The Terrorism Risk Insurance Act of 2002
December 2002
IRMI's Jeff Woodward looks at the new Act
and answers the questions: What are the significant provisions of the Act? How
will the language of standard property/casualty policies be shaped by those
provisions?
by Jeff Woodward
IRMI
On November 26, President Bush signed into law a Federal program that, in
effect, requires property and casualty insurers doing business in the United
States to offer coverage for incidents of international terrorism; and reinsures
a large percentage of that insured risk. The Terrorism Risk Insurance Act of 2002 produced
some immediate effects on commercial insurance coverage and will continue as
a significant feature of the domestic insurance marketplace at least through
calendar year 2004 and perhaps through 2005. Among commercial insurers and their
insureds, the enactment of this legislation raises two sets of questions:
- What are the significant provisions of the Act?
- How will the language of standard property and casualty policies be
shaped by those provisions?
What the Act Does
The Act addresses only a defined category of terrorism losses. To come within
the new Federal program, an “act of terrorism” must be certified as such by
the Secretary of the Treasury and must have the following characteristics:
- It must be a violent act or an act that is dangerous to human life,
property, or infrastructure.
- It must have resulted in damage within the United States, or to an air
carrier as defined in the United States code, or to a U.S. flag vessel or
other vessel based principally in the United States and insured under U.S.
regulation, or on the premises of any U.S. mission (e.g., an embassy or
consulate).
- It must have been committed by someone acting on behalf of a “foreign
person or foreign interest, as part of an effort to coerce the civilian
population of the United States or to influence the policy or affect the
conduct of the U.S. Government by coercion.”
- It must produce property and casualty insurance losses in excess of
$5 million.
Acts that might otherwise meet these criteria but that occur in the course
of a declared war cannot be certified as acts of terrorism under the Act, except
with respect to workers compensation claims.
All commercial insurers writing business in the United States are required
to participate in the Federal program and to offer insurance for terrorism risks
as defined above. That includes domestic property and casualty insurers; National
Association of Insurance Commissioners (NAIC)-recognized surplus lines insurers;
insurers approved by a Federal agency to provide insurance for maritime, energy,
and aviation risks; state residual market entities and state workers compensation
funds.
With respect to coverage offered in compliance with the Act, insurers will
receive reimbursement from the Federal government for a portion of paid losses.
This apportionment is structured as follows.
Insurer deductibles and retentions apply on a calendar-year basis, with the
period from November 26, 2002 (the effective date of the Act), to December 31,
2002, referred to as a “Transition Period.” During that transition period, insurers
will be liable for paying the initial amount of covered losses up to 1 percent
of the insurer’s direct earned premiums for the preceding calendar year. For
“Year 1” of the program (2003), this percentage “deductible” increases to 7
percent of the previous calendar year's direct earned premium. For “Year 2”
(2004), the deductible will be 10 percent. If the program continues (upon the
determination of the Treasury Secretary) into “Year 3” (2005), insurers will
be liable for an amount equal to 15 percent of their previous year’s direct
earned premium. This graduated deductible feature assumes—and is designed to
encourage—ongoing insurer success in underwriting, pricing, and reserving for
terrorism losses.
In addition to these deductibles, insurers will be responsible for paying
10 percent of remaining certified terrorism losses until aggregate insured losses
for the program year (or the “Transition Period” and program Year 1 combined)
reach $100 billion. At that point, no further Federal reimbursements will be
made under the Act, and individual insurers will not be liable for further loss
payments, assuming that they have met their deductible amounts. (In any program
year for which certified terrorism losses exceed $100 billion, the responsibility
for devising a plan to address further terrorism losses devolves upon Congress.)
The Act provides for the Federal government to recover a portion of any payments
it makes under the program. Two phases of recoupment are set up by the Act.
A mandatory recoupment of Federal payments will be made, based on the difference
between the total paid out in certified terrorism losses by insurers—that is,
the percentage-of-earned-premium deductibles plus the 10 percent insurer participation—and
a specified dollar amount, referred to as the “insurance marketplace aggregate
retention amount.”
