Emil Metropoulos, Senior Vice President
We excerpt here from the recently published Marsh report: Terrorism Risk Insurance 2010, the section authored by Guy Carpenter’s Emil Metropoulos.
Commercial insurers are strongly supportive of the Terrorism Risk Insurance Act of 2002 (TRIA), as it provides them an ultimate safety net for their terrorism exposures. However, the residual risk for terror events retained by insurers below the triggers and retention levels set by the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA), coupled with the relatively high cost of reinsurance in key exposure zones, means that insurers remain cautious about terrorism exposure. As a result, they continue to avoid accumulating high-profile urban exposures.
Managing the Gaps in TRIA Coverage
TRIA provides high-level reinsurance protection to primary insurers for commercial insurance lines. The Act’s design results in a number of gaps in reinsurance protection for insurers. These gaps include:
- personal lines insurance;
- the deductible, co-pay share, and event trigger for TRIPRA-certified events; and
- nuclear, chemical, biological, and radiological (NCBR), depending on primary policy coverage. Many traditional property policies exclude the nuclear and radiation risks.
TRIA is a commercial lines program; therefore, personal lines policies of insurers are fully exposed to both TRIA-certified and noncertified acts of terrorism. In general, insurers have addressed these risks by having full terrorism-certified and noncertified-included in their personal lines property/catastrophe reinsurance programs, often excluding NCBR losses. This protection is frequently provided with no explicit cost breakout.
From insurers’ perspectives, a large, non-reinsured gap in TRIPRA terrorism exposure for the period 2007-14 exists for certified acts in three areas:
1) Below the 20 percent deductible set by TRIPRA.
2) Within the 15 percent virtually unlimited co-participation corridor above the deductible.
3) In instances when an insurer’s direct exposure is disproportionally high relative to the minimum industry event trigger of $100 million. In such cases an insurer would be 100 percent exposed to any losses under the trigger.
The Obama Administration’s proposed 2011 budget would reduce federal support for TRIA. While Marsh’s terrorism experts believe there is little appetite among policymakers to support such a reduction, it is important to note such a change likely would affect the terrorism insurance and reinsurance markets. Specifically, any reduction in federal TRIA support would likely increase insurance market uncertainty around terrorism risks and affect reinsurers’ appetites to provide coverage for them. It would also cause an increase in insurers’ deductible and co-share percentages, which in turn would likely increase the demand for terrorism reinsurance, possibly beyond current market capacity.
Most cedents prefer to have commercial certified terrorism covered within their standard property and casualty reinsurance programs. Including such coverage in existing programs, however, can be expensive, depending on the location and values of the original insured terrorism policies. Another option for cedents is to purchase standalone terrorism reinsurance coverage. Pricing for such coverage has decreased in recent years, but overall activity levels for these standalone products have also declined.
Most reinsurers have identified a limited portion of their risk capital to make available to cover terrorism exposures, given the challenges in underwriting, modeling, and pricing for terrorism relative to other catastrophic perils. As mentioned above, reinsurers typically prefer to manage terror risk by offering terrorism coverage in a standalone contract where they can monitor and control exposure, rather than offering coverage within a normal “all-risk” catastrophe treaty, especially for insurers writing a national portfolio. Some regional insurers with exposures limited to rural or suburban areas are seeking to secure close to full terrorism coverage within their reinsurance programs since they are more likely to be exposed to a gap in TRIA coverage, as noted above. Rating agencies are also paying increasing attention to the possibility that a regional insurer could have a large loss relative to its policyholder surplus without any protection from TRIA.
Insurers that have not purchased standalone terrorism reinsurance cite the following factors:
1. Cedents’ target budget for catastrophe risk transfer is fully consumed by their current natural perils treaty(ies).
2. Cedents are comfortable with the level of risk transfer for terrorism included within their current “all-perils” reinsurance contracts.
3. There is an inability to pass along the full cost in primary insurance policies.
4. There are limited capacity/limits available at affordable rates, depending on the location of the original insured terrorism policies.
5. They feel that exposure concentrations are controlled and/or are limited, particularly for clients with little exposure in targeted urban centers.
6. They are comfortable with the protections provided under TRIPRA.
7. There is little coverage available for NCBR.
A growing concern in the insurance marketplace involves the more detailed questions asked by rating agencies-such as A.M. Best-regarding capital adequacy. A.M. Best now considers a cedent’s data quality; the frequency and severity of specifically defined terrorism scenarios, including their potential impact on the cedent’s surplus/capital after TRIPRA; and other inuring reinsurance. A host of data quality surcharges, city-specific probabilities, frequency multipliers, and even assigned workers compensation benefit levels are applied to an insurer’s combined line terror losses to generate a “terrorism charge” that can potentially be stress tested against their published A.M. Best’s Capital Adequacy Ratio (BCAR) and, in turn, impact their rating. With recent favorable earthquake catastrophe (CAT) model changes, the likelihood that the “terrorism charge” could be higher than the natural catastrophe alternative-especially for workers compensation-has increased. As the A.M. Best methodology notably differs from standard probabilistic and deterministic terrorism CAT modeling output, it is important that insureds evaluate it, along with their own enterprise exposure evaluations, when considering underwriting guidelines and reinsurance protection.
