Fitch Says Terrorism Bill a Mix Blessing for U.S. Insurers

Fitch Ratings commented that while the passage of a much anticipated terrorism insurance bill is overall a favorable development for the U.S. economy, and benefits the insurance industry, the passage of the bill will likely have a greater impact on industries other than property/casualty insurance, such as real estate and construction. Further, the timing of the passage of the bill may be indicative of a period of increased risk for the insurance market.

The bill, known as The Terrorism Risk Insurance Act of 2002, awaits the President’s signature for enactment after receiving Senate approval on Nov. 19, and House approval a week earlier. Fitch notes that the bill’s passage, after being stalled for over a year, comes following Congress’ authorization of President Bush to take military action against Iraq, and the Central Intelligence Agency’s announcement that the Al Qaeda terrorism network continues to pose a threat. Thus, while many insurers will be better protected from the economic consequences of another terrorism attack, the probability of another costly attack may now be higher based on these recent events.

The legislation will establish a three year cost-sharing program that applies to all primary commercial property/casualty insurance companies. Under the program, insurers would maintain a loss deductible equal to 7 percent of their direct earned premiums in the first full year of the program, 10 percent in the second year and 15 percent in the third year. Fitch estimates that at an assumed $150 billion of industry-wide commercial premium, the overall industry deductible would be $10.5 billion in the first year, $15 billion in the second year and $22.5 billion in the third year.

For losses in excess of those percentages, the federal government would cover 90 percent and insurers would cover 10 percent, subject to a recoupment program funded through subsequent surcharges on commercial policies of up to 3 percent of premium. The total amount of government coverage is set at $100 billion annually. The legislation requires that Congress determine the source of and procedures for payment of terrorist losses that exceed the $100 billion limit. The program covers acts of terrorism on all policies, and also includes acts of war for workers’ compensation.

According to Fitch, for insurers, there appears to be both positives and negatives in the legislation. The most significant positive is the government’s provision of catastrophic protection to insurers in the event of another major terrorist attack. This is especially beneficial for insurers writing coverages such as workers’ compensation, for which state insurance regulations prohibited any form of terrorism exclusion. It also aids insurers that have not been fully effective in gaining terrorism exclusions in their general commercial policies, and those in the 30 plus states that required use of the Standard Fire Policy, which does not permit exclusions for fire damage resulting from a terrorist attack.

The most significant negative is that all primary insurers are now required to offer terrorism insurance going forward along with their standard policies. Consequently, some insurers that were able to effectively eliminate the bulk of their terrorism exposure through policy exclusions may actually have an increased exposure to a moderate terrorism event because all insurers have a significant retention of terrorism-related losses, or ‘deductible’, that are borne before the government catastrophic protection becomes available.

The compulsory nature of participation in the program is also likely to hinder the development of other more market-oriented methods of managing and insuring terrorism exposures, which will add to uncertainty in three years when the current legislation expires.

Fitch also has some concerns that the structure of the program could induce insurers to take less prudent risks in pricing and accumulating terrorism exposures. The new program differs from traditional reinsurance structures, in which treaty terms are based largely on the cedants underlying risk profile and losses are funded by premiums ceded at actuarially determined rates. Rather, under this program, there is one policy limit for the entire industry, insurer retentions are dictated by size, and losses that exceed individual insurers’ retention are ultimately funded by future assessments on all commercial insurance policies.

Passage of the legislation creates some near term administrative challenges for commercial insurers. Upon passage, all terrorism exclusions in place under existing policies covered under the program will terminate. Insurers will be required to notify policyholders within 90 days of enactment of the change in coverage for terrorism exposures under this program, and the applicable increase in premium for this additional coverage. Insureds then have 30 days to decide whether to continue to exclude the terrorism coverage under the program or to pay the additional related premiums for coverage.

Several areas of uncertainty remain regarding the response to the program and this new availability of terrorism coverage. First, it is unclear what primary insurers will charge for the additional terrorism coverage under the program, how these rates will be derived, and what the impact of this program will have on broader commercial insurance pricing trends. The extent to which insureds will choose to pay for this additional coverage or opt out of receiving additional terrorism coverage is also unknown.

Additionally, insurers will be exposed to a high risk of adverse selection for a period of time. The suspension of any terrorism exclusions begins with the passage of the bill. If a covered terrorist act were to occur to an insured party after passage of the bill, but before that insured had accepted or declined the offer of additional coverage, the insured will certainly accept the offer. Fitch believes the length of this exposure will vary by insurer and can be anywhere from 31 to 120 days since the 30 day acceptance period begins when the insured receives written notice of the suspension of the exclusion and the new pricing for terrorism coverage. Thus, the sooner an insurer is able to provide customers with written notice, the shorter the company’s exposure to the risk of adverse selection.

Finally, it is also unclear whether reinsurers will be willing to remove terrorism exclusions from the protections they provide to primary insurers. Without reinsurance protection for losses within their retention, some insurers could actually be more exposed to terrorism losses when their terrorism exclusions are voided than before passage of the bill. Reinsurers are not protected by the program for any terrorism related losses that they assume.

Fitch does not anticipate any ratings actions due simply to the passage of the bill. On balance, the coverage provided in the bill will help to stabilize ratings if another costly attack were to occur.