Terrorism Insurance: Effects of the Terrorism Risk Insurance Act 
of 2002 (18-MAY-04, GAO-04-806T).				 
                                                                 
After the terrorist attacks of September 11, 2001, insurance	 
coverage for terrorism largely disappeared. Congress passed the  
Terrorism Risk Insurance Act (TRIA) in 2002 to help commercial	 
property-casualty policyholders obtain terrorism insurance and	 
give the insurance industry time to develop mechanisms to provide
such insurance after the act expires on December 31, 2005. Under 
TRIA, the Department of Treasury (Treasury) caps insurer	 
liability and would process claims and reimburse insurers for a  
large share of losses from terrorist acts that Treasury certified
as meeting certain criteria. As Treasury and industry		 
participants have operated under TRIA for more than a year, GAO  
was asked to assess Treasury's progress in implementing TRIA and 
describe how TRIA affected the terrorism insurance market.	 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-806T					        
    ACCNO:   A10116						        
  TITLE:     Terrorism Insurance: Effects of the Terrorism Risk       
Insurance Act of 2002						 
     DATE:   05/18/2004 
  SUBJECT:   Insurance						 
	     Insurance companies				 
	     Terrorism						 
	     Insurance regulation				 
	     Property losses					 
	     Prices and pricing 				 
	     National preparedness				 
	     Economic analysis					 
	     Property damage claims				 
	     Treasury Terrorism Risk Insurance			 
	     Program						 
                                                                 

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GAO-04-806T

United States General Accounting Office

                                 GAO Testimony

Before the Committee on Banking, Housing and Urban Affairs, United States
Senate

For Release on Delivery

Expected at 10:00 a.m. EDT TERRORISM INSURANCE

Tuesday, May 18, 2004

              Effects of the Terrorism Risk Insurance Act of 2002

Statement of Richard J. Hillman, Director Financial Markets and Community
Investment

GAO-04-806T

Highlights of GAO-04-806T, a testimony before the Senate Committee on
Banking, Housing, and Urban Affairs.

After the terrorist attacks of September 11, 2001, insurance coverage for
terrorism largely disappeared. Congress passed the Terrorism Risk
Insurance Act (TRIA) in 2002 to help commercial property-casualty
policyholders obtain terrorism insurance and give the insurance industry
time to develop mechanisms to provide such insurance after the act expires
on December 31, 2005. Under TRIA, the Department of Treasury (Treasury)
caps insurer liability and would process claims and reimburse insurers for
a large share of losses from terrorist acts that Treasury certified as
meeting certain criteria. As Treasury and industry participants have
operated under TRIA for more than a year, GAO was asked to assess
Treasury's progress in implementing TRIA and describe how TRIA affected
the terrorism insurance market.

GAO recommends that the Secretary of the Treasury, as part of Treasury's
study of the effectiveness of TRIA and after consultation with insurance
industry participants, identify for Congress alternatives that may exist
for expanding the availability and affordability of terrorism insurance
after TRIA expires. These alternatives could assist Congress during
deliberations on the insurance industry's capacity to provide terrorism
insurance.

www.gao.gov/cgi-bin/getrpt?GAO-04-806T.

To view the full product, including the scope and methodology, click on
the link above. For more information, contact Richard Hillman at
202-512-8678, [email protected].

May 18, 2004

TERRORISM INSURANCE

Effects of the Terrorism Risk Insurance Act of 2002

Treasury and industry participants have made significant progress in
implementing TRIA to date, although Treasury has important actions to
complete in order to comply with its responsibilities under TRIA. Treasury
has issued regulations on TRIA, created and staffed the Terrorism Risk
Insurance Program office, and begun mandated studies and data collection
efforts. However, Treasury has not yet made a decision on whether to
extend the mandate that insurers "make available" terrorism coverage,
using terms not differing materially from other coverage, for policies
issued or renewed in 2005. Treasury's ongoing studies and data collection
efforts will provide further insight into TRIA's effectiveness.

TRIA has enhanced the availability of terrorism insurance for commercial
policyholders, largely fulfilling a principal objective of the
legislation. In particular, TRIA has benefited commercial policyholders in
major metropolitan areas perceived to be at greater risk for a terrorist
attack, largely because of the requirement in TRIA that insurers offer
coverage for terrorism. Prior to TRIA, GAO reported concern that some
development projects had already been delayed or cancelled because of the
unavailability of insurance and continued fears that other projects also
would be adversely impacted. GAO also conveyed the widespread concern that
general economic growth and development could be slowed by a lack of
available terrorism insurance. Largely because of TRIA, these problems no
longer appear to be major concerns.

Despite increased availability of coverage, limited industry data suggest
that most commercial policyholders are not buying terrorism insurance,
perhaps because they perceive their risk of losses from a terrorist act as
being relatively low. The potential negative effects of low purchase
rates, in combination with the probability that those most likely to be
the targets of terrorist attacks may also be the ones most likely to have
purchased coverage, would become evident only in the aftermath of a
terrorist attack. Such negative effects could include more difficult
economic recovery for businesses without terrorism coverage or potentially
significant financial problems for insurers. Moreover, those that have
purchased terrorism insurance may still be exposed to significant risks
that have been excluded by insurance companies, such as nuclear,
biological, or chemical events. Finally, although insurers and some
reinsurers have cautiously reentered the terrorism risk market to cover
insurers' remaining exposures, industry sources indicated no progress to
date toward finding a reliable method for pricing terrorism insurance and
little movement toward any mechanism that would enable insurers to provide
terrorism insurance to businesses without government involvement.

