Terrorism Insurance
Effects of the Terrorism Risk Insurance Act of 2002 Gao ID: GAO-04-720T April 28, 2004After 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 describe how TRIA affected the terrorism insurance market.
TRIA has enhanced the availability of terrorism insurance for commercial policyholders, largely fulfilling a principal objective of the program. In particular, TRIA has benefited commercial policyholders in major metropolitan areas perceived to be at greater risk for a terrorist attack. Prior to TRIA, we 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. We also conveyed the widespread concern that general economic growth and development could be slowed by a lack of available terrorism insurance. Since TRIA's enactment, terrorism insurance generally has been widely available, even for development projects in perceived high-risk areas, largely because of the requirement in TRIA that insurers "make available" coverage for terrorism on terms not differing materially from other coverage. Although the purpose of TRIA is to make terrorism insurance available, it does not directly address prices. As part of its assessment of TRIA's effectiveness, Treasury is engaged in gathering data through surveys that should provide useful information about terrorism insurance prices in the marketplace. 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 and 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 contamination. Meanwhile, although insurers and some reinsurers have cautiously reentered the terrorism risk market to cover insurers' remaining exposures, little progress has been observed within the private sector toward either finding a reliable method for pricing terrorism insurance or developing any viable reinsurance alternatives to TRIA once it expires.
GAO-04-720T, Terrorism Insurance: Effects of the Terrorism Risk Insurance Act of 2002
This is the accessible text file for GAO report number GAO-04-720T
entitled 'Terrorism Insurance: Effects of the Terrorism Risk Insurance
Act of 2002' which was released on April 28, 2004.
This text file was formatted by the U.S. General Accounting Office
(GAO) to be accessible to users with visual impairments, as part of a
longer term project to improve GAO products' accessibility. Every
attempt has been made to maintain the structural and data integrity of
the original printed product. Accessibility features, such as text
descriptions of tables, consecutively numbered footnotes placed at the
end of the file, and the text of agency comment letters, are provided
but may not exactly duplicate the presentation or format of the printed
version. The portable document format (PDF) file is an exact electronic
replica of the printed version. We welcome your feedback. Please E-mail
your comments regarding the contents or accessibility features of this
document to Webmaster@gao.gov.
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed
in its entirety without further permission from GAO. Because this work
may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this
material separately.
Testimony:
Before the Subcommittee on Capital Markets, Insurance and Government
Sponsored Enterprises and the Subcommittee on Oversight and
Investigations, Committee on Financial Services, House of
Representatives:
United States General Accounting Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Wednesday, April 28, 2004:
Terrorism Iinsurance:
Effects of the Terrorism Risk Insurance Act of 2002:
Statement of Richard J. Hillman, Director, Financial Markets and
Community Investment:
GAO-04-720T:
GAO Highlights:
Highlights of GAO-04-720T, a testimony before the House Financial
Services Committee, Subcommittee on Capital Markets, Insurance, and
Government-Sponsored Enterprises and the Subcommittee on Oversight and
Investigations.
Why GAO Did This Study:
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 describe how TRIA affected the terrorism insurance
market.
What GAO Found:
TRIA has enhanced the availability of terrorism insurance for
commercial policyholders, largely fulfilling a principal objective of
the program. In particular, TRIA has benefited commercial policyholders
in major metropolitan areas perceived to be at greater risk for a
terrorist attack. Prior to TRIA, we 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. We also conveyed the widespread
concern that general economic growth and development could be slowed by
a lack of available terrorism insurance. Since TRIA‘s enactment,
terrorism insurance generally has been widely available, even for
development projects in perceived high-risk areas, largely because of
the requirement in TRIA that insurers ’make available“ coverage for
terrorism on terms not differing materially from other coverage.
Although the purpose of TRIA is to make terrorism insurance available,
it does not directly address prices. As part of its assessment of
TRIA‘s effectiveness, Treasury is engaged in gathering data through
surveys that should provide useful information about terrorism
insurance prices in the marketplace.
