Terrorism Insurance: Status of Efforts by Policyholders to Obtain Coverage
Released: 2008-09-15T00:00:00

Letter

Background

TRIA requires private insurers to offer terrorism coverage in commercial property and casualty insurance, including workers’ compensation insurance policies. Insurers must make terrorism coverage available to their policyholders on the same terms and conditions, including coverage levels, as other types of insurance coverage. For example, an insurer offering $100 million in commercial property coverage must offer $100 million in coverage for property damage from a certified terrorist attack. However, insurers could impose an additional charge for the coverage and policyholders, except in workers’ compensation policies, generally have the option of not purchasing it.

Under TRIA, the federal government is to reimburse insurers for a portion of their losses from certified terrorist acts. Specifically, the federal government would reimburse insurers for 85 percent of their losses after the insurers pay a deductible amounting to 20 percent of the previous year’s direct earned premiums. The federal funding is activated when aggregate industry losses exceed $100 million and is capped at an annual amount of $100 billion.

Originally enacted as a 3-year program, Congress has reauthorized the program twice and recently extended it until 2014. In December 2005, Congress passed the Terrorism Risk Insurance Extension Act that increased the required amount insurers would have to pay in the aftermath of a terrorist attack. In December 2007, Congress approved the Terrorism Risk Insurance Program Reauthorization Act and eliminated the distinction between terrorist acts carried out by foreign and domestic actors. It also clarified language on insurers’ liability, stating that insurers are not responsible for losses that exceed the federal government’s annual liability cap of $100 billion.

Commercial property insurance policies can be simple or complex, depending on the value and location of the properties being insured. Property owners may insure properties individually or consolidate multiple properties in a portfolio and insure them with a single policy. The benefits of grouping properties include spreading the cost (premium) across more than one building on the premise that all buildings in a portfolio are unlikely to be damaged by the same peril in the same event. Policies with high insured values can require multiple insurers to provide coverage, with each providing a portion of the coverage up to the full amount of the policy, because the total insured value is too great for any one insurer to absorb (see fig. 1). According to a representative of a large brokerage firm, policyholders typically buy property coverage, including terrorism coverage, through one all-risk policy, which insures losses from multiple perils.

Policyholders generally do not purchase terrorism insurance in amounts that would cover the total replacement value of the insured property, but rather purchase insurance in amounts that reflect the maximum amount of foreseeable losses that could occur in a terrorist attack. Also, policyholders may determine the amount of terrorism coverage to purchase based on amounts required by a lender providing the mortgage on the property.

States have primary responsibility for regulating the insurance industry in the United States, and state insurance regulators coordinate their activities in part through the NAIC. The degree of oversight of insurance varies by state and insurance type. In some lines of insurance, insurers may file insurance policy forms with state regulators that help determine the extent of coverage provided by a policy by approving the wording of policies, including the explicit exclusions of some perils. According to a NAIC representative, while practices vary by state, state regulators generally regulate prices for personal lines of insurance and workers’ compensation policies but not for commercial property/casualty policies. In most cases, state insurance regulators perform neither rate nor form review for large commercial property/casualty insurance contracts because it is presumed that businesses have a better understanding of insurance contracts and pricing than the average personal-lines consumer. Reinsurers generally are not required to get state regulatory approval for the terms of coverage or the prices they charge.

Terrorism Insurance Generally Is Available Nationwide, although Some Policyholders Had to Take Additional Steps to Obtain Coverage

According to a variety of sources, commercial property terrorism insurance currently appears to be widely available on a nationwide basis at rates viewed as reasonable, largely due to the TRIA program and the current “soft” insurance market. However, some policyholders in urban areas viewed as being at higher risk of a terrorist attack, particularly in Manhattan and to a lesser extent in some other high-risk cities such as Chicago and San Francisco, may be forced to take additional steps to overcome challenges they may have initially faced in obtaining desired amounts of coverage at prices viewed as reasonable. Policyholders generally have been able to obtain desired or required amounts of terrorism coverage by increasing the number of carriers in what already may be large and complex insurance programs, adding to what can be a time-consuming and complicated process for policyholders and their insurance brokers. Others secure needed coverage by purchasing all or a portion of their terrorism coverage in a separate insurance policy, or self- insuring through a captive insurance company.

Terrorism Insurance Generally Is Available Nationwide at Rates Viewed as Affordable Largely Due to the TRIA Program and the Soft Insurance Market

According to data compiled by two large insurance brokers, a majority of their commercial clients nationwide purchase terrorism insurance coverage, and the premium rates for such coverage generally have been stable in recent years. As shown in figure 2, one of these brokers reported that approximately 60 percent of its clients purchased some form of terrorism coverage each year from 2005 through 2007. Another large insurance broker reported that take-up rates for its large property clients have remained between 60 percent and 65 percent since 2004. According to a large broker, the Northeast, which includes New York City, has the largest percentage of companies that purchase terrorism coverage for properties, with about 70 percent having purchased it in 2007. Real estate companies account for the largest percentage of clients that purchased terrorism insurance coverage, with more than 80 percent of these clients having done so in 2007. Manufacturing and construction companies had the lowest purchase rates, with 45 percent and 34 percent, respectively, having purchased coverage in 2007. Data collected by one of these large brokers also show that the premiums that their clients paid for terrorism coverage, expressed as a percentage of the commercial property premiums, generally have been stable at around 4 percent since 2003 (fig. 2). Another large broker also reported that premiums have been stable at around 4 percent, on average, since 2006.

