Terrorism Insurance: Effects of the Terrorism Risk Insurance Act of 2002
Published: 2004-04-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: After the terrorist attacks of September 11, 2001, insurance coverage for terrorism largely disappeared. Congress passed the Terrorism Risk Insurance Act (TRIA) in 2002 to help commercial property-casualty policyholders obtain terrorism insurance and give the insurance industry time to develop mechanisms to provide such insurance after the act expires on December 31, 2005. Under TRIA, the Department of Treasury (Treasury) caps insurer liability and would process claims and reimburse insurers for a large share of losses from terrorist acts that Treasury certified as meeting certain criteria. As Treasury and industry participants have operated under TRIA for more than a year, GAO was asked to describe how TRIA affected the terrorism insurance market.
section_title: What GAO Found
paragraphs: TRIA has enhanced the availability of terrorism insurance for commercial policyholders, largely fulfilling a principal objective of the program. In particular, TRIA has benefited commercial policyholders in major metropolitan areas perceived to be at greater risk for a terrorist attack. Prior to TRIA, we reported concern that some development projects had already been delayed or cancelled because of the unavailability of insurance and continued fears that other projects also would be adversely impacted. We also conveyed the widespread concern that general economic growth and development could be slowed by a lack of available terrorism insurance. Since TRIA's enactment, terrorism insurance generally has been widely available, even for development projects in perceived high-risk areas, largely because of the requirement in TRIA that insurers "make available" coverage for terrorism on terms not differing materially from other coverage. Although the purpose of TRIA is to make terrorism insurance available, it does not directly address prices. As part of its assessment of TRIA's effectiveness, Treasury is engaged in gathering data through surveys that should provide useful information about terrorism insurance prices in the marketplace. Despite increased availability of coverage, limited industry data suggest that most commercial policyholders are not buying terrorism insurance, perhaps because they perceive their risk of losses from a terrorist act as being relatively low. The potential negative effects of low purchase rates, in combination with the probability that those most likely to be the targets of terrorist attacks may also be the ones most likely to have purchased coverage, would become evident only in the aftermath of a terrorist attack and could include more difficult economic recovery for businesses without terrorism coverage or potentially significant financial problems for insurers. Moreover, those that have purchased terrorism insurance may still be exposed to significant risks that have been excluded by insurance companies, such as nuclear, biological, or chemical contamination. Meanwhile, although insurers and some reinsurers have cautiously reentered the terrorism risk market to cover insurers' remaining exposures, little progress has been observed within the private sector toward either finding a reliable method for pricing terrorism insurance or developing any viable reinsurance alternatives to TRIA once it expires.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our report on the implementation  of the Terrorism Risk Insurance Act of 2002 (TRIA) and the act’s impact  on the economy. The terrorist attacks of September 11, 2001, drastically  changed the way insurers viewed the risk of terrorism. An industry that  had considered the risk of terrorism so low that it did not identify or price  terrorism risk separate from property and casualty coverage will  ultimately pay approximately $40 billion for losses arising from September  11, according to industry experts. Responding to terrorism risk after  September 11, reinsurers began excluding terrorism from coverage as  contracts between reinsurers and insurers came up for renewal. Without  reinsurance, insurers retained greater levels of risks than they could  responsibly carry, and their reaction was to exclude these risks from  commercial policies as they were renewed. In short, believing that neither  the frequency nor magnitude of terrorism losses could be estimated,  insurance companies withdrew from the market.
In the aftermath of September 11, we reported that terrorism insurance  was disappearing in the marketplace, particularly for large businesses and  those perceived to be at some risk. We also reported significant concern  that some development projects had already been delayed or cancelled  because of the unavailability of insurance and fears that others would  follow. Furthermore, there was widespread concern that general  economic growth and development would be slowed by a lack of  insurance availability and uncertainty in the marketplace. Because of  concerns about the lack of available and affordable terrorism insurance,  Congress passed TRIA, which took effect on November 26, 2002. TRIA is  currently scheduled to expire at the end of 2005.
Our report on the implementation of TRIA has two objectives. First, we  describe the progress made by Treasury and insurance industry  participants in implementing TRIA. We found that Treasury has made  significant progress in implementing the provisions of TRIA, but has  important work to complete in order to comply with all its responsibilities  under the act. Second, we discuss the changes in the market for terrorism  insurance coverage under TRIA. As requested, my testimony today focuses  on the second of these two objectives. That is, how TRIA has affected the  market for terrorism insurance and, more generally, the economy.  Additionally, I have included appendixes to this statement that provide  background information on TRIA and describe completed and ongoing  engagements that GAO has undertaken for this Committee that relate to  increasing the insurance industry’s capacity to provide insurance for  terrorism and natural catastrophe risks.
