Terrorism Risk Insurance: Market Challenges May Exist for Current Structure and Alternative Approaches
Published: 2017-01-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: After the terrorist attacks of September 11, 2001, insurers generally stopped covering terrorism risk because losses could be too high relative to the premiums they could charge. Congress enacted TRIA to share losses from a certified act of terrorism between insurers and the government, address market disruptions, and help ensure widespread availability and affordability of terrorism coverage. TRIA does not include an up-front federal charge for the government's share of potential losses. The act mandates that, when private industry's losses are below a certain amount, the federal government recoups some or all of the federal share of losses through policyholder surcharges.
The Terrorism Risk Insurance Program Reauthorization Act of 2015 includes a provision for GAO to review alternative funding approaches for TRIA. Among other things, this report examines (1) how insurers manage their terrorism exposure and federal recoupment of losses, (2) how alternative funding approaches could be designed and implemented, and (3) the potential effects of these approaches as well as the current structure. To assess these funding approaches, GAO reviewed related studies, analyzed several terrorism loss scenarios for each funding approach to estimate potential effects on market participants, and interviewed industry participants.
Treasury and NAIC provided technical comments on a draft of this report, which GAO incorporated as appropriate. GAO also incorporated technical comments received from selected third parties, as appropriate.
section_title: What GAO Found
paragraphs: Under the Terrorism Risk Insurance Act's (TRIA) current structure, insurers manage their terrorism exposure to cover their share of losses and not the federal share of losses, which may be recouped from policyholders after an event. Specifically, insurers do not assume the risk of the federal share of potential losses and, thus, do not consider the potential federal share of losses in how they manage their terrorism risk exposure and price coverage. Many insurers include a nominal charge for terrorism risk coverage, if they charge for it at all. Most insurers manage their exposure by limiting the amount of coverage they provide in certain geographic areas. Under the current structure, in some scenarios federal losses must be recouped through premium surcharges on policyholders with TRIA-eligible insurance coverage after a certified terrorism event. However, depending on the size of the terrorism event and the aggregate premiums of affected insurers, the federal government may not be required to recoup all of its losses. To date, no terrorism events have been certified under TRIA.
Designing and implementing alternatives to TRIA's current funding structure, such as a federal terrorism risk insurance charge or set-aside of insurer funds, would require trade-offs among various policy goals and involve complexities. For example,
Federal charge. A charge on insurers or policyholders could either (1) be a risk-based charge intended to help pay for the federal share of potential losses, replacing the current recoupment structure, or (2) be a charge, or fee, paid to the Treasury for the promise of payment of the federal share of loses with recoupment in place to cover the actual losses. A federal charge could help cover potential losses, but determining a price based on risk would be difficult.
Terrorism set-asides. An insurer set-aside to explicitly address terrorism exposure through liabilities, capital, or assets could be designed as (1) loss reserves for future terrorism losses, (2) separate or additional capital requirements for terrorism risk, or (3) separate assets that only could be used for terrorism losses. A set-aside of insurer funds could help cover insurers' potential losses but some approaches would be complex to implement due to implications related to current accounting practices and state laws.
TRIA's current recoupment structure and some alternative approaches could increase prices for policyholders and have various effects on market participants and the federal government. GAO's analysis indicated that the current structure and some alternative approaches could affect the price of coverage and policyholder decisions to purchase terrorism coverage. In addition, one set-aside approach could restrict the flexibility with which insurers can use assets (generally, for a variety of risks) and thus hamper risk management. Under each option, federal fiscal exposure exists. For example, a charge to cover the federal share of losses may be insufficient to cover losses in the near term. However, the design of an alternative approach can, in part, mitigate the magnitude of these effects. For example, lengthening recoupment time frames, charging a broad group of policyholders, or allowing flexibility in applying a set-aside could help mitigate the effects.

section_title: Letter
paragraphs: The terrorist attacks of September 11, 2001, which resulted in reported  total insured losses of roughly $44 billion (2015 dollars), drastically  changed the way insurers viewed the risk of terrorism. After September  11, insurers generally stopped covering terrorism risk because they  determined that the risk of loss was unacceptably high relative to the  premiums they could charge. In November 2002, Congress enacted the  Terrorism Risk Insurance Act of 2002 (TRIA) to help ensure the continued  availability and affordability of commercial property/casualty insurance for  terrorism risk and to address concerns that the lack of terrorism insurance  could have significant effects on the economy.
TRIA requires the Department of the Treasury (Treasury) to administer a  program in which the federal government would share some of the losses  with private insurers in the event of a certified act of terrorism. Insurers  can charge their policyholders premiums for the insurer’s potential share  of losses. However, the federal government does not charge premiums  for its potential share of losses before an event occurs. Rather, TRIA  includes a provision that allows Treasury to recoup some of or all the  federal share of losses after a certified terrorism event. To date, no  terrorism events have been certified under TRIA.
Policymakers and insurance industry representatives have continued to  debate the role of the federal government in supporting terrorism risk  insurance. The program originally was intended to be temporary (3  years), but was extended and modified three times––in 2005, 2007, and  2015. Over this period, the reauthorizations have reduced federal  responsibility for losses and increased private-sector responsibility for  losses. Proponents of TRIA believe that the program provides a layer of  protection the private market would not be willing to provide without a  federal program in place. Others believe TRIA exposes the federal  government to insurance losses on private properties and provides free  reinsurance for private insurers because it does not require up-front funds  for the losses that would be covered by the federal government.
The Terrorism Risk Insurance Program Reauthorization Act of 2015  includes a provision for GAO to review the effects and viability of  alternative funding options. This report examines (1) how insurers  manage their terrorism risk exposure and price terrorism risk insurance;  (2) the federal government’s recoupment requirements and how the  federal share of terrorism losses would be affected in different scenarios;  (3) how alternative funding approaches could be designed and  implemented; and (4) the potential effects of the approaches.
To address these objectives, we reviewed TRIA and its amendments in  2005, 2007, and 2015, and implementing regulations. We also reviewed  prior GAO work on this topic. We interviewed officials and reviewed  reports from Treasury, the National Association of Insurance  Commissioners (NAIC), the Congressional Budget Office, and  Congressional Research Service. We also interviewed and reviewed  relevant reports from academic researchers and several industry  participants, including insurers, reinsurers, state regulators,  representatives from insurance trade associations, a rating agency, and  insurance and reinsurance brokers. In all interviews, we asked  participants about practices under the current program funding structure,  the feasibility of the alternative funding options, and the importance of key  pricing objectives and set-aside design factors we identified. We also  asked participants about the potential effects on insurers and reinsurers,  state regulators, policyholders, and the federal government of the current  program’s recoupment mechanism and alternative funding options.
To describe insurers’ practices for managing their terrorism exposure and  pricing terrorism risk insurance, we reviewed NAIC guidance on terrorism  premium disclosures for policyholders, and information about applicable  insurance tax laws and insurance accounting standards. In this report, the  information on insurers’ practices reflects statements from 6 insurers,  including 4 of the top 10 insurers, and statements from industry  participants. These statements are not generalizable.
To assess the extent to which the federal share of losses could be  recouped, we conducted analyses of the federal and insurer shares of  losses in various scenarios and how the federal share of losses would be  apportioned between TRIA’s mandatory and discretionary recoupment  provisions.
To examine how alternative funding approaches could be designed and  implemented, we considered two broad funding options, each of which  could utilize various approaches in relation to purpose and design. First,  we reviewed two ways a federal terrorism risk insurance charge could be  structured: (1) as a premium-like charge to help pay for the federal share  of potential losses, or (2) as a backstop charge, or fee, paid to the  Treasury for the promise of payment of the federal share of losses, or  backstop. In addition, we developed a pricing framework based on prior  GAO work on government fees and interviewed industry participants. We  also assessed how the objectives of the pricing framework are expressed  in premiums or premium-like charges in selected federal and state  programs and in charges for government-provided backstops provided in  the national terrorism risk insurance programs of two selected countries.  Programs were selected to illustrate a range of approaches for structuring  and collecting charges. Second, we selected programs or proposals to  identify key design factors and implementation considerations for  policymakers if they implemented a requirement or incentives for insurer  terrorism set-asides. Programs or proposals were selected to illustrate  variation among the design factors. To describe the practices, laws, and  rules the federal government could take into account in relation to a set- aside, we reviewed documentation on the selected approaches and  sources describing relevant accounting standards, and tax laws. We also  collected information on selected countries that allow insurers to establish  set-asides to cover future losses. We identified the countries for review  through external outreach efforts with international entities, literature  review, and questionnaire and interview responses.
To assess the potential effects of recoupment and alternative funding  approaches, we interviewed industry participants and analyzed insurance  data from SNL Financial, annual terrorism risk insurance premium  estimates from A.M. Best, and estimates of the percentage of commercial  property insurance premiums represented by terrorism risk insurance by  Marsh and McLennan Companies, Inc. (Marsh). Specifically, we  assessed the potential effects of recoupment of the federal share of  losses, a federal terrorism risk insurance charge, and terrorism set-asides  on insurers and reinsurers, state regulation, policyholders, and the federal  government. Using data and a number of informed assumptions, we  illustrated the potential effects on policyholder prices and participation  and insurer volume of premium under recoupment and the alternative  funding approaches. The scenarios and potential effects are illustrative;  they are not specific determinations of market effects or federal fiscal  exposure. We determined that the data used in this report were  sufficiently reliable for providing illustrative examples of potential effects.  We also examined whether, and to what extent, the program provides an  economic subsidy and illustrated the potential size of any subsidy. In this  report, we define an economic subsidy as a payment or benefit from the  government to private market participants, for which the government  receives no commensurate benefit. The responses from industry  participants may or may not be representative of all participants in the  commercial property/casualty market, but their experiences and views  offer insights directly into this group of insurers. Appendixes I, II, V, and  VI provide more detailed information on our methodology.
We conducted this performance audit from January 2015 to January  2017, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: From an insurance standpoint, measuring and predicting terrorism risk is  challenging. The difficulties of measuring and predicting losses  associated with terrorism risks stem from factors including lack of  experience with similar attacks, difficulty in predicting terrorists’ intentions,  and the potentially catastrophic losses from terrorist attacks. To  underwrite insurance—that is, decide whether to offer coverage and at  what price—insurers consider both the likelihood of an event (frequency)  and the amount of damage it would cause (severity). Although insurers  increasingly have used sophisticated modeling tools to assess terrorism  risk, from a statistical perspective little data exist on which to base  estimates of future losses in terms of frequency or severity, or both.  Reinsurers (insurers for insurers) follow an approach similar to that of  insurers for pricing risk exposures and charging premiums based on that  risk and, therefore, face similar challenges in pricing terrorism risks.
Congress passed TRIA in 2002 to address some of the challenges the  insurance industry and businesses faced after the September 11 attacks,  when coverage for terrorism risk generally became unavailable. The  goals of TRIA are to (1) protect consumers by addressing market  disruptions and ensuring the continued widespread availability and  affordability of commercial property/casualty insurance for terrorism risk;  and (2) allow for a transitional period for the private markets to stabilize,  resume pricing of such insurance, and build capacity to absorb any future  losses, while preserving state insurance regulation and consumer  protections.
As required by TRIA, insurers must make terrorism coverage available to  commercial policyholders, although commercial policyholders are not  required to buy it. TRIA requires an insurer to make coverage for  terrorism losses available that does not differ materially from the terms,  amounts, and other coverage limitations applicable to losses arising from  events other than acts of terrorism. For example, an insurer offering $100  million in commercial property coverage must offer $100 million in  coverage for property damage from a certified terrorist event. As  discussed in greater detail later in this report, insurers can charge a  separate premium to cover their terrorism risk, although some include the  coverage in their base rates for all-risk policies. Neither insurers nor the  federal government charges for the government’s coverage of terrorism  risk under TRIA, but the government may recoup at least some of its  losses following a terrorism event.
For eligible lines, TRIA covers insured losses resulting from an act of  terrorism, which is defined, in part, as a “violent act or an act that is  dangerous” to human life, property, or infrastructure. The act is silent  about losses from attacks with nuclear, biological, chemical, or  radiological weapons (NBCR).
subsections: section_title: Public-Private Loss Sharing under TRIA
paragraphs: Initial loss sharing. In the event of a certified act of terrorism, TRIA’s  loss-sharing structure requires that insurers pay claims on covered  terrorism losses and that Treasury reimburse individual insurers for  losses that exceed a specified amount. For federal compensation to be  paid, aggregate industry insured losses from certified acts must exceed a  certain amount (program trigger). For calendar year 2016, this amount  was $120 million. An individual insurer with terrorism losses in excess of  a deductible (20 percent of its previous year’s direct earned premiums in  TRIA-eligible lines) may make a claim to Treasury for payment of the  federal share of compensation for its insured losses. As shown in figure 1,  Treasury would reimburse the insurer for a certain percentage of its  losses (84 percent for calendar year 2016) above the deductible, and the  insurer would be responsible for the remaining portion (16 percent).  Annual coverage for losses is limited (capped) so that aggregate industry  insured losses in excess of $100 billion are not covered by private  insurers or the federal government.
Recoupment. The federal share of losses may be recouped after a  terrorist event through premium surcharges. As previously discussed,  Treasury reimburses an insurer for a certain percentage of its losses  above its deductible. And, if insurers’ aggregate losses are below a  specified amount, Treasury may be required to recoup federal losses  through post-event premium surcharges. Figure 2 shows the TRIA  funding mechanism before and after a terrorism event. Specifically, the  program includes a provision for mandatory recoupment of at least a  portion of the federal share of losses if the aggregate sum of all insurers’  deductibles and co-shares are below an amount prescribed by TRIA— known as the industry aggregate retention amount. Under mandatory  recoupment, the insurers must impose and remit to Treasury a premium  surcharge on all policies in TRIA-eligible lines until total industry  payments reach 140 percent of any mandatory recoupment amount.  Treasury establishes the amount of the mandatory recoupment  surcharge. The collection timeframes for mandatory recoupment range  from 1 year and 9 months to about 6.5 years, depending on when the  terrorism event occurs.
When federal assistance exceeds the mandatory recoupment amount,  TRIA allows for discretionary recoupment. Under the discretionary  recoupment provision, Treasury may recoup additional amounts based on  the ultimate cost to taxpayers of no additional recoupment, economic  conditions in the marketplace, the affordability of commercial insurance  for small and medium-sized businesses, and other factors Treasury  considers appropriate. Treasury also sets the surcharge for  discretionary recoupment, but the increase to TRIA-eligible premiums  must not exceed 3 percent per calendar year.
Changes in TRIA reauthorizations. As shown in table 1, the TRIA  reauthorizations have changed several loss-sharing provisions of the  program. Over time, the reauthorizations have reduced federal  responsibility for losses and increased private-sector responsibility for  losses. The 2015 reauthorization requires further incremental decreases  in the federal share of losses over 5 years. In addition, the 2015  reauthorization requires insurers in the program to submit information to  Treasury about the coverage they write for terrorism risk, including the  lines of insurance with exposure to such risk, the premiums earned on  such coverage, and the participation rate for such coverage.
section_title: Regulation of Insurance
paragraphs: Insurance in the United States is primarily regulated at the state level.  State regulators license agents, review insurance products and premium  rates, and examine insurers’ financial solvency and market conduct. In  addition, through the NAIC, state insurance regulators (of the 50 states,  the District of Columbia, and the U.S. territories) establish standards and  best practices, conduct peer reviews, and coordinate their regulatory  oversight. For issues that involve a national standard or require uniformity  among all the states, the NAIC develops and distributes model insurance  laws and regulations for consideration among its member states.
Generally, state law requires insurers to file rates (and to file insurance  forms) with state regulators who review the rates to ensure they are not  excessive, inadequate, or unfairly discriminatory. States vary with regard  to the timing and depth of reviews of insurers’ rates and contractual  language. Many state laws have filing or review exemptions (or both) that  apply to large commercial policyholders. State insurance regulators do  not perform rate or form reviews for these entities because it is presumed  that large businesses have a better understanding of insurance contracts  and pricing than the average personal-lines consumer and as such are  able to effectively negotiate price and contract terms with insurers.
Capital requirements, accounting standards, and other tools help state  regulators, insurers, and other entities monitor and mitigate potential risks  and assess insurers’ financial strength.
Risk-based capital requirements: State regulators require insurance  companies to maintain specific levels of capital to continue to conduct  business. Regulators determine the minimum amount of capital  appropriate for an insurer to support its overall business operations,  taking into consideration its size and risk profile. Most U.S.  jurisdictions have adopted statutes, regulations, or bulletins that are  substantially similar to NAIC’s Risk-Based Capital for Insurers Model  Act, according to NAIC, and also use formulas that NAIC has  developed to establish a minimum capital requirement based on the  types of risks to which a company is exposed. NAIC has separate  models for different lines of insurance.
