The commercial real estate market breathed a sigh of relief when Congress finally renewed the Terrorism Risk Insurance Act (TRIA) on Jan. 12, nearly two weeks after it had expired. But borrowers and loan servicers are still dealing with headaches created by this short gap in coverage.
Many commercial mortgage documents require terrorism insurance over the life of the loan. The TRIA works as a backstop; when aggregate losses reach a certain level, the program kicks in, with the government sharing in the losses with insurers.
When Congress adjourned in December without renewing the TRIA, market participants were left wondering about the status of their existing policies, how much coverage insurers would be willing to provide on new policies in its absence, and at what cost. The odds of terrorist attacks are very difficult to predict and the potential liability is enormous.
New Law Less Attractive for Insurers
“We were very concerned that if program was not renewed, then we would see a repeat of what we saw after 9/11, when insurance capacity declined dramatically, especially in central business districts, and borrowers could not get financing to build or expand projects,” said Martin DePoy, steering committee coordinator for the Coalition to Insure Against Terrorism.
This was particularly a concern for securitizations of a single large commercial loans. Fitch Ratings had warned it December that it could put 20 deals under review for a possible downgrade if Congress fails to renew the TRIA. Each of them is backed by a single loan on a large office property; Fitch was worried that the deals’ servicers would force place insurance at a high cost.
The new law’s provisions are less attractive for insurers than the earlier version, enacted in November 2002, but not significantly so, and implementation will be spread out over several years. So getting terrorism insurance for new loans is no longer such a concern.
More pressing are complications stemming from riders that were triggered on many existing terrorism policies by the TRIA’s expiration. The riders typically either terminated the policies or changed terms and conditions, such as cost or coverage limit, in the absence of the federal backstop.
The simplest solution would be for the U.S. Department of the Treasury’s Federal Insurance Office (FIO) to interpret the new law as retroactive to Jan. 1, which would essentially mean that the riders never kicked in. If FIO determines the law cannot be interpreted as retroactive to Jan. 1, then covenants could be violated on thousands of securitized commercial real estate loans. For example, if a terrorist act in New York City before this issue is resolved could result in buildings collateralizing commercial mortgage bonds not being covered.
In addition, servicers would have to renegotiate loan covenants, given their obligation to make sure covenants are satisfied.
Guidance to that effect was anticipated to arrive imminently as Asset Securitization Report went to press.
“If you’re a servicer on these loans, you’re somewhat betwixt and between on how to address this,” said Scott Sinder, chair of Steptoe & Johnson’s government affairs and public policy group and outside counsel for the CRE Finance Counsel.
“If the answer is you have to renegotiate everything, that would be cumbersome and create additional administrative costs, but at least it’s a path forward. So we’re very much anticipating Treasury’s guidance.”
Gap in Coverage Triggered Riders on Existing Policies
Insurers would also have to renegotiate terms of the policies they offer.
In the event Treasury determines that its authority is insufficient to interpret the statute as retroactive, the CRE Finance Counsel and others have suggested backup solutions. Insurers are required by the law to make terrorism insurance available, and they could either offer new policies, requiring significant administrative work, or simply decide not to exercise the riders in the existing policies. One solution, Sinder said, may be for insurers to refrain from notifying policyholders that the riders are being exercised while continuing to bill them for the terrorism coverage premium.
Even if Treasury supports the retroactive interpretation, there may be other complications for commercial real estate market participants and their insurers. Large insurance companies and reinsurers wrote “gap coverage,” which covered borrowers in the event TRIA wasn’t renewed on time. Depending on how those policies were crafted, a retroactive interpretation could eliminate the need for gap coverage, and a refund might be due.
In addition, TRIA requires insurers to make terrorism coverage available and requires them to provide policyholders with certain notices about their coverage. Some notices given last year for Jan. 1 renewals, however, are no longer technically accurate and they may have to be adjusted to reflect that. For example, the name of the statute has changed slightly, and under the renewed version Treasury must consult with the Department of Homeland Security rather than the State Department to certify whether an event is an act of terrorism.
“So the question is whether insurers have to provide new notices or can they use the old ones,” Sinder said.
Such technicalities are unlikely to affect valuations of existing deals or the cost of new isuance, and neither are changes in the renewed law. There were concerns that TRIA might be amended to include coverage for acts of terrorism involving nuclear, biological or chemical weapons; this might have prompted insurers to rethink their offerings. But exclusions on these kinds of events remained in place.
Significant changes in other terms, such as insurers’ co-insurance rate, or the aggregate loss level at which the program is activated, known as the trigger, or the insurers’ deductible, could have prompted some insurers to step away from the market. However, those changes were all relatively modest.
“It might put some minor pricing pressure on policies, but nothing really market disruptive,” said Dan Rubock, senior vice president at Moody’s Investor Service.
Insurers’ co-insurance (which is similar to a deductible) increases to 20% from 15%, in 1.0 percentage point increments spaced out over five years. And starting in 2016, the event trigger increases by $20 million annually, from the current $100 million to $200 million, still a relatively low amount. And the amount of mandatory recoupment from policyholders will increase by $2 billion annually, from the current $27.5 billion to $37.5 billion. This is the ceiling under which government must eventually be repaid for covering damages after insurers’ deductibles are met.
These changes will have little direct impact on commercial real estate borrowers, however.
“Premiums may go up slightly, but it’s still a relief to most CRE and CMBS market participants,” said Joe McBride, a researcher at Trepp. “Terrorism risk is a big part of the modeling and valuations of large CRE assets.”
Opportunity for Private Capital to Step In
With the government reducing its backstop, there is an opportunity for private capital to step in and assume some of the risk of terrorism. William Dubinsky, head of insurance-linked securities at Willis Capital Markets & Advisory, said that private reinsurers and investors in insurance-linked securities could both step up their participation and “potentially fill that gap gradually over time, in a relatively orderly way.”
Outside of CMBS, terrorism risk has rarely been covered in the insurance-linked securities market. The only stand-alone deal so far was a $260 million, investment-trade securitization of terrorism risk by Fédération Internationale de Football Association in 2006. The Golden Goal Finance Ltd. bond payout was triggered if the 2006 World Cup in Germany was cancelled because of a terrorist act.
Dubinsky noted that the renewed law creates an advisory committee to explore private-market alternatives. “That could be a forum to promote securitization and other private alternatives, including contingent capital,” he said