In summary, it appears that Congress’s first objective in creating TRIA—to  ensure that business activity did not materially suffer from a lack of  available terrorism insurance—largely has been achieved. Since TRIA was  enacted in November 2002, terrorism insurance generally has been  available to businesses. But most commercial policyholders are not buying  the coverage. According to insurance industry experts, purchases have  been higher in areas considered to be at high risk of another terrorist  attack. However, many policyholders with businesses or properties not  located in perceived high–risk locations are not buying coverage because  they view any price for terrorism insurance as high relative to their  perceived risk exposure. Further, those that have bought terrorism  insurance remain exposed to significant perils because insurers have  broadened longstanding policy exclusions of nuclear, biological, and  chemical (NBC) events. Congress’s second objective—to give private  industry a transitional period during which it could begin pricing terrorism  insurance and develop ways to cover losses after TRIA expires—has not  been achieved yet. Industry sources indicated that under TRIA, insurance  market participants have made no progress to date toward the  development of reliable methods for pricing terrorism risks and little  movement toward any mechanism that would enable insurers to provide  terrorism insurance to businesses without government involvement.
In conducting this work, we reviewed and analyzed relevant information  concerning state legislation and publicly available and proprietary industry  data and studies on the terrorism insurance market. We interviewed  officials at Treasury, the National Association of Insurance Commissioners  (NAIC), and state insurance regulators from six states with high insurance  sales volumes. We also interviewed representatives of insurance  companies, reinsurance companies, brokers for insurance and reinsurance  companies, industry associations, property owners and developers, and  insurance filing services and credit rating agencies. In our discussions  with these organizations, we endeavored to gain an understanding of their  experience in implementing TRIA requirements, obtain their views on the  effects of TRIA on the terrorism insurance market, and identify  developments within the industry to address terrorism risks after TRIA  expires. We conducted this work in Chicago, New York City, and  Washington, D.C., from January 2003 through April 2004 in accordance  with generally accepted government auditing standards.
subsections: section_title: Although Available, Few Are Buying Terrorism Insurance and the Industry Has Made Little Progress Toward Post-TRIA Coverage
paragraphs: While TRIA has improved the availability of terrorism insurance,  particularly for high-risk properties in major metropolitan areas, most  commercial policyholders are not buying the coverage. Limited industry  data suggest that 10 - 30 percent of commercial policyholders are  purchasing terrorism insurance, perhaps because most policyholders  perceive themselves at relatively low risk for a terrorist event. Some  industry experts are concerned that those most at risk from terrorism are  generally the ones buying terrorism insurance. In combination with low  purchase rates, these conditions could result in uninsured losses for those  businesses without terrorism coverage or cause financial problems for  insurers, should a terrorist event occur. Moreover, even policyholders who  have purchased terrorism insurance may remain uninsured for significant  risks arising from certified terrorist events—that is, those meeting  statutory criteria for reimbursement under TRIA—such as those involving  NBC agents or radioactive contamination. Finally, although insurers and  some reinsurers have cautiously reentered the terrorism risk market,  insurance industry participants have made little progress toward  developing a mechanism that could permit the commercial insurance  market to resume providing terrorism coverage without a government  backstop.
subsections: section_title: TRIA Has Improved the Availability of Terrorism Insurance, Particularly for Some High-Risk Policyholders
paragraphs: TRIA has improved the availability of terrorism insurance, especially for  some high-risk policyholders. According to insurance and risk  management experts, these were the policyholders who had difficulty  finding coverage before TRIA. TRIA requires that insurers “make  available” coverage for terrorism on terms not differing materially from  other coverage. Largely because of this requirement, terrorism insurance  has been widely available, even for development projects in high-risk areas  of the country. Although industry data on policyholder characteristics are  limited and cannot be generalized to all policyholders in the United States,  risk management and real estate representatives generally agree that after  TRIA was passed, policyholders—including borrowers obtaining  mortgages for “trophy” properties, owners and developers of high-risk  properties in major city centers, and those in or near “trophy” properties— were able to purchase terrorism insurance.
