The building blocks of US risk management

The risks inherent in the built environment have traditionally been assessed and priced by the (re)insurance sector while public regulation has taken the control of the acceptable risk levels in the physical environment.

However, the process of understanding and managing terrorism risk requires a new process to develop the physical and operational solutions.

Terrorism risk is essentially new in the US and the threat is not well defined. The (re)insurance industry therefore has a challenge in meeting this threat and the traditional means of analysis are not proving effective as a basis for pricing the risk. The lack of experience also means it is hard for potential buyers to assess their insurance needs while those selling the cover need a defensible basis for the way they price the insurance.

The attacks on the World Trade Centre (WTC) graphically illustrated the terrorism risk for property and liability insurers. The losses came under various categories: property losses to the WTC and surrounding buildings; business income loss and rent loss; workers' compensation, life and health insurance for victims and tenants; liability losses for inadequate fire prevention and evacuation procedures; and financial losses associated with mortgage notes of lenders and investors.

The property and liability coverage is principally claimed by the building owner and as the aftermath of the WTC disaster has proven, the extent of the claim can be complex. Whether the building is to be rebuilt is an issue but the characterisation of the incident is also a factor. Most property policies are written on an occurrence basis and so the definition of what a terrorist incident is, is of critical importance in terms of what is covered and what is excluded. Due to the newness of these issues in the US there is a lack of interpretation by the courts.

Business interruption insurance presents a special set of problems. Loss of income policies, which have usually come under the standard fire policy, are written either for a specific time period of for actual loss sustained, but when the losses are on the scale of the WTC disaster it goes way beyond the scope of these policies. Problems also arise because of adjacent buildings.

Business loss is insurable if the building is damaged by an insurable peril - in the WTC case undamaged buildings were evacuated by order of the civil authorities. Evacuation in response to a call from a civil authority can be an excluded peril or covered for a limited time. Denial of access, where there is no physical damage, such as in a bio-terrorist attack, is currently excluded from coverage.

Workers' compensation cover for employees is a statutory requirement for building owners and tenants. Death and injury due to building failure is therefore a major financial concern, aside from the human cost. Life insurance is also a major potential loss as group benefits are typically a multiple of salary and most people have individual insurance as well.

In the face of building failure there is the potential for a concentration of exposure that large group insurers are now actively trying to avoid.

Liability losses seem, on the basis of past litigation, to indicate that building owners can be held liable for failure to provide appropriate active measures or direction in the case of evacuation. Financial losses are an issue for mortgage holders and investors who may suffer defaults caused by business failure. The vulnerability of the underlying asset in the face of terrorism risk requires evaluation and management.

Following the WTC disaster and the subsequent exclusion of terrorism cover, the Tria legislation was introduced to ensure coverage but only in the face of a defined category of terrorism loss which must have particular characteristics.

Participation in the Tria program is mandatory for insurers covering commercial lines property and casualty insurance. The government reimburses insurers for losses by terrorism, paying 90% of losses exceeding a deductible covered by insurance companies. However, Tria is an interim solution, currently expiring in 2005. It presumes that the private insurance market for terrorism cover will stabilise over that time and models for pricing the insurance will be in place. It is not clear at this stage whether all the issues will be resolved in this time.

New tools

There are developments in terrorism insurance models from the loss modelling companies which cover recognised risk sources but, there are still questions about the ability to model the scope and scale of a terrorist attack.

Tria requires insurers to include terrorism cover and then disclose the cost of the cover as a percentage of the total premium. The cost so far ranges from 0-80%, with the average being 9-11%. Key to accurate insurance rate setting is the actuarial prediction for future losses. In the absence of such specialised data, the Tria solution remains necessary. The lack of actuarial data means it is not possible for regulators to evaluate the rates set by (re)insurers and for the risk to be insurable there must be data. Models may help but real data is the long-term solution.

Full details of the FEMA risk management series of publications is available at www.fema.gov.