TERRORISM RISK COVERAGE AFTER 9/11: A COMPARISON OF NEW PUBLIC-PRIVATE PARTNERSHIPS IN FRANCE, GERMANY AND THE U.S.

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1 TERRORISM RISK COVERAGE AFTER 9/11: A COMPARISON OF NEW PUBLIC-PRIVATE PARTNERSHIPS IN FRANCE, GERMANY AND THE U.S. by Erwann Michel-Kerjan 1 and Burkhard Pedell 2 This Draft: January 31, INTRODUCTION Although international terrorism is not a new risk, the perceived nature of risk associated with terrorist attacks has changed radically with the unutterably abominable September 11, 2001 events (9/11) (Liedtke and Courbage, 2002). These attacks killed nearly 3,050 persons 3, leading people to perceive in which state of insecurity they were living 4. Until then the risk of such large-scale attacks was underestimated by a range of agents among which insurers, who may have considered that such a scenario appeared to be more a warlike event (so excluded by policies) and thus have underestimated the political difficulty to enforce war exclusions ex post 5. The levels of direct effect on insurance and reinsurance industry in particular and on insurability of terrorism risk in general are serious. Indeed, these attacks inflicted direct damage currently estimated at nearly $80 billion, about half of which was insured 6. Reinsurers (most of them European) will pay over half of the $40 billion insured losses. Having their capital base severely hit 7, most of them decided to drastically reduce their exposure to terrorism risk, or even stopped covering such a risk. Not only 9/11 constitutes the most costly event ever in the history of insurance (Swiss Re, 2002; Liedtke and Courbage, 2002), but this also reveals highly correlated risk at two different levels. First, multiple lines were affected instantaneously on 9/11 such that commercial property, business interruption, 1 The Wharton School, Center for Risk Management, Jon M. Huntsman Hall, Suite 500, 3730 Walnut Street, Philadelphia, PA 19104, USA, erwannmk@wharton.upenn.edu. ; (Corresponding author). 2 Munich School of Management, Institute for Production Management and Managerial Accounting, Ludwigstr. 28 RG V, Munich, Germany; pedell@bwl.uni-muenchen.de 3 This number represents victims of the attacks in New York, Washington, DC and Pennsylvania as well as among teams of those providing emergency service. 4 The view of a major shift in terrorism risk perception is actually supported by evidence that the likelihood of terrorist attacks has not increased after 9/11 but people assess the risk in a more realistic way (Sandler and Enders, in press). 5 Kent Smetters provided us with this interesting insight. 6 The exact amount is still evolving and can differ from a study to another depending on what types of loss are considered. 7 9/11 came on the top of a series of catastrophic natural disasters over the past decade (e.g. major floods affecting Central Europe during the summer of 2002) and portfolio losses due to stock market declines. 1

2 workers compensation, life, health, disability, aircraft hull, and general liability lines each suffered catastrophic losses. Second, there is now a well-recognized possibility that several catastrophic attacks can occur simultaneously in different densely populated and industrialized locations. Hence, this event confronted the insurance and reinsurance industries with an entirely new loss dimension. Indirect effects on social and economic activities in the United States (U.S.) (especially in New York City) and abroad were even more important (Lelain, Bonturi and Koen, 2002; de Mey, 2003). 9/11 attacks against the U.S. raised obviously numerous questions related to counter-terrorism, foreign policy as well as national security in the U.S. and abroad (White House, 2002; OECD, 2003; Michel- Kerjan, 2003-c). They also raised a fundamental question as who should pay for losses due to terrorism. Indeed, these events showed how insurers, deprived of reinsurance capacity at an affordable price, could decide to stop covering terrorism (or severely restrict the insurance supply) and hence let people and firms uncovered. However, because terrorism is now recognized to be capable of inflicting a debilitating impact on the social and economic activities of a country, covering it constitutes national issue. There is a bourgeoning literature debating whether government or the private sector is in a better position to cover more efficiently such losses should another attack occur (Brown, Kroszer and Jenn, 2002; Cummins and Doherty, 2002; U.S. General Accounting Office, 2001 and 2002; Russell, 2003; Brown, Cummins, Lewis and Wei, 2004). The question as to whether there should even be any government intervention in terrorism insurance market is discussed by others (Gron and Sykes, 2002; Priest, 2003; Jaffee and Russell, 2003). At that time, the debate tends to focus on the possible difficulties that the private market of insurance could face in providing terrorism insurance and as to whether these really constitute market failures anyway (Smetters, 2004). A third view, which builds on other recent contributions (Michel-Kerjan, 2003-b; Kunreuther, Michel- Kerjan and Porter, 2003), argues that international terrorism is, above all, a foreign policy issue and a matter of national security (Pillar, 2001). These very specific characteristics as a catastrophic risk, among others, call for governmental participation in any insurance scheme for covering against terrorism. Such a perspective must be clearly distinguished from government intervention because of possible so-called market failures. This latest view is actually largely supported by evidence not only in regards of solutions established in several countries after 9/11 but also on how these solutions emerged from interaction between representatives of government and private insurance industry. In this whole context, the question addressed by this paper is: how the public and private sectors have established partnerships for covering terrorism risk as a reaction to the 2001 terrorist attacks. The goal here is to analyze the situation as to how this question has been answered in the country that suffered these attacks as well as in two European countries, France and Germany. 2

