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Loss stoppers: alternative reinsurance designs can reduce some of the uncertainty surrounding terrorism.

Key Points

* Some reinsurers are writing terrorism reinsurance The contract made between an insurance company and a third party to protect the insurance company from losses. The contract provides for the third party to pay for the loss sustained by the insurance company when the company makes a payment on the original contract.  on an excess-of-loss basis.

* Quota-share reinsurance may provide some relief from losses due to terrorism.

* Whole account stop-loss reinsurance provides underwriting Underwriting

1. The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt).

2. The process of issuing insurance policies.
 protection with less restrictions.

Arguably ar·gu·a·ble  
adj.
1. Open to argument: an arguable question, still unresolved.

2. That can be argued plausibly; defensible in argument: three arguable points of law.
, terrorism has impacted the insurance industry as much if not more than any other industry. The bulk of the losses that resulted from the terrorist attacks of Sept. 11, 2001, were borne by the insurance industry. The Terrorism Risk Insurance Act The Terrorism Risk Insurance Act (TRIA) is a United States federal law signed into law by President George W. Bush on November 26, 2002. The Act created a federal "backstop" for insurance claims related to acts of terrorism.  of 2002 does provide significant protection to insurance companies, but there are a number of limitations that concern insurance company executives. Consequently, there is still much uncertainty regarding the potential exposure for insurance and reinsurance companies as a result of potential covered losses from acts of terrorism.

TRIA TRIA Terrorism Risk Insurance Act of 2002
TRIA Term Requirement in Average
 Limitations

TRIA provides for a federally funded backstop for insurers in the event of a "certified See certification.  act of terrorism;" in particular, acts committed by one or more persons acting on behalf of a foreign person or foreign interest. Domestic acts of terrorism are completely excluded from coverages afforded under TRIA.

TRIA excludes from coverage acts committed in the course of a declared war and sets a deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes).  for individual companies of 10% and 15% of direct earned premiums Earned premium is the portion of an insurance written premium which is considered "earned" by the insurer, based on the part of the policy period that the insurance has been in effect, and during which the insurer has been exposed to loss.  in 2004 and 2005, respectively. Collateral damage collateral damage Surgery A popular term for any undesired but unavoidable co-morbidity associated with a therapy–eg, chemotherapy-induced CD to the BM and GI tract as a side effect of destroying tumor cells  of personal property also may not be covered. Finally, TRIA automatically terminates on Dec. 31, 2005.

A certified act must have resulted in damage within the United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. , outside the United States in the case of a U.S.-flagged vessel, or on the premises of a U.S. mission. Terrorism losses incurred globally, such as the series of bombings of commuter trains in Madrid on March 11, 2004, that impact U.S. insurers may be completely excluded from coverages provided by TRIA.

Existing Reinsurance

Existing reinsurance programs may or may not provide much coverage for terrorism. Some reinsurers provide a blanket exclusion for all terrorism, domestic and foreign. Most, if not all, traditional contracts exclude losses tied to nuclear, biological or chemical (NBC NBC
 in full National Broadcasting Co.

Major U.S. commercial broadcasting company. It was formed in 1926 by RCA Corp., General Electric Co. (GE), and Westinghouse and was the first U.S. company to operate a broadcast network.
) explosion, release or containment. Small and regional companies are obtaining some terrorism coverage (other than NBC) in their traditional reinsurance programs. Larger companies that operate in major metropolitan areas, however, are not automatically obtaining terrorism coverage There are terrorism-only covers available in the market, but the economic cost, coupled with the limited coverage, is frequently not attractive to buyers of reinsurance.

If a company's existing reinsurance is a specific excess-of-loss program for each insured, no or little coverage will be afforded if the losses from acts of terrorism turn out to be high frequency/low severity losses instead of the high severity/low frequency losses such its those that occurred on Sept. 11. Even though losses from acts of terrorism may be tied to a common event or group, the definition of a single loss occurrence under existing property event catastrophe reinsurance may not be broad enough to integrate all the acts of terrorism losses into a single event. Accordingly, both per-insured and per-event reinsurance programs may not provide sufficient coverage. Thus, losses from acts of terrorism in the foregoing circumstances may fall to the bottom line as a hit or reduction to the insurance company's net income and surplus position.

Alternatively, quota-share reinsurance may provide some relief from losses from acts of terrorism, since quota-share reinsurance provides first-dollar coverage. Quota-share reinsurance, however, typically has per-occur fence limits of three times the per-risk limit, as well as a coinsurance A provision of an insurance policy that provides that the insurance company and the insured will apportion between them any loss covered by the policy according to a fixed percentage of the value for which the property, or the person, is insured.  or coparticipation clause. This coinsurance portion and per occurrence limit would obviously leave the insurance company exposed.

Stand-Alone Terrorism Coverage

Some reinsurers are writing on an excess-of-loss basis stand-alone terror ism reinsurance products. Nevertheless, these stand-alone products provide only limited coverage, usually equal to a fraction that is 20% or less of the ceding cede  
tr.v. ced·ed, ced·ing, cedes
1. To surrender possession of, especially by treaty. See Synonyms at relinquish.

