© 2004 Towers Perrin Casualty Actuaries in Reinsurance Terrorism Seminar — Alternative Solutions...

© 2004 Towers Perrin

Casualty Actuaries in Reinsurance

Terrorism Seminar —

Alternative Solutions Session

This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient hereof.

September 13, 2004

Charles Wolstein

2© 2004 Towers Perrin S:\09131\04EGS\fs\003\CARe Terrorism Seminar Remarks.ppt

Discussion outline

Study background/context Study objectives and structure Pool objectives Overview of prototype pool design Key issues and conclusions Areas of analysis Current status

9/11 context/perspective Key characteristics of terrorism risk

The Insurability of Terrorism Risk

WC Terrorism Reinsurance Pool Feasibility Study


The study was an effort by WCwriters to explore potential “privatemarket solutions” to managing terrorism exposure

In the aftermath of the September 11, 2001 attacks, insurers came to realize the enormous magnitude of their terrorism exposure

Exposure particularly acute for WC writers because of the statutory nature of the coverage

Terrorism Risk Insurance Act (TRIA) created temporary federal reinsurance backstop; sunsets December 31, 2005

14 insurers got together to explore the feasibility of a voluntary WC terrorism reinsurance pool

Tillinghast and Reinsurance businesses were jointly engaged to conduct the feasibility study

BACKGROUND/CONTEXT


The breadth and diversity of the sponsor group illustrates the universality of the concern

Represent ~40% of WC DWP

National and regional

Small and large

Private entities and state funds

Multi-line and mono-line

SPONSOR GROUP

Project Sponsors ACE USA AIG CNA Guard Insurance The Hartford Kentucky Employers’ Mutual Insurance Company Liberty Mutual Missouri Employers Mutual Insurance Company The PMA Group Royal & Sunalliance The St. Paul Companies Texas Mutual Insurance Company Travelers Zurich North AmericaOther Participants AIA NCCI PCI (formerly AAI and NAII) Risk Management Solutions (RMS)

Project Participants


The insurance industry sought toaddress the unique challenges thethreat of terrorism poses for WC writers

The objective of the study was to assess the feasibility of a Workers' Compensation terrorism reinsurance pool: an effective, equitable, voluntary WC terrorism risk-sharing mechanism

STUDY OBJECTIVES

Solicit industry perspectives to establish a set of common objectives

Develop an approach for measuring relative terrorism exposure

Develop a specific prototype pool design

Model potential pool liabilities, capital requirements and risk-sharing efficacy

Assess preliminary interest


The sponsors agreed on thestrategic objectives of the pool as well asa number of more specific tactical design objectives

Strategic Objectives Design Objectives/Considerations

Industry-

based Solutio

n

Mutualize the risk across the insurance industry; maximize the effective use of industrywide capacity; minimize risk of insolvency

Provide a tangible measure of terrorism cost, facilitating inclusion of terrorism load in approved primary WC loss costs

Establish a solution quickly

Provide a cost-effective, equitable and competitively neutral mechanism

Create a mechanism that can serve as a “window” to any proposed ongoing federal backstop program

Provide a tax-efficient mechanism to build up a fund to pay for these losses

Retain incentives for individual companies to manage risk

Keep the data requirements and administrative aspects of the program simple

POOL OBJECTIVES


Government Backstop

Small, aggregate post-fundedlayer, excess above pre-funded

layer

The pool would be an aggregateexcess reinsurer funded primarilythrough accumulated premiums paid by members

$XX million aggregate pre-funded layer,

excess over per-companyattachment

Companies choose from three levels of retention based on individual risk appetite; companies can reduce their retention with commercial reinsurance

The first pool layer is “pre-funded” via exposure-based premiums; losses (subject to a 10% co-participation) are paid from this layer until it is exhausted

As a transitional measure until sufficient funds are accumulated, a second pool layer is “post-funded” through a group retrospective rating mechanism

The premiums are placed in a captive reinsurer owned by the members. The captive is initially funded by paid-in capital, then increasingly by accumulated surplus. As the captive’s capacity grows, the pre-funded layer will be expanded.

