A backup plan is needed: without federal terrorism support, insurers would have only a few equally unattractive choices to protect their financial viability. (Property/Casualty: Underwriting Insight).

The passage of the Senate Terrorism Insurance Bill on June 18 brought hope to the insurance industry and commercial insurance buyers that a low-cost insurance solution for rapidly disappearing terrorism insurance coverage is just around the corner. I hate to burst your bubble. But even if the different approaches of the Senate and House can be reconciled into a bill that President Bush will sign into law, the insurance industry still will shoulder a significant portion of the financial responsibility that emanates from the terrorism peril.

The majority of commercial property carriers add comprehensive exclusions to all new and renewal policies for losses resulting directly or indirectly from terrorism. Most insurers, therefore, are operating under the impression that terrorism exposure in their commercial property portfolios has gradually diminished and will be close to zero on the first anniversary of the date that terrorism exclusions were introduced.

This is an illusion, because a small number of economically important states have yet to approve the use of terrorism exclusions for commercial property policies. For an insurer that is admitted in California, Georgia, New York and Texas to add a comprehensive terrorism exclusion without regulatory approval invalidates the use of the exclusion in these states. Regulators in these states consider total exclusions as overly broad and even reject limited terrorism coverage endorsements, such as the one developed by the Insurance Services Office Inc. These regulators hold that the $25 million industry loss event that voids the limited terrorism coverage is unreasonably low and that the 72-hour occurrence definition that is used to aggregate all losses in the event is arbitrary and unfair. They also feel that a total exclusion for biological and chemical agents is overly broad and unreasonable.

Of course, many insurers are trying to circumvent the position that these states have taken by writing commercial property business under only the generally liberal umbrella of excess and surplus lines insurance paper. Provided that the business underwritten actually qualifies as a special risk that can be underwritten in an E&S company, the insurer is entitled to add a terrorism exclusion, even in "difficult" states.

But the problem is by no means solved. About half of the states in the United States and all the provinces in Canada require insurers, admitted or not, to provide coverage for resulting fire damage for property located in their state/province, irrespective of the initiating cause. There are certain causes, however, that can be excluded--such as war, invasion and revolution--but terrorism is not among them. Canadian Provincial Insurance Acts allow for additional causes to be added to the list, but only if they are "just and reasonable." What qualifies under this definition is not clear, since no Canadian court has yet dealt with the issue.

Considering that probably 90% of the damage inflicted on the World Trade Center was not caused by the impact of the aircraft that were used as missiles but by the fire that followed it, insurers cannot afford to be in denial on the "fire following" issue. This is especially true, as there is a large disconnect between insurers and reinsurers on the subject. While insurers generally have to operate under the restrictions imposed by a consumer-oriented regulatory system, reinsurers are free to set their terms and conditions as they are dealing with educated parties deemed to be experts in the business. This means an insurer could find itself in a situation where the insurance contracts that were issued to consumers incur a liability in a future terrorism event that is simply not recoverable from reinsurers that have added comprehensive terrorism exclusions to their reinsurance contracts.

Without a government backstop, the solution to this quandary is not easy to find. Insurers have only a few, equally unattractive choices to protect their financial viability:

* they can withdraw from underwriting business in the states that require terrorism coverage or "fire following" terrorism coverage;

* they can relocate to an offshore domicile and underwrite U.S. risks as an alien insurer that is not subject to U.S. laws and statutes; or

* they can purchase costly and specific terrorism reinsurance and pass on the expense to consumers.

Klaus Gebhardt, a Best's Review columnist, is senior vice president of Ace Bermuda Insurance Ltd. He can be reached at [e-mail]