Since the September 11th attacks, the key dynamic taking place in the insurance industry has been a shifting of the risk for terrorism-related losses from reinsurers to primary insurers and then to the insured. Reinsurers and insurers have begun shedding their exposure to terrorism risk as insurance contracts come up for renewal, leaving policyholders increasingly exposed to losses from a terrorist attack. Prior to September 11, 2001, insured losses resulting from terrorism in this country were extremely infrequent. Insurance companies considered the risk so low that they did not identify or price potential losses from terrorist activity separately from the general property and liability coverage provided to businesses. But after the September 11th attacks, insurance companies recognized that their risk exposure was both real and potentially enormous. As a result, they began to express concern about continuing to include terrorism coverage as an unpriced component of commercial P/C insurance contracts. Insurers pointed out that experience with major terrorist events has been so limited, and the potential losses so large, that setting an actuarially sound price for such coverage is virtually impossible. Many insurers now consider terrorism an uninsurable risk, at least for the moment. Their response to any risk they consider uninsurable, as many Californians living on fault lines have found, is not to offer insurance. This trend has become evident in the case of terrorism insurance. Reinsurers—companies that routinely take on some of the risk that direct primary insurers face in return for a share of the premiums—are now unwilling to participate in terrorism coverage because of the enormous losses they suffered after September 11th and the newly recognized difficulties of pricing terrorism insurance. Reinsurance is a vitally important element of the insurance industry’s capacity to provide coverage to policyholders. As a mechanism for spreading the risks taken by insurance companies, reinsurance allows primary insurers to accept large risks and, by reinsuring a portion of those risks, to protect themselves from a potentially catastrophic loss. Like syndications of large loans by groups of lenders, reinsurance provides a way to insure large risks without exposing a single insurer to the possibility that its entire capital base would be wiped out because of a single event. Reinsurance companies also provide a channel through which investors can introduce capital to insurance markets without having to develop the extensive distribution channels required by direct primary insurers. However, because reinsurance markets are global in scope and because reinsurance transactions are considered to be contracts between sophisticated parties, neither the prices nor the conditions of such coverage are subject to direct regulation. As a result, after September 11th, reinsurers had little difficulty excluding terrorism from coverage. Generally, these exclusions become effective on the policy renewal date. As stated by witnesses before this Subcommittee in October, a large share of those contracts expired at the beginning of January. Industry sources confirm that little reinsurance is being written today that includes coverage for terrorism. There are exceptions. Low and medium risks, particularly in industries or geographic locations where there is little perceived exposure to a terrorist event, are the least affected. However, large companies, businesses of any size perceived to be in or near a target location, or those with some concentration of personnel or facilities are unlikely to be able to obtain a meaningful level of terrorism coverage at an economically viable price. Where coverage is available, it tends to have high deductibles and tight limits on the level of coverage. In general, reinsurers are being very selective on the exposures they will accept, if any. The higher the risk, the less likely it is that reinsurance coverage will be available. And even in those limited cases in which some reinsurance coverage for terrorism is still available, the prices are very high. As reinsurers walk away from terrorism insurance, primary insurers’ exposure increases, at least in the short run. However, while reinsurance contract renewals tend to be concentrated at the beginning of January and July, primary insurance contracts tend to renew at a relatively even rate over the year. As a result, industry observers and participants have told us that primary insurers’ exposures have increased dramatically and will not fall unless and until they can, in turn, exclude terrorism from their coverage. Faced with this kind of exposure and a risk they do not believe can be priced, industry observers and participates mentioned that primary insurers will need to emulate their reinsurance counterparts and exclude terrorism coverage from some commercial insurance policies. However, a number of factors are affecting both the speed and the extent to which primary insurers can insulate themselves from terrorism. First, in contrast to reinsurance, changes to the coverage provided by direct insurers require regulatory approval in most states, at least for low- and medium- risk companies. This regulatory hurdle caused ISO, acting on behalf of P/C insurers, to file a request in every state for permission to exclude terrorism from all commercial insurance coverage. As of February 22, 2002, 45 states and the District of Columbia and Puerto Rico had approved the ISO exclusion, according to information received by ISO and the National Association of Insurance Commissioners (NAIC). The