Trial by fire: Terrorism and nuclear exclusions are limited in states that adhere to the Standard Fire Policy. (Industry Strategies).

The tragic events of Sept. 11 have placed a staggering financial burden on the insurance industry. They represent the largest catastrophic insurance loss ever. The insured losses from the World Trade Center disaster alone are estimated to be in the $25 billion to $70 billion range. Because future, similarly disastrous attacks appear more possible than most people believed before Sept. 11, the insurance industry is re-examining its ability to insure such potential catastrophic events.

Insurers have said they will pay the losses stemming from the terrorist attacks. However, insuring future incidents of this nature, even if they are of lesser magnitude, could bankrupt some insurers and seriously weaken others. The prospect of such incidents has decreased the support insurers can expect to receive from reinsurers, alternative-risk financing and other risk-sharing techniques that serve to deflect or spread future losses.

Some reinsurers have excluded terrorism losses in their 2002 renewals, and others have indicated their intent to do so. A shortage of ways to spread or decrease exposure to terrorism losses could destabilize the insurance industry and the U.S. economy that it serves. Standard Fire Policy statutes can exacerbate the issue.

Property/casualty insurers did not anticipate losses of the magnitude of those that occurred on Sept. 11 when they wrote and priced their policies. Insurers do not have enough loss experience for terrorism in the United States, and threats of future attacks do not provide enough predictability to support standard insurance underwriting, risk management, loss control and actuarial techniques. Given the lack of adequate industry capital to handle such future catastrophic events, insurers now must decide how, and the extent to which, they can responsibly insure such risks.

Legislation may eventually create a federal reinsurance program or some other mechanism to help insurers respond to the heightened threat of terrorism, but the shape and timing of such legislation are still unknown. Such a federal backstop mechanism may reduce, but not necessarily eliminate, the need to exclude terrorism losses. The insurance industry is, therefore, re-examining its ability to responsibly assume this risk in the future and has developed tools for excluding terrorism coverage in property and liability policies.

The Insurance Services Office Inc. has developed and filed exclusions for the property and liability lines. These exclusions use a common definition of terrorism and enable insurers to reduce their catastrophic exposure. Most state insurance regulators have recognized the need for exclusions in the absence of federal legislation and have approved the ISO commercial lines filings.

Standard Fire Policy States

Nevertheless, more than half the states, representing about 70% of the premium volume for property insurance, require adherence to Standard Fire Policy minimum coverage standards. Some may argue full terrorism exclusions are not prohibited under Standard Fire Policy statutes. ISO assumed that full terrorism exclusions would not be enforced by courts or approved by regulators and, therefore, would provide, in Standard Fire Policy states, coverage via a specific fire exception.

This exception for fire losses can significantly limit the effectiveness of terrorism exclusions. The Standard Fire Policy covers all direct loss or damage by fire, lightning and removal from premises that are endangered by perils insured against in the policy. The policy does not cover loss by fire or the other perils if caused directly or indirectly by attack from enemy armed forces; action taken by military, naval or air forces in resisting an actual or immediately impending enemy attack; invasion; insurrection; rebellion; revolution; civil war; and usurped power.

This Standard Fire Policy exclusion, commonly known as the "war exclusion," has been a part of the standard form since its origin late in the 19th century. It reflects the generally accepted principle that war is an uninsurable exposure of potentially catastrophic nature. Insurers have implemented such an exclusion not only in fire policies but also generally across the board in all property insurance contracts. However, in the relatively few cases that have been decided on the war exclusion, the courts have generally applied the exclusion strictly, so that, for example, a warlike act was held in one case to be excluded only if it is between sovereign nations (Pan American World Airways vs. Aetna Casualty & Surety Co.).

Given the few court cases on the question, insurers could not know whether courts would hold that the recent terrorist attacks would be excluded under the Standard Fire Policy war exclusion. And as previously stated, insurers generally chose to pay the related claims. This issue need not be left to the results of court decisions nor to the drafting of policies that do not raise the issue by not excluding the fire risk.

