Expert Commentary

Captives, the Terrorism Risk Insurance Act, and the Market

While the Terrorism Risk Insurance Act of 2002 has been signed into law, many unanswered questions remain, particularly how captives are affected by the Act. Captives domiciled outside the United States are clearly not under the Act, but if owned by a U.S. entity, or if they are reinsurers of a U.S. licensed insurer, the Act is not as clear as some had hoped. When in doubt, get a letter from your insureds either accepting or declining the coverage. Charging a premium can be a separate consideration, but should also be in writing.


Terrorism Risk Management and Insurance
January 2003

As we commence a new year of challenges and opportunities, I would like to cover two topics in this article: captives and the Terrorism Risk Insurance Act, and the state of the market.

The Terrorism Risk Insurance Act

President George W. Bush, at the strong urging of the insurance industry, signed the Terrorism Risk Insurance Act of 2002. This legislation was critically needed in order to start bringing order and reason to a market which was dazed, confused, and in retreat following September 11, 2001.

Most urgently, there was a need to define an “act of terror.” Few, if any, policies addressed that issue prior to September 11. Additionally, the President consistently referred to the acts of that date as “acts of war,” a term which was defined, and excluded, by most underwriters. Furthermore, actuaries had never adequately priced acts of terrorism, if at all. Basically, it is impossible to cover an exposure that is undefined and therefore immeasurable. The lack of a definition and adequate pricing needed to be urgently addressed.

Since the insurance industry, pretty much at its own choosing, is regulated on a state-by-state basis, there was a need for Washington to step in quickly and provide an industrywide solution. All parties did come together and conduct the deliberations for the greater good, for which many are to be congratulated.

It should be clearly noted that while the Act has been signed into law, there are many, many unanswered questions, as of this writing. I will address some of these from a captive perspective.

The larger captive industry was significantly divided in what it sought from this legislation. That very real division prevented associations from mounting a campaign to put forth the views of their members. Their members were amazingly divided.

Who Would Be Included?

Captives, which are perceived to have no terrorism exposure, wanted what came to be called an “opt in/opt out” provision. If you saw no need for coverage, then you could choose to be left out of the Act. Some captives, seeking to receive federal terrorism benefits and to clarify their claim as legitimate risk bearers, wished to be included.

The percentage was amazingly close to 50/50 each way, with good arguments to support their positions. Both sides “lost” and “won” as most insurers are included to one degree or another.

What Constitutes "Terrorism"?

Congress determined that the secretary of the treasury would be the determiner of what defines an “act of terrorism,” who is an insurance company, and how assessments and claims will be handled. Captives were not a prime consideration in these discourses, although they are mentioned specifically in the Act.

The Act and the secretary make it clear that if you are licensed in the United States as an insurance company, including receiving direct earned premiums, you are covered by the Act. There are some exceptions, such as nonprofits and medical liability insurers, crop and hail, financial guarantees, and health and life insurance. As a covered entity, you must offer your insured the opportunity to be covered, or formally reject coverage. The captive may choose to charge a premium, or not. But the captive will receive a bill for 3 percent of its premiums in the event of another covered terrorism act.

The definitions of “acts of terrorism” require close inspection. For instance, an act which the secretary deems to be domestic terrorism may not be covered. A boiler and machinery loss may not be covered. If your captive is going to be considered under the authority of this Act, it is wise to seek competent legal and insurance counsel to be certain that you are taking the proper steps.

Limited Time To Comply

Time is critical as compliance with the Act is required by February 24, 2003. Insureds of your captive have 30 days to accept or reject the coverage being offered. Please note that any policies or endorsements which did not offer terrorism coverage previously were voided by this Act of Congress, effective November 26, 2002.

Captives domiciled outside the United States are clearly not under the Act, but if owned by a U.S. entity, or if they are reinsurers of a U.S. licensed insurer, the Act is not as clear as some had hoped. The offshores may have a responsibility to respond, and should review the Act carefully. The secretary may, in consultation with the National Association of Insurance Commissioners (NAIC) or appropriate state regulatory authority, apply this Act to other classes or types of captives.

Your captive may be using the services of a risk sharing partner for fronting and reinsurance. These carriers are subject to the Act, and will most likely pass on to your captive the costs of their required participation on your behalf.

While it is difficult to offer exact answers, I urge you to act as time is running out to be in compliance. When in doubt, get a letter from your insureds either accepting or declining the coverage. Charging a premium can be a separate consideration, but should be in writing. Until all constituencies are heard, there will be reactions not always based on the best interests of the captive in question. If the captive’s position is in writing and acknowledged by its insureds, it is in a better position.

State of the Market

Several captive owners and prospective owners have asked about the state of the market for the coming year. Obviously no one knows what will occur in 2003’s insurance market any better than stock analysts can give you the inside on which stock will dive or soar. Certainly not me. However, I will offer a few observations for the students and observers of captives.

The commercial property-casualty market will not see reduced pricing or increased availability of coverage and limits in 2003. I feel confident of that statement. Certainly there will be pockets of rational pricing and coverage opportunity, but in general many more people are going to be considering captives this year as a reaction to a really hard market.

As a proponent of alternative risk financing, it behooves me to say that not everyone should be in a captive. The cost of risk is changing, and players are leaving or being withdrawn from the field of combat. Your best bet may be to pay the premium, if you can get a quote. For some risks, in some geographic areas, coverage may simply not be available.

As I have urged elsewhere, regulators and lenders are going to have to reconsider their requirements for the ratings of insurers. This is also a discussion for another day, but I will continue to call for action in this area.

Risk retention groups will get more attention as risk sharing/fronting partners are all but universally opposed to getting involved with medical malpractice and other professional lines of coverage.

The new record-keeping and reporting requirements both onshore and offshore will cause many deals to be deferred or canceled as there will not be enough time, people, or systems to comply. Without adequate resources and facing low returns, insurers will renew a few accounts and take a pass on most new submissions.

Alternative risk finance has always meant that you pay your own way. Inherently that means that you must have the resources to do so. Increasingly, as the market withdraws, limits coverage, and raises retentions, the alternative participant will be required to put in more resources, to the point that the deal may not make sense. There are fewer and fewer “greater fools” left, which means the tough risk will be looking for alternatives, and may not be able to afford to finance their own risk.

The Risk Sharing Partner community is changing, and not necessarily to the positive for captive owners. The remaining Partners must become more selective in putting forth their paper, and they will do so. Their shareholders will demand it. They will want to see larger deals, with great loss pictures and substantial financial resources put at risk.

Submissions must be thorough, credible, and sparkling. Without insurer-generated loss runs, forget it.

While the commercial P/C industry is enjoying good profits, it is a very long way from restoring adequate surplus. It may be 5 years before adequate capital and surplus are restored to pay claims that exist today. Each time an insurer goes by the boards, it leaves more claims to be parceled out to the survivors. You may think that such would not happen, but we are seeing the governor of a major state proposing that that state’s health insurers be taxed to bail out the medical liability community.

Desperate times cause desperate deeds. We are called to a higher level of performance to see our way through this phase of the cycle.


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. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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