Terrorism Risks the Exclusion Dilemma

As a result of the September 11 terrorist attacks in New York and Washington D.C. in the U.S., the insurance industry around the world has struggled with the issue of what is appropriate to be covered by commercial property insurance policies regarding terrorist activities.

Immediately after September 11, there was speculation that some insurance companies might attempt to rely on the war exclusions provided in property policies. The insurance industry quickly decided that it was important that all claims resulting from the September 11 terrorist attacks be fully paid. However, as the cost of September 11 to the insurance industry quickly became evident, it was clear that the issue of coverage for terrorist acts needed to be clarified.

Aviation impact

The most immediate effect of September 11 on insurance coverages was the cancellation of war coverage for commercial airlines around the world. It was necessary in almost all countries for governments to become involved to provide temporary insurance coverage. In Canada, the federal government agreed to provide for a ninety-day period the same coverage that Air Canada and other airlines had prior to September 11, including the same limits and exclusions. This is arguably a preferable approach to that taken in the U.S. where an attempt was made to draft a new terrorism policy. The federal government coverage will continue until such time as commercially available coverages are available. It is likely that the federal government may be required to retain at least some catastrophe exposure for a significant period of time.

Terrorism exclusions

Since September 11, there has been a general movement by reinsurers to insert terrorism exclusions in their treaty renewals. This has created great uncertainty for insurance companies. One basic issue is whether terrorism can be excluded under applicable legislation. This appears to be an issue only with respect to property policies and not for liability and business interruption coverage. In Ontario, all property policies are required to comply with the requirements for coverage and limitations on exclusions contained in the Insurance Act (Ontario) (the “Act”). Reinsurance agreements covering property risks are not required to comply with these provisions and as a result any type of terrorism exclusion may be included.

Section 144 of the act states, in part, that property policies are deemed to insure against fire not occasioned by “riot, civil commotion, war, invasion, act of foreign enemy, hostilities (whether war be declared or not), civil war, rebellion, revolution, insurrection or military power”. Although this is a very broad provision, there is no judicial interpretation as to whether acts of terrorism such as those that occurred on September 11 would be deemed not to be covered.

It would also be possible to provide an express exclusion against terrorism activities. However, section 151 of the act states that an exclusion is not binding on the insured if it is held to be “unjust or unreasonable”. As a result, an insurance company may exclude a loss that is otherwise deemed to be covered under section 144 provided that the exclusion is not considered to be “unjust or unreasonable”.

Defining hostilities

There are court decisions that have provided interpretations of what “hostilities” are. Hostilities being defined as requiring something less than a formal aggressive act of a sovereign state. They have been found to mean hostile acts by persons acting as agents of sovereign powers or organized and considerable forces. It is not intended to cover rioters or individuals acting entirely on their own initiative, regardless of how hostile the act might be.

It is possible that a court might interpret terrorist acts such as the September 11 terrorist attacks to be considered to be hostilities and as a result not covered by a property policy. However, since the insurance industry has decided to pay all claims resulting from the September 11 terrorist attacks, a future terrorist act will likely be used to determine whether there is coverage. If a court found that terrorism activities were hostilities and there was no coverage, then the addition of a terrorism exclusion may simply provide greater certainty. If a court found that terrorism activities were not considered to be hostilities, then it would be necessary to determine whether the terrorism exclusion was enforceable. The courts have held that what is “just and reasonable” will depend upon the circumstances of the particular case and that no rule can be applicable to all cases. It will therefore be necessary for courts to determine whether a terrorism exclusion is “unjust or unreasonable” based upon the circumstances of specific acts as they occur in the future. As a result, there may be significant uncertainty over whether a terrorism exclusion is enforceable until there has been judicial interpretation of it.

Looking ahead

It is likely that some insurance companies will add blanket terrorism exclusions to their commercial property policies. Many insurance companies may be forced to add terrorism exclusions as a result of similar exclusions being added by reinsurers on the renewals of their reinsurance agreements.

One of the biggest concerns regarding the enforceability of a terrorism exclusion will be to define what terrorism really is. It is likely that courts in the future will provide this definition. It is important to note that the act has not been updated for a long period of time and that it does not contemplate terrorist acts of the type that occurred on September 11. It will therefore be necessary to determine whether the losses that occur are really the result of terrorist acts. It will also be important to determine whether a loss was a direct or consequential result of a terrorist act. In this respect, it may be necessary to look at the motives of the persons committing a particular act that results in a loss. For example, if someone burns down a building it will be necessary to determine whether it is a terrorist act or is considered to be arson.

The issue of terrorism exclusions is likely to result in significant confusion and inconsistency in the Canadian insurance market. The insurance industry is attempting to develop a standard terrorism exclusion. In addition, it is attempting to set up a terrorism pool that would be backed by the federal government.

It is likely that the federal government will be forced into a long-term role of being the “insurer of last resort” for certain types of terrorism risks. It may be a long period of time before normal pricing and availability occurs for certain types of risks such as aircraft, office buildings and public transportation systems.

Evaluating the risks

Furthermore, it will be important to distinguish between the types of terrorism risks that should reasonably be assumed by the insurance industry and those for which adequate premiums could never be charged to compensate for them. For example, a significant terrorist act may be considered to be similar to catastrophic event such as an earthquake, which is only likely to occur once in a significant number of years. The role of the government should be to assist the insurance industry in being able to accumulate sufficient premiums to be able to pay for the loss when it eventually occurs. During the period until sufficient premiums are accumulated, it may be necessary for governments to assume a greater proportion of terrorism risks. In addition to participating in a pool, it may be necessary for the government to provide tax relief with respect to reserves that are established by insurance companies for terrorism risks.

A good model for a terrorism pool is provided in England. The English model has been developed as a result of many years of experience with terrorist risks. The model provides terrorist insurance on a voluntary basis through the private insurance industry for specified limits for property, business interruption and boiler and machinery coverage. The insurance industry forwards the terrorism premiums to a reinsur ance pool which is guaranteed by the government in the event of claims exceeding assets. The government would treat the guarantee of the reinsurance pool in the same way as it would treat losses as a result of an act of war. It would not buy insurance against an act of war and would not need to do so to cover terrorist acts.

A pool based on the English model may provide a reasonably low cost solution to providing terrorist coverage. The immediate reaction of the insurance industry to events of September 11 was to determine how its assets could be protected against unanticipated catastrophic terrorism losses. The response of a blanket terrorism exclusion is not a satisfactory answer since it will not meet the needs of many insureds and lenders that will require coverage for terrorism risks. In addition, terrorism risk may be significantly lower in Canada than it is in many other countries. It is critical that the insurance industry in Canada be perceived as providing a solution that is done on a basis that is fair to all parties with respect to terrorism risks.

Future events

One of the greatest problems in developing a solution is dealing with uncertainty over what will occur next. In the event that September 11 is over time viewed as being an isolated terrorist act that is unlikely to be repeated again on the scale that occurred, the sensitivity to providing terrorism coverage will be reduced. However, if terrorist acts on a scale approaching that of the September 11 terrorism attack are repeated, the effects will be catastrophic to the insurance industry. Under such circumstances, governments will be forced into being insurers of last resort on a massive scale. It is important that the insurance industry be perceived as attempting to be providing solutions for their insureds. September 11 provides an opportunity for insurance companies and reinsurers to show leadership and assist their customers in dealing with an unprecedented period of uncertainty.