3 Nearly three years after 9/11 attacks and with the current tension of the international scene, confirmed by recent attacks and new alerts, this paper could help a range of stakeholders (insured, insurers, reinsurers, policymakers) to better understand how well foreign solutions are working in practice and whether some features would be more appropriate for each country. The paper is divided into two main sections. Next section describes and analyses the functioning of the three public-private partnerships (chronologically launched): the French GAREAT established in December 2001, the German Extremus established in September 2002 and the U.S. Terrorism Risk Insurance Act of 2002 (TRIA) that was passed in November Section 3 discusses several elements for comparison of these schemes such as limited exposure of the private sector, incentives for risk mitigation as well as the current level of demand as far as available data are considered and announced government exit strategy. A conclusion summarizes the results and raises open questions for future research. 2. INSURANCE SCHEMES FOR COVERING TERRORISM RISK 2.1. GAREAT: The French Scheme 8 Timeline Discussions took place in October 2001 between representatives of French insurers and government. On December 10, 2001, the French government signed an agreement with FFSA and GEMA 9, the two major representative institutions from the French insurance market. The reaction to the new paradigm of terrorism threats has been swift in this country for several reasons. First, the situation in France was really acute because the law does not allow commercial property insurers to dissociate terrorism coverage from commercial property. Indeed, the law of September 9, 1986 obliges insurers to provide terrorism coverage up to the overall limits of a property policy. As the law does not requires reinsurers to do that, most of them declined to cover acts of terrorism after 9/11. Because of that, French insurers that would not like to continue to cover against terrorism had not other choice than simply not offering any property policy at the 2001 renewals. As a result of that, many businesses considered as potential targets for terrorist attacks would have been left not only without coverage against terrorism but also without commercial property damage and business interruption protection. Another factor accelerated those negotiations: the expectation of possible new terrorist attacks against France or French interests in the world. The explosion of the chemical factory AZF (owned by TOTAL) that occurred on September 21, 2001 in a high densely populated area as the city of Toulouse in the south of France contributed to increase these threats. While the event occurred only 10 days after 9/11, its origin was still not publicly recognized 16 months after 10. This 8 This section benefited from discussions with Jacques de Paris and François Vilnet, respectively Chairman and vicechairman of GAREAT. 9 FFSA, Federation Française des Sociétes d Assurance, is the association of the French insurers; GEMA, Groupement des Entreprises Mutuelles de l Assurance, is the association of French mutuals. 10 The possibility that the catastrophe was due to a terrorist attack was still discussed by French media in January

4 chemical explosion, which constitutes one of the most important industrial catastrophes in the last 10 years in Europe, killed 30 people, injured several thousands, and inflicted more that 2.3 billion of direct insured damages. Negotiations between French government and the private sector of insurance took place in this highly turbulent context. A consensus was found quickly that led to drawing up an agreement establishing a reinsurance scheme against terrorism risks beginning on January 1, This agreement, signed on December 10, 2001, is based on a public-private partnership through the creation of a specific French terrorism pool of co-reinsurance, the GAREAT 11. Because of that, terrorism coverage for firms and households has never stopped since September 11, 2001 in France. Gareat is the first post 9/11 State backed terrorism pool. Eligibility for coverage To be eligible for this new coverage, the risks have to cross three concurrent factors. The pool covers French commercial and industrial risks for property damage and business interruption except for a few exclusions. For instance, it does not cover liability risks and personal lines. On a territorial aspect, the risk has to be located in France 12. Finally and this is an important point the pool covers only property for which the sum insured for direct property damage and business interruption is higher than 6 million (medium/large risks only) 13. Therefore, the French solution is not a total mutualization of risks but a combination of major risks reinsured by the pool and a normal reinsurance capacity provided by the market for simple commercial risks/cars. Premiums Reinsurance rates by Gareat apply to property premiums and only depend on the sum insured (based on the sum insured for the natural catastrophe coverage, a mandatory coverage first established in France in ) for which four categories are defined. For sums insured higher than 6 million and lower than 20 million, the insurer pays a premium equal to 6% of the commercial property and business insurance premium paid by the insured 15 ; for sum insured higher than 20 million but lower than 50, the applied percentage is 12%. When sum insured is higher than 50 million, the insurer pays a premium equal 11 Gestion de l Assurance et de la REassurance des risques attentats et Actes de Terrorisme (Management of Insurance and Reinsurance against Terrorist Acts, in French). 12 Including overseas territories and departments as well as Mayetta; Assaults to foreign affiliates of French firms are thus not covered. 13 When there is a contractual loss limit, this is considered as the sum insured. For contacts that do not specify such a sum insured, the risk is ceded to the Gareat if the total floor building area is higher than 20,000 m2 and if the premium paid by the insured to be covered by the French national insurance scheme against natural catastrophes (legally speaking; see Michel-Kerjan, 2001) exceeds 6, That scheme, called the Cat.Nat system, remains unique in the world (Michel-Kerjan, 2001). 15 The insurers continue to cover lower risks without the possibility for them to be reinsured by the pool. In particular, the insurance contracts of individuals are not modified. 4

