Disaster for an Obscure Industry

Estimates of the insurance payouts from the World Trade Center attack run from $40 billion to as much as $70 billion. That means that insurance companies are paying out a lot of money. Where are they coming up with all of that cash?

The answer lies in the inner workings of the insurance industry. Of course, insurance companies usually assume that their current premiums will cover their payouts during any given year. That is because many — if not most — of the insured people or businesses will not have a claim against the company.

But everybody has bad years — and insurance companies are no exception. To make sure that, even in a bad year, claims will be honored, insurance companies do two things.

First, they have “reserves” — investments that they can sell to cover losses if their current premiums receipts are not large enough. And, second, they can “reinsure” their risks.

What does this mean? It means that there are insurance companies for insurance companies. The “reinsurance” companies are large, and essentially provide a world-wide network for sharing risks.

A retail insurance might decide, for example, that too much of its risk is geographically concentrated — say, in lower Manhattan. Rather than cutting off loyal and profitable customers operating in that area, the insurance company in question can spread that particular risk around the world through reinsurance contracts.

The reinsurance companies, of course, must also be prepared for a bad day. They do this by keeping enough investments on hand to allow payouts even when claims are greater than payouts. And, of course, they trade risks among themselves. Essentially, that means that risks in a single area are spread all over the world.

As a result, major insurance “events” are felt around the world as well. Hurricane Andrew hit Florida in 1992 — but the financial blow was felt in Zurich and Tokyo as well as in Miami and New York.

Obviously, the September 11 destruction of the World Trade Center was a major insurance event. After all, a number of major office buildings besides the twin towers were destroyed.

That is an enormous amount of property. But, still, the property’s value wasn’t that great. After all, the 99-year lease for the World Trade Center that was signed in the spring of 2001 was worth just $3.2 billion — nowhere near the $40 to $70 billion payout the industry anticipates.

Of course, there were a surprising number of related payouts. (Auto insurance companies are paying for the careful cleaning of cars that were parked on the streets of lower Manhattan on September 11 — and therefore got covered with dust from the collapse of the buildings).

Through reinsurance, that risk — and cost — was spread around the world. Nobody has yet suggested that any single insurance company will fail. A great many — some in surprising places — gave their stockholders some unpleasant news.

And what is even more surprising is this: The major source of all those payouts was not the buildings — expensive though they are. The largest portion of losses from September 11 was from business interruption insurance.

That’s right. Some businesses carry insurance to make up for lost revenues in the event that they cannot operate. Businesses that especially need this insurance are those that do a lot of time-sensitive work. Like the financial brokers and traders that occupy lower Manhattan.

Even the huge reinsurance industry was staggered by the blow. The OECD estimates that one quarter of those rainy day assets that the reinsurance companies accumulated will be gone once all of the claims are paid out.

In other words, for the reinsurance industry, 2001 turned out to be a really, really bad year. Imagine: one-quarter of all assets of the entire industry wiped out by one event.

Lower Manhattan may well have been the worst place possible for a disaster of this magnitude, from the insurance point of view. Just as New York will spend years rebuilding Lower Manhattan, the global reinsurance business will be struggling for years to replace those lost assets.

It will all have a significant impact on the insured — which means all of the rest of us. Already, commercial mortgage lenders are insisting that borrowers have terrorism insurance.

And the insurance industry — having seen the risk that terrorism has created — is rather reluctant to get into that line of businesses.

One suspects that the reinsurance companies — now trying to get out from a huge financial blow — are hardly ready to branch out into a new and uncertain line of business.