Mr. Chairman and Members of the Committee:

I am pleased to be here today to discuss our report on the implementation
of the Terrorism Risk Insurance Act of 2002 (TRIA) and the act's impact on
the terrorism insurance market and, more generally, the economy.1 The
terrorist attacks of September 11, 2001, drastically changed the way
insurers viewed the risk of terrorism. An industry that had considered the
risk of terrorism so low that it did not identify or price terrorism risk
separate from property and casualty coverage will ultimately pay
approximately $40 billion for losses arising from September 11, according
to industry experts. Responding to terrorism risk after September 11,
reinsurers began excluding terrorism from coverage as contracts between
reinsurers and insurers came up for renewal.2 Without reinsurance,
insurers retained greater levels of risks than they could responsibly
carry, and their reaction was to exclude these risks from commercial
policies as they were renewed. In short, believing that neither the
frequency nor magnitude of terrorism losses could be estimated, insurance
companies withdrew from the market.

In the aftermath of September 11, we reported that terrorism insurance was
disappearing in the marketplace, particularly for large businesses and
those perceived to be at some risk.3 We also reported significant concern
that some development projects had already been delayed or cancelled
because of the unavailability of insurance and fears that others would
follow. Furthermore, there was widespread concern that general economic
growth and development would be slowed by a lack of insurance availability
and uncertainty in the marketplace. Because of concerns about the lack of
available and affordable terrorism insurance,

1U.S. General Accounting Office, Terrorism Insurance: Implementation of
the Terrorism Risk Insurance Act of 2002, GAO-04-307 (Washington, D.C.:
Apr. 23, 2004), and Terrorism Insurance: Effects of the Terrorism Risk
Insurance Act of 2002, GAO-04-720T (Washington, D.C.: Apr. 28, 2004).

2Reinsurance is a mechanism that insurance companies routinely use to
spread risk associated with insurance policies. Simply put, it is
insurance for insurance companies. Reinsurance is a normal business
practice that satisfies a number of needs in the insurance marketplace,
including the need to expand capacity and obtain protection against
potential catastrophes.

3U.S. General Accounting Office, Terrorism Insurance: Alternative Programs
for Protecting Insurance Consumers, GAO-02-199T (Washington, D.C.: Oct.
24, 2001), and Terrorism Insurance: Rising Uninsured Exposure to Attacks
Heightens Potential Economic Vulnerabilities, GAO-02-472T (Washington,
D.C.: Feb. 27, 2002).

Congress passed TRIA, which took effect on November 26, 2002. TRIA is
currently scheduled to expire at the end of 2005.

Our report on the implementation of TRIA has two objectives. First, we
describe the progress made by the Department of the Treasury (Treasury)
and insurance industry participants in implementing TRIA. Second, we
discuss the changes in the market for terrorism insurance coverage under
TRIA. As requested, my statement today discusses both of these objectives.
Additionally, I have included an appendix to this statement that provides
background information on TRIA.

In summary, Treasury and industry participants have made significant
progress in implementing TRIA to date, although Treasury has important
actions to complete in order to fully comply with its responsibilities
under TRIA. Treasury's progress includes issuing regulations on TRIA,
staffing the Terrorism Risk Insurance Program (TRIP) office, and beginning
mandated studies and data collection efforts. For example, in compliance
with one such study, Treasury decided not to extend TRIA to group life
based on its determination that insurers had continued to provide group
life coverage, although the availability of reinsurance was reduced.
Treasury also issued proposed rules defining a framework for the claims
process and litigation management under TRIA. Additionally, Treasury
recently hired a contractor to provide claims payment services, according
to a Treasury official. However, insurers have expressed reservations
about Treasury's implementation of TRIA. Specifically, insurers are
concerned about the potential length of time it may take for the Secretary
of the Treasury to certify a terrorist event, potential inefficiencies and
time lags in processing and paying claims once an event is certified, and
TRIA's impending expiration at the end of 2005.4 The industry has also
expressed concern about the timing of Treasury's pending decision to
extend the "make available" requirement to policies issued or renewed in
2005.5

4TRIA provides that the Secretary of the Treasury, in concurrence with the
Secretary of State and the Attorney General of the United States, shall
determine whether an event should be certified as an act of terrorism,
based on certain criteria. For example, "an individual or individuals
acting on behalf of any foreign person or foreign interest" must commit
the act. Under TRIA, insurers can claim reimbursement only for losses in
events thus certified. See Appendix I for more information.

5TRIA defines "make available" to mean that the coverage must be offered
for insured losses arising from terrorist events and that coverage not
differ materially from the terms, amounts, and limitations applicable to
coverage for losses arising from other types of events.

TRIA has largely achieved Congress's first goal-to ensure that business
activity did not suffer materially from a lack of available terrorism
insurance. Since TRIA was enacted in November 2002, terrorism insurance
generally has been available to businesses; however, most commercial
policyholders are not buying terrorism coverage. According to insurance
industry experts, purchase rates have been higher in areas considered to
be at high risk of another terrorist attack. Many policyholders with
businesses or properties not located in perceived high- risk locations may
not be buying coverage because they view any price for terrorism insurance
as high relative to their perceived risk exposure. Industry experts view
overall low purchase rates in combination with a high concentration of
purchases in areas thought to be most at risk as increasing the potential
for negative effects should a terrorist event occur-either making economic
recovery more difficult for those not insured or causing financial
problems for insurers with many policies in the affected area. Further,
those that have bought terrorism insurance remain exposed to significant
perils because insurers have broadened longstanding policy exclusions for
nuclear, biological, and chemical (NBC) events. Finally, Congress' second
key goal in establishing TRIA-to give private industry a transitional
period during which it could begin pricing terrorism insurance and develop
ways to cover losses after TRIA expires- has not yet been achieved.
Industry sources indicated that under TRIA, insurance market participants
have made no progress to date toward the development of reliable methods
for pricing terrorism risks and little movement toward any mechanism that
would enable insurers to provide terrorism insurance to businesses without
government involvement.

