As the cost of terrorism insurance soared, many borrowers found it difficult to secure insurers willing to provide coverage for terrorism at reasonable rates. Prior to September 11, 2001, insurers and reinsurers did not deem the risk of terrorist attacks material enough to fashion exclusions for such events in all-risk insurance policies covering high-rise office buildings. The state of the insurance industry, however, underwent a dramatic change following the destruction of the World Trade Center. Due to the scale of damages and the unpredictability of future terrorist attacks, many reinsurers began refusing to renew coverage for terrorist attacks. In response, as primary all-risk policies came up for renewal, almost all primary property and casualty insurance carriers began to exclude terrorist acts from coverage. This exclusion forced commercial property owners to look to stand-alone terrorism coverage.
As a result of the broad exodus of insurance carriers from the terrorism insurance market, stand-alone terrorism insurance became extraordinarily expensive and, in the case of some high-profile properties, simply unavailable. The few companies willing to provide terrorism insurance limited the amount of coverage they were willing to underwrite, which made obtaining coverage for the most valuable properties even more difficult. In addition, stand-alone coverage suffered from many drawbacks that standard all-risk policies did not, including that it was often prohibitively expensive, usually offered on an aggregate rather than a per-occurrence basis, and typically subject to a 30-day cancellation clause. Moreover, exclusions from coverage were numerous. The un-certainty surrounding the availability of terrorism insurance undermined the recovery of the commercial real estate market that had been battered by the terror attacks and the general economic slowdown.
As the cost of terrorism insurance soared, many borrowers found it difficult to secure terrorism coverage at reasonable rates. Some lenders, relying on mortgage provisions requiring standard all-risk policies or other "commercially reasonable" insurance, attempted to use "lock box" funds to secure terrorism coverage for their borrowers. Litigation between borrowers and lenders ensued over the scope of "all-risk" insurance, as well as what constituted "commercially reasonable" policies. Borrowers argued that all-risk policies covered losses due to a fire regardless of the cause and that specific terrorism coverage was therefore unnecessary (the "fire-following doctrine"). A Minnesota court upheld the fire-following doctrine and found that additional terrorism coverage (stand-alone or otherwise) offered little protection beyond what all-risk policies with terrorism exclusions already provided. However, the New York Supreme Court reached a contrary conclusion about the scope of coverage provided by standard all-risk policies. That court found that the fire-following doctrine might not apply in all cases because the damage from a terrorist attack could take many forms, including chemical, biological or nuclear damage. The conflicting outcomes of these two disputes created additional uncertainty for lenders and borrowers as they struggled to adjust to the post-September 11th climate.
Congress Steps Up
Recognizing this new reality, the real estate and insurance industries looked to the federal government for relief. On November 26, 2002, President George W. Bush signed the Terrorism Risk Insurance Act of 2002 ("TRIA") into law. TRIA is designed to ensure that all-risk policies include terrorism coverage at affordable rates by obligating the federal government to share the risk of losses in the event of future terrorist attacks. TRIA seeks to temporarily stabilize the volatile insurance market until the insurance industry develops the programs necessary to create a viable financial services market for private terrorism insurance.
TRIA coverage is triggered when the Secretary of the Treasury (the "Secretary"), in concurrence with the Secretary of State and the Attorney General, certifies an event causing losses of at least $5,000,000 as a foreign terrorist act, which is defined as an act that has been "committed by an individual or individuals acting on behalf of any 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 United States government by coercion." The Secretary's decision is not subject to judicial review.
Each participating insurance company will be responsible for paying out a certain amount in claims resulting from certified terrorist acts as a deductible before federal assistance becomes available. The deductible is based on a percentage of direct earned premiums from the previous calendar year, and rises from 7% during year one to 10% in year two and 15% in year three. The phrase "direct earned premiums" refers to any premiums that are earned for property and casualty insurance issued by any insurer against losses occurring in the United States or to a United States air carrier or flagged vessel. For losses above an insurance company's deductible, the federal government will cover 90% of such losses, while the insurance company contributes 10%. Losses covered under TRIA will be capped annually at $100 billion. Congress is to determine the procedures and the source for any payments above this amount.
Under certain circumstances, the federal government is required under TRIA to recoup financial assistance provided in connection with acts of terrorism. In addition, the Secretary has the discretion to recoup amounts expended. In both mandatory and dis-cretionary cases, the recoupment will be accom-plished through risk-spreading surcharges imposed on all policyholders of property and casualty insurance, which are not to exceed 3% of the policy premiums paid in a given year.
TRIA obligates all insurance companies to provide terrorism coverage to all policyholders of commercial lines of property and casualty insurance during the first two program years of TRIA. The Secretary has the discretion to determine whether coverage should be extended for the third program year. Insurance companies must disclose to policyholders the premiums that they charge for terrorism coverage and the existence of a sizeable federal backstop. Captive insurers or municipalities and other entities with self-insurance arrangements may participate in the program at the discretion of the Secretary.
