The Commonwealth Treasury


Terrorism Insurance Act Review: 2009

Close Window

Chapter 2: Need for the Terrorism Insurance Act

Issue

Whether there is a need for the Terrorism Insurance Act 2003 to continue in operation.

Background

Australia's terrorism insurance scheme was established on 1 July 2003 in response to the withdrawal of commercially available terrorism insurance cover, particularly after the events of 11 September 2001. As a result of significant changes in the terrorism insurance market, there was a large pool of assets uninsured for terrorism risk. In the United States in particular, the withdrawal of affordable terrorism insurance resulted in commercial properties operating without terrorism cover and commercial property developments being delayed or cancelled, with consequent job losses.1

Commercial property also plays an important role in the Australian economy in terms of business, employment and investment opportunities. The uncertainty for financiers and investors created by the withdrawal of commercially available terrorism insurance had the potential to delay the commencement of commercial property investment projects and to alter portfolio management decisions, with adverse consequences for the ongoing operation of those assets, as well as for the broader economy.

To protect the economy from the effects of the withdrawal of terrorism insurance, the Australian government established the scheme for commercial property and associated business interruption losses and public liability claims. The scheme is an interim measure, intended to operate only while terrorism insurance cover is unavailable commercially on reasonable terms.

At the time the scheme was established, the government also considered that uncertainty in the market made it impossible to stipulate the details or timing of its windup.2 As a result, section 41 of the Act requires that at least once every three years after the startup time, the Minister must prepare a report that reviews the need for the Act to continue in operation.

In accordance with section 41 of the Act, the Terms of Reference for this review require consideration of the need for the Act to continue in operation.

Discussion

The 2006 review examined the Australian terrorism insurance market in the context of the global terrorism insurance market and its characteristics before and after the 11 September 2001 terrorist attacks.

Before 11 September 2001, terrorism insurance was included implicitly and virtually free of charge in general property all-risks contracts. Higher cost standalone terrorism insurance was available to fill market gaps left by all-risks contracts.

The 11 September 2001 attacks resulted in unprecedented losses, an increase in the risk associated with high-rise commercial property and greater uncertainty about the ability of insurers to assess and spread risk globally. They also demonstrated the combined negative effects of:

The immediate effect of the 11 September 2001 attacks was the exclusion of terrorism cover in all-risks policies and increased demand for standalone terrorism cover. Premiums rose sharply and contracts were more restrictive as insurers selected their risks more carefully and required policy holders to meet stringent security requirements. The overall effect was a shortage of affordable terrorism insurance.

While the catastrophe underwriting market grew substantially in the months following September 2001, many insurers concluded that they could not sustain large terrorism losses. As a result, standalone cover remained expensive, restrictive and limited in its availability. Financial markets showed little appetite for terrorism risks and there was no expectation that market capacity would increase substantially in the short term.5

In countries with a history of political unrest, such as the United Kingdom and Spain, permanent government schemes had been established to provide reinsurance to support the provision of terrorism insurance, although both schemes were broadened following the September 2001 attacks.6 Following September 2001, other countries including the United States and Australia, implemented temporary schemes to address the economic consequences of a failure in the terrorism insurance market. In other countries such as Austria, India and Taiwan, private schemes were established that do not involve government support.7 See Chapter 3, International Approaches, for further information.

International market

Overview

Between 2003 and 2006, the international terrorism insurance market was characterised by improvements in the availability and affordability of terrorism insurance: insurance and reinsurance capacity increased; the financial stability of insurers improved; insurer retentions increased; premiums fell or stabilised at competitive rates; and participation rates increased. The development of government schemes to address the shortfall in commercially available reinsurance at affordable rates was probably the most significant contributing factor to these developments.

The same trends were maintained from 2006 to 2008. However, despite significant improvements in risk management and loss estimation modelling, insurers consistently expressed the view that there was insufficient commercial capacity to meet demand for terrorism insurance at affordable rates, particularly in high-risk locations, and that loss events beyond a certain scale surpassed the risk capacity of the industry. Contributing to this was the ongoing shortfall in reinsurance capacity for individual terrorism risks, even though global capacity for reinsurance of terrorism risk had improved for national pooled arrangements. In light of these market conditions, insurers considered that government schemes remained as relevant and necessary in 2008 as they were at the time of their establishment.