Own risk and solvency assessments: Starting in 2015, state  regulators began requiring large- and medium-size U.S. insurance  groups to begin regularly conducting own risk and solvency  assessments and submitting an annual written report to either the  insurer group’s lead state or state of domicile, depending upon if the  assessment is prepared on a group or legal entity basis. The  assessments are internal processes undertaken by insurers or  insurance groups to assess the adequacy of their risk management  and current and prospective solvency positions under normal and  severe stress scenarios.
Enterprise risk-management practices: Insurance companies use  these practices to obtain an enterprise-wide view of their risks and  help management engage in risk-based decision making. Enterprise  risk management generally has two goals: (1) to identify, evaluate,  and quantify risks; and (2) to ensure that the organization actively  implements risk-treatment strategies and manages appropriate risk  levels. Examples of specific enterprise risk-management practices  include identifying and categorizing risks, establishing well-defined  risk tolerances, assessing risk mitigation with cost-benefit analyses,  and conducting stress tests and other risk-modeling analyses.  Insurance companies must report much of this information annually in  their summary reports for own risk and solvency assessments.
Accounting standards and financial reporting: Insurers must  report their financial holdings on an individual legal entity basis to the  regulator in their state of domicile, using statutory accounting  principles (SAP). According to documentation from NAIC, SAP are  designed to assist state insurance departments in the regulation of the  solvency of insurance companies. The ultimate objective of solvency  regulation is to ensure that policyholder, contract holder, and other  legal obligations are met when they come due and that companies  maintain capital and surplus at all times and in such forms as required  by statute to provide a margin of safety. SAP stress the measurement  of ability to pay claims in the future. In addition to SAP, insurance  groups may report financial holdings information using generally  accepted accounting principles (GAAP), which in the United States  are promulgated by the Financial Accounting Standards Board  (FASB) and are designed to provide decision-useful information to  investors and other users of financial reporting. SAP and GAAP  recognize certain items differently and therefore may result in different  reported capital and net income amounts. Unless otherwise noted,  references in this report to accounting for or recording liabilities refers  to SAP.
Credit ratings: A credit rating is generally intended to measure the  likelihood of default for an issue or issuer, such as an insurer. To  determine an appropriate rating, credit rating agencies determine the  financial strength of insurance companies and their ability to meet  ongoing obligations to policyholders by analyzing companies’ balance  sheets, operating performance, and business profile.
section_title: Insurers Use Various Tools to Manage Their Terrorism Risk Exposure and May Charge Premiums for Coverage Although They Face Pricing Challenges
paragraphs: Insurers we interviewed stated that they manage their terrorism exposure  using several tools, and all said they generally charge premiums for  terrorism risk coverage although data to accurately price terrorism risk are  lacking. Insurers’ practices for managing their exposure and pricing  terrorism risk coverage are intended to cover their share of losses under  TRIA (their deductibles and coshares). Insurers do not consider in their  pricing the potential federal share of losses, which may be recouped after  an event.
subsections: section_title: Insurers May Establish Location-Based Risk Limits, Consider Terrorism Risk in Capital Adequacy Assessments, and Purchase Reinsurance
paragraphs: Based on interviews we conducted in our previous work and our work for  this report, insurers manage their terrorism exposure by establishing  geographic risk limits, considering potential terrorism losses when  assessing capital adequacy, and purchasing reinsurance.
Location-based risk limits. In our 2008 report, we found that the  insurers we interviewed determined the amount of terrorism coverage  they would be willing to provide in defined geographic areas, such as  financial districts where many large buildings are located or specific parts  of cities considered at high risk of attack. We also found that some  insurers used models available from risk modeling firms to estimate the  severity of potential attack scenarios to determine internal limits on the  aggregate coverage they would offer in defined areas (aggregation limits).  For example, they would limit their aggregate exposure in 250-foot, 500- foot, or quarter-mile circles around certain landmarks or areas where the  insurer had high concentrations of risk.
Officials from two insurers we interviewed for this report discussed how  they manage their terrorism exposure using aggregation limits. For  example, one insurer stated that it manages its exposure based on  estimated potential losses at more than 200 identified landmark locations  spanning its U.S. exposure base. The insurer told us that it calculates its  loss estimates for a conventional terrorism event that causes a building  collapse at a single location. As part of this calculation, it told us that it  considers the portion of potential losses that would be covered by the  insurer, its reinsurer, and the federal government in setting an internal  limit for terrorism exposure in each location.
Considering terrorism risk in managing and assessing capital. Most  insurers we interviewed also stated they manage their terrorism risk by  considering their terrorism risk exposure as part of external requirements  or internal assessments related to capital adequacy. Insurers’ capital  generally is intended to be available for purposes such as unexpected  losses and expanding the business and is not segregated for specific  purposes (see fig. 3). Insurers are generally free to manage their capital  as long as they satisfy external solvency and liquidity requirements as  well as internal assessments. State regulators require insurance  companies to maintain specific levels of capital (risk-based capital  requirements), but their capital calculations do not specifically address  terrorism risk exposure. However, rating agencies may assess insurers’  terrorism risk exposure specifically as an indicator of financial strength.  For example, A.M. Best’s ratings evaluation methodology for terrorism  risk includes calculating appropriate levels of capital for insurers with  material terrorism risk exposure.
In their own internal assessments of capital adequacy, insurers may  decide to exceed what is required. Most U.S. insurers hold several times  more capital than states require. In addition, although not required under  NAIC’s risk-based capital calculations, five of the six insurers we  interviewed stated that they specifically measure their terrorism risk  exposure in determining the appropriate amount of capital to maintain,  including three insurers which indicated that they specifically consider  their terrorism risk exposure due to rating agency assessments. One  insurer explained that its capital calculations include estimates for its  potential deductible and copayments under the current TRIA structure.
Three insurers we interviewed stated they also consider terrorism risk in  their internal enterprise risk-management assessments or their own risk  and solvency assessments—two internal processes insurers use to  monitor and mitigate potential risks. Because own risk and solvency  assessments are a recent requirement from state regulators applicable to  large- and medium-size insurers, few insurers and regulators we  interviewed had experience with them at the time of our review. For  example, one state regulator stated that it had reviewed some insurers’  filings for the assessments, which discussed risk management for  multiple terrorism events, while another state regulator had not yet seen  terrorism risk addressed specifically in insurers’ filings.
Insurers may consider terrorism risk exposure in their assessments of the  adequacy of capital, but they do not set aside funds specifically for  potential future terrorism losses in their assets or liabilities. Insurers’  assets are available for potential covered losses and generally are not  segregated or restricted for limited uses. However, in some  circumstances insurers may segregate or restrict their assets for specific  purposes such as for collateral. None of the insurers we interviewed  indicated doing so for potential terrorism losses. Insurers generally  account for actual or expected claims by establishing loss reserves as  liabilities on their balance sheet. As with all future losses, insurers cannot  create loss reserves for potential terrorism losses before an event occurs.  Specifically, accounting standards for recording insurance liabilities state  that insurers may create a loss reserve only for a covered event that has  occurred and for which the cost of the event is estimable. No liability  exists without the occurrence of a covered event. Insurance and state  regulatory officials we interviewed confirmed that insurers do not include  estimated potential future losses for terrorism or other potential  catastrophic events in loss reserves.
Purchasing reinsurance. Five of the six insurers we interviewed  purchase reinsurance to help manage their terrorism exposure. Most of  these insurers used a portion of the terrorism premiums they collected to  purchase the reinsurance. As we previously reported, primary insurers  may purchase reinsurance for potential terrorism losses up to the  difference between what they are willing to cover in a terrorism event and  the sum of their TRIA deductible and co-share under the program. Four  of the six insurers we interviewed said they purchased treaty reinsurance  coverage, which usually covers a part or a percentage of a book of an  insurer’s business across multiple risks. According to a reinsurance  broker we interviewed, the majority of terrorism reinsurance is sold along  with other property/casualty coverage. One insurer also stated that on  rare occasions it purchased facultative reinsurance (which covers  individual policies) for specific risks or unique cases. Finally, another  insurer we interviewed stated it purchased stand-alone terrorism risk  reinsurance—coverage for terrorism risks only—for all policies with  terrorism coverage.
section_title: Although Data to Accurately Price Terrorism Risk Insurance Are Lacking, Insurers That Charge Premiums for Their Share of Potential Losses May Use Loss Models and Factors Such as Location
paragraphs: Insurers we interviewed acknowledged the difficulty of pricing terrorism  risk and attributed it to the lack of data on terrorism risk. We previously  found that insurers’ primary concern with respect to covering terrorism  risks was limiting the amount of their exposures and that pricing was  secondary. For most insurance products, insurers typically estimate the  frequency and severity of an insurable risk based on data from past  events to help calculate premiums that are commensurate with their risk  exposure. However, as previously discussed, terrorism risk insurance is  challenging to price because the frequency and severity of terrorism  events are difficult to predict and quantify. As we concluded in prior work,  because the frequency and severity of terrorism events are difficult to  predict, the limits established in TRIA (which cap the potential severity of  losses to insurers) make underwriting the risk and determining a price for  terrorism coverage easier for insurers. However, one insurer and one  reinsurer we interviewed expressed concern that primary insurers do not  charge premiums sufficient to reflect their terrorism risk exposure.
The charge for terrorism risk coverage generally represents a small  percentage of the overall commercial property/casualty premium, if  insurers explicitly charge for it at all. According to insurers we interviewed,  terrorism risk insurance is generally provided in conjunction with   commercial property/casualty policies. For most TRIA-eligible lines, five  of the six insurers we interviewed told us that they generally charge a  percentage of overall property/casualty premiums for their share of  terrorism risk coverage under TRIA. A report from Marsh found that  from 2012 to 2015 policyholders paid between 3 percent and 5 percent of  their total property premium for terrorism risk coverage. According to  Treasury’s 2016 report, on average, reporting insurers that charged for  terrorism risk insurance charged about 2.6 percent of the total policy  premium for terrorism risk coverage and the percentage charged varied  from 0.7 percent to 7.1 percent, depending on the line of insurance.  However, according to Treasury’s 2016 report, although an explicit  premium is charged for terrorism risk coverage in the majority of cases,  about 23 percent of reporting insurers did not identify explicit terrorism  risk premiums for such coverage. The report stated that insurers may  not explicitly charge for terrorism risk coverage for reasons such as lack  of any cognizable terrorism risk in certain regions or under certain policies  or to ease administrative burden. An official from an insurance broker we interviewed also stated that some insurers do not include an additional  charge for terrorism coverage in many of their policies.
While one insurer we interviewed charges a flat rate for terrorism risk  coverage—that is, a premium rate per dollar of coverage that did not vary  with location or other risk factors—four of the six insurers we interviewed  consider location as a risk factor and thus charged policyholders located  in densely populated areas a higher rate for the coverage. For example,  one insurer stated it uses a model from the Insurance Services Office that  uses a risk classification system that places urban centers into one of  three tiers of risk classes. The insurer then enters its own terrorism risk  exposure information into the model to price terrorism risk coverage.
According to insurers we interviewed, other risk factors insurers consider  to price terrorism risk coverage include building occupancy rates;  industry; and proximity to airports, federal buildings, and subways. For  example, one insurer stated it created a range for terrorism risk insurance  pricing in which risks are slotted into low, medium, and high codes based  on industry sectors to determine the starting point for pricing. Once  assigned to a pricing slot, the insurer assesses risk-based factors such as  location and occupancy. Depending on the number of high-risk  characteristics that apply, the insurer will select a specific price from the  range.
Terrorism risk pricing for workers’ compensation lines of insurance— which cover an employer’s liability for medical care and physical  rehabilitation of injured workers and helps to replace lost wages of injured  workers—is more standardized when compared to other TRIA-eligible  lines. For workers’ compensation lines, insurers in 38 states use rates  developed by the National Council on Compensation Insurance (NCCI).  According to NCCI, to help set workers’ compensation premium rates that  include terrorism risk, NCCI uses information from modeling firms. These  firms select various scenarios (different weapons, locations, damages,  and frequencies), estimate the amount of damage to human life and the  amount of losses under each scenario, and assign probabilities to each  scenario. For workers’ compensation lines of insurance in general, NCCI  representatives stated that they typically set rates using actual data on  the number, types, and costs of workplace injuries. However, the paucity  of data about actual terrorism events—and the workplace injuries that  could result—necessitates the use of modeling techniques using various  assumptions to estimate potential losses from terrorism events.
According to NCCI officials, NCCI sets one rate for terrorism risk in each  of the 38 states it manages (that is, rates do not vary within a state for  other factors such as location, company size, or industry). Rates can vary  across states because of the perceived risk of terrorism being higher in  one state than another. Each state also may impose local surcharges on  the NCCI rate for that state. States that do not rely on NCCI either use a  state rating agency to set rates for terrorism risk, or require employers to  obtain workers’ compensation insurance from a compulsory state  fund. State rating agencies operate similarly to NCCI in setting one rate  for terrorism risk insurance for the entire state.
section_title: Federal Share of Terrorism Losses and Recoupment Requirements Depend on Event Size and Aggregate Premium Base of Affected Insurers
paragraphs: Our analyses showed that the federal government (initially) may sustain a  greater share of losses in more catastrophic terrorism events, and in  some scenarios recoupment may not be required. TRIA requires Treasury  to reimburse affected insurers for a certain percentage of their losses  above their individual deductibles and Treasury may recoup some or all of  its losses through post-event premium surcharges on all TRIA-eligible  policyholders. The federal share of losses depends on the size of the  terrorism event and the aggregate direct earned premiums in TRIA- eligible lines among affected insurers (premium base). In addition,  recoupment may be mandatory, discretionary, or a combination  depending on the size of the event and the premium base. Finally,  because the 2015 reauthorization incrementally shifts a greater share of  losses from the federal government to insurers from 2016 to 2020, the  date of the terrorism event also affects how losses would be shared and  how the federal share of losses would be apportioned between  mandatory and discretionary recoupment provisions.
subsections: section_title: Event Size, Deductibles, and Premium Base Drive the Initial Federal Share of Losses
paragraphs: As shown in figure 4 and consistent with the manner in which the program  is structured, our analyses showed that the initial government share of  losses (amounts the federal government would reimburse insurers and  prior to any recoupment from policyholders) would be greater following  events with more total insured losses. Using a number of informed  assumptions, we analyzed loss scenarios for hypothetical terrorism  events in 2016 with varying amounts of total insured losses ($25 billion,  $50 billion, $75 billion, and $100 billion) and affecting varying subsets of  insurers. An individual insurer’s losses are the sum of its deductible and  co-share. Under TRIA, an insurer’s individual deductible is calculated  based on its direct earned premium in TRIA-eligible lines of insurance.  For our analyses, we constructed insurers’ aggregate deductibles, which  are equal to the sum of 20 percent of each affected insurer’s previous  year’s direct earned premiums in TRIA-eligible lines (premium base).  We used direct earned premiums of the top 4, top 10, top 20, and all  TRIA-eligible insurers as proxies to represent various-sized premium  bases. For more information on these scenarios and others, see  appendix II.
Additionally, our analyses showed that the initial proportion of losses that  would be borne by the federal government and insurers depends, in part,  on the amount of losses from the terrorism event relative to aggregate  deductibles.
The federal government would not bear the cost of any losses if  the total losses were less than insurers’ aggregate deductibles.  For example, in an event that affected insurers with a premium base  equal to that of top 10 insurers and resulted in $5 billion in total  losses, insurers likely would sustain all losses, because insurers’  losses likely would fall below their respective deductibles.
Losses in excess of the insurers’ deductibles would be shared  between insurers and the federal government. For example, in an  event that affected insurers with a premium base equal to that of the  top 10 insurers and resulted in $50 billion in total losses, insurers and  the federal government would share the losses above the insurers’  deductibles. In this example, insurers’ deductibles would not cover all  losses.
As total losses increase above the insurers’ deductibles, the  government share of losses increases at a higher rate than the  insurers’ share of losses. Because the federal co-share is much  larger (84 percent in 2016) than the insurer co-share (16 percent in  2016), the initial federal share of losses is much higher than insurers’  share of losses in events with higher total losses. For example, in an  event that affected insurers with a premium base equal to that of the  top 10 insurers and resulted in $75 billion or $100 billion in losses, the  government share of losses would be much larger than the insurers’  share.
In addition, our analyses showed that as losses are shared by insurers  representing a larger premium base, the government share would  decrease. This occurs, in part, because as the aggregate premiums of  affected insurers increase, the aggregate insurers’ deductible also  increases. For example, as illustrated in figure 5, in an event that resulted  in $50 billion in losses, the portion of the losses covered by the federal  government decreases as the aggregate premium base among the  affected insurers increases.
section_title: Recoupment of Federal Losses Could Be Mandatory, Discretionary, or a Mixture of Both Depending on Event Size and Premium Base
paragraphs: The federal share of losses that could be recouped may fall under the  mandatory provision, the discretionary provision, or both. As illustrated in  figure 6, our analyses showed that the proportion of mandatory and  discretionary recoupment amounts depends on the total amount of  terrorism losses (event size), the subset of insurers that sustained losses,  and whether insurers’ losses were more or less than the industry  aggregate retention amount. General recoupment scenarios and  examples from our analyses are described below.