5 to 18% of her basic insurance premium 16 (see Figure 2). Finally, for special risks (nuclear, captives or property over 750 million euros 17, nuclear or captives) the rate is quoted individually. It must be stressed that these rates are the same whatever the location and the nature of the risk. Moreover, the agreement only focuses on reinsurance by Gareat and does not specify any pricing rule for the direct insurers to be levied against the insured. Gareat does not ask for an additional deductible than the one already applied to direct insurance contracts. Sum insured (Million euros) % 12% Rating scale applied to a risk s segmentation by size of sum insured for middle/high risks only 6 6% Insurers continue to cover small risks (individual, small business) without specific extra premiums Figure 2. Reinsurance premium rates by Gareat To date, on an annual basis, nearly 90,000 policies are contracted with Gareat. Around 70% of the policies are contracted for sum insured fewer than 20 million euros but represent only around 20% of the total premiums. Policies with sum insured above the threshold of 50 million euros represent only 10% but count for nearly 60% of the total premiums. (PartnerRe, 2003; Gareat, 2004). The 2002 estimations of the amount of sums reinsured overall are nearly 1,400 billion and have generated 1,500 million of commercial property and business interruption premiums. The estimations of the total premiums collected by Gareat for the terrorism insurance coverage were 200 million in 2002, 250 million in 2003 and are estimated now around 260 million for In 2002, the first year of operation of the system, the average reinsurance rate (6-18%) was hence 13.3% of the premiums collected by the insurers from their insured and the average terrorism coverage rate by the pool was around 0.14 of the sum insured. Structure of the partnership The GAREAT is a co-reinsurance pool organized under a four-tier structure of risk sharing and shareholders. It operates on an aggregate annual excess of loss basis. (Figure 3). 16 The French decree dated December 31, 2002 allows insureds with sum insured higher than 20 million to limit their cover for acts of terrorism to 20% of the property damage guarantee; if so a reduction could be granted if the cover is only partial. The insurers do not recommend such an action. 17 To date 25 policies enter into this category. 5

6 The first layer presents an annual aggregate capacity of 400 million 18 in It shares the risk through co-reinsurance between all members of the pool pro-rata to their share of ceded business (nearly 70 non life FFSA and GEMA companies for which the membership is compulsory and nearly 35 other companies operating in the French market which chose to join). This first layer keeps 30% of the premiums ceded to the pool 19. Some insurers participating in the first line of the GAREAT and reinsurers write the second layer 20, with an annual aggregate capacity of 1,250 million 21. This placement is led by Swiss Re in partnership with nearly 30 other firms among which AIG, AXA, AGF, Hannover Re, Munich Re and Scor, for a total annual charged premium that represents 50% of total premiums levied by Gareat. These two layers provide a total capacity of 1,650 million 22. The third layer is placed on international reinsurance markets for an additional 350 million and is led by Hannover Re ; they retain nearly 10% of pool premiums. The fourth layer is an unlimited guarantee by the French government provided through the Caisse Centrale de Réassurance (CCR), a state-own reinsurance company, that receives also nearly 10% of the total pool premium in return. (Figure 3) ( INSERT Figure 3. The French GAREAT ) Renewal and government exit strategy The pool was first set up for one year only with the option to be renewed as it was done in December 2002 for the year After two years of operation, a new three-year partnership was established last December and will end December 31, This renewal comes with an increasing capacity of private partners that has been already doubled between 2002 and This represents an important modification relative to the market in this country. Moreover, whereas retention by the first layer has not been modified since the creation of Gareat, it will start increasing in The increase of the total capacity of the scheme should continue in the coming years in order to limit governmental intervention to extreme events. 18 Versus 250 million in 2002 and 400 million A new decree was passed in 2002 authorizing equalization reserves for insurers on terrorism premiums in the cumulated limit of 500% of the annual terrorism premium. 20 Nearly 30 reinsurers participate among which Swiss Re, Munich Re, Hannover Re, AGF, AXA, SCOR AIG and Partner Re (Partner Review, 2002). 21 Versus 750 million excess of 250 million in 2002, respectively 1,100 million excess of 400 million in The maximum capacity for each reinsurer is based on capital and ratings, from 300 million for S&P AAA rated reinsurers to 10 million for BBB- ones. 6

