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Report n°3: Financial protection of critical infrastructure

Commercial terrorism insurance in the United States (TRIA)

As previously emphasized, before the events of 2001, terrorism was included in most commercial insurance policies in the United States. After the attacks, the very large majority of insurers decided to exclude terrorism from their contracts. It is to be remarked that contrary to French legislation (see below), coverage for property and insurance policies in the United States does not automatically include terrorism. Because of this, American insurers were able to exclude the terrorism risk while continuing to insure for property and casualty.

Paradoxically, on September 12, 2002, one year after the tragedy, companies working in the United States were facing a situation where offers to cover were few and far between and very costly, so that most of them were still without coverage. If another attack on the scale of September 11 had been perpetrated at that time, the economic impact would certainly have much greater than in 2001 because losses would not have been diversified throughout the global insurance and reinsurance market, but borne by the companies affected.

This situation was much decried and led to the passing of new legislation , the Terrorism Risk Insurance Act of 2002 (TRIA), which establishes a system of risk sharing between the federal government, the insured, and the insurers. It was adopted by Congress on November 26, 2002. It is an insurance system - reinsurers do not participate - and set up for of three years.

The TRIA system is rather complex and it will therefore not be described in this paper in any great detail (for an advanced analysis of the system, see Michel-Kerjan and Pedell, 2005; Kunreuther and Michel-Kerjan, to be published). TRIA makes terrorist insurance mandatory, but does not oblige corporations to take out coverage. In other words, all insurers must offer terrorist cover to their policy holders, who may decide to buy it or not to buy it. Unlike the European systems where the price of coverage by the pools is set at national level and known to all, American insurers are free to set the price of coverage (within the limits imposed by regulations applied to the insurance market in each of the 50 States).

Under TRIA, the attack must be certified as an "act of terrorism" by the Treasury Secretary among others. The definition requires that the attack be committed by foreign interests; an attack like the Oklahoma City bombing would not be covered by TRIA because it would be classified as "domestic terrorism".

Unlike the British, French, and German systems, there is no provision for mutualization of risks between insurers in the United States, so that insurers are directly liable for losses suffered by their policy holders. To be more precise, over and above a mandatory deductible, insurers are liable for 10% of losses suffered by their policy holders. This deductible is defined as a percentage of net premiums collected by the insurer over the previous year. The percentage was set at 10% in 2004 and 15% in 2005. Beyond that, the American federal government is committed to cover free of charge the remaining 90% of insured losses (the equivalent of free reinsurance in annual stop loss coverage).

To be noted however, that the federal government can request reimbursement of part of its ex post outlays through a special surcharge levied against all the policy holders, whether or not they had purchased terrorist coverage. This rather unusual clause ("recoupment process") operates as follows: for the amount of federal reimbursement comprised between reimbursement by insurers and an insurance market retention ceiling (12.5 billion dollars in 2004 and 15 billion in 2005) the federal government can levy a surcharge against all insurance policies. In doing so, TRIA injects an element of national solidarity into the system.

The introduction of TRIA was supposed to enable all corporations to benefit from terrorism coverage if they so wished. However, although terrorism coverage is now available everywhere, demand is still limited. In fact, the most recent data on the American market shows that although demand increased between 2003 and 2004, less than half of American firms had purchased terrorism coverage by the fall of 2004 (43%; Marsh 2004), and most of them consider that they are not potential victims (we have discussed this aspect of risk perception in section II) or that the cover provided by TRIA was too limited compared to possible attack scenarios.

What is TRIA's future fate? The system's three-year term draws to a close at the end of 2005 unless it is renewed. As of now, it is not known whether the federal government intends to renew its partnership with the insurance industry beyond 2005 (US GAO, 2005). If it did not, it would have to offer some alternatives. For certain industries, the creation of captives or of specific industrial pools is a possibility. Other opinions plead in favor of a more marked transfer of risk to the financial markets. There is no certainty however that the terrorist risk presents the kind of characteristics which could lead to a fair sized market for catastrophe bonds or indexed options. So far, only two cat bonds have been issued on the financial markets and neither of them cover exclusively against terrorism (see box below) (Kunreuther and Michel-Kerjan, 2004).

« Catastrophe Bonds » and Terrorism : So far a very limited niche market

The first catastrophe indexed bond (« catastrophe bonds » or « cat bonds ») providing coverage against terrorism emerged on the capital markets in August 2003. FIFA who will be organizing the 18th Football World Cup in 2006 in Germany were trying to protect themselves from economic losses in the event the final match had to be cancelled. FIFA therefore issued a cat bond (Golden Goal Finance Ltd), with specific features and particular contractual arrangements, covering their investment up to 262 million dollars. The contract stipulates that FIFA can reschedule the final in 2007 if needs be; the bond would only cover them if that turned out to be an impossibility. Furthermore, the German government has already guaranteed an exceptional level of security, which contributes to make such an event even more unlikely.

The financial cover, however, is not specific to terrorist action since it provides coverage for FIFA for all kinds of catastrophes, natural, terrorist, or others (U.S. General Accounting Office, 2003).

The second catastrophe bond (Vita Capital) was created in December 2003 by Swiss Re to transfer to financial markets exposure to mortality risk amounting to 400 million under a stop loss provision (life insurance; Swiss Re is the leading life reinsurer world wide). « Mortality » in this case is measured in comparison to a specific index defined according to the reinsurer's 2002 exposure in several countries (United States, France, England, Italy, Switzerland) weighted for age, country and gender.

If the weighted mortality index in this group of countries exceeds by more than 30% the 2002 figure, the reinsurer will use the bond to gain cover against the occurrence of this extreme scenario. Cover is index-based and not therefore specifically attached to the terrorist risk. According to Woo (2004), the threshold (more than 700,000 fatalities) could be crossed during one of the three years covered by the transfer only in the event of a combination of a major epidemic and a large-scale terrorist attack using weapons of mass destruction.

It is worth noting that these instruments cover against a whole range of possible catastrophic events and none of them are solely restricted to terrorism. Using multi-risk bonds would seem to be a more promising way of securitizing the risk by including it under broad umbrella-type coverage, rather than singling it out (Kunreuther et Michel-Kerjan, 2004).