As the long countdown to the war against Iraq ended in late March and cities across the U.S. braced for possible terrorist reprisals, the commercial real estate industry faced its own deadline. March 24 was the deadline for property owners who had received quotes for new terrorism coverage to either accept or decline.
The horrors of the World Trade Center attack on Sept. 11, 2001, galvanized the nation's major property owners, who realized that their buildings in major cities — or outlying trophy developments such as the Mall of America — could be terror targets. They also learned that the insurance and reinsurance industry was not going to write the kind of coverage that would help them in case of such an attack. Companies that had offered terrorism insurance in the past dropped it or repriced it at stratospheric levels.
Thus began the lobbying efforts that eventually yielded the Terrorism Risk Insurance Act (TRIA), which was signed into law by President Bush last November. The measure, providing a federal backstop for terrorist damage in excess of $5 million, was hailed as a victory for the commercial real estate industry. Property owners would be guaranteed coverage because the law required property and casualty underwriters to offer it. The insurance industry, for its part, was happy to have the federal backup.
Five months later, with the nation on heightened terror alert, terrorism insurance is not a done deal. Indeed, coverage remains spotty and — despite last year's lobbying efforts — not all property owners are buying coverage. Many landlords who believe their properties pose a low risk for a terrorist attack are declining to accept coverage because they think it's too pricey or unnecessary. Some are having a difficult time understanding the specifics of the new law.
Meanwhile, many lenders say they can't get information from borrowers as to whether they chose to accept or decline the terrorism coverage. They want to know if their collateral is protected, information lenders deem critical.
Information Gap
“Lenders just aren't getting the information that they need,” says Robert Vestewig, COO of Houston-based GEMSA Loan Services. He says that some GEMSA clients have notified the loan servicer about their intent to accept or decline the terrorism coverage, but many have not. It is critical, he says, for a loan servicer to know whether a property is covered for a terrorist attack or not.
“I just heard of a lender who sent out 3,000 notices to borrowers and has only heard back from 25% of them,” says Bernard Brown, president of Stamford, Conn.-based Insurance Advisors LLC, an insurance consultant.
Just last summer, GMAC Commercial Mortgage Corp. tried to force mall owner Simon Property Group to obtain terrorism coverage for its portfolio, which includes the Mall of America. Simon, in turn, sued GMAC and the suit was finally settled after Simon bought two stand-alone terrorism insurance policies, each with $100 million aggregate limits. The lesson here? GMAC, like other lenders, wants to protect its interests.
But owners, facing a soft leasing market, are concerned about the added cost, which can multiply the cost of ordinary property and casualty coverage. Some policyholders' premiums have risen 300% to 400% due to terror coverage, says Jill Dalton, North American property practice leader at global insurance services firm Marsh Inc.
Adds Brown: “I have yet to hear a borrower proclaim: ‘What a deal! Can I get some more of this terrorism insurance as soon as it is available?’”
CarrAmerica, a Washington, D.C.-based real estate investment trust (REIT) with an office portfolio of more than 36 million sq. ft. that the company owns and/or manages throughout the U.S., purchased a blanket terrorism insurance policy last June at an annual cost of approximately $2.2 million. The policy, which covers both domestic and foreign attacks but only physical damage, provides coverage limits of $200 million per occurrence with a deductible of $1 million per claim. The coverage does not include losses due to biological, chemical or radioactive contamination. “I think it's priced too high,” says Sandra Shoffner, CarrAmerica's vice president for risk management and safety. “I think the underwriters are in a quandary as to what to charge and how to make it reasonable.”
Basic property and casualty premiums also are rising dramatically. In 2002, CarrAmerica's premium for property and casualty coverage rose 155% over the previous year.
Equity Office Properties' overall insurance costs more than doubled from $21.8 million in 2001 to $44.3 million last year. Company officials declined to say how much of that increase was due to rising terrorism insurance premiums.
Who's Buying?
