Could terrorism derail Australia's insurers?

Yesterday's attack at pop star Ariana Grande's UK concert left 22 dead and many more injured. The UK Government has increased its terrorist threat level to ‘critical' – its highest rating – for the first time in a decade, with intelligence agencies suggesting another attack may be ‘imminent'.  

The events in Manchester are tragic and are a reminder that we live in an uncertain world. No companies know how to deal with uncertainty more so than the insurers. However, even for them, terrorist attacks are a nightmare because incidents are difficult if not impossible to predict and can lead to enormous liabilities.

The loss of property from the Manchester attack is likely to be minor, but larger incidents can cause colossal damage: the September 11, 2001 attack on the World Trade Centre in New York caused more than US$30bn of damage. Weapons of mass destruction could do far worse.

Many global insurers now exclude terrorism from coverage, though the Australian industry has taken a different approach.

The Terrorism Insurance Act 2003 overrides terrorism exclusion clauses in eligible insurance contracts and requires insurers to meet claims. This allows policyholders to remain covered for damage to property and business disruption.

Essentially, the Government has mandated that Australian insurers must cover against terrorism risk. This, however, could lead to devastating losses for insurers, or even bankruptcy, in the case of large-scale events, so the Act also formed the Australian Reinsurance Pool Corporation (ARPC). This scheme allows insurers to make claims for terrorism-related losses from pooled resources and the Government.

Commonwealth to the rescue

ARPC has this to say: ‘Claims against the scheme are met once an individual insurance company's risk retention is exhausted. ARPC's pool of retained earnings will meet claims until the agreed retrocession deductible is reached. Once retrocession is exhausted, claims will continue to be met by the Commonwealth guarantee. The total value of the scheme is over $13 billion.'

However, it all hinges on a single clause: for policyholders to be eligible, the event must be officially declared a ‘terrorist incident' by the Federal Treasurer, which has wide ranging implications for insurers such as Insurance Australia Group (ASX: IAG), QBE Insurance (ASX: QBE) and Suncorp (ASX: SUN).  

For incidents on the scale of the Manchester attack, the claims threshold needed for insurers to receive payment from ARPC is unlikely to be exceeded – the industry must meet the first $100m of claims. When claims are between $100m and $2.9bn, insurers receive payments from the scheme; the next $10bn of claims will be covered by the Government.

But what happens if the scheme's full $13bn of coverage is exhausted? For catastrophic losses – say, if a nuclear bomb went off in Sydney – where the amount payable by ARPC and under the Commonwealth guarantee is exceeded, the Treasurer would also announce a ‘reduction percentage' which reduces the amount payable by the insurer to the policyholder. 

With this system in place, Australian insurers are largely sheltered from catastrophic losses as far as terrorism is concerned. Though we hope it's never tested.