TRIA provides that any terrorism exclusion provision in a contract for property and casualty insurance that is in force on the date of enactment of TRIA is void to the extent that such provision excludes losses that would otherwise be insured losses. Moreover, TRIA, like much federal legislation, preempts state law, so that any state approval of such a terrorism exclusion that is in force on the date of enactment of TRIA is also void. However, under two very limited circumstances, TRIA allows the reinstatment of terrorism exclusions that are otherwise void.
Under TRIA, the federal government is immune from any and all punitive liability as a reinsurer. In addition, with certain exceptions, TRIA creates an exclusive federal cause of action, governed by applicable state law, for suits seeking recovery for property loss, personal injury or death arising out of a terrorist event. Following the determination by the Secretary that an act of terrorism under TRIA has occurred, the Judicial Panel on Multidistrict Litigation shall designate one district court (or, if necessary, multiple district courts) to have exclusive jurisdiction over all actions for any claim relating to such act of terrorism.
TRIA is set to expire on December 31, 2005, causing some concern among those in the commercial real estate industry who have long-term loans. Presently, it is unclear what will follow once the federal back-stop expires. However, not later than June 30, 2005, the Secretary must report to Congress on the effectiveness of TRIA and the likely capacity of the insurance industry to offer affordable insurance after the termination of the program. Congress will have detailed information about market conditions, enabling it to make a decision whether or not to continue the program. If the private market has not found a permanent way to address the terrorism insurance issue, there is a strong likelihood that Congress will renew TRIA or find another way to ensure that terrorism insurance remains available and affordable.
TRIA will have a significant impact on the requirements imposed on borrowers under the terms of their loan agreements. Prior to September 11th, most "all-risk" policies were deemed to incorporate the risk of terrorist attack. After September 11th, as insurers began to craft exclusions for terrorism insurance and the price of stand-alone policies skyrocketed, many borrowers argued that the procurement of terrorism insurance was commercially unreasonable and thus not required under the terms of their agreements. After TRIA, however, such arguments are undermined by the requirement that insurers include terrorism coverage in their standard policies at a more reasonable cost. As a result, it is likelier that lenders will insist on more stringent terrorism insurance requirements in their loan agreements.
Not a Perfect Solution
TRIA solves the problem of availability of coverage (albeit with a limited scope and for a limited time) and it reduces the financial exposure of insurance companies providing terrorism coverage, but it is unclear if TRIA will have a significant impact on the cost of such coverage. Companies that have purchased or are looking to purchase terrorism insurance should consult a sophisticated insurance brokerage company in order to ensure that the rates paid for such coverage are competitive in the marketplace. Marsh, Inc., a leading risk and in-surance services firm serving clients in more than 100 countries, conducted a recent survey of approxi-mately 1,500 existing policies and found that insurers were requiring around 8% to 9% in additional premiums for terrorism coverage. Whether or not a particular state adheres to the fire-following doctrine will also impact the price of terrorism coverage. In jurisdictions where the doctrine is applicable, coverage is likely to be priced at relatively low levels because the mandated coverage does not significantly increase the perceived risk. The opposite should be true where the doctrine is not followed.
While TRIA may provide a short-term solution, borrowers still have numerous concerns relating to their long-term loans. Many loans have terms that will extend far beyond the expiration of TRIA. In this situation, borrowers should try to include provisions in their loan agreements stating that if TRIA is not renewed or an alternative is not implemented, then the borrower will be required to procure replacement terrorism insurance only if it is available at commecially reasonable rates.
TRIA also makes it more likely that lenders will be able to successfully argue that borrowers must carry terrorism insurance because it is commercially reasonable and available. Prior to TRIA, borrowers could argue that terrorism insurance was pro-hibitively expensive and thus "commercially unreasonable." TRIA, as long as it exists, could make it more difficult for borrowers to adhere to that position.
Only time will tell whether TRIA achieves its objective of stabilizing the cost of terrorism coverage and preventing future litigation or if TRIA will be merely a complex, yet ineffective, solution to a serious problem.
Laura E. Hannusch is a Partner in the Houston office and may be contacted via e-mail at lhannusch@pillsburywinthrop.com or by phone at (713) 425-7321.
Suneil M. Thomas is an associate in the San Francisco office and may be contacted via e-mail at sthomas@pillsburywinthrop.com or by phone at (415) 983-1732.
Pillsbury Winthrop LLP is a global law firm with power and presence on both U.S. coasts and abroad, with core practice areas in: real estate, litigation, technology and intellectual property, energy, capital markets and finance. The firm has 17 offices and approximately 800 attorneys worldwide. For further information on the firm's real estate practice, please contact Jim Rishwain at jrishwain@pillsburywinthrop.com or (310) 203-1111.