In conducting our work, we reviewed and analyzed relevant information
concerning state legislation and publicly available and proprietary
industry data and studies on the terrorism insurance market. We
interviewed officials at Treasury, the National Association of Insurance
Commissioners (NAIC), and state insurance regulators from six states with
high insurance sales volumes. We also interviewed representatives of
insurance companies, reinsurance companies, brokers for insurance and
reinsurance companies, industry associations, property owners and
developers, and insurance filing services and credit rating agencies.6 In
our discussions with these organizations, we endeavored to gain an
understanding of their experience in implementing TRIA requirements,
obtain their views on the effects of TRIA on the terrorism insurance
market, and identify

6Filing services perform many services for insurance companies, including
submitting to state insurance regulators the documents required to sell a
line of insurance.

  Treasury and Insurers Have Made Progress in Implementing TRIA, although
  Important Work Remains

developments within the industry to address terrorism risks after TRIA
expires. We conducted this work in Chicago, New York City, and Washington,
D.C., from January 2003 through April 2004 in accordance with generally
accepted government auditing standards.

More than a year after TRIA's enactment, Treasury and insurance industry
participants have made progress in implementing and complying with its
provisions, although Treasury has yet to fully implement the 3-year
program. Treasury has issued regulations (final rules) to guide insurance
market participants, fully staffed the TRIP office, and begun collecting
data and performing studies mandated by TRIA. For example, Treasury
complied with a mandate to collect and assess data on the availability of
group life insurance and reinsurance; based on that data, Treasury
determined that group life would not be covered by TRIA. However, Treasury
has yet to make the claims payment function fully operational, although it
has recently hired contractors to perform claims payment functions.
Moreover, even though the act does not require Treasury to make a decision
about whether to extend the "make available" requirement through 2005
until September of this year, some insurers expressed concerns about
whether such a late decision would allow them sufficient time to make and
implement changes to policy rates and terms. Additionally, insurers have
voiced concerns about the time Treasury might take to certify an act of
terrorism as eligible for reimbursement under TRIA and pay claims after an
act was certified. Finally, as TRIA's midpoint nears, many insurers and
other market participants are concerned whether TRIA will be extended or
not and the timing of such a decision.

    Treasury Has Issued Regulations, Staffed the TRIP Office, and Begun Studies
    and Data Collection Efforts

To implement TRIA and make TRIP functional, Treasury has taken numerous
regulatory and administrative actions that include rulemaking, staffing a
program office, and collecting and analyzing data. To date, Treasury has
issued several final and proposed rules to implement TRIA; these rules
were preceded by four sets of interim guidance issued between December
2002 and March 2003 to address time-sensitive requirements. As of March 1,
2004, Treasury had issued three final rules that provided uniform
definitions of TRIA terms, explained disclosure (that is, notification to
policyholder) requirements, and determined which insurers were subject to
TRIA. Currently, Treasury is soliciting public comments on additional
proposed rules addressing claims processes and litigation management
issues. Also, as of September 2003 Treasury had fully staffed the TRIP
office. The office develops and oversees the operational aspects of TRIA,
which encompass claims management-processing, review, and payment-and
auditing functions. Staff will also oversee operations

performed by the contractors that actually pay claims and audit insurers
that have filed claims. Additionally, TRIP staff perform ongoing work such
as issuing interpretive letters in response to questions submitted by the
public and educating regulators, industry participants and the public
about TRIA provisions.

Treasury completed a TRIA-mandated study on group life insurance and has
begun other mandated studies and data collection efforts. Specifically,
TRIA mandated that Treasury provide information to Congress in four areas:
(1) the effects of terrorism on the availability of group life insurance,
(2) the effects of terrorism on the availability of life and other lines
of insurance, (3) annual data on premium rates, and (4) the effectiveness
of TRIA. After Treasury completed an assessment of the availability of
group life insurance and reinsurance, it decided not to make group life
insurance subject to TRIA because it found that insurers had continued to
provide group life coverage, although the availability of

7

reinsurance was reduced. Treasury has not yet reported to Congress the
results of a mandated study concerning the effects of terrorism on the
availability of life and other lines of insurance. The study was to have
been completed by August 2003, but as of March 2004 the report had not
been issued. Also, in November 2003 and January 2004, Treasury began
sending surveys to buyers and sellers, respectively, of insurance to
collect data on annual premium rates as well as other information for the
study that will assess the effectiveness of TRIA.

    Treasury Has Tasks to Complete before TRIA Can Be Fully Implemented

Before TRIA will be fully implemented, Treasury has to make certain
decisions and make additional TRIP functions operational. As of April
2004, Treasury had not yet decided whether to extend the "make available"
requirement to policies issued or renewed in 2005. TRIA gave Treasury
until September 1, 2004, to decide if the "make available" requirement
should be extended for policies issued or renewed in 2005, the third and
final year of the act. Treasury did clarify in a press release that the
"make available" requirement for annual policies issued or renewed in 2004

7According to life insurance experts, life insurers have continued to sell
group life policies in order to maintain customer relations that would be
difficult to reestablish if the coverage were discontinued. Additionally,
life insurance experts noted that business from other lines of insurance
would be lost if insurers were to discontinue group life, which is
typically sold as part of a package with disability and medical coverage.

extends until the policy expiration date, even though the coverage period
extends into 2005.