7 2.2. EXTREMUS AG: The German Scheme Timeline The German public-private partnership for terrorism insurance is based on a the creation almost a year after the terrorist attacks of 9/11 of a new firm, Extremus AG. The structure of Extremus, founded on September 3, 2002, results from several months of negotiations between the German government and major German insurance and reinsurance companies. 23 Until the events of 9/11, insurance against terrorism risk was included in commercial lines without an extra premium in this country. After these events, some insurance companies completely excluded terrorism risk; others offered coverage with fairly restrictive upper loss limits against an extra premium. The creation of Extremus aimed at filling this gap. Several weeks after the foundation, the Federal Commission for the Supervision of Financial Services approved Extremus on October 22, Shortly after, on November 1, 2002, it went into business. Extremus is based in Cologne, disposes of a staff of about ten employees, and shares office with the German nuclear power plant insurance pool, existing since It has no sales and claims management departments of its own, and relies on insurance brokers and the involved insurance companies. Lines for terrorism risk coverage only can be signed in connection with existing fire insurance. Moreover, terrorism insurance remains not compulsory in Germany. Eligibility for coverage Extremus covers terrorism risk for sums insured over 25 million. In Germany, nearly 40,000 firms are exposed to risks over this threshold. This corresponds to the number of potential contracts, as a firm has only one contract for all of its plants. Both, the act of terrorism has to be committed in Germany, and the damage has to be occurred in Germany to be eligible for coverage. Acts of terrorism are defined as actions by a person or a group of persons in pursuit of political, religious, ethnical or ideological aims that are appropriate to spread fear and terror in the population and to influence thereby a government or a governmental institution. 24 The damages have to be caused by fire, explosion, airplanes, and other evil-minded acts. Damages caused by computer viruses are explicitly excluded. War and civil war, looting, nuclear, biological and chemical risks as well as third party risk of aviation are not covered. Insurance by Extremus covers buildings, contents of buildings like machinery as well as business interruption. The annual compensation for every single firm is limited to a maximum of 1.5 billion. 23 Unit now, there exists no public-private partnerships for the insurance against natural catastrophes, which could have been a model for the design of a partnership for terrorism risk coverage, as was the case in France. Since the flooding in Germany in the summer of 2002, this issue is more intensely discussed. 24 Terrorakte sind jegliche Handlungen von Personen oder Personengruppen zur Erreichung politischer, religiöser, ethnischer oder ideologischer Ziele, die geeignet sind, Angst oder Schrecken in der Bevölkerung zu verbreiten und dadurch auf eine Regierung oder staatliche Einrichtung Einfluss zu nehmen. ; general conditions for the insurance of terrorism risk by Extremus AG, p. 1 ( 7

8 Premiums A firm that wants to cover one of its installations needs also to choose a specific maximum annual compensation for terrorism coverage (by definition lower than the basic sum insured). This annual compensation is capped at a maximum of 1.5 billion. The premium only depends on the sum insured and on the maximum annual compensation chosen by the insured. Although Extremus defined internally a premium function, only a few examples of these premiums are publicly available. The average premium rate increases non-linearly with the sum insured. This means that the premium increases super proportionally with the sum insured. At that time, the average premium of these contracts is below Table 1 gives an overview of these premiums as published by Extremus. These examples, however, do not allow extrapolating the premiums for higher levels of sum insured. Premiums are not differentiated with respect to kind and location of risk. For instance, there are no premium discounts for mitigation measures taken by the insured. The premium income is distributed between the participating partners of Extremus and the government who receives a fraction of 9%, which is planned to increase to 14% in the future. Table 1. Insurance Premiums published by Extremus Sum insured Maximum annual compensation Annual Premium in Euro in 25 million 25 million 6, million 25 million 8, million 25 million 10, million 10 million 6, million 30 million 9, million 40 million 10, million 50 million 12, million 50 million 63, million 100 million 84, million 150 million 104, million 200 million 124, Source: Extremus Versicherungs-AG (2003) 25 Extremus (Personal communication). 8

9 Structure of the partnership Extremus directly covers insured against terrorism risk and thereby is 100% reinsured by its shareholders, who are private insurance and reinsurance companies 26 and by the federal government. As depicted in Figure 4, the annual coverage capacity provided in three layers is limited to 13 billion. ( INSERT Figure 4: The German Extremus AG ) The shareholders of Extremus provide the first layer of 1.5 billion. Each shareholder has to underwrite for at least 5% of this layer. The second layer of another 1.5 billion is provided by international reinsurers lead by Berkshire Hathaway. It is only used if claims in a certain year pass 1.5 billion. The third trench comprises 10 billion. Here, the federal government comes into play. It takes the role of a reinsurer of last resort if claims in a certain year pass 3 billion. In contrast to the French scheme, government liability is limited. Indeed, according to German federal budget law, the government is prohibited to take unlimited liabilities. Each insured has to bear a general deductible of 1% of her maximum annual compensation. Renewal and government exit strategy The agreement with the federal government would be limited to The federal government announced to phase out its involvement thereafter. To reach this goal, it is critical that Extremus can build up reserves over the next three years. However, even if it is planned to increase the trench covered by insurance and reinsurance industries over the years, the shareholders of Extremus support the view that the federal government should extend its participation beyond The U.S. Terrorism Risk Insurance Act of 2002 (TRIA) 27 Timeline As did insurers in European countries in the aftermath of the September 11 attacks, many U.S. insurers warned that another event of comparable magnitude could do irreparable damage to the industry. Further, they argued that the uncertainties surrounding terrorism risk were so significant that it was, in fact, an uninsurable risk. A first proposition of partnership between insurance industry and the federal government introduced by the Congress in autumn 2001 did eventually not pass. By early 2002, no less than 45 States permitted insurance companies to exclude terrorism from their policies 28. On the one-year anniversary of the attacks, the United States remained largely uncovered (Hale, 2002). In only a few states or for specific insurance lines, as workers compensation, exclusion of terrorism risk was not allowed. As, at the same time, insurance regulators were reluctant to approve higher insurance rates for workers 26 The 16 shareholders are AIG, Allianz, AMB, Deutsche Rück, DEVK, Gerling Allgmeine, Gerling Globale, Gothaer, HDI, HUK Coburg, LVM, Munich Re, German Re, NOVA Allgemeine, R+V, Swiss Re, VHV and Zürich Agrippina. 27 This section is based on Kunreuther, Michel-Kerjan and Porter (2003) and Michel-Kerjan (2003-a). 28 Exclusion of terrorism risk for property insurance was not allowed in 5 states (California, New York, Texas, Florida and Georgia): i.e. for nearly 35% of the commercial insurance market. 9

