Terrorism Insurance: Rising Uninsured Exposure to Attacks
Heightens Potential Economic Vulnerabilities (27-FEB-02,
GAO-02-472T).
In the closing months of last year insurers stated that they
could not afford to continue providing coverage for potential
terrorism losses. Considerable debate has taken place on what the
federal government can do to keep commercial insurance companies
involved in providing terrorism insurance, even without the
protection that they normally receive from reinsurance. Because
insurance companies believe that neither the frequency nor the
magnitude of future terrorist losses can be estimated, they are
withdrawing themselves from the market. Insurance for losses from
terrorism is disappearing, particularly for large businesses and
those perceived to be at some risk. This withdrawal is happening
fastest among reinsurers. Because the insurers' withdrawal has
been gradual, the extent of the potential economic consequences
is still unclear. What is clear is that in the absence of
terrorism insurance, terrorist attacks would dramatically
increase direct losses to businesses, employees, lenders, and
other noninsurance entities. Furthermore, should the government
decide to intervene after a future attack it, would do so without
readily available claims-processing and payment mechanisms that
exist in the insurance industry. Even in the absence of an actual
terrorist event, there are indications that some sectors of the
economy are beginning to experience difficulties because some
properties and businesses are unable to find sufficient terrorism
coverage at any price. If allowed to go unchecked, these
difficulties are likely to increase as more insurance contracts
come up for renewal over the next year. The resulting economic
drag could slow economic recovery and growth.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-02-472T
ACCNO: A02814
TITLE: Terrorism Insurance: Rising Uninsured Exposure to Attacks
Heightens Potential Economic Vulnerabilities
DATE: 02/27/2002
SUBJECT: Economic analysis
Economic stabilization
Insurance
Insurance companies
Terrorism
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GAO-02-472T
United States General Accounting Office
GAO Testimony
Before the Subcommittee on Oversight and Investigations, Committee on
Financial Services, House of Representatives
For Release on Delivery Expected at 3:00 p.m. EDT
Wednesday, February 27, 2002 TERRORISM INSURANCE
Rising Uninsured Exposure to Attacks Heightens Potential Economic
Vulnerabilities
Statement of Richard J. Hillman Director, Financial Markets and Community
Investment
GAO-02-472T
Madam Chairman and Members of the Subcommittee:
The tragic events of September 11, 2001 brought to light the huge potential
exposures insurance companies could face in the event of another terrorist
attack. Faced with continued uncertainties about the frequency and magnitude
of future attacks, at the same time government and military leaders are
warning of new attacks to come, both insurers and reinsurers have determined
that terrorism is not an insurable risk at this time. As a result, in the
closing months of last year insurers began announcing that they could not
afford to continue providing coverage for potential terrorism losses. The
effects of this trend have yet to be fully realized, but there is some
indication that it has begun to cause difficulties for some firms in certain
economic sectors.
Considerable debate has taken place on what the federal government can do to
keep commercial insurance companies involved in providing terrorism
insurance, even without the protection that they normally receive from
reinsurance. While this Committee and the House of Representatives did pass
H.R. 3210, the Congress as a whole did not adopt legislation.
Today, two months into a new year, uncertainty and concerns continue, both
in the insurance industry and the economy, over the issue of terrorism
insurance. As you requested, my testimony today will describe how, in the
absence of federal action, insurance companies and the marketplace have
reacted to the events of September 11th. I will also present GAO's initial
observations on the potential consequences these market changes may have,
both in the event of another terrorist attack and, as we all hope, in the
absence of one. Finally, I have included a discussion of the language
developed by the Insurance Services Office (ISO) and adopted by most states
to exclude terrorism from commercial property and casualty (P/C) coverage
(appendix 1).
My statement today is based on discussions with a variety of insurance
industry participants, regulators, policyholders, and other affected
parties. Because many companies were deeply concerned about the possibility
that their difficulties in getting terrorism coverage might become general
knowledge, they spoke to us only on condition of anonymity. Finally, my
statement primarily addresses the availability of terrorism insurance
coverage. Despite rising prices in the remainder of the commercial P/C
market, insurance coverage is still available, though at prices above those
in effect prior to September 11, 2001.1
In summary, because insurance companies believe that neither the frequency
nor the magnitude of future terrorist losses can be estimated, they are
withdrawing themselves from the market. Insurance for losses from terrorism
is disappearing, particularly for large businesses and those perceived to be
at some risk. This withdrawal is happening fastest among reinsurers. Direct
commercial P/C insurers' withdrawal has been slower and less complete
because of regulatory constraints and legal requirements in some states that
preclude insurers from excluding terrorism from coverage for workers'
compensation and for fire (irrespective of its cause).
Because the insurers' withdrawal has been gradual, the extent of the
potential economic consequences is still unclear. What is clear is that in
the absence of terrorism insurance, another terrorist attack would
dramatically increase direct losses to businesses, employees, lenders, and
other noninsurance entities beyond those resulting from September 11th.
Furthermore, should the government decide to intervene after a future
attack, it would do so without readily available claims-processing and
payment mechanisms that exist in the insurance industry.