In addition, Treasury has not fully established a claims processing and
payment structure. Treasury has issued a proposed rule that would
establish an initial framework for the claims process, which includes
procedural and recordkeeping requirements for insurers. However, the
actual claims processing and payment function is not fully operational. A
Treasury official said it has recently hired a contractor that would
perform payment functions in the aftermath of a terrorist attack, but has
not yet written regulations to cover the latter stages of the claims
process such as adjusting over- and underpayments or hired a separate
contractor to review claims and audit insurers after an event to ensure
that underlying documents adequately support the claims paid by Treasury.
Treasury officials anticipate awarding this audit and review contract in
the fourth quarter of fiscal year 2004.

    Insurers Have Expressed Some Concerns Related to TRIA's Implementation

Insurers have expressed some concerns about Treasury's implementation of
TRIA. Insurers are concerned that Treasury has not already made a decision
about extending the "make available" requirement through 2005. They are
also concerned about the potential length of time it may take for the
Secretary of the Treasury to certify a terrorist event, potential
inefficiencies and time lags in processing and paying claims once an event
is certified, and the issue of TRIA expiration. As discussed already, TRIA
gives Treasury until September 2004 to make a decision about the "make
available" requirement for policies issued or renewed in 2005. Insurers
have stated that this deadline does not give them enough time to make
underwriting decisions and evaluate and possibly revise prices and terms,
actions they normally would want to undertake in mid-2004. Moreover, in
most states insurers will have to obtain regulatory approval for such
changes because TRIA's preemption of the states' authority to approve
insurance policy rates and conditions expired on December 31, 2003. Thus,
insurers are concerned that delay of Treasury's announcement on the "make
available" extension until the legal deadline may cost both companies and
policyholders money because policy changes will not be implemented in time
to issue or renew policies.

Insurers are also concerned that delays in the payment of claims by
Treasury, whether because of the length of time taken to certify that an
act of terrorism met the requirements for federal reimbursement or to
process and pay claims, might seriously impact insurer cash flows or, in
certain circumstances, solvency. While TRIA does not specify the length of
time available for determining whether an event meets the criteria for

certification, an NAIC official told us that insurers are bound by law and
regulations in most states to pay claims in a timely manner. As a result,
an insurer may have to pay policyholder claims in full while still
awaiting a certification decision, which could create a cash flow problem
for insurers. Insurers identified the anthrax letter incidents as an
example where law enforcement officials still have not identified the
source, whether foreign or domestic, more than 2 years after the
incidents. Moreover, if Treasury decided not to certify an event after
insurers had already paid policyholder claims, some insurers could become
insolvent. Unless the policyholder had paid for coverage of all terrorist
events- including those caused by domestic terrorists, which would be
excluded from reimbursement under TRIA-insurers would have paid for losses
for which they had collected no premium. An NAIC official explained that
insurers would have no way to recover payments already made to
policyholders for losses associated with the event other than to seek
remedies through the courts. Treasury officials have said that they
understand the difficulties facing insurers but cannot impose a time frame
on the certification process because it could involve complex fact-finding
processes. To facilitate the certification process, Treasury has met with
relevant individuals within the Department of Justice and the Department
of State to discuss their roles in the certification process. Insurers are
similarly concerned that the length of time Treasury may take to process
and pay claims could impact insurers' cash flow. In response to this
concern, Treasury has decided to use electronic fund transfers to
insurer's accounts to speed reimbursement to insurers with approved
claims. Treasury expects this method could speed payment of claims and
reduce potential cash flow problems for insurers.

Finally, insurance industry officials are worried that uncertainty about
the extension of TRIA past its stated expiration date of December 2005
would impede their business and planning processes. Although TRIA does not
contain any specific extension provisions, industry participants are
concerned that a late decision on whether or not to extend TRIA would deny
them the time needed to tailor business operations and plans to an
insurance environment that either would or would not contain TRIA.

  Although Available, Few Are Buying Terrorism Insurance and the Industry Has
  Made Little Progress Toward Post-TRIA Coverage

While TRIA has improved the availability of terrorism insurance,
particularly for high-risk properties in major metropolitan areas, most
commercial policyholders are not buying the coverage. Limited industry
data suggest that 10-30 percent of commercial policyholders are purchasing
terrorism insurance, perhaps because most policyholders perceive
themselves at relatively low risk for a terrorist event. Some industry
experts are concerned that those most at risk from terrorism are generally
the ones buying terrorism insurance. In combination with low purchase
rates, these conditions could result in uninsured losses for those
businesses without terrorism coverage or cause financial problems for
insurers, should a terrorist event occur. Moreover, even policyholders who
have purchased terrorism insurance may remain uninsured for significant
risks arising from certified terrorist events-that is, those meeting
statutory criteria for reimbursement under TRIA-such as those involving
NBC agents or radioactive contamination. Finally, although insurers and
some reinsurers have cautiously reentered the terrorism risk market,
insurance industry participants have made little progress toward
developing a mechanism that could permit the commercial insurance market
to resume providing terrorism coverage without a government backstop.