An official from one of these brokerages told us steady purchase rates between 2005 and 2007 may indicate that policyholders who want to purchase terrorism coverage have been able to purchase it. According to representatives from these two brokers, the primary reason why approximately 40 percent of clients did not purchase terrorism coverage is that they may not have perceived themselves at risk of a terrorist attack, particularly those in nonurban areas or those in industries perceived to be at lower risk of attack, such as manufacturing. Other reasons clients may not have purchased coverage include the absence of lender requirements or the cost of coverage, according to one large broker.

Information we collected in a range of interviews with policyholders, national and regional brokers, insurers, and others was consistent with the view that terrorism insurance coverage is available nationwide at premium rates viewed as reasonable. Several policyholders we contacted that own large and small portfolios of real estate throughout the United States, including national hotel chains, sports stadiums, office towers, shopping malls, and residential buildings, told us they could obtain as much terrorism coverage as they sought to obtain. Some policyholders and regional brokers also said that terrorism insurance premiums continue to decline while the quality of coverage improves. For example, a representative from a commercial real estate company that owns large office towers, a luxury resort, and an industrial property in major U.S. cities said the company recently increased its terrorism coverage by more than 50 percent and decreased its premium by more than 20 percent. In at least one state, an insurer and state regulator told us terrorism coverage may be provided at no additional cost to policyholders, especially those with properties perceived to be at low risk of a terrorist attack.

Insurers, policyholders, and other industry participants cited the TRIA program and the current soft, or competitive, market as the key reasons that terrorism coverage generally has been available nationwide. Without the federal backstop for potential insurance losses related to terrorism, industry participants said that coverage availability could decline substantially. For example, some insurers told us the amount of terrorism coverage they provide would decline—by more than 95 percent for one insurer—without the TRIA provision that provides reimbursement for insured losses that exceed the amount of an insurer’s TRIA deductible. In a soft market, insurance is widely available and sold at a lower cost, making it easier for buyers to obtain insurance. According to insurance industry participants, recent strong profits, increases in investment income, and a lack of large losses from major catastrophes have contributed to insurers’ ability to increase their capital levels in recent years. According to some brokers, high levels of capital have increased insurers’ capacity and willingness to provide terrorism insurance coverage.

However, some interviewees cautioned that another terrorist attack or “hardening” of the general terrorism insurance market could reduce the current supply of terrorism insurance coverage and increase pricing. In the past, insurers frequently have responded to catastrophic events by cutting back coverage significantly or substantially increasing premiums for policyholders. For example, such reactions took place in the Florida market after Hurricane Andrew in 1992, in California after the Northridge earthquake of 1994, and more widely following the September 11 attacks. A broker with a large national firm told us that the insurance industry has remained highly sensitive to the potential financial consequences of another terrorist attack since September 11. According to one industry analyst, even a modest terrorist attack in the future could cause significant fear and concern in the market and lead to increases in prices and restrictions on availability. Moreover, some industry analysts said that insurers could suffer significant losses for a variety of other reasons, such as the costs of a large hurricane or earthquake or declines in the values of their investment portfolios, which might make them less willing to offer terrorism coverage under current terms and pricing.

Some Policyholders in Major Cities Have Faced Initial Challenges in Obtaining Desired Terrorism Coverage at Rates Viewed as Favorable

While terrorism insurance coverage generally is available nationwide, many industry participants reported that some policyholders in major cities viewed as being at higher risk of terrorist attack, particularly in Manhattan, may initially experience challenges in obtaining desired amounts of coverage. Specifically, industry participants said that owners of large, high-value properties in financial districts or downtown locations, or near government offices or transit hubs, may face initial challenges in obtaining coverage in their all-risk property policies. For example, a policyholder with large office and retail properties in New York, San Francisco, and Chicago told us only a few insurers were willing to offer it coverage that it considered expensive and that provided only half of the $1.5 billion in coverage sought. In spite of these initial challenges, this policyholder was able to obtain the needed coverage by taking other approaches that will be discussed later in this report.

Brokers and policyholders mentioned these difficulties have been more severe in certain locations in Manhattan than anywhere else. In particular, they said the area surrounding Times Square—or midtown—and lower Manhattan, which contained the World Trade Center, presents difficulties because of the dense concentration of buildings, perceived risk of a future terrorist attack, and the overlapping insurance needs of building owners and tenants. For example, one broker active in the New York market told us of an approximately 15-block stretch of midtown Manhattan with a high concentration of property values in which each property is valued at $1 billion or more, creating strong demand by building owners for limited and expensive coverage. Another broker told us the availability of terrorism coverage is most constrained in the area surrounding the World Trade Center site in lower Manhattan. The brokers said retail clients that would like to establish themselves in this area worry about not enough coverage being available for terrorism, flood, and fire damage.

Representatives from large national brokers, as well as insurance companies and other industry participants, said that certain policyholders in Chicago and San Francisco also may face initial challenges in obtaining terrorism insurance coverage, although to a lesser extent than in Manhattan. As is the case in Manhattan, these policyholders typically own large buildings in proximity to other buildings and generally are located in financial districts or downtown locations. While owners of large buildings in such locations may face challenges in obtaining coverage, a broker told us that even a small building might be difficult to insure for terrorism risk if it were located near larger properties in high-risk areas.

