more immediate risk concerns to the banks, Murray adds, is the direct exposure they face through buildings owned in downtown centers. However, overall, he says, “the CBA does not expect that a lack of cover will cause significant disruption to the lending market”.