other five states either denied the suggested language from ISO or are still considering the language for approval or disapproval. States that have not approved the ISO exclusion expressed concerns about various issues. Among them are the low thresholds for exclusion ($25 million or 50 serious casualties); the all-or-nothing nature of the threshold (insurers pay nothing if either threshold is reached); the aggregation of all losses from multiple incidents within a 72-hour period and across most of North America into one event if they “appear to be carried out in concert or to have a related purpose or common leadership”; fear that the exclusion would leave some small and medium-sized businesses that could least afford the losses from a terrorist attack totally unprotected; and worry that the included definition of terrorism is overly broad. Nevertheless, because of regulatory concerns about the solvency of primary insurers who cannot get reinsurance, ISO’s exclusion language has been approved in 45 states and the District of Columbia and Puerto Rico. Primary insurers in those states can now exclude terrorism from coverage on various lines of commercial policies. While only five states have not (yet) accepted the ISO exclusion language, those five states account for more than 35 percent of the total U.S. commercial insurance market. Second, even though direct insurers now have regulatory approval to exclude terrorism from commercial P/C insurance contracts in most states, such a change in coverage generally would have to wait until the renewal date. According to some insurance regulators with whom we spoke, losing reinsurance would not generally be a sufficient reason for canceling or changing coverage for policyholders during the policy period. Moreover, even when an insurance policy terminates, insurers generally have to give 30 to 60 days advance notice to policyholders before non- renewing a policy or making a significant change in coverage. As a result, it could be as much as a year after a direct insurer loses reinsurance coverage for terrorism before a similar exclusion could be passed on to all its policyholders. Finally, even at renewal, laws existing in some or most states will affect the extent to which insurers can completely end their exposure to losses resulting from terrorist events. For example, laws in nearly all states preclude a workers’ compensation insurer from excluding coverage for a particular type of event. Workers’ compensation must cover all the risks to which an employee is exposed while at work, irrespective of the cause. Industry sources estimate that approximately 10 percent of the losses resulting from the World Trade Center attack will be due to payments for workers’ compensation claims. Similarly, insurance laws in approximately 30 states include what is called “standard fire policy” language, according to ISO officials. In that language, insurers are required to pay losses resulting from fire, irrespective of the cause. Thus, in an explosion like the World Trade Center attack, a terrorism exclusion would protect insurers from liability for losses resulting from the direct effects of the explosion, but not for the losses caused by the resulting fire. Estimates suggest that the fire, rather than the explosion itself, caused a substantial portion of the losses in the World Trade Center attacks. Industry sources have said that they expect an effort to change this requirement. In all of the states where the standard is written into state statutes, an act of the state legislature would be required to modify it. Thus, even though many reinsurers can and have moved quickly to exclude terrorism from reinsurance coverage, primary insurers’ ability to exclude terrorism is more limited, at least in the short run. However, the rapid submission of the ISO exclusion language to state insurance regulators, and their generally rapid and positive response, clearly indicate the urgency of primary insurers’ desire to be able to exclude terrorism from commercial P/C insurance coverage. Early indications suggest that many businesses, particularly those in large metropolitan areas, are already beginning to experience difficulty obtaining terrorism coverage as their insurance policies come to renewal. In our discussions with insurance industry participants, observers, and policyholders, we found that large commercial enterprises were among the first to feel the impact of terrorism exclusions. Some large property owners or developers reported that they are having to underinsure or “go bare” by self-insuring for terrorist risks because of the lack of available coverage or very limited coverage for the quoted prices. While the extent of the negative economic impacts of a lack of terrorism coverage is not yet clear, the potential for more severe economic impacts is increasing as the level of uninsured risk climbs. Over the next year, the level of uninsured risk for terrorism-related incidents is expected to continue to rise as commercial policies renew between primary insurers and policyholders and insurers seek to exclude terrorism-related coverage from policies they cannot reinsure. Therefore, the economic burden of another terrorist attack would fall increasingly on policyholders as the insurance industry sheds or limits its risks to such exposures, raising the potential for more devastating economic consequences should such an event occur. Additionally, as insurers exit the market for terrorism-related coverage, so too does their claims-processing capacity for administering recovery assistance to victims of a terrorist event.