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By Bob Lund,
General Counsel
Minnesota State Fund Mutual Companies
The Terrorism Risk Insurance Act of 2002 (“TRIA”) is scheduled to expire on December 31, 2005, and although bills1 to extend and modify TRIA have been introduced in both chambers of Congress, extension is far from a sure thing. Powerful lawmakers in both the House and Senate want to end the federal government’s involvement as a reinsurer and are demanding a private market solution to the problem of securing terrorism coverage. Moreover, the White House has yet to articulate a position on the future of TRIA.
What is almost certain, however, is that no action will be taken on TRIA extension legislation until after June 30, 2005,  the date by which the U.S. Treasury Department must deliver its report to Congress on the effectiveness of the current TRIA program.
Effectiveness of current TRIA program
As we all remember, insurance markets did not function well in the aftermath of the terrorist attacks of September 11, 2001. Commercial property and casualty insurers2 excluded acts of terrorism from coverage and increased premiums substantially. Reinsurance coverage for terrorist events was virtually nonexistent. This lack of coverage stymied large commercial building projects and further hampered an already reeling economy. In response to this situation, TRIA was designed to be a temporary program with two key objectives—make coverage for foreign terrorism broadly available to businesses that wanted it, and give the private insurance market time to reassess risks and to create a private terrorism insurance market.
According to the Congressional Budget Office, a vocal opponent of TRIA extension, “TRIA has served its purpose of immediately expanding the supply of terrorism insurance. It has also given private insurers time to raise financial capital and improve their models of risk, which have indirectly contributed to increasing the supply of coverage.”3 Although purchases of insurance against terrorism-related losses were initially low under TRIA, they have increased sharply in 2003 and 2004.4
Feasibility of a private market solution
House Majority Leader Tom Delay, R-Texas, is one of the strongest proponents of allowing TRIA to expire in December, thereby requiring the industry to devise a long-term, “free-market” solution. Unfortunately, insurers do not operate in a free market. Workers’ compensation and certain other insurers cannot exclude or limit terrorism coverage, and state insurance regulatory schemes limit the ability of other commercial insurers to modify coverages and to set rates adequately to finance unknowable exposures from manmade disasters like terrorism. In a recent5 statement submitted to the Senate Banking Committee’s Hearing on Oversight of the Terrorism Risk Insurance Program, on behalf of the American Insurance Association, Brian Duperrault, Chairman of ACE Limited, cited four characteristics of terrorism that make the risk of these catastrophic events uninsurable in the private market:
First, while the private sector has made significant progress in terms of accumulation management of terroristic risk, we continue to lack both the necessary capacity and sufficient marketplace data to handle catastrophic terrorism losses on our own. Under certain plausible event scenarios, estimated insured losses from future catastrophic terroristic attacks on U.S. soil could exceed $250 billion. These levels greatly surpass the entire commercial property-casualty industry’s estimated capacity of about $176 billion. * * *
Moreover, private market mechanisms remain insufficient to spread the risk of catastrophic terrorism in a meaningful way. In a 2004 Workers’ Compensation Terrorism Reinsurance Pool Feasibility Study, Tillinghast Towers Perrin cited “lack of capacity” as the primary reason why a voluntary workers’ compensation terrorism reinsurance pool would not be a viable mechanism to handle mega-terrorism risk. This conclusion is not surprising because pooling does not introduce new capacity for the terrorism risk – it merely moves it around for marginal increased efficiency. * * *
Second, the threat of catastrophic terrorism remains real and unabated. The Bush Administration has repeatedly alerted Americans to the increased possibility of terrorist attacks. Since September 11, 2001, the United States has been on a constant, elevated state of alert for terrorist activity. Recently, top intelligence and law enforcement officials from the Administration have reported that terrorists are regrouping and planning possible new attacks against the United States.
Third, private sector information about terrorism risk is incomplete. Contrary to traditional evaluation of insurance risks, information availability and sharing about terrorism risk is asymmetric. Insurers and policyholders do not have – nor should they have – access to classified generalized or specific threat information in the hands of the U. S. government. Therefore, insurers cannot properly evaluate the many complex risks associated with terrorism. This “information vacuum” makes all risk transfer and management decisions about terrorism a dicey proposition.
The relative infancy of terrorism modeling also contributes to the risk’s uninsurability. While modeling firms have worked diligently to produce terrorism risk models to predict terrorism events in the United States, they have not been able to model accurately the frequency of terrorist attacks; the terrorists alone control that variable. These models instead focus only on predicting the impact terrorism has on its victims. * * *
Fourth, while insurers strongly support risk mitigation efforts and are working with policyholders on terrorism risk analysis, mitigation alone cannot remove the terrorist threat or significantly reduce losses from certain types of terrorist attacks, such as those involving nuclear, biological, chemical, and radiological attacks. * * *
As Federal Reserve Chairman Alan Greenspan suggested to the House Financial Services Committee in February of this year, there might be some semblance of terrorism insurance without government involvement, but it’s a market that will not work very well.