The Standard Fire Policy does not contain a specific exclusion for loss or damage due to fire resulting from a terrorist act, as it does for fire resulting from war. Yet the line between war and terrorism has become blurred. Like war, terrorism can be catastrophic, is often state-sponsored, and its operatives may be state-trained, though anonymous. Various policy makers and national leaders have referred to the tragedy of Sept. 11 as war. And just as guerrilla warfare has become an alternative to conventional warfare, terrorism is, for some, the preferred method of fighting a war today.

The potential exposure to fire losses due to terrorism cannot be overemphasized. It is not hard to imagine a fire ensuing from a bomb explosion or an airplane crashing into a building, as was the case at the World Trade Center and the Pentagon, with the resulting damage too extensive for insurers to handle. Insurers can adequately protect their assets from this type of loss in non-Standard Fire Policy states by filing revised insurance policy language with state regulators. Insurers can attain the same level of protection against all terrorism losses only if the Standard Fire Policy statutes are changed by each individual state legislature.

Nuclear Exclusions

Exclusion of nuclear hazards is a closely related issue. Today, property policies exclude loss or damage due to a nuclear reaction, radiation or radioactive contamination arising from a nuclear event. In all states, the exclusions are subject to an exception for loss or damage due to fire following a nuclear event. In Standard Fire Policy states, it could be argued that the various related statutes combine to require the exception to the nuclear hazard exclusion to provide coverage for loss or damage due to fire following a nuclear event.

To remove this possible issue, state legislatures would need to alter the Standard Fire Policy to expressly permit insurers to exclude fire following a nuclear event. The nuclear exclusions were written at a time when access to nuclear materials was limited and well controlled. The known sources for nuclear and radioactive contamination incidents were believed to be limited to government-licensed nuclear power-generating facilities; limited research, industrial and medical facilities; and military-produced nuclear weapons.

Today, there are many purposes for nuclear materials, and they are more widely available. The opportunity for them to fall into the wrong hands has increased significantly, and many now believe that nuclear events can come from other sources--some suspected, others entirely unknown. Materials used in the nuclear-reaction process and radioactive nuclear-waste materials, for example, have become available to a greater number of people, making a nuclear or radioactive-contamination incident significantly more plausible. Some question the security of the Russian nuclear weapons stockpile. So-called "suitcase atomic weapons," once confined to espionage thrillers, are now considered a real possibility.

As the potential number of sources increases and the level of control decreases, the chance that a single occurrence or series of occurrences could be severe enough to threaten an individual insurer's solvency has increased dramatically. And fire, as well as radiation, is a risk that should be feared from nuclear blast. According to Nukefix, an award-winning Internet research site on nuclear weapons (www.nukefix.org), a significant characteristic of a nuclear blast is thermal energy (heat and subsequent fire), rather than the actual blast or explosion. If fire losses from a conventional weapon explosion are called catastrophic, fire losses from a nuclear blast could be cataclysmic.

Keep in mind that such losses would be excluded under most policies if resulting from an act of war and could be excluded from some policies if the terrorism exclusion is attached (non-Standard Fire Policy states only). However, we cannot overemphasize the catastrophic fire-loss potential resulting from fire following a nuclear blast.

In some Standard Fire Policy states, statutes allow insurers to exclude loss or damage caused by nuclear reaction, nuclear radiation or radioactive contamination directly or indirectly resulting from an insured peril. This reflects the generally accepted principle that nuclear events are uninsurable. The statutory language seems to make it clear that loss or damage caused by the nuclear reaction, radiation or contamination need not be covered, but the language does not specifically contain an exclusion for fire losses ensuing from a nuclear event. Thus, it cannot be stated with total confidence that the Standard Fire Policy requirement of fire coverage does not apply to fire following such an event.