Put simply, this aggregate retention is the maximum dollar amount that all
insurers participating in the program will be liable to pay out for certified
terrorism losses in a given program year. When the total of insurer deductibles
and percentage participation does not equal this aggregate retention, insurers
will have to pay the difference back to the Federal government. The Act specifies
the following insurance marketplace aggregate retentions:
| Transition Period + Year 1 (2003) |
$10 billion |
| Year 2 (2004) |
$12.5 billion |
| Year 3 (2005) |
$15 billion |
For any program year in which insurer deductibles and percentage participation
amounts equal or exceed the specified aggregate retention, there will be no mandatory Federal recoupment. The Act also
gives the Treasury Secretary the discretion to require additional recoupments
beyond the insurance marketplace aggregate retention, based on the Secretary’s
judgment concerning a number of industry factors, including the cost of the
Federal program to taxpayers and the financial condition of the insurance industry.
Recoupment will be achieved by means of a premium surcharge on property and
casualty insurance policies that are in force after the date the recoupment
amount is established by the Treasury Secretary. Regardless of the statutorily
defined recoupment amount, such surcharges may not exceed 3 percent of the policy
premium.
How Coverage Is To Be Provided
The Act renders void all terrorism exclusions currently in force on commercial
property and casualty policies of participating insurers (in other words, virtually
all the standard Insurance Services Office, Inc. (ISO) and American Association
of Insurance Services (AAIS) terrorism exclusions currently in place)—to
the extent that such exclusions eliminate coverage for certified acts of terrorism
as covered by the Federal program.
Likewise, state regulatory approval of such terrorism exclusions is voided
by the Act to the extent to which the approved exclusions eliminate coverage
as mandated under the Act. These provisions of the Act leave untouched those
elements of existing terrorism exclusions that deal with terrorist activity
outside the scope of the Federal program—acts of domestic terrorism, for example,
or terrorism losses that do not reach the $5 million threshold.
In some states, approval of the terrorism exclusions that were filed late
in 2001 was given subject to a “sunset” clause that suspends the filings’ approval
a stated number of days after Federal backstop legislation was signed into law.
The status of those state approvals—as they affect terrorism losses that do
not come under the new Federal program—remains uncertain, and would depend on
the specific conditions of each state’s approval. In the meantime, ISO and AAIS
are moving quickly to file new endorsements that address terrorism risks not
included in the Federal program. (IRMI will have a report on these filings as
soon as details of them become available.)
To be eligible for Federal reimbursement of certified terrorism losses, insurers
must provide notice to their insureds of the premium for coverage being provided
under the program, and the extent to which losses paid under the program are
reimbursed by the Federal government. This notice must be given to insureds
within 90 days of the enactment of the program (November 26, 2002) for policies
already in effect on that date. For policies written or renewed within 90 days
of enactment, notice must be given at the time of offer, purchase, and renewal.
For policies issued more than 90 days after enactment, the notice must be included
as a separate line item of the policy itself.
Although terrorism exclusions applicable to certified terrorism losses under
the program were voided as of November 26, they can be reinstated if the insured
decides not to purchase the Federally backed coverage. Either of two conditions
must be met before an existing terrorism exclusion can be reinstated on an insured’s
policy:
- A written statement from the insured affirmatively authorizing the reinstatement;
or
- Failure of the insured to pay the terrorism premium within 30 days after
the insurer provides notice as required by the Act.
The New Terrorism Endorsements
For use with policies currently subject to a terrorism exclusion, the two
major policy-drafting and statistical bureaus—ISO and the AAIS—have filed endorsements
that define the newly mandated coverage for certified terrorism losses, or alternatively
(for insureds that have declined the coverage) reinstate an exclusion of certified
terrorism losses, or all losses resulting from terrorism. These filings have
been made under a provision of the Act that exempts them from individual states’
prior approval laws. This means that the endorsements become available for use
immediately upon filing.
For property coverages subject to the Federal program, including commercial
property, boiler and machinery, commercial crime, commercial inland marine,
and farm coverages, the ISO endorsements are classified as interline, since
they are designed for use in many cases with more than one of those coverage
lines. The ISO property endorsements already filed and available for use fall
into five categories:
- Endorsements that modify existing terrorism exclusions
to bring them into compliance with the Act. These endorsements define
a “certified act of terrorism” in accordance with the Act’s definition of
“act of terrorism,” specify that any terrorism exclusion attached to the
policy does not apply to a “certified act of terrorism,” and limit the insurer’s
obligation to pay covered losses in keeping with the $100 billion cap on
total payments created by the Act.