Even in the absence of an actual terrorist event, however, there are growing
indications that some sectors of the economy-notably real estate and
commercial lending-are beginning to experience difficulties because some
properties and businesses are unable to find sufficient terrorism coverage,
at any price. If allowed to go unchecked, these difficulties are likely to
increase as more insurance contracts come up for renewal over the next year.
The resulting economic drag could slow economic recovery and growth.
1 Prices were already increasing for commercial coverage prior to September
11th. Industry participants have told us that the increases were a part of
the underwriting cycle normal in this insurance market. Industry losses from
the terrorist attack almost certainly exacerbated the rise in prices, as any
major catastrophe would have. While there may be some examples of excessive
price increases in the market, as long as insurance continues to be
available, it is likely that competitive pressures will ultimately remedy
that problem.
Insurers Are Shifting Terrorism Risk to Property Owners and Businesses
Since the September 11th attacks, the key dynamic taking place in the
insurance industry has been a shifting of the risk for terrorism-related
losses from reinsurers to primary insurers and then to the insured.
Reinsurers and insurers have begun shedding their exposure to terrorism risk
as insurance contracts come up for renewal, leaving policyholders
increasingly exposed to losses from a terrorist attack. Prior to September
11, 2001, insured losses resulting from terrorism in this country were
extremely infrequent. Insurance companies considered the risk so low that
they did not identify or price potential losses from terrorist activity
separately from the general property and liability coverage provided to
businesses. But after the September 11th attacks, insurance companies
recognized that their risk exposure was both real and potentially enormous.
As a result, they began to express concern about continuing to include
terrorism coverage as an unpriced component of commercial P/C insurance
contracts. Insurers pointed out that experience with major terrorist events
has been so limited, and the potential losses so large, that setting an
actuarially sound price for such coverage is virtually impossible. Many
insurers now consider terrorism an uninsurable risk, at least for the
moment. Their response to any risk they consider uninsurable, as many
Californians living on fault lines have found, is not to offer insurance.
This trend has become evident in the case of terrorism insurance.
Reinsurers Are Withdrawing from the Market for Terrorism Insurance
Reinsurers-companies that routinely take on some of the risk that direct
primary insurers face in return for a share of the premiums-are now
unwilling to participate in terrorism coverage because of the enormous
losses they suffered after September 11th and the newly recognized
difficulties of pricing terrorism insurance. Reinsurance is a vitally
important element of the insurance industry's capacity to provide coverage
to policyholders. As a mechanism for spreading the risks taken by insurance
companies, reinsurance allows primary insurers to accept large risks and, by
reinsuring a portion of those risks, to protect themselves from a
potentially catastrophic loss. Like syndications of large loans by groups of
lenders, reinsurance provides a way to insure large risks without exposing a
single insurer to the possibility that its entire capital base would be
wiped out because of a single event. Reinsurance companies also provide a
channel through which investors can introduce capital to insurance markets
without having to develop the extensive distribution channels required by
direct primary insurers.
However, because reinsurance markets are global in scope and because
reinsurance transactions are considered to be contracts between
sophisticated parties, neither the prices nor the conditions of such
coverage are subject to direct regulation. As a result, after September
11th, reinsurers had little difficulty excluding terrorism from coverage.
Generally, these exclusions become effective on the policy renewal date. As
stated by witnesses before this Subcommittee in October, a large share of
those contracts expired at the beginning of January.2 Industry sources
confirm that little reinsurance is being written today that includes
coverage for terrorism. There are exceptions. Low and medium risks,
particularly in industries or geographic locations where there is little
perceived exposure to a terrorist event, are the least affected. However,
large companies, businesses of any size perceived to be in or near a target
location, or those with some concentration of personnel or facilities are
unlikely to be able to obtain a meaningful level of terrorism coverage at an
economically viable price. Where coverage is available, it tends to have
high deductibles and tight limits on the level of coverage. In general,
reinsurers are being very selective on the exposures they will accept, if
any. The higher the risk, the less likely it is that reinsurance coverage
will be available. And even in those limited cases in which some reinsurance
coverage for terrorism is still available, the prices are very high.
As Primary Insurers' Exposure Increases, They Also Are Excluding Terrorism
Coverage
As reinsurers walk away from terrorism insurance, primary insurers' exposure
increases, at least in the short run. However, while reinsurance contract
renewals tend to be concentrated at the beginning of January and July,
primary insurance contracts tend to renew at a relatively even rate over the
year. As a result, industry observers and participants have told us that
primary insurers' exposures have increased dramatically and will not fall
unless and until they can, in turn, exclude terrorism from their coverage.
Faced with this kind of exposure and a risk they do not believe can be
priced, industry observers and participates mentioned that primary insurers
will need to emulate their reinsurance counterparts and exclude terrorism
coverage from some commercial insurance policies. However, a number of
factors are affecting both the speed and the extent to which primary
insurers can insulate themselves from terrorism. First, in contrast to
reinsurance, changes to the coverage provided3 by direct insurers
2 Whether 70 percent of all reinsurance policies did in fact expire at that
time, as was suggested, is difficult to determine. However, the consensus of
industry sources is that the majority of reinsurance contracts did expire
then and that reinsurance contract renewal cycles tend to be concentrated at
the beginning of January and the beginning of July.