Additionally, the terrorism insurance market hardened during 2008 and into 2009 as insurers and reinsurers responded to a decline in the value of investment portfolios due to the impact of the global financial crisis.

The following discussion focuses on the US as the largest terrorism insurance market and one that has attracted industry analysis and commentary over recent years. However, industry views that are more internationally representative indicate that the trends and issues faced by the terrorism insurance and reinsurance markets are more widely shared in the context of global markets.

Detail

In 2006, the US President's Working Group (PWG) on Financial Markets was required to conduct a study of the long-term availability and affordability of terrorism insurance following the passage of the Terrorism Risk Insurance Extension Act 2005 (TRIEA) which extended the Terrorism Risk Insurance Act 2002 (TRIA) from December 2005 to December 2007. The PWG found that the availability and affordability of terrorism insurance had improved since 2001. They also identified better risk management and measurement, improved modelling capabilities, greater reinsurance capacity and the improved financial health of insurers as conducive to encouraging additional capacity in the long term.8

The PWG identified the increased availability of reinsurance capacity as contributing to the 're-emergence of the insurance industry', but noted that the 'presence of subsidised Federal reinsurance through TRIA appears to negatively affect the emergence of private reinsurance capacity because it dilutes demand for private sector reinsurance'. Lloyds of London noted that, while it is possible that the withdrawal of TRIA after 2007 would encourage the development of some limited private market solutions, 'significant growth to the point at which reinsurance is generally available at prices that insurers are prepared to pay appears questionable'.9

The PWG concluded that the uncertainty associated with predicting the frequency of terrorist attacks, along with an apparent unwillingness of some policyholders to purchase terrorism insurance, made any evaluation of the potential degree of long- term development of the terrorism insurance market 'somewhat difficult'.10

In October 2006, Marsh commented on the PWG report noting that, while improved modelling and risk management had allowed insurers to better identify exposures and accumulations, this had resulted in a reduction in capacity, rather than an increase. They considered this to be especially true for risks in urban areas, perceived target risks such as utilities, and locations with large concentrations of employees.11

Marsh noted that the estimated $6 billion to $8 billion12 of available capacity in the reinsurance market for terrorism property risks was inadequate to fill the gap should TRIA be allowed to expire. Its view was that 'it would be prudent to consider a period of at least 10 or more years until the reinsurance market has sufficient capacity to respond to a catastrophic terrorism loss'.13

Marsh commented that the premise on which TRIA was enacted, that is protection of the broader economy from the effects of the withdrawal of terrorism insurance, remained valid. Without TRIA, its view was that capacity would not rise to meet demand, but that insurers would supply their net terrorism capacity, resulting in reduced availability of terrorism insurance. Marsh concluded that 'use of the commercial insurance marketplace to adjust losses, distribute funds, and collect a recoupment is one of the most efficient ways for the federal government and business to work together. It should be an important consideration in the development of a future plan'.14

In its 2006 analysis of the US market, Marsh described it as 'changing and uncertain'. It observed that terrorism insurance take-up rates increased to record levels (nearly 60 per cent of businesses surveyed). This was despite increased premium rates due to increased property prices and a hardening of the property insurance market, compared to 2005 when terrorism insurance rates generally decreased. Increased take-up rates also occurred despite TRIA being due to expire on 31 December 2007. Although this caused some uncertainty, Marsh's view was that the market was generally optimistic that TRIA would be extended again15 as fewer insurers were insisting on sunset clauses that would terminate terrorism cover if it was not extended.16

Marsh also described terrorism insurance and associated risk management strategies as 'dynamic and complex issues, with many interdependent factors contributing to managing the risk'. It cited foreign relations, the effectiveness of homeland defence and the ambiguous nature of terrorism risk as factors that make it difficult for insurers to effectively price and reserve capacity for potential exposure to catastrophic terrorism losses.17