Many industry participants reported that premiums were higher in cities considered to face greater financial risks from the likelihood of terrorist attacks occurring there, adding to the challenge of obtaining terrorism coverage. For example, according to one large insurance broker, terrorism insurance premiums in New York City can be twice as high as prices for similar buildings in other cities considered to be at high risk of a terrorist attack, and more than five times higher than prices in lower-risk cities. The premium amount dedicated to insuring properties in certain locations against terrorism risks may, on a relative basis, significantly exceed the amount necessary to cover such risks in other geographic areas. For example, a broker in the San Francisco Bay area told us average terrorism pricing for owners of certain buildings there can be from 20 to 30 percent of the all-risk property premium, whereas the national median was around 4 percent in 2007.

While some policyholders in high-risk cities face challenges, we note that this is not necessarily the case in all such cities. In particular, policyholders we contacted with properties in Washington D.C. said while it may have been difficult or more expensive to obtain terrorism coverage immediately following September 11, coverage is now readily available and affordable. For example, policyholders we interviewed that own properties in the city said they were able to include full terrorism coverage in their all-risk property policies even though they own or manage commercial and residential properties in proximity to potential targets such as the White House, the Capitol, subway stops, or foreign embassies. Industry participants said that policyholders generally experience fewer challenges in Washington, D.C. because the buildings are not as high or as densely concentrated as in downtown areas of other high-risk cities.

To Obtain Full Terrorism Coverage, Policyholders May Add Additional Carriers to Existing Insurance Programs, Purchase Terrorism-only Policies, or Self-Insure

Policyholders that have experienced initial difficulty obtaining terrorism coverage in their primary all-risk property policies generally have been able to meet current terrorism insurance requirements by one of several approaches or a combination thereof, according to industry participants. For example, some policyholders and brokers reported obtaining coverage from a greater number of insurers in what may already have been a complex insurance program. As discussed earlier, policies with high insured values can require multiple insurers to provide portions of coverage up to the full amount of the policy. However, a few policyholders told us more insurers are now required to assemble terrorism coverage because insurers are taking smaller amounts of risk (that is, offering smaller amounts of coverage), requiring a greater number of insurers to fill out an insurance program and adding to what can be a time-consuming and complicated process for policyholders and their insurance brokers. Some policyholders said more than 20 insurers may participate in a single insurance program. One policyholder told us more than 40 insurers participate in its property insurance policy. Layering an insurance program has costs, especially for large and complex programs. A representative of a large hotel chain told us that layering insurance is “painful” because of the effort involved in convincing insurers to become comfortable with a risk.

Moreover, several brokers and policyholders reported purchasing property terrorism insurance in a stand-alone policy to cover portions or all of the required coverage. For example, the owner of multiple large office buildings in Manhattan’s midtown and downtown financial districts told us the company purchased all of its terrorism coverage as a stand-alone insurance policy because it could obtain just half of the $800 million in coverage sought. Another policyholder that owns a nationwide chain of hotels, with properties in Manhattan, Chicago, and San Francisco, decided to purchase all of its terrorism coverage in a stand-alone policy to avoid the high and inconsistent cost of embedding terrorism coverage in its all- risk policy. A representative of this policyholder noted that cost was a particular issue following the 2005 hurricane season when property insurance prices generally increased. Some policyholders told us stand- alone terrorism coverage was more expensive than obtaining coverage as part of an all-risk property policy. However, data from a national broker show that the difference in pricing between stand-alone coverage and coverage included in an all-risk policy was small for most of 2007, with the median price for stand-alone coverage at 5 percent of the overall property premium compared to around 4 percent for coverage in the all-risk program.

Finally, according to brokers and policyholders some policyholders have used self-insurance as a means to assemble coverage. That is, they placed all or a portion of their terrorism coverage in a captive insurance company, which insures the risks of the owner. For the purpose of insuring property terrorism risk, a captive insurer would generally be a wholly owned insurance company within the corporate structure of the property owner. The typical owners of captives used for insuring terrorism risk are large corporations that own large or well-known buildings in major urban areas and have not been able to obtain coverage through other means. For example, a policyholder we contacted sought to obtain $1.2 billion in property coverage for multiple buildings in Manhattan, including terrorism coverage, which would cover the total replacement cost of the largest building in its portfolio. However, a representative of this policyholder told us the company could obtain just $500 million of all- risk property insurance that included terrorism coverage, leaving a gap of $700 million in coverage for terrorism risk. The policyholder considered filling the gap by obtaining terrorism coverage in the form of a more expensive stand-alone insurance policy, but decided instead to establish a captive insurance company to supplement the coverage provided in the all-risk policy and make up the $700 million difference. Another policyholder with a lender requirement to purchase about $1.6 billion in coverage on a single building in midtown Manhattan was unable to obtain sufficient terrorism coverage in an all-risk policy in 2008. This policyholder purchased an all-risk policy that excluded terrorism risk and assembled property coverage for terrorism risk in the form of a $250 million stand- alone policy and about $1.3 billion in a newly formed captive insurance company. Although these examples show policyholders may create captive insurance companies for the sole purpose of insuring terrorism risk, this approach may not be typical of the way in which captives are used. Representatives of two large insurance brokers said most companies simply add terrorism risk to captives that already have been established to cover other insurance risks, such as environmental and product-recall risks.