43

2

1

Member Attachment Points

5Captive may, in turn, access reinsurance or capital markets to securitize risk

Reinsurance/Capital Markets

Industry CaptiveCo

-par

tici

pat

ion

Commercialreinsurance

Individual companyretained losses

OVERVIEW OF PROTOTYPE POOL DESIGN


Developing a pricing formula to ensure equity for participants is theoretically possible Could use commercial terrorism risk models and/or a “proxy” measure of

exposure Models differ in their underlying assumptions and their results

For pool pricing, only relative risk matters Agreeing on a formula for pricing would ultimately be a “negotiation” among

founding pool members; sponsors did not reach consensus on pricing formula

Employee headcount by location is the appropriate exposure base Since 9/11 many insurers have been collecting this type of exposure data The data appear sufficient to be used by the pool to measure participants’

exposure, coupled with appropriate data validation protocols

Voluntary pool cannot accumulate enough capacity to meaningfully help insurers absorb mega-terrorism events, even over many years and under favorable assumptions

Pool does provide risk diversification benefit to participants and could help individual insurers withstand moderate terrorism events

Capacity limitations mean pool can’t provide industry-level solution

The feasibility studyfocused on several key issues

KEY ISSUES/CONCLUSIONS

Achieving equity

Measuring terrorism exposure

Capacity

Key ConclusionIssue


Risk Diversification Benefits

Cumulative WC Pool Market Share (WC DWP)

Pool Members’ Loss Distribution Compared to Share of Pool Loss Distribution

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

0%

Risk Reduction

100%10% 20% 30% 40% 50% 60% 70% 80% 90%

Reduction in 1

achieve at least a 50% risk reduction

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

0%

Risk Reduction

100%10% 20% 30% 40% 50% 60% 70% 80% 90%

Reduction in 1-in-500 loss

Roughly 70% of the market would achieve at least a 50% risk reduction

For very small WC writers, low exposure coupled with a $5 million retention causes the risk diversification benefit to be beyond 1-in-500

There were four mainareas of analysis during the study

AREAS OF ANALYSIS

Terrorism Exposure Modeling —RMS and “Proxy”

ILLUSTRATIVE

0.0

0.5

1.0

1.5

2.0

2.5

3.0

A B C D E F G H I J K L

RMS

Proxy

Terrorism Share Divided by Headcount Share

Company

Pool Funding (Structure, Level and Basis)

Distribution of Aggregate Losses

54

33

45

0

5

10

15

Minimum Retention Max imum Retention0

1,000

2,000

3,000

4,000

1 2 3 4 5 6 7 8 9 10

Pre-Funded Capacity

Accumulation ofDeposited Premiums ($M)

Years to Achieving Target Capacity (2006)

Years

RMS/Proxy BlendYears

Pre-funding Level

1-in-1,000

1-in-500

1-in-250

Minimum Retention Option (All Members)

Maximum Retention Option (All Members)

Capacity needed tofund 1-in-500 loss

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Unfunded

Covered by Pool

Retained

Pool Members' Aggregate Terrorism Losses* ($ Billions)

Stochastic Modelingof Pool Performance

Pool composition Event size,

concentration and timing

Pool design/funding Impact of TRIA

Comparison of RMS Model Results and Proxy

Measure of Exposure

Pre-funded Pool Capacity Accumulation

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© 2004 Towers Perrin S:\09131\04EGS\fs\003\CARe Terrorism Seminar Remarks.ppt

The sponsor group decidednot to pursue the detailed designand implementation of a pool at this time

Two main reasons: The pool would not offer enough capacity to help the industry

absorb losses from catastrophic terrorism events — While not considered a viable industry solution, some participants

remain quite interested Uncertainty about the future of federal backstop protection was an

important consideration

This outcome reflected a variety of factors: Findings and conclusions of the study (i.e., capacity) Political considerations and the uncertainty of external political

environment Diversity of sponsor group

CURRENT STATUS

The sponsors agreed that the effort provided important insights into the key philosophical, conceptual and practical issues associated with creating a pool — and laid the foundation for future work on a pool, if and when appropriate

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Study background/context Study objectives and structure Pool objectives Overview of prototype pool design Key issues and conclusions Areas of analysis Current status

9/11 context/perspective Key characteristics of terrorism risk

The Insurability of Terrorism Risk

WC Terrorism Reinsurance Pool Feasibility Study

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Estimated Insured Losses — Select Cat EventsCurrent Loss Equivalents ($ Billions)

Note: Hurricane losses adjusted to reflect current demographic/habitation patterns, property values and inflation.*Represents midpoint of Tillinghast’s estimated range of losses.Source: Florida Department of Insurance (Andrew, original), Property Claims Services (original losses for hurricane losses other than Andrew); Tillinghast estimates (A Macro Validation Data Set for U.S. Hurricane Models).

