Insuring Against Terror

The September 11 terrorist attacks on New York and Washington are likely to have a major impact on how insurance firms define and manage risk. In a way, these events have presented companies with scenarios that only science fiction writers could have dreamed up one year ago.

The insurance industry plays a unique role in managing terrorism risk — via underwriting property risk and offering protection against business disruptions. In theory, insurance companies can deny claims on losses that result from acts of war.

Yet, after the attacks on September 11, no company dared to refuse claims resulting from these events. All of these companies had adequate capital to satisfy the claims made against them.

Reinsurance companies, however, have now suspended coverage of terrorism risk in the United States. Many primary insurers also plan to withdraw from the market. There are even some anecdotal reports about banks becoming more cautious in their real estate lending.

U.S. history provides some fascinating examples of how insurance firms cope with both war and natural disasters. These instances may provide some guidelines for the debate about terrorism risk — and what action that the country’s government should take.

Back in 1861, at the start of the U.S. Civil War, leading insurance companies in the Northern states suspended business in the newly-created Confederacy. They also reduced fire coverage for property in Washington, D.C.

The following letter from a Northern insurance company to its Southern policyholders was characteristic of the time:

“We do not consider outstanding policies vitiated by the simple act of secession, but if any loss occurs consequent upon this act, or by any causes enumerated in the clauses to which you call our attention, we most emphatically consider that the policy covering such property is thereby rendered null and void.”

Some property owners in the states of the new Confederacy continued to have coverage for their assets during the war’s first year. In one instance, a Charleston, South Carolina property owner who suffered fire damage sent a claim to Hartford Insurance for $800.

The claim was paid, but no local bank would honor the check until the war had ended. In general, though, property owners in the Southern states had to seek compensation from local or British insurance companies — and not firms in Hartford, New York and Philadelphia.

The major concern of insurance companies in the Union during the Civil War was managing maritime risk. The Confederacy had three naval attack vessels which inflicted significant damage on the North’s commercial shipping.

The costs of shipping insurance rose from 2.5% to between 4 and 5%. Firms even attempted to manage their coverage by tracking the Confederate fleet. Many shipping companies also tried to reduce risk by reclassifying their boats as British, rather than U.S. vessels.

The maritime losses resulting from the U.S. Civil War totaled close to $15.5 million. During the war, U.S. shipping tonnage fell from 2,496 tonnes to 1,387 tonnes.

The property losses in the Confederacy during the conflict were also devastating. In 1860, the census reported assets in the Southern states totaling close to $4.3 billion. In 1865, the value of these assets had shrunk to a figure slightly over $1.6 billion. Only $1.6 billion of that $2.7 billion in losses resulted from the abolition of slavery.

In the 1860s, the U.S. insurance industry was too small to offer coverage for more than a tiny fraction of potential losses resulting from the conflict. Back then, the total assets of the U.S. life insurance industry were $24 million in 1860 and $64.2 million in 1865.

The largest property casualty insurance companies had only a few million dollars of capital. As a result of the insurance industry’s modest size, substantial compensation for property losses during the war came from the federal government.

It offered to pay compensation to property owners — provided they could demonstrate that they had been loyal to the Union cause.

No precise data exists for the amount of the claims, but the U.S. government archives have data for thousands of property owners in the Southern states who sought compensation from the federal government.

Perhaps the best historical analogy to the contemporary problem of terrorism risk is the policy pursued by the U.S. government to insure shipping after the outbreak of World War I in 1914. At the time, the United States of America was enjoying a surge in export orders from Europe. Thus, the conflict threw the market for shipping insurance into chaos.

The U.S. government’s response to the conflict was to establish the War Risk Company to insure boats. The War Risk Company offered insurance coverage of over $2 billion — and ultimately earned a total profit of $16.5 million on gross premium income of $46.7 million.

After the start of World War II, the U.S. government acted in a similar manner, with a slight twist. In 1942, it also established a company — called the War Damage Corporation Fund. This government company, however, operated in partnership with private insurance companies.

Under this plan, private companies continued to operate as they did before the war — providing coverage to businesses and households. The U.S. government stood in reserve to help absorb losses in the event of underwriting catastrophes.

All in all, the War Damage Corporation Fund provided insurance coverage of over $30 billion. It collected $544 million in premium income, and disbursed $386 million before mid-1947 — with claims of $17 million a few years after the war. The Fund operated through 546 insurance companies, and maintained 1450 policy writing offices.

Both of these precedents for insuring maritime risk during the two world wars are highly illuminating. So it’s extraordinary that now in early 2002 — four months after the U.S. Congress has started debating how to manage terrorism risks — there has been no broader media or industry discussion of the importance of these issues.

In both 1914 and 1942, it was obvious to everyone that the private sector alone could not assume the entire risk for insuring the merchant marine during a war. The September 11 attacks demonstrate that America is once again at war. And in this war, there is no way of predicting exactly when or how the enemy will strike again.

The U.S. government had more freedom to move decisively in both world wars. After all, a war had been formally declared by many countries. No tort lawyer lobby then existed to resist limitations on the freedom to pursue lawsuits.

But while the legal and political background to the war against terrorism is different from 1914 and 1942, it is hard to escape the conclusion that there is a need for government action. The private sector will not be able to provide insurance coverage against enemies who could use nuclear, chemical or biological weapons against the people of the United States.

February 17, 2002