RESPONSE OF THE U.S. INSURANCE INDUSTRY AND FEDERAL GOVERNMENT TO THE INCREASED RISK OF TERRORISM

by Charles S. LiMandri, Esq.

The September 11, 2001 terrorist attacks on New York and Washington, D.C. changed the property-casualty insurance marketplace in a day. Terrorism coverage had previously been provided for free to property-casualty policyholders because the United States had been considered immune to terrorist attack. From that day forward, such coverage has become a real and complex problem that must be addressed as the threat of further terrorist attacks remains.

Economic losses resulting from the 9/11 attacks in New York City are forecast to be as high as US$97 billion. Most estimates predict that US$40 to US$50 billion of these losses are covered by insurance. Notwithstanding the paramilitary nature of the attacks and the responsive declaration of "war on terror" by the United States, however, insurers generally refrained from asserting the standard "act of war" exclusion found in most commercial policies.

While such restraint was probably motivated by patriotism - and certainly resulted in good public relations for the insurers - it was also a practical choice. Commentators were virtually unanimous in concluding that the general war risk exclusion would not apply to the 9/11 acts of terrorism. In light of precedential case law, it is unlikely that courts would have enforced the exclusion. This is because the war exclusion is only applicable in cases of: (1) internal strife in the form of an insurrection, rebellion, revolution or civil war which actually attempts to overthrow the government; or (2) a conflict between two sovereign nations or de facto governments. As a result, the insurance industry had to absorb the most catastrophic losses in its history.

In light of the inapplicability of the "acts of war" exclusion, specific "acts of terrorism" exclusions became more common. At the same time, because of the new reality of risk, many insureds sought affirmative coverage for losses resulting from terrorist acts. However, since 9/11, reinsurers generally have been unwilling to assume the risks of terrorism. The ability of insurers to survive catastrophic losses, such as those acts of terror might inflict, depends upon their ability to be reimbursed for at least a part of their losses by reinsurers. Loathe to provide such coverage without reinsurance, some primary insurers have left the marketplace, leaving much of the financial responsibility for future attacks on their former policyholders. Nevertheless, while coverage disappeared for some businesses (which is what happened during the 1980's pollution coverage "crisis" and in the wake of Hurricane Andrew), the good news is that the market did not completely collapse. Terrorism coverage has been available since 9/11; the bad news is that it has been offered at prices which are prohibitively expensive for many policyholders.

Specific capacity and pricing problems in the insurance industry, like the ones currently affecting terrorist act coverage, are not uncommon and are usually self-correcting with time. If we could confidently posit that 9/11 defines the upper boundary of potential terrorist losses in the United States, we might conclude that no new response is required from the insurance industry or the government. Catastrophic losses are not new to the insurance industry, and terrorism arguably stands as simply another kind of catastrophe - - a peril not quantitatively different from various kinds of natural disasters. Hurricanes, earthquakes, volcanic eruptions, tidal waves, and even asteroids - - all have the possibility of causing insured losses in the tens or even hundreds of billions of dollars. In theory, both terrorism and natural disaster losses could be so "mega-catastrophic" that private risk-spreading mechanisms would be rendered insignificant. In that event, government institutions would necessarily become the means of repairing damage and spreading the risk of future losses.

In practice, however, there are important differences between natural catastrophes and terrorism events. The frequency of earthquakes and hurricanes can be estimated by scientists based on past experience and sophisticated predictive models. In contrast, terrorism involves human-caused losses, the timing, severity, and frequency of which are not subject to reliable predictability based on past events. The problem is that we cannot be certain that the upper boundary has been reached, and we are uncertain about where the mean now rests in the distribution of terrorism losses. One lesson learned from 9/11 is that the mean loss level with respect to terrorism exceeds all prior estimates. This lack of predictability raises doubts about the capacity of the industry to cope with future attacks by terrorists.

While the financial capacity of the property-casualty industry is finite, the potential harm that terrorists can inflict could produce practically limitless losses. Until the uncertainty surrounding the terrorism risk abates and markets stabilize, problems of cost and availability will persist. This has been true in other insurance sectors in the past, and temporary dislocations do not necessarily justify government intervention. In fact, as noted above, private markets have demonstrated admirable resiliency in the aftermath of 9/11.