In August 2007, the Credit Risk Officers (CROs) of major reinsurance companies Allianz, Chubb, Munich Re and Zurich released an Emerging Risks Initiative Position Paper on terrorism insurance. Like Marsh, the CROs observed that, despite comprehensive data pooling and the development of risk management tools, a number of factors combine to limit the amount of terrorism insurance on offer. They noted the unpredictability of terrorist attacks, combined with insurers needing to sell assets (to pay major claims in multiple business lines) at reduced prices due to the capital market's reaction in the event of a terrorist attack, might lead to overall losses exceeding coverage and act as a significant disincentive.18

The CROs concluded that loss events beyond a certain scale surpass the risk capacity of the insurance industry and could be classified as uninsurable. Like Marsh, their view was that while the insurance market can meet the demand for insurance against most conventional terrorist attacks, for larger risks there is insufficient private capacity and a 'sensible solution' is for governments to provide some type of reinsurance that supports the provision of terrorism insurance. While acknowledging that there is no 'one-size-fits-all' solution, the CROs saw permanent private-public terrorism insurance partnerships between insureds, insurers, reinsurers, capital markets and governments, as essential to an effective solution.19

In September 2008, the US Government Accountability Office (GAO) reported to Congressional Committees on the status of efforts of policyholders to obtain terrorism insurance coverage. Amongst other things, the GAO examined factors limiting insurers' willingness to provide coverage in the US market. They found that commercial property terrorism insurance was widely available on a national basis at reasonable rates, largely due to TRIA and the 'soft' or competitive insurance market. The majority (around 60 per cent) of commercial clients were found to have purchased terrorism insurance at rates that had been generally stable since 2003 at around 4 per cent of commercial property premiums. Insurers' capacity to provide terrorism insurance was attributed to increased capital levels arising from strong profits, increased investment income and a lack of large losses from major catastrophes. It was also noted that a 'hardening' of the market, whether due to another terrorist attack, natural disasters or a decline in the value or investment portfolios, would result in reduced terrorism insurance capacity at current terms and prices.20

The availability of reinsurance was identified as a factor that might limit the supply and increase the price of terrorism insurance, particularly in high-risk locations. While reinsurance capacity had increased due to capital growth, the absence of another terrorist attack and improvements in insurers' ability to underwrite risk, reinsurers were still managing aggregation levels by limiting coverage, with location being an important factor in determining whether reinsurance is offered and at what price. Insurers and reinsurers also cited the views of credit rating agencies on the amount of capital allocated to terrorism risk and the location of risks as factors influencing the availability of terrorism cover.21

The GAO also found terrorism insurance to be less available and affordable in locations considered to be at higher risk of terrorist attack. To mitigate their risks, insurers set limits on the amount of coverage provided in these locations, or for buildings over a certain size or in close proximity to other high risk properties, and set premiums higher.22

In February 2009, Marsh estimated standalone terrorism insurance market capacity in the US and internationally of US$3,080 million. They also noted that, while market capacity is relatively stable, it can vary considerably depending on the location of the risk, individual insurers limiting capacity in particular locations due to the accumulation and concentration of exposure where demand for coverage is high, that is, metropolitan areas. Marsh reported that premium rates remained competitive in 2008 and, in some cases, more aggressively priced than more restrictive terrorism coverage embedded in property programs. They also reported that the global economic crisis began to affect the standalone terrorism insurance market in the fourth quarter of 2008, with premium rates flattening as insurers reacted to the uncertain business environment.23

Marsh has also commented that, while total standalone capacity is available in excess of $1.5 billion, it is more expensive and location sensitive.24 Aon describes the standalone market as the market for 'difficult risks', noting that it has a history of global claims, relies on private capital commitments and is priced accordingly. It represents a relatively small proportion of the market, with government schemes accounting for most demand.25

Aon has assessed total 2009 total market per risk capacity at $US2.585 billion, with North America accounting for approximately 40 per cent of demand and South America, Eastern Europe and Asia being growth markets. Aon comments that non-US demand is driven by access to state pools and therefore accounts for less of the standalone market. In terms of the relative importance of the standalone market in the US, Aon notes that it accounts for 10 per cent of their clients. 'TRIA and non-certified coverage' accounts for 43 per cent of their clients, and 36 per cent choose not to purchase cover. Aon reported that, as of 31 March 2009, 63 per cent of its clients purchased some kind of terrorism cover, indicating that participation rates have been stable over the 2006 to 2009 period.26