While renewed hostilities in Iraq may have inspired some last-minute converts to terrorism insurance, it's clear many owners are holding out. According to estimates by Marsh, as of early March, for every policyholder who accepted the TRIA coverage, three declined. Of 1,500 property and casualty policies analyzed on behalf of their commercial property clients, Marsh found that price increases for terror coverage averaged 8% to 9% of the total premium.
“The range on these quotes has been pretty dramatic. Rates for real estate tend to be much higher than for retail, manufacturing and healthcare sectors,” says Dalton. She declines, however, to say how insurers rate different policyholders for terrorism coverage, or what areas of the country are embracing TRIA coverage.
Jeffrey DeBoer, president and COO of the Real Estate Roundtable, an industry advocacy group that lobbied for TRIA, says he isn't surprised by the mixed reaction among property owners, because the market for terrorism insurance is so new. “Anecdotally, we think that the bill is addressing the objective of making this insurance available. The pricing should come down as a competitive market forms for the insurance,” says DeBoer.
Since TRIA expires in three years, skeptics wonder if such a market can develop by then. Even if it doesn't, the government can renew the program. “Without inducing free market competitive forces, commercial coverage availability will die on the vine,” says Brown of Insurance Advisors.
Coverage Shortfalls
TRIA hardly offers universal coverage against any type of attack. First, a terrorist act must cause over $5 million in damages in order for the federal backstop to kick in. The attack must also be committed by, or on behalf of, a foreign interest. Nuclear, biological and chemical attacks are excluded from the coverage.
TRIA also contains some major loopholes that limit its overall appeal to property owners, says Shoffner of CarrAmerica. For example, TRIA fails to establish pricing guidelines for insurers, she contends. “TRIA allows the insurance companies to pretty much charge what they want,” says Shoffner. “We've seen proposals from our insurance companies that are all over the place. There is no rhyme or reason, there is no justification.”
Insurers have also indicated that workers' compensation policyholders will pay a surcharge to cover the increased risk of terrorism, Shoffner points out. In Washington D.C., for example, the additional cost to employers is estimated at 4 to 7 cents per $100 of annual payroll. That surcharge is the result of a loophole in TRIA which enables insurers to build in terrorism charges for each line of coverage, says Shoffner. “The insurance companies that underwrite workers' compensation are saying that terrorism can strike anywhere, so therefore they're going to put in a charge for workers' compensation for the terrorism aspect.”
It's unclear how many lenders will demand that borrowers obtain a separate policy covering domestic acts of terrorism. Currently, some lenders require domestic coverage, while others do not. The lending community needs to develop some level of consistency on this issue, says Jan Sternin, senior vice president of the portfolio management group at Kansas City-based Midland Loan Services.
In the event of an attack, the claims process is not straightforward, either. The Secretary of the Treasury must first certify the attack is an act of terror by a foreign entity in order for the federal backstop to be applied.
Such discretion on the part of the Treasury worries some industry executives. “Let's say there is a terrorist attack tomorrow, and no one claims responsibility,” says Vestewig of GEMSA. “How long will it take for the Secretary of the Treasury to make a decision about whether to certify it or not?”
If an attack destroys a building, the time it takes for the event to be certified is pivotal — and unclear under TRIA. “What will happen in that interim period while the secretary is trying to make that determination?” asks Sternin of Midland. “Will the insurance companies pay the claim? We don't have any rules for this, and this is what should be concerning us.”
The war in Iraq has only added to the confusion surrounding TRIA coverage. “Terrorism is similar to war, and we are in a so-called war on terror,” says Robert Hartwig, a senior economist with the Insurance Information Institute, a New York-based trade group. “My question is this: What's terrorism vs. an act of war? That's like unscrambling an egg,” says Hartwig. In his view, banks are the most exposed if their borrowers forego terror coverage. He believes that more property owners should be buying the coverage, given the risk.
