Reinsuring Unnatural Risks.

Man-made catastrophes include airplane crashes, falling satellites and sinking oil rigs, but e-commerce may pose the greatest risks.

The much-dreaded Y2K computer glitch proved to be a dud, but the kinds of concerns it generated in the insurance industry are alive and well.

The concerns deal with a world that is more connected and interdependent than ever before. At the heart of that connectedness is fast-evolving electronic technology. For insurers, the new challenge is to understand the risks of insuring the technological net work against breakdown or sabotage.

While natural catastrophes continue to outrank man-made catastrophes in the amount of insurable damages, many insurance experts expect manmade catastrophe losses to continue to grow. Swiss Re reported that in 1999, insurers paid claims totaling $24.4 billion for storm, earthquake and flood losses, as compared with $4.2 billion for man-made catastrophes. Last year, catastrophes accounted for $10.6 billion of losses, according to a March report by Swiss Re. Nearly one-quarter of those losses was due to a single man-made event--the "I love you" computer virus.

The risks of insuring electronic commerce are meanwhile growing along with the technology, equipment and data, and the implications are not yet well known.

"Electronic risks as they exist to day have not been around for a long time," said Clint Harris, vice president of insurance research and publications at Conning & Co., Hartford, Conn. "They have more nuances to them than physical property risks. You can have cyber-attacks from multiple directions, and the question of where losses originated and occurred is more difficult to determine,"

Y2K Opens Eyes

Before Y2K, the insurance industry tended to look at exposures as isolated events, said Tom Walker, spokesman for American Re-Insurance Co., Princeton, N.J. "The Y2K issue really forced the industry to do a 'what-if' scenario," he said. "It forced us into a much different way of looking at a potential interruption, and it raised a lot of issues about the responsibilities that companies will have to third parties in disaster situations."

Walker said American Re already has gone beyond its traditional thinking about man-made catastrophe losses to include what the insurance industry may consider more of a "clash" loss. For example, transmission of a computer virus might reverberate to losses of data and other property, business interruption, lost profits and third-party liabilities. "While this may be more inclusive than what Swiss Re has historically measured in its global cat-loss statistics, it is what we think insureds and insurers/reinsurers are increasingly concerned about, "Walker said.

These clash losses also can extend to events with a natural origin. An ice storm, for example, causes first-party property damage claims as well as liability claims for power interruptions experienced by third parties. "We believe that interdependency is an increasingly important aspect of large man-made losses, just as it is with other phenomena of the 21st century," Walker said.

Insuring man-made losses is nothing new for the insurance industry, but it often presents challenges for the industry and offers a chance to develop new business. "The most basic casualty insurance is fire insurance, and most fires are the result of man made hazards," said Michael Schell, president and chief operating officer at St. Paul Reinsurance Co., New York. Other kinds of insurance against man made catastrophes include marine insurance, which protects hulls and cargoes, and aerospace and satellite insurance. All are characterized by low frequencies and high costs per claim.

The most extreme example of re cent times is insurance covering disasters at nuclear power plants. Schell said the insurance industry originally didn't believe it could handle that coverage because of the potential for unlimited liability, but government worked to limit liability, and the industry was able to pool its catastrophe resources.

Underwriting New Risks

When new insurance needs evolve, the first reaction of the industry is to proclaim that its existing policies don't cover the new need because it didn't contemplate the need when it wrote the policies, Walker said. In the meantime, the industry works to exclude those claims until it can understand them and underwrite them sensibly. "That's where we are with cyber-risk," he said. "The ISO [Insurance Services Office Inc.] has introduced a new policy form that will clearly carve out exposures that are arguable under existing policies. When the industry figures out which claims it can write, coverage will become available again. We're seeing that in the cyber-risk area and some other interconnected exposures'

Reinsurers get into the game after the direct writers. Employers Reinsurance Corp., an Overland Park, Kan. based affiliate of GE Global Insurance Group, is cautious about underwriting man-made catastrophes in general and electronic technology in particular. "We're not supporting any full-fledged cyber-risk products now," said Gene Mason, second vice president and practice leader for errors and omissions reinsurance and intellectual property. "The coverage is young, and we're not comfortable with the way it's being priced. We're in what you could probably say is our testing stage on cyber-risk, and we're looking to partner with one or two direct writers. There's practically nothing in our portfolio now."