10 compensation (Hartwig, 2001), insurers cancelled those contracts completely, leaving industry uncovered not only against terrorism risk but also against others risks as well. The President and the U.S. Congress viewed such a situation as unsustainable. If the country suffered future attacks, it would inflict severe financial consequences on affected businesses deprived of coverage. The Terrorism Risk Insurance Act of 2002 (TRIA), which provides for up to $100 billion of federal terrorism insurance, was passed by Congress in November 2002 and signed into law by President Bush the next month. Eligibility for coverage According to TRIA, an act of terrorism has to be committed by an individual or individuals acting on behalf of any foreign person or foreign interest, as part of an effort to coerce the civilian population of the U.S. or to influence the policy or to affect the conduct of the U.S. Government by coercion. Therefore, an event like the Oklahoma City bombing of 1995, which killed 168 people and had been the most damaging attack on domestic soil, would not have been covered under TRIA. Moreover, insured losses from commercial lines of insurance as well as business interruption due to an attack are covered under TRIA only if the event is certified by the Treasury Secretary as an act of terrorism and only for total losses higher than $5 million. Premiums As opposite to how Gareat and Extremus operate, TRIA does not define any national rule to be applied for insurance premiums. Because of that, there is no simple answer to as how two different insurance companies have priced terrorism coverage for their clients. It must be stressed that the law obliged U.S. insurers to offer terrorism coverage to all their insured in a three-month period of time after the passage of the law in November However, clients could turn this coverage down; i.e. a mandatory offer but no mandatory coverage 29. The main challenge for insurers was to quantify the risk to be in a position to price coverage for a risk they would have preferred not to cover. The recent development of a new generation of models to quantify exposure to terrorism risk in the U.S. (created separately by AIR, RMS and EQECat) could help the insurers establish more precise figures regarding premiums as a function of the exposure of a client (e.g. its location, type of activities, well-known name, etc.). Because terrorism models have been applied to thousands of potential targets, they can provide a picture of the relative risk by state, city, zip code and even by individual location. For example, at the start of 2002, the Insurance Services Office (ISO) used the estimates provided by AIR (one of its subsidiaries) to file advisory loss costs with the insurance commissioner for each state Except for worker compensation coverage that is required for every firm. 30 A loss cost is defined by ISO as the long-term average annual expected loss (as generated by the AIR model) per $100 of insured property value. It is used to set insurance rates, or premiums, after the addition of such things as an expense load to cover administrative fees, a profit margin, and a risk load. Once an ISO advisory loss cost has been approved by a state, any insurance company can adopt it without having to undertake their own often lengthy and expensive rate filing process. 10

11 ISO defined three tiers for the country. ISO s study placed Washington, DC, New York, Chicago and San Francisco in the highest tier and recommended loss costs in those cities of $1 per $1000 (1 ) of property value. A second tier consisted of Boston, Houston, Los Angeles, Philadelphia and Seattle; the rest of the country fell into the third tier. ISO s recommendations were not, however, well received by cities in the first tier who felt they were being treated unfairly and some of whose politicians complained that such premiums would drive out businesses. Negotiations ensued and compromises were made. ISO filed revised loss costs for first-tier cities based on zip code level model results, which differentiated between the higher risk of downtown city centers and the lower risk of properties on the outskirts. Nevertheless, nowhere did the new advisory lost costs exceed Thus, while the new official advisory loss costs no longer adequately reflected the risk in the eyes of the modelers, they became more palatable for a number of stakeholders. The Departments of Insurance of all 50 states eventually approved ISO s 2003 loss costs. A revised scale for 2004 is now being filed. These levels hence seem quite subjective and there are only for advisory purpose. It is up to insurers to follow them or not. The Treasury Department is required by Congress to undertake studies of the supply and demand for terrorism coverage so that more informed decisions on whether TRIA should be renewed in 2005 may be made. Those studies should contribute to a better understanding of the current level of demand for terrorism insurance as well as to suggest possible improvements in the partnership to create a more stable insurance market should another attack occur. Structure of the U.S. partnership Under TRIA s three-year term 32, there is a specific risk-sharing arrangement between the federal government and insurers that operates as follows. First, the federal government is responsible for paying 90% of each insurer s primary property-casualty losses during a given year above the applicable insurer deductible up to a maximum of $100 billion. The insurer s deductible is determined as a percentage of the direct commercial property and casualty earned premiums of each insurer the preceding year. The percentage varies over the three-year operation of the public-private partnership: 7% in 2003, 10% in 2004 and 15% in The federal government does not receive any premium for providing this coverage. If the insurance industry suffers terrorist losses that require the government to cover part of the claims payment, then these outlays shall be partially recouped ex post through a mandatory policy surcharge. That surcharge is applied on all property and casualty insurance policies whether or not the insured has purchased terrorist coverage, with a maximum of 3% of the premium charged under that policy (see Figure 5). The federal government will pay for insured losses above specific insurance marketplace retention amount (MR) as depicted in Figure The second tier settled at 0.18 of property value and third tier at From November 26, 2002 to December 31, The partnership is first established for two years until December 31, At this date, the Treasury should decide to renew it for one more year. 11

