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Federal Document Clearing House
Congressional Testimony
February 27, 2002 Wednesday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 3167 words
COMMITTEE:
HOUSE FINANCIAL SERVICES
HEADLINE:
NEED FOR FEDERAL TERRORISM INSURANCE ASSISTANCE
TESTIMONY-BY: MARK J. WARSHAWSKY,, DEPUTY ASSISTANT
SECRETARY FOR
AFFILIATION: ECONOMIC POLICY, U.S.
TREASURY
BODY: DEPARTMENT OF THE TREASURY OFFICE OF
PUBLIC AFFAIRS
Testimony of
Mark J. Warshawsky, Deputy Assistant
Secretary for Economic Policy, U.S. Treasury
Before the Financial
Services Subcommittee on Oversight and Investigation United States House of
Representatives
Wednesday, February 27, 2002
Chairwoman Kelly,
Representative Gutierrez, Members of the Subcommittee, I appreciate the
opportunity to present to you the views of the Office of Economic Policy at the
Treasury Department on the current and possible future impacts of the lack of
terrorism risk insurance on the American economy. We appreciate the speedy
action of the House in passing legislation last year that would have created a
temporary federal back-stop to insured losses from terrorist attacks. We look
forward to continuing to work with you to achieve our shared objective of
restoring private insurance coverage for this risk. Terrorist attacks have the
potential for significant nationwide costs and thus justify a carefully designed
collective approach to insuring against the losses from such events, utilizing
the already existing coverage and payment mechanisms of private insurance
markets.
The terrorist attacks have had a negative impact on the ability
of businesses and property owners to insure against risk. Industry estimates of
insured losses resulting from the attacks of September 11, over all principal
lines of coverage, range from $30 billion to $90 billion, with the consensus
estimates in the $36 billion to $54 billion range. These losses hit many major
lines of the property/casualty insurance business including property, business
interruption, workers' compensation, and liability, as well as life and health.
Wherever the final figures settle, these will be the largest insured losses in
history. By contrast, Hurricane Andrew, which led to significantly higher
premiums and reduced availability of insurance in flood prone areas, caused, in
today's dollars, $19.3 billion of insured losses in all lines, although it
should be noted that the industry was much better capitalized on the eve of the
September 11 th tragedy than it was when Andrew hit.
Investment losses
experienced by primary property/casualty (P/C) insurance and reinsurance
companies, which had been growing prior to September 11, accelerated
dramatically immediately after that date. Hence, unlike other insured events,
the insurance losses from these terrorist attacks were highly correlated with
investment losses at the time -- a difficult and risky situation for insurance
and reinsurance companies.
In addition to these two types of losses
actually experienced, the attacks revealed to the insurance industry a potential
for huge future losses which it had not priced before and cannot yet readily
model. Terrorism creates the possibility of a large loss, but it does so with an
uncertain probability. This is unlike other insurable events where the law of
large numbers operates to effectively pool risk, as in personal lines such as
life, health, long-term care or automobile. It is more comparable to dramatic
natural catastrophes, such as hurricanes or earthquakes, causing large losses.
But unlike terrorism risk, natural catastrophes have predictable patterns and
probabilities quantifiable by sophisticated models, based on past weather
conditions or seismic activity, that better allow the assumption and
diversification of risk. It is well known that primary insurers in most lines of
coverage reduce their risk by laying it off to reinsurers. Reinsurance is a
valuable, sensible, and well-established way of spreading risk. Many
participants in the reinsurance market are large sophisticated organizations,
are often foreign-owned and operate world wide, thus assuring that risks in any
one country or type of business are spread around the world. As a consequence of
the September 11 losses, which reduced their capital base, and the inability to
model
terrorism risk, at least at the present time, the
reinsurance industry has almost entirely stopped assuming
terrorism risk.
Primary insurers have also withdrawn,
and continue to withdraw, from covering this risk in states and lines of
coverage where the law or insurance regulators have not prevented them from so
doing.
I will be brief in summarizing the insurance market impacts; I
understand that the testimony of the GAO will cover this in detail.
Primary insurers are being allowed by insurance commissioners in all
states, with the prominent exceptions of New York, California, and Georgia, to
exclude terrorism coverage above certain dollar amounts from smaller, regulated
commercial policies. Most states, however, do not allow an exclusion from damage
caused by fire following a terrorist attack. No states have allowed the
exclusion of terrorism risk in personal insurance lines. Terrorism is defined
broadly in the exclusion as activity that involves the threat of, or actual use
of, violence if the effect is to intimidate the government or disrupt some
segment of the economy and the intent is to further political or ideological
objectives. The definition includes the use of nuclear, chemical or biological
weapons. It apparently does not make a distinction between the foreign or
domestic origin of the act of terrorism.
