Time, Money, and a Possible New "Maginot Line"?
June 2007
For the first few months of this year, many
insurance industry observers believed that the 2-year extension of the Terrorism
Risk Insurance Act (TRIA) would be reauthorized long before its scheduled year-end
expiration. It seemed like a sure thing.
by James
Macdonald1
Navigant
Consulting
Trade journals reported that a new bill was possible by the end of April.
In February and March, House and Senate hearings focused not on "whether" but
rather on "how" the program should be extended. But despite the momentum, nothing
happened.
The popular thinking now is that there will be an extension of the federal
terrorism insurance backstop. However, much like the late December 2005 enactment
of Extension Act, we may not know the details until the waning hours of 2007.
Part 1 of this article considered the changing
nature of the terrorism threat. In this, the second installment, I explain the
reasons why some form of an extension appears to be certain. I then consider
several important issues related to either timing or money, and some creative
options that need to be considered as potential building blocks to a constructive
new approach.
What Explains the Optimism?
Understanding the reasons for the current optimism provides insight into
the specific reforms that may be in the offing. There are at least four reasons
for the confidence expressed by many stakeholders. The three most recognized
are the following.
- The surprising November elections putting key Democrats in favor of
the program in charge of important Congressional Committees (notably Dodd,
Frank, and Kanjorski);
- The general belief that the threat of another large-scale terrorism
attack inside the United States is at least as real today as it was in late
2002 when the terrorism insurance program was created; and
- The consensus that the federal backstop program has been highly successful
in achieving almost all of its original goals (i.e., assuring an affordable
and available market for terrorism insurance, giving insurers time to rebuild
their capital bases in the wake of September 11, and also providing time
for insurers and reinsurers to develop new approaches to measure and price
this risk.) (See Marsh MarketWatch™ 2006.) Simply stated: "Why mess with
success?"
On a more specific but less recognized level, the foundation for common ground
between all parties may have been cemented by important shared conclusions in
two separate September 2006 reports from the Presidential Working Group (PWG)
and the Government Accountability Office (GAO). Both reports noted that a terrorist
attack involving a nuclear, biological, chemical, or radiological (NBCR) device
would be largely uninsured today. One reason for this deficiency is that the
TRIA law subordinates the "make available" terrorism insurance requirement to
the normal policy terms and conditions that otherwise apply. As a result, property
or liability insurance losses from a weapon of mass destruction could largely
not be covered (assuming the standard nuclear, contamination, pollution, war,
or some other policy limitation is deemed to be applicable). Another reason
is that surveys show many buyers are not buying the insurance or investing in
loss mitigation because they do not believe they are at risk.
The reports also noted:
- The inherent limitations of new catastrophe models at estimating possible
losses from "worst-case" attack scenarios (especially considering that most
information about specific terrorism threats is classified, PWG page 28,
GAO page 8).
- The unique challenge that terrorism risk presents to the nation's critically
important workers compensation insurance line, given the fact that no state
gives insurers the ability to limit or exclude terrorism (PWG page 8, GAO
pages 2 & 15).
- The limited capacity from the private market reinsurance market, estimated
by the Reinsurance Association of America at not more than $8 billion in
2006 for a conventional weapons attack, and another $900 million to $1.6
billion for an NBCR attack (PWG page 26 and GAO page 8).
Importantly, both reports predict little to no probable future interest in
the traditional reinsurance or alternative capital markets in insuring NBCR
(with the GAO saying the development of private sector NBCR capacity is "highly
unlikely in the foreseeable future" and the PWG report concluding that "there
may be little potential for future market development").
By essentially concluding that, despite the many successes of the program,
"the sum of all fears" remains largely uninsured, the PWG and GAO have defined
what could be specific minimum necessary public policy goals for this year's
legislative reform. A full discussion of all the issues being debated exceeds
the limits of this article. But let's consider two important obstacles which,
in short, focus on time and money.
Time: Does TRIA "Time Out" the Development of New Capacity?
The initial TRIA legislation was explicitly defined as a "temporary" measure
to address economic disruptions in the wake of the September 11 attacks. This
is a favorite refrain of the program's most fervent opponents. Once again, their
strong desire is to keep any extension to a minimum. Their basic rationale for
another short extension is that, because there is no premium charged for the
federal portion of the program, the program "crowds out" the development of
new terrorism insurance capacity from traditional or alternative capital market
sources. Legislators supporting TRIA have stated that they favor an extension
of at least 8 to 10 years, and one has argued for an unlimited extension subject
to periodic reviews.
If we take a closer look, TRIA's critics are missing a key point with their
focus on the "crowd out" argument. What it really does is "time out" the creation
of new approaches.
For example, from early 2003 through the first quarter of 2004, 15 large
and small insurers cosponsored an inquiry into the feasibility of forming a
voluntary terrorism reinsurance pool for workers compensation. I was personally
involved with the effort as an employee of one of the larger insurance companies.
The exhaustive collaboration did not proceed to implementation, but it did produce
an informative and frequently cited report detailing the key findings and hurdles
to forming a voluntary pool. (The Towers
Perrin report is still available for download.)
