Wharton Study Recommends Short-Term TRIA Renewal, Study of Long-Term Solution

August 10, 2005

A 224-page report from the Wharton School at the University of Pennsylvania recommends that Congress renew the current federal Terrorism Risk Insurance Act backstop but “only for a relatively short period of time.”

The study suggests that the trigger for providing TRIA coverage should be raised from $5 million to $500 million.

The Wharton study concludes that there is a need for long-term government involvement with the private sector in providing terrorism insurance. It stresses that after renewing the TRIA short-term program, Congress should study the entire terrorism coverage issue and various long-term options before installing a permanent program.

The Wharton Risk Management and Decision Processes Center this week published TRIA and Beyond, an analysis of the Terrorism Risk Insurance Act of 2002, which will expire December 31, 2005, if not renewed, and what roles the public and private sectors should play with respect to terrorism risk coverage in the U.S.

A nine-person team, led by Howard Kunreuther, co-director of the center, and Erwann Michel-Kerjan, a senior research fellow at the center, produced the report. The other authors include Neil Doherty, Wharton professor of insurance and risk management; Paul Kleindorfer, Wharton professor of operations and information management; Mark V. Pauly, Wharton professor of health care systems and business and public policy; Scott Harrington, Wharton professor of health care systems; Center research associate Esther Goldsmith, and senior fellows Irv Rosenthal and Peter Schmeidler.

TRIA now requires insurers to offer coverage against foreign, but not domestic, terrorism. The federal government agreed to underwrite most of the risk for the three-year life of TRIA after the private reinsurance industry largely withdrew from coverage following the September 11 attacks.

The U.S. Treasury and the Congressional Budget Office have argued that TRIA was meant to be a transitional program and that private markets should have been able to find ways to offer coverage at reasonable rates by now.

However, the TRIA and Beyond report suggests that the necessary changes and adjustments have not yet been made and that some form of long-term private-public partnership is needed.

The Wharton report calls upon U.S. Congress to name a national commission on terrorism risk coverage to comprehensively assess the issues involved before permanent legislation is enacted.

The study says that the current private-public TRIA partnership should be “modified so it is more equitable and efficient” and that Congress should consider other arrangements to deal with catastrophic losses in the long run. These include allowing insures to establish tax-deferred reserves, actions that could stimulate private reinsurance, the possible creation of mutual pools and federal reinsurance with explicit premium charges.

The far-reaching report discusses factors that currently prevent the private market from confidently pricing terrorism coverage risk, as well as factors including state mandated workers compensation and fire coverage that restrict free markets.

“The mandatory coverage of terrorism losses in workers’ compensation policies in all states and mandatory coverage in approximately one-third of the states of any losses from fires that occur following a terrorist attack, whether or not the firm has purchased terrorism insurance, opens up insurers to the possibility of large losses that could lead to some insolvencies,” notes the report.

The funding for the report came from 10 companies — ACE INA, American Insurance Association, American International Group, American Re, Liberty Mutual, Lockheed Martin, Property Casualty Insurers Association of America, State Farm Fire and Casualty Company, Swiss Re, Wyndham Partners Consulting, Ltd. (an Affiliate of Renaissance Re Holdings, Ltd.) and Zurich North America — and was provided before the study began.

“We benefited from the funding and from discussions with the sponsors, but the Risk Center had complete control over the contents of the report and the conclusions we reached are entirely our own,” says Kunreuther, one of the authors.

The insurance industry has already taken steps to utilize policy forms that would exclude terrorism coverage on January 1, 2006, should TRIA not be renewed. Congress is expected to act on the future of terrorism insurance in the U.S. in the next weeks or months.

“I would hope that TRIA will be renewed with appropriate modifications but that over the next two years Congress will also authorize a study of the whole terrorism insurance program,” Kunreuther said.

The authors reached their principal findings and conclusions after an comprehensive examination of the intrinsic characteristics of terrorism risks, its insurability, and regulatory restrictions that impede a private market solution for terrorism coverage. Special attention is given to the supply and demand for terrorism insurance coverage. Using scenarios of terrorist attacks in major cities in the United States, the report examines loss-sharing arrangements between victims, insurers, policyholders and taxpayers under TRIA and alternative programs.
The researchers also analyzed the current demand for terrorism coverage by firms in different parts of the country with special attention given to the real estate, chemical and retail sectors, and the role that domestic captive insurance companies play.

The study concludes that there is a role and responsibility for government in collaboration with the private sector to provide protection against terrorism losses. There are several reasons for this private-public partnership:

• Federal government policy and actions significantly influence the risk of terrorism.
• The private market currently has limited capacity to provide coverage for extreme losses from terrorism.
• States constrain insurance rates, and mandate coverage for particular lines of coverage, such as workers’ compensation and property insurance.
• Federal disaster assistance following a major attack will likely be significantly greater if there is no predefined public sector role in a terrorism insurance program.
• Creation of a pure government program excludes insurer expertise and financial and operational capacity.

The report also includes specific policy recommendations for members of Congress who are currently drafting legislation to restructure the TRIA program for the short-term. The authors call for increasing the program’s trigger for “certified events” from $5 million to $500 million, so that private insurers and reinsurers would be wholly responsible for any attack where aggregate losses totaled less than $500 million.

The second short-term recommendation is to clarify how any government recoupment process provision applies to all affected parties. Currently, according to the authors, there is uncertainty associated with TRIA’s recoupment process. They note that “aside from the equity issues associated with this feature of TRIA, the law has introduced additional uncertainty in the loss sharing process between the insurers, all commercial policyholders and taxpayers. Knowing in advance who is responsible for paying losses is an important component of any program that involves the public and private sectors.”

If a TRIA-like program is renewed for a short period of time, then the authors recommend options be considered in designing a long-term program for managing financial risks associated with terrorism. These options are not mutually exclusive and include:

• Having businesses self-insure through capital management strategies such as decreased use of debt finance in relation to equity, and by utilizing warrants.
• Reduce insurers/reinsurers tax costs of holding capital by allowing some form of tax-deferred reserves for terrorism coverage.
• Deploying capital of reinsurers by creating a TRIA-like program without individual insurer deductibles that only would provide government payments once losses exceeded a large aggregate threshold.
• Creation of mutual insurance pools to deal with specific lines of coverage, possibly with limited federal backing for large-scale terrorist attacks.
• Creation of publicly administered mutual insurance wherein each insurer would choose a level of protection and pay an estimated premium.
• Provision of federal reinsurance with explicit premiums, which would reduce or eliminate the need for ex post recoupment against all policyholders.

In addition to these recommendations, the authors list critical issues that require further consideration or investigation. Among these issues are:
• Gaining knowledge of the amount of terrorism premiums collected by insurers;
• Possible federal pre-emption of certain state insurance regulations and requirements;
• Including domestic terrorism in any national terrorism insurance program;
• Developing incentive programs for security investment and mitigation.

The study builds on research undertaken by the Risk Management and Decision Processes Center over the past four years, coupled with 17 years of research on how to manage and finance low probability-high consequence events.

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