The federal government may be required to recoup its total share  of losses. If the total losses from the terrorism event were less than  the industry aggregate retention amount, all government losses must  be recouped under the mandatory recoupment provision. For  example, in an event that resulted in $25 billion in losses regardless of  the premium base of affected insurers, all recoupment would be  mandatory because the total losses would be below the industry  aggregate retention amount ($31.5 billion in 2016). The amount  recouped would be the difference between total losses and the  insurers’ share of losses.
The federal government may not be required to recoup any of its  losses. If insurers’ share of losses exceeded the industry aggregate  retention amount, all government losses would fall under the  discretionary provision and equal the difference between all losses or  the maximum loss cap (whichever was lower) and the insurers’ share  of losses. For example, our analyses showed that all recoupment  would be discretionary for an event where all insurers were affected  because the aggregate insurer deductible would exceed the industry  aggregate retention amount.
The federal government may be required to recoup only a portion  of its losses. If total losses exceeded the industry aggregate  retention amount and insurer losses were less than the retention  amount, the government share of losses would fall under both the  mandatory and discretionary provisions. The mandatory portion would  be the difference between the retention amount and the insurers’  losses. The discretionary portion would be the difference between  total losses or the maximum loss cap (whichever was lower) and the  aggregate industry retention amount. For example, when affected  insurers had an aggregate premium base equal to that of the top 4 or  top 10 insurers and the total losses exceeded $31.5 billion ($50  billion, $75 billion, or $100 billion in total losses), recoupment would  be split between mandatory and discretionary because the insurers’  losses were less than the industry aggregate retention amount but the  total losses exceeded the aggregate retention amount.
As figure 6 illustrates, our analyses also showed patterns in the portions  of losses to be recouped under the mandatory and discretionary  provisions. Losses recouped under the mandatory provision decreased  as the aggregate premiums base of insurers with losses increased. Of the  event sizes that we analyzed, events with $40-50 billion in losses  generally resulted in the highest mandatory recoupment across the  premium bases. The discretionary recoupment amount increased as the  size of the event increased, and in very large events could exceed $60  billion. Discretionary recoupment generally was not affected by the  aggregate premium base of affected insurers. For example, for all insurer  subsets, the discretionary portion of recoupment increased with the event  size, but the size of the discretionary portion for each event size generally  would be the same whether the affected insurers’ aggregate premium  base was equal to that of the top 4, top 10, or top 20 insurers.
section_title: Loss Sharing and Recoupment Amounts Also Affected by Date of Terrorism Event
paragraphs: In addition to the total amount of losses and the aggregate premium base  of insurers with losses, the date of a terrorism event would affect how  losses would be shared after a terrorism event and how federal losses  would be apportioned between recoupment provisions. Specifically, the  2015 reauthorization of TRIA incrementally shifts a greater share of  losses from the federal government to insurance companies in 2016- 2020, as shown in table 2. For example, for loss sharing, the increases  in the program trigger will increase the total insured losses that must  occur before the government would incur any losses. In addition, the  increase in insurer co-share will decrease the federal share for losses  above the insurers’ aggregate deductible. For federal losses apportioned  between mandatory and discretionary recoupment, the industry  aggregate retention increases by $2 billion per year. This change  potentially shifts a portion of the federal share of losses from the  discretionary recoupment provision to the mandatory provision.
The differing mandatory recoupment collection time frames from 2016 to  2020 could affect potential premium increases due to recoupment  surcharges. While discretionary recoupment surcharges must not  increase annual TRIA-eligible premiums by more than 3 percent,  mandatory recoupment surcharges in part would be determined by the  deadlines for collecting mandatory recoupment. For example, our  analyses showed potentially large surcharges resulting from events that  occurred in 2017 (the year with the shortest collection time frame).
section_title: Alternative Funding Options Pose Trade- offs and Complexities
paragraphs: The two alternative funding options we analyzed would require trade-offs  and present complexities. First, the option of a federal charge for  terrorism risk insurance could be collected to pay for the federal share of  potential losses or to cover the cost of the federal guarantee under TRIA.  Second, the option of insurer set-asides—through which insurers would  more explicitly address their terrorism exposure through their capital,  assets, or liabilities—could be used to help cover insurers’ share of  potential terrorism losses or both insurers’ and the federal government’s  share of potential losses.
subsections: section_title: A Federal Charge for Terrorism Risk Insurance Would Involve Significant Trade-offs
paragraphs: Depending on the approach, a federal terrorism insurance charge may  help promote some pricing objectives but could involve significant  limitations and trade-offs. Based on our prior work on designing and  assessing federal user fees, other government-collected funds, and user- based taxes, we identified pricing objectives and characteristics that could  have some applications for policymakers in considering various  approaches for a federal charge for terrorism risk insurance, as shown in  table 3. Using four pricing objectives (promoting economic efficiency,  equity, revenue adequacy, and limiting administrative burden), we  evaluated two approaches for a voluntary or required federal charge for  terrorism risk insurance:  Premium-like charge: A charge that would be intended to help pay for  the federal share of potential losses and could replace the current  recoupment provision. Such a charge could be an amount based on risk  using insurance principles or it could be designed as a flat rate or vary  based on insurer or insured characteristics.
Backstop charge: A charge or fee paid to the Treasury for the promise  of payment of the federal share of losses, or backstop. Such a charge  could be determined in a variety of ways, but it would not necessarily be  based on insurance principles. In addition, recoupment could still be in  place to cover the federal share of losses as the charge would not be  intended to be adequate to cover potential losses.
Policymakers may face tradeoffs among the pricing objectives as no  single design will satisfy all parties on all dimensions, and the level of  importance different policymakers may place on different objectives will  vary, depending on how they value the characteristics of each.
Economic efficiency. A premium-like charge could address risk and  insurable value—characteristics of promoting economic efficiency—but  would be difficult to price. Specifically, a premium-like charge could be  based on existing premiums that policyholders paid insurers. However,  this approach has some limitations because the existing, underlying  premiums are not accurately priced according to risk. As we previously  discussed, insurers lack data to accurately price terrorism risk insurance  and may charge a nominal percentage of the underlying commercial  property/casualty premium. Four industry associations, three insurers, an  insurance broker, and a state regulator said a reliable method or model to  estimate manmade catastrophes like terrorism events is currently not  available and representatives questioned how the federal government  could set risk-based prices to promote economic efficiency in the absence  of a viable method to estimate terrorism risk.
Taking into account risk mitigation activities—another characteristic of  economic efficiency—would be challenging to incorporate into a premium- like charge. Three insurers stated that, due to the unpredictable nature of  potential terrorism events, risk-mitigation measures could be more costly  than beneficial because terrorists might change tactics in response to  mitigation efforts. One of the insurers further noted that mitigation efforts  would be less effective at an individual insurer or policyholder level than  at a national level, and a state regulator said the federal government is  the primary body for taking mitigation actions such as through national  security. While mitigation efforts may be difficult to incorporate into the  premium pricing process for terrorism risk, an insurer said it takes certain  mitigation efforts into consideration when making decisions to accept a  client. For example, the insurer said that 24-hour guard service, perimeter  fencing, and intrusion detection devices are some mitigation efforts  considered in the decision.
In contrast, a backstop charge does not need to be closely tied to an  estimate of each participant’s terrorism risk exposure or risk-mitigation  activities. For example, a backstop charge would only need to cover the  cost of its administration rather than potential losses and, therefore, does  not need to be risk-based.
Equity. With either a premium-like charge or backstop charge,  policymakers may need to consider trade-offs between fairness and  affordability. Industry stakeholders noted challenges in structuring a  federal charge for terrorism risk to promote the characteristics of equity  (fairness), which involve the extent to which the pricing structure (1)  provides similar treatment to participants with similar levels of risk, and (2)  considers affordability. One insurer stated that to achieve equity, all  participants with similar levels of terrorism risk should be charged similar  rates. Two other insurers and a state regulator cautioned that prices  needed to be affordable to maintain participation rates and support a  thriving market that offers coverage for terrorism risk. One insurer pointed  out that affordability is important to consider because it was a factor in the  withdrawal of insurers and reinsurers from offering terrorism coverage  after the September 11 terrorist attacks. One state insurance regulator  said an affordability goal could be problematic to the extent it competes  with the goal of each participant paying their fair share, and another state  regulator said that an equitable charge would be more achievable if  collected after a terrorism event—as currently structured under TRIA’s  recoupment provision—when more information would be known about the  amount of losses.
Revenue adequacy. If policymakers wanted to focus on raising adequate  revenue to cover expected losses over time, a premium-like charge might  be a better option than a backstop charge. However, some industry  stakeholders we interviewed stated that a charge that could generate  enough revenue to cover the federal share of losses would be cost- prohibitive. An annual charge would need to be very high to accumulate  enough funds over time to cover very large losses which, an insurer  surmised, could drive down take-up rates and require other sources of  funds, such as surcharges or taxes. Also as discussed, industry  associations, insurers and others we interviewed said that determining a  price that would provide adequate revenues to pay for the federal share  of potential losses would be difficult because estimating terrorism  frequency and loss is not possible with any statistical accuracy. In  contrast, a backstop charge approach would not be intended to cover  expected losses.
Administrative burden. If policymakers focused on reducing  administrative burden, a backstop charge might result in lower  administrative costs than a premium-like charge. Industry stakeholders  generally held similar views that a premium-like charge would bring about  higher levels of administrative burden than the current program—that is,  the responsibilities of program staff or third parties to collect and process  the charge and oversee the effort. Officials from the Congressional  Budget Office and the Congressional Research Service cautioned that  collecting and managing federal charges from the more than 1,000  commercial property/casualty insurers would entail a large resource  commitment from the federal government. According to our interviews, if  such a charge was implemented, increases in staff and expertise would  be required to collect, manage, and oversee the charges. Officials from  Treasury estimated that a program that collected an upfront charge would  necessitate an additional 15-20 more full-time staff to collect the charges  and audit primary insurers—up from the three staff that would be needed  to administer third-party service contracts following a certified terrorism  event. The officials said more staff could be needed to operate on an  independent board and to manage the collection and investment of the  funds. According to one insurer, pricing a federal charge as a flat rate on  premiums across all TRIA-eligible insurance lines and including it on  policyholders’ statements similar to premium taxes would be transparent  and easily audited and thus may require less administrative burden than a  variable rate. Two insurers emphasized that the current method— recouping the federal share of losses after a terrorism event—is the least  burdensome, with relatively low administrative costs to Treasury.
In contrast, under the backstop charge approach, administrative burden  may be less than a premium-like charge because staff and operations  would not be needed to estimate losses and set a corresponding pricing  structure.
section_title: Depending on Approach, Implementing Terrorism Set-Asides Could Be Complex
paragraphs: Another alternative funding method for TRIA—designing and  implementing an insurer set-aside—could be complex because of existing  state laws and insurance accounting standards, among other reasons. An  insurer set-aside could be designed to help cover insurers’ share of  potential terrorism losses, the federal government’s share of potential  losses, or both. Insurer set-asides could be structured in at least three  ways: (1) loss reserves for events that have not yet occurred, (2) separate  capital requirements for terrorism risk exposures, or (3) segregated  assets that only can be used for a specific purpose such as potential  terrorism losses. We identified four proposals or current programs with  insurer set-aside approaches to illustrate ways a potential set-aside could  be designed, according to the three structures (see table 4). These  approaches also varied in participation requirements, target amounts, and  use of the set-asides.
The first two ways an insurer set-aside could be structured, establishing  (1) loss reserves for events that have not yet occurred and (2) separate  capital requirements for terrorism risk exposures, might not involve a  formal or legal segregation and limitation of assets dedicated for a  particular purpose, as illustrated in the following examples.
The NAIC catastrophe reserve proposal uses loss reserves for events  that have not yet occurred. Under this proposal, a participating  insurer’s set-aside would be structured as a separate liability on its  balance sheet—distinct from loss reserves for events that have  already occurred—without specific segregation of assets. In addition,  the set-side could be available to cover losses from multiple types of  perils.
The NAIC catastrophe risk weight uses capital requirements. In 2013,  insurers began testing a weighted measure in their minimum risk- based capital determinations, taking into account earthquake and  hurricane risks to determine a target amount of capital to maintain that  would preserve their solvency following a natural catastrophe.  Insurers’ capital is not limited to covering losses from hurricanes and  earthquakes.
A third way of structuring an insurer set-aside involves segregation of  assets for a specific purpose and is illustrated by proposals by House  members to build segregated insurer set-asides for terrorism losses to  help stabilize the marketplace following a terrorism event. Under these  proposals, insurers could set aside a portion of terrorism risk premiums  collected from policyholders as specifically segregated assets to be used  only for potential terrorism losses. We discuss these approaches and  examples of set-asides used in other countries in more detail in appendix  IV.
Implementing a set-aside for TRIA could be complex. Specifically, a loss  reserve similar to NAIC’s catastrophe reserve proposal could involve a  significant departure from existing insurance statutory accounting  standards. Implementing set-asides also could involve revisions of state  insurer solvency laws, and federal tax law changes (for example, to  provide a tax deduction). In addition, a catastrophe risk-weight approach  would involve significant data and model development.
Accounting practices. The four proposals and programs use a range of  structures. One approach, in particular, would have implications for  current practices related to statutory accounting for insurance losses.  Specifically, an approach similar to the NAIC catastrophe reserve  proposal—in which insurers would create loss reserves for events that  have not yet occurred—would be contrary to the current general basis for  recording insurance losses under SAP. As previously discussed, SAP  states that insurers only may create loss reserves for an event that has  occurred and for which the cost of the event is estimable. Implementing  an approach for potential terrorism losses similar to the NAIC catastrophe  reserve proposal would involve NAIC modifications of SAP to allow  insurers to maintain loss reserves for events that have not yet occurred.
In addition, using some of the set-aside approaches may affect the total  amount of assets that an insurer holds to support its ability to pay current  and future claims.
Under a structure in which insurers would establish loss reserves for  events that have not yet occurred (similar to the NAIC catastrophe  reserve proposal), an insurer’s assets would remain available for all  types of insured risks. However, initially establishing such new loss  reserves would reduce capital. If, as a result, the insurer’s capital  would fall below the minimum capital requirements, the insurer would  need to raise additional funds to continue to meet capital  requirements. However, most U.S. insurers hold several times more  capital than states require. If the insurer’s capital still exceeded  minimum capital requirements even after establishing such new loss  reserves, creating a loss reserve for events that have not yet occurred  might have no immediate impact on the amount of assets an insurer  holds.
Under a structure that would establish separate capital requirements  for terrorism risk exposures similar to NAIC’s catastrophe risk weight,  an insurer’s assets also would remain available for all types of insured  risk. If an insurer holds several multiples of the minimum required  capital, an additional minimum capital component might have no  immediate impact on the amount of capital an insurer holds.
A structure in which insurers would be required to establish  segregated assets that could be used only for a specific purpose such  as potential terrorism losses (similar to the legislative proposals)  would limit such assets from being used for other types of insured  risks. One state regulator and two insurers raised concerns that  segregating assets for potential terrorism losses could prevent such  assets from being used to pay for other losses. In addition, holding  assets that are specifically segregated for terrorism losses may  require insurers to raise additional capital. However, if an insurer  holds several multiples of the minimum required capital, the  segregation of assets might have no immediate impact on the amount  of assets the insurer already holds.
State laws. The complexity of implementing set-asides also could include  revising state laws to recognize or account for how to treat the assets in  the event states needed to oversee and resolve insolvent insurers. For  instance, accommodating a set-aside with segregated assets might  require amending NAIC’s model laws and later adoption and enactment  by the states. Furthermore, two state regulators pointed out that  implementing a set-aside with segregated assets for potential terrorism  losses could affect state oversight related to laws and practices for  insurers that become insolvent. For example, the two state regulators  pointed out that policymakers should consider if funds in the TRIA set- aside would become part of state receivership procedures to pay non- TRIA claims of insolvent insurers.
Federal tax laws. Some set-aside approaches also may have  implications for federal tax laws. For example, current federal tax rules do  not allow insurers to deduct potential losses. However, providing  preferential tax treatment for potential terrorism losses—in conjunction  with changes to SAP that would allow such reserves—could provide  incentives for insurers to establish related loss reserves. Such revisions  would need to incorporate limitations to prevent overestimation of  potential loss reserves, as an overstatement of loss, if allowed, would  improperly decrease the amount of taxable income.