As part of its 2010 Budget, the US Government has announced its intention to reduce 'an excessive Federal subsidy' under the Terrorism Risk Insurance Program Reauthorization Act 2007 (TRIPRA), from 2011. The proposal draws on the findings of the PWG report of September 2006 that the property and casualty insurance market has improved its ability to absorb losses from a terrorist attack. It refers to reducing the subsidy as a means of encouraging the private sector to better mitigate terrorism risk through other means such as alternative reinsurance options and safer buildings. The proposal is estimated to generate savings of $263 million by 201427 when the US terrorism insurance arrangements under TRIA and its successors are due to expire.28

In response to the proposal and consistent with industry views on the terrorism insurance and reinsurance markets over the 2006 to 2009 period, Aon has commented that the proposal will reintroduce market uncertainty, reduce capacity, increase retention requirements and increase the price of terrorism insurance. Its view is that the proposal will disrupt the terrorism insurance market at a time when insurers and reinsurers are dealing with asset write-downs of 10 to 15 per cent since 2008, due to the global financial crisis. Aon also reports that the majority of insurers have indicated their intention not to provide cover in the absence of TRIA's mandatory requirements, and that 70 to 80 per cent of the commercial property market will revert to absolute exclusions.29

Australian market

The Australian general insurance industry is relatively well-positioned compared to its international counterparts, despite the global economic environment, difficult underwriting conditions due to weather-related events, and a significant fall in industry share prices. In the context of the global financial crisis, foreshadowed increases in premiums reflect insurers' concerns regarding reduced liquidity and the reduced value of investment portfolios, combined with natural catastrophe losses, rather than changes in their assessment of terrorism risk.

In its Financial Stability Review of March 2009, the Reserve Bank of Australia reported that the industry had post-tax profits of $2.2 billion in 2008 which, while less than in previous years, were consistent with the average for the 10 years to 2008. Profits were mainly attributable to conservative investment strategies with around three-quarters of financial assets held in fixed-income securities and less than 10 per cent held directly in equities, combined with no reported direct exposure to US sub-prime mortgage assets and associated structured investments. Insurers' holding capital was around twice the regulatory minimum at mid-2008 and ratings agencies generally rate the industry highly at A+ or higher. However, aggregate claims increased by 33 per cent over 2008 compared to 3 per cent over the previous three years, partly due to significant weather-related events, and insurers recorded a loss on their underwriting business over 2008. There were increases in net premium revenue of around 4 per cent in 2008 compared to 2 per cent over previous years. Australian general insurers' share prices also fell significantly over 2008, but less than their US counterparts.

In terms of reinsurance, Australian general insurers ceded around one-quarter of gross premium revenue to reinsurers over 2008, mostly to large global reinsurers. Although they have sustained large investment losses and experienced large claims, also due to significant weather-related events, the majority of large global reinsurers are rated A or higher by Standard and Poor's.30

The National Insurance Brokers Association (NIBA) reported a hardening of the Australian insurance market in 2009, following generally soft conditions through 2008, due to the global financial crisis and weather-related events that are estimated to cost the Australian community $2.5 billion in insured losses. NIBA's view is that, while the Australian insurance industry has escaped much of the fallout from the global financial crisis, it represents the most important event impacting on the market in 2008 in terms of business confidence and investment decisions. Nonetheless, the Australian public retains confidence in the Australian prudential regulatory system and in the financial viability of Australian regulated insurers.31

Additionally, the attractiveness of national pooled arrangements, the established and well-understood nature of the scheme, the standard of the scheme's administration by the ARPC and the ARPC's highly regarded risk assessment and loss estimation modelling techniques, combine with high levels of participation32 to make the Australian market relatively attractive to global reinsurers. Australia's geographic location allows reinsurers to diversify their risk and also contributes to the relative attractiveness of the Australian terrorism insurance market, although Australia remains at a 'medium' level of alert.33

In turn, the financial stability of the scheme, both through growth of the pool and the ARPC's purchase of retrocession, means that it supports financial stability for policyholders, insurers and financiers without placing undue financial pressure on insurers or policyholders, while continuing to meet its primary objective of protecting the Australian economy from the adverse effects of the withdrawal of terrorism insurance. See Chapter 3, which deals with Premiums and the Pool, and Chapter 4 on ARPC's Performance and Financial Stability of the Scheme, for further information.