Insurer and Reinsurer Efforts to Mitigate Their Risks Appeared to Be Why Certain Policyholders Faced Initial Challenges in Obtaining Terrorism Insurance Coverage

While TRIA limits insurers’ potential losses from a terrorist attack, the efforts of insurers’ to manage the remaining risks they faced appeared to be the primary reasons for certain policyholders experiencing initial challenges in obtaining desired amounts of coverage at prices they viewed as reasonable. To mitigate their risks, many insurers set limits on the amount of coverage that they would provide to policyholders in confined geographic areas within a city, such as downtown locations or financial districts where many large buildings are clustered, or in specific areas of cities considered to be at high risk of attack. According to a variety of sources we contacted, these limits generally make obtaining coverage more difficult or costly for certain policyholders in these areas. Further, industry participants and analysts said that the availability of reinsurance and the views of credit rating agencies also may limit the supply and increase the price of terrorism insurance coverage in certain high-risk cities.

Insurers’ Concerns about Amounts of Future Terrorism Losses Influence Their Willingness to Provide Coverage, Affecting Availability and Price in Certain Cities

Representatives from several insurance companies we contacted said that despite the TRIA financial backstop, they remain significantly concerned that a future terrorist attack would result in substantial losses. In the event of another terrorist attack, industry participants said that certain large insurers may face TRIA deductibles that would result in losses of billions of dollars. For example, one of the largest insurers providing commercial property coverage would face a $5 billion TRIA deductible based on 2007 data. The representative of one large insurer said that the company’s TRIA deductible was three times the net losses the company suffered due to the September 11 attacks. Furthermore, even a terrorist attack that caused losses below the $100 million TRIA program trigger could cause substantial losses to a small insurer. For example, the company surplus might be exhausted from paying the entire loss, according to the representative of a small insurer.

Insurers said that they seek to mitigate potential losses from a single terrorism attack by limiting the amount of property coverage that they offer in confined geographic areas within cities. For example, some insurers told us that they would not insure certain types of properties, buildings over a certain size, or buildings near others that might be considered terrorist targets. In addition, several large insurers and brokers told us that insurers limit the terrorism insurance they provide in these areas to amounts well below their TRIA deductible.

To help insurers determine how much risk, or coverage, they can write in any given location, several industry participants we interviewed said insurers often use computer models to estimate the effect, or severity, of terrorist attacks on their existing book of business. Using models available from risk-modeling firms, insurers can map the locations of properties they cover as well as other types of coverage they provide in the area such as building contents, business interruption, or workers’ compensation. Therefore, insurers can consider the extent to which one terrorist attack could trigger losses among multiple lines of insurance. The models also can map the locations of nearby properties considered to be potential terrorist targets. With these mapped locations, an insurer is then able to identify areas where it has the greatest aggregated exposure within a city. The modeling program places a circle around a specific location, such as a building in the insurer’s book or a potential terrorist target, and aggregates the amount of exposure an insurer has within this defined area. These models take into account the severity of various attack scenarios on properties in the area (for example, a 5- or 10-ton truck bomb) and allow users to quantify potential losses under different attack scenarios.

Insurers we interviewed noted that they are not as comfortable with the estimates of the probability, or frequency, of an attack, from these models and, therefore, make more limited use of this information. While insurers and risk-modeling firms have access to large historical databases and scientific studies of the frequency and severity of natural catastrophes, such as hurricanes, the data on terrorist attacks are limited. Furthermore, according to industry analysts, the tactics, strength, and effectiveness of terrorist groups can be very unpredictable, so predicting the frequency of such attacks is very difficult and perhaps impossible. For example, terrorists might respond to increased security measures in one area by shifting attention to more vulnerable targets in another. Without more information, industry analysts note that it is difficult for modeling firms to make projections about the capability and opportunities of terrorists to undertake future attacks.

While insurers find estimates of the probability of a terrorist attack of limited use, they often use the estimates of the severity of potential attacks in determining the amount of coverage they are willing to provide. Considering potential attack scenarios and estimated losses from the models, insurers impose internal limits, referred to here as aggregation limits, on the amount of all types of coverage they will offer in defined areas. Depending on the amount of capital and risk tolerance of the company, insurers determine the amount of coverage they are willing to provide in defined geographic areas within a city, such as in 250-foot, 500- foot, or quarter-mile circles around certain landmarks or areas where the insurer has high concentrations of risk. Insurers then monitor the amount of coverage that they provide in these areas on an ongoing basis to ensure that they do not exceed their aggregation limits. As shown in figure 3, an insurer might decline to provide any coverage for a new property since adding the property to the book of business would exceed the insurer’s aggregation limit on exposures within the defined area. Alternatively, an insurer might charge a higher price or offer a lower coverage limit if adding the property would exceed the aggregation limit.

The amount of coverage insurers are willing to provide in these defined areas may change frequently as new clients or properties are added to or removed from their books of business. An insurer may have available capacity in a specific area one month, but be near its limit the next. For example, one policyholder noted that her real estate investment company contacts its insurer before considering acquiring a new property to determine if the insurer has capacity where the new property is located. Although the insurance company may decide it can provide property insurance for the building at the time of the request, the policyholder said that when the acquisition is completed several months later, the insurance company may no longer have the capacity available to insure the building. In that case, the policyholder said that the company might have to purchase a stand-alone terrorism policy for that particular building, which the policyholder reported as being more expensive than simply adding it to the existing portfolio. As a result, the policyholder said it might no longer be profitable for the company to acquire the new building. In some cases, this policyholder said the company has canceled or deferred an acquisition until it simultaneously disposed of a building in the same area to be sure that the insurer would have capacity available for the new building. However, several other policyholders we interviewed said that any concern about the availability of insurance has not affected their companies’ acquisitions or development projects.