Additionally, TRIA contributed to better credit ratings for some  commercial mortgage-backed securities. For example, prior to TRIA’s  passage, the credit ratings of certain mortgage-backed securities, in which  the underlying collateral consisted of a single high-risk commercial  property, were downgraded because the property lacked or had  inadequate terrorism insurance. The credit ratings for other types of  mortgage-backed securities, in which the underlying assets were pools of  many types of commercial properties, were also downgraded but not to  the same extent because the number and variety of properties in the pool  diversified their risk of terrorism. Because TRIA made terrorism insurance  available for the underlying assets, thus reducing the risk of losses from  terrorist events, it improved the overall credit ratings of mortgage-backed  securities, particularly single-asset mortgage-backed securities. Credit  ratings affect investment decisions that revolve around factors such as  interest rates because higher credit ratings result in lower costs of capital.  According to an industry expert, investors use credit ratings as guidance  when evaluating the risk of mortgage-backed securities for investment  purposes. Higher credit ratings reflect lower credit risks. The typical  investor response to lower credit risks is to accept lower returns, thereby  reducing the cost of capital, which translates into lower interest rates for  the borrower.
To the extent that the widespread availability of terrorism insurance is a  result of TRIA’s “make available” requirement, Treasury’s decision on  whether to extend the requirement to year three of the program is vitally  important. While TRIA has ensured the availability of terrorism insurance,  we have little quantitative information on the prices charged for this  insurance. Treasury is engaged in gathering data through surveys that  should provide useful information about terrorism insurance prices. TRIA  requires that they make the information available to Congress upon  request. In addition, TRIA also requires Treasury to assess the  effectiveness of the act and evaluate the capacity of the industry to offer  terrorism insurance after its expiration. This report is to be delivered to  Congress no later than June 30, 2005.
section_title: Most Policyholders Have Not Bought Terrorism Insurance
paragraphs: Although TRIA improved the availability of terrorism insurance, relatively  few policyholders have purchased terrorism coverage. We testified  previously that prior to September 11, 2001, policyholders enjoyed “free”  coverage for terrorism risks because insurers believed that this risk was so  low that they provided the coverage without additional premiums as part  of the policyholder’s general property insurance policy. After September  11, prices for coverage increased rapidly and, in some cases, insurance  became very difficult to find at any price. Although a purpose of TRIA is to  make terrorism insurance available and affordable, the act does not  specify a price structure.
However, experts in the insurance industry generally agree that after the  passage of TRIA, low-risk policyholders (for example, those not in major  urban centers) received relatively low-priced offers for terrorism  insurance compared to high-risk policyholders, and some policyholders  received terrorism coverage without additional premium charges. Yet  according to insurance experts, despite low premiums, many businesses  (especially those not in “target” localities or industries) did not buy  terrorism insurance. Some simply may not have perceived themselves at  risk from terrorist events and considered terrorism insurance, even at low  premiums (relative to high-risk areas), a bad investment. According to  insurance sources, other policyholders may have deferred their decision to  buy terrorism insurance until their policy renewal date.
Some industry experts have voiced concerns that low purchase rates may  indicate adverse selection—where those at the most risk from terrorism  are generally the only ones buying terrorism insurance. Although industry  surveys are limited in their scope and not appropriate for market-wide  projections, the surveys are consistent with each other in finding low  “take-up” rates, the percentage of policyholders buying terrorism  insurance, ranging from 10 to 30 percent. According to one industry  survey, the highest take-up rates have occurred in the Northeast, where  premiums were generally higher than the rest of the country.
The combination of low take-up rates and high concentration of purchases  in an area thought to be most at risk raises concerns that, depending on its  location, a terrorist event could have additional negative effects.
If a terrorist event took place in a location not thought to be a terrorist  “target,” where most businesses had chosen not to purchase terrorism  insurance, then businesses would receive little funding from insurance  claims for business recovery efforts, with consequent negative effects on  owners, employers, suppliers, and customers.
Alternatively, if the terrorist event took place in a location deemed to be a  “target,” where most businesses had purchased terrorism insurance, then  adverse selection could result in significant financial problems for  insurers. A small customer base of geographically concentrated, high-risk  policyholders could leave insurers unable to cover potential losses facing  possible insolvency. If, however, a higher percentage of business owners  had chosen to buy the coverage, the increased number of policyholders  would have reduced the chance that losses in any one geographic location  would create a significant financial problem for an insurer.