12 That amount evolves as follows: $10 billion in 2003, $12.5 billion for 2004 and $15 billion for ( INSERT Figure 5. The U.S. TRIA ) Some Illustrative Scenarios under the U.S. TRIA To illustrate how the US public-private partnership for terrorism risk coverage operates, consider an act of terrorism occurring in 2004 in the U.S. Suppose that K insurance companies cover all terrorist losses and that the commercial and workers compensation lines premiums for those I insurers were $30 Billion in 2003 (subject to the deductible). As each insurer has to pay its deductible (10% in 2004), the total insurers deductible is equal to $3 billion. Let S max be the maximum ex post surcharge that the government can levy for the year Now consider three different scenarios with increasing levels of insured losses. Case 1. The insured losses are $400 Million. That amount is below the insurers deductible, $3 Billion, so exclusively the insurers reimburse losses. The U.S. federal government pays nothing. Case 2. The insured losses are $4 billion. The insured losses are above the insurers deductible. Insurers would have to pay $3.1 billion: the total deductible (i.e., $3 billion) as well as 10% of the remaining insured losses (i.e., 10% of $1.0 billion). The federal government pays 90% of $1 billion (i.e., $0.9 billion). As the $4 billion losses are lower than the $12.5 billion market retention, the government can be reimbursed by levying the surcharge S max. Under that scenario, S max covers all federal payments 33. After the surcharge is levied, the insurers and insureds cover the entire claims payments; government pays nothing. Case 3. The insured losses are $40 billion. Here again, insurers would have to pay the total deductible (i.e., $3 billion) as well as 10% of the remaining amount of insured losses (10% of 37 billion), i.e. a total $6.7 billion. The federal government pays 90% of the remaining amount of $37 billion, i.e. $33.3 billion. The government will recoup the difference between the $12.5 billion market retention and the $6.7 billion that private insurers paid out, i.e. a surcharge levied ex post against policyholders of $5.8 billion 34. In this case, the government pays $27.5 billion of the losses with the remainder covered by insurers providing terrorist coverage and all the property and casualty policyholders. Table 2 summarizes these three cases. As done in the European cases, the U.S. federal government focuses its intervention (and reimbursements) to the situation of large scale and extremely costly attacks in regards of the market of insurance in the country As the surcharge is applied to all property and casualties insurance policies and not only to those covered by the K insurers, S max is, by definition, much higher than 3% of $30 billion in that example; i.e. much higher than $0.9 billion. 34 If that amount is greater than the 3% threshold (S max ), the surcharge will be levied over several years. 35 Of course, the thresholds of governmental intervention in the French, German and US schemes should be compared relative to the national market of insurance and not in absolute terms. 12

13 Table 2. TRIA under three simple cases (all numbers in $ billion) Insured losses Losses retained by the I insurers Reimbursement by federal government Via 2004 surcharge (policyholders) Min (S max ; 5.8) Renewal and government exit strategy The important question for the U.S. insurance industry for the time being is of course to know what will happen after December 31, One possibility would be that TRIA would be renewed with some evolutions in the thresholds of risk sharing between insurance industry and the federal government. However, if the program ends on December 31, 2005, alternative solutions will need to be found. (Kunreuther et al., 2003). An Appendix at the end of this paper summarizes main characteristics of the three schemes discussed in this section DISCUSSION In the three post-9/11 programs for terrorism risk coverage are compared with respect to their general design and to the impact on demand for terrorism insurance Governmental Participation: Temporary versus Permanent At that time, governmental involvement is planned to be temporary in all of the three schemes with different expiry dates. Most obviously, private insurances and reinsurances already are building up pressure to prolong the public participation in the partnerships beyond these dates. In this context, the credibility of the governments announcements to withdraw from the partnerships is of major importance. In this regard, 36 Even if analyzing the system Pool Re established in the UK in 1993 is not the purpose of this paper, we mention some of its key features there so as to give some elements for comparison. Pool Re charges a separate, optional premium for terrorism coverage that can be calculated as a percentage of the total sum insured under a fire and accident policy and mainly depends on four possible locations of the property: Central London, other London and major cities, the rest of England excluding Devon & Cornwall, and Devon & Cornwall. The Treasury as the reinsurer of last resort backs Pool Re. Until September 11, 2001 terrorism exclusions within insurance policies in the UK were usually limited to property policies. They were based on the Terrorism Act of 1993 and designed to deal with the IRA bombing campaign on mainland Britain. Fire and explosion were excluded by insurance companies, but were covered under Pool Re. The scale of 9/11 attacks in the US led to the need for an extending protection under Pool Re to all risks (including damage caused by chemical and biological as well as nuclear contamination, with effect on January 1, 2003). This extension in cover to all risks reflected in a doubling of the pre September 11 th 2001 premiums charged by the pool. Moreover, insurers are now free to set the premiums for underlying terrorism policies, thereby introducing competition into the terrorist insurance market. There was also an intention to set the maximum insurance retention for the next four years, with individual insurers retentions being based on market share. It is now set at 30 million ( 43 million) per event and 60 million ( 86 million) per annum for 2003; it will increase up to 100 million ( 144 million) per event and 200 million ( 288 million) per annum for