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 and 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 contamination. Meanwhile, although
insurers and some reinsurers have cautiously reentered the terrorism
risk market to cover insurers‘ remaining exposures, little progress has
been observed within the private sector toward either finding a
reliable method for pricing terrorism insurance or developing any
viable reinsurance alternatives to TRIA once it expires.
What GAO Recommends:
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.
[End of section]
Mr. Chairman, Madam Chairwoman, and Members of the Subcommittees:
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 economy.[Footnote 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.[Footnote
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.[Footnote 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, 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 Treasury and insurance industry
participants in implementing TRIA. We found that Treasury has made
significant progress in implementing the provisions of TRIA, but has
important work to complete in order to comply with all its
responsibilities under the act. Second, we discuss the changes in the
market for terrorism insurance coverage under TRIA. As requested, my
testimony today focuses on the second of these two objectives. That is,
how TRIA has affected the market for terrorism insurance and, more
generally, the economy. Additionally, I have included appendixes to
this statement that provide background information on TRIA and describe
completed and ongoing engagements that GAO has undertaken for this
Committee that relate to increasing the insurance industry's capacity
to provide insurance for terrorism and natural catastrophe risks.
In summary, it appears that Congress's first objective in creating
TRIA--to ensure that business activity did not materially suffer from a
lack of available terrorism insurance--largely has been achieved. Since
TRIA was enacted in November 2002, terrorism insurance generally has
been available to businesses. But most commercial policyholders are not
buying the coverage. According to insurance industry experts, purchases
have been higher in areas considered to be at high risk of another
terrorist attack. However, many policyholders with businesses or
properties not located in perceived high-risk locations are not buying
coverage because they view any price for terrorism insurance as high
relative to their perceived risk exposure. Further, those that have
bought terrorism insurance remain exposed to significant perils because
insurers have broadened longstanding policy exclusions of nuclear,
biological, and chemical (NBC) events. Congress's second objective--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 been achieved yet. 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 this 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.[Footnote 4] 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
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.
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.[Footnote 5] 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.[Footnote 6] 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.[Footnote 7] 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
market-wide 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.
* 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.
* 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
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.[Footnote 8]
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 treaty 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 (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 the
terrorist attacks of September 11, 2001, 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.[Footnote 9] 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 7 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.
Reinsurers Have Cautiously Returned to the Market, but Many Insurers
Have Not Bought Reinsurance:
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. In spite of reinsurers' willingness to
offer this coverage, company representatives have said that many
insurers have not purchased 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.[Footnote 10] 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.[Footnote 11] 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 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.[Footnote 12] And as discussed
previously, almost immediately after September 11 reinsurers began
broadening NBC exclusions beyond scenarios involving industrial
accidents, such as nuclear plant accidents and chemical spills, to
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 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.
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 development has suffered to a great extent--even in
lower-risk 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, Madam Chairwoman, this concludes my statement. I would be
pleased to respond to any questions that you or other members of the
Subcommittees may have.
Contacts and Acknowledgements:
For further information regarding this testimony please contact Richard
J. Hillman or Davi M. D'Agostino, Directors, or Lawrence D. Cluff or
Wesley M. Phillips, Assistant Directors, Financial Markets and
Community Investment, (202) 512-8678. Individuals making key
contributions to this testimony include Sonja Bensen, Rachel DeMarcus,
Tom Givens III, Jill Johnson, Barry Kirby, Caitlyn Lam, Tarek
Mahmassani, Angela Pun, and Barbara Roesmann.
[End of section]
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.[Footnote 13] 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.[Footnote 14] 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.
Figure 1: Prerequisites for and Limits of Coverage Under TRIA:
[See PDF for image]
[A] The percentage of direct earned premiums increases each year: 7
percent in 2003, 10 percent in 2004, and 15 percent in 2005.