Availability of Reinsurance Also Can Affect Insurers’ Willingness to Provide Terrorism Coverage

Insurers and other industry analysts cited the limited availability of reinsurance as another factor influencing insurers’ willingness to provide terrorism coverage in certain areas. Reinsurance plays a crucial role in insurance markets by permitting primary insurers to transfer some of the risks that they incur in offering coverage. In so doing, reinsurance may allow primary insurers to offer additional coverage than otherwise would be the case while mitigating potential losses.

Insurers and other industry participants we contacted said that reinsurance for terrorism risk, which largely was unavailable after September 11, continues to be expensive and available in limited amounts. In a 2004 report, we found that reinsurers had reentered the terrorism insurance market cautiously, but that the amount of coverage offered to primary insurers was limited and the premium rates were viewed as high. In conducting our current work, reinsurers and industry analysts said that reinsurance capacity for terrorism has continued to increase for a variety of reasons including an influx of new capital into the industry, the absence of another terrorist attack, and improvements in insurers’ ability to underwrite the risk. However, insurance brokers and large insurers with significant exposures in urban areas told us that terrorism often still is excluded in reinsurance contracts and that insurers have been able to purchase only limited amounts of very expensive coverage. A recent Congressional Budget Office report similarly found that the ability of primary insurers to transfer terrorism risk to reinsurers is limited.

As has been the case with primary insurers, the efforts of reinsurers to manage their aggregation levels appear to be why the coverage that they offer for terrorism is limited. The provision in TRIA requiring insurers to offer terrorism coverage at terms and conditions that do not differ materially from other coverage does not apply to reinsurance transactions, so these companies have discretion in deciding how much terrorism coverage to offer to primary companies. Reinsurance company representatives told us that the location of the insured risks is an important factor that influences whether they will offer reinsurance and at what price. For example, one reinsurance company representative said that the company was less willing to write contracts covering properties in cities viewed to be at high risk of terrorist attack. Others said that while their companies still would be willing to reinsure an insurer’s book of business with concentrations of risk in multiple high-risk cities, they might offer more expensive coverage to compensate for the increased risk and the increased capital they need to maintain to back up the risk.

Views of Rating Agencies Also May Influence the Availability of Terrorism Insurance for Some Policyholders in Areas Viewed as at High Risk of Attack

Insurers and reinsurers cited the views of rating agencies on the amount of capital insurers allocate to terrorism risk and the location of risks they insure as other factors influencing their willingness to provide terrorism coverage. Rating agencies assess the financial strength of companies and the credit quality of their obligations. Maintaining a high rating can be very important for an insurance company’s business because a firm with a low rating may, among other things, pay a higher interest rate on its debt. In addition, several policyholders and lenders told us many lenders that require their mortgagees to carry terrorism coverage also require that they use only highly rated insurers. A variety of industry participants and analysts told us that rating agencies’ views can be very influential on the amount of capacity insurers decide to allocate to terrorism risk, affecting how much coverage they provide to policyholders. For example, one reinsurance industry analyst noted that the amount of capital rating agencies required insurers to maintain to support terrorism risk was significant. The representative said that these requirements may encourage insurers not to offer this type of business because it is difficult to maintain large amounts of capital and earn an adequate return on the money.

In conducting their assessments, representatives of the rating agencies we interviewed said they look closely at insurers’ terrorism exposures. They request specific information about the types of policies insurers write, the risks in their books of business, the steps insurers take to manage their risks, and whether they have concentrations of risk in any areas, including large urban areas or cities considered to be high risk. With workers’- compensation insurers, the rating agencies request information about the number of employees at different locations across the different insureds. As a result of discussions with the rating agency about the company’s rating, rating agency representatives said that some companies have purchased additional reinsurance or divested risk.

Various Proposals to Increase the Availability and Affordability of Terrorism Insurance Coverage Have Both Advantages and Disadvantages

Insurance industry participants and analysts did not express consensus on whether TRIA should be modified or additional actions taken to increase the availability of terrorism insurance coverage. They cited a variety of advantages and disadvantages associated with five proposals that have been offered in legislation, discussed in our prior reports, or suggested by industry participants to increase the availability and perhaps limit the cost of terrorism insurance. These proposals include lowering insurers’ TRIA deductibles following large terrorist attacks, permitting insurers to establish tax-deductible reserves for future terrorism losses, forming a group of insurance companies to pool assets for terrorism losses, facilitating the issuance of onshore catastrophe bonds through changes in the tax code, and limiting certain state regulations and requirements. We note that improvements in terrorism insurance coverage and pricing that might result from the adoption of some of these proposals (such as tax- deductible reserves, insurance pools, and catastrophe bonds) likely would take place over the longer term and that such proposals could increase the federal government’s exposure to terrorist-related losses or otherwise reduce federal revenues.

Option 1: Lowering Insurers’ TRIA Deductibles following Large Terrorist Attacks

One recent legislative proposal to increase the availability of terrorism insurance coverage involved lowering the TRIA deductible for insurers from future terrorist attacks after they experience losses. Under this proposal, if there were a terrorist attack that resulted in more than $1 billion in damages, the insurer deductible under TRIA immediately would be reduced to 5 percent (from 20 percent) for those insurers suffering losses in the attack. Table 1 below shows the potential effect on the deductibles of five large insurers under this proposal.