3 Called "policy form" by state regulators.
require regulatory approval in most states, at least for low- and
medium-risk companies.4 This regulatory hurdle caused ISO, acting on behalf
of P/C insurers, to file a request in every state for permission to exclude
terrorism from all commercial insurance coverage.5 As of February 22, 2002,
45 states and the District of Columbia and Puerto Rico had approved the ISO
exclusion, according to information received by ISO and the National
Association of Insurance Commissioners (NAIC). The other five states either
denied the suggested language from ISO or are still considering the language
for approval or disapproval.6 States that have not approved the ISO
exclusion expressed concerns about various issues. Among them are the low
thresholds for exclusion ($25 million or 50 serious casualties); the
all-or-nothing nature of the threshold (insurers pay nothing if either
threshold is reached); the aggregation of all losses from multiple incidents
within a 72-hour period and across most of North America into one event if
they "appear to be carried out in concert or to have a related purpose or
common leadership"; fear that the exclusion would leave some small and
medium-sized businesses that could least afford the losses from a terrorist
attack totally unprotected; and worry that the included definition of
terrorism is overly broad. Nevertheless, because of regulatory concerns
about the solvency of primary insurers who cannot get reinsurance, ISO's
exclusion language has been approved in 45 states and the District of
Columbia and Puerto Rico. Primary insurers in those states can now exclude
terrorism from coverage on various lines of commercial policies. While only
five states have not (yet) accepted the ISO exclusion language, those five
states account for more than 35 percent of
7
the total U.S. commercial insurance market.
4 Many states do not require regulatory approval for "large" risks. The
resulting contracts are sometimes called "manuscript" or "script" policies
and are considered to be contracts between sophisticated parties.
5 The blanket approval does not compel insurers to exclude terrorism from
every contract, but it assures them of regulatory approval when they choose
to exclude such losses.
6 A description of the ISO terrorism exclusion can be found in appendix 1.
7 There is no reliable information, however, on the share of the commercial
P/C insurance market in those states that is actually affected by the
rejection of the exclusion. Each of these states already exempts "large,
sophisticated buyers" from the regulations governing the terms of insurance
contracts. These buyers could, and many may already have, renewed insurance
contracts without terrorism coverage.
Second, even though direct insurers now have regulatory approval to exclude
terrorism from commercial P/C insurance contracts in most states, such a
change in coverage generally would have to wait until the renewal date.
According to some insurance regulators with whom we spoke, losing
reinsurance would not generally be a sufficient reason for canceling or
changing coverage for policyholders during the policy period. Moreover, even
when an insurance policy terminates, insurers generally have to give 30 to
60 days advance notice to policyholders before non-renewing a policy or
making a significant change in coverage. As a result, it could be as much as
a year after a direct insurer loses reinsurance coverage for terrorism
before a similar exclusion could be passed on to all its policyholders.
Finally, even at renewal, laws existing in some or most states will affect
the extent to which insurers can completely end their exposure to losses
resulting from terrorist events. For example, laws in nearly all states
preclude a workers' compensation insurer from excluding coverage for a
particular type of event. Workers' compensation must cover all the risks to
which an employee is exposed while at work, irrespective of the cause.
Industry sources estimate that approximately 10 percent of the losses
resulting from the World Trade Center attack will be due to payments for
workers' compensation claims.
Similarly, insurance laws in approximately 30 states include what is called
"standard fire policy" language, according to ISO officials. In that
language, insurers are required to pay losses resulting from fire,
irrespective of the cause. Thus, in an explosion like the World Trade Center
attack, a terrorism exclusion would protect insurers from liability for
losses resulting from the direct effects of the explosion, but not for the
losses caused by the resulting fire. Estimates suggest that the fire, rather
than the explosion itself, caused a substantial portion of the losses in the
World Trade Center attacks. Industry sources have said that they expect an
effort to change this requirement. In all of the states where the standard
is written into state statutes, an act of the state legislature would be
required to modify it.
Thus, even though many reinsurers can and have moved quickly to exclude
terrorism from reinsurance coverage, primary insurers' ability to exclude
terrorism is more limited, at least in the short run. However, the rapid
submission of the ISO exclusion language to state insurance regulators, and
their generally rapid and positive response, clearly indicate the urgency of
primary insurers' desire to be able to exclude terrorism from commercial P/C
insurance coverage. Early indications suggest that
As Business Exposure to Uninsured Risks Rises, so Do the Potential Economic
Consequences
many businesses, particularly those in large metropolitan areas, are already
beginning to experience difficulty obtaining terrorism coverage as their
insurance policies come to renewal. In our discussions with insurance
industry participants, observers, and policyholders, we found that large
commercial enterprises were among the first to feel the impact of terrorism
exclusions. Some large property owners or developers reported that they are
having to underinsure or "go bare" by self-insuring for terrorist risks
because of the lack of available coverage or very limited coverage for the
quoted prices.