[End of figure]
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.[Footnote 15] Commercial
property-casualty policyholders would pay for the recoupment through a
surcharge on 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
operations--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.[Footnote 16] 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 occurred, 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.
[End of section]
Appendix II: Summary of Completed and Ongoing GAO Work Related to
Insurance for Terrorism and Natural Catastrophe Risks:
Terrorist attacks and natural catastrophes---such as hurricanes and
earthquakes---pose unique challenges to insurers. Forecasting the
timing and severity of such events is difficult and the large losses
associated with catastrophes can threaten insurer safety and soundness.
Insurers also frequently respond to catastrophic events by cutting back
coverage significantly or substantially increasing premiums for
policyholders. Over the years, several approaches have been suggested
to expand the capacity of the insurance industry to cover catastrophic
events. These approaches include securitization of catastrophe risk,
changing tax and accounting treatment of catastrophe risk, and
permitting risk-retention groups to cover property as well as liability
exposures. At the request of the Chairman of the House Financial
Services Committee and others, we have completed reports that address
some of these issues or have work ongoing in these areas. Our work may
assist the Committee in its oversight of the insurance industry and
consideration of the industry's ability to both insure against and
respond to catastrophic events.
Securitization of Catastrophe Risk:
Given the enormous financial losses associated with catastrophic events
and questions about insurers' ability to cover such losses, interest
has been generated in transferring some of these risks to the capital
markets, which had total value of about $29 trillion as of the first
quarter of 2003. Since the mid-1990s, some insurance companies,
reinsurance companies, and capital market participants have developed
various financial instruments, the most prevalent of which are
catastrophe bonds. [Footnote 17] These bonds offer a relatively high
rate of return to investors that are willing to accept some of the
substantial risks associated with catastrophes.
In two previous reports, we assessed the development of the catastrophe
bond market.[Footnote 18] We found that some insurance companies view
catastrophe bonds as an important component of their overall strategy
for managing natural catastrophe financial risks. In addition,
representatives from some institutional investors we contacted
expressed positive views about catastrophe bonds because they offer
attractive yields compared to traditional investments and help
diversify investment risks. However, other insurers and investors are
not willing to issue or purchase catastrophe bonds because they are
more costly than traditional reinsurance, too risky, or illiquid. We
also reported that developing catastrophe bonds to cover terrorism
risks in the United States is considered challenging for many reasons,
including the difficulties associated with developing computer models
to predict the frequency and severity of terrorist attacks.
Sophisticated models have been developed to predict the frequency and
severity of natural catastrophes--particularly hurricanes--that have
facilitated the development of catastrophe bonds covering such risks.
Tax and Accounting Treatment of Catastrophe Risk:
We are currently conducting follow-up work on potential tax and
accounting issues raised in our previous reports that might affect the
use of catastrophe bonds. As we reported in September 2002, most
catastrophe bonds are issued offshore--for example, in Bermuda--rather
than in the United States due to favorable tax considerations. Some
insurance industry groups have argued for changes in U.S. tax laws to
encourage insurers to issue catastrophe bonds onshore to lessen
transaction costs and afford regulators greater scrutiny over these
activities. As part of our ongoing work, we are reviewing the tax
treatment of catastrophe risk coverage in selected European countries.
Furthermore, in 2003 we reported that the Financial Accounting
Standards Board had issued guidance that may require insurers or
investors to list catastrophe bond assets and liabilities on their
balance sheets. We reported that this guidance had the potential to
limit the appeal of issuing catastrophe bonds but that insurers and
financial market participants were not certain of the impact of this
guidance. We are continuing to investigate developments on these tax
and accounting issues and will discuss them in an upcoming report.
Some believe removing accounting and tax barriers that prevent U.S.
insurance companies from establishing tax-deductible reserves to cover
the financial risks associated with potential natural catastrophes and
terrorist attacks would supplement private-sector capacity. Under
current U.S. accounting standards and tax law, insurers must build any
reserves for events that have not yet occurred from after-tax income
(retained earnings). As a result, insurers do not usually establish
reserves in anticipation of catastrophic events, such as hurricanes.
