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Revealed
For Group Life insurers, terrorism risk incurs one of the largest catastrophe capital charges under Solvency II. To keep up with the changing landscape of terrorism threats, Aon Benfield Impact Forecasting’s UK terrorism model incorporates up to date inputs from counter terrorism experts on elements such as credible attack types and damage profiles. One way to mitigate for terrorism risk is by purchasing adequate level of catastrophe excess of loss cover. At an average cost of 1% ROL, it remains a cost effective method which should not be overlooked.
Introduction
Under Solvency II, Life insurance companies are required to hold capital for the impact of 1 in 200 year extreme mortality events. To grasp what this definition means, in essence, this translates to not only considering one specific scenario with the probability of 0.5%, but thinking of holding enough capital to withstand the cost of extreme events at the 99.5th percentile and therefore consider multiple tail events. Such events include, but are not limited to, pandemics, terrorist attacks and natural catastrophes. The extent to which a company is exposed to catastrophe risk depends on various features of the underlying portfolio such as demographic profile, geographical location and product types.
Terrorism risk
Terrorism has become an increasingly recognised risk factor over the last two decades. In the wake of the 9/11 terror attack, where approximately 3000 lives were lost and the insured losses to Life insurers were estimated at USD$2.7bn (Robert P. Hartwig, http://www.globalresearch.ca/articles/HAR312A.html, Exhibit 2), insurers took a large hit on their balance sheets but most survived by risk spreading through reinsurance/retrocession. Since then, most insurers have focused more on their management of concentration risk.
Terrorism is a major catastrophe risk event for Group business providers, especially if their portfolios have concentrated exposure in high risk areas. Similar to other catastrophe events, terrorism is difficult to predict when and where it will next strike. However, the act of terror is usually carried out to maximise casualty/publicity/economic damage; which explains why the World Trade Centre and the Pentagon were chosen as the 9/11 targets instead of suburban areas.
In determining the exposure to terrorism risk, Aon Benfield has drawn on the knowledge and experience of Aon’s counter terrorism experts to develop a probabilistic terrorism model. Firstly, a list of potential terrorism targets is identified, along with different types of attacks ranging from nuclear devices to a shooting rampage of a single gunman. For each type of attack, the likely impact radius and casualties/fatalities in the hit zone is analysed. The probability of occurrence for each attack or weapon type is also assigned.
Another major piece of the puzzle is in determining the frequency of terrorist attacks. Historical records have shown that attack frequency has increased over the last few decades; therefore expert opinion is relied upon in this rapidly changing environment with reference to a range of frequencies indicated by the Impact Forecasting database. As the model has been calibrated at postcode level, client exposure is illustrated by postcode to evaluate terrorism risk at various return periods. The terrorism model is helping insurers to better understand their exposure of terrorism risk and possible financial impact. In addition it can be adopted as an integral part of an internal capital model and as an enterprise risk management (ERM) tool to negotiate optimal reinsurance terms and demonstrate their ERM strength to rating agencies.
Terrorism risk can also be mitigated through Catastrophe Excess of Loss (Cat XL) cover. Aon Benfield’s Global Death and Disability catastrophe benchmarking study examines the catastrophe reinsurance purchasing pattern between countries. The study shows that the average cost of a catastrophe XL is around 1% ROL. Although the competitive pricing of catastrophe XL reinsurance depends on a variety of factors such as attachment point and the relative risk associated with the portfolio, catastrophe XL remains a very cost effective method to mitigate extreme mortality events other than pandemic. In addition, the cost of ceding the catastrophe risk to reinsurers is well below the internal cost of capital of insurers.
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