    TRIA Has Improved the Availability of Terrorism Insurance, Particularly for
    Some High-Risk Policyholders

TRIA has improved the availability of terrorism insurance, especially for
some high-risk policyholders. According to insurance and risk management
experts, these were the policyholders who had difficulty finding coverage
before TRIA. TRIA requires that insurers "make available" coverage for
terrorism on terms not differing materially from other coverage. Largely
because of this requirement, terrorism insurance has been widely
available, even for development projects in high-risk areas of the
country. Although industry data on policyholder characteristics are
limited and cannot be generalized to all policyholders in the United
States, risk management and real estate representatives generally agree
that after TRIA was passed, policyholders-including borrowers obtaining
mortgages for "trophy" properties, owners and developers of high-risk
properties in major city centers, and those in or near "trophy"
properties- were able to purchase terrorism insurance.

Additionally, TRIA contributed to better credit ratings for some
commercial mortgage-backed securities. For example, prior to TRIA's
passage, the credit ratings of certain mortgage-backed securities, in
which the underlying collateral consisted of a single high-risk commercial
property, were downgraded because the property lacked or had inadequate
terrorism insurance. The credit ratings for other types of

mortgage-backed securities, in which the underlying assets were pools of
many types of commercial properties, were also downgraded but not to the
same extent because the number and variety of properties in the pool
diversified their risk of terrorism. Because TRIA made terrorism insurance
available for the underlying assets, thus reducing the risk of losses from
terrorist events, it improved the overall credit ratings of
mortgage-backed securities, particularly single-asset mortgage-backed
securities. Credit ratings affect investment decisions that revolve around
factors such as interest rates because higher credit ratings result in
lower costs of capital. According to an industry expert, investors use
credit ratings as guidance when evaluating the risk of mortgage-backed
securities for investment purposes. Higher credit ratings reflect lower
credit risks. The typical investor response to lower credit risks is to
accept lower returns, thereby reducing the cost of capital, which
translates into lower interest rates for the borrower.

To the extent that the widespread availability of terrorism insurance is a
result of TRIA's "make available" requirement, Treasury's decision on
whether to extend the requirement to year three of the program is vitally
important. While TRIA has ensured the availability of terrorism insurance,
we have little quantitative information on the prices charged for this
insurance. Treasury is engaged in gathering data through surveys that
should provide useful information about terrorism insurance prices. TRIA
requires that they make the information available to Congress upon
request. In addition, TRIA also requires Treasury to assess the
effectiveness of the act and evaluate the capacity of the industry to
offer terrorism insurance after its expiration. This report is to be
delivered to Congress no later than June 30, 2005.

    Most Policyholders Have Not Bought Terrorism Insurance

Although TRIA improved the availability of terrorism insurance, relatively
few policyholders have purchased terrorism coverage. We testified
previously that prior to September 11, 2001, policyholders enjoyed "free"
coverage for terrorism risks because insurers believed that this risk was
so low that they provided the coverage without additional premiums as part
of the policyholder's general property insurance policy. After September
11, prices for coverage increased rapidly and, in some cases, insurance
became very difficult to find at any price. Although a purpose of TRIA is
to make terrorism insurance available and affordable, the act does not
specify a price structure.

However, experts in the insurance industry generally agree that after the
passage of TRIA, low-risk policyholders (for example, those not in major

urban centers) received relatively low-priced offers for terrorism
insurance compared to high-risk policyholders, and some policyholders
received terrorism coverage without additional premium charges.8 Yet
according to insurance experts, despite low premiums, many businesses
(especially those not in "target" localities or industries) did not buy
terrorism insurance. Some simply may not have perceived themselves at risk
from terrorist events and considered terrorism insurance, even at low
premiums (relative to high-risk areas), a bad investment.9 According to
insurance sources, other policyholders may have deferred their decision to
buy terrorism insurance until their policy renewal date.

Some industry experts have voiced concerns that low purchase rates may
indicate adverse selection-where those at the most risk from terrorism are
generally the only ones buying terrorism insurance. Although industry
surveys are limited in their scope and not appropriate for marketwide
projections, the surveys are consistent with each other in finding low
"take-up" rates, the percentage of policyholders buying terrorism
insurance, ranging from 10 to 30 percent. According to one industry
survey, the highest take-up rates have occurred in the Northeast, where
premiums were generally higher than the rest of the country.

The combination of low take-up rates and high concentration of purchases
in an area thought to be most at risk raises concerns that, depending on
its location, a terrorist event could have additional negative effects.

o  If a terrorist event took place in a location not thought to be a
terrorist "target," where most businesses had chosen not to purchase
terrorism insurance, then businesses would receive little funding from
insurance claims for business recovery efforts, with consequent negative
effects on owners, employers, suppliers, and customers.

o  Alternatively, if the terrorist event took place in a location deemed
to be a "target," where most businesses had purchased terrorism insurance,
then adverse selection could result in significant financial

8According to industry experts, the insurers that provided "free"
terrorism insurance likely did so for policies already in place at the
time TRIA was enacted and may have deferred operational changes and
difficult pricing decisions because they lacked the resources to do so.