In my opinion, the uncertain duration of the initial federal program was
one of the major impediments to the possible creation of the pool. If, for example,
we had known that the federal TRIA backstop would be in place for another 5
years or more, there is a real possibility that this pool may have been formed
by at least some of the participants.
Alternative capital market solutions also take considerable time and effort
to launch. It can take well more than a year to go from concept, to approaching
investors, to the creation of new risk-taking legal entities, to the final implementation
of operations.
Because two installments of the federal terrorism insurance program have
been certain only for an initial 3-year period, and then a 2-year increment,
there simply has not been enough time or certainty to test the possibility of
developing creative, new capacity solutions. Any extension of less than 5 years
will almost certainly continue to render hypothetical the feasibility of new
pooling arrangements or capital market solutions for terrorism risk.
Money: Is TRIA Really a Benefit to Federal
Taxpayers?
Critics of the terrorism insurance program argue passionately that TRIA is
an unjustified "subsidy" of an industry that is enjoying historical profits.
They accurately point out that commercial insurers have more than recovered
from losses on September 11 (with domestic property and casualty insurer capital
and surplus approaching $500 billion at year end 2006). To limit the post-loss
funding risk they believe the program presents to federal taxpayers, these critics
argue that the required insurer retentions should be progressively increased.
What no one seems to have considered is the possibility that TRIA has actually
been a benefit to federal taxpayers. The
PWG report came close to recognizing this contrarian point when it estimates
that after-tax TRIA terrorism premiums paid to insurers "increased policyholder
surplus by a total of approximately $1.7 billion during 2002 through 2004" (page
33). Although the report projects that additional capacity for terrorism risk
could grow as this contribution to after-tax surplus develops, there is no attempt
to quantify the incrementally larger investment income growth that would be
possible if, like many European terrorism insurance programs, American insurers
were allowed to set aside pre-event and pre-tax terrorism loss reserves.
It is also remarkable that the PWG report does not recognize the significant
real-world benefit to federal revenues from the federal taxes that insurers
have been paying on these premiums. Citing a number of sources, the PWG authors
estimate the total collected terrorism insurance premium to be between $3 billion
and $8 billion through year-end 2005 (page 33). If we add another $2 billion
to $4 billion for 2006 and 2007, and assume the federal corporate tax rate of
35 percent, federal tax coffers will be the cumulative beneficiaries of between
$2 billion and $4 billion in tax revenues by the end of this year.
As Senator Everett Dirksen might have said,2 this is "real money." It is at least as worthy of public policy-making consideration
as the theoretical macroeconomic costs and benefits of the program argued by
both sides of the ongoing debate.
A second "money" issue very much in dispute is whether a premium should be
charged for the federal backstop protection. Insurers make a strong case that
the "free reinsurance" is best understood as a "trade-off" in return for the
federal requirement that they provide the terrorism insurance (despite the fact
that many believe that this risk, like war risk, is inherently uninsurable at least for a major
attack). If private capital is to remain in the market, and the TRIA "make available"
requirement is continued, they argue cogently that this "trade-off" is essential
and fair.
Opponents of the current approach offer some compelling rebuttal arguments
for the introduction of some federal premium charge. If the pricing is set at
a level above a conservative actuarial estimate of the needed price, it would
set a new incentive for the development of new capacity. Charging a premium
for the federal protection would also enable a federally managed fund to accumulate,
gradually limiting pos-loss taxpayer risk.
Establishing federal premium charges could also enable some creative solutions
to major issues that are now simply not feasible. For example, if the federal
program set different prices for optional retentions or triggers, small insurance
companies could be allowed to "buy down" the minimum coverage trigger from the
current $100 million to some lower amount more reflective of their capital bases.
When we consider that many hundreds of domestic commercial insurers have well
less than a total of $500 million in capital supporting all their obligations,
a breakthrough of this nature could be critical to preserving the competitive
balance in the commercial marketplace.
Conclusion: A New "Maginot Line" Would (Once Again) Be a Bad Idea
In recent weeks, there has been some speculation that the extension of TRIA
may only cover workers compensation (for conventional attacks and NBCR) and
only NBCR losses to the other commercial lines still included in the law. Although
it is easy to understand why this thinking may be popular, it would be a major
error. If we agree that one of the main goals of private sector terrorism insurance
is to optimize economic resiliency after an attack, then limiting the triggers
to that responsiveness to only nuclear, biological, chemical, or radiological
attacks seems ill advised. Daunting as an NBCR attack would be, the simple fact
is that terrorism experts believe that the probability of a major attack using
conventional weapons is much greater than an attack using a NBCR agent or device.
For the insurance program to be effective, it needs to be as flexible as
the threat itself.
In many ways, this idea is reminiscent of the "Maginot Line" built by the
French after World War I to block the anticipated route of a future generation
of German or Italian forces. If the French learned anything as they watched
Nazi tanks sweep around their defenses in World War II, it was that static,
fixed defenses against highly mobile enemies are a bad idea. In a similar vein,
a federal program limited to NBCR could simply increase the likelihood that
the next major attack—like the attacks on September 11—will not involve these
agents or devices.
Part 3 of this series considers the two additional
issues reportedly presenting major hurdles to policymakers: coverage and insurer
retentions.
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