The topic of exposure and risk that insurance companies have to terrorism is an incredibly complex one, employing the efforts of many actuaries and risk management experts. It's a problem without a solution. There isn't any way to know what terrorists might do next. Therefore, there isn't any way to know with certainty what the worst-case scenario is or what the probability of its occurrence might be.
And that's at the heart of why the Terrorism Risk Insurance Act was created in 2002. Without going into the details, it's basically a backstop for the insurance companies to assure their solvency in the case of an unpredictable catastrophic terrorist action. It kicks in after $10 billion in overall claims and is good for more than $80 billion in damages. For example, damages from the 9/11 attacks have been estimated at about $40 billion, though insured losses were a much lower $3.5 billion.
Investors were lulled into complacency until the Madrid train bombing and heightened terror alerts worldwide brought the issue to the forefront once again. Property and casualty insurer American International Group
That spooked investors on concerns about the company's exposure to claims from damages caused by terrorism. Property and casualty insurers Allstate
The problem with being invested in these companies is twofold.
First is the obvious, however unlikely: risk that the companies would have to pay large claims due to some terrorist-related event. This is unlikely, not so much because of the probability of a terrorist event occurring, which is an unknown, but because the companies have taken steps to limit their individual exposures. While reinsurance for terrorism-related claims is hard to come by and expensive, property and casualty companies have diversified their exposure by limiting policy sizes in the most likely locations and limiting overall exposure to specific geographic areas. In other words, their exposure is more spread out and diluted than it was before Sept. 11, 2001. So the current concerns about risks to profits are probably exaggerated.
The second problem, which is more compelling, is how investors would react if a series of small terrorist strikes occurs and claims are filed. The problem isn't so much what the size of the claims would be. At least to date, weather-related claims have been a much larger problem. Rather, it is how investors would react to the increased risk. Would they run away from the stocks of property and casualty insurers? I think they would. Investors don't like indefinable risks. If they can get the same return elsewhere without the unknown risk, they are going to move their money. And that could mean significant price depreciation.
Investors should be asking themselves if the property and casualty insurance companies are the best places to put their money when there are other equivalent choices out there with better risk/reward ratios.
Fool contributor Mark Mahorney doesn't own shares of any companies mentioned.