9Howard Kunreuther, Erwann Michel-Kerjan, and Beverly Porter, Assessing,
Managing and Financing Extreme Events: Dealing with Terrorism (National
Bureau of Economic Research: December 2003), 13.

problems for insurers. A small customer base of geographically
concentrated, high-risk policyholders could leave insurers unable to cover
potential losses, facing possible insolvency. If, however, a higher
percentage of business owners had chosen to buy the coverage, the
increased number of policyholders would have reduced the chance that
losses in any one geographic location would create a significant financial
problem for an insurer.10

    Tighter Exclusions Leave Policyholders Exposed to Significant Perils

Since September 11, 2001, the insurance industry has moved to tighten
long-standing exclusions from coverage for losses resulting from NBC
attacks and radiation contamination. As a result of these exclusions and
the actions of a growing number of state legislatures to exclude losses
from fire following a terrorist attack, even those policyholders who
choose to buy terrorism insurance may be exposed to potentially
significant losses. Although NBC coverage was generally not available
before September 11, after that event insurers and reinsurers recognized
the enormity of potential losses from terrorist events and introduced new
practices and tightened policy language to further limit as much of their
loss exposures as possible. (We discuss some of these practices and
exclusions in more detail in the next section.) State regulators and
legislatures have approved these exclusions, allowing insurers to restrict
the terms and conditions of coverage for these perils. Moreover, because
TRIA's "make available" requirements state that terms for terrorism
coverage be similar to those offered for other types of policies, insurers
may choose to exclude the perils from terrorism coverage just as they have
in other types of coverage. According to Treasury officials, TRIA does not
preclude Treasury from providing reimbursement for NBC events, if insurers
offered this coverage. However, policyholder losses from perils excluded
from coverage, such as NBCs, would not be "insured losses" as defined by
TRIA and would not be covered even in the event of a certified terrorist
attack.

In an increasing number of states, policyholders may not be able to
recover losses from fire following a terrorist event if the coverage in
those states is not purchased as part of the offered terrorism coverage.
We have previously reported that approximately 30 states had laws
requiring coverage for "fire-following" an event-known as the standard
fire policy

10Casualty Actuarial Society, Foundations of Casualty Actuarial Science,
4th ed. (United Book Press, Inc.: 2001), 51, 86.

(SFP)-irrespective of the fire's cause. Therefore, in SFP states fire
following a terrorist event is covered whether there is insurance coverage
for terrorism or not. After September 11, some legislatures in SFP states
amended their laws to allow the exclusion of fire following a terrorist
event from coverage. As of March 1, 2004, 7 of the 30 SFP states had
amended their laws to allow for the exclusion of acts of terrorism from
statutory coverage requirements.11 However as discussed previously, the
"make available" provision requires coverage terms offered for terrorist
events to be similar to coverage for other events. Treasury officials
explained that in all non-SFP states, and the seven states with modified
SFPs, insurers must include in their offer of terrorism insurance coverage
for fire following a certified terrorist event because coverage for fire
is part of the property coverage for all other risks. Thus, policyholders
who have accepted the offer would be covered for fire following a
terrorist event, even though their state allows exclusion of the coverage.
However, policyholders who have rejected their offer of coverage for
terrorism insurance would not be covered for fire following a terrorist
event. According to insurance experts, losses from fire damage can be a
relatively large proportion of the total property loss. As a result,
excluding terrorist events from SFP requirements could result in
potentially large losses that cannot be recovered if the policyholder did
not purchase terrorism coverage. For example, following the 1994
Northridge earthquake in California, total insured losses for the
earthquake were $15 billion-$12.5 billion of which were for fire damage.
According to an insurance expert, policyholders were able to recover
losses from fire damage because California is an SFP state, even though
most policies had excluded coverage for earthquakes.

Under TRIA, reinsurers are offering a limited amount of coverage for
terrorist events for insurers' remaining exposures, but insurers have not
been buying much of this reinsurance. According to insurance industry
sources, TRIA's ceiling on potential losses has enabled reinsurers to
return cautiously to the market. That is, reinsurers generally are not
offering coverage for terrorism risk beyond the limits of the insurer
deductibles and the 10 percent share that insurers would pay under TRIA
(see app. I). In spite of reinsurers' willingness to offer this coverage,
company representatives have said that many insurers have not purchased

    Reinsurers Have Cautiously Returned to the Market, but Many Insurers Have
    Not Bought Reinsurance

11According to the National Association of Mutual Insurance Companies,
Louisiana, Michigan, Minnesota, Nebraska, New Hampshire, Oklahoma, and
Virginia have amended their standard fire policies to allow for exclusion
of terrorism from statutory fire coverage. State legislators in
Massachusetts have introduced a similar bill.

reinsurance. Insurance experts suggested that the low demand for the
reinsurance might reflect, in part, commercial policyholders' generally
low take-up rates for terrorism insurance. Moreover, insurance experts
also have suggested that insurers may believe that the price of
reinsurance is too high relative to the premiums they are earning from
policyholders for terrorism insurance.

The relatively high prices charged for the limited amounts of terrorism
reinsurance available are probably the result of interrelated factors.
First, even before September 11 both insurance and reinsurance markets
were beginning to harden; that is, prices were beginning to increase after
several years of lower prices. Reinsurance losses resulting from September
11 also depressed reinsurance capacity and accelerated the rise in
prices.12 The resulting hard market for property-casualty insurance
affected the price of most lines of insurance and reinsurance. A notable
example has been the market for medical malpractice insurance.13 The hard
market is only now showing signs of coming to an end, with a resulting
stabilization of prices for most lines of insurance. In addition to the
effects of the hard market, reinsurer awareness of the adverse selection
that may be occurring in the commercial insurance market could be another
factor contributing to higher reinsurance prices. Adverse selection
usually represents a larger-than-expected exposure to loss. Reinsurers are
likely to react by increasing prices for the terrorism coverage that they
do sell.