However, if the industry were required to face a second 9/11-type event, the industry's weakened condition could produce a much different scenario. Moreover, there looms the possibility of a mega-catastrophe - - or series of smaller events in close succession that would have the cumulative impact of a mega-catastrophe - - that could overwhelm the insurance industry. More stability and predictability are needed in the marketplace before insurers can reasonably assess, measure, and spread the risks of terrorism. All of this suggests the desirability of a role for the federal government.

One way the federal government could become involved in terrorism coverage would be to provide insurance directly, totally displacing the private markets. Another approach would be for the government to create a reinsurance company covering acts of terrorism. Yet another way would be to have the federal government share the risk along with private entities. The challenge of crafting this last approach is to design a system that requires insurer participation in bearing an appropriate share of the risk and in compensating losses, while not placing disincentives on the private placement coverage. The advantage is that such a system can be adjusted or dismantled as private markets improve their ability to underwrite terrorism coverage and manage this previously unfathomable risk.

The governmental risk sharing approach involves underwriting the portion of the terrorism risk that is beyond the industry's capacity to absorb. This kind of limited backstop would cap the industry's losses. It makes explicit what is already commonly understood: if a mega-catastrophe were to occur, the government would provide disaster assistance after the fact. By making this informal understanding explicit, the federal government could play a useful role in facilitating a market for affordable coverage. This, in general terms, is the approach which the U.S. Congress has adopted in creating a federal backstop program.

Almost immediately after 9/11, the U.S. insurance industry began working with the White House and Congress to manage the crisis. They sought to develop a transitional mechanism that could address the capacity and pricing problems that the industry was facing until the insurance marketplace could functionally deal with terrorism risks. Several proposals were considered, including a "pooling" arrangement favored by actuarial experts, that is modeled after programs in the United Kingdom and Israel. Eventually, a temporary federal backstop program, mirroring the risk-sharing relationship between primary insurers and reinsurers, was designed and introduced through legislation on Capitol Hill.

Terrorism Risk Insurance Act of 2002

On November 26, 2002, President George W. Bush signed the Terrorism Risk Insurance Act of 2002 ("TRIA") into law. The law creates a federal terrorism reinsurance program to serve as the federal backstop for insurers in the event of future terrorist attacks. TRIA establishes the "Federal Terrorism Insurance Program." The Program will administer a system of shared public/private compensation for insured losses, resulting from acts of terrorism, in order to protect consumers and create a transitional period for private insurance markets to stabilize.

Under TRIA, property and casualty insurers are required to "make available" coverage for losses resulting from certain intentional acts of terrorism, which coverage had been excluded from many policies since the terrorist attacks of September 11, 2001. In essence, terrorism becomes a covered peril. However, subject to a premium-based deductible, insurers will be reimbursed by the federal government for 90 percent of their terrorism-related losses. TRIA does not establish prices for terrorism insurance; the power to regulate premium rates remains with the states. TRIA is intended to serve as a temporary program; it is scheduled to terminate after three years, on December 31, 2005.

The following is a summary of the key provisions that comprise TRIA, along with some observations regarding its implementation:

Definition of Terrorism

An "act of terrorism" under TRIA is an act certified by the Secretary of the Treasury in concurrence with the Secretary of State and the Attorney General:

• To be an act that is dangerous to human life, property or infrastructure;
• To have resulted in damage within the United States¹ (or outside the United States in the case of U.S. airliners or ships);
• To have been committed by an individual or individuals acting on behalf of any foreign person or foreign interest, as part of any effort to coerce the civilian population of the United States or to influence the policy or affect the conduct of the United States Government; and
• To have resulted in property and casualty insurance losses in excess of US$5,000,000.

Acts which otherwise meet these criteria but that occur in the course of a war declared by Congress cannot be certified as acts of terrorism under TRIA². The certification (or determination not to certify) by the Secretary of the Treasury is final and not subject to judicial review.

Thus, TRIA brings into the federal backstop only that terrorism that is motivated by a foreign influence. Domestic terrorism or terrorism losses that occur outside the United States, or in the course of a declared war, do not fall within its scope.