Borrower Frustrations
Meanwhile, owners are questioning why their lenders are so insistent on coverage. Midland Loan Services' Sternin says that many borrowers who entered into a loan agreement prior to 9-11 are struggling to understand why lenders and servicers are now imploring them to accept terrorism insurance coverage.
Because acts of terrorism were covered under property and casualty insurance policies prior to 9-11, the terrorism coverage was implied, Sternin says.
Moreover, the lender assumed that the borrower would maintain the continuity of coverage throughout the life of the loan. “That's very difficult for borrowers to understand,” says Sternin. “They say, ‘OK, if I must have terrorism insurance, show me in my loan document where it says so.’” Loan documents produced before 9-11 never anticipated a terrorist attack, she adds.
Back then, the standard exclusions to property and casualty policies were flood and earthquakes as well as acts of war, but not terrorist attacks, emphasizes Sternin. “Therefore, since it [terrorism coverage] was not excluded, it was included.” Loans closed after 9-11 clearly spell out the need for borrowers to obtain terrorism insurance coverage, Sternin says.
Sternin urges borrowers to talk with their lenders if they have any questions about their coverage. “It's never the intent of the servicer or the lender to alienate or aggravate a borrower,” she emphasizes.
“These are tough times for everybody, and the more we all communicate and get through all these housekeeping and administrative issues related to their loans, the better off we all are,” Sternin believes.
It appears the lenders are in a position to demand coverage. Most loan documents require borrowers to carry all-risk insurance coverage to protect the value of loan collateral. If a borrower declines to buy terror coverage, lenders can often use the “all risk” wording to force them into buying the policies anyway. In cases where the borrower refuses to pay for the added terror coverage, many lenders have used so-called “force-placed” insurance.
“In a force-placed situation, the lender buys the terror insurance policy for the borrower and then just bills it back to the borrower,” says William Wheaton, managing director of loan servicing at Holliday Fenoglio Fowler's Houston office. “If a borrower refuses to reimburse the lender, the lender can hold the borrower in default of their loan documents and foreclose,” says Wheaton.
Role of Rating Agencies
Susan Merrick, managing director of Fitch Ratings' CMBS group, says that lenders are pressuring many owners into buying TRIA coverage, but plenty of owners are playing the odds and going without it.
Moody's Investors Service and Fitch Ratings downgraded billions of dollars in commercial mortgage-backed securities (CMBS) last year because of a lack of terror insurance. The ratings services feared that property owners' ability to finance a property or new project would be compromised, thereby paralyzing the real estate market.
Fitch put a total of 13 single-asset CMBS transactions on watch for downgrades last summer due to inadequate terror coverage.
But the new terrorism insurance coverage has not changed the rating agency's view of the risks. Why? One reason is that after disasters, insurers have historically cancelled policies, something that Merrick worries might happen again if another terrorist attack is launched against the United States.
There is another factor at play when owners resist terrorism insurance: Some of them suspect that insurers have priced the coverage to help shore up their balance sheets.
J. Paul Beitler, president of Beitler & Co., a Chicago-based high-rise developer, believes that the insurers, stung by sharp declines in the stock market, have used the terror attacks to gouge policyholders.
“The 9-11 attacks weren't an assault on office buildings, they were against U.S. icons. There have been no attacks on U.S. office buildings since then,” says Beitler. “[The insurers] have found a niche where there is no accountability, and they have no foundation to make these claims.”
Crying Wolf?
If insurers face a credibility gap because of their approach to terrorism insurance, critics argue, so does the commercial real estate industry, which lobbied aggressively for the TRIA law and now appears reluctant to live with the costs.
Last September, for example, The Real Estate Roundtable reported that over $15 billion worth of projects were stalled or cancelled due to a scarcity of terrorism insurance. Real estate projects and deals in 17 states were affected, according to the Roundtable. Those claims were central to the TRIA lobbying effort.