While the extent of the negative economic impacts of a lack of terrorism
coverage is not yet clear, the potential for more severe economic impacts is
increasing as the level of uninsured risk climbs. Over the next year, the
level of uninsured risk for terrorism-related incidents is expected to
continue to rise as commercial policies renew between primary insurers and
policyholders and insurers seek to exclude terrorism-related coverage from
policies they cannot reinsure. Therefore, the economic burden of another
terrorist attack would fall increasingly on policyholders as the insurance
industry sheds or limits its risks to such exposures, raising the potential
for more devastating economic consequences should such an event occur.8
Additionally, as insurers exit the market for terrorism-related coverage, so
too does their claims-processing capacity for administering recovery
assistance to victims of a terrorist event.
Even in the absence of another terrorist event, adverse impacts due to the
lack of adequate terrorism coverage appear to be surfacing, although their
ultimate impact on the economy as a whole cannot yet be gauged. Additional
cases of adverse economic impacts to individual firms caused by the absence
or high price of coverage for terrorism-related events are likely to become
more evident as policies continue to be renewed over the next year.
8 Of course, direct insurers are still bearing some of the risk and may not
be able to shift all the risk to policyholders in the near term. If an event
were to occur soon, this exposure could result in insolvency and failure for
some otherwise healthy insurance companies, potentially affecting the
availability of other kinds of insurance.
Another Terrorist Attack
Could Have More Severe
Economic Consequences
Many of the most severe potential negative consequences resulting from the
lack of terrorism insurance coverage will only become evident if another
terrorist attack occurs. The shifting of risk from reinsurers to primary
insurers to commercial policyholders and other affected parties could place
more risk and economic burden on businesses and the public at large should
another terrorist attack similar to September 11th occur. 9 Consequently, a
lack of such coverage in the event of another attack could have much broader
effects on the economy.
Recent estimates of the losses paid by insurers as a result of the attacks
on the World Trade Center are about $50 billion, of which reinsurers are
expected to ultimately pay about two-thirds. If another terrorist event of
similar magnitude were to take place, all those losses would still be
incurred. However, depending on the timing of the event, the effect would be
very different, because even today the reinsurers would be responsible for a
much smaller share of the losses. As the event moves farther into the future
and primary insurers successfully exclude terrorism from insurance coverage,
the losses will increasingly be left to the affected businesses and their
employees, lenders, suppliers, and customers. Because these entities lack
the ability to spread such risks among themselves the way insurers do,
another terrorist attack similar to that experienced on September 11th could
have significant economic effects on the marketplace and the public at
large. These effects could include bankruptcies, layoffs, and loan defaults.
Another significant consequence of the insurers' exiting the market for
terrorism coverage is the absence of a claims-processing mechanism that can
effectively and efficiently respond to victims of an attack. After September
11th, insurance companies, working with public risk-management groups, are
reported to have mobilized extensive resources to pay many claims quickly.
The administrator of the special government program to compensate victims in
the aftermath of the September 11th attacks has noted the challenges of
creating a mechanism for identifying victims and properly disbursing aid,
even several months after the attacks. If, without insurers, the government
should emerge as a principal source of financial recovery after another
attack, it would first have to create the
9 In this statement, we assume that another terrorist event would be
property-damage intensive, similar to the World Trade Center attacks. Of
course, a successful terrorist attack, such as a biochemical or nuclear
incident, would pose significantly different challenges to the insurance
industry and the economy, although the ISO language contains a total
exclusion for nuclear, biological, or chemical attacks.
infrastructure to process claims and disburse financial assistance to
victims, duplicating the mechanism already in place in the insurance
industry. Therefore, the potential economic impacts of another incident on
the scale of a September 11th attack could become even more devastating
absent insurance mechanisms to quickly help businesses recover and restore
economic activity. The current movement by insurers to insulate themselves
from terrorism-related losses, however, means that their involvement in the
recovery process after another terrorist event would also likely be
substantially lessened.
Some Examples of Adverse Impacts Are Surfacing Due to the Lack of Adequate
Terrorism Coverage
Even if no other terrorist attacks occur, some adverse conditions are
beginning to appear in the marketplace due to the lack of adequate terrorism
coverage, though the impacts on the economy as a whole are still unclear. As
noted earlier, commercial property owners and businesses are now facing
higher P/C rates coupled with substantially reduced protection for
terrorism-related risks as P/C policies renew over the coming year.
Insurance industry observers and policyholders report that while limited
coverage for terrorism-related losses is currently available at very high
rates, full coverage is often not available at any price, forcing larger
commercial policyholders to operate with little or no coverage for such
risks. Cases of adverse economic impacts to individual firms caused by the
absence or high price of coverage for terrorism-related events are likely to
become more evident as policies continue to be renewed over the next year.