Although terrorism is by no means a new phenomenon, the September 2001 attack was a watershed event

WTC (2001)*

Hurricane Andrew (1992)

Hurricane Hugo (1989)

Hurricane 1938-B (1938)

Hurricane Betsy (1965)

Hurricane Carol (1954)

Hurricane Hazel (1954)

Estimate in event-year dollars/values

Adjustment to reflect current exposures, values, dollars

$44

$24.5

$5.5

$10.8

$11.5

$8.2

$6.3

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For additional perspective, 9/11 losses had a significant impact on overall industry claims

Source: Tillinghast estimates.

Impact of 9/11 on Industry Annual Claims

As bad as it was, the devastation could have been much worse, particularly the human toll (and WC losses) (e.g., time of day, point of impact, time between impacts/collapse)

It is easy to imagine substantially higher fatalities…with WC losses increasing from ~$3 billion to as much as $6 billion – $12 billion

Billions

+12%

+458%

+75%

+9%

+14%

0 10 20 30 40 50 60

Workers' Comp

Aviation

Comm Property, BI

Life, AD&D

Liability

Other

Average annual claims (industry)

9/11 claims

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The key question: What makes terrorism risk different?

Inability to Price Potential Magnitude

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Can terrorism risk be priced?

Requirements for pricing risk: Frequency Severity

Three credible commercial terrorism loss modelers… …three different

theories of terrorism …three different loss

profiles

Even if these risks could be priced, there are significant practical/ political constraints to realizing true risk-based premiums

Reasons You May Not Be Able to Price Terrorism Exposure

Primary difficulty is estimating frequency

Net effect of “offense” and “defense” Supposed to be highly

secret How can experts know?

Terrorism risk is intrinsically dynamic Contrast with essentially

static nature of other risks

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The dynamic nature of the riskcreates fundamental conflict between the expectations/requirements of insureds and insurers

Exchange uncertainty for certainty

[Reasonably] stable insurance costs

Underlying risk can change dramatically over short periods of time Policy duration (one

year) too long Potential for extreme

fluctuations in premium

Contrast with natural catastrophe pricing Historical costs Adjust for changes in the environment (i.e., exposure), not for

changes in the underlying risk

Insured Insurer

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A mega-event exceeds the industry’s capacity to absorb or willingness to assume

Tillinghast Estimates of Industry Capital (2002)

Primary (commercial) insurers: $125 billion

Global reinsurers: $110 billion

Risk Management “Rule of Thumb”

Limit net exposure to 2% – 3% of capital for any single event Aggressive posture may go as

high as 10% (statutory limit in some states)

Estimated losses: $32B – $56B; could have been $10B – $20B higher

Sabotage of Indian Point Nuclear Power Plant Large release of radioactive

material; southerly wind Potential losses: $218B

Large weaponized aerosol anthrax release in downtown NYC; weekday 2pm Estimated 173,000 deaths

Potential losses: $244B

The industry won’t and shouldn’t expose this much of its capital base to a single terrorist event

Source: Risk Management Solutions, Inc. (nuclear and biological attack scenarios) estimates; Tillinghast estimates.

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A few final thoughts ...

“Alternative ‘solutions’” — no such thing, at least foreseeably In long term, may be possible; would require fundamental

changes to current regulatory and accounting practices

Some form of ongoing federal reinsurance program is necessary to protect the insurance system — analogous to Federal Reserve protecting the banking system Especially true for Workers’ Compensation

Failure to extend federal backstop creates potential for major economic disruption and dislocation

“Partial solutions” could be effective in concert with a federal backstop — includes a pool, and possibly others

“Stay tuned for 200X…same bat time, same bat channel” — if it is extended, what will be different when the extension expires?

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Are there any questions?Q&A

© 2004 Towers Perrin Casualty Actuaries in Reinsurance Terrorism Seminar — Alternative Solutions...

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