(MONEY Magazine) – The insurance industry wasn't the direct target of the terrorist attack on Sept. 11, but it might as well have been. First, there were the lost lives and business disruptions inflicted on insurers, brokers, agents, even government regulators who maintained offices near ground zero. More than 20 staffers in the New York City offices of the National Association of Insurance Commissioners had to flee their offices at 7 World Trade Center, a 47-story building that collapsed within hours of the Twin Towers. "All of our people got out safely," says NAIC spokeswoman Kristin Welschmeyer. "We were lucky." Others weren't. AON, one of the largest insurance brokers in the world, lost approximately 200 workers when the towers collapsed, while Marsh & McLennan, another giant insurance brokerage, lost nearly 300, including a staffer on one of the hijacked planes.

Then there was the financial damage. At last count, estimates of insurers' losses ranged from $30 billion to an assessment by British actuarial firm Milliman UK that put the figure at roughly $75 billion, nearly five times the $15.5 billion tab for 1992's Hurricane Andrew, up to now the most costly disaster. And while no one would attempt to compare tragedies in terms of the human losses they exact, previous man-made disasters like the 1995 bombing of the Oklahoma City federal building ($125 million in damages), the first bombing of the Trade Center in 1993 ($510 million) and even the 1992 Los Angeles riots ($775 million) pale in comparison in strict dollar figures. Says Donald Watson, a director in Standard & Poor's insurance rating division: "This promises to be the single largest insured loss in world history."

So you can't help but wonder: Can any industry--even one that specializes in helping other businesses survive unexpected and catastrophic events--withstand such a huge hit? And, equally important: Will the money be there when policyholders--both businesses and individuals--file their claims?

No one really knows at this point how bad the fallout will be. Insurers and policyholders face a mass of tangled liabilities and mounting claims. This type of catastrophe is known in insurance circles as a "clash" event, one that generates huge simultaneous losses across a broad spectrum of coverages--life, health, workers' compensation and property damage, to name just a few. The sheer scope of the potential liabilities makes it difficult to gauge the financial impact of this disaster.

There are also concerns about the very system that insurers use to reduce risk--essentially a chain of "reinsurers," each of which assumes part of the liability for a policy. If just a few companies along that interlocking line can't meet their obligations, companies all the way back up the chain could face more claims than they can handle. In the aftermath of Hurricane Andrew, for example, a dozen or so small insurers went bust. What follows is a look at the fundamental issues that insurers, policyholders, regulators and Congress will be grappling with.

What Will This Cost Insurers?

Life insurance. Within hours of the plane crashes, insurers began scrambling to determine their potential losses. Ironically, though, insurers most directly affected by lost lives and injuries--life and workers' compensation insurers--will bear the smallest burden. "The ultimate cost for life insurance companies will be a small fraction relative to what property/casualty insurers will face," says Robert Riegel, managing director of life and health insurance at Moody's Investors Service.

That said, those claims will hardly be negligible. Many of the people who died earned incomes that were well above average and thus likely had large amounts of life insurance. Many were also covered by employer-provided group life policies. Riegel figures that life insurers will probably pay out $2 billion to $5 billion in death claims, more than for any other single event.

Workers' compensation. Claims for workers' comp--the coverage that pays benefits to workers who are killed or injured on the job--will likely come in somewhere between $2 billion and $3 billion. That figure could easily balloon, however, because there's generally no cap on payments for medical expenses, which could mount quickly as insurers are inundated with claims not just for physical injuries but for those involving emotional stress and psychological problems.

Property and casualty. Clearly, property damage claims will be enormous. In addition to the Twin Towers, another six buildings collapsed or partially collapsed, while at least another 10 have major damage. It's also likely that dozens of other buildings in downtown Manhattan have sustained structural or other damage as a result of shock waves from the collapse of the towers or falling debris. Property/casualty insurers will also face losses resulting from the destruction of property such as computers, telecommunications equipment, office furnishings and even cars that were parked in the garages under the towers and on surrounding streets. Add the loss of the four aircraft commandeered by the terrorists, and analysts estimate that property losses alone will cost insurers from $9 billion to $11 billion.

