2013 PLUS International Conference speaker Dr. Erwann Michel-Kerjan, Managing Director, Risk Management and Decision Processes Center, The Wharton School, University of Pennsylvania offered written testimony to the Committee on Banking, Housing and Urban Affairs of the U.S. Senate on September 25, 2013 on the terrorism insurance market and TRIA. An excerpt of his testimony is below.
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SECTION I. WHAT DO WE KNOW ABOUT THE TERRORISM INSURANCE MARKET?
NEW EMPIRICAL EVIDENCE
The lack of availability of terrorism insurance shortly after the 9/11 attacks led to a call from some private sector groups for federal intervention. For example, the Government Accountability Office reported in 2002 that the construction and real estate industries complained that the lack of available terrorism coverage delayed/prevented projects from going forward because of concerns by lenders or investors.
In response to such concerns, the Terrorism Risk Insurance Act of 2002 (TRIA) was passed by Congress
and signed into law by President Bush on November 26, 2002.1 This program was originally aimed at providing a three-year temporary measure to increase the availability of risk coverage, but the program has been renewed twice since, in 2005 and 2007. TRIA is now extended up to the end of 2014.
In brief, TRIA requires insurers to offer terrorism coverage to all their commercial clients (a legal “make available” requirement). (Note that residential coverage is not included in this program and it is not clear who would pay for residential losses from terrorism). These firms have the right to refuse this coverage unless it is mandated by state law, as in the case of workers’ compensation in most states.
Loss sharing under TRIA is organized as follows: The first layer is provided by insurers through a deductible. That deductible is calculated as a percentage of the direct earned premiums each insurer
received in the preceding year from its policyholders for all lines of business covered under TRIA. In order to increase the role of the private market over time, this percentage has increased sharply from 7% in 2003, to 10% in 2004, 15% in 2005, and it has been 20% since 2007—i.e. nearly tripling over time. For several large insurers, this represents billions of dollars before they receive any federal assistance. The second layer up to $100 billion is the joint responsibility of the federal government and insurers. Specifically, the federal government is responsible for paying 85% of each insurer’s primary losses during a given year above the applicable insurer deductible; the insurer covers the remaining 15%.
Contrary to what is done in other countries (see the review in Section III), the U.S. federal government does not collect any premiums for covering 85% of the insurer’s losses above the deductible. It provides insurers with free up-front reinsurance for exposure that would ordinarily require a substantial amount of (costly) capital should the insurers seek protection from the private reinsurance market alone. The “up front” is important here since the U.S. Treasury can recoup part of its payment from insurers over time; they can in turn recoup this amount against all their policyholders, victims of the attack or not.
Has TRIA Worked as Intended?
The main policy goal of TRIA was to ensure that commercial firms across the nation could access
subsidized coverage, and as a result, more companies would purchase this coverage.
Market Penetration Has Increased Substantially. The empirical evidence reveals that this strategy has
worked. Market data from the two largest insurance brokers, Aon and Marsh, on their own clients (which
tend to be larger firms), indicate that take-up rates for terrorism insurance by large firms has more than
doubled, from 27% in 2003 to 58% in 2007, a level that has remained stable since (it is 62% today).
These figures have been cited in a number of publications and by my fellow panelists today.
Three important points should be noted about this 62% take-up rate. First, this is not a TRIA take-up rate but combines all types of terrorism coverage: U.S. risks only (TRIA only), U.S. risks and non-U.S. risks (clients with foreign values; referred as “TRIA and non-certified”), high risks not covered by the market (referred to as “standalone coverage”), and programs structured as a combination of standalone and TRIA coverage (often done through a captive). Second, these are based on the portfolio of clients of the above two brokers which tend to be medium to large size clients (in other words, these are samples only not the full market). Third, there is a lot of heterogeneity across industries (e.g., take-up rate for
media, education, financial institutions is around 80% but only 43% in the energy sector; Marsh, 2013).
While we should certainly feel good about the increase observed in 2003-2006, this also means that probably about 4 out of 10 large corporations in the U.S. don’t have coverage against terrorism today. Whether they will be able to sustain a large loss with internal or external capital is an open question Congress might want to analyze further. We need to better understand the demand side of this market. Let’s remember that on 9/11 terrorism was included as an unnamed peril in most insurance policies so the take-up rate was virtually 100%.
An important element of the discussion about the future of TRIA is that there has been no analysis in recent years of terrorism insurance penetration for small businesses which constitute a vital part of our economy. They are the most vulnerable to financial shocks.
Decrease in Insurance Cost. The increase in coverage discussed above is partly due to the fact that
terrorism insurance prices have continuously decreased since 2003. The median premium for terrorism
insurance for middle-size and large firms was down from $57 per million of total insured value in 2004,
$42 per million to $37 per million in 2008, then to $25 per million in 2009 (data from Marsh); the 2013
Marsh report shows that prices have continued to decrease for those firms to about $20 per million today.
This translates into terrorism premiums representing 3% to 5% of property premium paid by those firms.
A 2012 report by insurance broker Aon provides similar information on take-up rates for the twelve months ending March 2012: $20 per million for TRIA coverage only (which translates into an average of about 3.5% of the premium charged for property coverage for TRIA only and about 5% for TRIA and non-certified).
This price decrease is largely explained by the absence of a major attack on U.S. soil since 9/11, thanks to the hard work of our government services here and abroad. It is also explained by the natural effect of competition in insurance markets. The 2013 Boston attack had no impact on terrorism risk insurance markets. While the surveys from leading brokers have provided a great deal of information about how much coverage their clients purchase and how much they pay for it, they do not say much about how sensitive that demand is to changes in terrorism insurance cost. A recent analysis utilizes these data to show that terrorism insurance is quite price inelastic. This finding has profound policy implications as Congress contemplates different design changes for TRIA.