section_title: Tighter Exclusions Leave Policyholders Exposed to Significant Perils
paragraphs: Since September 11, 2001, the insurance industry has moved to tighten  long-standing exclusions from coverage for losses resulting from NBC  attacks and radiation contamination. As a result of these exclusions and  the actions of a growing number of state legislatures to exclude losses  from fire following a terrorist attack, even those policyholders who choose  to buy terrorism insurance may be exposed to potentially significant  losses. Although NBC coverage was generally not available before  September 11, after that event insurers and reinsurers recognized the  enormity of potential losses from terrorist events and introduced new  practices and tightened treaty language to further limit as much of their  loss exposures as possible. (We discuss some of these practices and  exclusions in more detail in the next section.) State regulators and  legislatures have approved these exclusions, allowing insurers to restrict  the terms and conditions of coverage for these perils. Moreover, because  TRIA’s “make available” requirements state that terms for terrorism  coverage be similar to those offered for other types of policies, insurers  may choose to exclude the perils from terrorism coverage just as they  have in other types of coverage. According to Treasury officials, TRIA  does not preclude Treasury from providing reimbursement for NBC  events, if insurers offered this coverage. However, policyholder losses  from perils excluded from coverage, such as NBCs, would not be “insured  losses” as defined by TRIA and would not be covered even in the event of  a certified terrorist attack.
In an increasing number of states, policyholders may not be able to  recover losses from fire following a terrorist event if the coverage in those  states is not purchased as part of the offered terrorism coverage. We have  previously reported that approximately 30 states had laws requiring  coverage for “fire-following” an event—known as the standard fire policy  (SFP)—irrespective of the fire’s cause. Therefore, in SFP states fire  following a terrorist event is covered whether there is insurance coverage  for terrorism or not. After the terrorist attacks of September 11, 2001,  some legislatures in SFP states amended their laws to allow the exclusion  of fire following a terrorist event from coverage. As of March 1, 2004, 7 of  the 30 SFP states had amended their laws to allow for the exclusion of acts  of terrorism from statutory coverage requirements. However as discussed  previously, the “make available” provision requires coverage terms offered  for terrorist events to be similar to coverage for other events. Treasury  officials explained that in all non-SFP states, and the 7 states with  modified SFPs, insurers must include in their offer of terrorism insurance  coverage for fire following a certified terrorist event because coverage for  fire is part of the property coverage for all other risks. Thus, policyholders  who have accepted the offer would be covered for fire following a terrorist  event, even though their state allows exclusion of the coverage. However,  policyholders who have rejected their offer of coverage for terrorism  insurance would not be covered for fire following a terrorist event.  According to insurance experts, losses from fire damage can be a  relatively large proportion of the total property loss. As a result, excluding  terrorist events from SFP requirements could result in potentially large  losses that cannot be recovered if the policyholder did not purchase  terrorism coverage. For example, following the 1994 Northridge  earthquake in California, total insured losses for the earthquake were $15  billion—$12.5 billion of which were for fire damage. According to an  insurance expert, policyholders were able to recover losses from fire  damage because California is an SFP state, even though most policies had  excluded coverage for earthquakes.
section_title: Reinsurers Have Cautiously Returned to the Market, but Many Insurers Have Not Bought Reinsurance
paragraphs: Under TRIA, reinsurers are offering a limited amount of coverage for  terrorist events for insurers’ remaining exposures, but insurers have not  been buying much of this reinsurance. According to insurance industry  sources, TRIA’s ceiling on potential losses has enabled reinsurers to return  cautiously to the market. That is, reinsurers generally are not offering  coverage for terrorism risk beyond the limits of the insurer deductibles  and the 10 percent share that insurers would pay under TRIA. In spite of  reinsurers’ willingness to offer this coverage, company representatives  have said that many insurers have not purchased reinsurance. Insurance  experts suggested that the low demand for the reinsurance might reflect,  in part, commercial policyholders’ generally low take-up rates for  terrorism insurance. Moreover, insurance experts also have suggested that  insurers may believe that the price of reinsurance is too high relative to  the premiums they are earning from policyholders for terrorism insurance.
The relatively high prices charged for the limited amounts of terrorism  reinsurance available are probably the result of interrelated factors. First,  even before September 11 both insurance and reinsurance markets were  beginning to harden; that is, prices were beginning to increase after  several years of lower prices. Reinsurance losses resulting from  September 11 also depressed reinsurance capacity and accelerated the rise  in prices. The resulting hard market for property-casualty insurance  affected the price of most lines of insurance and reinsurance. A notable  example has been the market for medical malpractice insurance. The  hard market is only now showing signs of coming to an end, with a  resulting stabilization of prices for most lines of insurance. In addition to  the effects of the hard market, reinsurer awareness of the adverse  selection that may be occurring in the commercial insurance market could  be another factor contributing to higher reinsurance prices. Adverse  selection usually represents a larger-than-expected exposure to loss.  Reinsurers are likely to react by increasing prices for the terrorism  coverage that they do sell.