Mason said ERC believes it may have an advantage in reinsuring cyber-risk through its access to the knowledge and expertise of experts in other General Electric businesses. "The security area of cyber-risk is critical, and we can tap into our own security professionals at GE," Mason said.

Despite the risks of the unknown, there appears to be much optimism among reinsurers that they can handle the new underwriting. "Undoubtedly, insurance protections will be provided and a special segment of the industry will be established, and it will be in short order," Schell said. "It's likely to be high risk with a high profit-and-loss potential, but with all the emphasis on insurance companies' part in developing the tech industry business, there's no doubt this will be handled by the U.S. commercial insurance market."

Schell predicted that risk-taking among insurers and reinsurers on this new line of business will be "balanced." Reinsurers will become more involved once the direct writers build up the number of policies and become more interested in protection from catastrophic events, he predicted. Interest also will increase as reinsurers exclude coverages in existing policies for electronics-related events and offer a separate product for electronics-related coverages. "It will become a new product area for reinsurers, and direct writers will want it," he said.

As of early May, St. Paul Re hadn't had any losses in the electronic realm, Schell said. The company is trying to develop some methodologies in the area, and it has risked a limited amount of coverage, he said. "We'll have a great deal of discussion and a product in the next couple of years," he said. "Insurance companies are building their books and their exposure now. As that becomes more commonplace, they'll want the coverage, and we'll want to provide it."

Mason said that probably a handful of direct writers of national size are willing to write and develop cyber-products without the backing of reinsurance. "They'll test the waters and develop pricing as they go along," he said. "It's important for them to monitor the cases and watch the litigation."

He said the major direct writers--those with nationwide businesses--tend to have more resources and underwriters than reinsurers, and they will minimize the risks of cyber-coverage through diversification of their overall portfolios.

One of the major difficulties of underwriting coverages involving use of the Internet is that it has no geographic boundary. Normally, geographical location is a factor in helping limit risks. "With the Internet, loss and exposure can run around the world very quickly," said Carl Hedde, vice president and leader of the catastrophe evaluation unit at American Re.

Hedde said the developed world is more likely to sustain these losses because it is where the value of e-commerce is concentrated. But that expectation is not a given, since the developed world also is likely to be where processes and systems are in place to protect against cyber-attacks. "So a problem may begin in the developed world, but the loss may extend beyond that, and it can happen the other way around, too"

Man-Made Catastrophe Modeling 

Another tool not yet available to the insurance industry for underwriting e-commerce and other areas subject to disasters caused by humans is catastrophe-modeling programs. These have been of value in identifying where and how frequently natural disasters are likely to strike. Hedde said his company expects to have some modeling capability for man made disasters within the next four or five years.

Modeling earthquakes depends on understanding geology. In modeling man-made catastrophes, the industry will need to find predictable patterns in the historical record. For example, in modeling power outages, insurers might tap into the history of power generating companies that was never examined because it hadn't previously been considered relevant, Hedde said. "Many man-made activities have been studied for as long as the activity has been going on," he said.

Similarly, in modeling the chance of an accident closing down a major oil refinery and all of the associated problems that could cause, Hedde said the industry might consider the consolidations in the oil industry of the past few years. "Before, there may have been 50 refineries producing a given amount of product, but now there may be just one" he said.

If any reinsurers have developed a modeling tool for use in man-made catastrophes, they are probably keeping a tight lid on that news, said ERC's Mason.

"We continue to build information ourselves," he said. "We look at surveys, at court cases and at new laws. It all has a lot to do with how we will position ourselves."

The industry may not know much yet about how to predict or control man-made catastrophes. But Harris pointed out that even though experts were wrong about the havoc they expected Y2K to wreak, their awareness may have staved off the expected disasters.

"Y2K is evidence that once you're able to foresee a problem, you're able to control it," he said. "A great deal of effort and money was spent on avoiding the potential catastrophe."