Applicable Insurers/Insurance

TRIA applies to any insurer that is:

• Licensed or admitted to engage in the business of providing primary or excess insurance in the United States;
• Listed as an eligible surplus lines carrier by the National Association of Insurance Commissioners ("NAIC");
• Approved by a federal agency in connection with maritime, energy or aviation insurance;
  
  

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  ¹ In addition to each of the fifty States, the "United States" includes: the District of Columbia, Puerto Rico, the Northern Mariana Islands, American Samoa, Guam, the U.S. Virgin Islands, any territory or possession of the United States, and the territorial sea and continental shelf of the United States, as well as any U.S. mission (embassy or consulate).

  ² Unlike other lines of coverage, workers' compensation losses resulting from acts of war are covered by the program.

• A state residual market insurance entity or workers' compensation fund; or
• Determined by the Secretary of the Treasury to otherwise fall under TRIA. (TRIA authorizes the Treasury Secretary to extend coverage to additional captive insurance companies, as well as to self-insurance arrangements such as workers compensation self-insurance programs and state workers compensation reinsurance pools, and to group life insurers. However, any such determination must have been made prior to an applicable act of terrorism).

TRIA applies to commercial lines of property and casualty insurance, including excess insurance, business interruption insurance, workers' compensation insurance, and surety insurance. It does not apply to crop insurance, livestock insurance, private mortgage insurance, financial guaranty insurance issued by monoline financial guaranty insurers, medical malpractice insurance, health or life insurance (including group life insurance), flood insurance provided under the National Flood Insurance Act, or to reinsurance.

If a foreign or alien insurer is not on the NAIC Quarterly listing of Alien Insurers, it is probably not subject to TRIA. Initial indications from the NAIC is that the language is intentionally vague in this area so that type of entity (e.g., a nonadmitted, alien Bermuda company not listed in the NAIC's Quarterly Listing) can avail itself of TRIA's reinsurance protections and the accompanying mandatory offer of coverage - if it elects to do so. That is, the Treasury Department will not compel its participation in the TRIA program. Many such carriers operating in Bermuda, Europe and elsewhere are electing to interpret the law as not applicable to their business.

Mandatory Availability of Terrorism Insurance; Limited Preemption of State Law

Between November 26, 2002 and December 31, 2004, every property and casualty insurer must "make available" terrorism coverage in all of its insurance policies (existing and new), in amounts and on conditions that do not differ materially from those offered by that insurer for other types of risks. Prior to September 1, 2004, the Secretary of the Treasury will determine whether this requirement should be extended through December 31, 2005.

TRIA nullifies any terrorism exclusions in existing commercial property and casualty policies (in other words, virtually all the standard forms in place as of the date of enactment) - - to the extent such exclusions preclude coverage for losses resulting from "acts of terrorism" as defined in TRIA.³

³ ISO and AAIS, the two major insurance policy-drafting and statistical bureaus, are moving quicky to file new endorsements that address terrorism risks not included in the federal Program. They have already filed certain endorsements for use with policies currently subject to a terrorism exclusion, including:

Likewise, state regulatory approval of such terrorism exclusions is voided by TRIA to the extent the approved exclusions eliminate coverage as mandated under TRIA. These provisions of TRIA leave untouched those elements of existing terrorism exclusions that deal with terrorist activity outside the scope of the federal Program - - acts of domestic terrorism, for example, or terrorism losses that do not reach the US$5,000,000 threshold.

An insurer may reinstate a terrorism exclusion that was in effect on November 26, 2002 if:

• The insurer obtains written authorization to do so from the insured; or
• The insured fails to pay any increased premium for the terrorism coverage after 30 days' notice.

Thus, an insured may elect to pay an additional premium for the terrorism coverage or to reinstate the terrorism exclusion for the remainder of the policy period.

Primary and excess insurers are required to offer the protection at full policy limits and can only exclude or sublimit the coverage at the pleasure of the insured. In practice, many carriers plan to continue exclusions, sublimits, and special deductibles for "non-certified" events and offer full limits for "certified" events at a given premium. In addition to their full limit TRIA pricing, the initial Treasury Guidance (dated 12/3/03) indicated that insurers can request, and can offer sublimited terrorism coverage - - provided that (1) the insurer first makes an offer for full coverage; and (2) state regulations allow sublimiting of the coverage.