Because this proposal was designed to significantly reduce potential industry losses, some insurers and industry participants we contacted said that it might make them more willing to offer coverage in areas affected by a future attack. As a result, supporters of the proposal argue that it would stabilize insurance markets in affected areas and facilitate rebuilding and recovery efforts. Moreover, the representative of one large insurer said that if the deductible was lowered to 5 percent, the insurer immediately would be willing to write more terrorism coverage, especially in downtown areas of larger cities. Since the insurer would be able to access the federal reimbursement at a lower level, the insurer’s potential losses on its current book of business would be lower, thus freeing up additional capacity for terrorism coverage without having to purchase reinsurance from the private market to cover the additional risk.

While other insurers and industry participants we contacted were not necessarily opposed to this proposal, they remarked that its effects might be limited. As discussed previously, some large insurers already try to limit potential losses associated with a future terrorist attack to levels well below their current TRIA deductible of 20 percent of direct premiums. Therefore, it is not clear what effect lowering the TRIA deductible would have for such insurers in terms of the terrorism coverage that they are willing to offer. Second, as also discussed earlier, there may be significant market disruptions associated with another terrorist attack, which could limit coverage availability even if the federal government did assume greater liability for associated losses. For example, reinsurers, which are not subject to TRIA’s requirements to make terrorism coverage available, again might limit the coverage they were willing to provide in the wake of another attack, which might limit the amount of coverage that primary insurers could offer. In addition, as happened following Hurricane Katrina, ratings agencies might increase the capital requirements or other standards insurers must follow to maintain and improve their ratings, potentially further limiting insurers’ willingness to continue providing terrorism coverage in certain areas. Further, we note that lowering the TRIA deductible would increase the federal government’s potential liability for terrorism-related losses.

Option 2: Permitting Insurers to Establish Tax- Deductible Reserves for Future Terrorism Losses

Another option would permit insurers to establish tax-deductible reserves, over a period of years, to cover the potential losses associated with future terrorist attacks. Under current federal tax law, insurers can take a deduction for losses that already have occurred and for setting aside reserves for fair and reasonable estimates of the amount the insurer will be required to pay on future losses. However, reserves for uncertain future losses are not currently tax deductible. Because the size and timing of terrorist attacks are uncertain, any reserves set aside for potential terrorism losses would be taxed as corporate income in the year in which they were set aside.

We have reported previously that amending the tax code and permitting insurers to establish tax-deductible reserves could provide insurers with financial incentives to increase their capital and thereby expand their capacity to cover catastrophic risks, such as terrorism. We also reported that supporters of this proposal argued that establishing such reserves would lower the costs associated with providing coverage and encourage insurers to charge lower premiums, which could increase coverage among policyholders. In addition, industry participants we interviewed said if insurers were able to establish tax-deductible reserves, a large terrorist attack could cause less of a strain or shock to industry surplus, or capital, which could help prevent insurer insolvencies in the wake of an attack.

However, several important challenges and tradeoffs may be associated with this option. For example, some industry participants we contacted said it would be difficult for insurers to determine the amount of funds to contribute to such a reserve each year because of the significant challenges associated with estimating the frequency of potential terrorist attacks. Without a reliable method for conducting such estimates, insurers would lack an analytical basis for reserving funds to cover potential losses.

Furthermore, we have reported that overall terrorism insurance capacity might not increase because insurers might use the reserves as a substitute for reinsurance that may have been purchased previously to manage the risks of potential terrorist attacks (reinsurance premiums are already tax- deductible). Because reserving also would convey tax advantages, some insurers might feel that they could limit the expense of purchasing reinsurance. To the extent that insurers reduced their reinsurance coverage in favor of tax-deductible reserves, the industry’s overall capacity would not necessarily increase. Insurers also might use the reserves to shield a portion of their existing capital (or retained earnings) from the corporate income tax or inappropriately use tax-deductible reserves to manage their financial statements by increasing the reserves during good economic times and decreasing them in bad times. Finally, we note that this proposal likely would reduce federal tax revenues.

Option 3: Forming a Group of Insurance Companies to Pool Assets for Terrorism Risks

Another proposal involves establishing a group of insurance companies to pool their assets, which may allow them to provide a greater amount of terrorism insurance coverage than could be provided by individual companies acting independently of one another. Insurance pools typically are formed to cover large risks, such as hurricanes, which traditional insurance markets do not address readily. For example, a pool could be created at the national level or state level; it could involve mandatory or voluntary participation from insurers; it could be prefunded or postfunded; and if losses exceed the reserves of the pool, the government could provide a financial guarantee or the pool could draw on some other method such as issuing bonds or borrowing funds to make up any shortfall. Table 2 shows that insurance pools have been established in Florida to cover hurricane risks and in the United Kingdom for terrorism risks.

In addition to these programs, one large insurance broker, in consultation with several industry groups, has developed a proposal to form a $40 billion national reinsurance pool for commercial property terrorism risk. Under this proposal, all insurance policies would cover losses from acts of terrorism and insurers would continue to charge policyholders their own rates for terrorism coverage in accordance with state laws. Insurers would purchase reinsurance coverage from the pool, which would determine its reinsurance premium rate based on analysis of a range of potential losses in urban, suburban, and rural areas. The claim reserves of the pool would be tax-exempt, allowing it to accumulate reserves tax-free from which to pay future losses. In the event of a certified terrorist attack, the insurance industry would pay 5 percent of losses and the pool would pay 95 percent of losses up to $40 billion. In the event the pool did not have the resources to pay its share of losses, the pool would be funded through the issuance of bonds. The federal government would be responsible for losses in excess of $40 billion up to $100 billion. According to the plan, losses above $100 billion would be reviewed by Congress.