In spite of the reentry of reinsurers into the terrorism market, insurance  experts said that without TRIA caps on potential losses, both insurers and  reinsurers likely still would be unwilling to sell terrorism coverage  because they have not found a reliable way to price their exposure to  terrorist losses. According to industry representatives, neither insurers nor  reinsurers can estimate potential losses from terrorism or determine  prices for terrorism insurance without a pricing model that can estimate  both the frequency and the severity of terrorist events. Reinsurance  experts said that current models of risks for terrorist events do not have  enough historical data to dependably estimate the frequency or severity of  terrorist events, and therefore cannot be relied upon for pricing terrorism  insurance. According to the experts, the models can predict a likely range  of insured losses resulting from the damage if specific event parameters  such as type and size of weapon and location are specified. However, the  models are unable to predict the probability of such an attack.
Even as they are charging high prices, reinsurers are covering less. In  response to the losses of September 11, industry sources have said that  reinsurers have changed some practices to limit their exposures to acts of  terrorism. For example, reinsurers have begun monitoring their exposures  by geographic area, requiring more detailed information from insurers,  introducing annual aggregate and event limits, excluding large insurable  values, and requiring stricter measures to safeguard assets and lives where  risks are high. And as discussed previously, almost immediately after  September 11 reinsurers began broadening NBC exclusions beyond  scenarios involving industrial accidents, such as nuclear plant accidents  and chemical spills, to encompass intentional destruction from terrorists.  For example, post-September 11 exclusions for nuclear risks include  losses from radioactive contamination to property and radiation sickness  from dirty bombs.
As of March 1, 2004, industry sources indicated that there has been little  development or movement among insurers or reinsurers toward  developing a private-sector mechanism that could provide capacity,  without government involvement, to absorb losses from terrorist events.  Industry officials have said that their level of willingness to participate  more fully in the terrorism insurance market in the future will be  determined, in part, by whether any more events occur. Industry sources  could not predict if reinsurers would return to the terrorism insurance  market after TRIA expires, even after several years and the absence of  further major terrorist attacks in the United States. They explained that  reinsurers are still recovering from the enormous losses of September 11  and still cannot price terrorism coverage. In the long term and without  another major terrorist attack, insurance and reinsurance companies  might eventually return. However, should another major terrorist attack  take place, reinsurers told us that they would not return to this market— with or without TRIA.
section_title: Conclusions
paragraphs: Congress had two major objectives in establishing TRIA. The first was to  ensure that business activity did not suffer from the lack of insurance by  requiring insurers to continue to provide protection from the financial  consequences of another terrorist attack. Since TRIA was enacted in  November 2002, terrorism insurance generally has been widely available  even for development projects in high-risk areas of the country, in large  part because of TRIA’s “make available” requirement. Although most  businesses are not buying coverage, there is little evidence that  development has suffered to a great extent—even in lower-risk areas of  the county, where purchases of coverage may be lowest. Further, although  quantifiable evidence is lacking on whether the availability of terrorism  coverage under TRIA has contributed to the economy, the current revival  of economic activity suggests that the decision of most commercial  policyholders to decline terrorism coverage has not resulted in  widespread, negative economic effects. As a result, the first objective of  TRIA appears largely to have been achieved.
Congress’s second objective was to give the insurance industry a  transitional period during which it could begin pricing terrorism risks and  developing ways to provide such insurance after TRIA expires. The  insurance industry has not yet achieved this goal. We observed after  September 11 the crucial importance of reinsurers for the survival of the  terrorism insurance market and reported that reinsurers’ inability to price  terrorism risks was a major factor in their departure from the market.  Additionally, most industry experts are tentative about predictions of the  level of reinsurer and insurer participation in the terrorism insurance  market after TRIA expires. Unfortunately, insurers and reinsurers still  have not found a reliable method for pricing terrorism insurance, and  although TRIA has provided reinsurers the opportunity to reenter the  market to a limited extent, industry participants have not developed a  mechanism to replace TRIA. As a result, reinsurer and consequently,  insurer, participation in the terrorism insurance market likely will decline  significantly after TRIA expires.