(1) Endorsements that modify existing terrorism exclusions to bring them into compliance with TRIA - - i.e., specifying that the exclusions do not apply to a "certified act of terrorism";

(2) Endorsements that remove existing terrorism exclusions altogether, - reiterating the statutory limits on the insurer's obligation to pay losses in connection with a "certified act of terrorism," with noncertified acts of terrorism covered on the same basis as any other insured property loss;

(3) Endorsements that merely impose the statutory cap on "certified acts of terrorism" losses - - for use with mid-term policies which have no terrorism exclusion attached; and

(4) Endorsements that exclude "certified acts of terrorism" losses altogether or, in those states requiring property coverage for certain fire losses with an exception for other such losses - - these may be used only if the insured has rejected federal coverage in writing or has failed to pay the terrorism premium within 30 days of notification.

These filings have been made under a provision of TRIA that exempts them from individual states' prior approval laws; thus, the endorsements are available for use immediately.

TRIA does not regulate premium rates. Each state retains the authority to regulate both premium rates and policy forms (but it may not deviate from TRIA's definition of an "act of terrorism"). Any state may invalidate a rate if it is found to be excessive, inadequate or unfairly discriminatory. In order for insurers to meet TRIA's requirement for immediate implementation, any state law providing for prior approval of rates or forms (or time delays in implementing a rate or form) is not applicable during the first year of the program.

Under TRIA, pricing eventually will be subject to state regulatory review and insurers will need to provide state regulators with information to support their pricing. Insurers will likely arrive at pricing by assessing the severity profile of each insured's risk, the cost of reinsurance to protect their retention under TRIA, and the cost of capital relating to their net retained line.

It is still too early to state definitively what trends are emerging from insurers with respect to the pricing of terrorism coverage mandated by TRIA. So far, many insurers seem to be taking a "surcharge" approach (i.e., a percentage of the property insurance premium) in most cases. Early indications show a wide variety of pricing surcharges ranging from as little as 2 percent to as much as 100% of a policy's premium. Undoubtedly, this early disparity in pricing reflects a wide range in underwriters' affinity for this risk.

A recent survey of brokers by the Council of Insurance Agents and Brokers indicates that few policyholders are buying terrorism insurance - - fewer than 10% of small commercial accounts and fewer than 20% of medium and jumbo accounts. Many of these businesses simply do not believe they are prime targets of terrorists. But even those who would prefer to have coverage are finding the price too expensive or the coverage too narrow. The solution for those companies might be to purchase separate "stand-alone" policies. The carriers offering those policies do so willingly, not because they are forced to so by government mandate. Consequently, they are more likely to provide more comprehensive coverage.

Federal Government's Share of Losses; Deductibles

With respect to coverage offered in compliance with TRIA, insurers will receive reimbursement from the federal government for a portion of paid losses. Specifically, the federal government will reimburse an insurer for 90 percent of all terrorism-related property-casualty losses that exceed the applicable insurer's deductible. Each insurer's deductible will be calculated by comparing that insurer's covered losses in that year to its direct earned premiums for lines of business covered by the program in the prior year. The amount of each insurer's deductible (individual retention) scales upward each year of the program, as follows:

• Between November 26, 2002 and December 31, 2002, the insurer deductible was equal to one percent of its 2001 direct earned premiums;
• For the calendar year 2003, the insurer deductible is equal to seven percent of its 2002 direct earned premiums;
• For the calendar year 2004, the insurer deductible will be equal to 10 percent of its 2003 direct earned premiums; and
• For the calendar year 2005, the insurer deductible will be equal to 15 percent of its 2004 direct earned premiums.

This graduated deductible feature assumes - - and is designed to encourage - - ongoing insurer success in underwriting, pricing, and reserving for terrorism losses.

In addition to these deductibles, insurers will be responsible for paying 10 percent of the remaining certified terrorism losses until aggregate insured losses for the program year reach US$100 billion. Without further authorization by Congress, the federal government's payment responsibility for insured losses cannot exceed that US$100 billion cap in any one year. At that point, no further federal reimbursements will be made under TRIA, and assuming an individual insurer has met its deductible, it will not be liable for any further payment with respect to terrorism-related losses. In any program year for which certified terrorism losses exceed US$100 billion, the responsibility for devising a plan to address further terrorism losses falls on Congress.

Any determinations made by the Secretary of the Treasury with respect to the allocation of losses between an insurer and the federal government are final and not subject to judicial review. The federal government's portion of insured losses will be reduced by the amount of compensation otherwise provided by the federal government to any person in connection with such losses.