Therefore, insurers attempt to limit their exposure to catastrophic
risks through the underwriting process, the purchase of reinsurance, or
issuance of catastrophe bonds, among other alternatives.
There is considerable disagreement about the appropriateness and
effectiveness of tax-deductible reserving. Advocates believe that
allowing insurers to establish such reserves would provide increased
capacity at lower cost. On the other hand, critics of tax-deductible
reserving have argued that, in addition to lowering federal tax
receipts, there is no assurance that insurers would actually increase
their catastrophe insurance capacity, but rather either shield existing
capital from taxes or substitute tax-deductible reserves for
reinsurance.
At the Chairman's request, we are currently reviewing the tax treatment
of catastrophe risk reserves in selected European countries---France,
Spain, Germany, Switzerland, and Italy. We continue to review these
practices and will comment on them in a forthcoming report. In addition
to discussing reserving practices, we are gathering information on
general approaches to insuring against catastrophic risks in these
countries.
Implementation of the Liability Risk Retention Act:
Congress enacted the Liability Risk Retention Act of 1986 (Act) to
facilitate the formation of risk-retention groups (RRGs) and risk-
purchasing groups (RPGs), insurance entities initially established to
increase the availability and affordability of liability insurance
during the 1980s.[Footnote 19] As authorized by the Act, these groups
may only provide commercial liability insurance. An RRG is simply a
group of businesses with similar risks that join to create an insurance
company to self-insure their risks. An RPG, on the other hand, is a
group formed to purchase insurance as a single entity from a
traditional insurer. The majority of our ongoing work focuses on RRGs
because, as insurers, they have the potential to provide new insurance
capacity. A wide variety of groups, such as professional groups
(doctors, attorneys), institutions (universities, hospitals), and
businesses (trucking firms, homebuilders) have created RRGs. As of mid-
April 2004, about 150 RRGs were operational and approximately 72 were
formed in the last year and half.[Footnote 20] In contrast to most
other insurers, an RRG can sell insurance in as many states as it
chooses but is to be regulated by only one state--the state in which it
is chartered. [Footnote 21]
Our ongoing work focuses on assessing the extent to which RRGs have met
the Act's intent that they increase the availability and affordability
of liability insurance. We will also assess how the unique regulatory
structure of RRGs--where only one state serves as regulator--has
promoted the establishment of RRGs and if this structure has resulted
in uneven or ineffective regulation. The recent failure of four RRGs
has resulted in some regulators questioning the efficacy of having a
single-state regulator and the standards used by some states to charter
and regulate RRGs. If we identify any problems as part of our work, we
will evaluate what legislative or regulatory changes might be needed.
These changes, if needed, could be important whether or not, as some
advocates have suggested, the Act is expanded to include commercial
property insurance. Finally, in the event the Act were expanded to
include property insurance, we also are exploring the potential of RRGs
to provide additional capacity for terrorism insurance.
[End of section]
Appendix III: Prior GAO Reports and Testimonies Related to Insurance for
Terrorism and Natural Catastrophe Risks:
U.S. General Accounting Office, Terrorism Insurance: Implementation of
the Terrorism Risk Insurance Act of 2002, GAO-04-307 (Washington, D.C.:
Apr. 23, 2004).
U.S. General Accounting Office, Catastrophe Insurance Risks: Status of
Efforts to Securitize Natural Catastrophe and Terrorism Risk, GAO-03-
1033 (Washington, D.C.: Sep. 24, 2003).
U.S. General Accounting Office, Catastrophe Insurance Risks: The Role
of Risk-Linked Securities, GAO-03-195T (Washington, D.C.: Oct. 8,
2002).
U.S. General Accounting Office, Catastrophe Insurance Risks: The Role
of Risk-Linked Securities and Factors Affecting Their Use, GAO-02-941
(Washington, D.C.: Sep. 24, 2002).
