S&P’s: Little Ratings Cheer for Insurers in Terror Law

November 26, 2002

The newly mandated adoption of terrorism risk by commercial property/casualty insurers in the U.S. casts a shadow on ratings prospects, compounding Standard & Poor’s negative outlook on
the industry, according to the ratings service.

Although hailed as a boon for commercial activity, the Terrorism
Risk Insurance Act, signed into law Tuesday, creates numerous pitfalls and grey areas for insurers to contend with, according to S&P’s.

“The legislation amounts to a command from government for insurers to get back into the pool of terror risk,” Steve Dreyer, managing director in S&P’s insurance ratings, commented. “Compared to where they were, which was on dry land, the risk profile has to be worse with them in the water.”

Between Sept. 11, 2001 and passage of the Act, the insurance industry managed to extricate itself very effectively from terrorism risk. Except in the case of workers’ compensation business, most states allowed insurers to write terror exclusions into standard policies, while in the few states where insurers were compelled to offer the coverage, they could segregate the risk into an affiliate, surplus-lines company and enjoy considerable leeway in setting prices and conditions.

All that has changed with passage of the new Terrorism Risk Insurance Act. Terror exclusions are now prohibited both at the individual company level and at the state level. Insurers must offer terrorism insurance and quote a distinct price for it, although the policyholder may opt to waive the coverage and the associated fee.

For 2003, each insurer has a deductible of 7 percent of its direct premiums before government reimbursement would apply for a covered act of terrorism. That deductible increases to 10 percent in 2004 and 15 percent in 2005. The insurer would then retain 10 percent of additional losses, and the government 90 percent, up to a $100 billion cap.

According to S&P’s, from a ratings perspective, the positive effects are few.

The insurance industry gains a safety net in its workers’ compensation business that it did not have before, while the reinsurance industry has scope to gain business in the layers of risk where primary insurers are exposed.

The problems Standard & Poor’s sees for insurers, are manifold:

* Insurer deductibles under the Act are calculated as a percentage of
gross premiums, but companies that rely heavily on reinsurance base their capital levels on net premiums, which for them is a much smaller number. This means their liability under the Act could represent an extremely large proportion of their capital.

*Although the legislation does much to ease anxiety among the
insurance community, it cannot cure ignorance. By and large, insurers do not know how to price terror risk and could use government backing as a crutch for taking on exposure irresponsibly. Moreover, if insurers are pricing something they do not understand, they will tend to undercut each other.

*Claims for the effectiveness of terrorism pricing models, now coming
to market, are wildly exaggerated. Bathed in an aura of invincibility by such obfuscatory phrases as “fully probabilitistic,” they are at best a blunt instrument that could nevertheless lull insurers into a false sense of security.

*The legislation does not provide federal backing for an act committed in the course of a war declared by Congress. Does that mean acts by citizens or associates of Iraq, or of any other country with which the U.S. might be at war, would be excluded?

*The Act applies only to terrorism that has been carried out by an
individual or individuals acting on behalf of a foreign person or foreign
interest. This may be hard to determine if U.S. citizens are implicated.

*How long would it take for the government to reimburse insurers for
their payouts? Any delay could cause a devastating liquidity shortfall and threaten the solvency of some players. Some of the grey areas described above would have to be resolved by legal process, adding further delay.

*The Act prohibits the use of public funds to cover any payments that insurers must make to reimburse punitive damages against their clients. However, the Act does not outlaw punitive damages altogether. Insurers will therefore be entirely on the hook for these payouts, even though trial proceedings will be limited to federal court, where judgments tend to be smaller than in state courts.

*The Act states that each insurance company “shall make available
property and casualty insurance coverage for insured losses that does not differ materially from the terms, amounts, and other coverage limitations applicable to losses arising from events other than acts of terrorism.” How strictly will this clause be applied?

*States have the prerogative to determine a premium rate to be

According to S&P’s, although the progress of government-backstop legislation has been glacial, its implications for insurers could prove sudden and dramatic. The industry is on the hook for greater risk but has limited savvy or experience in managing it.

From a ratings standpoint, Standard & Poor’s will adjust its measure of
capital adequacy to take into account the terrorism risk that both insurers and reinsurers will be taking on, and it will call on them to demonstrate a thorough understanding of the new exposure.

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