- Endorsements that remove existing terrorism exclusions
altogether. These endorsements simply nullify the policy’s existing
terrorism exclusion, while at the same time reiterating the statutory limits
on the insurer’s obligation to pay losses in connection with a “certified
act of terrorism.” Endorsements of this type leave claims in connection
with noncertified acts of terrorism (e.g., domestic terrorism) covered on
the same basis as any other insured property loss.
- Endorsements that merely impose the statutory
cap on “certified act of terrorism” losses. Endorsements of this
type limit the insurer’s obligation to pay “certified act of terrorism”
claims in keeping with the Act’s $100 billion cap on total payments. ISO
rules prescribe these endorsements for use mid-term on policies that have
no terrorism exclusion attached.
- Endorsements that exclude “certified act of terrorism”
losses altogether. These endorsements, which may be used only if
the insured has rejected Federal terrorism coverage in writing or has failed
to pay the terrorism premium within 30 days after being notified of it,
eliminate coverage with respect to terrorism losses as covered under the
Federal program.
- Endorsements that exclude “certified act of terrorism”
losses with an exception for certain fire losses. In a number of
states, coverage is statutorily required for property losses from fire regardless
of cause. In these so-called standard fire policy or SFP states, even terrorism exclusions
must make an exception for direct loss by fire.
AAIS has filed similar endorsements, also exempt from state prior approval
requirements, for use with its property coverage forms. Additionally, AAIS has
filed, subject to state regulatory approval, a number of new endorsements to
exclude “noncertified act of terrorism” losses. (IRMI will report on these endorsements
in a future update.)
Endorsements to bring standard liability policies into compliance with the
new Federal program are similar in scope and content to the property endorsements
already discussed—with the obvious difference that separate versions of the
new liability exclusion are not necessary for SFP and non-SFP states. There
are four basic categories of liability endorsements for the coverage options
created by the Act.
- Endorsements that modify existing terrorism exclusions
to bring them into compliance with the Act. These endorsements specify
that any terrorism exclusion already attached to the policy (such as standard
exclusionary endorsement CG 21 69) does not apply to a “certified act of
terrorism.” It also states that the insurer’s obligation to pay any claims
in connection with certified acts of terrorism is capped by Federal legislation.
- Endorsements that remove existing terrorism exclusions
altogether. These endorsements stipulate that any existing terrorism
exclusion attached to the policy is removed, and restate the possible limitation
on the insurer’s obligation to pay certified act of terrorism losses under
the Federal legislation.
- Endorsements that exclude certified acts of terrorism. These endorsements, as explained in connection with category 4 of the property
endorsements described above, may be used only in cases when the insured
has declined or refused the terrorism coverage that must be offered under
provisions of the Act—affirmatively in writing, or by failure to pay the
terrorism premium on time. It incorporates the Federal program’s definition
of a “certified act of terrorism” and excludes any injury or damage arising
directly or indirectly from such an act.
- Endorsements that merely impose the statutory
cap on “certified act of terrorism” losses. Endorsements of this
type limit the insurer’s obligation to pay “certified act of terrorism”
claims in keeping with the Act’s cap on total payments. ISO rules prescribe
these endorsements for use mid-term on policies that have no terrorism exclusion
attached.
Conclusion
As the Terrorism Risk Insurance Act of 2002 is implemented over the next
few months, a number of issues currently still unresolved will come into clearer
focus. The status of captives and other self-insurance mechanisms is still to
be determined by the Secretary of the Treasury. Likewise, the status of insureds
under noncancelable stand-alone terrorism policies—which some commercial insureds
were able to procure in 2001—remains a question. Perhaps of prime concern to
the average commercial insured, how will the newly mandated terrorism coverage
be priced? These are all questions that only the passage of time can answer.
Watch IRMI Insights for answers as they become available.
Note: See other terrorism articles
on IRMI.com.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
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