Not only has no private-sector mechanism emerged for supplying  terrorism insurance after TRIA expires, but to date there also has been  little discussion of possible alternatives for ensuring the availability and  affordability of terrorism coverage after TRIA expires. Congress may  benefit from an informed assessment of possible alternatives—including  both wholly private alternatives and alternatives that could involve some  government participation or action. Such an assessment could be a part of  Treasury’s TRIA-mandated study to “assess…the likely capacity of the  property and casualty insurance industry to offer insurance for terrorism  risk after termination of the Program.”
section_title: Recommendation for Executive Action
paragraphs: As part of the response to the TRIA-mandated study that requires Treasury  to assess the effectiveness of TRIA and evaluate the capacity of the  industry to offer terrorism insurance after TRIA expires, we recommend  that the Secretary of the Treasury, after consulting with the insurance  industry and other interested parties, identify for Congress an array of  alternatives that may exist for expanding the availability and affordability  of terrorism insurance after TRIA expires. These alternatives could assist  Congress during its deliberations on how best to ensure the availability  and affordability of terrorism insurance after December 2005.
Mr. Chairman, Madam Chairwoman, this concludes my statement. I would  be pleased to respond to any questions that you or other members of the  Subcommittees may have.
section_title: Contacts and Acknowledgements
paragraphs: For further information regarding this testimony please contact Richard J.  Hillman or Davi M. D’Agostino, Directors, or Lawrence D. Cluff or Wesley  M. Phillips, Assistant Directors, Financial Markets and Community  Investment, (202) 512-8678. Individuals making key contributions to this  testimony include Sonja Bensen, Rachel DeMarcus, Tom Givens III, Jill  Johnson, Barry Kirby, Caitlyn Lam, Tarek Mahmassani, Angela Pun, and  Barbara Roesmann.
section_title: Appendix I: TRIA Background
paragraphs: Under TRIA, Treasury is responsible for reimbursing insurers for a portion  of terrorism losses under certain conditions. Payments are triggered when  (1) the Secretary of the Treasury certifies that terrorists acting on behalf of  foreign interests have carried out an act of terrorism and (2) aggregate  insured losses for commercial property and casualty damages exceed  $5,000,000 for a single event. TRIA specifies that an insurer is responsible  (that is, will not be reimbursed) for the first dollars of its insured losses— its deductible amount. TRIA sets the deductible amount for each insurer  equal to a percentage of its direct earned premiums for the previous year.  Beyond the deductible, insurers also are responsible for paying a  percentage of insured losses. Specifically, TRIA structures pay-out  provisions so that the federal government shares the payment of insured  losses with insurers at a 9:1 ratio—the federal government pays 90 percent  of insured losses and insurers pay 10 percent—until aggregate insured  losses from all insurers reach $100 billion in a calendar year (see fig. 1).  Thus, under TRIA’s formula for sharing losses, insurers are reimbursed for  portions of the claims they have paid to policyholders. Furthermore, TRIA  then releases insurers who have paid their deductibles from any further  liability for losses that exceed aggregate insured losses of $100 billion in  any one year. Congress is charged with determining how losses in excess  of $100 billion will be paid.
TRIA also contains provisions and a formula requiring Treasury to recoup  part of the federal share if the aggregate sum of all insurers’ deductibles  and 10 percent share is less than the amount prescribed in the act—the  “insurance marketplace aggregate retention amount.” TRIA also gives the  Secretary of the Treasury discretion to recoup more of the federal  payment if deemed appropriate. Commercial property-casualty  policyholders would pay for the recoupment through a surcharge on  premiums for all the property-casualty policies in force after Treasury  established the surcharge amount; the insurers would collect the  surcharge. TRIA limits the surcharge to a maximum of 3 percent of annual  premiums, to be assessed for as many years as necessary to recoup the  mandatory amount. TRIA also gives the Secretary of the Treasury  discretion to reduce the annual surcharge in consideration of various  factors such as the economic impact on urban centers. However, if  Treasury makes such adjustments, it has to extend the surcharges for  additional years to collect the remainder of the recoupment.