14 TRIA offers the advantage to include a detailed plan for the stepwise phasing out of governmental participation, which is currently free of charge for the private insurers, by increasing year by year the portion of the risk that has to be borne by private insurers as well as the market retention. The overall effect on the crowding-out of private solutions is not clear a priori. For the time being, neither the German scheme nor the French one has any detailed plan for phasing out the level of participation of private insurers and government. However, the latter seems to induce the strongest crowding-out due to the compulsory character of terrorism insurance in this country and the existence of an unlimited state guarantee Limited Exposure of the Private Sector of Insurance The exposure of the private sector of insurance is limited in all schemes, with comparable levels of retention by the private sector through GAREAT or Extremus. As TRIA links the insurers deductible to the premium income of the previous year, there is no specific amount of insurers exposure known in advance. This level would depend mainly on which insurers would suffer the losses should new attacks occur. On the other hand, in absolute terms, the U.S. presents obviously the most important level of potential losses associated with terrorism risk among the three countries. The comparison is more relevant, however, if made relative to each country market rather than in absolute terms. In this regard, in relation to premium income for instance, the deductibles appear to be much higher in France and Germany than in the U.S. Let us consider the French case. Although a deep analysis of the French market of Property insurance is not the purpose of this paper, some data are quite illustrative. As it discussed, it is not possible for insurers there to dissociate their coverage against terrorism from the basic property policy. A broad estimation of the total Property insurance premium perceived by insurers in 2002, for the same risks Gareat covers against terrorism, is 1.5 billion. Under 2003 operation of Gareat, the threshold for governmental intervention was settled at 1.75 billion; i.e. only after imposing a deductible to insurers that corresponds to 115% of the direct earned premiums the previous year. Although this estimation could be done more precisely, the 10% level of deductible 37 imposed by TRIA for the same year of operation falls short of it Risk Mutualization among Insurers An important feature is related to which insurers would have to pay in case of international terrorist attacks in one of these three countries. The answer is obviously very clear in France nearly all insurance/mutual companies operating in this country are members of GAREAT, which means that the system is close to the highest possible degree of mutualization among insurance industry in the country. Losses would be shared among all these companies as part of the first layer and nearly 30 insurance and 37 The percentage is actually much lower indeed when it is reported to the total direct premiums earned by all insurance companies in the US and not only to those earned by insurers who suffer the losses. 14

15 reinsurance companies would share losses for the two next trenches of the system (see Section 2). This provides national and international risk diversification for levels of liability that would continue to be easily manageable by each of them. Indeed, whatever happens, the portion of losses each insurer will suffer remains very small compared with other lines of their portfolio. The situation in Germany is quite similar. On the opposite, the U.S. TRIA does not create mutualization through insurance companies, as only the insurers who suffer an attack will pay for the losses. Through the ex post surcharge policy, however, every policyholder could be in a position to pay for losses due to terrorist attacks even not being a victim herself, which creates some degree of national solidarity, but not at the insurance industry level Incentives for Risk Mitigation Insurance coverage when adequately designed can also play an important role in encouraging firms to invest in mitigation measures (Kunreuther, 2002). Concerning the insured s financial participation in losses due to terrorism, the French and the U.S. scheme use similar levels of deductible that are applied in direct insurance contracts whereas the German scheme stipulates a general deductible of 1% of the insured s maximum annual compensation. Thereby, GAREAT and TRIA could give insurers more flexibility to influence the incentives for the insured to engage in mitigation measures. However, at that time, none of these three systems has developed incentive program (e.g., premium or deductible reduction) for encouraging insured to invest in security measures (some anecdotes are reported but this is not done systematically). In that spirit, French and German programs, in which the premium does not depend on any estimation of risk exposure but only on total sum insured, do not provide incentives either for firms to spend additional money in mitigation measures. Here, the market based TRIA approach could offer in the future some opportunities to include much more incentives for private investment in security. Whether this absence of systematic link between terrorism insurance and mitigation is mainly due to a lack of interest of the insurers themselves or results from the difficulty to evaluate the real efficiency of such security measures is not clear yet Demand for Terrorism Coverage and its Implications As the U.S. TRIA and the German Extremus have been operating for only 12 months, it is too early to get precise data on the market penetration of terrorism insurance. Only a few studies have been published yet. They present, however, an interesting picture of the demand for terrorism coverage two years after the 9/11 attacks. In the United States, although insurance is now available nationwide, there have been few takers (Treaster, 2003). The Council of Insurance Agents and Brokers (CIAB) 38 undertook the first national 38 The council represents the top tier of the nation s insurance brokers who collectively write 80 percent of the commercial property/casualty premiums annually. 15

