The Illusion of Protection: Terrorism, War and Workers’ Compensation

The impact of the terrorist attacks of Sept. 11 on the property/casualty insurance industry can hardly be overstated—the largest catastrophe loss ever; an unprecedented convergence of coverages, creating a previously unimaginable combination of huge losses from widely divergent lines of insurance; and the specter that future terrorism losses of even greater magnitude are not only imaginable, but something we are being warned about by the highest levels of government.

The situation facing the workers’ compensation line of business is even more perilous. Employers are required to provide workers’ comp benefits by law, and for good reason; the system provides the essential replacement income, medical treatment, and rehabilitation services needed by injured workers and their families. Employers are required to “insure” their ability to pay these benefits through traditional insurance, self-insurance or state funds in some states. The benefits provided cannot be changed by an employer or insurer. They are defined by state law and can only be changed by changing the law itself.

The critical problem facing the workers’ comp industry is clear. The reinsurance needed to diversify the risk of future terrorist attacks has disappeared or become extremely limited for many insurers, including many of the nation’s largest, writing large numbers of risks. The reinsurance available now typically contains broad exclusions for terrorism exposures. Risks which previously would have been diversified through reinsurance in the world’s financial markets are increasingly being concentrated and focused on U.S. domestic capital allocated to the workers’ comp line of insurance. This significantly reduces the ability of these insurers to respond to and support the risk financing needs of American employers.

The implications of this situation extend well beyond workers’ comp insurers. Employers, especially those with large numbers of employees working in a single plant or office, will likely face increased difficulty getting coverage, or getting it without agreeing to absorb substantial risk themselves. When they cannot find coverage in the “voluntary” market, these employers will have to purchase it from residual market insurance pools, from state funds or self insured residual market pools. Residual market pools are supported by the same insurers who may have declined to insure these employers voluntarily, meaning that the insurers cannot escape the risk of terrorism losses. If an employer turns to one of the state funds, they are no more secure because these funds also face the same problem getting terrorism reinsurance. In other words, employers may well get insurance on insurance policies, but may continue to lack real protection from losses due to terrorist acts.

Other obligations
Because workers’ comp is required by law, employers have to be able to buy workers’ comp insurance coverage. States have established systems to serve as the “market of last resort” or “residual market” for employers who cannot get coverage any other way. In most states, insurers must participate in these systems either by accepting employers assigned to them or by participating in a pooling of losses. In 19 states, state funds have been created to serve as the market of last resort.

In all states that allow private workers’ comp insurance, insurers have been required to establish guaranty funds to pay benefits if the responsible insurer becomes insolvent. Because of this, private insurers end up being responsible for terrorism coverage for those whose insurer is unable to pay its claims. Given the residual market and guaranty fund systems, workers’ comp insurers who try to reduce their own exposure to terrorism risk by choosing not to insure certain businesses, will still face the risk via the residual market or guaranty funds. There’s no way to escape it.

Self-insured employers have a similar exposure. Self-insured guaranty funds exist in between 30-40 states tying employers to this exposure. Finally, in some states, the state government itself may be obligated to provide financial backing to their state funds.

Terrorism and war coverage
Workers’ comp statutes require coverage for all injuries (and diseases) that “arise out of and in the course of employment.” The meaning of that phrase is determined by workers’ comp agencies and state courts. With the exception of Pennsylvania, workers’ comp statutes do not contain exclusions for injuries to employees resulting from acts of war or terrorism. Over the years, courts have moved in the direction of holding that an injury arises out of employment if the employment brings the individual to the point where the injury occurs. The exception is when the harm is personal to the employee (for example, if an employee’s spouse comes into a workplace and injures the employee as a result of a marital dispute).

Most state workers’ comp statutes do not specifically address acts of war and terrorism because, until Sept. 11, the probability of such injuries was reasonably perceived as being very low. Even during World War II, civilian casualties from acts of war occurred only in territories (Alaska and Hawaii) or in other Pacific Island territories. There is only one reported workers’ comp case involving an act of war (a torpedoing of a ship in a European war zone in World War I) and two bombing cases that could be considered as terrorist acts.

Even in Great Britain, the only reported workers’ comp cases were from World War I. When World War II began, Britain recognized that its civilian population was at risk and that such a risk was not in the capacity of private insurers to handle. In 1939, the British adopted the Personal Injuries Act of 1939 to cover such injuries. During World War II, the U.S. government recognized that injuries to civilian workers in war zones working on defense bases were not within the capacity of private insurers to cover. Congress enacted the Defense Base Act and several similar acts that made the federal government the ultimate payer of these benefits through reimbursement of the employers involved.

Given this history, can anyone seriously argue that state courts would deny comp to workers who might be injured in future terrorist attacks?

Role of re, excess insurance
The ability to share the risk of loss is essential to workers’ comp insurers and to employers. One of the primary purposes of insurance is to spread the impact of catastrophic losses. If workers’ comp insurers had to bear the full cost of a catastrophe, each company would have to look to its individual financial strength, rather than the strength of a worldwide financial network.

Excess insurance provides similar protection for the self-insured employer and its employees. Without it, a large self-insurer that finds itself the target of a terrorist attack at one of its locations may easily face workers’ comp claims that wipe out its entire net worth.