Early indications are that the financial community is worried about the government's mandate that insurers get back into the pool of terror risk. The chief concerns are: (1) the untested underwriting pricing models they will necessarily use for this risk; (2) whether the government reinsurance may tempt insurers to undercut one another's pricing; and (3) the degree to which the deductibles pose a threat to insurers' financial viability. While insurer deductibles under TRIA are calculated as a percentage of gross premiums, insurers that rely heavily on reinsurance base their capital levels on net premiums, which is a much smaller number. This means their liability under TRIA could represent a large proportion of their capital. It is reasonable to anticipate that insurers' concerns regarding their financial ratings may have a significant impact on the pricing they propose for TRIA coverage and may influence them to reduce their overall net capacity offerings in order to limit their TRIA exposure.

Recoupment/Policy Surcharges

TRIA provides for the federal government to recover a portion of any payments it makes under the Program through policy surcharges. Payment recovery is mandated for any gap between the total amount of insurer loss payments (i.e., the percentage-of-earned-premium deductibles plus the 10 percent insurer participation share) and a specified dollar amount, referred to as the "insurance marketplace aggregate retention amount." Put simply, this aggregate retention is the maximum dollar amount that all insurers participating in the Program will be liable to pay out for certified terrorism losses in a given Program year. When the total of insurer deductibles and percentage participation does not equal this aggregate retention, insurers will have to pay the difference back to the government. The industry aggregate loss figures used to determine whether or not there will be surcharges are:

• US$10.0 billion in year 1 (the balance of 2002 and 2003);
• US$12.5 billion in year 2 (2004); and
• US$15.0 billion in year 3 (2005).

For any program year in which insurer deductibles and percentage participation amounts equal or exceed the specified aggregate retention, payment recoupment is at the discretion of the Secretary of the Treasury. That decision will be based on the Secretary's judgment concerning a number of industry factors, including the cost of the federal program to the taxpayers and the financial condition of the insurance industry.

Payment recovery will be achieved by means of a premium surcharge on property and casualty insurance policies that are in force after the date the recoupment amount is established by the Treasury Secretary. However, regardless of the statutorily defined recoupment amount, no surcharge may exceed three percent of the premium under any policy. All surcharges would be collected from policyholders by insurers and remitted to the Treasury.

Reinsurance

Insurers are free to obtain commercial reinsurance coverage for their remaining terrorism exposure (i.e., for the deductible and their 10% share). To the extent that the proceeds of commercial reinsurance - - combined with recoveries under TRIA - - exceed the aggregate amount of an insurer's terrorism-related losses, the excess must be returned to the Treasury, unless the reinsurance agreement provides otherwise. As stated above, a reinsurer's obligations for terrorism-related losses under a reinsurance policy are not covered under TRIA.

Because TRIA excludes reinsurers from coverage, it must be assumed for now that some carriers positioned as reinsurers will retain their terrorism exclusions. It may be advantageous to some insurers to obtain the terrorism reinsurance provided by the government, particularly since the deductible in TRIA is defined as a percentage of the insurers' direct earned premiums in the previous year. This arrangement could also serve to ease overall program administration by avoiding issues of complex plans with multiple reinsurers. Still other insurers may prefer to modify their program structure to have access to risk transfer through a freestanding terrorism policy.

Notification to Policyholders

In order to be eligible for reimbursement by the federal government for terrorism-related losses, the insurer must provide "clear and conspicuous disclosure" to the policyholder of: (1) the premium to be charged for terrorism coverage; and (2) the federal share of compensation for any losses. The disclosure must be given on a separate line item in the policy, at the time of offer, purchase, and renewal. Details concerning the form of disclosure will likely be set forth in regulations being developed by the Treasury Department. Interim rules were released on February 25, 2003 and were published in the Federal Register on February 28, 2003 at 31 C.F.R. Part 50.

Exclusive Federal Jurisdiction; Punitive Damages

TRIA creates an exclusive federal cause of action for property damage, personal injury, or death arising out of or resulting from an act of terrorism. All causes of action that are otherwise available under state law are preempted. The substantive law to be applied by the federal court will be derived from the law of the state in which the terrorism occurred.