In addition, policymakers also would need to clarify the tax implications  related to a set-aside with segregated assets. For example, policymakers  would need to clarify whether amounts added to segregated assets would  receive favorable tax treatment (such as tax credits or reductions to  taxable income). The two legislative proposals we considered were not  clear on the specific amounts available for insurers to use or if any  amount contributed to the set-aside would receive favorable tax  treatment.
Data and model development. Implementing any of the terrorism set- aside approaches, particularly a risk weight as part of insures’ risk-based  capital calculation requirements—similar to NAIC’s existing catastrophic  risk weight—would require historical and reliable data on terrorism losses.  It would also require models to estimate potential losses, which could  take several years to develop, test, and implement if data were available.  For example, NAIC officials said that detailed property location data and  the ability to reasonably model losses helped in the creation of the  catastrophe risk weight, a process that took more than 10 years.
Similar types of information would be needed to develop target amounts  and time frames for set-asides or a risk weight for terrorism risk. While  insurers increasingly have used sophisticated modeling tools to assess  terrorism risk, little data exist on which to base estimates of future losses  in terms of frequency or severity, or both. NAIC officials told us that they  have begun high-level discussions to consider adding a terrorism risk  weight and weights for other risks. Although they expect that they could  shorten the development time frame because of their experience  developing the catastrophe risk weight, such an approach remained a  challenge because of the difficulties of measuring and predicting losses  associated with terrorism risks.
section_title: Both TRIA’s Current Funding Structure and Alternative Funding Options Could Adversely Affect the Market, but Some Factors Could Help Mitigate the Effects
paragraphs: TRIA’s current recoupment mechanism and alternative funding options  could affect affordability and participation for policyholders, the flexibility  of the use of insurers’ assets, and the exposure and role of the federal  government. We examined the potential effects of TRIA’s current  recoupment provisions and the alternative funding options of a federal  charge for terrorism risk insurance and set-aside approaches as follows.
Recoupment of federal share of losses (current TRIA structure).  Following a certified terrorism event, Treasury recoups federal losses  through premium surcharges on all policyholders with TRIA-eligible  insurance line coverage.
Federal charge for terrorism risk insurance. A federal charge on  insurers or policyholders structured as either (1) a premium-like  charge intended to help pay for the federal share of potential losses  and replace the current recoupment provision, or (2) a backstop  charge paid to the Treasury for the promise of payment of the federal  share of losses with recoupment still in place to cover the federal  share of losses.
Terrorism set-asides. Insurers would be permitted or required to  establish terrorism set-asides, potentially using one of the different  types of set-aside approaches discussed in the previous section: (1)  loss reserves for future terrorism losses, without segregating assets  (similar to NAIC proposal); (2) separate or additional capital  requirements for terrorism risk, without segregating assets (similar to  catastrophe risk weight); or (3) segregated assets that could only be  used for terrorism losses (similar to legislative proposals). We  assumed the terrorism set-aside approaches would retain TRIA’s  recoupment provision, but analyzed set-asides and recoupment  independently of each other.
subsections: section_title: Limitations to Illustrating Potential Effects of TRIA’s Recoupment Structure and Alternative Funding Options on Insurance Markets
paragraphs: We present illustrative estimates of potential market impacts that  recoupment and a federal terrorism charge could have on the price of  TRIA-eligible insurance line coverage, policyholder participation in  purchasing TRIA-eligible insurance line coverage, and the volume of  TRIA-eligible insurance written. The lack of data on the terrorism risk  insurance market and the low frequency of terrorism events (certified or  otherwise) relative to other catastrophic events make estimating potential  market effects challenging. For example, our analysis of the size of  effects was limited by the lack of data on prices and participation rates  and uncertainty about insurer and policyholder reactions to recoupment  and alternative funding options. As such, our numerical estimates of  market effects rely on a number of informed assumptions (see app. I).  Also, the results we discuss throughout this objective are based on  average elasticity estimates (see app. V for results for the high and low  elasticity estimates). Elasticities could be affected by factors such as  location of policies.
Our numerical estimates also are necessarily uncertain and speculative.  A terrorism event could affect the demand or supply of insurance and  thus affect premium rates and insurers’ volume of business. Actual  market effects likely will differ depending on factors including insurer and  policyholder behavior and federal actions for all options, and specifically  for recoupment, the timing of the terrorism event, the amount of losses,  and the subset of insurers affected. In addition to the potential effects we  estimated, it is possible there could be no or minimal effects on the price  that businesses pay for TRIA-eligible insurance, policyholder  participation, or the volume of insurance written, as we note throughout  this report. Finally, there are limitations on how the potential effects of the  alternative funding options can be compared to the potential effects of  recoupment because recoupment would occur only after an event, while  the effects of the alternative funding would occur regardless of whether  an event occurred.
In this section, we discuss the most significant potential effects of  recoupment and the alternative funding options on policyholders,  insurers, and the federal government. See appendix V for more  information about our analysis and additional results, including effects on  reinsurers and state regulators. Generally, the magnitude of potential  effects varies for recoupment by the amount of losses caused by the  terrorism event, the proportion of losses borne by insurers and the federal  government, and the length of the collection period. The magnitude of  potential effects for the alternative funding options varies by the design  and the implementation.
section_title: Some Options Could Decrease Affordability and Participation, but Longer Time Frames or Broader Application Could Help Mitigate Effects
subsections: section_title: Decreases in Affordability and Participation
paragraphs: Recoupment surcharges and alternative funding options could increase  prices for policyholders; thereby, decreasing affordability and participation  rates. According to Treasury’s 2016 report, if reporting insurers charged  for terrorism risk coverage, they charged between 0.7 percent and 7.1  percent of the total policy premium depending on the TRIA-eligible line of  coverage, and the participation rates among policyholders was about 70  percent. We estimated potential effects on prices, policyholder  participation, and insurers’ net premium revenue of (1) recoupment  surcharges or (2) a federal charge in specific scenarios. We used two  potential pricing methods that rely on different assumptions about  insurers’ pricing strategies in reaction to a recoupment surcharge or  federal charge. Under one method (the percentage load method), we  assumed that insurers fully pass through to policyholders a percentage  increase in premium rates that may be specified by Treasury or future  legislation. Under another method (the revenue target method), we  assumed that insurers have the incentive to attempt to increase prices to  collect as much additional direct earned premiums as possible up to the  annual collection or target amount. Using these two methods, we  estimated price and participation changes that could result from (1)  recoupment and (2) a premium-like charge. For example
For terrorism events that result in mandatory recoupment amounts  exceeding $20 billion, when using the percentage load method, we  estimated that recoupment surcharges would increase TRIA-eligible  insurance line prices by about 3 percent and could decrease  policyholder participation by about 2 percent on average. When using  the revenue target method, we estimated that premiums could  increase by about 8 percent on average and participation could  decrease by about 5 percent on average. After the recoupment  collection period, policyholders could see price decreases.
Using multiple assumptions, we estimated the effects of a premium- like charge directly imposed only on policyholders with terrorism risk  coverage. Specifically, when using the percentage load method, we  estimated that terrorism risk insurance prices would increase by about  16 percent and participation on average could decrease by about 10  percent. When using the revenue target method, we estimated that  prices on average would need to increase by about 43 percent to  collect the target amount, which could result in an average  participation decrease of about 27 percent.
Set-aside approaches that result in the need for insurers to raise  additional capital to cover other types of insured risks may result in price  increases and participation decreases. In particular, the approach in the  legislative proposals may result in price increases for two reasons: (1) a  portion of insurers’ terrorism risk premiums would be shifted to a  segregated asset account that could only be used for potential terrorism  losses, and insurers might increase prices if, as a result, they needed to  raise additional capital to cover other insured losses; or (2) depending on  the size and timing of a terrorism event, some of the segregated assets  might be used to pay for some of or all the federal share of losses, so that  not all the premiums collected would necessarily be available to cover the  insurer’s own share of losses.
The potential size of any price increase may depend on such factors as  the cost of raising any additional capital,  the perceived likelihood of events resulting in payments towards the  federal share of losses,  the perceived likelihood and timing of any recoupment payments, and  the perceived likelihood that the federal government would reimburse  insurers whose assets contributed to covering the federal share of  losses.
Other set-aside approaches that do not require segregation of assets may  have a minimal impact, if any, on pricing. An insurer only would pay for its  own losses, and its assets would remain available for all types of insured  risks. If the insurer already had enough capital to meet required  standards, an additional reserve or capital requirement might have no  impact on the amount of capital it needed to hold, as discussed earlier.
Price increases from recoupment surcharges or alternative funding  options could vary by the extent to which insurers passed costs to  policyholders and by insurer size. Two stakeholders stated that insurers  likely would pass recoupment surcharges to policyholders, but other  stakeholders pointed out that some insurance companies could choose to  absorb the cost to maintain competitive prices. Stakeholders’ opinions  varied on whether insurers would pass on the federal charge to  policyholders. Treasury officials said that insurers would want to pass the  cost of a charge to policyholders, but market forces would dictate the  extent to which they could. Another stakeholder said that most insurers  likely would absorb the cost of a charge by spreading it across all the  lines of business they wrote. This amount could be categorized as a  general expense and might not be a significant addition to a premium  rate. Additionally, the stakeholder said that the rate increase attributed to  this expense likely would be too small to attract state regulators’ scrutiny  and policyholders would not notice the additional cost. Small insurers  might be less able to absorb the cost and, consequently, more likely to  pass the cost to their policyholders, according to one stakeholder.
Declines in policyholder participation from recoupment surcharges or  alternative funding options could vary by industry and other factors. For  example, any reduction in participation among commercial property  builders likely would be constrained due to lender requirements to  maintain terrorism risk coverage as a condition of financing development  projects. Furthermore, state requirements to maintain workers’  compensation coverage (from which terrorism risk cannot be excluded)  generally could moderate the reductions in policyholder participation.
section_title: Mitigating Factors
paragraphs: Our estimates indicated that longer time frames and broader application  could help mitigate the potential adverse effects on policyholders of a  recoupment surcharge, especially since the 2015 TRIA reauthorization  increases the potential amount of funds that the government could collect  through mandatory recoupment. Mandatory recoupment deadlines  (ranging from 1 year and 9 months to 6 years and 9 months after a  terrorism event) were introduced in the 2007 and continued in the 2015  reauthorizations of TRIA. Longer mandatory recoupment collection  periods could result in smaller price increases and impacts on affordability  compared to shorter time frames.
Table 5 shows differences that the collection time (determined by the date  of an event) can have on the required annual collection amount and the  potential increase in premiums following a terrorism event resulting in $40  billion of losses. We estimated that the mandatory recoupment that  would follow an event of that size occurring in 2017 could lead to a larger  increase in TRIA-eligible commercial property/casualty premiums than an  event of equal size occurring in 2019. For example, when using the  percentage load method, we estimated prices would increase about 6  percent. When using the revenue target method, we estimated that prices  on average could increase about 17 percent. These estimates are about  two times the increase resulting from the case with a longer collection  time for an event occurring in 2019. See appendix V for more  information on this analysis.
According to Treasury officials, minimizing disruption to the terrorism risk  insurance market and maintaining affordability are key considerations for  how they would determine a recoupment surcharge amount under TRIA’s  mandatory recoupment provision. They said that longer recoupment time  frames could give them more flexibility in considering affordability than  shorter time frames.
Our analysis also indicated that designing a federal charge for terrorism  risk insurance to apply to a broad group of policyholders could mitigate  potential price increases. Specifically, price increases could be  significantly smaller if the charge were imposed on insurers that could  spread the cost among a wide range of policyholders. For example, if  insurers spread the charge among policyholders with TRIA-eligible lines,  when using the percentage load methods, we estimated that prices would  increase by 0.8 percent, and participation on average could decrease by  0.5 percent. When using the revenue target amount method, we  estimated that prices on average could increase by 2.1 percent and  participation on average could decrease by 1.3 percent. Similarly, if  insurers spread the federal charge among policyholders of all  property/casualty lines, when using the percentage load method, we  estimated prices would increase by 0.3 percent and participation on  average could decrease by 0.2 percent. When using the revenue target  amount method, we estimated that prices on average could increase by  0.8 percent and participation on average could decrease by 0.5 percent.
These changes were significantly smaller than changes we estimated  from a charge imposed on policyholders with terrorism risk coverage. In  that scenario, when using the percentage load method, we estimated that  terrorism risk coverage prices would increase by about 16 percent, and  participation on average could decrease by about 10 percent. When using  the revenue target amount method, we estimated that prices on average  could increase by 43 percent and participation on average could  decrease by 27 percent. See appendix V for more details. Although  applying a federal charge to a larger group of policyholders could reduce  potential market disruptions by decreasing the impacts on price and  participation, it also could create a cross-subsidy and might not be  equitable.
section_title: Requiring an Insurer Set- Aside for Terrorism Risk Could Hamper Risk Management, but Broadening the Use for Additional Purposes Could Help Mitigate These Effects Restrictions on Flexibility of Assets
paragraphs: Because restricting the use of assets could hamper risk management,  insurers likely would be more affected by the government requiring the  type of set-aside involving segregated assets for potential terrorism  losses than the other set-aside approaches. Insurers, state regulators,  and NAIC officials we interviewed stated they were concerned with  requiring segregated assets for potential terrorism losses because the  funds might not be available for other types of losses. Industry  stakeholders, including insurers, state regulators, and representatives  from insurance trade associations, also stated that having the flexibility to  use funds for a variety of purposes is an important tool for managing the  risks of their various lines of business and related business operations.
If required to be restricted for terrorism losses, assets that otherwise  would be available to cover losses from any line of business would be  reduced and insurers might need to raise additional capital to meet  external requirements or internal assessments of capital adequacy.  Insurers, state regulators, and NAIC officials also said that while  segregated assets might help ensure solvency following a terrorism  event, they could decrease the likelihood of solvency following more  common events, such as natural catastrophes, and representatives of an  association said that the impact could be greater on insurers with less  capital.
subsections: section_title: Mitigating Factors
paragraphs: The set-aside approaches we reviewed that did not involve segregated  assets (loss reserves or risk-based capital requirements for potential  terrorism losses) would continue to allow insurer loss reserves or capital  to be available to pay claims for other lines of insurance, which could  mitigate the potential adverse effects on insurers. For example, under the  NAIC proposal for recording reserves for future potential natural  catastrophe losses, loss reserves would not be limited to one type of loss.  Rather, the reserves would be available to pay claims for any type of  catastrophic loss—man-made or natural. Under the NAIC proposal, the  reserves also would be available to insurers to pay claims to protect their  solvency if needed, subject to certain criteria. Another approach we  reviewed—establishing separate capital requirements for terrorism  losses—would not limit the use of insurer capital. NAIC has been  implementing a similar approach for natural catastrophe risk to better  measure an insurer’s ability to remain solvent following a catastrophic  loss.
section_title: All Funding Options Result in Federal Fiscal Exposure and the Alternative Funding Options Could Require Expanding Federal Capabilities
subsections: section_title: Fiscal Exposure and Mitigating Factors
paragraphs: Recoupment and alternative funding options result in federal fiscal  exposure; however, some factors could mitigate the exposure.
First, the federal government risks significant explicit fiscal exposure  after a terrorism event because it is statutorily required to make  payments (reimbursements to insurers) if losses exceed insurers’  deductibles following a certified event under TRIA. This exposure  exists until the federal share of losses is recouped. However, if  Treasury opted not to fully exercise the program’s recoupment  provisions, an implicit fiscal exposure would remain. By statute, the  federal government must recoup any mandatory portion of losses  following a terrorism event but can choose not to recoup any  discretionary portion of losses, which represents a fiscal exposure.
Much of the estimated recoupment amounts resulting from larger,  catastrophic losses would be considered discretionary under TRIA’s  provisions, and could exceed $60 billion. Because the program  mandates a 3 percent cap on the increase of premium rates in TRIA- eligible lines for the discretionary portion of recoupment, we estimate  that in an extreme case Treasury might need to collect a premium  surcharge for as long as 28 years to fully recoup the discretionary  portion of losses. The effects of a protracted period of premium  surcharges could be a factor in Treasury’s determination of whether to  pursue discretionary recoupment in such a scenario. In addition, the  weakened economic environment that resulted after the September  11, 2001, terrorism events suggests that an event large enough to  trigger TRIA likely would result in a weakened economic environment.  As such, one insurer questioned whether the federal government  would follow through with mandatory or discretionary recoupment. As  we previously discussed, mandatory recoupment could lead to large  price increases, especially in shorter collection time frames, which  could affect the political will to carry out recoupment.