Because state laws do not allow
companies offering workers' compensation insurance to exclude terrorism risk,
some primary insurers have chosen to drop the workers' compensation line
completely, rather than underwrite
terrorism risk absent
reinsurance. Others are issuing it on a more selective basis,
forcing many businesses into state sponsored insurance pools. In one case
brought to our attention workers compensation insurance was not renewed because
the insured had over 500 employees located in a tall office building in
Pennsylvania. Insurance brokers report that terrorism coverage for large
commercial properties, whose insurance policies are unregulated, is difficult to
obtain, and importantly, subject to limits of coverage that are much lower than
customers want. And premiums for these properties have increased dramatically.
In some instances the total policy cost with limited terrorism coverage is
reported to be roughly double the cost of the P/C policy without the terrorism
coverage. Stand alone coverage for terrorism risk is very limited and quite
expensive where it is available. In fact, separate terrorism risk coverage costs
more than the insurance covering all other risks while it provides a lower limit
and responds to only one event.
Owners of large commercial properties
and holders of mortgages on such properties (pension funds, trusts, etc.) are
reluctant to discuss the extent and nature of their insurance coverage because
few property owners want to make public the fact that they are uncovered or
inadequately covered. This makes it especially difficult to gage the extent of
the coverage and cost problems, but we have indications that they are widespread
on many types of properties, especially those currently thought to be most at
risk from terror attacks.
The effects of conditions in the market for
terrorism risk insurance are being heightened by rising rates for types of
insurance coverage unrelated to terrorism risks, where the insurance market is
tightening. Insurance brokers, who deal in most commercial P/C coverage, report
that median rate increases are 30-50 percent and mean rate increases are 40-70
percent. Industry sources report that rates had begun to rise and coverage
shrink well before September 11 as part of the classic underwriting cycle. This
cycle is generally started when insurance company earnings on investments
decrease, reducing their capacity to underwrite insurance. Insurance industry
capital losses as a result of September 11, however, have exacerbated the cycle,
as has the increased risk for primary insurers remaining after excluding
allowable terrorism risk coverage. While some increase in premiums might be
expected in response to the low earnings in the insurance industry before
September 11 and the attacks themselves, the recent increases have been so
dramatic that they harm the Nation's economic recovery.
These insurance
difficulties in turn are affecting the financing of new real estate projects and
sales of existing properties.
Reports to us indicate that financing is
limited for new construction and/or acquisition of high-profile properties which
are at risk for terrorist attack and inadequately insured. Lenders are carefully
screening the location and size of buildings. Some are simply refusing to lend
on trophy properties that are not fully insured. Others will lend on
underinsured properties, but only if the owner will provide recourse. In one
case, a large construction project in the Midwest known to be financially viable
prior to September 11 is now at risk of being abandoned because of gaps in the
available terrorism coverage. Eventually the market might be able to price for
the new risks facing such properties. Both the severity and timing of changes to
date, however, make them harmful to the economy.
The impact on existing
properties at risk is equally troubling. While, technically, properties without
adequate insurance are in default of financing covenants, lenders may well not
foreclose but, rather, raise their fees to cover their own risk. Rating agencies
have indicated that they will substantially increase subordination levels on new
issues of commercial mortgage backed securities whose collateral properties have
inadequate insurance coverage. They are also in the process of establishing risk
criteria that would lead to the downgrading of securities collateralized by
properties inadequately insured and at an elevated risk of attack. Those deemed
high risk by the agencies include trophy assets, symbols of America, structures
for large gatherings of people (arenas, stadiums, and convention centers),
critical infrastructure (major bridges, tunnels, and transportation hubs), and
critical energy-providing structures. It also includes structures that are tall,
located in a central business district, or with a highly visible tenancy.
Ratings downgrades would, of course, have a major negative impact on the
value of such securities, which are widely held by mutual funds and pension
plans. Spreads between the yields for large property commercial mortgage backed
securities and Treasury securities have in fact widened recently, especially for
properties with greater exposure to terrorism risk. And we have received reports
that the volume of commercial mortgage backed securities issued since the
beginning of the year has fallen.
We have particular concern about the
impact of high premium rates and lack of insurance availability for smaller
projects being built near what is considered potential terrorist targets.
Hospitals, municipal entities and other nonprofits where trustees feel a
fiduciary responsibility may well forgo terrorism coverage if they see the cost
is equal or greater than what they're paying for all other perils.
Of
equal concern to us is the steep rise in rates for commercial and other
insurance policies for all developers, because this rise has the potential to
cause significant impact on the economy and is likely to last for the next year
or two. While low interest rates may be offsetting some of the increased
insurance costs right now, we cannot count on that situation to remain constant.
Finally, the full effects of the terrorist attacks on insurance
conditions have yet to be felt, because about a third of the reinsurance
treaties and many primary insurance contracts negotiated prior to September 11
have not yet expired. Many real estate lenders are still deciding how to adjust
their lending strategies to the lack of coverage for their properties. Others
may delay bringing properties to markets in hopes of improvement later. These
impacts are difficult to quantify and document because they are dispersed, and
the affected policyholders may be reluctant to publicize that they are having
trouble finding financing for real estate projects, or that outstanding debt
secured by inadequately insured property risks a ratings downgrade. In this
regard, I understand that the SEC is considering whether to require businesses
left without commercial terrorism risk insurance after the September 11 attacks
to disclose the loss to investors as a material risk factor.
