Last Tuesday the Senate passed the Terrorism Risk Protection Act, with implementation expected by the end of this year. Though clearly a positive development for the single-asset CMBS universe - as it makes the product more available and affordable to borrowers - industry observers are still in a wait-and-see mode, because the true success of the bill will largely depend on the reaction of the insurance industry to it.
"There is a whole mechanism here that has to play out," said a source. "It's not like the Senate passes a bill, and then borrowers get instantly insured. There's a series of steps that have to occur."
Rating agencies, in particular, need to know if the act will actually result in increased terrorism coverage before they renege previous ratings actions associated with insufficient insurance on the properties backing the deals. In other words, they would have to see whether the implementation of the bill would cause the insurance industry to offer more insurance and borrowers on the affected deals to obtain it.
"The bill's passage is an important step toward making terrorism insurance available and affordable." said Tad Philipp, managing director at Moody's Investors Service. "We have to assess how it will be implemented and the effect it will have on the transactions we rate."
Analysts from Fitch Ratings echo this sentiment. "We think it's a very positive development because it's going to make the insurance available as it should make it more affordable," said Susan Merrick, managing director at Fitch. "The insurance companies would know what the limit of their liability is and then they could price policies accordingly." However, she added that it will not immediately affect the transactions that Fitch had earlier downgraded because borrowers still have to actually go out and procure the insurance.
Indeed, experts are hesitant to cast firm forecasts before the full process unfolds. Within 30 days or so after the President signs the bill into law, the insurance industry has to assess and price the risk under the act, and then a new policy has to be sent out to the borrowers. The borrowers would then have to decide whether they are going to accept or to reject the policy being offered, also within 30 days. The results are rather uncertain.
As Merrill Lynch analysts wrote, "Existing terrorism insurance coverage may be at risk as the terms and conditions of the policies are revised to match the property and casualty terms (lower deductibles and greater coverage) and then repriced within the first 30 days of the act becoming effective."
But at what price?
Though analysts expect that the bill will certainly make it easier for borrowers to purchase terrorism insurance, the actual pricing of the coverage remains tricky.
Darrell Wheeler, director of CMBS research at Salomon Smith Barney, said the bill basically provides a cap, which relieves insurers of unlimited liability, so insurers should be able to price coverage to a worst-case loss cap that increases with each calendar year.
He noted that, at the same time, the insurers still have risk exposure before the cap is met, so they will likely be cautious in pricing the coverage.
However, he felt the terrorism insurance bill was very necessary to the economy and that the competition encouraged by the bill should cause terrorism coverage premiums to eventually decrease. He stressed that the terrorism insurance bill was not an immediate magic solution.
But he does expect the terrorism insurance bill will gradually have a positive effect on the market. Wheeler predicts that single-asset transactions would see spreads tighten 10 to 20 basis points, but not all the way back to where they were before Sept. 11. Further, the single-asset deals that were downgraded by Fitch and Moody's, because of inadequate terrorism coverage, could now be placed on watch list for upgrades as they obtain sufficient terrorism coverage.
Wheeler noted, however, the damage done to the single-asset market will take time to heal. The most obvious examples being the ongoing disputes between servicers and borrowers as well as the resulting interest shortfalls to the lower rated single-asset certificates. He felt that any new deals would have to have some kind of liquidity facility for non-monetary events as well as to more carefully define the servicing fees payable for a non-monetary default.
Aside from rating and pricing issues, there are other questions that have been raised about the bill, specifically in terms of its coverage.
Analysts from Banc of America Securities said that there is a potential gap in the bill due to the definition of terrorism. The bill states that for an act to be deemed as terrorism it should "have 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 researchers explained that because insurers are only required to cover acts that meet this definition, it is really not clear that domestic terrorist acts are covered. They cite the Oklahoma City bombing and the current anthrax threat, which are both domestic. Another analyst brings up a different instance, "How you define foreign could be interesting. What's if it involves a U.S. citizen with a different ethnicity?"
Further, BofA researchers said that the final determination of what makes up a "terrorist act" lies in the Secretary of the Treasury, with some help from the Secretary of State and the Attorney General. Other analysts said this might actually present a problem because there may be instances where it would be a year or two before the terrorist is actually identified.
There are also concerns pertaining to the insurance markets such as constraints on capacity as well as the willingness of reinsurers to cover the insurance companies' share of risk, according to researchers from Merrill.
They said that capacity should increase theoretically because insurers are required to participate in the program and to offer the product under the same terms and conditions as the related property and casualty insurance. But uneconomical premiums may limit supply.
In terms of reinsurers, Merrill said that though the act does encourage insurers to obtain reinsurance for their share of risk, it does not really support the global reinsurance market.
Merrill also noted that Standard & Poor's previously warned that the mandate to offer terrorism insurance may actually cause insurance companies to take on more risk than they can effectively predict or price, a factor that may result in downgrades. Insurance providers are required to have at least a double-A rating in most CMBS deals.