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					Insurance against terrorism risks
             OECD-IAIS-ASSAL
  IV Conference on insurance regulation and
         supervision in Latin America
    Session 3: Insurance against terrorism
                     risks



                Cécile Vignial
                   OECD

                                              1 1
      Ministerial mandate on terrorism
                  insurance
    It requests policy analysis and recommendations on:

   the definition of terrorism risks
   the coverage of terrorism risks, with an assessment
    of the respective role of the insurance (and
    reinsurance) industry, the financial markets and the
    government
   the special case of mega-terrorism risks


                                                     2 2
1. Defining terrorist acts for
indemnification purpose




                                 3 3
      1.1. Focus of OECD work on the
            definition of terrorism

   This work does not aim at a general definition of
    terrorism acts, but at an approach of the concept of
    terrorism for cover purposes;
   This work does not aim at enunciating a single and
    rigid definition for all Member countries, but at
    identifying key elements of definition on which OECD
    countries could agree.
   The adoption of such definition criteria is not meant to
    be binding.
                                                         4 4
     1.2. Defining terrorism: what for?


   The events of 11 September 2001 made Member
    country insurers and reinsurers aware of the need to
    redefine and assess their commitments with respect
    to terrorism risk.
   In many States, the risk of terrorism was generally
    not cited explicitly in contracts, and cover for it was
    extended at no additional cost, generally as part of
    the protection against fire.
   Since 11 September, exclusion or coverage is made
    explicit, and their precise scope is specified.
                                                        5 5
   It is important to differentiate between terrorist acts
    and other manifestations of violence and, in
    particular, acts of war, the latter being systematically
    excluded from insurance cover.

   “Terrorism lies on the borderline between political
    perils, considered as uninsurable by (re)insurers, and
    socio-political perils, ordinarily covered by those
    same (re)insurers” (see SR graph)


                                                          6 6
7 7
    1.3.2. The means used
    Terrorism is manifested by:
   a violent or dangerous act, i.e. causing serious harm
    to human life, tangible or intangible goods.
   The qualification of “serious” implies that damages are of a
    certain magnitude/significance. This notion is important to
    differentiated acts of terrorism from acts of vandalism for
    instance.
   “Dangerous” may apply to acts that are not violent as such,
    although they could potentially inflict grievous harm on the life,
    safety or health of persons, or on the environment. Cyber
    attacks or the pollution of ground water illustrates this point.


   a threat of such act entailing severe damage
                                                                  9 9
    1.3.3. Certification

   In various Member countries (France, the UK,
    Northern Ireland, the US), another element is added
    to the definition of a terrorist act: its certification by a
    governmental representative, which can usually not
    be subject to appeal to be effective.

   Such certification is certainly a guarantee of
    seriousness in the examination of the nature of the
    act, although the certification may also induce some
    political bias.


                                                            10 10
1.2. Elements of a definition of terrorist
      acts that can be indemnified

    Among the acts defined as terrorist acts according to
    the criteria listed above, decision makers in the
    insurance sector need to identify those for which
    coverage can be made available, i.e. :

   acts meeting the criteria for insurability,

   compensable acts, or acts that will be indemnified
    even though they do not meet the criteria for
    insurability.
                                                      11 11
     1.2.1. Acts meeting the criteria for
                 insurability
    acts that are technically insurable, i.e. that meet the
    criteria of:
   assessibility (probability and severity of losses must
    be quantifiable)
   randomness (the time at which the insured event
    occurs must be unpredictable, and the occurrence
    itself must be independent of the will of the insured)
   mutuality (numerous persons exposed to a given
    hazard must join together to form a risk community
    within which the risk is shared and diversified)
                                                         12 12
   acts that are economically insurable, i.e. meeting the
    criteria of :

   capacity: their magnitude does not exceed the
    capacity of the private (re)insurance market, or the
    capacity of a mix of private/public multi-layer
    mechanisms when it exists.
    If a specific terrorism insurance scheme is to be established, the
    scope of intervention of the various “layers”, reflecting their
    respective capacity, will need to be defined through
    quantitative thresholds. The nature of the thresholds, their
    quantitative level, and the basis on which they should be
    calculated, should also be defined ex ante.


