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?
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.
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.
See other terrorism articles on IRMI.com.
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