Historically, businesses operating in the United Kingdom have relied on terrorism insurance for protection. Then, in 1992, this situation changed drastically. Due to several costly terrorist incidents, the U.K. insurance market decided to exclude terrorism coverage from their policies. As a result, the United Kingdom is the only region in Europe where it is currently not possible to purchase terrorism coverage in the traditional market. Although the British government established a state-run alternative for terrorism insurance, the program does not yet run smoothly. For risk managers with operations in the United Kingdom, obtaining terrorism coverage has therefore been a tremendous challenge. Without reform of the government-backed program, U.K. businesses will continue to have difficulty protecting themselves from the long and deadly arm of terrorists. Although their actions are the most extreme and highly publicized, the Irish Republican Armies (IRA) are by no means the only terrorist group operating in the United Kingdom. The country is also exposed to extremist political activists from the Middle East, North Africa and local organizations such as the Animal Liberation Front. Last October, Kurdish separatists launched coordinated attacks against 60 Turkish targets in London and other European cities. One of these attacks was directed at British Telecom, whose offices were mistaken for a Turkish bank.
The terrorists’ tools of the trade, although enormously destructive, are typically incendiary devices that are easy to buy or make. Examples of these devices include an incendiary used by the Animal Liberation Front that is small, easy to conceal and results in intense heat when burned. When strategically placed, these incendiaries can cause fires that result in extensive damage - in one case, one of these devices caused losses that exceeded £20 million.
Booby trap devices are also widely used. A typical example is an under vehicle booby trap attached to a car by magnets and that contains two to four pounds of Semtex plastic explosives. Another example is a typical IRA hand-delivered blast bomb, which contains several pounds of Semtex in the holdall and can be enhanced with “dockyard confetti” - in common parlance, nuts, bolts and nails. As one would expect, the aftermath of these bombs is nasty indeed. Another type of bomb recently used with such devastating effect is bags containing a mixture of sugar, weed killer and gun powder and normally detonated by a small charge of Semtex. Yet another common terrorist weapon is homemade mortars similar to the one used a few years ago to attack Downing Street. These devices can have a range of up to 600 meters.
As recent events in London graphically illustrate, a car or van can be turned into a mobile bomb when the vehicle is packed with substantial quantities of ammonium nitrate-based materials and detonated. The two major bombs that recently struck the City of London made use of more than one ton of these materials. Preventing such attacks, however, is notoriously difficult since it is impossible to predict which targets terrorists will attack.
Pool Re Emerges
Besides causing untold destruction, the activities of terrorist groups in the United Kingdom have also had a devastating effect on insurance coverage. Following the St. Mary’s Axe bomb in London in 1992, which at the time was estimated to cost up to £800 million, the insurance and reinsurance markets realized that they could not accurately calculate their potential loss exposures for terrorist events, particularly since they cannot know the tonnage of the explosives used or where they will be planted. This situation was aggravated by the fact that the insurance industry was suffering through a period of enormous losses due to events such as Piper Alpha, the U.K. hurricane losses in 1987 and 1989, and many other worldwide catastrophic events. Reinsurers also realized that direct insurers did not have figures showing their aggregations of risk potentials in areas such as the City of London. Fearing devastating losses, reinsurers subsequently decided to cancel terrorism cover. Without reinsurance protection, the direct British insurance market shortly followed suit, and in November, 1992, announced this to the business community. Since the time scale was so short for those who had renewals on January 1, 1993, there was a horrified outcry from the Association of Insurance and Risk Managers in Industry and Commerce (AIRMIC) and the risk management community.
The situation soon became highly political, and enormous pressure was put on both the insurance market and the British government to find some solution to the problem. AIRMIC, together with the U.K. broker community and the British Insurance and Investment Brokers Association (BIIBA), suggested a scheme that would maximize the traditional insurance market capacity while requiring government backing: it was later discovered that the Association of British Insurers was talking to the government about a similar proposal. The net result was “Pool Re,” a government-backed insurance facility in which the Department of Trade (DTI) acts as a reinsurer of last resort to the insurance market. Without the creation of Pool Re, there would be no insurance market for terrorism risks in the United Kingdom. Consequently, those who were severely damaged by the Bishopsgate bomb in 1993 would probably have had no or very little insurance cover. As a result, several of these companies would have gone out of business.