Our analysis indicates that the program could provide an economic  subsidy to the extent that the federal government is not expected to  recoup all of its losses. As we explain in appendix VI, we assess the  presence of a subsidy on the basis of whether and to what extent the  federal government would be expected to recoup its losses,  regardless of whether a terrorism event or recoupment occurred.  Using various assumptions and taking into account several limitations,  we analyzed the potential size of any subsidy by estimating the  annual forgone federal terrorism risk insurance premiums. We  estimated the annual economic subsidy amount could be as high as  $1.6 billion, if the government were not expected to recoup any of its  losses. However, if the federal government were expected to recoup  all of its losses as described in TRIA, the economic subsidy amount  would be $0 (no subsidy). For more information on our subsidy  analysis, see appendix VI.
Second, a premium-like charge also could affect federal fiscal  exposure but including a recoupment provision could mitigate such  effects. A premium-like charge could reduce federal fiscal exposure if  sufficient funds were collected to pay for losses. However, if terrorism  losses exceeded funds collected from the charge and no recoupment  provision was in place, the federal government would need to cover  the difference. For example, it could take many years to accumulate  sufficient funds to cover potential losses, and if the federal share of  losses from a terrorism event exceeded the collected funds, the  financial exposure to the federal government could be higher than  under the current program in the absence of recoupment. However,  the federal fiscal exposure could be mitigated if recoupment were to  remain a part of the program, providing a mechanism by which the  federal government could recover losses that exceeded the funds  collected from a premium-like charge.
Third, implementing a premium-like charge could result in increased  prices for terrorism risk or TRIA-eligible insurance, which in turn could  lead to decreased participation in private insurance and, therefore,  fewer private funds available to fund recovery. However, a backstop  charge (with recoupment to cover the actual federal share of losses)  might result in lower price increases on policyholders and have less  effect on affordability and policyholder participation.
Finally, we found that implementation of some terrorism set-aside  approaches likely would have minimal impacts on federal fiscal  exposure due to losses and others could increase federal fiscal  exposure by allowing deductions for taxes before a terrorism event  occurs. Set-aside approaches that do not involve segregated assets  might have minimal impact on federal fiscal exposure. However, to  the extent that a segregated assets approach could be designed to  cover the federal share of losses, it could reduce federal fiscal  exposure. Additionally, officials from NAIC, Treasury, and state  regulators expressed concerns that insurers could overstate any pre- event loss reserves or segregated assets for terrorism risk in an  attempt to reduce their tax exposure. This could increase federal fiscal  exposure. The overall net impact of a segregated assets approach is  unclear.
section_title: Expanding the Federal Role
paragraphs: Alternative funding options could represent a major change to the federal  role in the terrorism risk market and entail administrative costs. Under the  current program, Treasury generally has a passive role in the insurance  market but becomes active following a terrorism event. With a federal  charge, the government would potentially take on administrative  responsibilities (such as collecting and managing funds) before an event  occurred. In an April 2016 report on terrorism risk insurance programs in  other countries, we found that the costs for carrying out these  responsibilities were generally a small percentage of the programs’  overall income. Similarly, the administrative costs to the federal  government of implementing a federal charge could be low and funded by  the charge collected. A set-aside approach also could involve some  administrative costs for data collection. As NAIC officials pointed out, the  data required to implement a set-aside requirement—for example, to  reliably estimate a set-aside target amount—do not currently exist. In  addition, in a segregated assets set-aside approach—which would  require insurers to set aside funds that could be used for both their share  and the federal share of terrorism losses—the federal government would  need to determine the appropriate amount of the segregated assets that  would be held for the federal share of losses.
Pricing a premium-like charge could present significant challenges for the  federal government, partly because Treasury has limited data on  collected terrorism premiums, amounts of coverage, or location of  coverage. In addition, setting an appropriate amount to charge or an  appropriate target amount to collect could present significant challenges  to Treasury because of the difficulty of estimating the magnitude and  frequency of terrorism events. By using data and modeling, other nations’  terrorism risk insurance programs have developed methods to address  limitations related to estimating the frequency and severity of terrorism  events. Specifically, some programs use data on premiums collected,  coverage amounts, and location in pricing the charge under their  programs. For example, some programs base their charges on the  amount of coverage or the terrorism risk premium that is charged by the  primary insurers. Such programs also use models with specific terrorism  event scenarios and frequencies. Alternatively, a backstop charge might  require less data and be less challenging to implement. For example, the  United Kingdom Treasury collects a backstop charge to reflect the  potential cost of capital, which may present fewer data challenges than  collecting a risk-based charge. Specifically, as we found in our April 2016  report on terrorism risk insurance programs in other countries, the  program in the United Kingdom annually pays a backstop charge to the  United Kingdom Treasury for access to an unlimited line of credit should it  be needed to cover policyholder claims. According to a United Kingdom  Treasury official, this charge is intended to reflect the potential cost of  capital to the government for backing this liability.
Additionally, in pricing a premium-like charge, the government would face  decisions about which participants to charge and would need to consider  whether the charge was affordable. For example, our analyses indicated  that the government would need to charge a larger set of policyholders  than those purchasing terrorism risk coverage (similar to its current  recoupment methodology) to avoid potentially steep percentage  increases in prices. Furthermore, as one stakeholder stated, an  affordable federal charge only on policyholders that purchased terrorism  risk coverage would not go far in helping the federal government  accumulate funds for its share of losses (because of the potential size of  the federal share under TRIA). Pricing a premium-like charge that is  equitable, and provides adequate revenue could involve trade-offs  between participation and covering expected losses.
section_title: Agency Comments
paragraphs: We provided a draft of this report for review and comment to Treasury,  including the Federal Insurance Office, and NAIC. Treasury and NAIC  provided technical comments, which we incorporated as appropriate. In  addition, we provided relevant sections to NCCI, selected state programs  (California Earthquake Authority; Florida Hurricane Catastrophe Fund;  and Property/Casualty Insurance Security Fund, New York), and relevant  government officials in selected countries (Austria, Australia, Canada,  Finland, France, and Mexico) for their technical review.  We incorporated  technical comments we received from these entities, as appropriate.
We are sending copies of this report to the appropriate congressional  committees, Treasury, NAIC, and other interested parties. In addition, the  report will be available at no charge on the GAO website at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or garciadiazd@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. Key contributors to this report are listed in  appendix VIII.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of our report were to examine (1) how insurers manage  their terrorism risk exposure and price terrorism risk insurance; (2) the  federal government’s recoupment requirements and how the federal  share of terrorism losses would be affected in different scenarios; (3) how  alternative funding approaches could be designed and implemented; and  (4) the potential effects of the approaches.
subsections: section_title: Document Review and Interviews
paragraphs: To address these objectives, we reviewed the Terrorism Risk Insurance  Act of 2002 (TRIA), Terrorism Risk Insurance Extension Act of 2005,  Terrorism Risk Insurance Program Reauthorization Acts of 2007 and  2015, implementing regulations, and congressional records. We also  reviewed prior GAO work on this topic. We interviewed officials from the  Department of the Treasury (Treasury), National Association of Insurance  Commissioners (NAIC), Congressional Budget Office, and Congressional  Research Service and reviewed relevant reports. We also interviewed  and reviewed reports from academic researchers and several industry  participants to obtain information for all our objectives, including insurers,  reinsurers, state regulators, representatives from insurance trade  associations, a rating agency, and insurance and reinsurance brokers.
Specifically, we obtained information from six insurers, four reinsurers,  and four state regulators. In all interviews, we asked participants about  practices under TRIA’s current structure, the feasibility of the alternative  funding options, the importance of key pricing objectives and set-aside  design factors we identified, and the potential effects on different  stakeholders of the alternative funding options and recoupment under the  current program. We initially contacted 12 insurers—7 from among the  largest U.S. commercial property/casualty insurers in TRIA-eligible lines  of business according to SNL Financial’s insurance data and 5 additional  small and mid-sized insurers recommended by insurance brokers and  trade associations. Due to scheduling challenges and a lack of response  from some insurers, we ultimately interviewed 6 insurers, including 4 from  among the largest in TRIA-eligible lines. We determined that the  information we obtained from these 6 insurers was sufficient for the  purposes of our reporting objectives. To select reinsurers, we reviewed  Treasury’s 2014 reinsurance report (which listed the top 50 global  reinsurers of the reinsurance market) and Marsh and McLennan  Companies, Inc.’s (Marsh) 2014 terrorism report (which listed stand-alone  property terrorism risk reinsurers and insurers involved in the terrorism  risk insurance market). We selected the top 2 reinsurers from each  report and obtained suggestions from an industry association. To select  state regulators, we identified states that are members of NAIC’s  Terrorism Insurance Working Group, have cities considered to be at high- risk for terrorism, have top insurers headquartered there, or were  recommended by NAIC officials. From these states, we selected  California, Illinois, Massachusetts, Rhode Island, and New York. Due to  scheduling conflicts, we held interviews with four of the five state  regulators, which we determined were sufficient for the purposes of our  reporting objectives. Our selections did not represent the views and  practices of other insurers, reinsurers, or states not included.
section_title: Current Practices
paragraphs: To describe current practices for managing terrorism risk exposure and  pricing terrorism risk insurance, we interviewed selected insurers, NAIC  and Treasury officials, brokers, and insurance associations about how  insurers manage their terrorism risk, determine the terrorism risk  premium, what that premium covers, how premiums are managed, and  the extent to which insurers maintain funds to cover potential terrorism  losses. We also reviewed NAIC guidance on terrorism risk premium  disclosures for policyholders and information about insurance accounting  standards and applicable insurance company tax laws. To describe how  insurers and the federal government would pay for and recoup their share  of losses, we reviewed laws and regulations related to how claims would  be paid to policyholders and how insurers would be reimbursed for the  federal share of losses.
section_title: Recoupment
paragraphs: To determine the extent to which the federal government could recoup its  share of terrorism losses, we first conducted analyses on how losses  would be shared between the federal government and insurers in various  scenarios, using insurance market data as described below. For more  information about how the government and insurers would share losses  under TRIA, see appendix II. Second, using the program’s recoupment  structure, we analyzed how the federal share would be apportioned  between mandatory and discretionary recoupment in various scenarios.
section_title: Federal Charge
paragraphs: To examine methods the federal government could consider if it were to  implement a federal charge for terrorism risk, we developed a pricing  framework and interviewed industry participants. To develop the pricing  framework, we adapted economic principles and concepts from our prior  work on assessing user fees, other government-collected funds, and  user-based taxes to develop a framework of four pricing objectives  (promoting economic efficiency, equity, and revenue adequacy, and  limiting administrative burden) and related characteristics. We reviewed  standard insurance pricing principles, such as actuarial standards of  practice, but we did not rely on these standards to develop the framework  because from a statistical perspective, existing data on terrorism events  are not sufficient to meet some of the basic principles of insurance theory.  To validate our pricing framework we obtained feedback on the four  pricing objectives from stakeholders in the insurance industry, including  insurers and reinsurers. We also interviewed insurers and state regulators  to gain some insight about the importance and feasibility of the pricing  objectives in relation to developing a charge for terrorism risk and the  extent to which trade-offs among the objectives might exist.
We also assessed seven selected state and federal catastrophic or  insurance programs as well as two foreign terrorism risk insurance  programs to observe the implementation of these objectives. The seven  state and federal programs were selected to illustrate a range of  approaches for structuring and collecting premiums and methods for  managing and ensuring adequate funding is available to cover program  costs. They also cover a variety of risks, including natural catastrophes,  and have varying types of participants such as borrowers, pensioners or  insurance policyholders, and sources of funding. We used publicly  available information to make our assessments of the seven programs.  We did not use all the programs to illustrate each pricing objective  because the information was not publicly available, and some programs  offered clearer examples than others. See appendix III for more  information about the seven federal and state programs we reviewed.  Based on our recent work on national terrorism risk insurance programs,  we identified terrorism risk insurance programs in two countries, Australia  and the United Kingdom, in which a charge is paid to the government for  the benefit of a government backstop. We used documents and  interviews from our prior work to observe the implementation of the  pricing objectives in the charge component of the programs.
section_title: Insurer Set-Asides
paragraphs: To examine approaches the federal government could consider if it were  to require or provide incentives for insurers to maintain terrorism set- asides for potential terrorism losses, we reviewed prior GAO work on  designing fees and selected programs or proposals to identify key design  factors and implementation considerations (such as, accounting practices  and state laws) policymakers could consider if they implemented such an  approach. We selected four proposals or current programs with set- aside approaches that illustrate variation among the design factors. For  example, we selected some approaches that require participation and  others that are voluntary. In addition, the approaches reflect different  structures, including loss reserves (liabilities), insurers’ levels of capital,  and segregation of assets. We selected an NAIC proposal,
Austria’s terrorism risk insurance program, a combination of congressional proposals, and a catastrophe risk weight approach.
Two of the four approaches applied to potential terrorism losses  specifically, while the other two were for potential natural catastrophe  losses. For the two natural catastrophe set-aside approaches, we  consulted with relevant stakeholders about their application to potential  terrorism losses, and for our work, found their application to potential  terrorism losses appropriate. To describe the practices, laws, and rules  the federal government could take into account, we reviewed  documentation on the selected approaches and sources describing  relevant accounting standards and laws. We also interviewed insurers,  reinsurers, and state regulators on the approaches and reviewed  documentation on the process for making changes to accounting  standards. See appendix IV for more information on the selected  proposals and current programs with set-aside approaches. Appendix IV  also includes information on selected countries that allow insurers to  establish set-asides to cover future losses. The countries were identified  for review through external outreach efforts with international entities,  literature review, and questionnaire and interview responses.
section_title: Potential Effects
paragraphs: To assess the potential effects of recoupment of the federal share of  losses, a federal charge for terrorism risk insurance, and terrorism set- asides on policyholders, insurers, the federal government, state  regulators, and reinsurers, we interviewed market participants.  Additionally, for recoupment and a federal charge, we quantified the  potential effects on policyholder price, participation, and insurers’ direct  earned premiums. We also assessed the extent to which TRIA provides a  subsidy and estimated the size of any subsidy. As we describe below, to  conduct our analyses, we used U.S. property/casualty insurance market  data, estimates of U.S. terrorism risk premiums, information on  international reinsurance rates, models from various alternative funding  approaches, and economic literature. We also describe inherent  uncertainties related to our estimates and the informed assumptions we  used in our analyses. See the remainder of this appendix for more details.
Using U.S. insurance market data and industry estimates: To  determine the direct earned premiums associated with the TRIA-eligible  insurance lines and market share of subsets of insurers (top 4, top 10, top  20, and all) in 2014, we analyzed 2014 insurance data on direct earned  premiums from SNL Financial. We used the top 4, top 10, and top 20,  and all TRIA-eligible insurers as proxies to represent different sized  premium bases. The direct earned premium associated with the insurers  rather than the number of insurers is important because prior year direct  earned premium determines the aggregate insurer deductible. For  example, the total of direct earned premium for a different subset of  insurers’ could equal the direct earned premiums of the top 4 insurers. To  assess the reliability of SNL Financial’s data, we reviewed prior GAO  assessments of the data and performed electronic testing. We  determined that the data used in this report were sufficiently reliable for  the purposes of our reporting objectives. To project the annual change in  the size of the TRIA-eligible market from 2015 to 2018, we used  estimations of terrorism risk premiums from 2004 through 2013 from A.M.  Best. We found the data sufficiently reliable for this purpose. We  calculated the annual change to be an increase of 2 percent. To estimate  the percentage of TRIA-eligible premiums that was paid for terrorism risk  insurance, we used estimates of the percentage of commercial property  insurance premiums paid for terrorism risk insurance from Marsh and  Treasury. We found the data sufficiently reliable for this purpose. We  used peer-reviewed, published information on the price elasticity of  corporate demand for insurance that we determined to be reliable and  suitable for illustrating potential effects of recoupment and alternative  approaches. Specifically, we used low and high premium elasticity of  demand for commercial property/casualty insurance of -0.43, and -0.82  respectively. We calculated average elasticity of -0.63 from the high and  low values. We used elasticity of demand for commercial  property/casualty insurance rather than for corporate demand for  terrorism risk insurance, which ranges from -0.31 to -0.71, because most  premium adjustments would be imposed on commercial property/casualty  policyholders. Although we did not analyze variations in the effects of the  options by location, size of the insurer, industry covered by the insurance,  or the extent to which some policyholders might be required to purchase  terrorism risk coverage, we used a range of elasticities that may capture  some of these differences.
Estimating potential effects of recoupment: To show the potential  upper range of effects of recoupment on TRIA-eligible policyholder price  and participation, and insurers’ direct earned premium after a terrorism  event, we estimated effects of (1) a large mandatory recoupment amount,  (2) the shortest time frame for collecting the mandatory recoupment  amount (which would result in an upper range effect), and (3) a large  discretionary recoupment amount (to show the longest collection time  frame).