In spite of the reentry of reinsurers into the terrorism market, insurance
experts said that without TRIA caps on potential losses, both insurers and
reinsurers likely still would be unwilling to sell terrorism coverage
because they have not found a reliable way to price their exposure to
terrorist losses. According to industry representatives, neither insurers
nor reinsurers can estimate potential losses from terrorism or determine
prices for terrorism insurance without a pricing model that can estimate
both the frequency and the severity of terrorist events. Reinsurance
experts said that current models of risks for terrorist events do not have
enough historical data to dependably estimate the frequency or severity of
terrorist events, and therefore cannot be relied upon for pricing
terrorism insurance. According to the experts, the models can predict a
likely range

12Capacity is the amount of reinsurance or insurance that is available for
a defined risk.

13U.S. General Accounting Office, Medical Malpractice Insurance: Multiple
Factors Have Contributed to Increased Premium Rates, GAO-03-702
(Washington, D.C.: June 27, 2003).

of insured losses resulting from the damage if specific event parameters
such as type and size of weapon and location are specified. However, the
models are unable to predict the probability of such an attack.

Even as they are charging high prices, reinsurers are covering less. In
response to the losses of September 11, industry sources have said that
reinsurers have changed some practices to limit their exposures to acts of
terrorism. For example, reinsurers have begun monitoring their exposures
by geographic area, requiring more detailed information from insurers,
introducing annual aggregate and event limits, excluding large insurable
values, and requiring stricter measures to safeguard assets and lives
where risks are high.14 And as discussed previously, almost immediately
after September 11 reinsurers began broadening NBC exclusions beyond
scenarios involving industrial accidents, to include events such as
nuclear plant accidents and chemical spills and encompass intentional
destruction from terrorists. For example, post-September 11 exclusions for
nuclear risks include losses from radioactive contamination to property
and radiation sickness from dirty bombs.

As of March 1, 2004, industry sources indicated that there has been little
development or movement among insurers or reinsurers toward developing a
private-sector mechanism that could provide capacity, without government
involvement, to absorb losses from terrorist events. Industry officials
have said that their level of willingness to participate more fully in the
terrorism insurance market in the future will be determined, in part, by
whether any more events occur. Industry sources could not predict if
reinsurers would return to the terrorism insurance market after TRIA
expires, even after several years and in the absence of further major
terrorist attacks in the United States. They explained that reinsurers are
still recovering from the enormous losses of September 11 and still cannot
price terrorism coverage. In the long term and without another major
terrorist attack, insurance and reinsurance companies might eventually
return. However, should another major terrorist attack take place,
reinsurers told us that they would not return to this market- with or
without TRIA.

14Christian Brauner and Georges Galey, "Terrorism Risks in Property
Insurance and Their Insurability after 11 September 2001," (Swiss
Reinsurance Company: 2003), 25.

Conclusions

Congress had two major objectives in establishing TRIA. The first was to
ensure that business activity did not suffer from the lack of insurance by
requiring insurers to continue to provide protection from the financial
consequences of another terrorist attack. Since TRIA was enacted in
November 2002, terrorism insurance generally has been widely available
even for development projects in high-risk areas of the country, in large
part because of TRIA's "make available" requirement. Although most
businesses are not buying coverage, there is little evidence that
commercial development has suffered to a great extent-even in lowerrisk
areas of the county, where purchases of coverage may be lowest. Further,
although quantifiable evidence is lacking on whether the availability of
terrorism coverage under TRIA has contributed to the economy, the current
revival of economic activity suggests that the decision of most commercial
policyholders to decline terrorism coverage has not resulted in
widespread, negative economic effects. As a result, the first objective of
TRIA appears largely to have been achieved.

Congress's second objective was to give the insurance industry a
transitional period during which it could begin pricing terrorism risks
and developing ways to provide such insurance after TRIA expires. The
insurance industry has not yet achieved this goal. We observed after
September 11 the crucial importance of reinsurers for the survival of the
terrorism insurance market and reported that reinsurers' inability to
price terrorism risks was a major factor in their departure from the
market. Additionally, most industry experts are tentative about
predictions of the level of reinsurer and insurer participation in the
terrorism insurance market after TRIA expires. Unfortunately, insurers and
reinsurers still have not found a reliable method for pricing terrorism
insurance, and although TRIA has provided reinsurers the opportunity to
reenter the market to a limited extent, industry participants have not
developed a mechanism to replace TRIA. As a result, reinsurer and
consequently, insurer, participation in the terrorism insurance market
likely will decline significantly after TRIA expires.

Not only has no private-sector mechanism emerged for supplying terrorism
insurance after TRIA expires, but to date there also has been little
discussion of possible alternatives for ensuring the availability and
affordability of terrorism coverage after TRIA expires. Congress may
benefit from an informed assessment of possible alternatives-including
both wholly private alternatives and alternatives that could involve some
government participation or action. Such an assessment could be a part of
Treasury's TRIA-mandated study to "assess...the likely capacity of the

property and casualty insurance industry to offer insurance for terrorism
risk after termination of the Program."

  Recommendation for Executive Action

As part of the response to the TRIA-mandated study that requires Treasury
to assess the effectiveness of TRIA and evaluate the capacity of the
industry to offer terrorism insurance after TRIA expires, we recommend
that the Secretary of the Treasury, after consulting with the insurance
industry and other interested parties, identify for Congress an array of
alternatives that may exist for expanding the availability and
affordability of terrorism insurance after TRIA expires. These
alternatives could assist Congress during its deliberations on how best to
ensure the availability and affordability of terrorism insurance after
December 2005.

Mr. Chairman, this concludes my prepared statement, and I would be pleased
to respond to any questions that you or other members of the Committee may
have.