Stakeholder views

Stakeholders consulted for the purposes of this review are uniformly of the view that, while global capacity for reinsurance of terrorism risk is returning for pooled arrangements, there is insufficient capacity at reasonable prices for individual risks. A small number of commercial providers compete with the scheme, but stakeholders consistently expressed the view that there are no commercial providers with the appetite or capacity to cover the risks covered by the scheme. This is consistent with views conveyed to both the PWG in the course of its study of the long-term availability and affordability of terrorism insurance, and the GAO in the course of its examination of terrorism insurance and the status of efforts of policyholders to obtain coverage.

Particular views were that:

Need for the Act to continue

Although the Australian general insurance industry is relatively well positioned despite the global economic environment and difficult underwriting conditions, it is, nonetheless, part of the international reinsurance market. Munich Re has commented that the effects of the global financial crisis, combined with underwriting losses due to severe weather-related events, are driving an increased demand for reinsurance. At the same time, reinsurers are facing the same pressures, leading to an increase in reinsurance prices.34

The global financial crisis has produced an unprecedented fall in reinsurance and insurance capital due to international equity pressures arising from collateralised debt obligations and the 'knock-on' effect of general revaluations. The additional effect of deteriorating underwriting performance and large hurricane losses also reduced industry capital. The impact on the insurance and reinsurance sector has been significant and far-reaching. Available reinsurance capital has reduced significantly as a result of asset revaluation taking place in the fourth quarter of calendar 2008.

Insurers will be focusing on returning to solid levels of underwriting profit and not relying on reserve leverage or investment earnings to supplement inadequate risk pricing. Industry's view is that premiums are expected to increase across the board and similar increases are expected for reinsurance. In response to insurance rate increases, it is likely that original policy holders will consider increasing deductibles or buying less cover as perceived asset values decrease.

These developments have occurred against an underlying shortage of reinsurance capacity for individual terrorism risks at affordable prices: a situation that has remained unchanged since 2006. Government schemes have been an important factor in addressing this shortage, encouraging market stability and protecting economies from the adverse effects of the withdrawal of terrorism insurance. The changes to TRIA and its successors demonstrate that the market is reactive to changes in government schemes, and Aon's view of the changes proposed in the US Government's 2010 Budget is that they could be 'the single biggest factor in terms of pricing and capacity for clients as we move through 2009 and into 2010 renewals'.35

In light of the underlying shortage of affordable reinsurance for terrorism risk and the final impact of the global financial crisis on the availability and affordability of reinsurance, which is as yet unknown, this review concludes that there is a need for Government involvement and for the Act to continue in operation for another three years to protect the broader Australian economy from the adverse effects of the withdrawal of terrorism insurance.

However, the scheme was established to operate only while terrorism insurance cover is unavailable commercially on reasonable terms, and maintain, to the greatest extent possible, private sector provision of terrorism insurance to the Australian market. Permanent government-subsidised reinsurance would remove any incentive for the private sector to develop alternative risk transfer mechanisms.

Recommendation

That the Act continues in operation, subject to a further review in no more than three years, at which time further examination of the availability of commercial reinsurance on reasonable terms be undertaken.

1 op cit, CRO Forum, 'CRObriefing', August 2007, p 6.

2 Terrorism Insurance Bill 2002, Revised Explanatory Memorandum, paragraph 1.8, p 2.

3 The Treasury, Terrorism Insurance Act Review: 2006, Canberra, June 2006, pp 29-30.

4 op cit, CRO Forum, 'CRObriefing', p 7.

5 op cit, The Treasury, Terrorism Insurance Act Review: 2006, pp 5-6, 27-30.

6 op cit, Guy Carpenter, 'Global Terror Update 2009', pp 19-21.