In workers compensation, most insurers-other than small regionals-incorporate some level of terrorism coverage into their corporate catastrophe programs. The most common structure is for insurers to add coverage for certified acts of terror, excluding NCBR, to their existing workers compensation catastrophe programs. Pricing and capacity for terrorism coverage have continued to improve over the past year, and more reinsurers are now willing to provide options for NCBR perils. Terrorism coverage is offered on both a per-occurrence and aggregate excess basis (exclusively on an aggregate basis if NCBR is covered). When clients add terrorism coverage, excluding NCBR, to an existing catastrophe program, reinsurers have priced the additional coverage as a surcharge above the natural perils pricing. This pricing has become more competitive, with reinsurers now charging 5 percent to 15 percent of additional premium.
Cedents continue to offer terrorism insurance where they are required by law to do so, or where it is standard market practice; many provide local coverage on an admitted basis.
Cedents continue to limit their offer to cover terrorism in most international territories where there is no local government-sponsored pool. Treaties also continue to exclude any coverage for international terrorism.
In the current marketplace, up to USD700 million of per-occurrence coverage is estimated to be available, although that figure may vary based on the location and severity of the original insured policies. For certain programs, notably workers compensation programs where the terrorism exposure is limited to a single state, it is feasible to secure more than USD1 billion of capacity. Such capacity may expand or contract based on price, type of risk, and overall reinsurance market conditions. With reinsurer capital levels at historically high levels, the marketplace is approaching the peak of hypothetical capacity, however, we have yet to see demand to test that availability.
Modeling methodologies have been continually refined and updated relative to the peril of terrorism. However, quantifying the economic and human losses from an act of terrorism continues to pose major challenges for insurers and reinsurers. A variety of approaches exist for insurers to model terrorism risk. Most models involve three techniques:
1. Producing probabilistic loss estimates.
2. Conducting exposure-concentration analysis.
3. Generating deterministic loss estimates.
• Probabilistic modeling, also known as CAT modeling, estimates losses based on a large number of events. A key factor is the estimated frequency a modeler applies to all the possible events that could occur. The industry and rating agencies continue to question the credibility of probabilistic terrorism modeling as it requires predictions of human behavior. As a result, unlike hurricane and earthquake CAT modeling, little consideration is placed on probabilistic terrorism modeling.
• Exposure-concentration analysis, also known as accumulation assessment, identifies and quantifies concentrations of exposures around potential terrorist targets as defined by the modeler. Target-based accumulation assessment locates potential targets-typically with high economic, human, and/or symbolic value-and aggregates an insurer’s exposures in and around various distances from these targets.
An important variation of this analysis looks at an insurer’s largest exposure concentrations, independent of what any particular source defines as a target. Therefore, the scanning of clusters of multi-line exposure exceeding an economic threshold within a portfolio-irrespective of these perceived and defined targets-is essential. According to A.M. Best’s “terror charge” methodology, it is these largest of insured locations (differentiated by city) that can be potentially stress tested against published BCAR, regardless of their proximity to landmarks.
• Deterministic modeling represents a compromise between the lack of accuracy in accumulation analysis and the vast uncertainty surrounding probabilistic models. By imposing an actual event’s damage “footprint” at a specified target, a specific-yet hypothetical-scenario can be analyzed with some certainty. Major modeling firms offer an array of deterministic-analysis tools for conventional and NCBR attacks at defined target and non-target locations. This approach can be effective where coarse screening studies show that exposures for an area or event could be high, and a detailed assessment may reduce uncertainties and help decision making.
Relative to natural perils such as hurricane or earthquake, terrorism modeling is still young and untested. Insurers, reinsurers, and modeling companies are constantly learning, assessing and refining their models and the assumptions that underlay those models, thereby increasing their ability to manage terrorism risk in an educated and more quantitative fashion. Currently, deterministic, scenario-based testing is the most common tool used by insurers to assess their vulnerability to terrorism. Given the human and societal nature of the risk, it cannot be expected that the probability of terror events can be determined with the certainty needed to make critical risk management decisions.
While terrorism modeling challenges remain, Guy Carpenter & Company, LLC, a Marsh affiliate, helps insurers explore various terrorism loss scenarios and perspectives using a judgment-based multi-model approach that goes beyond purely probabilistic and/or deterministic modeling. And since terrorism model accuracy is highly dependent on the quality of the underlying data, which continues to evolve and improve, Guy Carpenter employs data quality benchmarking and refinement best practices to ensure that the exposure and output contemplated is accurate for proper enterprise risk management.
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