16 survey on the level of demand for terrorist coverage (CIAB, March 2003). At that time, 48% of its members that handle the largest accounts (customers who pay more than $100,000 annually in commission and fees to the broker) indicated that less than 1 in 5 of their customers had purchased terrorism insurance. The low demand was even more pronounced for smaller companies (less than $25,000 in commission and fees to the broker): 65% of the brokers indicated that less than 1 in 5 customers were purchasing insurance against terrorism. According to another national survey by the CIAB a few months later, 72% of the brokers indicated that their commercial customers are still not purchasing terrorism insurance coverage (CIAB, July 2003). Even in locations like New York City, the level of demand remains low. The New York-based insurance brokerage firm Kaye Insurance Associates recently surveyed 100 of its clients in the New York area on a series of insurance-related issues, including terrorism insurance. According to this survey, just 36% of companies surveyed have bought terrorism insurance. If the low level of demand is widely confirmed in the ensuing months in the U.S. that may mean a deeper impact on business continuity should a large-scale terrorist attack occur. Most businesses would not be covered so that an attack similar to the one on the World Trade Center, would very likely have much more devastating effects on business continuity today than after September 11 th (Kaye, 2003). In Germany, the demand for terrorism insurance is even much lower. 39 By the end of October 2003, the numbers of contracts managed by Extremus have risen to 1,100 contracts with an annual premium income of 105 Million, sums insured of 650 billion and maximum annual compensations of 65 billion. As an element for comparison, there exists an estimated number of 40,000 firms exposed to risks over 25 million in Germany, as discussed above. Building the ratio between the existing 1,100 contracts and an estimated market size of 40,000 contracts yields an estimate of only 2.75% 40. When focusing on largest companies, the level of demand is higher. According to a survey published in 2003, 40% of the DAX100 companies and 13 of the DAX30 41 companies had insurance contracts with Extremus. (Frankfurter Allgemeine Zeitung, 2003). How could this level of demand be explained? As well documented by works on insurance against other catastrophic risks such that natural disasters, this may result from a myopia effect: decision making mainly focuses on short-term criteria (Kunreuther et al., 1993). Two years after 9/11, the concern with damage from terrorism has assumed a back seat in most people s minds. Today most firms believe that if a 39 The following data have been provided by members of Extremus, AG (personal communication). 40 This estimate has to be dealt with carefully as the size of the contracts is not accounted for, but according to expert opinion of members of Extremus, it gives a fairly realistic picture and underlines the prevailing very low dimension of market penetration. Unfortunately, it is impossible to get more precise information for the time being. 41 The DAX100 (DAX30) comprises the 100 (respectively 30) largest listed companies in terms of market capitalization of the free float. 16

17 terrorist attack occurs it will not happen to them, whereas in the first few months after 9/11 they had the opposite belief. Other reasons may be due to the system itself established in these countries. One year after its inspection, the operation of the German scheme for covering terrorism risks raises some fundamental questions in this regard. First, on the scope of coverage; the above-cited definition of terrorism in the general terms and conditions of Extremus opens scope for some subjective judgments. The distinction between terrorism and acts of war is not very clear either. Moreover, the coverage is limited to property losses and business interruption losses. Terrorist attacks with nuclear, biological and chemical weapons are not covered. 42 Second, on the eligibility for coverage; all sites of a firm have to be included. It is not possible to get coverage for single buildings, production facilities or even locations. In addition, the insurance contract for terrorism coverage can be cancelled within only one month, which constitutes a strong limitation of the coverage from the viewpoint of the insured. Finally, there is a limitation to risks located in Germany, which excludes foreign affiliates affected by a terrorist attack in Germany. Because of the financial involvement of the government, it is very unlikely to reach an agreement to extend the coverage to foreign affiliates. It is obvious that these limitations do not make the coverage against terrorism risk by Extremus particularly attractive for large internationally orientated conglomerates. Similar questions may be raised for the U.S. scheme. (Kunreuther, Michel-Kerjan and Porter, 2003). One of the major points of criticism may come from the insurance industry itself as many insurance companies found themselves back in the situation of having to set a price for a new extreme risk they would rather not write. Indeed, U.S. insurers are required under TRIA to offer terrorist coverage for commercial property, commercial casualty and workers compensation 43 lines to all their policyholders. This terrorism coverage must not differ from non-terrorism coverage and the insured can turn down the coverage. Companies were given only 90 days after TRIA was enacted on November 26, 2002 to develop and disclose to policyholders new premiums and coverage terms 44. As illustrated above with three simple cases, although their exposure to terrorism risk was much reduced through the public-private partnership created by TRIA, it is still significant. For all these reasons, insurers may be induced to ask expensive premiums to their clients who hence prefer not to be covered. Another limit concerns the limit of coverage. Indeed, some businesses are 42 Damages due to chemical material stored on-site for business purposes before an eventual terrorist attack are covered. 43 Terrorist coverage for workers compensation covers both terrorist attacks and acts of war. 44 At the same time, many insurers and reinsurers chose to take advantage of newly available tools designed to help them estimate their potential losses and therefore make rational and informed pricing decisions. Catastrophe modelers, leveraging their considerable experience and expertise in modeling natural hazard events, released the first generation of models to provide insurers with credible estimates of loss across multiple lines from terrorist attacks. The value of such models is in their ability to reduce uncertainty in risk estimates. One effect of that reduced uncertainty will be a lowering of premiums for terrorist insurance; see Grossi and Kunreuther (eds). (in press). 17