Some parties took no steps to protect against Y2K, particularly individual computer owners and European businesses. But Harris said U.S. businesses had much older systems than the Europeans, and it might be unfair to say U.S. businesses misused their money and time.

"The money insurers spent to prepare for Y2K was used to improve the front-end and back-room processing," he said. "The government's involvement has brought attention to the potential of cyber-attacks; President Clinton formed a panel on that, and President Bush has put in a great deal of effort. And that's all before we have real losses. That's good."

An Attorney's Perspective: Beware of Punitive Damages 

Claims from man-made catastrophes are likely to grow faster in coming years than those from natural catastrophes, according to a veteran insurance attorney in Chicago. That's largely because the risks are not well understood and are less capable of being modeled, said Lori Nugent of the insurance department of the law firm Cozen & O'Connor.

Nugent said there is much concern about e-commerce risks, but another fast-growing category deserves the attention of insurers and reinsurers: punitive damages awarded by courts.

"Punitive damages overarch all areas," she said. "They can be assessed against any insured without regard to lines of business. Also, punitive damages can be assessed against insurers in bad-faith disputes."

In the 1980s, a million-dollar verdict was a big deal noteworthy of major newspaper coverage. "Today, a million-dollar verdict is a defense verdict," she said. "To generate headlines now, verdicts have to be in the high hundreds of millions or even billions of dollars."

Punitive damages are based on sentiment of jurors. or what Nugent calls their "modulus." The modulus is determined by what jurors consider to be big amounts based on what they see and hear in the news, such as state lottery prizes or recent professional athletes' contracts, both of which have ballooned in size.

Most of the time, defense attorneys concentrate on winning a no-liability verdict, but their tendency is to ignore punitive damages. This needs to change, Nugent said.

Fortunately for the defense, the U.S. Supreme Court has provided a means for attorneys to keep down the size of punitive damages before resorting to an appeal. Judges now have three guideposts to follow in reducing a jury award, Nugent said. One is when jury awards exceed the maximum civil fine or criminal penalty. The second is to consider whether the conduct is sufficiently reprehensible to support a large award. And the third is a 10-to-1 rule-of thumb ratio, punitive damages to compensatory damages. "Some courts adhere to that ratio, but if they exceed it, the award may be unconstitutional," she said.

These guidelines stemmed from a 1995 case in Alabama, BMW vs. Gore. In it, a jury awarded the plaintiff $4 million in damages after he learned the new car he purchased had been repainted after sustaining acid rain damage while it was shipped from Europe. An appeals court reduced the award to $2 million, but the case eventually went to the U.S. Supreme Court, which reduced the award to $54,000.

Excessive damage awards are a phenomenon largely restricted to the United States, Nugent said. "A lot of syndicates in London won't insure U.S. businesses, in part because of runaway punitive damages. And courts in Germany, Switzerland and Japan have refused to enforce U.S. punitive-damage judgments, holding that these run away judgments are not worthy of international recognition" she said.

Nugent points to a friend or me court affidavit written by Walter Kielholz, who in 1994 was a member of Swiss Re's executive board, to illustrate her point. In the affidavit--which he filed as part of the BMW vs. Gore case--Kielholz said entities that manufacture or sell products in the United States often pay higher rates for insurance than entities in Europe. And he said insurers in the United States pay higher rates for reinsurance. As a result, Nugent said, entities doing business in the United States are at a competitive disadvantage in the global marketplace.

Nugent has been involved with thousands of punitive-damage claims, and she has discovered patterns to be avoided. Punitive-damages claims deserve special attention, she said. "We found that 'terrier counsels,' like yapping dogs, work the files," she said. A lot of times, they're not taken as seriously as a "name brand" (an attorney who is famous and can win a big verdict). But if they believe they have a good case, they'll bring in a name brand for the trial, she said.

Tom Walker, a spokesman for American Re-Insurance Co., Princeton, N.J., acknowledged that the U.S. bar "is creative in attaching responsibility" and in creating the environment of "connectedness" that leads to third-party liability.

"Risks are man-made in a lot of different ways--because our technology connects them, but also because our notions of who ought to be responsible are manmade," he said. "As long as we stay in the property realm, most of those things are governed by physical common sense, but liability is a man-made concept."