Liability. In an event like this that involves the deaths of hundreds if not thousands of high-level executives, it's virtually inevitable that we'll see multimillion dollar lawsuits claiming that the deaths were the result of incompetence or negligence of some sort. Those claims alone could run well into the billions of dollars. Then there may be similar liability claims by survivors and even people who lived or worked close to ground zero. One major issue: possible asbestos contamination in the wake of the building's collapse. "That's a huge liability that could come into play," says Matthew Mosher, group vice president of property/casualty ratings at A.M. Best. "All this new exposure could have an impact in terms of cost that will take years to figure out." Any calculation of the cost of these claims is obviously iffy at best, which is why analysts estimates range from $8 billion to $20 billion.

Business interruption. Virtually all insurance experts agree that business-interruption claims will be both the largest and the most nettlesome. Essentially, this coverage reimburses companies for losses they incur when a catastrophe or other unforeseen event disrupts their business. It also covers the cost of moving to and setting up operations in a new location. Not only will virtually every one of the 400 or so businesses that had been operating in the World Trade Center complex at the time of the crash likely file such a claim, but so will hundreds, if not thousands, of businesses that were forced to shut down when the city closed virtually all of lower Manhattan to aid the rescue effort. In fact, the ripple effect could extend much farther. "Even companies located outside the disaster area that do business with companies located there might have business-interruption claims," says Finley Harckham, a partner at Anderson Kill & Olick, a law firm with a large insurance practice. So insurers could see claims, for example, from commodities firms that were unable to trade coffee or cocoa futures when the New York Board of Trade's commodity exchange floor in the World Trade Center was destroyed or from investment firms that suffered losses because the New York Stock Exchange was shut down. Estimates range from $8 million to $25 billion.

If history is any guide, all of the preliminary estimates given above may end up understating the ultimate total. In the wake of the 1994 earthquakes in Northridge, Calif., for example, early loss estimates came in at around $2 billion, but the final tally was more than $15 billion.

Whose Liability Is It Anyway?

Issues of liability are crucial in determining which insurers eventually pick up the tab. You could argue, for example, that the airlines or the airports failed to provide adequate security against hijackers, and thus they--and their insurers--should bear the liability for the subsequent damage. Or you could make a case that the property damage and loss of life resulted, at least in part, from the building owners' failure to provide adequate evacuation procedures or the architects' design flaws. "One can imagine the lawyers having a field day with this sort of thing, searching for all sorts of deep pockets to pay for this," says David Sanders, a senior actuary with Milliman UK.

Such issues won't determine who pays immediate claims. Businesses and individuals will file their claims with the company that wrote their policy. And while some claims will no doubt be the subject of negotiation between the policyholder and the insurer, most will be quickly paid by the policyholder's insurer. But if that insurer believes liability for the loss lies with another party--say, the airlines, the building owner or their insurers--it may very well end up suing.

That said, the search for deep pockets could turn out to be something less than the usual feeding frenzy. The reason: A section of the bill that Congress passed in the wake of the attacks to prop up ailing airlines provides for the establishment of a victims fund that would compensate families of those who were killed or injured, on the condition that they give up the right to sue. As of late September, details such as how large the compensation would be and how the fund would be financed had yet to be worked out, although Congress did stipulate that the fund would not pay punitive damages and that payments would be reduced by the amount of any compensation victims receive from "collateral sources," such as life insurance and pension funds.

Many insurance policies limit payments for any single incident, a restriction that can have a huge impact on the size of the hit an insurer takes. "Two related events that occur within a 72-hour period are usually considered one occurrence by insurers," says A.M. Best's Mosher. Under that line of reasoning, if the World Trade Center is insured for somewhere between $3 billion and $4 billion as several analysts estimate, that would be the limit of the insurers' exposure. On the other hand, if each jet crash is ultimately deemed a separate incident, then the insurers' liability could expand to $6 billion to $8 billion.

Other policy restrictions could also affect the amount insurers end up paying. In the days immediately following the incident, for example, there was much talk as to whether "act of war" exclusions might allow insurers to sidestep claims. In what appeared to be a magnanimous gesture, many major insurers immediately announced that they had no plans to invoke such a provision. As it turns out, such an exclusion probably wouldn't apply anyway. In deciding a dispute between Pan Am and Aetna Casualty & Surety over claims resulting from the hijacking of a Pan Am airliner, the U.S. Court of Appeals for the Second Circuit held in 1974 that act-of-war exclusions require hostilities between sovereign governments or similar entities, as opposed to violence by radical political groups.