                                                                  13 13
Defining quantitative risk thresholds (see annex 2)

nature of threshold: the amount of the financial
damage incurred is usually the criterion enforced

amount of the threshold: it reflects the amount of
losses insurable by a given coverage mechanism and
ultimately the limit of global national capacity above
which a risks would need to be excluded as currently
uninsurable. Risks can be classified according their
magnitude, on which depends the type of coverage
mechanisms or “layer” to be triggered when claims
arise (privately insurable terrorism risks, risks insurable through
national private/public partnership (when existing), risks currently
uninsurable although they can be compensated through State support,
risks that can currently not be indemnified).
                                                                 14 14
Minimum amount: terrorism insurance schemes
typically cover risks above a certain critical mass
ex: under the US Terrorism Risk Insurance Act for instance, an
act must cause at least $5 million in damage to be covered by
the programme.

In France, GAREAT covers only risks of an insured value above
Euro 6 million.

In Germany, Extremus AG covers risks of and insured value
above Euro 25 million.




                                                            15 15
Maximum amount: at the other end of the risk
spectrum, the maximum amount of insurable losses
represents the upper limit of insurability at a given
moment in time, defined as the available capacity of
the private market to cover terrorism risk, or, in case
of State guarantee, as the estimated maximum
financial involvement that the State is able or willing
to supply for the compensation of losses entailed by
terrorism, without endangering national economic
stability.
This upper limit may for instance correspond to the $100 bn per
year set in the USA for State involvement, or to the Euro 10bn
limit fixed in Germany.


 –                                                          16 16
Basis on which the threshold is calculated

The various thresholds differentiating the risks
according to their magnitude can be established on
different basis: event vs time period, single company
vs entire market, upon each company performance,
as measured by its market share or amount of
premiums collected, etc.



                                                   17 17
   price: premiums are both actually fair and affordable

    Further to recent developments on some OECD
    insurance markets, the relationship between premium
    rates and insurability strikes out as an issue more
    complex and long-lasting than could have been
    expected.

    Ex: current difficulties encountered on the US market
    further to the introduction of compulsory terrorism
    insurance through the TRIA


                                                       18 18
   Acts that are legally/regulatory insurable:

   they have been identified by regulatory authorities as
    insurable/insurance against this risk is made
    compulsory. In this case only, a risk may be insurable
    while the other criteria may not be met.



   According to the criteria above, insurers and national
    terrorism coverage schemes when existing have
    defined which types of losses/business lines they are
    able/willing to insure, establishing a qualitative
    segmentation of risks

                                                       19 19
 Establishing a qualitative classification of risks
                          (see annex 2)

Such classification will define which lines of business
the various insurance coverage mechanisms can
cover. Individual insurers, but also national terrorism
coverage schemes, are still far from covering all
types of losses. Interestingly, the various national
schemes are not always covering the same lines of
business.

The exclusion of certain insurance lines, such as third party
liability, has been lengthy debated in several countries. Worker
compensation (covered even in case of war under the US
scheme, but excluded by the UK Pool Re for instance), or bodily
injury, are not treated the same way across borders. Lastly, the
extend of coverage may also evolve in a given country: ex: Pool
Re for nuclear risks coverage                                  20 20
     1.2.2. Acts meeting the criteria for
    compensation (but failing to meet the
           criteria for insurability):
   Compensation by the State: their magnitude does not
    exceed the maximum financial involvement that the
    State is able or willing to supply, above insurance
    coverage, for the compensation of losses entailed by
    terrorism

   Other     compensation       mechanisms:      technical
    characteristics of terrorism acts may allow them to be
    covered through other instruments (e.g. bonds placed
    on capital markets).