2.
 company's natural peril The designated contingency, risk, or hazard against which an insured seeks to protect himself or herself when purchasing a policy of insurance.

Among the various types of perils for which insurance coverage is available are fire, theft, illness, and death.


PERIL.
 catastrophe program. The overall capacity in the market for terrorism-only products is less than $200 million of limit for property-only coverage and up to $500 million for workers' compensation-only coverage excess of a certain deductible or retention, usually at rates of 10% or more. There may be some potential profit sharing profit sharing, arrangement by which employees receive, in addition to their wages, a share of the net profits of a business. The purpose is to give them an incentive to increase their output through enhanced morale, less wasteful use of materials, better care of  in the event of favorable fa·vor·a·ble  
adj.
1. Advantageous; helpful: favorable winds.

2. Encouraging; propitious: a favorable diagnosis.

3.
 loss experience, but the profit-sharing terms do not address the limited income or surplus protection benefits provided by the standalone stand·a·lone  
adj.
Self-contained and usually independently operating: a standalone computer terminal. 
 terrorism covers.

Whole-Account Stop-Loss

Whole-account stop-loss reinsurance is providing an opportunity for those buyers of reinsurance who desire significant underwriting protection without overly restrictive terms and conditions. Since stop-loss reinsurance attaches at an agreed-upon loss ratio, uncertainty as to whether losses from acts of terrorism will be reinsured is addressed. Stop-loss reinsurance will cover both the severity and frequency of losses, subject to the terms and conditions contained in the stop-loss agreement.

A risk that is difficult to reinsure re·in·sure  
tr.v. re·in·sured, re·in·sur·ing, re·in·sures
To insure again, especially by transferring all or part of the risk in a contract to a new contract with another insurance company.
 on a stand-alone basis is more reinsurable in a whole-account stop-loss cover for several reasons. The insurance risk associated with losses from acts of terrorism (the amount of loss and timing of los payment) now are being spread or combined with the other risks or lines of business. There will be some correlation of risk among the exposed lines of business such as workers' comp comp

See comparison.
 and general liability. Nevertheless, there is a mitigation MITIGATION. To make less rigorous or penal.
     2. Crimes are frequently committed under circumstances which are not justifiable nor excusable, yet they show that the offender has been greatly tempted; as, for example, when a starving man steals bread to satisfy
 of the uncertainty associated with losses from acts of terrorism when combined with other lines of business in other geographic areas.

In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently
, the dispersion dispersion, in chemistry
dispersion, in chemistry, mixture in which fine particles of one substance are scattered throughout another substance. A dispersion is classed as a suspension, colloid, or solution.
 of risk is extended through the diversification Diversification

A risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance.

Notes:
Diversification is possibly the greatest way to reduce the risk.
 of exposures that allows favorable experience and predictability in one line of business to be offset by adverse development and uncertainty in another line. This diversification of risk, as described in portfolio theory, mitigates the total risk.

Lastly; the loss-ratio retention for a whole-account stop-loss is applied to the entire premium base, since all the lines are covered by the contract.

This results in a greater dollar retention. This greater dollar retention enables the reinsurer re·in·sure  
tr.v. re·in·sured, re·in·sur·ing, re·in·sures
To insure again, especially by transferring all or part of the risk in a contract to a new contract with another insurance company.
 to offer the insurance company more attractive pricing, including a lower profit margin and premium for limit. On a present-value basis, the reinsurer does not expect to lose at the lower ultimate loss ratios. It is reasonably possible, however, that the reinsurer will lose economically at the higher ultimate loss ratios. For a higher ultimate loss ratio to occur, typically more than one adverse loss contingency may need to occur.

Design Features

The stop-loss cover can be designed so that the ceding company pays a minimum margin--a kind of reservation of capacity charge--if no losses are ceded to the stop loss. Only in the event that losses are ceded does the insurance company pay additional premiums. The additional premiums for the stop loss typically range from 40% to 60% for each dollar of coverage purchased. These favorable rates-on-lines will provide significant underwriting benefit to the insurance company.

Do the Math

Suppose a company is able to buy at attractive pricing $100 million of standalone terrorism coverage excess of some agreed-upon retention or deductible. Furthermore, assume the premium for this coverage is $10 million or a 10% rate-on-line. Thus, the company could obtain up to $90 million of underwriting benefit ($100 million recovery less $10 million premium expense) if the full limit is utilized. If no loss is ceded to the cover, the company is out $10 million of ceded premium. The reinsurer can profit by $10 million (no loss) or lose $90 million.

The probability of loss being ceded to stand-alone terrorism cover is remote. This remote type of coverage is called "sleep insurance. "A company buys "sleep insurance" in order to protect its surplus from a devastating dev·as·tate  
tr.v. dev·as·tat·ed, dev·as·tat·ing, dev·as·tates
1. To lay waste; destroy.