Current law a public/private cost-sharing partnership
Although the federal government provides a financial backstop for foreign acts of terrorism under TRIA and also pays the minimal costs of administering the program, insurers have plenty of skin in the game. All entities meeting the definition of “insurer” under the Act (including all state funds) are required to participate in the program and must “make available” coverage for insured losses resulting from acts of terrorism in all commercial property and casualty insurance policies subject to TRIA.
If damages resulting from an act of terrorism are under $5 million, the federal government does not contribute. In other cases, participating insurers would pay all insured losses up to a deductible calculated as a percentage of the insurer’s direct earned premiums during the previous year. In 2005 this percentage is 15%, a deductible that could easily exceed $100 million for many carriers. The federal government covers 90% of losses above an insurer’s deductible; the insurer covers 10%. Even so, the government is entitled to recoup (through surcharges on commercial property and casualty policies) amounts it pays during any year to the extent such amounts have been contributed toward the industry’s aggregate retention for such year. The industry’s retention for 2005 is $15 billion.
Key provisions of extension legislation
The key provisions of the Terrorism Insurance Backstop Extension Act of 2005 (H.R. 1153) introduced in the House by Rep. Michael Capuano, D–Mass., are similar to the operative terms of the Terrorism Insurance Extension Act of 2005 (S. 467), introduced by Senators Robert Bennett, R–Utah and Christopher Dodd, D–Connecticut in February of this year. Both bills extend TRIA for two years (through December 31, 2007) and include a third, run-off year for insured losses on policies issued before January 1, 2008 until such policies expire, but in no event beyond December 31, 2008. Both bills also extend all of TRIA’s provisions to group life insurance and increase the industry’s aggregate retention level to $17.5 billion in 2006 and $20 billion in 2007 and 2008.
Under the Senate bill, individual insurer deductibles would remain at 15% of prior year direct earned premiums throughout the duration of the program. The House version would maintain the deductible at 15% in 2006 but increase it to 20% for 2007 and 2008.
Both bills tie the short-term extension of TRIA to mandatory studies of a longer-term solution. The Dodd-Bennett bill requires the Presidential Working Group on Financial Markets, in consultation with the NAIC and insurer and policyholder representatives, to submit a report to Congress by June 30, 2006 containing recommendations for legislation to address the long-term availability and affordability of terrorism insurance. The House bill requires the Treasury Department to conduct a study and submit a report to Congress on alternatives for expanding the availability and affordability of terrorism insurance after termination of the TRIA program that do not involve a federal financial backstop.
Clearly, either of these bills would be acceptable to the insurance industry. As indicated above, both chambers of Congress have intimated that no action will be taken on these measures until after the Treasury issues its long-awaited report on the effectiveness of TRIA. Accordingly, the big push for passage will probably begin sometime after Labor Day.
Consequences if TRIA not extended
What are the consequences of Congress’ failure to extend TRIA beyond December 31, 2005? One likely scenario goes like this: Terrorism insurance will soon become scarce in all commercial property and casualty lines where terrorism coverage is not mandatory. Where coverage is available it will be priced beyond the reach of most policyholders. Reinsurers will show about as much appetite for covering foreign acts of terrorism as they exhibited before TRIA—little to none. Business activity, especially in the commercial construction and real estate markets, will be disrupted and significantly hampered.
Workers’ compensation insurers may be seeking (futilely) changes in state laws to enable them to exclude acts of terrorism from coverage. In the alternative, they will be exploring ways to finance the added risk of insuring against the uninsurable, unknowable risks of terrorism without a federal backstop. The result will surely be higher insurance premiums, but never high enough to cover the effects of a devastating terroristic event.
And if in this environment a catastrophic nuclear, biological, chemical or other attack occurred, the federal government would end up paying the lion’s share of the costs of reconstruction. Some unlucky insurers, most likely workers’ comp carriers, would be forced out of business, and any remaining private market for voluntary terrorism coverage would soon dry up.
Contrast this scenario with the current TRIA arrangement, under which insurers would share in the risk, make significant payments of insured losses, and even repay much of the government’s contributions over time.
It is critically important to the economy, to the insurance industry and to state workers’ compensation funds that Congress act before the end of 2005 to extend TRIA for two more years. However, what is even more important is for the insurance industry to work together and with trade associations, policy makers, policyholders and others. These groups must unite to devise a long-term solution to manage terrorism risk. Such a solution has to continue to include risk-sharing between the insurance industry and the federal government. Only in this way can we ensure that the industry continues to make needed coverages available and has the capacity to respond appropriately to unthinkable events. Finally, only in this way will the federal government continue to bear the ultimate financial responsibility (and consequences) for protecting us from the risks of nuclear, biological, chemical and radiological attacks.
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