Pool Re is a mutual company, consisting of an amalgam of local British Insurers, Lloyd’s syndicates, overseas insurers and captives. When they elect to sign up for Pool Re, each of these companies agrees to abide by the rules of the system and not to compete against it by providing terrorism cover elsewhere, thereby effectively debarring an alternative market. The pool is reinsured by the British government, meaning that insurers’ liability is capped, giving them a ten percent profit-or loss-making potential. If the scheme runs badly, which indeed it has to date, then everyone who has put premium into the system is obligated to fund another ten percent of premium before the government reinsurance applies.
The original rating plan produced for Pool Re created two basic zones in which coverage applied. Zone 1 covered major city zones such as London and Manchester, and Zone 2 applied to everywhere else. The rates varied according to the total assets held by any one insured in a particular zone. Some large companies that had many assets used a spread factor to aggregate their total values and as a consequence received a discounted rate.
The new rating system, applied July 1, 1993, divided the system into four zones. Zone A covers the center of London, Zone B constitutes other areas in London and other cities, and Zone C is everywhere else in the British Isles except Cornwall and most parts of Scotland, which are covered by Zone D.
Under the new system, most companies have experienced significant premium increases. These increases occurred because of the Bishopsgate bomb. Also, the government realized that once they made a commitment to reinsurance, there would be no money in their budget to pay for losses. The DTI’s reaction, influenced by the Treasury, was to substantially increase their prices - a mixed blessing, since it influenced many people not to buy cover. Incidentally, this step was taken against the advice of the Association of British Insurers, which indicated that raising rates would be counterproductive.
Up to now, it had taken a long time to organize and legalize the operation of Pool Re. However, it is now known that there is insufficient money in the pool so far. Naturally, this is a worrisome situation.
Pool Re’s Flaws
Many observers believe that there are significant problems with Pool Re. So what makes Pool Re flawed? First, the program is enormously complicated both for insurer participants and for clients, who must provide detailed information not necessary under traditional insurance arrangements. Secondly, for the reasons just outlined, one cannot presume there is any degree of price stability in the arrangements since the British government is clearly determined to ultimately pass costs on to the public. Indeed, the government's perceived tactic seem to be to try and recover the cost of the Bishopsgate and St. Mary’s Axe losses by placing very high rates on businesses located in certain sections of London. However, there is simply not enough potential spread for the principle of insurance to operate sensibly. So, if another big loss occurs, there will be yet another public furor over the effectiveness of Pool Re. This will give the IRA exactly what they are seeking - another propaganda victory.
One serious flaw with Pool Re is the fact that the program is operated by separate certification. This means that insurers have excluded terrorism cover from their basic policies, although the system provides a certificate for terrorism cover for those that elect to take the cover out. Another major problem with Pool Re concerns the definition of terrorism loss. For example, the Bishopsgate and St. Mary’s Axe incidents themselves were considered terrorism losses, but the subsequent looting and thefts fell under the category of traditional market losses. Also, the situation is somewhat unclear insofar as groups such as the Animal Liberation Front are concerned - is damage caused by their acts terrorism and hence coverable under Pool Re, or are these merely traditional property losses? Problems with the definition of terrorism could also arise in other ways. For example, consider the London Flood Barrier. Does terrorism occur if extremist destroy this barrier and London is damaged by flood?
Under the Pool Re system, clients are asked to make a basic decision to insure or not to insure in a system that has no selectivity. For example, if a firm wants to insure one part of its program, then it has to insure all of it unless there were totally separate policies and structures in force prior to the beginning of 1993. This would be the case even if a major company had only one property in the City of London and the rest of their assets in Cornwall and Scotland.
At one time, some observers predicted that alternative markets for terrorism coverage would develop. However, in reality, any company in the United Kingdom with a major exposure has little alternative to Pool Re. The DTI in the United Kingdom has strongly exercised its rule that if a company joins Pool Re, then it cannot complete with that system. Some international firms have argued that their U.K. operations are the only ones affected by this ruling, but the DTI has different views on the subject.