The
implication of these insurance market conditions and economic consequences makes
it critical for Congress to enact a federal terrorism risk insurance backstop
for at least four reasons.
1. The lack of coverage and high premium
rates imply a drag upon our economy and a burden to the nascent recovery,
including the potential for a loss of even more jobs. Some are now arguing that
the lack of a dramatic economic impact resulting from Congress' failure to enact
a federal terrorism risk insurance backstop prior to January 1 means that the
legislation is not necessary. This argument reflects a fundamental
misunderstanding of the nature of the problem and the drag that terrorism risk
is placing on an economy that is in the early stages of recovery. As I've
indicated, the insurance industry has been significantly destabilized, with
coverage well below "equilibrium", and prices for coverage well above normal
levels. Investors in new properties and lenders on properties on which contracts
have expired are paying disequilibrium costs, either directly, because of the
spikes in renewal policy costs, or indirectly, because they are the ones now
bearing this risk.
The economic impact is therefore two-fold: first, the
decreased returns and higher risk experienced by businesses and developers are a
disincentive to future investment over this interim period. Second, as suppliers
of capital in turn seek to lay off the cost, the impact is passed through to
consumers and workers. Further, it will increase as more and more insurance
contracts come up for renewal. In brief, the impact is just like a "tax"
increase on productive capital. What is the ultimate impact on consumer prices
and jobs? While it is always difficult to estimate accurately, we know that in
the long run, in our open and elastic capital markets, workers and consumers
will bear the brunt of the burden.
2. The cost of lost and postponed
investment opportunity is potentially large for future economic growth. Many
real estate lenders are still deciding how to adjust their lending strategies to
the lack of coverage for their properties. Many developers may be delaying
bringing properties to capital markets in hopes of improvement in insurance
conditions later, which in turn is now dependent on government action. Thus
capital is not committed to worthy projects--that would have received financing
and created jobs had insurance markets been in a better equilibrium.
3.
Inaction paralyzes the private sector. Furthermore, the lack of government
action, one way or another, is itself costly as insurers, financiers, and
businesses wait to see what new institutions the government might set up before
themselves committing to creating new insurance mechanisms, even ones
significantly less efficient than a robust private insurance market.
Moreover, economic activity itself could adjust in the design and
location of building projects.
Planning and decision making would be
much better if they knew the insurance environment they faced. We can do better
by our investors, consumers, and workers than this.
4. The economic
impact of another terror attack could be even greater than the September 11
attack. Finally, there is a real concern about the potential costs to the
federal government and the economy in the event of another attack, with no
backstop program in place to stem the tide of uninsured and underinsured
properties. Private insurance covered a significant percentage of losses arising
from the September 11 attacks. Following the attacks, insurance companies
quickly stated that they would pay claims on the World Trade Center and other
losses (including business interruption) incurred because of its destruction.
The ability of the insurance industry to make this simple and credible promise
was likely instrumental in calming investors after the attacks and giving
business confidence that funds would be available to resume business operations,
particularly in New York City.
The subsequent rapid disbursement of
payments has been vital in speeding New York City's recovery according to a
report commissioned by that city's Chamber of Commerce.
Nearly half of
the projected payouts are expected to be made within a year of the attack. Such
rapid disbursement will be possible only because a payment scheme (via
well-established insurance conduits) was in place prior to the attacks. Trying
to devise such a scheme on short notice and in the aftermath of another terror
attack would be considerably less effective and would slow recovery.
But
without a backstop program in place to encourage participation by private
insurance that might well happen. In the event of a major terrorist strike, many
of the losses would likely be borne by the federal government. We would expect
defaults on commercial mortgages and other losses. It might be difficult to
resist the call for federal assistance to compensate uninsured property owners
and businesses victimized by the terrorist strike. Compensation for losses by
private insurance industry has worked smoothly and efficiently. It is highly
unlikely that a federal payment system, hastily conceived in the aftermath of a
major attack, could perform as well.
We need action now.
As the
President has stated strongly, our enemies are persistent, clever, and should
not be underestimated: future incidents may be quite different from the attacks
we have already experienced. Our enemies have stated that their intent is to
cause economic harm, as well as physical harm, to us. We firmly believe that our
Nation's battle against the scourge of terrorism will ultimately be successful.
We also believe that private markets will stabilize--capital levels will be
restored and insurers' ability to price this risk will improve. But we now know
how difficult and costly it can be for an economy to adjust to terrorist events.
We bear responsibility for assuring that our citizens are adequately protected
against terrorism. This includes our citizenry's ability to obtain insurance in
the interim against this insidious threat, as well as reducing the costs of
restoring their financial well-being were another event to occur. And we want to
encourage economic growth. Hence, we have proposed a federal insurance backup.
Congress should act before the economic damage caused by lack of terrorism risk
insurance takes too great a toll. We want to work with you to create the best
possible support for our economy, job creation, and consumers.
LOAD-DATE: March 1, 2002