Treasury Report on Terrorism Insurance: Exec Summary

June 30, 2005

The following is the Introduction and the Executive Summary of the June 30, 2005 report from the Treasury Department on the Terrorism Risk Insurance Act of 2002 including its assessment of the act and recommendations for Congress on whether to reneiw it.

Based on our research, we offer our assessment of TRIA. Treasury is required to assess:

A. The effectiveness of the Program;
B. The likely capacity of the property and casualty insurance industry to offer insurance for terrorism risk after termination of the Program; and,
C. The availability and affordability of such insurance for various policyholders, including railroads, trucking, and public transit.

A. Effectiveness
As discussed above, we evaluate the effectiveness of TRIA in terms of the purposes given in the legislation.

Item 1: Protect consumers by addressing market disruptions and ensure the continued widespread availability and affordability of property and casualty insurance for terrorism risk.

The year 2003 marked the first of three full years of subsidized Federal terrorism risk reinsurance. Surveys of insurers and policyholders through early 2005 suggest that policyholder take-up and the number of insurers writing terrorism risk insurance improved somewhat between
2002 and the period subsequent to enactment of TRIA (2003 through 2005). TRIA’s insurer deductibles have increased each year since 2003, shifting ever more of the burden of coverage from the Federal government back to the industry. In spite of this shift, the data show
policyholder take-up rose or stayed stable between 2003 and 2004 and between 2004 and early 2005, a pattern suggestive of a market increasingly able to provide coverage.

Availability of Terrorism Coverage
Insurer Survey Results – Insurers wrote terrorism risk coverage on 67 percent of commercial property and casualty insurance policies, a 7 percentage point increase from 2002. This increase is in part due to more insurers writing coverage for terrorism risk. Whereas 73 percent wrote coverage in 2002, fully 91 percent of insurers surveyed wrote terrorism insurance in 2003. The measures of terrorism risk insurance were generally stable between 2003 and 2004.

Policyholder Survey Results – Between 2002 and 2003, after the enactment of TRIA, take-up of terrorism risk insurance increased from 27 percent of policyholders to 39.5 percent. In 2004, 54 percent of policyholders reported having terrorism risk insurance coverage.
We note that these changes were correlated with the enactment of TRIA, but not necessarily a result of TRIA. Other factors, such as the general insurance underwriting cycle, likely had some
effect on market outcomes during this time. While we cannot quantify the share of observed coverage changes caused by TRIA, we do show evidence that suggests some effect of the Federal subsidy.

Pricing of Terrorism Coverage
Results from both the survey of insurers and the survey of policyholders suggest insurers resumed, or more accurately began, pricing terrorism risk insurance during the time TRIA was in effect.

Insurer Survey Results – In 2002, over 75 percent of insurers providing coverage for terrorism risk did not charge for it. That share declined to 46 percent in 2003 and just over 40 percent in 2004. As a consequence of more insurers charging for coverage during this period, the average
cost of terrorism insurance (measured as the share of total premiums paid for terrorism coverage) increased from 0.9 percent to 1.8 percent of premiums by 2004.

Among insurers who charged for terrorism insurance in 2002, however, average cost did not follow a straight pattern. The share of premiums charged for terrorism coverage first declined from 3.7 to 2.4 percent of premiums between 2002 and 2003, but then increased to 3.1 percent of
premiums by 2004.

Policyholder Survey Results – In 2002, 70 percent of policyholders with terrorism risk insuranc coverage reported that they received the coverage at no cost. That share declined to 42 percent in 2003 and further to 37 percent in 2004. As a consequence of more policyholders paying for terrorism risk insurance, the average cost of such coverage increased from 1.2 percent of premium in 2002 to 1.6 percent in 2003, and further to 1.7 percent of premium by 2004.

Among policyholders who reported paying for terrorism coverage, cost declined steadily over the period: from 4.0 percent of premium in 2002 to 2.8 percent in 2003 and further to 2.7 percent of premium in 2004.
Policyholders located in high-risk cities faced declining costs for terrorism risk coverage that varied from 2.8 percent of premiums in 2002, 3 percent in 2003 and 1.9 percent in 2004. This overall decline in the cost of terrorism coverage is the outcome of two opposing trends: an increasing share that are paying for coverage and declining prices among those who report paying for the coverage. More than half of policyholders in cities that are considered to be at high risk for a terrorist attack reported receiving coverage at no cost in 2002, but less than 30 percent reported free coverage in 2004.

On the other hand, the cost of terrorism coverage for paying policyholders in these high-risk cities declined substantially from 6.1 percent of premium in 2002, to 5.1 percent in 2003, and further to 2.6 percent in 2004.

Item 2: Allow for a transitional period for the private markets to stabilize, resume pricing of such insurance (described above), and build capacity to absorb any future losses, while preserving state insurance regulation and consumer protections.

Building Capacity to Absorb Future Losses
Industry surplus, a major source of insurer capacity, has returned to pre-September 11th levels. Insurers are financially stronger and more able to bear unexpected losses than they were prior to the enactment of TRIA.

Insurers might have begun charging for terrorism risk insurance, and insurer financial strength would have improved whether or not TRIA was enacted. We therefore cannot determine that TRIA effectively caused these changes to take place.

Reinsurance is another important component of an insurer’s capacity to absorb losses. Our data show a modest net increase in use of reinsurance over the period. Seventy percent of insurers reported purchasing reinsurance for terrorism risk in 2003, this fell to 65 percent in 2004 before increasing to 75 percent in the first months of 2005. Smaller and medium-sized insurers generally reported greater use of reinsurance for terrorism risk exposure (TRIA deductibles and
co-payments) between 2003 and 2005. During this same period, however, larger insurers reported less use of reinsurance for terrorism risk exposure.

