Transcript Disasters, Politics, and Insurance: Theory and Practice Michael G. McCarter, FCAS, MAAA

Disasters, Politics, and Insurance:
Theory and Practice
Michael G. McCarter, FCAS, MAAA
October 7, 2002
CAS Catastrophe Risk Management Seminar
Disasters, Politics, and Insurance
• Theory: AAA Monograph on Insurance Industry Catastrophe
Management Practices
• Practice: Congress and the debate on a Federal Terrorism Backstop
• Theory Vs. Practice: Issues for actuaries to consider
• Society and Risk: Constraints on Actuarial Models
AAA Catastrophe Management Monograph
• Presented to NAIC and Federal Reserve in June, 2001
• An overview of theory and practice of insurers in managing catastrophe
exposures
• Designed to help the Federal Reserve Board better understand insurers
given its role as the umbrella financial services regulator under GrammLeach-Bliley
AAA Catastrophe Management Monograph (cont.)
• Definition of catastrophes
• Insurer capital considerations
• Insurer management of catastrophe exposures (5 iterative steps)
• Reinsurance and risk transfer
• Public policy implications
AAA Catastrophe Management Monograph (cont.)
• Emphasized challenge to insurer capital caused by lack of
independence of catastrophe exposures
• Discussed exposures to natural disasters and methods of modeling,
controlling and financing such exposures
• No mention of exposure to catastrophes caused by terrorism
• Public policy discussion included the implications of various possible
capital and reserve requirements
The World Before September 11, 2001
• Pool Re established in the UK in 1993 as a result of IRA bomb attacks
• Compulsory government scheme in Spain covers Basque terrorist
attacks
• But we never thought serious terrorism could happen here, even though
it already had begun
The World Before September 11, 2001 (cont.)
• 1993 First World Trade Center Bombing: 6 Killed,
Insured Loss $725 Million
• 1995 Oklahoma City Bombing: 166 Killed, Insured Loss $145 Million
• Terrorist attacks on US lives and property in a number of foreign
countries
The World Before September 11, 2001 (cont.)
• Each event was regarded as unique, a subject for Tom Clancy or
Hollywood, but not as a precursor of more to come
• AAA Catastrophe Risk Management Committee presented its paper to
the NAIC and Federal Reserve Bank staff in June 2001
• It provided a good conceptual overview and primer on catastrophe risk
management for insurers, but there was no serious discussion of
terrorism risk (I served on that committee)
The World Before September 11, 2001 (cont.)
• So, in that far away world, we can see why:
• Most insurance policies were silent on terrorism exposure, and by
implication covered it
• Most reinsurance policies were silent on terrorism exposure, and by
implication covered it
• There was no significant push to evaluate or do anything about US
terrorism exposure
September 11, 2001
• A stunning, coordinated attack by foreign terrorists on US soil
• 3,014 victims killed
• Insured losses estimated to exceed $40 billion
• A sudden sea change in our assumptions: it can happen here
Insurance Industry Reaction to September 11, 2002
• Announced that claims would be paid without invoking war risk
exclusions
• Insured loss estimates have been as high as $70 Billion
• A majority of those losses will fall to the relatively small reinsurance
industry due to the prevalence of excess of loss reinsurance
• An already hardening market hardened more
Ins. Industry Reaction to September 11, 2002 (cont.)
• Reinsurers realized they could not withstand another such event and
saw terrorism exclusions as the only short-term solution that could
protect their solvency
• Insurers realized that their solvency could be threatened by terrorism
exposure, especially with reinsurance coverage vanishing, but terrorism
exclusions weren’t going to be the complete answer
• Many exclusions would require regulatory approvals, and workers
compensation and the standard fire policy did not permit such
exclusions
Ins. Industry Reaction to September 11, 2002 (cont.)
• But the “exclusion solution” is unsatisfactory because it transfers the
terrorism risk back to insurer customers without giving them any tool to
deal with it
• Private insurers did step up to develop facilities to provide some
terrorism coverage, e.g., for aviation where insurers thought they could
understand and quantify the terrorism risk
• To enable insurers to provide more generally the coverage their
customers need, US insurers outlined a “Pool Re” type proposal within a
month of 9/11
The US “Pool Re” Proposal
• A nationally chartered mutual insurance company that would offer
reinsurance to member companies.
• In turn, it would buy reinsurance from the Federal government to cover
losses in excess of its aggregate retention
• The proposal existed in outline form, with many issues left for resolution
during the debate
• Potentially, this was the most market-oriented proposal
The US “Pool Re” Proposal (cont.)
• Possibly would have required some anti-trust exemptions for the rate
and coverage determination process
• Many other issues had not been resolved, including the tax treatment,
who would be the principal regulator, or even whether membership
would be voluntary or mandatory
• However, insurers might have been able ultimately to choose to
compete against Pool Re’s prices and coverages, re-introducing
competition into the terrorism insurance market
The US “Pool Re” Proposal (cont.)