Some examples of large projects canceling or experiencing delays have
surfaced, with the lack of terrorism coverage being cited as a principal
contributing factor. Overall, it is still unclear to what extent financing
arrangements for existing or planned projects will be jeopardized as lenders
and investors are faced with the prospect of absorbing additional
terrorism-related risks that cannot be insured. These financing arrangements
encompass both development and resale markets, where financing is contingent
upon full insurance coverage for collateral assets backing the loan or
investment. Some industry observers believe private markets will eventually
develop and expand the capital available for terrorism insurance coverage,
but whether or how quickly an adequate market can materialize is not yet
evident.
Our contacts with various industry and regulatory sources indicate that some
financial problems are surfacing due to the lack of terrorism coverage,
though it is still too early to gauge how widespread these problems will
become. Though we could not independently validate each
Property Owners and Developers
of the assertions provided, we found consistency among the sources in the
reasons contributing to delays or cancellation of projects. These reasons
can be attributed to uncertainty and an unwillingness among lenders and
investors to accept risks that cannot yet be reasonably estimated and that
insurance companies are unable to price.
Two of the most common adverse impacts being cited by commercial sources,
particularly owners and developers, are the conditions of having to go bare
or only partially insure assets against terrorism due to the inability to
obtain meaningful terrorism coverage. Even when limited coverage is
available, uncertainties about the frequency and cost of future events cause
insurers to set premiums very high. This condition appears to be
particularly acute for properties located in central business districts of
major metropolitan areas.
Specifically, several property owners that we spoke to with properties
across the United States reported not being able to purchase the amount of
terrorism coverage they need because the capacity they require is not
available in the current market. As a result, these owners are largely bare
for terrorism risks and liable for any uninsured damages that would result
from a terrorist attack on their properties.
For instance, a major North American commercial real estate firm that owns
trophy10 properties and office buildings in the central business districts
of several major U.S. cities reported that it cannot find enough terrorism
insurance to cover the value of its properties. This firm previously had a
blanket property insurance policy providing $1 billion of total
coverage-including terrorism-that expired in October of 2001. Since that
time, the firm has been able to find only one insurer who would offer it a
quote for stand-alone terrorism insurance for a maximum $25 million of
coverage. The firm stated that minimal damage to its buildings could surpass
$25 million in claims and that this limit was inadequate.
In another example, a New York insurance brokerage firm reported that it
tried to obtain terrorism coverage for a client's portfolio of non-trophy
office buildings in New York City. The incumbent insurer agreed to provide
$100 million of insurance coverage on the portfolio that included
10 For purposes of this report, "trophy" properties are those properties
that are sometimes regarded as icons of American business, culture or
history, or that could be considered as representative of American culture
or values. Because of their symbolic status, insurers consider them to be at
high risk for a terrorist attack.
Lenders and Borrowers
terrorism, at double the cost of the previous year's $500 million policy.
The broker could not find more terrorism coverage for these properties.
Industry consultants also reported that their clients were experiencing
difficulty finding sufficient liability insurance for terrorism risk.
An owner and operator of a midwestern city's principal airport and several
smaller area airports reportedly experienced a 280 percent increase in its
aviation liability premium for 2002. The new policy does not include war
risk. The insurer offered $50 million in war risk and terrorism coverage
back to the airport owner in a stand-alone policy for a premium of $1
million. The owner needs $500 million in coverage to satisfy its obligation
to customers.
Property owners' search for terrorism coverage has been driven not only by
the fear of personal liability for terrorist attacks to their properties,
but also by the fact that lenders are requiring this coverage on the
collateral backing existing mortgage loans. Therefore, the shifting of risk
back to the policyholders is also creating adverse business conditions for
lenders and investors. Lenders typically require borrowers to carry all-risk
insurance coverage to protect the value of loan collateral.
Lenders and investors are now voicing their concern over their increasing
exposure to terrorism-related risks as collateral assets on mortgages become
uninsured for such risks. Post-September 11th, many lenders began notifying
borrowers with properties considered at risk for terrorism of the
requirement to carry insurance for the risk of terrorism. If borrowers
cannot obtain the requisite terrorism coverage, lenders may find them in
violation of their loan covenants. Lenders and investors are now being faced
with the dilemma of either allowing their risk exposure to increase or
acting to terminate existing loan agreements because terrorism coverage is
not available to satisfy insurance requirements on the agreement. Overall,
it is not yet clear how financial institutions will react to borrowers that
cannot satisfy insurance requirements on existing loans.
In one case, a firm that develops large-scale buildings and that owns over a
hundred non-trophy office and residential buildings both in the suburbs and
central business districts of cities in several East Coast states reported
that it cannot find enough terrorism coverage to cover the replacement value
of its holdings and satisfy the lenders' insurance requirements. The firm
currently has mortgage loans on each of its properties with over 30
different lenders ranging from local savings banks to investment banks,
pension funds, and the securities market. All of the firms' lenders notified
the firm that insurance policies on the properties must include the risk of
terrorism. As the firm's current umbrella policy expires in March 2002, the
firm began looking for the requisite insurance coverage to maintain
compliance with the lenders' terms. For fiscal year 2001-2002, the firm had
purchased a blanket property insurance policy covering $300 million per
property per occurrence for a premium of $1 million. The firm reported that
the same amount of coverage was available for 2002-2003 for $5 million, but
it excluded terrorism. The firm found only one insurer who would offer a
quote for a stand-alone terrorism insurance policy. This quote specified a
maximum coverage of $75 million for a premium of 1.5 percent, or $1,125,000.