2. To overwhelm; confound; stun: was devastated by the rude remark.
 event so management can sleep at night. However, the cost of the terrorism-only cover is in addition to the cost of other natural peril catastrophe covers that the company buys. Furthermore, the terrorism coverage will more than likely exclude NBC coverage and contain a large retention or high deductible. Consequently, the probability-weighted risk-reward relationship for the stand-alone terrorism cover will probably not be attractive to the ceding company.

As an alternative, suppose the company buys a whole-account stop-loss reinsurance coverage that protects the loss ratio of the entire book of business retained by the company. Suppose its expected losses of all lines combined are $1 billion. Under the stop-loss arrangement, the company is protected for perhaps $200 million excess the expected losses for the current accident year. The minimum premium is $3 million; the actual premium may be 40% of the first $100 million of ceded losses and 50% of the next $100 million of ceded losses. The reinsurer also requires a $100 million sublimit sub·lim·it  
n.
A limit or ceiling placed on a subdivision of a larger category, especially of nuclear weapons: negotiating sublimits on the number of land-based, intermediate-range missiles.
 on the total combined amount of unbudgeted losses from acts of terrorism and property catastrophe losses that are subject to the stop loss. Within the $1 billion of expected losses by the company is an allowance or budget of $30 million for net retained property catastrophe losses, but no amount is budgeted for retained losses from acts of terrorism. Thus, the company could theoretically incur $100 million of additional unexpected losses from acts of terrorism, including NBC or property catastrophe losses, in the current accident year; recover $100 million from this cover; and still have $100 million of limit available for other potential adverse loss contingencies.

Under the above stop-loss example where $100 million of NBC losses from terrorism and $100 million of losses from natural peril are ceded, the company would cede $90 million of premium for a $200 million recovery and thereby obtain $110 million of underwriting benefit. This is at least $60 million more than the underwriting benefit obtained in the stand-alone terrorism cover example because of the NBC exclusion (stand-alone cover is at a cost of $10 million with no covered NBC losses, while the stop-loss cover will provide at least $50 million of benefit for the NBC losses).The coverage under the stop loss is broader, which is critical for management to be able to "sleep" more soundly at night. Also, the $3 million minimum premium for the stop loss probably compares quite favorably fa·vor·a·ble  
adj.
1. Advantageous; helpful: favorable winds.

2. Encouraging; propitious: a favorable diagnosis.

3.
 with the combined cost of the standalone terrorism cover and the natural peril catastrophe reinsurance, since the whole-account stop-loss reinsurance provides both types of coverage.

Rating Agencies

Disclosures on terrorism exposure required by the Securities and Exchange Commission and rating-agency questionnaires highlight the potential vulnerability of both individual companies and the industry as a whole to losses from acts of terrorism. The A.M. Best Co. Supplemental Rating Questionnaire now includes a section (Part IV) dedicated entirely to terrorism. All companies rated by A.M. Best are required to complete this section. Each company needs to delineate its process for monitoring and managing its aggregate exposure to terrorism. When the coverage afforded under TRIA expires, this information will be critical to assess how much of a company's capital is at risk.

As noted earlier, reinsurance is an effective tool to mitigate the net capital an insurance company has at risk. Reinsurance will not make "unprofitable" business profitable over the long term. The fundamental pricing and risk selection must be sound. Consequently, the rating agencies will evaluate the contingent nature of the reinsurance coverage, as well as the broadness of coverage and potential economic risk transfer under the terms and conditions of the reinsurance contract.

The Sept. 11 targets were "trophy" properties and Americans in the United States. The March 11 targets were transit properties and Spanish commuters. The bombings in Madrid are a reminder of the uncertainty in the world for buyers of reinsurance. Consequently, buyers of reinsurance now more than ever need to evaluate "all their options. Alternative reinsurance designs may offer a more cost-effective approach. Stop-loss coverage will not eliminate all the uncertainty surrounding losses from acts of terrorism. Stop-loss coverage is, however, an effective and practical way for insurance companies to mitigate some of the uncertainty surrounding terrorism exposure.

Hugo Kostelni is a principal and senior vice president and Thomas Salina Salina (səlī`nə), city (1990 pop. 42,303), seat of Saline co., central Kans., on the Smoky Hill River; founded 1858 by settlers opposed to slavery, inc. 1870.  is an assistant vice president at Towers Perrin Towers Perrin is a global professional services firm.

It was established 1 March 1934 as Towers, Perrin, Forster & Crosby. The umbrella name of Towers Perrin was adopted in 1987.
 Reinsurance in Weatogue, Conn.
COPYRIGHT 2004 A.M. Best Company, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2004, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Reinsurance/Capital Markets
Comment:Loss stoppers: alternative reinsurance designs can reduce some of the uncertainty surrounding terrorism.(Reinsurance/Capital Markets)
Author:Salina, Thomas
Publication:Best's Review
Geographic Code:1USA
Date:Jul 1, 2004
Words:1972
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