• Pool Re was a tested concept. It had worked in the UK
• However, there were a lot of details to resolve, and it entailed creating a
permanent entity
• Politicians quickly concluded that what was needed was an “interim”
solution, one which gave the private insurance market time to recover,
adjust, and begin providing terrorism coverage
• The first proposal to emerge became the first proposal to die politically
The White House / Treasury Plan
• Designed to reassure markets that terrorism insurance was available in
the short run and provide time for markets or government to develop a
more permanent solution
• A three-year plan, paying 80 to 90 percent of claims from the ground up
to $100 billion in payments each year
• Many limits on the types of claims eligible for compensation (no claims
for punitive damages)
The White House / Treasury Plan (cont.)
• Insurers would not pay premiums for the plan or repay plan payments
• Those features seemed too generous to Congress, and the White
House Plan was never actually introduced.
• Some of its ideas were incorporated in the Sarbanes-Gramm-Dodd
“Senate Compromise” plan
Sarbanes-Gramm-Dodd Senate Bill
• Similar to the White House Plan (no insurer payments for the plan)
except:
• One year plan, with an option for an additional year
• Industry deductible ($10 billion first year, $15 billion second year)
apportioned to insurers based on gross written premium market share
• Federal aid capped at $100 billion a year, but insurers freed from
liabilities exceeding that amount
Sarbanes-Gramm-Dodd Senate Bill (cont.)
• State law pre-empted on definition of terrorism and on prior approval of
rates and forms
• Probably less agreement on tort limitations, although it’s hard to tell
since the bill did not reach final form in 2001
• Terrorism defined as acts by foreign entities
• This is the bill the Senate didn’t pass at year-end 2001
H.R. 3210 - Oxley Bill
• Passed the US House of Representatives on November 29, 2001
• Political advantage: not a taxpayer “bailout” of the insurance industry,
since the federal assistance was characterized as a loan rather than
direct aid
• The facility would pay (as a “loan”) 90% of aggregate terrorism losses
exceeding an industry or individual company trigger
• However, the “loans” are not repaid by the insurers receiving them, but
by assessments on all insurers based on market share
H.R. 3210 - Oxley Bill (cont.)
• If the total “loans” exceed $20 billion, surcharges could be imposed on
policies to repay the federal government.
• Total “loans” could not exceed $100 billion, and the program would be
for two years with an option to extend for another two years
• Terrorism defined as an act by a foreign entity
• Includes a number of restrictions on the damages covered and partially
preempts state laws
H.R. 3210 - Oxley Bill (cont.)
• Some concerns with H.R. 3210:
• The “loan program” appears unlikely to attract capital to providing
terrorism coverage
• It also provides little incentive for good underwriting of the terrorism
exposure. Like guaranty funds, it leaves strong companies to pick up
the pieces of weak ones.
• It doesn’t deal with domestic or “unknown” terrorists, or losses greater
than $100 billion
At the end of 2001
• The perception was that a federal terrorism backstop needed to be
passed, or the sky would fall in January, 2002
• Oxley’s bill, H.R. 3210, passed, but the Senate could not agree on any
bill, apparently due to opposing positions on tort reform language
• Congress adjourned before Christmas, and in January 2002 the sky did
not fall
• The perception of the chances of Senate action on a Federal Terrorism
Backstop became very negative
2002: The Sky may be Falling, only Slowly
• Although there appeared to be no enthusiasm in the Senate for action
on Terrorism insurance, there appeared a slow drumbeat of studies
building a case for action
• February 26, 2002: GAO releases report on terrorism insurance
• “Rising uninsured exposure to attacks heightens potential economic
vulnerabilities”
• Contained some anecdotal evidence of the impact of lack of terrorism
insurance on commercial property transactions
2002: The Sky may be Falling, only Slowly (cont.)
• April 15, 2002: ISO and NAII release property/casualty industry results
showing first ever net loss ($7.9 billion) for a full year. Including
unrealized losses, industry surplus fell $27.7 billion, or 8.7%, to $289.6
billion compared to $317.4 billion a year earlier
• And these numbers included only about $10 billion of 9/11 losses on a
net basis. There could be another $15 billion to come on that basis
• Financial results like these provided incentive for a hardening market
2002: The Sky may be Falling, only Slowly (cont.)
• April 17, 2002: AAA Extreme Events Committee releases statement
entitled Terrorism Insurance Coverage in the Aftermath of September
11th
• It reports on the significant acceleration of the market price firming post
9/11, and on exposure and coverage issues facing insurers and
reinsurers.
• It points out that Workers Compensation and other coverages can pose
a serious solvency threat due to terrorism exposure
2002: The Sky may be Falling, only Slowly (cont.)
• May 1, 2002: JEC releases a study, “The Economic Costs of Terrorism”
• This study discusses how the costs of terrorism impose a drag on the
economy through increased transaction costs and other inefficiencies
• Effectively functioning insurance markets are needed to reduce those
inefficiencies
2002: The Sky may be Falling, only Slowly (cont.)
• May 23, 2002: JEC releases second study entitled “Economic
Perspectives on Terrorism Insurance”
• It concludes that the market for terrorism insurance remains limited, and
very expensive where available
• The problems associated with terrorism insurance “pose a significant
threat to sustained economic growth”
Have the terrorists gone away?