                                                        21 21
2. Coverage of terrorism risk




                                22 22
Three types of actors may be involved
  in the coverage of terrorism risks:


   the private insurance and reinsurance market

   the States

   financial markets




                                                   23 23
    2.1.Ups and Downs of private sector
     involvement in terrorism coverage
   Evolution of the role of the private sector
   Terrorism risks potentially comprise events of such magnitude
    and diversity that, after the heavy losses incurred in the wake of
    the attacks of 11 September 2001, some insurers and reinsurers
    have preferred to adopt a prudent stand and exclude them
    altogether as uninsurable or restrict drastically the cover while
    substantially raising the level of premium.
   This trend has been slow down in 2002, to try to stretch the
    limits of coverage, make terrorism risks, as far as possible,
    insurable, and, for some private operators, to take advantage of
    a potentially highly profitable niche.


                                                                  24 24
   factors underlying changes
   technical evolutions
    ex: encouraging progress in terrorism risk modelling:
    risk modeller agencies (like Applied Insurance
    Research (AIR), Eqecat and RMS), among other
    actors, have developed sophisticated models that
    they sell to insurers around the globe
   capacity building
    it has been achieved through re-capitalisation of
    terrorism activities, creation of new ventures, or
    establishment of private pools (e.g. Austria)




                                                      25 25
   Change in the conditions under which insurers
    and reinsurers are willing to assume terrorism
    risks (SR)
   coverage conditions, wordings and clauses: update the
    definition of risk, covered perils, excluded perils. Apply sublimits
    and specify named perils to restrict the scope of cove
    ex: aviation activities, transport, high-risk property, credit loan,
   pricing and underwriting: develop more refined pricing
    methods and procedures, adjusted to risk type, country, region,
    loss experience and expectancy.
   risk and capital management. For example: extend
    scenarios and capacity management procedures to make
    allowance for possible terrorist attacks, enhance analysis for
    correlations between lines of business and between
    underwriting/investment/credit/operational risks, develop
    alternative risk transfer products and systems addressing
    terrorism risk.                                                  26 26
2.2. The crucial role of governments in
          terrorism coverage
   Rationale for government intervention

   market failure, given the potential magnitude of risks
    and the uncertainty regarding their technical
    characteristics
   political and social consequences of terrorism attacks
   impact on the economy: the government may have to
    intervene in case of major disruptions in key
    economic sectors

                                                       27 27
   The wide scope of government tools (see annex 2)
   indirect role: promotion of market mechanisms:
    -- tax incentives for terrorism provisioning, specific
    forbearance measures, changes in the accounting of
    assets, imposing special levies on insurance
    premiums
    -- making such insurance mandatory under specific
    criteria guided by economic efficiency. Terrorism risks
    falls into the risk categories that may require the insurance
    compulsion (severity could be particularly great, with a large
    number of innocent persons being harmed because of a single
    event)
    Some OECD countries are already applying compulsory
    coverage of terrorism at least for certain lines of business: e.g.
    Belgium, France (for casualty & property insurance), Spain, and
    the US.
                                                                   28 28
                       Risk Sharing within government support

                 self-insurance (risk      co-reinsurance supplied by
         retention) by enterprises          members within the pool
              and individuals             (or reinsurance supplied by
                      insurance
      high                                 the specialist reinsurance
                                                   company)
                                           reinsurance supplied by
  loss
frequency                                       government(s)
                                                                back-stop guarantees
                                                                provided by
       low
             0                                                  government(s)
                     low                                         high
                                    loss severity




                                                                                 29 29
   Direct role
    -- subsidiary role
    ex: in Spain, the State, through the Consorcio de
    Compensacion de Seguros, plays a subsidiary role if
    private insurers are not able to cover the risk.
    -- loan facilities to face immediate liquidity problems
    -- guarantee: the State intervenes as reinsurer of last
    resort
    ex: GAREAT, Pool Re, Extremus AG




                                                        30 30
   Country experience (see annex 2)
   While many OECD countries (apart from Spain and
    the United Kingdom) did not set-up in the past
    specific mechanisms to deal with terrorism insurance,
    most of them have reassessed their position in the
    light of the 11th September events.
   State backing, and the enforcement of private and
    public/private mechanism specifically devoted to the
    coverage of terrorism risks, has proven in various
    countries to be is a key condition for private player’s
    to re-enter the terrorism market and be involved
    above certain level of risk exposure.