To illustrate potential effects of a very large mandatory recoupment  amount, we used an event resulting in $40 billion of insured losses  under TRIA that occurred in 2019 (year with the maximum industry  aggregate retention) that affected a small set of insurers—insurers  with a prior-year premium base equal to that of the top four insurers of  TRIA-eligible lines ($49 billion in 2018).
To maximize potential market effects of a very large mandatory  recoupment amount, we used the same event size and group of  insurers (direct earned premiums of $47 billion in 2016), but an event  date of 2017 because the effective collection time frame for  mandatory recoupment is the shortest (1 year 9 months), assuming  collection starts in the January after the event.
To illustrate potential effects of a very large discretionary recoupment  amount, we used an event size of $100 billion in 2019 affecting  insurers with a prior-year premium base equal to that of the top 10  TRIA-eligible insurers—direct earned premium of $87 billion in 2018.
Estimating potential effects of a federal terrorism risk insurance  charge: To estimate the potential effects of a federal charge for terrorism  risk insurance on all property/casualty, TRIA-eligible, and terrorism risk  policyholder price and participation, and insurers’ direct earned  premiums, we constructed annual federal charges using (1) reinsurance  rates and (2) frequency models.
We used the amount estimated in our size of subsidy analysis as  discussed below to calculate the increase in premium in 2016 for  three different policyholder bases (all property/casualty policyholders,  with prior-year direct earned premium of $572 billion in 2015; TRIA- eligible policyholders, with prior-year direct earned premium of $205  billion in 2015; and policyholders making actual payments for  terrorism risk insurance under TRIA, estimated as 5 percent of TRIA- eligible prior-year direct earned premiums, or $10 billion in 2015).
We used the maximum total government share of losses and  assumed event frequencies of 20, 50, and 100 years to calculate the  increase in premium for the three different policyholder bases (all  property/casualty, TRIA-eligible, and terrorism risk premiums).
Potential effects of insurer terrorism set-asides: We did not quantify  the potential effects of insurers’ terrorism set-asides on TRIA-eligible  policyholder price and participation, and insurers’ direct earned premium,  because the approaches we chose were not expected to require  significant changes in these measures. We considered the following set- aside approaches:
The NAIC proposal specifies a set-aside buildup time frame of 20  years, with a targeted accumulation amount of $40 billion.
The Austrian program specifies a set-aside build-up time frame of 10  years and a maximum total reserve amount equal to the potential  share of losses—an estimated $35 billion for all U.S. insurers.
One of the U.S. legislative proposals directs insurers to annually set  aside 50 percent of terrorism risk premiums to cover future losses, but  does not specify a reserve buildup time frame or a target reserve  amount. We considered target reserve amounts of $43.6 billion (20  percent of estimated TRIA-eligible premiums in 2018) and $100 billion  (the maximum for the total losses covered under the program).
Finally, although TRIA’s current recoupment provision would remain in  place under the terrorism set-asides option, we assess recoupment and  set-asides independently of each other.
Reflecting uncertainties in estimates of potential effects: While we  calculated some illustrative estimates of potential market impacts, such  numerical estimates are necessarily uncertain and speculative. None of  the alternative funding options exist in the United States. Sources of  uncertainty are explained below.
Recoupment has not been tested because the United States has not  experienced a terrorism event large enough to have triggered TRIA.  Furthermore, the methodology for setting post-event recoupment  surcharges would be based on a number of factors and parameters of  the specific terrorism event.
Our analysis is limited by the lack of data on the current insurance  market, particularly prices and the participation rate.
The reactions of insurers and policyholders in the TRIA-eligible  insurance market to government actions (imposing a recoupment  surcharge or a federal charge for terrorism risk insurance or requiring  insurers to establish terrorism set-asides) is uncertain.
We researched and found reliable estimates for elasticity of demand  for commercial property/casualty insurance. However, we did not  research other market dynamics related to insurers’ pricing behavior  in response to recoupment or an alternative funding requirement, or  insurers’ underwriting capacity following a terrorism event. We also  did not research changes in businesses’ need for terrorism risk or  property/casualty insurance before or after a terrorism event.
In the case of recoupment, the terrorism risk and TRIA-eligible insurance  market reactions may be more uncertain because a terrorism event could  affect the demand or supply of insurance, and thus affect premium rates  and insurers’ volume of business. While policyholders’ demand for  terrorism risk insurance may increase following a terrorism event,  demand for TRIA-eligible insurance likely would be less affected. At the  same time, although TRIA requires insurers to make terrorism risk  insurance available, a terrorism event could lead to price increases by  participating insurers based upon their reassessment of the likelihood of  future events, and thus depress demand. Such insurers may be reluctant  to devote additional capital to potential terrorism losses. However,  industry participants have indicated that a terrorism event could increase  the availability of terrorism risk coverage because as premiums  increased, new sources of capital could enter the market.
To reflect the uncertainty of the process and outcomes, we used two  methods (percentage load method and revenue target method) that rely  on different hypothetical assumptions about the insurers’ pricing  strategies in reaction to recoupment or a federal terrorism risk insurance  charge. (See table 6 for a comparison of the methods.)
Percentage load method. We assume that insurers fully pass  through to policyholders a percentage increase in premium rates (that  is, the load) based on the annual collection or target amount and  insurers’ aggregate direct earned premium. For example, if the annual  collection amount resulted in a 3 percent recoupment surcharge on  premium rates, we assumed that insurers fully would pass through  that percentage increase to policyholders and raise premium rates (by  3 percent). This method would result in larger effects than the revenue  target method in the form of insurer loss of direct earned premium.
Revenue target method. We assume that insurers have the incentive  and would attempt to increase prices to collect, at the margin, as  much additional direct earned premiums as possible up to the annual  collection or target amount. Such price increases would be above and  beyond a full pass through to make up for some or all of the loss of  net revenue resulting from decreased policyholder participation in  reaction to the price increase. For example, if Treasury annually  recouped $6 billion from insurers, we assumed insurers would raise  prices to collect, at the margin, an additional $6 billion in direct earned  premiums. This method would result in larger effects than the  percentage load method in the form of premium increases and  decreases in participation rates.
Generally, our analyses using the revenue target resulted in a larger  impact for policyholders in terms of prices and participation, while the  percentage load analysis resulted in a larger impact for insurers in terms  of impact on direct earned premiums.
Assumptions related to analyses of potential effects: Due to the  prospective nature of this analysis, we made a number of assumptions.
When necessary, we assumed market reactions to the changes in  insurers’ prices due to recoupment or alternative funding options,  such as the sensitivity of participation in TRIA-eligible insurance to  price changes (price elasticity) and the pricing behavior of insurers.
For all options, we assumed prices would increase.
For each step in our analysis, we assumed that only the variables of  interest changed, and all other variables remained constant during the  collection or build-up period. For example, for recoupment we ignored  other dynamics that could occur in the TRIA-eligible insurance market  due to a terrorism event such as policyholders or insurers exiting or  entering the market and price changes not directly related to terrorism  risk.
We assumed that a terrorism event or an additional terrorism event  would not occur during the collection or build-up period.
We assumed that insurers’ actions primarily would be to collect the  federal recoupment surcharges or charge for terrorism risk insurance.
In all cases, we used SNL Financial’s direct earned premium data to  determine the size of the property/casualty insurance market and  submarkets (see app. II for further details). We assumed that the  baseline annual total direct earned premiums for commercial  property/casualty insurance and the market share of subsets of  insurers remained unchanged for the implementation period and after  a terrorism event during the recoupment period.
We assumed that the current average price elasticity of -0.63  remained constant over the range of price increases considered.
We assumed insurers would impose any increase in the first year of  the collection or build-up period and obtain the annual cost from the  increase in direct earned premiums. In the second and the remaining  years of the collection or build-up period, we assumed insurers would  not adjust prices further since the annual cost would remain constant,  and insurers would collect the same new direct earned premiums as  in the first year.
Assessing the presence and size of a subsidy: To evaluate the extent  to which insurers and policyholders receive an economic subsidy under  TRIA, we reviewed and synthesized literature on government subsidies  taking into account the program’s recoupment feature. We determined  that a subsidy exists in the program to the extent that the federal  government is not expected to recoup all its losses. To estimate the  potential annual size of the subsidy, we estimated forgone federal  premiums for the federal share of losses. Because we could not  determine premiums using an actuarial method, we used reinsurance  rates paid by other national terrorism risk insurance programs. We were  told by the broker of many reinsurance deals in other national terrorism  risk insurance programs that the rates were fairly stable across countries  and generally ranged from 2 percent to 3 percent of the amount of  coverage. We use a rate-on-line (the ratio of premium paid to loss  recoverable in a reinsurance contract) of 2.5 percent of reinsurance  coverage purchased, assumed the federal government purchased  coverage for its maximum annual losses under TRIA, and added 5  percent as a collection fee. We performed calculations in scenarios in  which the government is expected to (1) recoup neither mandatory nor  discretionary recoupment amounts, and (2) only recoup mandatory  amounts. Specifically, to determine the maximum annual losses under  TRIA, we used SNL Financial’s insurance market data as described  above and modeled the maximum terrorism event size ($100 billion in  insured losses) in 2016 and assumed insurers with an aggregate  premium base equal to the top 20 insurers were affected by the event.  We estimated the portion of federal losses that would be subject to  mandatory and discretionary recoupment. To estimate the forgone federal  premium amount, we multiplied the maximum federal loss amount by the  reinsurance rate. For more information on our subsidy analysis including  limitations and assumptions, see appendix VI.
We conducted this performance audit from January 2015 to January  2017, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Estimating the Government Share of Losses under the TRIA Program
paragraphs: Under the Terrorism Risk Insurance Act (TRIA), the federal government  and insurers potentially share losses from a certified terrorism event if  total losses exceed the program trigger ($120 million in 2016) and losses  exceed any individual insurer’s deductible.
Each insurer’s share of losses is the minimum of its actual losses or  the sum of its deductible (measured as 20 percent of its previous  year’s direct earned premium in TRIA-eligible lines) and its co-share  portion (16 percent of losses exceeding the deductible amount in  2016). Assuming an insurer has satisfied its deductible, its losses are  capped in the event the program cap ($100 billion) for all losses  (insurers and federal) has been reached.
The federal share of losses is the difference between the total losses  (or the $100 billion program cap, if smaller) and the sum of insurers’  losses.
Some recent program changes shift a greater share of losses from the  federal government to insurance companies over time, such as changes  to the program trigger and the insurer co-share.
To illustrate a range of potential terrorism loss scenarios for insurers and  the federal government, we analyzed terrorism events affecting insurers  with aggregate premium bases equal to the top 4, top 10, top 20, and all  insurers with TRIA-eligible lines of insurance. Using SNL Financial’s  data, we determined the direct earned premiums and market share  earned by the top 4, top 10, top 20, and all insurers in 2014 in TRIA- eligible lines of business. As figure 7 shows, insurers earned $201 billion  in direct earned premiums for TRIA-eligible lines in 2014, according to  SNL Financial’s data, and the four insurers with the most direct earned  premiums from TRIA-eligible lines of insurance earned 22.5 percent of  such premiums.
Using these subsets of insurers, we estimated the insurer and federal  shares of terrorism losses under single-event scenarios, varying by size  of event (losses of $5 billion, $25 billion, $40 billion, $50 billion, $75  billion, and $100 billion) and year of event (from 2016 to 2019). We  estimated the insurer deductible for each insurer group by multiplying  their direct earned premium by 20 percent. If the insurers’ deductible was  greater than or equal to the loss total, there was no insurer co-share and  no federal share. If the insurers’ deductible was less than the loss total,  we estimated the insurers’ co-share by subtracting the insurers’  deductible from the loss total and multiplying the result by the insurers’  co-share percentage. The estimated federal share of losses is the  difference between the total loss and the insurers’ share. Figure 8  illustrates an example of loss sharing under TRIA.
The relative size of the federal share of losses depends on the amount of  insured losses from the terrorism event and the direct earned premium of  insurers affected, as shown in table 7. The federal share of losses would  be greater in events with more insured losses. For example, in the  scenarios in which affected insurers had an aggregate premium base  equal to that of the top 20 insurers, the federal share of losses would  increase from $1.9 billion in the case of an event with $25 billion in losses  to $64.9 billion in an event with $100 billion in losses. This shows that the  government plays a greater role in more catastrophic events, consistent  with the manner in which the program is structured. Additionally, the  share of losses the government sustains depends on the aggregate  TRIA-eligible direct earned premium of the insurers with losses.  Specifically, the federal share of losses is smaller when losses are shared  among insurers with larger aggregate premium bases. For example, in a  $25 billion loss scenario, the government share of losses would be $13.2  billion if the affected insurers had a premium base equal to that of the top  4 insurers and $1.9 billion if the affected insurers had a premium base  equal to that of the top 20 insurers.
section_title: Appendix III: Information on Pricing Structure of Selected State and Federal Insurance or Insurance-like Programs
paragraphs: The tables in this appendix provide general information on select state  and federal insurance or insurance-like programs that address the risks of  natural catastrophes and severe financial conditions, such as  earthquakes and home foreclosures, respectively. These programs  illustrate a variety of approaches for pricing and managing federal  charges that could provide insight on how a charge for terrorism risk  insurance could be designed. For example, policymakers could consider  how aspects of these programs’ participation requirements, inputs used in  setting charges, additional funding mechanisms, and oversight could  apply to a federal charge for terrorism risk insurance. Selected programs  are described below.
California Earthquake Authority: A public entity that manages the  privately funded program and operates as a primary insurer to provide  catastrophe earthquake insurance to residential property owners and  renters through participating insurance companies. Participating  insurers must offer earthquake insurance to their residential property  insurance policyholders such as those with homeowners/fire  insurance. Some of the fund’s risk is ceded through reinsurance,  which is financed through direct purchase of reinsurance or through  capital markets using a special purpose reinsurance entity specifically  designed to purchase reinsurance. Insurers apply to participate in the  California program and must submit data for computer modeling to  determine the insurer’s potential earthquake loss. Newly participating  insurers with higher risk than other insurers of similar size may be  charged an annual surcharge if the exposures they present to the  Authority are higher than the normal risks of the Authority before they  can participate in the program. Each year, this situation is examined  and the surcharge is dismissed when the exposures of the new  participating insurer closely match that of the normal Authority  exposure base.
Federal Crop Insurance Corporation: This program was first  authorized in 1938 to alleviate the economic distress caused by crop  failures during the Dust Bowl era. The program helps farmers manage  the risks inherent in farming by allowing them to insure against losses  caused by poor crop yields, declines in prices, or both. Farmers can  insure against losses on more than 100 crops, including the five major  crops of corn, soybeans, wheat, cotton, and grain sorghum. Approved  private insurance companies share a percentage of the risk of loss  and opportunity for gain on each policy. The federal government  encourages farmer participation by subsidizing premiums and is the  primary reinsurer to approved insurers.
Florida Hurricane Catastrophe Fund: A tax- exempt trust fund  created by the State of Florida to ensure ongoing reinsurance  capacity to insurers for catastrophic wind losses from hurricanes and  foster an affordable wind insurance market in Florida. Under this  program, insurers pay premiums and are reimbursed for a portion of  their losses.
Mutual Mortgage Insurance Fund: Title II of the National Housing  Act, enacted in 1934, authorized a single family mortgage insurance  program and established the Mutual Mortgage Insurance (MMI) Fund  to fund it. The program allows single-family homes to be purchased  with small down payments and long-term mortgages. The Federal  Housing Administration (FHA), through the MMI Fund, insures lenders  against loss from defaulted loans. The Fund is funded primarily  through premiums paid by borrowers and the proceeds of foreclosed  homes. FHA’s single-family mortgage insurance program has  provided mortgage credit to families of low and moderate income not  adequately served by the conventional private mortgage market.
National Flood Insurance Program: The program makes federally  backed flood insurance available to property owners in communities  that participate in the program. Communities participate by adopting  and enforcing floodplain management regulations designed to prevent  and mitigate the effects of flooding. The Federal Emergency  Management Agency, an agency of the Department of Homeland  Security, administers this program.
Pension Benefit Guaranty Corporation: As a wholly-owned  government corporation established to insure the pension benefits of  participants in and beneficiaries of private-sector defined benefit  plans, the corporation operates a single-employer program and a  multi-employer program. Under both programs, plan sponsors pay  per-participant flat premiums. In addition, under the single-employer  program, a plan sponsor pays a variable rate premium based on its  plan underfunding.
Property/Casualty Insurance Security Fund, New York: This fund  receives premiums from insurers doing business in New York, based  on each insurer’s direct written premiums on policies it writes. This  fund pays certain insurance claims of insolvent insurance companies  when such payments are allowed in accordance with New York  Insurance Law. The payments are subject to policy limits and a  statutory cap. The superintendent of New York’s Department of  Financial Services is the administrator of the fund.
Table 8 provides information about the type of individual or business  entity that participates in each program, whether participation in the  program is mandatory, and briefly describes the benefit payment  transaction.
