Impending legislation renewing the federal backstop for terrorism insurance could pare down this safeguard, creating havoc in the market for commercial real estate (CRE), and, by extension, commercial mortgage-backed securities (CMBS). Despite advances in modeling this risk since the attack on New York’s Twin Towers, it may prove challenging for capital markets investors to pick up the slack.
A preliminary bill from the U.S. Senate Committee on Banking, Housing and Urban Affairs is anticipated within weeks, and the House Committee on Financial Services is expected to take up the issue by late April. Current talk on K Street points to a law by summer’s end, before elections rev up into full gear. However, CRE borrowers, whose loans provide fodder for the CMBS market, would prefer a solution sooner rather than later.
Many businesses seeking to renew annual property and casualty policies this Spring faced new legal language saying that insurers would provide terrorism insurance through the year’s end. However, depending on the outcome of the reauthorization of the Terrorism Risk Insurance Act (TRIA), they reserved the right to cancel terrorism coverage at that time. Another big group of policy holders will face similar renewal stipulations in June.
“It’s very unnerving to business and creates uncertainty that’s not good for the economy overall,” said Martin DePoy, a spokesperson for the Coalition to Insure Against Terrorism (CIAT), which represents a wide range of business-insurance policy holders.
The worst fears, however, have apparently subsided. The House Committee’s chairman, Jeb Hensarling (R-Texas), was skeptical about renewing the backstop altogether in early 2013, but after two hearings on the issue he now supports moving a bill to extend the law, DePoy said. “Now it’s a question of what does the program look like going forward,” he said.
Ever since the Twin Towers attack nearly 13 years ago, most CRE financings have required property and casualty policies that cover terrorist events. Thomas Fink, a senior vice president at Trepp, a provider of CMBS and CRE analytics, said that this is actually a legal requirement in a dozen states, including California, New York, and Illinois, where there are concentrations of trophy properties considered more likely to be terrorism targets.
“We ran those states where it’s a requirement against the loans in CMBS deals in our database and found those represent more than 40% of the outstanding balance of CMBS,” Fink said.
“The thinking is a failure to renew TRIA will throw a lot of sand into the gears of CMBS market and CRE in general,” he added. “If renewal doesn’t occur, then we think there will likely be a big rush of CRE transactions seeking to close by the end of the year.”
Even changes to TRIA that limit the government’s exposure but don’t remove it entirely may be problematic.
Richard Jones, co-chair of Dechert’s real estate and finance practice, noted that most CRE loans today require borrowers to purchase terrorism insurance. If pressed, most lenders will eliminate the requirement if it becomes unreasonable expensive — typically expressed as a multiple of borrowers’ property and casualty (P&C) insurance premium, often two times. So if a building’s P&C policy costs $200,000 and terrorism insurance can be acquired by paying an extra $400,000, the borrower must pay a premium of up to $600,000—a potential deal buster for many.
Dan Rubock, senior vice president at Moody’s Investors Service, said that it government fails to renew its backstop, the rating agency would look for clauses in loan agreements whereby the borrower promises to pay at least two times for terrorism insurance what they pay for all other P&C insurance. While this could potentially resolve the issue for many assets, “it would represent a tremendous drain on the economy.”
Jones said the inside-the-Beltway view is TRIA will be extended, but that remains far from certain in today’s political environment. “One political problem with TRIA is that sometimes it gets conflated with flood insurance,” he said. “But intellectually it’s very different, because you can choose not to buy a big house in a flood zone, but it’s harder to choose not to live in a major city where your job is located.”
Additionally, while TRIA does put tax payers on the hook for potentially billions of dollars should there be a major terrorist attack, that liability is designed to be paid down over time. Fink noted that the current version of the law sets a $100 million trigger, after which the reinsurance backstop kicks in — the Boston Marathon bombing damages were below that level, and so TRIA was never activated. Then each insurer’s claims must exceed a deductible equal to 20% of its P&C premiums of the prior year, after which the government pays 85% of claims and the insurer the rest.
A new version of TRIA may tweak those factors or others, such as reducing the types of policies covered by the law, to reduce the government’s exposure to terrorism risk. DePoy said CIAT isn’t opposed to such changes, but he cautions that there is a tipping point, at least in the short term. For example, raising the trigger too high could push away smaller insurers that can’t sustain higher losses, while increasing the deductible past a certain point could turn big insurers away from the market.
However, the current law also establishes a formula allowing the government to recoup any money it shells out from insurers over subsequent years. “Some people on the Hill have stated this is a subsidy to the insurance industry, but is it really a subsidy if you have to pay it back?” Fink said, adding, “TRIA was really designed to remove the unquantifiable risk” that could inhibit private insurers from underwriting terrorism risk.
That risk, however, has become more quantifiable than it was 12 years ago, when TRIA was first introduced. Chris Folkman, director of model product management at RMS, which models catastrophe risks such as hurricanes and earthquakes, said that significant advances have been made in modeling the impact of blasts.
Terrorism can take many forms, however. Fortunately, there have been no nuclear, biological, chemical or radiological (NBCR) attacks, but neither are there data points with which to validate calibrations. Folkman said modeling NBCR attacks relies on difficult-to-calculate factors, such as how effectively a chemical agent is aerosolized under conditions present during the attack.
Hundreds of plots involving conventional weapons provide a wealth of data for calculating the frequency of those attacks, but that is not the case for NBCR attacks. So the RMS model uses three components to scale the likelihood of events, with the first being the type of attack—an anthrax attack, for example, is far more difficult to accomplish than a car bomb. It also considers the city and type of target—any attack will have greater impact in densely populated New York than in Houston, and nightclubs are easier to hit than embassies.
And thanks to Edward Snowden, Folkman said, RMS has a much fuller picture of the state counter-security infrastructure, which today makes the likelihood of a large-scale act of terrorism extremely slim. “A good analogy is comparing terrorism to other perils: Flood insurance provides protection against failure of the flood infrastructure, such as levies and dams, while terrorism insurance protects against the counter-security infrastructure being thwarted” he said.
Of course, no one imagined terrorists hijacking planes and flying them into skyscrapers, and persuading the private-market risk takers that a model covers all the possible terrorist risks may be the biggest challenge. Guy Carpenter estimates that property catastrophe reinsurance capital at just over $320 billion, with $275 billion from traditional reinsurance and the rest from capital markets sources, from which the greatest increase if capacity is anticipated in coming years.
However, persuading investors to take on terrorism risk may face hurdles.
The modeling firms are paid to uncover all the pertinent risks and develop risk frameworks at academically robust levels, said John Brynjolfsson, who oversees investment activity at Armored Wolf, an investment manager owned by Eaton Vance that provides advisory services to mutual funds and hedge funds.
“The concern is that insurance companies and developers may not be especially motivated to dig that deep into the questions no one is asking,” Brynjolfsson said. “Part of an investor’s job is to think outside the box, in an effort to protect clients.”
