Study Says Terror Reinsurance Backstop Provides Too Little Economic Protection 1446 words 21 June 2005 Best's Insurance News WASHINGTON (BestWire) - While observers anxiously await the imminent release of a U.S. Treasury Department report that many believe will help determine the fate of the federal terrorism insurance backstop, a new monograph commissioned by Rand Corp. suggests the existing program doesn't go nearly far enough. Authored by researchers at Rand's Center for Terrorism Risk Management Policy, and released in connection with a June 20 symposium on the future of terrorism insurance hosted by Rand at the University of Southern California, the study concludes that neither current market responses nor the federal reinsurance program provided under the 3-year-old Terrorism Risk Insurance Act provide adequate protection against economic threats posed by both foreign and domestic terrorists. The study comes as members of Congress await a Treasury survey, due by June 30, on the TRIA program and the current state of capacity for terrorism-related risks. Both House Majority Leader Tom DeLay, R-Texas, and Sen. Richard Shelby, R-Ala., chairman of the Senate Banking Committee, have said the report's recommendations will be crucial to determining whether Congress should extend or reauthorize TRIA, which is set to expire at year end. Though the cost of terrorism coverage has fallen over the program's history -- representing about 4% of total premium for property coverage in the third quarter of 2004, compared with 10% in the third quarter of 2003 -- the study's authors note that take-up rates remain at only about 50%, leaving open the possibility of large uninsured losses even if TRIA is extended. "Instead of allowing TRIA to sunset, particularly in the face of economically motivated terrorist attacks, Congress might prefer to consider policy measures that increase the take-up of terrorism insurance and lower its price," the study's authors wrote. "These measures might include offering subsidies for the purchase of terrorism insurance or providing more risk sharing within the insurance industry in the form of lower TRIA 'deductibles' for insurance companies. With lower individual company deductibles, if the entire industry's backstop remains the same -- the industry 'retention' of $15 billion -- the price of terrorism insurance is likely to fall without increasing costs to taxpayers." Under the TRIA program, the government will provide certain coverage for "certified" acts of terrorism -- those that cause at least $5 million in damage and are committed by foreign interests -- that result in claims on commercial property, business interruption, workers' compensation and general liability lines of business. Reinsurance is provided for 90% of losses, to a cap of $100 billion, on events that cause total damage in excess of 15% of the entire industry's prior-year commercial property and casualty direct earned premium, which is estimated to be between $15 billion and $20 billion for 2004. If a terrorist attack fails to exceed the industrywide retention, then the government will provide "temporary liquidity" to those companies whose losses exceed 15% of their prior year's direct earned premiums, but the program requires those companies to repay those funds over time. According to Aaron Davis, vice president of the U.S.property syndication group at Aon Corp., the Rand study's conclusions about the inability of the private terrorism market to function without some form of backstop mirror the broker's own findings. However, he expressed concern that the report was "based upon the assumption that either TRIA will be reauthorized or some other form of alternative will be presented, and that is not foregone conclusion." "If you talk to any of our clients, we are at the 11th hour in the sense that they are already seeing exclusions being imposed for contracts that have a term that extends being 12/31/05, so it's a very real issue for the industry right now," Davis said. "The further we move along from a time-line standpoint, I think the greater pricing volatility and capacity constraints we're going to see in the market for terrorism. We're already seeing the stand-alone terrorism market simply not being able to offer any capacity at any price." An alternative to securing coverage from an all-risk carrier, the stand-alone terrorism market currently provides about $1.2 billion of per-risk capacity for terrorism risks, of which roughly $500,000 is provided by Berkshire Hathaway Inc., Davis noted. However, writers in the market have limited the aggregate capacity they will devote to any one geographic area, and they are allocating that capacity on a very restricted basis, particularly in areas such as New York, Washington, and Chicago, he added. Critics of the TRIA program have argued that by reducing the market price to insure terrorist risks, it provides disincentives for companies to invest in security and other loss-mitigation strategies, such as greater diversification of financial holdings and operations. During a recent forum hosted by the Center on Federal Financial Institutions, economist Kent Smetters of the University of Pennsylvania -- who published one of the first papers critical of the TRIA program in early 2004 -- said granting companies and insurers the ability to accumulate terrorism reserves tax-free and loosening state insurance regulations that limit the ability of companies to tap the capital markets through onshore securitizations would help provide the essential framework for offsetting terrorism risks through the private market. "Basically, the only type of securitization contracts that are allowed in the U.S. as recoverable assets on primary insurers' balance sheets are contracts that pretty much look like standard insurance contracts," Smetters said. "They have to look like standard indemnity contracts with no basis risk. And that kind of rule undermines the whole point of doing securitization. If we actually had a reasonable policy that allowed for securitization, we could start tapping into the capital markets, and $30 billion losses would seem like nothing." But according to Davis, catastrophe bonds are unlikely to solve the short-term problem of a capacity crunch in terrorism insurance because they rely heavily on modeling to set the price and yield for bond issuances. While noting that terrorism models continue to improve in predicting the severity associated with a wide range of potential events, the lack of historical data and the fact that attacks are man-made place the same limits on the ability to model frequency for bonds that insurers face in underwriting terrorist risks. "That is not to say the capital markets might not present a solution in the long term," Davis said. "They are the most obvious solution. But the market would need to solve the pricing issue associating with those bonds before it would be a realistic approach for most clients." Programs similar to the federal Defense Advanced Research Projects Agency's now-defunct Policy Analysis Market -- which would have allowed investors to place wagers on economic, civil and military futures of Egypt, Jordan, Iran, Iraq, Israel, Saudi Arabia, Syria and Turkey and the impact of U.S. involvement with each -- may hold potential for the industry to get a better gauge of frequency, Davis said, but he added that governmental and private assessments of such risks thus far haven't succeeded in sharing information. "In practice, most of the private firms that are providing any sort of private forecasting or predictive results -- and Aon does this, as well -- tend to keep that information confidential to certain client classes," Davis said. "The real issue in making information like that public or even quasi-public as part of an exchange is that there is so much secrecy that surrounds terrorism mitigation. I think even many of the private firms that would like to disseminate this information have come up against hurdles from the government and others." Another frequent criticism, raised before several congressional committees by J. Robert Hunter, director of insurance for the Consumer Federation of America, is that TRIA currently doesn't require insurers to pay any premium for reinsurance, which some have speculated could lead to a certain crowding out of private reinsurance capacity. J. Stephen Zielezienski, associate general counsel for the American Insurance Association, said the industry could be open to paying a premium for TRIA coverage, so long as the prices were fair and insurers didn't see their rates for the underlying risks suppressed in the marketplace. "The current TRIA deductible is akin to payment for the federal backstop, since our system of government price controls means that we are not taking in sufficient premium to cover that deductible," Zielezienski said. "So, the characterization of TRIA as 'free reinsurance' is incorrect." (By R.J. Lehmann, Washington bureau manager: raymond.lehmann@ambest.com)