But that still leaves room for possible exclusions for acts of terrorism. While such exclusions are rare among U.S. insurers, Standard & Poor's has pointed out that they are common among European insurers, many of whom have large exposure to the World Trade Center attacks. But will they come into play? "I've talked to numerous European insurers," says Georgia insurance commissioner John Oxendine, who heads a national task force that deals with foreign insurers on a variety of issues. "And every one has said that if such provisions exist they don't plan to invoke them." Any firm that did, he adds, would have trouble doing more business in the U.S.

Can Insurers Survive the Hit?

Catastrophic events are nothing new for insurers. Many routinely run an RDS (realistic disaster scenario), such as two jumbo jets colliding over a large city or a major earthquake hitting Los Angeles, to determine their PML (probable maximum liability). But no one envisioned a catastrophe like the one that occurred on Sept. 11. How, then, could the industry possibly hope to be able to pay claims and continue operating?

The answer lies in two lines of defense. First, insurers pass along some of their liability to reinsurers, essentially companies that insure other insurance companies. Let's say, for example, an insurer writes a $100 million policy on a large office building. The insurer might keep $10 million of that coverage and then "cede" $90 million to a reinsurer. The reinsurer, in turn, might keep just $10 million of coverage and pass the remaining $80 million on to yet another reinsurer, in a process known in insurance circles as "retrocession." When large policies are involved--such as many in the World Trade Center incident--it's not uncommon to see a chain of 20 or more insurers.

Insurers' second line of defense is their capital base, or as it's known in insurance lingo, their surplus. When insurers realize that they will face claims against one of their policies, they begin shifting money from their surplus into a reserve account to cover those claims. (This is an accounting transaction only. Insurers don't actually begin selling their investments to raise cash until they start paying claims. Since it's still not clear how much insurers must pay, no one can predict the market impact of any asset sales.) In the final analysis, then, insurers' ability to weather claims comes down to whether they have a large enough surplus.

Overall, both of these lines of defense appear plenty solid. U.S. property/casualty insurers alone have an estimated $300 billion or more in surplus. And U.S. insurers, at least, get Uncle Sam to share the burden. Claims payouts are considered expenses, and thus are tax deductible. Assuming a corporate tax rate of 35%, that means that a payment of, say, $100 million effectively translates to a $65 million draw on the insurer's surplus.

Similarly, the chain of reinsurers that would be called upon to pay claims in this case includes such highly respected and well-capitalized companies as Berkshire Hathaway, Employers Reinsurance (a General Electric subsidiary) and foreign reinsurers such as Munich Reinsurance and Swiss Reinsurance.

But there could be some chinks in the industry's lines of defense. Standard & Poor's estimates that about half the industry's surplus--some $150 billion or so--belongs to companies, like State Farm, that provide mostly home and auto coverage to individuals and have minimal exposure in this case. By contrast, many insurers that provide the types of business property and casualty coverage that will bear the bulk of claims have been depending on investment gains to compensate them for the money they've been losing on their insurance coverage. For example, large insurers such as the St. Paul Companies, CNA, Hartford Financial and Citigroup all lost money last year on the property/casualty portion of their businesses, although in each case investment income and gains more than offset the losses. Clearly, the stock market hasn't been of much help recently, and it remains to be seen whether the markets will help bolster insurers' capital or drain it.

No one doubts the ability of the top reinsurers--Munich Re, Swiss Re, Berkshire and others--to meet their obligations. But some smaller reinsurers or ones with inadequate capital cushions could falter. "We would call it close to a 100% probability that some reinsurers will fail and be unable to pay claims as a result of this event," Morgan Stanley insurance analyst Alice Schroeder wrote in a report published within a week of the attack.

Schroeder expressed particular uneasiness about Lloyd's of London, which as of late September estimated its losses at approximately $1.9 billion. Schroeder notes that Lloyd's--which operates under an unusual system where various competing "syndicates" provide coverage--had been struggling even before the World Trade Center incident and predicts that this event "will certainly bring down several Lloyd's syndicates." For its part, Standard & Poor's downgraded Lloyd's financial-strength rating from A+ to A and left it on "credit watch with negative implications"--Standard & Poor's lingo meaning that the rating could fall yet another notch. Lloyd's chairman Sax Riley noted that while "a figure of this size will have a significant impact on the Lloyd's market, the market's strong capital base will absorb this loss."