As $75 million is not enough to cover the replacement value of any of the
buildings it owns, the firm stated that it would be in technical default of
its loan covenants when its current insurance policy expired.
In another case, the owners of a major midwestern mall reported that when
their all-risk insurance policy on the property expired at the end of 2001,
they purchased a terrorism-excluded insurance policy because they could not
find one that would cover the risk of terrorism. The mall's mortgage lender
objected to the policy's terrorism exclusion and argued that it violated the
"all-risk" insurance requirement stipulated in the loan documents.
Consequently, the lender notified the owners that it had purchased a
stand-alone $100 million terrorism insurance policy to protect the mall from
this risk. Furthermore, the lender demanded repayment by the mall of the
$750,000 premium. The mall owners protested the lender's action, arguing
that they could not be required to purchase insurance that was not available
to them or other owners of similar properties. The owners successfully
sought a temporary restraining order from the courts to prevent the lender
from forcing repayment of the insurance premium.
Similarly, another lender described the adverse business relationships
created as the bank responded to the technical default of mortgages when
full terrorism insurance was not in force. From the bank's perspective, it
is being asked to absorb risk that it had not previously priced into the
mortgages and is therefore putting pressure on its mortgage holders to
obtain terrorism coverage. At the same time, the bank recognizes that the
unavailability or increased cost of terrorism coverage will also negatively
impact the mortgage holder's ability to service the loans. Consequently, the
bank's likely course of action will be to review each loan on a case-by-case
basis.
New Lending and Investment While owners with existing mortgages are not sure
what actions lenders Activities will take if sufficient terrorism coverage
is not available, firms interested
in buying and selling properties reported that the lack of adequate
terrorism coverage has delayed or prevented certain projects. Several
developers, financiers, and insurance industry observers noted a number of
examples where lenders or investors were reluctant to commit resources to
projects that could not be insured against terrorist acts. A common
financing requirement places the responsibility on borrowers to fully insure
the assets used as collateral in lending arrangements. In these instances,
lenders and investors were unwilling to supply financing because the buyer
or seller could not obtain adequate terrorism coverage on the property.
For instance, a general contracting firm in New York City reported that its
bank will not provide financing for a proposed construction project unless
it obtains all-risk insurance that includes terrorism coverage. The planned
project is a 30-story apartment building in a high-risk area in New York
City. The firm reported it has not been able to find an insurer that will
sell it terrorism coverage at any price. Without this coverage, the firm
cannot obtain the financing needed to hire construction workers and begin
construction. The firm stated it typically hires 500 construction workers
for projects such as this one.
Similarly, a firm stated that it could not obtain mortgage financing on an
office building it owns on the East Coast because the firm could not
purchase enough terrorism insurance to cover the replacement value of the
property. Only one insurer offered a quote-for a premium of $800,000, at a
level far below what the lender is requiring. Before September 11th, the
insurance for this building, including terrorism coverage, was $60,000 for
$80 million of coverage. The firm stated the mortgage lender refused to lend
the money, despite the fact that the building had a guaranteed
multimillion-dollar cash flow for the next 20 years. Without this loan and
others like it, the firm's future growth potential is severely limited.
In another case, an insurance broker stated that a client who was interested
in purchasing a major property found terrorism coverage available in the
needed amount to satisfy the lender, but the coverage was too expensive to
make the deal economically viable. This buyer needed $300 million in
terrorism insurance to cover the replacement value of the asset and satisfy
the lender' s insurance requirements. According to the broker, the buyer
received a quote of $6 million for a $300 million stand-alone terrorism
insurance policy. Although the buyer was able to find coverage, he was
unable to purchase it, as the building in question generates only $75
million annually in rent. The buyer had budgeted $750,000 for all of the
building's insurance needs. Given all the other
expenses associated with the building's operation, maintenance, and loan
service, the buyer believed that he could not afford terrorism insurance at
that price. However, without that insurance, the buyer could not obtain
financing for the deal and it was not completed.
Again, a mortgage broker reported that a client interested in the purchase
of a trophy property in New York City could not obtain the $200 million
necessary to finance its purchase. The broker stated that arrangements for
financing with one lender were almost complete before the events of
September 11th. After the terrorist attacks, the lender's credit committee
reportedly decided it would not approve the loan unless the client could get
enough terrorism coverage to cover the replacement value of the property.
The prospective buyer could not find coverage or another bank that would
lend the money without it.
