Nature abhors a vacuum, and insurers abhor uncertainty. Since September 11, uncertainty about if and when additional terrorist attacks might occur has led the insurance industry to cancel or limit terrorism coverage, causing ripple effects throughout the rest of the economy.

Many sectors--such

as real estate, construction, and airports--now have either no terrorism coverage or reduced amounts that cover only a fraction of their exposure, and they are paying significantly more for it. Inadequate coverage, in turn, has the potential to jeopardize funding from financial institutions.

Whether the mechanics of the economy will adjust to this new state of affairs is a matter of debate. In the U.S., the insurance industry is supporting proposed legislation that would make the federal govermnent the reinsurer of last resort, maintaining that this would help the system return to business as usual. Others, however, say the marketplace is already accommodating the changed circumstances, so government backups or guarantees are not necessary, at least not right now. (In the next issue, Risk & Insurance will take an in-depth look at the terrorism insurance products offered by commercial insurers.)

Will the murky insurance picture affect credit ratings? That, too, is uncertain. "If regulators force the insurance industry to accept risk without a backstop, then there will be ratings consequences," explains Mark Puccia, managing director for ratings quality and criteria in Insurance Ratings at Standard & Poor's. "That means we could be changing ratings over the 2002 to 2003 period."

Primary Insurer Issues

Reinsurers, which operate on a global scale and face much less regulation, notified primary insurers soon after September 11 that they would drop terrorism coverage when policies came up for renewal. About two-thirds of property insurers lost their terrorism reinsurance coverage on January 1, and the remainder will lose it on July 1.

A majority of state regulators have agreed to let primary insurers in the U.S. follow suit and drop terrorism coverage for corporate clients. "It could be as much as a year after a direct insurer loses reinsurance coverage for terrorism before a similar exclusion could be passed on to all its policyholders," according to a U.S. General Accounting Office (GAO) report on terrorism coverage.

This gap, coupled with steep price increases for the little reinsurance still available, means that primary insurers have dramatically increased their retention of risk, even if only on a temporary basis.

"Companies that last year had $10 million of exposure now have $100 million or $200 million," observes Donald Watson, director for insurance in North America at Standard & Poor's. "Corporations are doing the same thing. Insurance is too expensive, so they are choosing to retain more risk."

Insurers' greater risk retention will lead to larger premiums, and larger premiums call for increased capital requirements, putting pressure on insurance companies. "For years, the insurance industry in general has enjoyed strong capitalization," notes Steven Dreyer, managing director in Standard & Poor's Insurance Ratings sector. "Now, this one strength has been weakened. You will see ratings affected if insurers' retentions increase dramatically."

Primary insurers in five states (California, Florida, Georgia, New York, and Texas) have not received permission to cancel terrorism coverage when corporate policies come up for renewal. To avoid a regulatory squeeze, they are turning to largely unregulated surplus lines to write policies that eliminate terrorism coverage at renewal time.

With the exception of workers' compensation insurance, which by law cannot exclude certain events regardless of their cause, insurers and reinsurers will have drastically reduced or removed most risk coverage arising from terrorism by the end of 2002.

In the very limited market that still exists for terrorism insurance, a few insurers and reinsurers would restrict coverage to modest amounts for nontrophy properties, taking into account geographic location as well as concentration of facilities and staff. Insurers may want to offer some terrorism insurance because of pressure from long-term clients or for competitive reasons.

But major urban areas and prominent office buildings would likely be excluded. Even some major retailers have encountered problems in renewing the terrorism portion of their policies, according to Diane Shand, director in Standard & Poor's Retail Ratings sector.

"The insurance industry can accept some terrorism coverage if it's well dispersed and fairly limited in terms of exposure," says Puccia. Although the risk probability of terrorism cannot be modeled, insurers can use urban aggregates and zonal distributions to lower geographic and concentration risk through diversification.

But the insurance industry has not shown a coordinated response to terrorism coverage. "Standard & Poor's goal is to identify those insurers that are better managing the process through lower risk concentrations," Puccia says. "Those insurers will likely retain their ratings. The insurance companies that are not effectively managing their exposures could be downgraded."