Some industry participants we contacted expressed general support of an insurer pool to enhance the availability of terrorism insurance coverage. For example, they said a pool could allow insurers to transfer a significant portion of their terrorism-related risk to an outside entity over time, and they could use the accumulated surplus in the pool to provide higher amounts of coverage in the future. Industry participants also noted that a national pool would spread out terrorism risk across a wider base of policyholders of varying risk levels than individual insurers could do alone and would allow insurers to better manage their total accumulations of terrorism risk.

However, several challenges and disadvantages also may be associated with this option. For example, as is the case with tax-deductible reserves, it may be difficult to develop a reliable basis for determining the appropriate size of the pool because of the inherent challenges in estimating the frequency of terrorist attacks. Moreover, other information suggests that insurance pools would not necessarily increase the industry’s capacity or ability to offer additional terrorism insurance coverage. According to a study by a global consulting firm on a proposed workers’-compensation pool for terrorism risk and other industry participants, a reinsurance pool might not create new industry capacity or bring in additional capital to support writing more business. The study notes that if the industry as a whole does not have enough capital to manage terrorism risk, then neither can an industry pool that simply combines existing industry capital in a new structure. Furthermore, we note that if premiums paid to the pool were tax deductible as are traditional reinsurance premiums, insurers simply might substitute pool reinsurance for traditional reinsurance, as might be the case with tax- deductible reserves for individual insurers. Finally, if the pool was a tax- exempt entity, tax-deductible reserves for an insurance pool could reduce federal revenues.

Option 4: Facilitating the Issuance of Onshore Catastrophe Bonds through Revisions to the Federal Tax Code

Another proposal is that the federal government establish certain tax advantages for catastrophe bonds, which supporters argue could facilitate their use for covering terrorist attacks. Catastrophe bonds generally have been issued to cover natural events, such as earthquakes or hurricanes, rather than terrorist attacks and historically have been created in offshore jurisdictions where they are not subject to income or other tax. Under this proposal, tax treatment of catastrophe bonds would be similar to the treatment received by certain issuers of asset-backed securities, which generally are not subject to tax on the income from underlying assets that is passed on to investors. We previously reported that the total costs of issuing catastrophe bonds—including transaction costs such as legal fees—significantly exceed the costs of traditional reinsurance, which may have limited the expansion of the market. Facilitating the creation of onshore transactions by changing the tax code to encourage issuance of catastrophe bonds within the United States could reduce transaction costs.

Some insurance industry participants we contacted said that catastrophe bonds, by tapping into the securities markets, offered the opportunity to expand the pool of capital available to cover terrorism risk. They also said that amending the tax code to facilitate the bonds’ issuance in the United States could be beneficial in achieving that goal. However, many industry participants said, consistent with findings in our previous reports, that the development of catastrophe bonds for terrorism risks involves significant challenges. These challenges may greatly exceed any benefit that would be derived from amending the tax code. As with other options discussed previously, the industry participants said that because of the difficulties associated with estimating the frequency of terrorist attacks, it would be very difficult to structure a catastrophe bond for terrorism that would be acceptable to investors. Data are available on the historical frequency and severity of natural events, such as hurricanes and earthquakes, which helps investors assess the risks that they face in purchasing catastrophe bonds for such risks. Without similar data for terrorist attacks, it is unlikely that a viable market for catastrophe bonds will be established regardless of revisions to the tax code that are designed to help ensure such an outcome. We also have previously reported that the federal government could lose tax revenue under this option and that the proposed changes to the tax code might create pressure from other industries for similar tax treatment.

Option 5: Revising Certain State Regulations and Insurance Coverage Requirements

Some industry participants have suggested that states could take certain actions to revise their insurance statutes or regulations to increase insurer capacity for terrorism risk, including amending rate regulation policies and laws on coverage requirements. While, according to information from NAIC, most state insurance regulators do not review rates for large commercial property/casualty insurance contracts, several insurance company representatives said that their ability to charge risk-based prices for terrorism coverage was constrained by insurance statutes and regulations in certain states and the prices these states approved did not reflect the risk to which the insurers were exposed. Additionally, a few industry participants said that terrorism insurance availability may be limited in states that have adopted the Standard Fire Policy (SFP). Under the SFP, property insurers are required to cover losses from fire regardless of the cause of the fire, including a terrorist attack, even if the policyholder declined terrorism coverage. Consequently, the industry participants said that the SFP influences the amount of property insurance that insurers provide, including terrorism insurance, and the premiums that they charge in states that have adopted it. Therefore, some insurers have suggested that states amend their SFP statutes so that insurers would not be responsible for fire losses resulting from terrorism.

While most states do not regulate prices for commercial property risks, where prices are regulated the state regulators are unlikely to disapprove insurers’ rate requests because insurers are in a better position to judge the necessity of the price than the regulator, as long as the request is generally in line with current market prices, according to a representative from NAIC. In addition, other available information suggests that state actions on rate regulation or coverage requirements may have a limited effect on the availability of terrorism insurance coverage. As discussed in this report, some policyholders, particularly in Manhattan, may face initial challenges in obtaining terrorism coverage at prices viewed as reasonable. However, according to state regulatory officials, New York is one of the states that generally does not regulate premium rates for large commercial properties, so state regulation does not appear to be a significant factor in the city where insurance challenges appear to be most pronounced. On the other hand, unlike several other states, New York and California have not revised the SFP to limit insurer liability resulting from the fires associated with terrorist attacks, according to information from industry analysts. While the SFP may therefore have an influence on the availability of terrorism insurance in such locations as Manhattan and San Francisco, it is difficult if not impossible to determine the influence as compared to other factors in these cities, particularly the potential losses associated with attacks on high-value buildings that may be in proximity to one another.