                                                        31 31
       2.3. Financial markets: a viable
      alternative to palliate to capacity
                  shortage?
   After September 2001, terrorism risk securitisation
    onto global debt or equity markets appeared as a
    promising solution to (re)insurance capacity shortage

   The launching of cat bonds in the mid 90s provided a
    model for the expansion of a possible the coverage of
    natural catastrophes (bond securitisations /
    Californian Earthquake authority)



                                                      32 32
   However, against certain expectations, terrorism risk
    securitisation has not had the kick-start anticipated
    from the hardening of the conventional market, and
    many obstacles still prevent its development. In
    particular:
   structuring such securities can prove still more expensive than
    reinsurance
   While investors are reluctant to buy a product they are not
    familiar with, especially when the assessment of the underlying
    risk is highly complex


    The continued hardening of reinsurance market may
    eventually give a chance to the development of ART
    markets, bearing in mind that it generally takes more
    than one cycle for new solutions to become
    successful.                                        33 33
    2.4. Towards multi-pillar risk-sharing
               mechanisms

   Multi-layer risk-sharing mechanisms are a common
    solution to extend capacity in insurance markets.

   Possible State and financial market intervention can
    to be added to classical models of co- and re-
    insurance in the case of terrorism risk coverage.




                                                      34 34
  MULTI PILLAR RISK SHARING MECHANISM TO COVER
                 TERRORISM RISKS




FIFTH                  DOMESTIC GOVERNMENT
LAYER

FOURTH      REINSURANCE                 FINANCIAL MARKETS
LAYER

THIRD                      INSURANCE POOL
LAYER

SECOND      INSURERS                  SELF-INSURANCE
LAYER

FIRST         INSURED (fair level of premium + deductibles,
LAYER         ensuring better prevention and control of moral
                                  hazard )


                                                                35 35
                  Options for Risk-Sharing Networks

                                                     risks facing
                                                     enterprises
                                                   and individuals
                                                                       self -insure
                                                                      (retain risk)
                                                      enterprises
                                                    and individuals                      risk
                                                                risk transfer
                                                             through insurance         transfer
                                                                                       through
                                                           national
                                                                                      securitizat
                                             reinsuran insurance                          ion
                                                 ce        market reinsura
                            reinsurance pool                          nce               risk
                              or specialist                           national        transfer
                  can          reinsurance        can raise new         and           through
                provide                           equity capital    internation    securitization
                                company
                 debt   reinsurance     or can          or                al
                capital     and      provide debt subordinated      reinsurance    risk
                         guarantees capital to         debt
  international                                                       markets   securitizati
                                      specialist            can raise new
    agencies,        government(s) reinsurance                                      on
                                                            equity capital
e.g. World Bank                        company                                   vehicles
                                                               or      risk securitization
                                   can raise              subordinated onto global debt or
                                   new debt                   debt       equity markets
                      can raise     capital
                      new                        national
                      debt                      and global                                          36 36
                      capital                     capital
                                                 markets
3. Compensation for damage caused
        by mega-terrorism




                                37 37
      3.1. Definition of mega terrorism

   Mega terrorism refers to risks beyond the current
    capacity of the insurance industry and the
    government in a determined country since they
    involve damages potentially exceeding a country
    financial capacity - or willingness - to palliate to
    market failure and to indemnify for losses, without
    endangering the national economy.