Additionally, some may argue that the simplification of Pool Re’s new rating structure is a positive development, but there are heavy penalties for larger companies since they do not get a discount for spread of assets, nor any recognition for introducing additional risk management measures or security precautions. The Corporation of London, for example, has spent millions on their “Fortress City” policing policy, but their insurance premiums have yet to be reduced. Additionally, both insurers and brokers provide the administration, claims handling and other service for Pool Re at considerable cost to themselves, and with no mitigation in the price of premiums. Clearly, this is a situation that is not commercially viable in the long term.
The fact is, the Pool Re system is not working. For the government, the system is failing because it is committed to a reinsurance obligation for which there is insufficient premium in the system to pay claims. By past indications, the government’s likely response to a shortfall in the kitty will be to increase rates. In the meantime, the government is borrowing money to pay for existing losses, thereby only increasing the debt. Also, under the current system, the government does not have a sensible exit strategy; it has thus indicated that its objective is to pass the risk back to the commercial market at the first opportunity.
The system is also not working well for insurers. Although they are in a situation where they can provide, with government support, a degree of continued coverage where necessary, they have a very diversified client base and an enormous administrative burden for which there is no reward unless they are able to obtain specific fee increases from clients for these services. One company, for example, has 30 full-time employees working solely on Pool Re issues. When one extrapolates this burden to the many composite insurers and other firms throughout the United Kingdom, one can appreciate the significant administration costs created by this system.
The system also seems not to be working for clients. In addition to increased premiums, if a firm wants to continue to purchase terrorism insurance, it faces significantly increased administration costs and potential implications in relation to their cover.
What, then, can be done to improve the system? In AIRMIC’s view, there are three potential ways forward. The first option is to introduce a system similar to the one used in Northern Ireland. (See Sidebar on page 34) In fact, there is considerable argument that since Northern Ireland is part of the United Kingdom, then why should different regimes apply to both territories? From an insurance purchaser’s perspective, however, there are certain limitations in the Northern Ireland system relating to extent of coverage and claims payment procedures. The Northern Ireland program is also bureaucratic and thus costly. Nevertheless, although certain business interruption claims have taken a long time to settle in Northern Ireland, businesses there have continued to operate effectively under this system.
The second way forward is to enact measures to improve Pool Re. Inevitably, any system hastily introduced will experience “teething” troubles. For example, the South African system, which is now operating satisfactorily, certainly suffered in its early stages. AIRMIC is working together with other buyer organizations including BIIBA, the British Retail Council, the British Property Federation, The Corporation of London and the Confederation of British Industry to find ways to suggest improvements for Pool Re. If there is no radial alternatives, then efforts to improve the existing arrangement are the only way forward.
Finally, the third option. This can be summarized as “some other way” - in other words, a solution that has yet to be conceived. Although this option may seem nebulous, there is a considerable body of opinion that still believes in the principle of insurance and the necessity to spread risks. However, Pool Re does not provide an adequate foundation to realistically spread the risk. Many observers feel that the only way to do so is by making terrorism insurance compulsory and charging a levy on the premium. AIRMIC holds the view that there is much to be said for this option. However, the government is anxious not to be seen as introducing some form of levy or surcharge that could be regarded as a tax; insurers also do not see why they should have to subsidize what they perceive to be a political issue.
AIRMIC nevertheless believes there is a compromise solution, and is currently in discussion with other insurance organizations to find a successful formula.
This synopsis may seem somewhat downbeat, but, after all, terrorism itself is awful in the extreme. Terrorism’s wastage of property - and most importantly of human lives - is evil, and there is no doubt that the vast majority of people abhor these atrocities.
The risk management and insurance communities must find a way to provide workable terrorism coverage for businesses.
Successfully doing so would prevent the perpetrators of terrorist attacks from benefiting from propaganda victories resulting from the ineptitude of the insurance industry.
The Pool Re system is evolving, and by the time this article is published, the situation will have changed again.
Since the initial draft of this piece, Pool Re has showed some signs of flexibility in relation to deductibles. AIRMIC is optimistic that some recognition will be given for risk management improvements.
There are some fringe markets developing, but they are limited and expensive. AIRMIC is continuing to lobby for improvements in the system.
Alan J. Fleming is director of IC Insurance Limited in London, England. This article is reprinted by permission of Risk Management magazine.