Terror Risk: stuck in third gear?

News of the broad, 10-year terrorism 'backstop' plan introduced into the US House of Representatives earlier this summer prompted me to reflect on the state of our global industry's ability to manage the terror risk. It seems reasonable that a robust, private terrorism-insurance market would evolve over four phases, following the same ebb and flow as insurance for other challenging risks. Or would it?

Consider the typical path: Phase I is the calm before the storm, the time when (re)insurers are relatively comfortable with the risk. Cover is provided (or not excluded) under existing policies.

Phase II is the shock phase, triggered when an unexpectedly large loss sends (re)insurers retreating to their drawing boards (or modelling tools), believing a risk to be higher than previously estimated.

Phase III is the experimentation phase, when an ongoing study of a risk makes insurers comfortable enough to dip their toes back in - albeit keeping their guards high with claims-made policies, sub-limits, co-participation and the like.

Phase IV is maturity: a new insurance sector comes of age, and customised solutions become available at reasonable rates.

There are several examples of coverages making this transformation - everything from medical malpractice to environmental insurance, even hurricane cover (since Hurricane Andrew) - has evolved in this way. Will terrorism exposure follow suit?

A changed world

The nature of terror risk is changing. In the 1970s and 1980s, terrorism was a tactic used to draw attention to a cause. Terrorists sought to shock and attract media attention, then use the spotlight to explain their cause and garner support. While terrorism events were immeasurably tragic in causing loss of life, in the insurance world, they were low-severity exposures.

The tide began turning in the 1990s, shifting abruptly in 1992 when an IRA truck bomb in London's financial district caused hundreds of millions of pounds in damage. This dramatic increase in terrorism's economic toll catalysed the creation of a UK pool for the terror peril, known as Pool Re. Years later, the terrorist attacks on 11 September 2001 catapulted the industry's notion of a worst-case terror event to a new level, prompting governments in the US and elsewhere to create mechanisms to maintain some 'insurability' for terrorism risk.

Today, (re)insurers worldwide continue to exclude terror coverage from their contracts. As is detailed in the recent Guy Carpenter report, Global Terror Insurance Market: The World Continues on High Alert, many governments are becoming more involved in mitigating the terrorism-risk exposure of insurance and reinsurance companies.

Some reinsurers are offering some coverage to complement these government solutions. At Guy Carpenter, our terror team reports that a growing number are even experimenting with coverage for nuclear, biological, chemical and radiological (NBCR) exposures, albeit with low sub-limits. We see some product innovation on the scene, with non-traditional sources of reinsurance capital, specifically banks and hedge funds, circling the exposure. Modelling has improved, and data-management tools help insurers analyse accumulations and exposures across lines of business.

There is also increased interest in multiyear, multi-line structures, in sync with the new plan proposed by the democratic majority in the US and, notably, normally playing below the limits of the proposed government backstop.

Terrorism today

Despite these activities, nearly six years after the tragic events of 11 September 2001, reinsurance capacity for terror cover is reported to be less than $10bn. Terrorism insurance seems stalled in the experimentation phase.

Terrorism is an extremely catastrophic exposure. In 2007, terrorists are motivated by hatred, revenge and religious extremism, such as in Al-Qaeda. Their interest in unconventional weaponry is well documented; their goal is a calamitous event and spectacular economic disruption. The risk is severe and unpredictable in a way no risk has been before. The element of intent sets it markedly apart from the natural catastrophes our industry has wrestled with in the past. There is good reason to doubt whether NBCR exposure can ever be rendered insurable in a meaningful way.

A resolute industry

So what is our industry to do to ensure that we continue to march toward a sustainable solution for insuring terrorism? We must continue to collaborate with governments providing backstop mechanisms, support the hardening of terrorist targets, invest in analysing the risk, and elevate the modelling of terrorism exposure management to new levels.

In the meantime, the terrorists' methods of operation could change again, ratcheting the risk back to low severity. Despite their will, perpetrating future devastation on the scale of the attacks on 11 September 2001 may not be within the terrorists' reach. Down the road, we may see Al-Qaeda rendered ineffective.

Right now, we simply don't know whether our industry's collective efforts will be enough to fuel a private terrorism-insurance market to maturity. The best we can do is to continue to collaborate, gain knowledge and strengthen our industry for whatever lies ahead.