It's hard to prove, or disprove, the claims. But it is clear that sales of commercial real estate, especially among the trophy buildings that would be top targets, have not suffered. “There were twice as many trophy towers sold in CBD areas last year than there were in 2001,” says Bob White, president of New York-based real estate research firm Real Capital Analytics. Seven of the top 10 most expensive office sales last year were in midtown Manhattan. The other three were in Chicago, Los Angeles and Boston — cities roundly viewed as targets. Just last month, the John Hancock Tower, one of Boston's most prominent skyscrapers, sold for nearly $1 billion.
Even 450 Lexington Ave., which was the poster property for the notion that uninsured properties could not be sold, moved. In late 2001, billionaire investor Marvin Davis backed out of a $335 million deal to buy the building, citing the inability to secure affordable terrorism insurance. But San Francisco-based owner and developer Shorenstein Co. subsequently bought the building for $320 million last summer. “We haven't seen many deals held up over the terror insurance issue. It looks like people were underwriting around it,” says John Fowler, executive managing director of Boston-based Holliday Fenoglio Fowler.
With the federal backstop on terror insurance still evolving, it's hard to gauge how, or if, it will change the market for affordable coverage. The real estate industry has more clarity on the issue than it did prior to TRIA, but there is also a sense that there is more to do before owners, lenders and insurers are satisfied.
“I think the federal government was pressured to do something,” says CarrAmerica's Shoffner. “TRIA is only good for a three-year period. I think that when the review time comes, it will be a different product than what it is now.”
Key Components of Terrorism Risk Insurance Act
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mandatory federal program that expires in 2006.
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covers events that cause at least $5 million in damages
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covers only foreign-led attacks on U.S. property
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does not cover nuclear, chemical or biological attacks
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federal government pays for 90% of any losses above a company's deductible
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insurer of record responsible for 10% of any losses
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annual losses covered by the program capped at $100 billion
The road to a federal backstop on terrorism insurance
Sept. 2001
Sept. 12, 2001: Insurers exclude terrorism coverage from their policyholders' property and casualty policies.
Oct. 24, 2001: Kemper Insurance CEO calls for “immediate enactment” of a federal backstop at House Financial Services Capital Markets subcommittee hearing.
May 31, 2002: Moody's places $5 billion worth of CMBS transactions on watch for rating downgrades, citing inadequate terrorism coverage.
Sept. 19, 2002: Real Estate Roundtable reports that over $15 billion worth of real estate projects had been adversely affected by lack of terrorism coverage.
Nov. 26, 2002: President Bush signs Terrorism Risk Insurance Act of 2002 into law.
Feb. 24, 2003: Insurers notify policyholders on premium increases related to terrorism risk insurance coverage. Policyholders are given 30 days to respond.
March 2003
Mar. 24, 2003: Deadline for owners to accept or decline coverage.
Three Degrees of Risk
The Insurance Services Office, a private corporation, issued insurers this three-tiered chart on risk and pricing guidelines in property and casualty policies. Cities in the high-risk tier are 10 times more likely to be attacked than cities in the medium-risk category, for example.
Low
All other U.S. cities
Guidelines: additional .001 cents per $100 of P & C coverage
High
Chicago, New York, San Francisco and Washington, D.C.
Guidelines: additional 3 cents per $100 of P & C coverage
Medium
Boston, Houston, Los Angeles, Philadelphia and Seattle
Guidelines: additional 1.8 cents per $100 of P & C coverage
Top Five Costliest U.S. Disasters for Insurers*
(as measured by insured losses in 2001 U.S. dollars)
| Incident | Cost |
|---|---|
| 9/11 terror attacks | $40.2 billion |
| Hurricane Andrew (August 1992) | $19.6 billion |
| Northridge Earthquake (January 1994) | $16.3 billion |
| Hurricane Hugo (September 1989) | $5.9 billion |
| Hurricane Georges (September 1998) | $3.2 billion |
| Estimated totals include property and business interruption losses, plus liability, workers' compensation, as well as life, aviation and other insurance coverages. | |
| Source: Insurance Services Office, Insurance Information Institute | |