Although TRIA does not prohibit an award of punitive damages in litigation arising out of acts of terrorism, no punitive damages will be paid by the federal government under TRIA. In other words, punitive damages will not count as insured losses subject to government reimbursement.

Enforcement

The Secretary of the Treasury will oversee the Program. Thus, the Treasury Department is responsible for promulgating regulations implementing TRIA, as well as administering and enforcing the Program. The Secretary may impose civil monetary penalties up to US$1,000,000 for each instance of failing to pay assessments or surcharges, submitting erroneous data, or any other violation of the implementing regulations.

Through its monitoring and oversight responsibilities, TRIA is effectively requiring the Treasury Department to develop expertise in the financial solvency, rating, and market conduct of the insurance industry, at least in the limited context of the terrorism insurance program. Some experts expect Congress to rely on this newfound expertise in an eventual expansion of the the federal government's role in insurance, at the expense of the individual states.

Conclusion

Although the Terrorism Risk Insurance Act of 2002 provides a three-year time bridge for the insurance marketplace to adapt to the new world of terrorism, it does not ultimately spare insurers, policyholders, and the U.S. economy from the economic costs of terrorism. While TRIA should provide some stability to the insurance marketplace, it is not a panacea. The risks associated with trying to underwrite terrorism have not changed, and that reality still hangs over the insurance industry, even with the involvement of the federal government.

Although TRIA provides a federal reinsurance mechanism, the complex questions of how to assess and price coverage for terrorism losses remain. This is where risk management will need to meet new challenges. As with all exposures, the issues of frequency and severity, as well as mitigation, will likely govern the pricing models and decisions of underwriters concerning TRIA coverage. Therefore, insurers will likely seek data that reflects concentrations of risks (property and people) in areas that are most likely prone to such attacks. It would also behoove insureds to make certain that their disaster recovery plans are up to date and prominent in the exposure data supplied to underwriters. In any event, the immense unpredictability of terrorism risks means that premiums will remain difficult to determine, at least until insurance company actuaries and scientific modeling are better able to gauge potential losses.

Additionally, TRIA's impact on Directors and Officers liability coverage must be considered. With the recent advent of terrorism exclusions in D&O policies, the insurance industry has distanced itself from shareholder suits that might assert negligence on the part of corporate governors for not protecting property from losses related to terrorist events. This risk, and the "failure to purchase insurance" exposure of boards of directors, are among the issues that corporate insureds need to consider before they elect to decline the TRIA-mandated coverage.

Finally, the logistical, capacity, and pricing challenges involved with trying to cover the inherently unpredictable risks of terrorism will undoubtedly remain with us as long as the threat of terrorism exists.

References

Defending the U.S. Economy Against Terrorism: The Terrorism Risk Insurance Act of 2002, AIA Advocate, November 26, 2002.

Gordon, Peter J. et al., Terrorism Risk Insurance Act of 2002, Simpson Thatcher & Bartlett, http://www.stblaw.com/FSL5CS/memos/memos1469.asp, February 19, 2003.

LiMandri, Charles S., Terrorist Attack Coverage Should Not Be Barred by War Risk Exclusion in Standard Policies, California Insurance Law & Regulation Reporter, October 2001; http://www.limandri.com.

Woodward, Jeff, The Terrorism Risk Insurance Act of 2002, IRMI.com, http://www.irmi.com/insights/articles/woodward008.asp, December 2002.

Charles S. LiMandri, Esq. received a Diploma in International Law and Relations after a year of graduate study in Great Britain at the University of Wales at Aberystwyth, on a Rotary Ambassadorial Scholarship. He completed his studies in international law at the Georgetown University Law Center in Washington, D.C. While in Washington, he worked as a U.S. foreign policy analyst on Middle Eastern affairs for a firm specializing in international law. Since graduating from Georgetown in 1983, he has been representing insurance companies and insureds in coverage and bad faith litigation. He has represented various London Underwriters on issues relating to insurance. He is a member of the American Board of Trial advocates, the National Board of Trial Advocacy, and the State of California and District of Columbia Bar Associations. He is a frequent author and lecturer on insurance coverage issues. His firm is located in Rancho Santa Fe, California and can be visited at http://www.limandri.com. One of the firm's attorneys, Teresa Mendoza, assisted in the preparation of this article.