• USA Today Headline (June 11, 2002) “U.S.: ‘Dirty bomb’ plot foiled”
• Other headlines: “U.S. won’t dismiss possible July 4 plot”
• “U.S. Fears Use of Belt Bombs”
• “U.S. Alters Estimate of Threats” - The new National Intelligence
Estimate says that the U.S. is more likely to suffer a terrorist attack
using weapons of mass destruction than an attack by a foreign country
using long range missiles
Even Bankers are starting to understand
• Well, not all of them: “Insurance Gap Has Little Effect According to Fed
Poll”. But:
• “Terror-Insurance Flap Ensnares Opryland Deal”
• “Moody’s Real-Estate Review Puts Terrorism Insurance in Spotlight”
• “Terror Insurance Cost Pits Lenders, Owners”
The Senate Acts
• A version of the Sarbanes-Gramm-Dodd bill was introduced as S. 2600
and was passed on June 18, 2002
• However, tort liability issues appear to be separating people as much as
ever
• Congress is scheduled to adjourn on Friday, October 11 for the
elections, and it needs to get the appropriations bills done
• The Conference Committee has not yet produced a compromise bill
But will Congress Act?
• The Conference Committee would have to agree on a compromise
between the House and Senate versions.
• Then both Houses of Congress would have to pass the compromise
version to send it to President Bush for his signature
• Could it happen? Yes
• Will it happen? Possibly in a “lame duck” session
Workers Compensation Issues
• A coalition of business leaders has asked Washington to consider action
on a Federal Backstop for Workers Compensation
• No terrorism policy exclusions are permitted for Workers Compensation,
so the risk to solvency of a terrorism catastrophe is particularly great
• WC is a “no-fault” type coverage, so the tort liability issues holding up
action on other proposals can be finessed here
• This proposal is in its early days, and no bill draft is yet available
Assume Congress Acts: Actuarial Issues
• The Federal Terrorism Backstop proposals are temporary - one or two
years with possible extensions for a similar period
• The terrorism threat is not temporary
• The CIA National Intelligence Estimate evaluates major terrorist attacks
as more likely than long-range missile attacks
• Actuaries and insurers must consider how to deal with the “sunset
clause” of the Federal Backstop proposals
Assume Congress Acts: Actuarial Issues (cont.)
• The Federal Terrorism Backstop proposals have limitations on coverage
in terms of deductibles, limits, and definitions of covered events
• The NAIC has indicated it wants to reconsider the issue of terrorism
exclusions in the event Congress passes Federal Backstop legislation
• Actuaries and insurers need to consider how to pay for insurers’ residual
terrorism exposure, and the exposure that might be returned to them if
state regulators disapprove terrorism exclusions
Assume Congress Acts: Actuarial Issues (cont.)
• Are manmade and terrorist-caused insurance catastrophes an entirely
new thing?
• No - even natural disasters have a manmade component, as it is
manmade things that are insured and paid for
• No - aviation coverage and ocean marine coverage have often included
war risk coverages for a price
• Yes - modern complexity and interconnection gives the terrorist a
broader selection of bigger potential targets
Society and Risk: Constraints on Models
• Do we model and attempt to cost all possibly conceivable manmade
events, even the most unlikely?
• No - some events are too big to finance. Consider the dinosaur-killer
asteroid. Insurers don’t need to charge for it, because they won’t be
around to pay for it.
• No - some events are too rare to finance. The 1-in-10,000 year asteroid
(or hurricane, or earthquake, or volcano) may do significant insured
damage, but policyholders aren’t willing to pay for such coverage
(unless such an event has just happened).
Society and Risk: Constraints on Models (cont.)
• Is risk financing the only issue in considering how to deal with manmade
and terrorist caused catastrophe risks?
• No - Consider the risk mitigation efforts undertaken by our government
in Homeland Security, air transport security, and in the war against
terrorism
• It should be harder today than it was pre-September 11 for a terrorist to
cause a large loss
Society and Risk: Constraints on Models (cont.)
• Is the tradeoff between risk financing and public risk mitigation a new
concept?
• No - Remember “Millions for defense but not one cent for tribute”. The
United States Navy was founded as a risk mitigation device. Even 200
years ago marine insurance premiums reflected the cost of the
depredations of the Barbary Coast pirates.
Other Manmade Catastrophe Modeling Issues
• Severity modeling is key for controlling accumulations of exposure. This
is a natural outgrowth of similar modeling for natural hazards.
• Frequency modeling is in its infancy, and may be difficult to make
credible in a numerical sense. Given responsive risk mitigation efforts,
the standard modeling assumption of independent events is unlikely to
hold for terrorism.
Summary: Disasters, Politics, and Insurance
• There’s been a rapid and deep change in the U.S. insurance industry’s
consideration of its exposure to manmade catastrophes
• Congressional action, assuming it occurs, will allow management of
aggregate exposure, but will not remove the need for insurer
consideration of and action on terrorism issues
• Society as a whole will focus on mitigating the risk of manmade and
terrorist catastrophes
• Actuaries will focus on how to finance the residual catastrophe risk,
considering the bounds of what society is willing to pay for
Thank you!
Any questions?