In some cases investors have been unwilling to buy securities when the
availability of terrorism coverage on assets backing the securities is
uncertain. One example included a large insurance company with a loan of
approximately $250 million on an office building in New York. An investment
firm reported that this loan was scheduled for securitization as a way for
the company to reduce exposure. Potential investors in the loan reportedly
said they would not buy shares of the loan without terrorism coverage. The
investment firm stated that since the insurance company cannot reduce its
exposure in this type of loan, it is unlikely to provide capital for similar
projects in the future unless terrorism coverage becomes available. In a
second example, a capital management firm stated that it led the marketing
effort for a domestic commercial mortgage-backed securities deal in the
United States at the end of 2001. Investment firms in the United States and
Europe chose not to purchase these securities primarily out of concern that
terrorism insurance would not be available in the future.
The examples cited above do not allow definitive conclusions about the
ultimate economic effects of the ongoing risk shift from reinsurers to
insurers and on to property owners and businesses. However, they do indicate
greater uncertainty, which may affect both financial decisions and real
economic activity.
The Potential Negative Consequences of Not Having Terrorism Insurance Are
Cause for Concern
Contacts and Acknowledgments
Our government leaders continue to warn of imminent and credible terrorist
threats. Should one of these threats become a reality in a world where
insurers are no longer the first line of protection for businesses, the
economic consequences could be very different from those following September
11th. As businesses both large and small are faced with uninsured losses
that threaten their ability to survive, Congress could be faced with a
time-critical decision to intervene or not. A decision not to act could have
debilitating financial consequences for businesses, together with their
employees, lenders, suppliers, and customers. At the same time, a decision
by Congress to act could be difficult to implement quickly-and extremely
expensive.
Even if, as we all fervently hope, another terrorist attack does not occur,
there are indications that the lack of adequate terrorism insurance is
beginning to affect firms in some sectors of the national economy. The
ultimate scope of these effects is uncertain at this time, but they could
become potentially significant in an economy recovering from a recession.
Deciding whether Congress should act to help businesses obtain insurance
against losses caused by terrorism is properly a matter of public policy.
The consequences of continued inaction, however, may be real and are
potentially large.
Madam Chairman, this concludes my statement. I would be happy to respond to
any questions that you or other members of the Subcommittee may have.
For further information regarding this testimony, please contact Richard J.
Hillman, Director, or Lawrence D. Cluff, Assistant Director, Financial
Markets and Community Investment Issues, (202) 512-8678. Individuals making
key contributions to this testimony include James Black, Rachael DeMarcus,
Thomas Givens III, Ronald Ito, Stefanie Jonkman, Monty Kincaid, Barry Kirby,
and Angela Pun.
Appendix I: Information on the Insurance Services Office (ISO) Exclusions
for Terrorism and War Risk
The Insurance Services Office (ISO) develops standardized policy contract
language -forms and endorsements -for use by property-casualty (P/C)
insurers. Last October, ISO developed terrorism exclusion language and filed
the language with each state's insurance department for use by its
insurer-customers. ISO also offered the use of these endorsements for free
to insurers that were not its clients. Insurers operating in states that
have approved ISO's endorsements can choose to incorporate them into their
insurance policies; insurers operating in states that have rejected or have
not yet approved ISO's endorsements typically cannot.
Generally, ISO's endorsements describe, among other things, events that are
considered "terrorism" and "war," define various thresholds that trigger the
exclusion of insurance coverage, and describe events that would trigger the
exclusion of all insurance coverage. For terrorism events, ISO wrote
endorsements that could be used for different lines of insurance to explain
when claims are not covered by an insurance policy. These endorsements
contain essentially the same language. Concerning commercial property
insurance lines, two endorsements were written - one for states that have
statutory requirements for fire coverage and one for states without such a
requirement. Another endorsement was written for commercial general
liability policies.
As of February 22, 2002, forty-five states, the District of Columbia and
Puerto Rico have adopted ISO's terrorism exclusions, while five states have
either rejected the exclusions or are still evaluating them, according to
NAIC officials. To gain further insight at the state regulatory level, GAO
interviewed NAIC and several state regulators.
According to NAIC officials, ISO initially developed very broad exclusionary
language and filed it with insurance regulators across the country. State
insurance regulators raised concerns about the overly broad exclusionary
language and recommended that ISO develop more consumer-friendly language
that did not endanger insurer solvency. Late last year, when NAIC assessed
that Congress would not be passing a federal solution, NAIC facilitated
communications between ISO and state insurance regulators to narrow the
impact of the exclusionary language. ISO has amended that language.
NAIC and many state regulators that GAO interviewed said that their primary
motive for adopting the ISO endorsements was to protect insurer solvency.
NAIC officials also told GAO that they have worked with ISO in developing a
level of coverage that individual insurers could bear. NAIC agreed with
insurers that without reinsurance, insurers' solvency could be
at risk if they were required to provide insurance for terrorism. However,
regulators told us that they were uncomfortable with ISO's original proposal
to exclude all terrorism, from the first dollar of losses, because of the
potential to exclude acts that may not be the result of terrorism. NAIC
officials stated that the $25 million threshold was acceptable because it
reflected the maximum losses that a single company could absorb. They told
GAO that losses of $25 million born by a single insurer would threaten the
solvency of 886 insurers representing approximately 44% of the P/C insurance
companies writing commercial lines of insurance in the United States.