7 President's Working Group on Financial Markets, Terrorism Risk Insurance: Report of the President's Working Group on Financial Markets, September 2006, p 13.
http://www.treas.gov/offices/domestic-finance/financial-institution/terrorism-insurance/pdf/report.pdf.

8 op cit, President's Working Group on Financial Markets, Terrorism Risk Insurance, pp 23, 31, 44-45 and 79-80.

9 ibid, pp 30-31.

10 ibid, p 80.

11 Marsh, 'Marketwatch: Terrorism Insurance 2006 President's Working Group Report to Congress', October 2006, p 3.

12 The Reinsurance Association of America, Swiss Re and Aon also estimated reinsurance capacity of $6 billion to $8 billion 'at current market conditions' for terrorism insurance. Source: President's Working Group on Financial Markets, 'Terrorism Risk Insurance', p 26.

13 op cit, Marsh, 'Marketwatch: President's Working Group Report to Congress', Marsh, p 3.

14 ibid, pp 4-6.

15 On 18 December 2007, Congress approved the extension of TRIEA until 31 December 2014. The Terrorism Risk Insurance Program Reauthorization Act 2007 was signed by President George W Bush on 26 December 2007.

16 Marsh, 'Marketwatch: Terrorism Insurance — 2006 Market Conditions and Analysis', 2007, pp 1, 5, 8, http://global.marsh.com/documents/MarketConditionsAnalysis2006.pdf.

17 ibid, p 1.

18 op cit, CRO Forum, 'CRObriefing', pp 1-2.

19 ibid, pp 7-11.

20 United States Government Accountability Office, Terrorism Insurance: Status of Efforts of Policyholders to Obtain Coverage, report to Congressional Committees, September 2008, pp 9-12, http://www.gao.gov/new.items/d081057.pdf.

21 ibid, pp 20-22.

22 op cit, United States Government Accountability Office, Terrorism Insurance, pp 13-14, 16-17.

23 Marsh, 'Marketwatch: Terrorism Insurance 2009 — The Standalone Terrorism Market', First Quarter 2009, pp 1-2, http://global.marsh.com/documents/Marketwatch_Standalone_Terrorism_Market_Q1_2009.pdf.

24 ibid, p 2.

25 Aon Risk Services, 'Global Risk Alert: TRIA in Jeopardy', 14 May 2009, p 13, http://aon.mediaroom.com/index.php?s=65&item=349.

26 ibid, p 9, 13-14.

27 Savings are based on potential claims in the event of a terrorist attack. Source Aon Risk Services, 'Global Risk Alert: TRIA in Jeopardy', p 7.

28 United States Office of Management and Budget, Terminations, Reductions and Savings: Budget of the US Government — Fiscal Year 2010, Office of Management and Budget, Washington, DC, 2009, p 90, http://www.whitehouse.gov/omb/budget/fy2010/assets/trs.pdf.

29 op cit, Aon Risk Services, 'Global Risk Alert', pp 6-7.

30 Reserve Bank of Australia, Financial Stability Review, March 2009, pp 34-36, http://www.rba.gov.au/PublicationsAndResearch/FinancialStabilityReview/Mar2009/Pdf/financial_stability_review_0309.pdf.

31 Noel Pettersen, 'Report on Australia by the National Insurance Brokers Association', undated, pp 1-3, http://www.niba.com.au/resource/report%20on%20Australia%20for%20April%202009%20meeting%20doc.doc.

32 Insurers operating in the Australian market are not required to reinsure their terrorism risk with the ARPC. Some commercial reinsurance is available for insurers who choose to purchase it, but most insurers participate in the scheme, which is generally considered to be competitive compared to commercial alternatives.

33 Australia has been at a 'medium' level of alert since the four levels of national counter-terrorism alert were introduced in 2003.

34 'Financial crisis increases demand for reinsurance', insuranceNEWS.com.au, 24 November 2008, http://www.insurancenews.com.au/analysis/financial-crisis-increases-demand-for-reinsurance.

35 op cit, Aon Risk Services, 'Global Risk Alert', p 15.

 

Next: Chapter 3: Refinements to the Scheme

Previous: Chapter 1: International Approaches