Contacts andFor further information regarding this testimony please
contact Richard J. Hillman, Director, or Lawrence D. Cluff, Assistant
Director, Financial

Acknowledgments Markets and Community Investment, (202) 512-8678.
Individuals making key contributions to this testimony include Rachel
DeMarcus, Barry Kirby, Tarek Mahmassani, Angela Pun, and Barbara Roesmann.

                      Appendix I: TRIA Background �

Under TRIA, Treasury is responsible for reimbursing insurers for a portion
of terrorism losses under certain conditions. Payments are triggered when
(1) the Secretary of the Treasury certifies that terrorists acting on
behalf of foreign interests have carried out an act of terrorism and (2)
aggregate insured losses for commercial property and casualty damages
exceed $5,000,000 for a single event.1 TRIA specifies that an insurer is
responsible (that is, will not be reimbursed) for the first dollars of its
insured losses- its deductible amount. TRIA sets the deductible amount for
each insurer equal to a percentage of its direct earned premiums for the
previous year.2 Beyond the deductible, insurers also are responsible for
paying a percentage of insured losses. Specifically, TRIA structures
pay-out provisions so that the federal government shares the payment of
insured losses with insurers at a 9:1 ratio-the federal government pays 90
percent of insured losses and insurers pay 10 percent-until aggregate
insured losses from all insurers reach $100 billion in a calendar year
(see fig. 1). Thus, under TRIA's formula for sharing losses, insurers are
reimbursed for portions of the claims they have paid to policyholders.
Furthermore, TRIA then releases insurers who have paid their deductibles
from any further liability for losses that exceed aggregate insured losses
of $100 billion in any one year. Congress is charged with determining how
losses in excess of $100 billion will be paid.

1Aggregate insured losses are the sum of insured property and casualty
losses from all commercial policyholders that result from a certified act
of terrorism.

2Section 102(4) of TRIA defines direct earned premiums as "a direct earned
premium for property and casualty insurance issued by any insurer for
insurance against losses ..." Treasury provided further clarification that
direct earned premiums are "earned as reported to the NAIC in the Annual
Statement in column 2 of Exhibit of Premiums and Losses (commonly known as
Statutory Page 14)" and cover all risks, not only for risks from
terrorism. The percentage of the direct earned premium allowed as an
insurer deductible varies over the program years: 7 percent in 2003, 10
percent in 2004, and 15 percent in 2005.

Figure 1: Prerequisites for and Limits of Coverage Under TRIA

Criteria for TRIP payments

                                  Event occurs

 Secretary of Treasury certifies the event as an act of foreign terrorism 90% 0

                            Payment responsibilities

Federal government reimbursement to insurers Insurer payments to
policyholders (not federally reimbursed) Source: GAO analysis of Terrorism
Risk Insurance Act of 2002. aThe percentage of direct earned premiums
increases each year: 7 percent in 2003, 10 percent in 2004, and 15 percent
in 2005.

TRIA also contains provisions and a formula requiring Treasury to recoup
part of the federal share if the aggregate sum of all insurers'
deductibles and 10 percent share is less than the amount prescribed in the
act-the "insurance marketplace aggregate retention amount." TRIA also
gives the Secretary of the Treasury discretion to recoup more of the
federal payment if deemed appropriate.3 Commercial property-casualty
policyholders would pay for the recoupment through a surcharge on

3According to Treasury officials, the formula for the mandatory portion of
the recoupment is intended to ensure that the insurance industry is
financially responsible for a prescribed level of the first dollars of
losses. The prescribed loss levels are as follows: $10 billion in 2003,
$12.5 billion in 2004, and $15 billion in 2005. Therefore, if the sum of
insurers' aggregate payments for deductibles and the 10 percent share-the
amounts paid by industry-is less than the level prescribed for that year,
then a recoupment would be required to collect the difference. On the
other hand, if the amounts paid by industry exceed the prescribed level,
then a recoupment would not be needed.

premiums for all the property-casualty policies in force after Treasury
established the surcharge amount; the insurers would collect the
surcharge. TRIA limits the surcharge to a maximum of 3 percent of annual
premiums, to be assessed for as many years as necessary to recoup the
mandatory amount. TRIA also gives the Secretary of the Treasury discretion
to reduce the annual surcharge in consideration of various factors such as
the economic impact on urban centers. However, if Treasury makes such
adjustments, it has to extend the surcharges for additional years to
collect the remainder of the recoupment.

Treasury is funding the Terrorism Risk Insurance Program (TRIP) office
-through which it administers TRIA provisions and would pay claims- with
"no-year money" under a TRIA provision that gives Treasury authority to
utilize funds necessary to set up and run the program.4 The TRIP office
had a budget of $8.97 million for fiscal year 2003 (of which TRIP spent $4
million), $9 million for fiscal year 2004, and a projected budget of
$10.56 million for fiscal year 2005-a total of $28.53 million over 3
years. The funding levels incorporate the estimated costs of running a
claims-processing operation in the aftermath of a terrorist event: $5
million in fiscal years 2003 and 2004 and $6.5 million in fiscal year
2005, representing about 55-60 percent of the budget for each fiscal year.
If no certified terrorist event occurrs, the claims-processing function
would be maintained at a standby level, reducing the projected costs to
$1.2 million annually, or about 23 percent of the office's budget in each
fiscal year. Any funds ultimately used to pay the federal share after a
certified terrorist event would be in addition to these budgeted amounts.

4"No-year money" is budget authority that remains available for obligation
until expended, usually until the objectives for which the authority was
made available are attained.

(250201)

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