The result is a potential nightmare: If the fire following a nuclear event were excluded in the insurance policy, a statutory construction issue would need to be resolved to determine coverage in the aftermath of a potentially cataclysmic event. Fortunately, no court cases have been required to deal with this point, but the issue should be clarified by state legislatures before such an awful event occurs, rather than relying on litigation after the fact.

In non-Standard Fire Policy states, the industry can adequately and confidently protect insurer assets from nuclear-related catastrophic fire-loss potential by filing revised insurance-policy language with state regulators (as is the case with terrorism). To attain the same goal in Standard Fire Policy states, legislatures would have to change the Standard Fire Policy to specifically allow the exclusion of loss or damage due to fire following a nuclear event and eliminate the risk that a court could declare that the Standard Fire Policy does not exclude fire losses ensuing from a nuclear event.

To specifically allow insurers to exclude loss or damage due to fire caused by a nuclear or terrorist event, state legislatures would have to change the Standard Fire Policy. Fire losses following terrorism or nuclear events would be excluded just as fire losses caused by war are excluded now, and the original intent of the Standard Fire Policy to cover insurable losses due to the peril of fire would be maintained.

RELATED ARTICLE: Standard Fire Policy Dates Back to 19th Century

Development of the Standard Fire Policy began in the late 19th century. As fire insurance developed, simplicity of contract language gave way to complexity. Fire policies became filled with restrictions, exclusions, conditions and legalese. Insureds found they could not collect against their policies due to the fine print; insurers found it hard to settle claims, because widely varying policy provisions were increasingly nullified by widely varying court decisions. Fire insurance became an enigma to many insureds, and the insurance industry was increasingly viewed with suspicion. It became apparent that simplicity and uniformity of policy language were a desirable goal.

The first serious attempt to develop a standard policy was undertaken by the National Board of Fire Underwriters in 1868. Massachusetts, Michigan and New Hampshire subsequently adopted standard fire forms, and in 1887, the New York Legislature adopted what came to be known as the General Standard Fire Policy.

In 1916, the National Convention of Insurance Commissioners (now the National Association of Insurance Commissioners) recommended a new standard form that removed many of the moral hazard clauses and simplified the policy. This form, known as the "200-line form' was adopted by the New York Legislature in 1918. In 1936, the NAIC recommended further changes to the standard form and, in 1943, New York adopted this "165-line form" which has come to be known as the Standard Fire Policy. This policy, or slight variations of it, has been adopted in 30 jurisdictions as the minimum requirements for fire insurance coverage. The 30 jurisdictions that mandate the Standard Fire Policy are shown in the map on page 51.

Although the mandatory provisions of the Standard Fire Policy have been incorporated into simplified insurance contracts over the last three decades, the minimum standards for coverage, and the court decisions interpreting and applying those standards, continue to be based primarily on the language of the "165-line form" Standard Fire Policy This "165-line form" is hardly an example of clarity or simplification. For example, the first sentence of the Standard Fire Policy contains 225 words and stretches across 11 lines of text.

As the provisions of simplified standardized forms have been updated over the years, seeming contradictions between the Standard Fire Policy and the simplified forms to which it is attached have made it increasingly difficult for both consumers and practitioners to read and interpret the contract. There have been increasing instances where, based on these seeming contradictions, the courts have often liberally interpreted policy language in favor of the insured, creating uncertainty in insurers' underwriting and claims-settlement practices. In the jurisdictions where the Standard Fire Policy does not mandate the minimum standards for fire insurance coverage, the regulated insurance market handles the provision of fire coverage without these problems. And four of those states--Kansas, New Mexico, South Dakota and Wyoming--once required compliance with the minimum provisions of the Standard Fire Policy, but no longer do so. A modernization of the Standard Fire Policy, to at least address the terrorism and nucle ar exposures, may be warranted.

Frank J. Coyne is president and chief executive officer, Insurance Services Office Inc., Jersey City, N.J.