Some state regulators have not yet adopted ISO's terrorism exclusion
endorsements for various reasons. These states include California, Florida,
Georgia, New York and Texas. GAO interviewed these state regulators to
obtain their views and concerns. In general, their concerns were related to
the definition of terrorism, the loss thresholds for which coverage would
apply, and the impact that such exclusions would have on small businesses in
their states.
One state regulator maintained that ISO's definition of terrorism is overly
broad, and could exclude insurance coverage of relatively minor incidents
such as vandalism. ISO officials told us that the $25 million threshold, in
effect, addresses lower levels of events that may come from domestic
terrorism or vandalism. Another state regulator said the $25 million
threshold is too low and that a minor incident in a central business
district would trigger the total loss of coverage. One regulator found the
exclusion language reasonable, but was concerned about the exposure small
businesses would bear because they are least able to afford terrorism
insurance.
ISO endorsements contain several key elements. One key aspect of the
endorsements is its definition of terrorism. ISO's definition of a terrorist
act provides that:
Terrorism means activities against persons, organizations or property of any
nature:
1. That involve the following or preparation for the following:
* Use or threat of force or violence; or
* Commission or threat of a dangerous act; or
* Commission or threat of an act that interferes with or disrupts an
electronic, communication, information, or mechanical system; and
2. When one or both of the following applies:
* The effect is to intimidate or coerce a government or the civilian
population or any segment thereof, or to disrupt any segment of the economy;
or
* It appears that the intent is to intimidate or coerce a government, or to
further political, ideological, religious, social or economic objectives or
to express (or express opposition to) a philosophy or ideology.
Although ISO's endorsements are commonly referred to as terrorism
exclusions, they also contain language to define acts of war and to exclude
war from coverage. While the endorsements' definition and application of the
war exclusion did not change the war risk exclusion already used for
commercial property lines, its application of the war exclusion was greatly
extended for commercial general liability lines. ISO officials explained
that historically, the war exclusion was limited to contractual liability in
commercial general liability insurance lines, but now it will be applied
much more broadly, similar to its application in commercial property lines.
A second key element of the ISO terrorism exclusion endorsements relates
to the thresholds at which losses are excluded from coverage. The
endorsements for both the commercial property and commercial general
liability lines contain a $25 million loss threshold. Along with this
threshold, the terrorism exclusion threshold for commercial general
liability lines will also be met if an event causes death or serious injury
to
fifty or more people. Specifically, if a terrorism event causes aggregate
damages of $25 million or less, insurance will cover insured property
losses to policyholders.1 However, if aggregate damages exceed $25
million, insurers will not be liable for any resulting losses, not even the
first $25 million. In some urban centers the value of many individual
buildings, even those not considered to be trophy properties, exceed $25
million.
The $25 million threshold has a geographic component, an insured damage and
business interruption losses definition, and a timeframe definition. The
geographic component specifies the geographic location of the damages that
would aggregate towards the $25 million threshold. For
1 Property damages and interruption losses at the damaged property.
commercial property lines of insurance, insured damages to all types of
property located in the United States and its territories and possessions,
Canada, and Puerto Rico would be included. For commercial general liability
lines of insurance, ISO officials said damages anywhere worldwide would be
included. The exclusion also states that "...all insured damages...and
business interruption losses" would be added towards the $25 million
threshold. ISO officials explained that "all insured damages" means damaged
property that is covered by personal and commercial property insurance plus
damage that would be covered by any insurance but for the application of any
terrorism exclusions. "Business interruption losses" would be limited to
properties that were damaged by a terrorism event. The exclusion further
states that multiple events that occur within seventy-two hours and that
appear to be carried out "in concert" are considered to be one incident. ISO
officials explained that "in concert" means terrorism events that appear to
be working together.
ISO exclusions provide an alternative fifty-person threshold for commercial
general liability policies. If a terrorist event causes death or serious
physical injury to fifty persons or more, insurance will not cover any
losses to the policyholder, not even for the first fifty persons killed or
seriously injured, and not even if aggregate damages are $25 million or
less.
The thresholds do not apply to events of war, and use of nuclear,
biological, and chemical agents of terrorism, any of which can trigger the
exclusion of all commercial property and general liability coverage to the
policyholder. For an exclusion of coverage, the ISO endorsements look at the
intent of a terrorism event involving biological or chemical agents. If the
intent of the terrorism is to release biological or chemical agents,
insurance will not cover any losses to the policyholders. However, if
biological or chemical agents were released in the course of any other
incident, the $25 million threshold would apply, and the fifty-person
threshold would apply for commercial general liability policies.
In an interview with the GAO, the National Association of Insurance
Commissioners (NAIC) stressed that the ISO exclusionary language was meant
as an interim solution to bring some level of certainty to the insurance
marketplace while awaiting enactment of federal legislation. Accordingly,
NAIC recommendation includes a sunset clause. Specifically, the sunset
clause provides that the approval be withdrawn fifteen days after the
President signs into law a federal backstop to address insurance losses
attributed to acts of terrorism, consistent with state law.
*** End of document. ***