The potential losses from terrorism dwarf even the most damaging natural catastrophes. So far, the World Trade Center disaster has generated over 5,000 New York workers’ comp claims, with about 2,200 death claims. This represents four to five years worth of the “normal” annual number of death claims in New York state. Workers’ comp losses alone from the Sept. 11 attack are estimated to exceed $3.5 billion. If the two planes had hit lower on the Twin Towers, these losses could have been much higher.

The American public continues to receive warnings from the highest levels of government of the likelihood of additional attacks even more damaging than those of Sept. 11. As Secretary of Defense Donald Rumsfeld said in a speech to the National Defense University on Jan. 31, “…And as they gain access to weapons of increasing power—and let there be no doubt but that they are—these attacks will grow vastly more deadly than those we suffered several months ago.”

The implication of this warning for workers’ comp insurers and employers is obvious. Future terrorist attacks could easily produce workers’ comp losses many times worse than those created on Sept. 11.

• In the face of Secretary Rumsfeld’s warnings, insurers face very difficult issues regarding the risks from terrorism. As Morgan Stanley insurance analyst, Alice Schroeder, has written, terrorism risk is fundamentally different from the risks inherent in insurable natural catastrophes:Natural catastrophes generally occur in locations that can be zoned for underwriting purposes, allowing insurers to measure and limit their aggregate exposure to risk. Terrorists, on the other hand, can move the locations of their targets, which prevents them from being zonable.
• Natural catastrophes, have historical recurrence patterns that repeat with a reasonably reliable degree of statistical accuracy. Terrorists, do not act randomly and avoid predictable patterns.
• Natural catastrophes do not attempt to surprise (their) victims by moving to unexpected locations in order to engender the maximum amount of fear on the part of onlookers. They occur naturally and randomly. Windstorms and earthquakes do not use technology to leverage the damage they cause, do not purposefully seek to cause any particular outcome, and especially, do not learn from experience. Terrorists seek to cause maximum damage, use technology, learn from experience, and do not act randomly.

Market today
The availability of reinsurance coverage for losses from war or terrorism has substantially shrunk, leaving many workers’ comp insurers, and state funds either currently, or about to be, uninsured or underinsured. While terrorism reinsurance is available for some insurers, locations and risks, there is no doubt that it typically carries many more limitations, offers much less protection, and is much more expensive. For larger insurers writing all types of risks nationally, as well as for those writing business with larger employment concentrations, the problem is particularly acute.

Many self-insured employers are expected to face the same problem soon if they haven’t already. Many excess insurance contracts are just beginning to renew for the first time since Sept. 11. Given the restrictions in the reinsurance market, these employers are likely to be dramatically affected.

From the perspective of the broad market, we see a serious problem that can become a financial crisis with any significant future terrorist attack. While terrorism reinsurance coverage may still exist for risks currently perceived to be “main street” business in lower-risk areas (rural or low population, low-profile business), this does nothing to solve the problem faced by many other workers’ comp insurers, self-insured employers, residual markets and employers in general all across the country. Further, with each reinsurance exclusion, the risks of terrorism-related losses becomes more concentrated in the same insurer and on the same base of capital support. This must reduce the risk diversification and spreading, financial, resilience, and ability to pay claims which existed before. It gnaws away the strength of the workers’ comp insurance system, in the same way that termites consume the strength of wood timbers, while scarcely touching the outside appearance of the house.

The insurer dilemma
Workers’ comp insurers must be able to pay all claims for which they have agreed to be responsible. The lack of reinsurance is forcing insurers to reassess the level of risk they can safely bear. In doing this, they must consider their obligations to policyholders, shareholders, claimants and employees. Without adequate reinsurance, they will have to limit their exposure. In many cases, this will mean that employers that were very desirable risks before Sept. 11 may no longer be desirable. The only other option (which is no option at all) is to make a promise to pay benefits even though the insurer knows it is a promise it cannot keep, should a major terrorist attack occur. Because workers’ comp benefits are statutory, insurers cannot limit this coverage by contractual exclusions for terrorism and acts of war.

Failure to act will produce a disruption in the workers’ comp marketplace. Insurers will shed customers they would rather insure, only to face this risk again through the pools for “residual” risks or the guaranty funds. Self-insurers will be forced to buy insurance, frequently in a residual market or from a state fund, and state legislatures in state fund states will have to examine the state’s potential liability should the fund fail.

If Congress fails to act and a terrorism attack occurs that produces casualties of the Sept. 11 magnitude or even greater, workers’ comp insurers will likely become insolvent; guaranty funds will be overwhelmed by losses, and in some states, employers may be liable for benefits they thought that they had insured, and injured workers’, whether from a terrorist act or otherwise, will go unpaid.

Congress must recognize that what is developing is an illusion of coverage for injuries to workers’ caused by acts of terrorism and war. This illusion will be quickly shattered if a major terrorism attack occurs, and Congress will be faced with much more costly and difficult choices than it faces today.

Gregory W. Heidrich is Senior Vice President of the Alliance of American Insurers. He joined the Alliance in 1983 and has served in a variety of research and management positions. Presently, he is responsible for policy development in the workers compensation and safety/loss control areas.