Assessment (Items 1 and 2)
Overall we find that TRIA was effective in terms of the purposes it was designed to achieve.

TRIA provided a transitional period during which insurers had enhanced financial capacity to write terrorism risk insurance coverage. While we don’t ascribe a causal effect, during this period insurers began pricing for terrorism coverage and insurer financial strength improved.

More generally, TRIA provided an adjustment period allowing both insurers and policyholders to adjust to the post-September 11th view of terrorism risk.

TRIA’s effectiveness for these purposes does not imply continuation of the program. The sunset of TRIA should encourage the development of the private reinsurance market and other risktransfer mechanisms.

B. Insurance for Terrorism Risk after Termination of the Program
The likely capacity of the property and casualty insurance industry to offer insurance for terrorism risk after expiration of the program is the primary focus of Chapter 7 of the report.

TRIA provided a Federal backstop for terrorism losses that effectively subsidized terrorism risk insurance. It is reasonable to expect that the removal of the subsidy will result in a short-lived adjustment in coverage and pricing. We also sketch briefly the likely dynamics of the long run
adjustment.

Modeling
To provide and price insurance efficiently, insurers should be able to quantify their exposure to losses from terrorism risk. Insurers’ primary tool for quantifying loss exposure is modeling terrorism risk. Modeling terrorism risk has two critical components: (1) the ability to identify
and quantify the severity of an event in terms of insurers’ losses, and (2) the probability of the loss occurring. Our assessment of developments in risk modeling over the past few years is positive, but we note that challenges do remain.

Insurers’ ability to identify and quantify the severity of an event in terms of insurers’ losses has improved greatly. In particular, insurers are much better able to assess their exposures or accumulations of risk for a given terrorist event on an overall and individual customer basis.
This is important because it allows insurers to more effectively underwrite coverage.

Nevertheless, challenges remain, particularly in assessing the probability of the loss from terrorism. Because of the difficulty inherent in assessing these probabilities, use of models to predict terrorism risk is tempered by the uncertainty of their predictions.

Financial Capacity
We also assess capacity in terms of insurer financial strength, which incorporates both balance sheet strength and operating performance. The financial health of insurers, especially surplus, improved in the past three years. Among insurer groups providing coverage in TRIA-eligible
property and casualty lines, surplus was higher in the third quarter of 2004 than it was in the third quarters of 2001, 2002 and 2003.

Our surveys of insurers and policyholders also provide some indications of the development of private market capacity. Take-up of terrorism risk insurance, for example, continued to increase, while the ratio of policies written by insurers including terrorism coverage has been flat to rising,
even as the TRIA deductible rose over time.

It would not be surprising if the expiration of TRIA changes industry behavior since the business environment will change. Insurers, for example, will likely consider factors such as the possibility of insolvency from terrorism losses given the levels of surplus available and the effect on credit ratings. Experience with natural catastrophe risk underwriting and assignment of agency ratings suggests that in order to avoid ratings downgrades, insurers may significantly alter their approach to terrorism risk insurance after TRIA’s expiration. Among the changes
insurers may institute are increasing the use of private reinsurance, building surplus by tapping into capital markets, and raising premiums or placing exclusions on some policies.

The policyholder and insurer surveys include direct responses on the availability of coverage after the expiration of TRIA. Responding to questions about policies written in early 2005 that continue into 2006, nearly 50 percent of insurers reported that they are not writing coverage for terrorism risks in 2006 (after the scheduled expiration of TRIA) that is similar to the coverage they write under TRIA. One quarter of policyholders with terrorism risk coverage indicated that their coverage excludes terrorism coverage after the expiration of TRIA.

Assessment
TRIA’s expiration will conclude the transitional assistance first provided to the insurance markets in the uncertain economic environment of 2002. Overall, our assessment is that the immediate effect of the removal of the TRIA subsidy is likely to be less terrorism insurance
written by insurers, higher prices and lower policyholder take-up. While TRIA is in effect, however, it crowds out development of some reinsurance markets, and delays the development of private capacity to provide terrorism risk insurance. Over time, we expect that the private
market will develop additional terrorism insurance capacity. We anticipate that the initial response of premiums in the market will spur the buildup of surplus as insurers tap into capital markets and the development of additional private reinsurance and other risk shifting
mechanisms.

C. Availability and Affordability of Such Insurance for Various Policyholders, Including Railroads, Trucking, and Public Transit

Chapter 4 discusses terrorism risk insurance take-up and cost for various classes of policyholders, including railroads, trucking and public transit. Among railroads, estimated takeup rates were approximately 25 percent in 2002, 31 percent in 2003, and 32 percent in 2004. In
trucking, we estimate that take-up rates increased from 23 percent in 2002 to 31 percent in 2003 and 43 percent in 2004. The corresponding estimates for public transportation are 2 percent in 2002, 20 percent in 2003, and 36 percent in 2004.

Cost estimates for these populations are less precise because they are based on smaller sample sizes (only respondents with terrorism coverage provide cost information), and are more likely to
suffer from selection bias. The cost estimates for railroads are 5 percent of premiums in 2002 and 2003, increasing to 8 percent of premiums in 2004. These estimates, however, are based on only 13-15 observations (out of a population of 421 railroads). Cost estimates for trucking,
where sample sizes are reasonably good, fall from 0.68 percent in 2002 to 0.55 percent in 2003 and rise to 1.06 percent in 2004. Cost estimates for public transit are based on samples too small to report.

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