   Such “mega risks” could only be covered if an
    international mechanism was to be created,
    involving States last resort capacity. It would basically
    aim at adding an international layer to current
    coverage arrangements and pre-organise financial
    aspects of international solidarity in case of attack.
                                                           38 38
3.2. Why preparing for mega terrorism
   Increasing magnitude of terrorism attacks
    Over the past few decades, dozens of aggressive
    movements have emerged espousing varieties of
    nationalism, religious fundamentalism, fascism and
    apocalyptic millenarianism.
    E.g. aircraft hijackings in the 1970s, the 1983 suicide attack on US and
    French contingents of the multinational peacekeeping force in Beirut,
    the 1993 attack on the World Trade Center, the 1993 bombing in the
    City of London, the 1995 sarin gas attack in the Tokyo metro and the
    1996 bombing of a US military compound in Saudi Arabia, which put
    terrorism at the forefront of the subsequent G7 summit.
    Recent terrorist attacks (Oklahoma City, Khobar Towers, US
    Embassies in Kenya and Tanzania) have been increasingly more
    destructive and claimed a growing number of victims.
    The 11 September attacks exceeded in scale and audacity those of
    previous events. Yet, intelligence and military experts actively prepare
    protection against attacks on an even broader scale.
                                                                        39 39
   Assessing the economic impact of such a
    terrorist attack is nearly impossible – it could in
    any case exceed the capacity of many individual
    states
    Ex: An attack against New York City using a nuclear weapon
    could leave most of the metropolitan area uninhabitable for
    years. The direct impact would reduce the country’s production
    potential by about 3 per cent, that is, the equivalent of a small
    OECD country’s GDP.

   New terrorism is international by nature: no
    country is protected from new forms of terrorism,
    and new attacks could target or contaminate
       many countries simultaneously
    Ex: explosion of nuclear device or release contagious viruses in
    a populous metropolitan area

                                                                   40 40
                   3.3. Possible models
   ICAO scheme for the aviation sector:
    the ICAO aims at creating a non-profit insurance company which would
    provide liability coverage for war risks of up to USD 1.5 billion, subject
    to a franchise of USD 50 million. This approach would require
    premiums to be paid by each party insured in order to constitute a
    reserve to pay claims for losses covered by the policies. It also
    provides for guaranteed reinsurance to be given to the insurance
    company by the participating States. This scheme has not yet been
    approved by a sufficient number of countries to be implemented;
   CEA proposal for a European insurance mechanism:
    this November 2001 proposal aimed at a coordinated European
    mechanism combining local public resources at EU or EEA
    level;
   Paris Convention and the Brussels Supplementary
    Convention providing for the compensation of losses
    resulting from the peaceful use of nuclear energy – probably
    the most useful model at this stage

                                                                          41 41
                3.4.Pending issues

    Many issues have to be solved when considering the
    implementation of a system of international solidarity
   definition of terrorism acts to be covered
   conditions of access
   definition of losses covered (life/property/environment
    - geographical coverage)
   criteria for contribution by parties to the agreement
    (GDP/population,etc.)
   procedure for submitting contributions/ competent
    tribunals
   dispute settlement procedure
   duration of the agreement
                                                        42 42
                     Conclusion

   There is no ideal risk-sharing model to cover
    terrorism: each cover arrangement should be
    designed to address the specificity of a national
    market according to pre-determined public policy
    goals.
   However, in defining how terrorism risk should be
    covered, decision makers -be they private sector or
    governmental representatives- should take into
    account several underlying principles in order to
    provide the most adequate cover and respect all
    parties involved in this endeavor. Some of these
    objectives have been inter alia highlighted by the
    working group on Pool Re's reform               43 43
    Adopt:
   a long-term perspective to terrorism coverage defining and
    separating the short-term needs and longer-term challenges
    relative to the coverage of terrorism;
   a flexible approach: the form of terrorism events may evolve in
    time, as well as their insurance market coverage. Coverage
    should be able to adapt to these new situations or be
    reevaluated;
   a balanced approach between the role assigned respectively to
    the insurance industry, the financial markets and the state as
    reinsurer of last resort,


    while
   avoiding crowding out effects for the private sector that could
    discourage the adaptation of insurance markets to terrorism
    risks;
   avoiding and properly assessing the negative externalities
    stemming out of insufficient terrorism coverage for the rest of the
    economy.
                                                                   44 44

				
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