Table 9 briefly describes upfront charges, other upfront funding sources,  and post-event funding sources for each program and statutory  appropriation requirements. Information on these charges includes  general information on the key inputs used in setting the level of or  structuring the charge. The table also presents various statutory funding  mechanisms. Although this table provides primary revenue sources, it is  not intended to be an exhaustive list of each program’s revenue sources.
Table 10 provides examples of who—program staff or third parties— perform the day-to-day operations of key functions and oversight for each  program. The table highlights certain large activity components such as  issuing policies, collecting premiums, and servicing policies and is not  intended to provide an exhaustive list of all operational activities. The  table also provides information about the oversight approach each  program uses to help ensure its participants report accurate information  and pay the correct charges. Finally, the table also highlights the reviews  or assessments each program performs to determine the adequacy of its  charges and the financial viability of its fund.
section_title: Appendix IV: Accounting Practices and Some Domestic and International Set-Aside Approaches
paragraphs: This appendix provides an overview of U.S. insurance accounting  practices, in-depth information about identified domestic approaches, and  examples of set-aside approaches used in other countries.
The current U.S. insurance accounting standards (statutory accounting  principles, or SAP) permit insurers to establish loss reserves only after an  event has occurred and U.S. insurers have the flexibility to manage their  capital to cover unexpected or catastrophic losses across all lines of  business. Although, insurers may consider terrorism risk exposure in their  assessments of the adequacy of capital, they do not segregate assets  that are restricted for potential terrorism losses or establish loss reserves  for events that have not yet occurred.
Loss reserve. For this report, we define a loss reserve as the  company’s estimate of amounts needed to cover indemnity payments  that will come due on policies already written for losses from events  that have already occurred and the administrative expenses of dealing  with the associated claims. Loss expenses related to increases in loss  reserves reduce an insurer’s taxable income. Such liabilities are  typically the largest single liability on an insurer’s balance sheet.
Capital. For this report, we define capital as the excess of an  insurance company’s assets above its liabilities. Capital generally is  not segregated for specific purposes. It provides a cushion to an  insurer against insolvency for any unexpected or underestimated  losses. For example, if the recorded loss reserves are insufficient, the  insurer’s capital is available to pay claims. Insurers are generally free  to manage their capital as long as they satisfy external solvency and  liquidity requirements and internal assessments of capital adequacy.  Insurers may also use their capital to expand their business.
Accounting standards and financial reporting. Insurers must  report their financial holdings on an individual legal entity basis to the  regulator in their state of domicile, using statutory accounting  principles of the National Association of Insurance Commissioners  (NAIC). According to NAIC, SAP are designed to assist state  insurance departments in the regulation of the solvency of insurance  companies. The ultimate objective of solvency regulation is to ensure  that policyholder, contract holder, and other legal obligations are met  when they come due and that companies maintain capital and surplus  at all times and in such forms as required by statute to provide a  margin of safety. In addition to SAP, insurance groups may issue  audited financial statements using U.S. generally accepted accounting  principles (GAAP), which in the United States are promulgated by the  Financial Accounting Standards Board and are designed to provide  decision-useful information to investors and other users of financial  reporting. SAP stress the measurement of ability to pay claims in the  future. SAP and GAAP recognize certain items differently and  therefore may result in different capital and net income amounts.  Accounting standards for recording insurance liabilities state that  insurers only may create a loss reserve for a covered event that has  occurred and for which the cost of the event is estimable. No liability  exists without the occurrence of a covered event. Unless otherwise  noted, references in this report to accounting for or recording liabilities  refer to SAP.
Tax deduction. Federal tax laws allow tax deductions for an increase  to loss reserves that result from incurred losses for events that  occurred during the period.
Risk-based capital requirements. State regulators require insurance  companies to maintain specific levels of capital to continue to conduct  business. Regulators determine the minimum amount of capital  appropriate for an insurer to support its overall business operations,  taking into consideration its size and risk profile. All state regulators  have adopted NAIC’s Risk-Based Capital for Insurers Model Act and  also use formulas that NAIC has developed to establish a minimum  capital requirement based on the types of risks to which a company is  exposed. NAIC has separate models for different lines of insurance.
Assets. For this report, we define assets to represent the resources  that contribute to an entity’s future net cash flow and that an entity  might use to pay its debts. Insurers’ assets are available for potential  covered losses and generally are not segregated or restricted for  limited uses. But in some instances, an insurer’s assets may be  segregated or restricted for specific purposes. For example, insurers  may segregate or restrict their assets for specific purposes such as  holding assets for collateral.
Liabilities. For this report, we define liabilities as present obligations  to transfer assets or provide services to other entities in the future as  a result of past transactions or events.
subsections: section_title: Details on Selected Domestic Set-Aside Approaches
paragraphs: For further details on the domestic approaches described in the report,  see the following.
NAIC catastrophe reserve proposal. According to a study on the NAIC  catastrophe reserve proposal, the proposal’s design includes voluntary  participation, a specific formula for an insurer to calculate its annual set- aside amount to cover catastrophic losses, and a loss reserve structure  for catastrophic events that have not yet occurred. The proposal was  developed to address constraints faced by insurance companies when  catastrophes occur and pose significant challenges to the economy.  Under the proposal, a reserve cap for each participating insurer would be  calculated with a formula based on each insurer’s net written premiums  written on qualifying business lines. Each insurer participating on a  voluntary basis would determine the amount to set aside each year in a  catastrophe reserve over a 20-year time frame. The proposal would  establish a target amount of $40 billion across the property/casualty  insurance industry, which was based on written premiums in 1999.  Individual companies’ contributions would occur over a 20-year period.
Each participating insurer’s set-aside would be structured as a separate  liability on its balance sheet (distinct from other loss reserves and  unearned premium reserves) without specific segregation of assets. The  proposed federal tax treatment would provide for tax deductions over a  period of 20 years for contributions into the set-aside.
According to the proposal, an insurer could use its reserve to cover its  share of losses for multiple perils, among other uses. The reserve would  be used primarily for catastrophic losses resulting from multiple perils  such as wind, hail, or earthquake—and the drawdowns would be subject  to criteria designed to protect solvency and limit use of the reserve for  only catastrophic losses. Insurers also could use the reserve when the  reserve balance exceeded the reserve cap or if their domiciliary state  commissioners required them to release the catastrophe reserve as a  rehabilitation, conservation, or liquidation measure or to forestall  insolvency.
Catastrophe risk weight. In 2013, NAIC began testing a catastrophe risk  weight (a weighted measure included in assessments of the adequacy of  insurers’ capital) to better measure an individual insurer’s ability to remain  solvent, when taking into account the insurer’s earthquake and hurricane  risk exposures. When fully implemented, the catastrophe risk weight will  be incorporated into an insurer’s risk-based capital requirements, and will  have no limitations on its use. All insurers will include an estimate of their  hurricane and earthquake exposure as part of their risk-based capital  calculations. The catastrophe risk weight was developed from historical  data on catastrophe losses. An insurer enters its individually calculated  modeled losses into a formula to determine a target amount of capital to  maintain against these two exposures.
However, the company’s available capital is not limited to covering losses  from hurricanes and earthquakes and could be used for any purpose,  such as paying claims for other types of catastrophic losses. Hurricane  and earthquake risks were included as part of the catastrophe risk weight  because they were the two perils most likely to cause losses that could  significantly affect an insurer’s solvency and the models for these risks  were considered advanced enough to estimate the effect of such losses  on insurers’ business. NAIC officials leading this effort also told us that  they plan to consider similar risk-based capital weights for other risks,  including for terrorism.
Selected aspects of legislative proposals. Two proposals by House  members that we reviewed included provisions to establish set-asides  with segregated insurer assets for terrorism losses to help stabilize the  marketplace following a terrorist event. Key aspects of one or both of the  proposals included (1) requiring insurers that sold terrorism coverage to  participate, (2) providing for a specific target annual contribution (a  percentage of the premiums collected from policyholders for terrorism  coverage to be set aside), and (3) specifying the use of funds for insurer  and federal shares of terrorism losses. Each insurer participating in the  Terrorism Risk Insurance Act (TRIA) program could establish and  maintain a set-aside with segregated assets for terrorism losses (the  TRIA Reserve Fund) in fiduciary capacity on behalf of the Secretary of the  Treasury.
Other aspects of one or both proposals provide additional details on the  structure of a set-aside. Specifically, each year an insurer would place 50  percent of the premiums collected from policyholders for terrorism  coverage in a set-aside with segregated assets. The set-aside would be  maintained in a segregated account, be held by the insurer on behalf of  the Secretary of the Treasury, and kept until the program terminated.  Therefore, the premium income diverted to this set-aside likely would not  be part of an insurer’s taxable income, according to an insurer we  interviewed. Funds in these set-asides would be collected and used by  the Secretary of Treasury to offset the federal share of compensation  provided to any affected insurers under TRIA in the event of a certified  terrorism event, except that insurers could use these funds first to pay for  any of their own covered terrorism losses (including losses below TRIA’s  program trigger level). If the Department of the Treasury (Treasury) used  insurers’ set-asides to offset any of the federal share of losses, Treasury  would reimburse the companies for such amounts after the federal share  of terrorism losses had been recouped.
section_title: Examples of Set-Aside Approaches Used in Other Countries
paragraphs: We identified some countries in which insurers are allowed to establish  set-asides for events that have not yet occurred, although the use,  participation, and structures of set-asides differed among some of these  countries (see fig. 9). Generally, the set-asides could be available for  multiple perils and solvency purposes, and three of the selected countries  explicitly allowed insurers to recognize potential terrorism losses. In  addition, four of the selected countries mandated insurer participation to  establish set-asides, two allowed for voluntary participation, and one  country had mandatory and voluntary set-asides. The structures of set- asides took distinct forms such as loss reserves and specific risk-based  capital requirements, and some provide a tax deduction for the increases  to such set-asides. We discuss the identified international set-aside  approaches for events that have not yet occurred on the following  pages.
Australia. Australian insurers must establish a mandatory set-aside,  generally structured as a specific risk weight in capital requirements. It is  intended to help insurers to maintain adequate capital against the risks  associated with insurance concentration in their activities, including  natural catastrophe risks. Natural catastrophes can include all natural  events, including earthquakes and storms. This insurance risk weight  represents the net financial impact on the insurer from either a single  large event or a series of smaller events, within a 1-year period. The risk  weight takes into account all possible perils in all regions to determine the  size of loss that could occur from a single event. The insurer must retain  at least this calculated target amount of capital for all these risks,  including natural catastrophes, at all times.
Austria. Austria’s Terrorism Risk Insurance Program design includes  voluntary insurer participation and loss reserve structure with specified  insurer target amounts equal to their deductibles. The set-aside in this  program was established for potential terrorism losses, according to the  Austrian program representative. It is unknown whether the set-aside may  be used for other purposes such as solvency.
Participating insurers would structure the set-aside as a loss reserve to  cover their program deductible on terrorism losses. The reserve is  structured as a loss reserve in which the amount that is contributed to the  set-aside reduces an insurer’s taxable income, according to a program  representative. This set-aside would help to cover potential terrorism  losses and the target amounts are based on each insurer’s market share  of terrorism coverage, according to the program representative. Initially,  the reserves were accumulated over 10 years. The time frame was  increased to 15 years to allow insurers additional time to accumulate  increased program deductibles.
Canada. According to insurance regulatory officials, Canadian insurance  companies must include mandatory set-asides for specific risk exposures  as part of minimum capital requirements and also have the option to  establish a voluntary set-aside in capital for earthquake events that have  not yet occurred. The mandatory capital set-asides account for potential  losses from earthquake, nuclear, and mortgage risks in risk-based capital  requirements. The Canadian insurance regulator provides guidance for  an insurer to determine the supervisory target level of required capital for  each risk (risk weights) that would be included as part of an insurer’s risk- based capital requirements. The supervisory capital target for earthquake  risk is calculated based on a 500 year probable maximum loss. In  addition, for potential earthquake losses, insurers also may participate in  establishing a voluntary set-aside in capital. Officials said that this  voluntary set-aside is not typically used by insurers for various reasons  including the fact that it locks-in capital that may otherwise be used  elsewhere. Officials also told us that assets are not specifically  segregated in either the mandatory or voluntary set-asides and that the  voluntary set-asides provide a deduction for income tax purposes.
Finland. According to insurance department representatives, nonlife  insurers in Finland must establish set-asides structured as equalization  reserves—a type of loss reserve—that serves as a buffer for  exceptionally high claims. These mandatory insurers’ equalization  reserves can cover events that have not yet occurred, including losses  from natural catastrophes and terrorism. The calculations of target  amounts and contributions to such equalization reserves are based on  European Union capital requirements. The equalization reserve also has  a maximum amount, which can be up to four times the target amount.  Representatives also told us that the set-aside is not subject to tax on an  ongoing basis but may be subject to income taxes as the set-aside is  decreased.
France. According to French insurance regulatory officials, insurance  companies in France may establish set-asides generally structured as  equalization reserves to cover events that have not yet occurred,  including natural disasters and terrorism. Insurers establish equalization  reserves on a voluntary basis that allow for tax deduction by the French  Tax Administration, but these reserves are not allowed to be included on  financial statements prepared under international accounting standards  because the event has not occurred, according to officials. Insurers  benefit from a tax deduction to reduce an insurer’s taxable income for  contributions to these set-asides if certain standards are met, such as not  exceeding a target amount set by the French Tax Administration. The  target amount and time frames depend on the risk that the equalization  reserve is meant to cover. For example, an equalization reserve that  includes terrorism risk can be kept for 12 years.
Mexico. According to a representative from the insurance regulator,  insurers in Mexico are required to establish set-asides for catastrophic  events that have not yet occurred and structure these set-asides as  special catastrophe reserves to cover natural catastrophe risks as well as  other catastrophe risks. Insurers create the catastrophe reserves with a  target amount based on probable maximum loss that is calculated at the  end of each fiscal year. In addition, insurers record these set-asides as  loss reserves on the balance sheet and contributions to these set-asides  are tax deductible. Once a catastrophic event occurs, insurers must first  exhaust their reinsurance options before utilizing their own catastrophic  set-asides.
section_title: Appendix V: Additional Potential Effects of Recoupment and Alternative Funding Options
paragraphs: In this appendix, we discuss additional details about our methodology and  results regarding how recoupment under the Terrorism Risk Insurance  Act (TRIA) and alternative funding options could affect market  participants. As noted previously, while our analyses of potential market  effects of TRIA recoupment and alternative funding options rely on  assumptions regarding price increases under each option, it is also  possible that there could be no change in price, policyholder participation,  or insurers’ volume of premium. In addition, we discuss additional  information we obtained from our interviews with industry participants  such as insurers and state regulators.
subsections: section_title: Additional Potential Effects of Recoupment under TRIA Following a Terrorism Event
paragraphs: We estimated the potential upper ranges of effects of recoupment on  TRIA-eligible policyholder price and participation, and insurers’ direct  earned premium after a terrorism event, under scenarios that result in the  very large mandatory and discretionary recoupment amounts.  Specifically, we estimated effects of (1) a very large mandatory  recoupment amount, (2) the shortest time frame for collecting the  mandatory recoupment amount (which would result in a very large annual  surcharge), and (3) a very large discretionary recoupment amount (to  show a very long collection time frame). See table 11 for a summary of  the results.
To illustrate potential effects of a very large mandatory recoupment  amount we used an event size of $40 billion that occurs in the year  2019 (year with the maximum industry aggregate retention) that  affected a small set of insurers—insurers with aggregate prior-year  direct earned premium equal to those of the top four TRIA-eligible  insurers. Using SNL Financial’s 2014 data, the top four insurers of  TRIA-eligible lines carried 22.5 percent of the prior-year TRIA-eligible  direct earned premium. We estimated the TRIA-eligible insurance line  direct earned premium in 2018 to be $218 billion.
To maximize potential market effects from a very large mandatory  recoupment amount, we used the same event size and subset of  affected insurers, but the event occurs in 2017 when the time frame  for mandatory recoupment is the shortest (1 year and 9 months when  collection begins the January following the event). We estimated the  TRIA-eligible insurance line direct earned premium in 2016 to be $209  billion.
To illustrate potential effects of a very large discretionary recoupment  amount, we used an event size of $100 billion in 2019 that affected  insurers with aggregate prior-year direct earned premium equal to  those of the top 10 TRIA-eligible insurers. Using SNL Financial’s 2014  data, the top 10 insurers of TRIA-eligible lines carried 39.8 percent of  the prior-year TRIA-eligible direct earned premium.
We discuss our results from each of the two analysis methods used  (percentage load method or revenue target method). These two  methods rely on different assumptions about insurers’ pricing  strategies.
