Risk Management

Political Risk: Run for Cover?

Companies stripped of terrorism protection by property insurers might have another place to go for coverage.
Jennifer CaplanJanuary 22, 2002

On 9/11, in a matter of minutes, CFOs and their risk managers came smack up against a risk that until then seemed minor: terrorism. The problem, however, was that the insurers that covered the exposure had a similar encounter.

Traditionally, companies bought terrorism coverage for both domestic and foreign assets from property insurers. Responding to the attacks, and griping about the lack of a federal law that would cap their future losses, however, those carriers have almost universally excluded terrorism coverage on recently renewed policies. That’s left many companies bare of insurance for a risk without apparent limits.

“The amount of property that was insured for terrorism coverage under property and casualty policies before the exclusions were made was in the trillions of dollars,” estimates Ken Horne, senior vice president in the political risk insurance practice at insurance broker Marsh.

But there may be an antidote for insurance-generated panic attacks: Some observers believe that political risk insurers could fill at least a small part of the void. While the political risk market is not nearly big enough to close the coverage gap, it might provide some much-needed relief, says Horne.

Indeed, the private political risk insurance market, particularly Lloyd’s, is already offering stand-alone terrorism coverage. Lloyd’s coverage is going for rates of between 1 percent and 5 percent of insured limits, for both domestic and foreign assets. The policies cover physical damage or business interruption caused by terrorist acts. AIG is also providing stand-alone terrorism coverage, but sold out of the insurer’s property and casualty shop.

Horne says that the stand-alone coverage provides similar protection to that previously provided under property policies. “There won’t be any gaps between the two types of coverage,” he notes. “In fact, we’ve been trying to manuscript the wording in the new policies to match the exclusion under the property policy.”

Raiding the Package Store

Another choice is to buy terror coverage as part of an overall political risk package. Political risk insurers already underwrite terrorism perils in that context, usually as a component of political-violence policies. Those policies also cover losses associated with sabotage, war, civil conflict, and revolutions.

The catch is that political risk insurance packages cover only overseas assets against terrorist attacks, leaving domestic assets uncovered. But the packages remain “a particularly good option for those companies that are now more concerned about increased political risks in the places they do business,” says John Minor, an insurance broker at Aon Trade Credit in Chicago.

Apparently, the concern is mounting to a crescendo. “We are seeing companies looking to get all the coverage they can afford right now,” says Daniel Riordan, a managing director at Zurich North America. “Some banks, for instance, are not just getting currency inconvertibility coverage, but also political violence and expropriation, even in markets where we wouldn’t see a pressing risk.”

Unfortunately for buyers, the surge in demand has teamed up with a retreat by reinsurers to spawn high prices and scant capacity. And insurers are as edgy about global perils as their clients are. At the end of 2001, capacity in the political risk insurance market declined in a big way.

The reduction was seen mainly at Lloyd’s, the single biggest private provider of political risk coverage, as syndicates retrenched after incurring hefty losses associated with the attacks. “The reduction in Lloyd’s capacity has taken out about one-third of the entire political risk market virtually overnight,” reckons Riordan.

Since 9/11, there has also been a 25 percent to 50 percent across-the-board premium rate increase for political risk insurance, he notes. (In the less volatile public market, the Overseas Private Investment Co. has been boosting its average worldwide rates by an average of about 10 percent.)

Alternative Press

Facing the capacity shortage and the high premiums, risk managers might just throw up their hands and begin searching for alternate risk-transfer strategies. “Companies will absolutely have to devise alternative strategies, not only because prices are going to be exorbitant but also because the capacity is just not going to be available,” stresses Minor.

One fairly complex alternative that CFOs and risk managers are exploring is finite risk insurance, he says. A buyer employing such coverage, which carries a limit on liability, typically plunks down a huge premium — enough to fund the bulk of the anticipated losses with an insurer for 5 or 10 years.

Why would you give away so much money to an insurance company? A prime reason is to avoid a big hit in any one year and thus stabilize earnings. The way it works is this: A company that expects to have $10 million of political risk claims over a 10-year period, for example, pays an insurer the discounted value of $10 million over 10 years. The insurer pays the claim when losses are incurred, and part of the investment may be rebated to the insured if losses are less than expected.

“Finite risk insurance could be a good vehicle for large companies that have the historical ability to fairly accurately predict what their claims are going to be over an extended period of time,” says Charles Soucy, a vice president and principal at J.H. Albert, a risk management consulting firm based in Needham, Massachusetts. But because political risks are extremely hard to predict, the use of finite risk in political risk insurance is likely to be limited.

Captive insurance companies, on the other hand, can be a simpler, more effective strategy for transferring political perils. They’re particularly useful for Fortune 500-size companies that have already set up well-capitalized captives to insure a variety of exposures, say risk management experts.

That would yield a broad enough spread of risk to buffer the volatility of political risk exposures. Indeed, the unpredictability and downright scary potential of political risks has long held back companies from using their captives to fund the exposures. “Because political losses tend to be low frequency and high severity, many captives don’t usually want to expose their own balance sheets to catastrophic losses,” explains Horne.

Still, in times like these, subjecting a captive to some exposure might be a better alternative for a corporation than to find itself out in the cold, bare of coverage.