Treasury is funding the Terrorism Risk Insurance Program (TRIP) office  operations—through which it administers TRIA provisions and would pay  claims—with “no-year money” under a TRIA provision that gives Treasury  authority to utilize funds necessary to set up and run the program. The  TRIP office had a budget of $8.97 million for fiscal year 2003 (of which  TRIP spent $4 million), $9 million for fiscal year 2004, and a projected  budget of $10.56 million for fiscal year 2005—a total of $28.53 million over  3 years. The funding levels incorporate the estimated costs of running a  claims-processing operation in the aftermath of a terrorist event: $5  million in fiscal years 2003 and 2004 and $6.5 million in fiscal year 2005,  representing about 55 - 60 percent of the budget for each fiscal year. If no  certified terrorist event occurred, the claims-processing function would be  maintained at a standby level, reducing the projected costs to $1.2 million  annually, or about 23 percent of the office’s budget in each fiscal year. Any  funds ultimately used to pay the federal share after a certified terrorist  event would be in addition to these budgeted amounts.
section_title: Appendix II: Summary of Completed and Ongoing GAO Work Related to Insurance for Terrorism and Natural Catastrophe Risks
paragraphs: Terrorist attacks and natural catastrophes—-such as hurricanes and  earthquakes—-pose unique challenges to insurers. Forecasting the timing  and severity of such events is difficult and the large losses associated with  catastrophes can threaten insurer safety and soundness. Insurers also  frequently respond to catastrophic events by cutting back coverage  significantly or substantially increasing premiums for policyholders. Over  the years, several approaches have been suggested to expand the capacity  of the insurance industry to cover catastrophic events. These approaches  include securitization of catastrophe risk, changing tax and accounting  treatment of catastrophe risk, and permitting risk-retention groups to  cover property as well as liability exposures. At the request of the  Chairman of the House Financial Services Committee and others, we have  completed reports that address some of these issues or have work ongoing  in these areas. Our work may assist the Committee in its oversight of the  insurance industry and consideration of the industry’s ability to both  insure against and respond to catastrophic events.
subsections: section_title: Securitization of Catastrophe Risk
paragraphs: Given the enormous financial losses associated with catastrophic events  and questions about insurers’ ability to cover such losses, interest has  been generated in transferring some of these risks to the capital markets,  which had total value of about $29 trillion as of the first quarter of 2003.  Since the mid-1990s, some insurance companies, reinsurance companies,  and capital market participants have developed various financial  instruments, the most prevalent of which are catastrophe bonds.  These  bonds offer a relatively high rate of return to investors that are willing to  accept some of the substantial risks associated with catastrophes.
In two previous reports, we assessed the development of the catastrophe  bond market. We found that some insurance companies view catastrophe  bonds as an important component of their overall strategy for managing  natural catastrophe financial risks. In addition, representatives from some  institutional investors we contacted expressed positive views about  catastrophe bonds because they offer attractive yields compared to  traditional investments and help diversify investment risks. However,  other insurers and investors are not willing to issue or purchase  catastrophe bonds because they are more costly than traditional  reinsurance, too risky, or illiquid. We also reported that developing  catastrophe bonds to cover terrorism risks in the United States is  considered challenging for many reasons, including the difficulties  associated with developing computer models to predict the frequency and  severity of terrorist attacks. Sophisticated models have been developed to  predict the frequency and severity of natural catastrophes—particularly  hurricanes—that have facilitated the development of catastrophe bonds  covering such risks.
section_title: Tax and Accounting Treatment of Catastrophe Risk
paragraphs: We are currently conducting follow-up work on potential tax and  accounting issues raised in our previous reports that might affect the use  of catastrophe bonds.  As we reported in September 2002, most  catastrophe bonds are issued offshore—for example, in Bermuda—rather  than in the United States due to favorable tax considerations. Some  insurance industry groups have argued for changes in U.S. tax laws to  encourage insurers to issue catastrophe bonds onshore to lessen  transaction costs and afford regulators greater scrutiny over these  activities. As part of our ongoing work, we are reviewing the tax treatment  of catastrophe risk coverage in selected European countries. Furthermore,  in 2003 we reported that the Financial Accounting Standards Board had  issued guidance that may require insurers or investors to list catastrophe  bond assets and liabilities on their balance sheets. We reported that this  guidance had the potential to limit the appeal of issuing catastrophe bonds  but that insurers and financial market participants were not certain of the  impact of this guidance. We are continuing to investigate developments on  these tax and accounting issues and will discuss them in an upcoming  report.
Some believe removing accounting and tax barriers that prevent U.S.  insurance companies from establishing tax-deductible reserves to cover  the financial risks associated with potential natural catastrophes and  terrorist attacks would supplement private-sector capacity. Under current  U.S. accounting standards and tax law, insurers must build any reserves  for events that have not yet occurred from after-tax income (retained  earnings). As a result, insurers do not usually establish reserves in  anticipation of catastrophic events, such as hurricanes. Therefore, insurers  attempt to limit their exposure to catastrophic risks through the  underwriting process, the purchase of reinsurance, or issuance of  catastrophe bonds, among other alternatives.
