In the days following the September 11 attacks against America, dire warnings were issued about the class of companies that provide life, casualty and property insurance to people and businesses affected by the tragic events. As Paul Kleindorfer, a Wharton professor of decision sciences, economics, and business and public policy, said at the time, “World War II and Vietnam had considerably larger losses, but if we’re talking about insured losses, this is the largest catastrophe in the history of the industry.”


Approximately one year ago, in the immediate wake of the attack, Kleindorfer and other Wharton faculty considered its long-term and short-term effects on the insurance industry. Drawing on a combination of historical data and anecdotal evidence, they identified some major issues and forecast some of the ways they might be resolved.


Now, with the benefit of hindsight, it appears that many of their prognostications were accurate, although in some cases, the passage of a year is still not long enough to tell how some of the most critical issues will be played out.

As might be expected, the primary concerns were finance related: Would life insurance companies honor Sept. 11th-related claims? Would international reinsurers (secondary companies that cover all or a part of the liability assumed by a primary insurance company) either withdraw their terrorism coverage or even go belly up? Wharton faculty also considered some rescue strategies, such as the possibility that the federal government would step in with a bailout, similar to the $15 billion aid package extended to the airline industry, or would directly enter the industry, either as a reinsurer of last resort or directly as an insurer.


A look at the industry’s recent past offers little comfort. When Hurricane Andrew, for example, struck in 1992 and generated about $19 billion in insurance payouts, eight small U.S. companies folded. The September 11 attacks, in contrast, are expected to dwarf that disaster, costing the industry somewhere around $40 billion, according to the Insurance Information Institute, a New York City-based trade organization.



The Buffett Factor


Despite the severity of the Sept. 11 attack, Wharton professors did not suggest a wholesale collapse of the insurance industry. Jean Lemaire, professor of insurance and actuarial science, believes today that no reinsurance company has gone bankrupt as a result of September 11, although he notes that many reinsurers have seen significantly reduced profits and even losses.


Indeed, according to the Insurance Information Institute, 2001 marked the first year ever in which the property and casualty industry suffered a full-year net loss. Meanwhile, analysts and reinsurance executives have forecast that 60% to 80% of the losses from September 11 will lie with the reinsurance industry.


Kleindorfer, however, suggests that reinsurance companies may not be in much financial danger over the long term. “What we have seen is that right after September 11 two forces moved in opposite directions,” he says. “First, insurance companies began to pay claims,” which placed a drag on their financial results.


But right after the event, as reinsurance rates climbed, Warren Buffett and other investors bought into selected reinsurance companies, indicating that they saw the firms as a good investment. “Why would investors go into these companies unless they anticipated that they would make losses back … in a measured pace over the foreseeable future?” asks Kleindorfer. “Shareholders and others also appear to be comfortable with reinsurers’ new debt and other efforts to raise capital.”


In fact, the long-term viability of selected insurance companies, as measured by the activity in their stock prices, was dramatically demonstrated in a July 2002 paper co-authored by insurance and risk management professor J. David Cummins and Christopher M. Lewis, titled “Catastrophic Events, Parameter Uncertainty and the Breakdown of Implicit Long-term Contracting in the Insurance Market: The Case of Terrorism.”


According to Cummins and Lewis, “The immediate effect of the attack was a general decline in insurance stock prices. However, during the period after the first post-event week, the stock prices of insurers with strong financial ratings rebounded while those of weaker insurers did not, thus providing support for the flight to quality hypothesis.”


While Kleindorfer is bullish, he is also aware of potential risks. He maintains, as he did a year ago, that it will be a while before we know the cost of the attack. One category of claims, business interruption (which could range from “a few billion to several tens of billions” of dollars) is typically negotiated in a drawn-out process. “In one to three years we’ll see the full impact on reinsurers,” he says. “One question concerns how much of the total that they will have to bear has already been quantified and booked. Some reinsurers, like Swiss Re and Munich Re, are known for their conservatism and have probably already booked most of the liability to reserves.”


Government Role in Terrorism Coverage?


Of course, September 11’s blow to the insurance industry went beyond pure finances. As decision sciences professor Howard Kunreuther observed right after the attacks, “This is a good example of an event that the insurance industry, in its own planning process, did not think could happen … We, as a society, will have to re-think our strategies for dealing with low-probability events, and reconsider the role of government. It will be extremely difficult for the private market to do what may be necessary for dealing with future events. And the insurance and reinsurance industries will have to re-think which events are insurable.”


Kunreuther’s concerns about the private market’s ability to “deal with future events” were on target, while hopes for potential solutions appear to have gotten bottlenecked in political squabbling.


For example, according to United States General Accounting Office congressional testimony released at the end of February, the insurance industry, following the September 11 attacks, has been shifting the risk for terrorism-related losses from reinsurers to primary insurers and then to the insured.


This trend was also documented in an August 2002 presentation by the Insurance Information Institute titled, “The Long Shadow of September 11: Terrorism & Its Impacts on Insurance Markets.” According to the Institute, exclusions for terrorism-related insurance coverage have already been approved in 45 states, Washington, D.C. and Puerto Rico.


Although Kunreuther and others have called for consideration of a government role in providing terrorism coverage – similar to the way the National Flood Insurance Program provides residential flood insurance coverage in exchange for community adoption of certain mitigation measures, and the Federal Crop Insurance Program provides agricultural producers with coverage for crop losses from natural hazards – final action has not been taken. Although the Senate and the House have each passed some version of such a bill, the two versions have yet to be reconciled.

Cummins – who has given Congressional testimony on the subject – weighed the advantages and risks of federal reinsurance in a paper titled, “Federal Terrorism Reinsurance: An Analysis of Issues And Program Design Alternatives” that he co-authored with insurance and risk management professor Neil A. Doherty.


In the paper, they raised such issues as the danger of politicizing such a program, recognizing the lobbying power of “well organized interest groups.” The most efficient form of such reinsurance, they say, would be “securitization through the auction of federal excess of loss reinsurance call option spreads covering terrorist attacks.”


Finally, any consideration of the industry must consider the concept of predictability of risk, its relation to pricing models, and the difficulty in quantifying risk when terrorism is involved.


As Kunreuther pointed out a year ago, “With hurricanes and earthquakes, the insurance industry has some estimates of the chances of these events occurring. You have scientific and engineering data, and a sense of what’s likely to occur. With terrorism, everything is up for grabs.” Today, he says, uncertainty is still a factor. “Ambiguity is an important part of any event that has a low probability, and we don’t have a lot of data. “Unlike natural disasters, terrorists’ actions are taken on a conscious level. They can move, and try to overcome defenses.”


As the federal government continues its efforts to protect America’s shores, the insurance industry and academics will continue their efforts to hone their predictive tools. But in both cases, the struggle promises to be a difficult one.