U.S. General Accounting Office, Terrorism Insurance: Rising Uninsured
Exposure to Attacks Heightens Potential Economic Vulnerabilities, GAO-
02-472T (Washington, D.C.: Feb. 27, 2002).
U. S. General Accounting Office, Terrorism Insurance: Alternative
Programs for Protecting Insurance Consumers, GAO-02-199T (Washington,
D.C.: Oct. 24, 2001).
U.S. General Accounting Office, Terrorism Insurance: Alternative
Programs for Protecting Insurance Consumers, GAO-02-175T (Washington,
D.C.: Oct. 24, 2001).
U.S. General Accounting Office, Insurers' Ability to Pay Catastrophe
Claims, GAO/GGD-00-57R (Washington, D.C.: Feb. 8, 2000).
FOOTNOTES
[1] U.S. General Accounting Office, Terrorism Insurance: Implementation
of the Terrorism Risk Insurance Act of 2002, GAO-04-307 (Washington,
D.C.: Apr. 23, 2004).
[2] Reinsurance 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.
[3] U.S. General Accounting Office, Terrorism Insurance: Alternative
Programs for Protecting Insurance Consumers, GAO-02-175T (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).
[4] Filing services perform many services for insurance companies,
including submitting to state insurance regulators the documents
required to sell a line of insurance.
[5] TRIA 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.
However, TRIA gives Treasury the option of determining whether the
"make available" requirement should be extended through 2005, the third
year of the act, and gives the agency until September 1, 2004, to do
so.
[6] According 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.
[7] Howard Kunreuther, Erwann Michel-Kerjan, and Beverly Porter,
Assessing, Managing and Financing Extreme Events: Dealing with
Terrorism (National Bureau of Economic Research: December 2003), 13.
[8] Casualty Actuarial Society, Foundations of Casualty Actuarial
Science, 4th ed. (United Book Press, Inc.: 2001), 51, 86.
[9] According 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.
[10] Capacity is the amount of reinsurance or insurance that is
available for a defined risk.
[11] U.S. General Accounting Office, Medical Malpractice Insurance:
Multiple Factors Have Contributed to Increased Premium Rates,
GAO-03-702 (Washington, D.C.: June 27, 2003).
[12] Christian Brauner and Georges Galey, "Terrorism Risks in Property
Insurance and Their Insurability after 11 September 2001," (Swiss
Reinsurance Company: 2003), 25.
[13] Aggregate insured losses are the sum of insured property and
casualty losses from all commercial policyholders that result from a
certified act of terrorism.
[14] Section 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.
[15] According 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.
[16] "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.
[17] Catastrophe bonds are an example of risk-linked securities. This
statement focuses on catastrophe bonds that are privately placed
securities sold to institutional investors under Securities and
Exchange Commission Rule 144A. In general, a qualified institutional
investor under Rule 144A owns and invests on a discretionary basis at
least $100 million in securities of issuers that are not affiliated
with the investor.
[18] See U.S. General Accounting Office, Catastrophe Insurance Risks:
Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk,
GAO-03-1033 (Washington, D.C.: Sep. 24, 2003) and Catastrophe Insurance
Risks: The Role of Risk-Linked Securities and Factors Affecting Their
Use, GAO-02-941 (Washington, D.C.: Sep. 24, 2002).
[19] The Product Liability Risk Retention Act of 1981 established these
groups but limited them to providing product liability insurance. In
1986, in response to another shortage of liability insurance, Congress
amended the Act and allowed these groups to offer most types of
commercial liability insurance.
[20] Data estimates were provided by the Managing Editor, Risk
Retention Reporter.
[21] The McCarran-Ferguson Act of 1945 left regulation and taxation of
the insurance market to the states. (15 U.S.C. 1011) As a result,
states have primary responsibility for regulating the insurers
operating in their states and each state has its own insurance
department.