Government as a Backstop

The reinsurance industry, supported by primary insurers, has lobbied for the U.S. government to become the reinsurer of last resort. It has the support of the GAO, many members of Congress, and other officials.

A precedent for government intervention exists in the U.K., where a 1992 attack by the Irish Republican Army led to the establishment of Pool Re, a mutual company owned by more than 200 insurers and guaranteed by the British government, which acts as the reinsurer of last resort.

Under the U.K. system, primary insurers individually cover the first [pounds sterling]100,000 of terrorism claims. Pool Re would pay claims beyond this amount through assessments on members. If still more money is needed, the government steps in and makes payments as the final stage of the system.

To date, the government has never had to intercede. Pool Re and primary insurers were able to handle the o800 million in claims generated by a subsequent IRA attack in 1993 as well as losses from bombings in 1996. The pool has also reduced its premiums since its inception, but other insurers offer less expensive and broader coverage. The biggest concern about Pool Re, however, is that it could not cover a major terrorist attack like the World Trade Center catastrophe, because it has an accumulated cap of only [pounds sterling]1 billion.

There is also debate about extending coverage. "The extent of protection by Pool Re isn't as comprehensive as it could be," explains Rob Jones, director in the insurance sector at Standard & Poor's London office. Currently, Pool Re covers only property damage caused by fire or explosion in the commercial and public sectors. Many believe Pool Re should broaden its coverage beyond property damage to include chemical attacks, such as an attempt to poison the water supply. But the U.K. government is reportedly reluctant to expand Pool Re's scope.

The French government responded to the gap between insurance and reinsurance coverage after September 11 by announcing it would provide a backstop. Caisse Centrale de Reassurance, the government reinsurer, will cover losses from terrorism once they exceed $1.32 billion, with no cap. A pool of primary insurers and reinsurers will cover claims up to that threshold amount.

In Germany, the government has insisted on a liability cap before it will provide backup coverage for terrorism claims, and this has stymied an agreement with the insurance industry. Disturbed by the lack of coverage, German corporations are talking about establishing their own pool.

Sector Concerns

The September 11 tragedy hit hardest among airlines and airports, in terms of insurability as well as business losses. These two sectors were already hurting from lost revenue when the U.S. government closed airports and grounded planes for several days after the attacks, followed by a dramatic falloff in business because of the public's reluctance to fly. Airlines and airports suffered another blow as insurers quickly canceled their third-party war and terrorism coverage.

Federal governments, in the U.S. as well as Europe, have interceded to help airlines keep flying, since air transportation is seen as an essential service. "Third-party liability coverage is also required by airline leasing companies and banks that provide financing for aircraft, and airlines cannot operate planes without it," stresses Phillip Baggaley, managing director in the Transportation and Aerospace Ratings sector at Standard & Poor's.

In construction, since September 11, insurance companies have imposed more stringent requirements before they will issue surety bonds, which construction companies need to work on projects. "It's much more difficult today than six or nine months ago to get bonding capacity," says Joel Levington, director in the engineering and construction ratings sector at Standard & Poor's.

Insurance companies are less willing to work with some of the weaker credits. MG, one of the largest surety bond insurers, announced last summer that it would work only with construction companies having at least $50 million of tangible net worth. Weaker credits can try to negotiate letters of credit or post cash if they cannot obtain surety bonding, although this hurts their financial flexibility.

The tougher market has sometimes provided more opportunities for the larger construction companies that can demonstrate strong creditworthiness. But even they are paying 30 percent to 40 percent more for their surety bonding.

Many oil and gas companies, utilities, and electric power companies found themselves in the same situation as the general marketplace, when reinsurers and then insurers began canceling coverage. Policies for power companies, which must use specially markets, cost 1 percent to 10 percent of the limits they cover. That means $50 million of coverage could cost anywhere from $5000,000 to $5 million. The specialty markets also offer a standard cancellable policy as well as a non-cancellable version, which cost anywhere from $500,000 to $5 million. The specialty markets also offer a standard cancellable policy as well as a non cancellable version, which costs 40 percent more.

Libby Bruch is managing editor at Standard & Poor's. This story was adapted from a Standard & Poor's report. For more information, please send and e-mail to steven_dreyer@standardandpoors.com.