If Lloyd's or any other reinsurer were to fail to meet its obligations, it could start a chain reaction that would essentially result in a reversal of the reinsurance risk-reducing process, mag- nifying liabilities each step of the way instead of shrinking them. "It's not likely," says S&P's Watson, "but you could...see a wave of insolvencies." Ultimately, the "primary" insurer, the one who wrote the original policy, would be on the hook for the coverage, although the liability could be far higher than the primary insurer had planned on.

Will Policyholders Collect?

Most insurance experts believe that the overwhelming majority of claims will be paid in a timely manner. Within a week or so of the disaster, several life insurance companies had already begun paying death benefits, and the New York State insurance department has instructed insurers in the state to use a standardized proof-of-death affidavit to help families get life insurance payouts in cases where there's difficulty in obtaining an actual death certificate. Property damages where the amount of the loss is easily ascertainable should also be paid relatively quickly, probably within months and certainly within a year or so. Workers' comp claims should also be straightforward, although medical claims involving stress-related and other tough-to-diagnose maladies could stretch out if insurers raise questions about their validity.

Clearly, other types of losses will be more complicated to sort out. Property damage to large buildings damaged but left standing, for example, could lead to disputes about the extent of structural defects. Some such claims could take several years or longer to settle. Liability claims that go to court often drag out even longer, although in this case victims' families would have the option of receiving compensation from the victims fund set up by the federal government. Of course, there will undoubtedly be some claims that trickle in over the years, such as property damage that wasn't readily apparent and asbestos-related illnesses that take time to manifest themselves. Milliman UK's Sanders points out, for example, that some claims in the 1988 explosion of Pan Am Flight 103 over Lockerbie, Scotland have only recently been paid. Says Sanders: "It could take 10 to 15 years to settle all the bits and pieces and pay all the claims."

Given the magnitude of this disaster, it would be surprising if no insurers failed. But unless something truly unexpected happens, most analysts believe that the failures will be limited to a handful of small companies. In short, at this point most industry experts believe that the vast majority of insurers will be able to make good on policyholders' claims.

If an individual or business policyholder's insurer does fail, things can get hairy to say the least. Unlike bank customers, who can rely on federal deposit insurance, insurance policyholders have no federal regulatory system to fall back on. Instead, insurers are regulated state by state. In the event that an insurer fails, the insurance commissioner in the insurer's home state puts it into receivership and then decides whether to "rehabilitate" it--keep the company in business so it can build up its capital and pay claims--or liquidate the company's assets. If the commissioner decides to liquidate, then state insurance guaranty funds--essentially, funds created by the states to pay claims of insolvent insurers--would step in to pay policyholders' claims. It can sometimes take several months before the guaranty funds begin making payments, however, and the funds also have limitations on the type and size of claims they will pay. Fortunately, it's doubtful that any significant number of policyholders will have to travel this route.

Many policyholders will, however, face higher rates for many types of coverage. In fact, rates had already been going up for business property and casualty coverage as insurers began to realize that competition had driven premiums well below profitable levels. The events of Sept. 11 will accelerate that trend, partly because insurers will need more premium income to replenish their capital in the face of heavy losses, but also because the terrorist attacks showed that insurers are taking on a lot more risk than they'd previously believed. The attacks shouldn't have much of an effect on personal lines such as home and auto coverage, since damage there was relatively minor. There could be a slight bump in life insurance rates, though, because reinsurers will pick up much of the tab for life and workers' comp claims. As those reinsurers raise rates to replenish their surplus, life insurance companies may decide to pass those rate increases along to policyholders.

Finally, this tragedy may also spur some fundamental changes in the way we as a society insure ourselves against certain risks. With few exceptions, we have relied on the private insurance market, which for the most part has been up to the task. But these attacks have awakened us to just how enormous the risks can be--and how unpredictable, which makes them difficult to price. In his testimony before the House Financial Services Committee in late September, Chubb chairman and CEO Dean R. O'Hare warned that "it is becoming apparent that as current reinsurance agreements expire, they will be renewed only with a terrorism exclusion, and therefore it will be impossible to provide our customers with terrorism coverage." The industry has begun working with Congress to come up with a way to make coverage available without exposing insurers to debilitating claims. One possibility: a fund similar to that used in Britain, where insurers pool resources and, if those reserves are exhausted, the government steps in to cover remaining losses.

Like many of the claims stemming from Sept. 11, these issues will take months, if not years, to sort out. But this much is already clear: Insurers will be more careful in assessing the risks in the policies they offer, and the rest of us will take a lot more care in choosing the insurer we go to for our coverage.