There is considerable disagreement about the appropriateness and  effectiveness of tax-deductible reserving. Advocates believe that allowing  insurers to establish such reserves would provide increased capacity at  lower cost. On the other hand, critics of tax-deductible reserving have  argued that, in addition to lowering federal tax receipts, there is no  assurance that insurers would actually increase their catastrophe  insurance capacity, but rather either shield existing capital from taxes or  substitute tax-deductible reserves for reinsurance.
At the Chairman’s request, we are currently reviewing the tax treatment of  catastrophe risk reserves in selected European countries—-France, Spain,  Germany, Switzerland, and Italy. We continue to review these practices  and will comment on them in a forthcoming report. In addition to  discussing reserving practices, we are gathering information on general  approaches to insuring against catastrophic risks in these countries.
section_title: Implementation of the Liability Risk Retention Act
paragraphs: Congress enacted the Liability Risk Retention Act of 1986 (Act) to  facilitate the formation of risk-retention groups (RRGs) and risk- purchasing groups (RPGs), insurance entities initially established to  increase the availability and affordability of liability insurance during the  1980s. As authorized by the Act, these groups may only provide  commercial liability insurance. An RRG is simply a group of businesses  with similar risks that join to create an insurance company to self-insure  their risks. An RPG, on the other hand, is a group formed to purchase  insurance as a single entity from a traditional insurer. The majority of our  ongoing work focuses on RRGs because, as insurers, they have the  potential to provide new insurance capacity. A wide variety of groups,  such as professional groups (doctors, attorneys), institutions (universities,  hospitals), and businesses (trucking firms, homebuilders) have created  RRGs. As of mid-April 2004, about 150 RRGs were operational and  approximately 72 were formed in the last year and half.  In contrast to  most other insurers, an RRG can sell insurance in as many states as it  chooses but is to be regulated by only one state—the state in which it is  chartered.
Our ongoing work focuses on assessing the extent to which RRGs have  met the Act’s intent that they increase the availability and affordability of  liability insurance. We will also assess how the unique regulatory structure  of RRGs—where only one state serves as regulator—has promoted the  establishment of RRGs and if this structure has resulted in uneven or  ineffective regulation. The recent failure of four RRGs has resulted in  some regulators questioning the efficacy of having a single-state regulator  and the standards used by some states to charter and regulate RRGs. If we  identify any problems as part of our work, we will evaluate what  legislative or regulatory changes might be needed. These changes, if  needed, could be important whether or not, as some advocates have  suggested, the Act is expanded to include commercial property insurance.  Finally, in the event the Act were expanded to include property insurance,  we also are exploring the potential of RRGs to provide additional capacity  for terrorism insurance.
section_title: Appendix III: Prior GAO Reports and Testimonies Related to Insurance for Terrorism and Natural Catastrophe Risks
paragraphs: U.S. General Accounting Office, Terrorism Insurance: Implementation of  the Terrorism Risk Insurance Act of 2002, GAO-04-307 (Washington, D.C.:  Apr. 23, 2004).
U.S. General Accounting Office, Catastrophe Insurance Risks: Status of  Efforts to Securitize Natural Catastrophe and Terrorism Risk, GAO-03- 1033 (Washington, D.C.: Sep. 24, 2003).
U.S. General Accounting Office, Catastrophe Insurance Risks: The Role of  Risk-Linked Securities, GAO-03-195T (Washington, D.C.: Oct. 8, 2002).
U.S. General Accounting Office, Catastrophe Insurance Risks: The Role of  Risk-Linked Securities and Factors Affecting Their Use, GAO-02-941  (Washington, D.C.: Sep. 24, 2002).
U.S. General Accounting Office, Terrorism Insurance: Rising Uninsured  Exposure to Attacks Heightens Potential Economic Vulnerabilities, GAO- 02-472T (Washington, D.C.: Feb. 27, 2002).
U. S. General Accounting Office, Terrorism Insurance: Alternative  Programs for Protecting Insurance Consumers, GAO-02-199T (Washington,  D.C.: Oct. 24, 2001).
U.S. General Accounting Office, Terrorism Insurance: Alternative  Programs for Protecting Insurance Consumers, GAO-02-175T (Washington,  D.C.: Oct. 24, 2001).
U.S. General Accounting Office, Insurers’ Ability to Pay Catastrophe  Claims, GAO/GGD-00-57R (Washington, D.C.: Feb. 8, 2000).
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