Agency Comments

We provided a draft of this report to Department of the Treasury and NAIC for their review and comment. In oral comments, Treasury and NAIC officials said that the report was informative and useful. They also provided technical comments that were incorporated where appropriate.

We are sending copies of this report to the Department of the Treasury, NAIC, and other interested committees and parties. We will also make copies available to others upon request. In addition, the report will be available at no charge on GAO’s Web site at http://www.gao.gov.

If you or your staffs have any questions about this report, please contact me at (202) 512-8678 or jonesy@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made major contributions to this report are listed in appendix II.

Appendix I: Objectives, Scope, and Methodology

Our objectives were to describe (1) whether the availability of terrorism insurance for commercial properties is constrained in any geographic markets and the effect of any constraints on pricing and coverage amounts, (2) factors limiting insurers’ willingness to provide coverage, and (3) advantages and disadvantages of some public policy options to increase the availability of property terrorism insurance.

To assess whether the availability of terrorism insurance for commercial properties is constrained in any geographic markets and the effect of any constraints on pricing and coverage amounts, we reviewed relevant literature and compiled and analyzed available data on insurance and reinsurance industry capacity, terrorism insurance take-up rates, and terrorism insurance pricing. We also interviewed representatives of more than 100 organizations with knowledge of the nationwide terrorism insurance market and with expertise in specific geographic markets. Entities with a national perspective included insurer and policyholder trade associations, individual policyholders, national insurance and reinsurance brokers, and insurance and reinsurance companies. We obtained information on specific geographic markets from state regulators, regional insurance brokers and insurance companies, and local property owners. The geographic markets we studied represent locations considered to be at high, moderate, and low risk of exposure to terrorist attacks—Atlanta, Boston, Chicago, New York, San Francisco, and Washington, D.C. We selected these markets based on rankings of locations by risk of terrorism exposure that accounts for the risk of terrorist attacks and the potential for associated losses from the Insurance Services Office, an insurance industry analytics firm. We spoke with representatives of policyholders that own hundreds of properties nationwide, including more than 200 properties in New York City, more than 100 properties in Washington, D.C., at least 30 properties each in Chicago and San Francisco, about 30 properties in Boston and 60 in Atlanta, and numerous properties across the United States including major cities such as Los Angeles and Houston.

These properties included large office towers in major U.S. cities, properties in proximity to high-profile federal buildings, hotels, industrial buildings, hospitals, sports stadiums, and residential properties in locations throughout the United States. The policyholders also represented a variety of industries that included real estate, transportation, financial services, health, hospitality, and entertainment. In addition to one-on-one interviews, we also conducted group discussions with representatives of 14 policyholders at the annual Risk and Insurance Management Society conference in San Diego, California, in April 2008. Although we selected industry participants to provide broad representation of market conditions geographically and by industry, their responses may not necessarily be representative of the universe of insurers, insurance brokers, policyholders, and regulators. As a result, we could not generalize the results of our analysis to the entire national market for commercial property terrorism insurance. We determined that the selection of these sites and participants was appropriate for our objectives and that this selection would allow coverage of geographic areas, key markets, major insurers and policyholders, and other organizations related to terrorism insurance so as to generate valid and reliable evidence to support our work.

To identify the factors limiting insurers’ willingness to provide terrorism insurance coverage, we selected large, national insurance companies to interview based on their market share in the states we studied. These national insurance companies held from 37 to 52 percent of the market share in the states we studied, according to information provided by the Insurance Information Institute. In addition, we interviewed representatives of regional insurance companies in our selected markets. We also spoke to representatives of seven reinsurance companies, including two of the largest worldwide reinsurance companies, risk modeling firms, state regulators, and two credit rating agencies. Although we selected insurers to provide broad representation of size and geographic scope, we could not generalize the results of our analysis to the entire population of commercial property insurers.

To explore the advantages and disadvantages of some public policy options to increase the availability of property terrorism insurance, we relied on our interviews with the industry participants described above. We also interviewed academics who have written on the topic of terrorism insurance, and representatives of research organizations and consumer interest groups. We selected the option that would reduce insurers’ TRIA deductibles in areas affected by a future large terrorist attack from two recent legislative proposals. We selected the other options—allowing insurers to establish tax-deductible reserves, forming a group of insurance companies to pool assets, and facilitating the use of catastrophe bonds through changes in the tax code and amending state regulations or statutes—from literature we reviewed, our prior reports, and interviews we conducted with industry participants. The selected options were representative of the range of possible options. We did not attempt to evaluate the prospective effect of these options and, therefore, did not come to any conclusions about the advisability of implementing these options.

We conducted this audit in Atlanta, Georgia; Boston, Massachusetts; Chicago, Illinois; New York, New York; San Diego, California; San Francisco, California; and Washington, D.C., from January 2008 to September 2008, 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.

Appendix II: GAO Contact and Staff Acknowledgments

Staff Acknowledgments

Wesley M. Phillips, Assistant Director; Farah Angersola; Joseph A. Applebaum; Rudy Chatlos; Andrea Clark; Katherine Bittinger Eikel; Barry Kirby; Rich LaMore; Marc Molino; Jill M. Naamane; Linda Rego; Barbara Roesmann; Kathryn Supinski; Thomas Taydus; and Shamiah Woods made key contributions to this report.