In addition to the effects previously discussed, recoupment could lead to  a loss of direct earned premium for insurers following a terrorism event.  However, according to one insurer, recoupment may not affect the  marketwide availability of terrorism risk coverage. We describe some  results and observations from our illustrative analyses relating to insurers’  potential loss of premium revenue and findings from literature and  interviews.
The potential losses of TRIA-eligible direct earned premium to  insurers vary with factors such as the size of the event, the year of the  event, the assumed elasticity of demand, and the assumed insurer  pricing methodology. The potential direct earned premium loss could  be higher or lower depending on whether coverage was mandatory for  the line. For example, states require workers’ compensation  coverage, so any increase of prices due to a requirement to collect a  recoupment surcharge likely would have a small effect on the  premium revenue of a workers’ compensation insurer.
In certain scenarios, insurers’ potential loss of direct earned premium  could be less when losses were recouped under discretionary  recoupment compared with mandatory recoupment, because the price  increase to policyholders is capped for discretionary recoupment.
For losses recouped under mandatory recoupment, the time allowed  to recoup determine the size of the effect. Greater loss of direct  earned premium could occur if the time frame to collect the losses  were short. For example, the time frame to collect is shorter for an  event that occurs in 2017 (less than 2 years) compared to 2019 (less  than 5 years). Using scenarios that had $40 billion in losses and  resulted in high mandatory recoupment (exceeding $20 billion), we  estimated that if premiums were increased by a specified percentage,  the 2017 event, on average could lead to about a 4.4 percent loss of  TRIA-eligible direct earned premium, compared to about 1.9 percent  for the 2019 event. Or if insurers increased prices to collect target  amounts, direct earned premiums on average could decrease by 1.8  percent for the 2017 event, compared to about 0.4 percent for the  2019 event.
subsections: section_title: State Regulators
paragraphs: Federally imposed premium increases in the form of recoupment  surcharges might limit the ability of state insurance regulators to restrain  potential price increases. State regulators told us that when they review  rate increases from insurers, they consider whether the increases are  excessive, inadequate, or unfairly discriminatory to policyholders. Two  state regulators stated that to the extent the federal government  mandated an increase in policyholder premiums through recoupment  surcharges, they likely would not have a reason to deny such premium  increases. However, regulators might be able to influence the size of any  increase that insurers might submit above the federal surcharge.
section_title: Policyholders
paragraphs: In addition to the potential effects of mandatory recoupment, we also  estimated potential policyholder price increases and participation  decreases resulting from discretionary recoupment. TRIA-eligible  insurance prices could increase by a maximum 3 percent and we  estimated participation on average could decrease by about 2 percent.  For terrorism events that result in very large discretionary recoupment  amounts (more than $60 billion), we estimated the collection period to be  as much as 28 years.
section_title: Additional Potential Effects of a Federal Charge for Terrorism Risk Insurance
paragraphs: We estimated the potential effects of a premium-like federal charge for  terrorism risk insurance under TRIA on policyholder price and  participation, and insurers’ direct earned premium, using (1) international  reinsurance rates and (2) frequency assumptions.
We estimated the annual federal charge in 2016 as the cost of  reinsurance for the maximum federal share of losses and analyzed  the effect if the charge was imposed on three different policyholder  bases (all property/casualty, with estimated prior-year direct earned  premium of $572 billion in 2015; TRIA-eligible, with estimated prior- year direct earned premiums of $205 billion in 2015; and TRIA, with  direct earned premiums estimated to be 5 percent of TRIA-eligible  direct earned premium or $10 billion in 2015).
We estimated annual federal charges using the maximum government  share of losses from assumed events that occurred at frequencies of  every 20, 50 and 100 years and calculated the increase in premium  for the three different policyholder bases described above.
Table 12 shows a summary of potential market effect for the federal  charge by policyholder group charged.
Insurers’ overall volume of premium could be negatively affected under  recoupment and a federal charge for terrorism risk insurance.  Additionally, potential insurer loss of direct earned premium resulting from  a federal charge for terrorism risk insurance would depend on several  factors, including the extent to which insurers pass the cost to  policyholders and insurer characteristics.
If insurers were to spread the cost among policyholders from all TRIA- eligible lines of business, our modeled results show potential losses of  direct earned premium of 0.5 percent on average if premiums were  increased by a specified percentage or less than 0.1 percent on average  if insurers increased prices to collect a target amount. If spread among  policyholders from all property/casualty lines, the losses of direct earned  premium could be 0.2 percent on average if premiums were increased by  a specified percentage or less than 0.1 percent on average if insurers  increased prices to collect a target amount.
A federal charge for terrorism risk insurance could affect insurers’ loss of  business unevenly. One stakeholder said that the potential loss of  business due to a federal charge could vary by insurer size. In particular,  small insurers—which may not collect explicit premiums for terrorism— might be affected more than larger ones. An insurer and broker said that  small insurers would be less able to absorb the cost from a federal charge  and, consequently, more likely to pass the charge to their policyholders.  This could increase loss of business of small insurers in two ways:  retention of existing clients would decline and attraction of new clients  would become increasingly difficult, especially if larger insurers did not  pass the charge to their clients and had lower prices. However, one large  insurer said it would not be able to absorb a federal charge and would  need to pass this cost to its policyholders.
According to insurers, they would incur administration costs associated  with a federal charge for terrorism risk insurance. Administration costs  would be incurred if insurers would need to collect premiums from  policyholders on behalf of the government.
subsections: section_title: Reinsurers
paragraphs: Implementation of a federal charge for terrorism risk insurance could  affect reinsurers differently based on policymakers’ design decisions,  according to stakeholders. For example, a charge could be designed as  voluntary or mandatory. In a voluntary charge, the federal role matches  that of a reinsurer, and if Congress allowed private reinsurance to  compete with the government under this option, reinsurers could see an  increase in market opportunity. If Congress mandated that insurers  purchase reinsurance from the government (disallowed competition),  reinsurers might see their business decline because insurers would have  less funds available to purchase private reinsurance.
section_title: State Regulators
paragraphs: Similar to recoupment surcharges, state regulators’ ability to restrain  potential price increases might be limited under the federal charge option.  For example, one stakeholder said that if a federal charge substantially  increased prices, states might stop requiring terrorism coverage if it  harmed the workers’ compensation market. One stakeholder stated that  the portion of rate increases that insurers imposed to make up for  premium revenue losses likely would receive more scrutiny from state  regulators.
section_title: Additional Potential Effects of Terrorism Set-Asides
paragraphs: We obtained information on the potential effects of insurer terrorism set- aside approaches on different industry stakeholders. Approaches that  did not involve segregated assets likely would result in no or minimal  impact on price, participation, or insurer direct earned premium.  Approaches that involved segregated assets (as in our interpretation of  the legislative proposals) could have some impact on price, participation,  and insurer direct earned premium because they might require insurers to  raise additional capital. However, we did not determine the size of any  increase.
subsections: section_title: Insurers
paragraphs: To the extent that prices increased, insurers’ overall direct earned  premium could be negatively affected under the terrorism set-aside  approaches. Stakeholders said that if a segregated set-aside were  required, insurers might need to raise more capital to increase capacity  for their other lines of business and would need to earn an acceptable  return on capital for shareholders. Stakeholders reported that capital  could be raised in the markets, which would increase the insurer’s cost of  doing business, or it could be raised by increasing premiums on  policyholders.
Insurers may also incur administrative costs associated with a terrorism  set-aside for terrorism risk. Specially, three insurers indicated increased  business costs associated with a terrorism set-aside and one insurer  stated that any effect on its business costs would depend on the tax  implications for any capital considerations.
section_title: Reinsurers
paragraphs: Reinsurers could experience decreases in market opportunities under the  terrorism set-aside option, but reinsurance availability likely would not be  affected. As discussed above, most insurers fund reinsurance purchases  from premiums. To the extent that insurers would need to build terrorism  set-asides, they might have less capital available to purchase reinsurance  unless one purpose of the set-aside was to build funds to purchase  reinsurance. For this reason, reinsurers also could experience a loss of  business as a result of a requirement for a terrorism set-aside.  Furthermore, if the government were to give the same tax advantage to  the set-asides as post-event loss reserves, insurers could have less need  for reinsurance.
Two industry participants stated that the potential supply of reinsurance  for terrorism likely would be unaffected by a terrorism set-aside  requirement. For example, one industry participant stated that insurer  actions would not strain reinsurance supply or affect reinsurance pricing.
section_title: State Regulators
paragraphs: Unlike with a federally mandated premium increase, state regulators  might have purview over any insurer increases to cover the cost of a  terrorism set-aside because increases likely would be determined by  insurers rather than be federally mandated. In this case, insurers likely  would need to follow normal rate increase protocol. If premium increases  to cover the cost of a terrorism set-aside were minimal, regulators and  policyholders might not notice the increase. However, regulators may  have additional oversight responsibilities under set-aside approaches. For  example, two state regulators pointed out that implementing a set-aside  for potential terrorism losses with specifically segregated assets could  affect state oversight related to laws and practices involving receivership  and liquidation should an insurer become insolvent.
section_title: Policyholders
paragraphs: Stakeholders had differing opinions on whether insurers would increase  premiums as a result of terrorism set-asides. For example, three insurers  stated that such a set-aside would require insurers to increase premiums,  while another stakeholder stated that any effect on premiums might be  negligible. One stakeholder estimated that companies with exposure in  high-risk areas such as New York City had a need for a large set-aside,  while others may not; however, these estimations assume that the set- aside only would be for insurers’ share of the losses. The approach in  which insurers would set aside funds that could be used for both insurer  and federal losses likely would require a larger target amount. One  insurer said that insurers could spread costs across all lines of business.  Similar to the federal charge, that type of cost sharing for the set-aside  would have a negligible impact on policyholder premiums.
section_title: Appendix VI: Extent to Which an Economic Subsidy Exists within the Terrorism Risk Insurance Act
paragraphs: In this appendix, we discuss the extent to which the role of the federal  government under the Terrorism Risk Insurance Act (TRIA) creates an  economic subsidy for market participants and the potential size of such a  subsidy. We determined that TRIA could produce a federal government  economic subsidy to the extent the government was not expected to fully  recoup its losses. Estimating the size of an economic subsidy depends on  many factors and requires several assumptions that we discuss later in  this appendix.
subsections: section_title: To the Extent That Losses Are Not Expected to Be Recouped, the Federal Government Provides an Economic Subsidy under TRIA
paragraphs: Under TRIA, the federal government initially shares responsibility for  some of the insured losses with private insurers in the event of a certified  terrorism event and may recoup all or some of its losses through  policyholder surcharges. Unlike private insurers or reinsurers, the  government does not charge premiums for its potential share of terrorism  losses but may recoup some or all of its losses post-event. Specifically,  Treasury reimburses an insurer for a certain percentage of its insured  losses above its deductible. If insurers’ aggregate losses are equal to or  below the industry aggregate retention amount, TRIA requires mandatory  recoupment of the federal losses up to the retention amount reached by  the losses through post-event premium surcharges on all policyholders  with TRIA-eligible insurance, including those with no insured losses and  those without terrorism risk coverage. In addition, TRIA allows for  discretionary recoupment when losses exceed the industry aggregate  retention amount. As structured, the program potentially exposes the  federal government to a significant amount of financial risk and it does not  require recoupment of all losses and expenses in some scenarios.
For the purpose of this report, an economic subsidy can involve a  payment by the government that reduces the buyer’s price below the  seller’s price. Whether there is no payment involved or in addition to a  payment, an economic subsidy can involve the full or partial absence of a  charge by the government for an action that benefits private market  participants. Either case implies a payment or benefit from the  government to private market participants, for which the government  receives no commensurate benefit. Certain types of government  intervention could produce an economic subsidy. Table 13 lists some  government interventions and their applicability to TRIA.
While TRIA is designed to recoup at least a portion of the federal share of  losses, in some scenarios recoupment could adversely affect the market.  For example, in some scenarios, the mandatory recoupment time frames  could lead to large increases in policyholders’ premiums, which could  affect the political will to carry out mandatory recoupment. In addition, the  discretionary portion of recoupment could require a protracted collection  period of premium surcharges, which could be a factor in Treasury’s  determination of whether and to what extent to pursue discretionary  recoupment. As a result, market participants and others may not expect  the government to fully implement TRIA’s recoupment provisions. As  such, in this report we assess the presence and potential size of an  economic subsidy on the basis of whether and to what extent the  government would be expected to recoup the federal share of losses,  regardless of whether a terrorism event occurs.
To the extent the losses to the federal government were not expected to  be fully recouped, the federal government would be providing an  economic subsidy because insurers and policyholders would receive a  benefit from the federal government in the absence of a charge. In  certain ways, the economic subsidy could benefit private insurers and the  policyholders. However, if the government was not expected to fully  recoup its losses, the primary recipients of the subsidy would be the  policyholders because they would have received insurance coverage  without paying either pre-event premiums for the federal share of losses  or the actual full costs post-event.
section_title: Potential Size of an Economic Subsidy Depends on Extent to Which Recoupment Is Expected to Be Implemented and Certain Factors Affect Ability to Accurately Estimate the Size
paragraphs: Using various assumptions and taking into account several limitations, we  analyzed the potential size of an economic subsidy under different  recoupment scenarios. We estimated the size of a subsidy by determining  the value of insurance coverage without knowledge of whether, and to  what extent, claims would occur. Specifically, using the cost of private  reinsurance in other national programs we estimated annual forgone  federal terrorism risk insurance premiums in scenarios in which the  government would be expected to (1) recoup only the mandatory amount  of losses, and (2) recoup no losses. We estimated the annual cost of the  economic subsidy could be as high as $1.6 billion if the government were  not expected to recoup any of its losses. However, if the government  were expected to recoup all of its losses as described in TRIA, the  economic subsidy would be $0 (no subsidy).
Certain factors, such as limited data, limited our estimation method and  affected our ability to accurately estimate the potential size of any  subsidy. We used terrorism risk reinsurance rates in other national  programs to estimate forgone premiums in the TRIA program because we  lack data to determine premiums that would be required for any other  estimation method. Currently premiums are not collected from  policyholders for the federal share of losses, and the government would  need to consider many factors in potentially setting a federal charge for  terrorism risk insurance. Using reinsurance rates charged by private  reinsurers to other national terrorism risk insurance programs for our  estimate of forgone premiums could provide information on how the  private market values terrorism risk insurance and the cost of capital to  provide that insurance. We were told by the broker of many reinsurance  deals in other national programs that premium rates were fairly stable  across countries and generally ranged from 2 percent to 3 percent of the  dollar amount of coverage. For example, the Australian terrorism risk  insurance program purchased reinsurance in 2014 for six layers of  reinsurance, with the rates ranging from 1.85 percent to 5.5 percent of  coverage. Rates decreased with each additional layer of cover. For our  analysis, we used an average cost of 2.5 percent of coverage and we  assumed that the government would purchase coverage for its maximum  payout. Use of other data or another estimation method could result in a  different estimate of a subsidy amount.
Finally, the estimation of the size of any subsidy could be affected by  different assumptions about the private reinsurance market. There are  limitations to our use of the cost of private reinsurance in other national  programs to estimate forgone federal terrorism risk insurance premiums  to the United States.
First, the private reinsurance market may price coverage differently for  the U.S. program or may be limited in the amount it is willing to cover.  For example, the private reinsurance market may not consider the risk  within the United States commensurate with risks in other countries;  U.S. risk may not be sufficiently geographically diverse to qualify for  the same pricing; or Treasury may not have sufficient information on  the risk of the underlying portfolio for reinsurers to price the  coverage.
Second, the capacity of the private reinsurance market may not be  sufficiently large for the amount that we assume would be purchased  in this analysis. Programs in other countries purchase much smaller  amounts of reinsurance. For example, the Australian program  purchased just under $2 billion (about A$3 billion) of reinsurance  coverage in 2014. Our analysis assumed that the United States would  need to purchase more than 30 times that amount (about $65 billion in  reinsurance coverage).
Third, the government might not choose to purchase this much  reinsurance. For example, the government might choose to self- reinsure or charge less in premiums.
Fourth, our analysis assumes the entire amount would be covered by  private reinsurance. However, reinsurance purchasers generally must  pay a deductible, co-share, or both, which would decrease the actual  amount of reinsurance coverage purchased.
section_title: Appendix VII: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Jill Naamane (Assistant Director);  Charlene J. Lindsay (Analyst in Charge); Robert Dacey; Pamela  Davidson; Karen Jarzynka-Hernandez; DuEwa Kamara; John Karikari;  Alma Laris; Emei Li; Efrain Magallan; Scott McNulty; Susan Murphy;  Joseph O’Neill; Laurel Plume; Angela Pun; Oliver Richard; Barbara  Roesmann; Jessica Sandler; Jena Sinkfield; Shannon Smith; Andrew J.  Stephens; and Frank Todisco made key contributions to this report.