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TERROR INSURANCE

Mandatory-coverage extension major victory for developers

BY DONNA MITCHELL

Things would have gotten most unpleasant for the retail real estate finance industry without the federal government’s extension last month of a provision in the Terrorism Risk Insurance Act, according to a consensus of development, banking and insurance executives. The provision, which requires insurers to provide the coverage, was set to expire Dec. 31.

Lenders would have balked at financing projects with insufficient terrorism insurance, and investors, who have been stockpiling shopping center properties for the past three years, might have shifted into reverse.

This was no alarmist scenario, knowledgeable sources say. Had the Treasury Department chosen not to extend the act’s so-called make-available provision, retail real estate finance and development would have slowed dramatically.

“We will not invest in a new project or the refinancing of a project if the property owners do not have adequate terrorism coverage,” says Kathleen M. Nelson, managing director and group leader at TIAA-CREF, the largest institutional investor in real estate. TIAA-CREF’s $40 billion mortgage and real estate portfolio includes $6 billion on the retail side.

That has happened before. After the Sept. 11 attacks, GMAC Commercial Mortgage threatened to pull its financing of Mall of America unless the property got terror coverage. Simon Property Group ended up buying $100 million worth of such insurance for the megamall and an additional $100 million in coverage for all its other properties. Simon said at the time that the coverage on Mall of America cost three times what the firm paid for all other types of insurance on the property.

Treasury’s decision was welcomed by Simon spokesman Les Morris. “This is an extreme benefit for our industry,” he said.

The terror coverage act, which became law in November 2002, provides a federal government backstop for the insurance industry. Under the three-year program, the government agreed to reimburse insurance companies up to $100 billion for terror-related losses. Washington would pay 90 percent of claims in excess of $10 billion the first year, $12.5 billion the second year and $15 billion the third.

The U.S. insurance industry absorbed somewhere between $30 billion and $58 billion in damage claims after the Sept. 11 attacks, according to Tillinghast-Towers Perrin, a Stamford, Conn.–based actuarial and consulting firm. That wide margin is attributable to the lack of a single repository for insurance claim data, says David K. Bradford, a co-founder and executive vice president of New York City–based Advisen, which provides strategic research and analysis for insurers.

After that, reinsurance agencies, from which the primary insurers recover losses after paying out claims, dropped terrorism coverage, saying they would not be able to absorb the costs of another such attack. As a result, primary insurers themselves either stopped offering terror insurance for commercial properties altogether or sharply raised their premiums.

Consequently, real estate industry executives worked hard to keep the make-available provision, which applies to primary insurers, alive. At the very least, they pleaded, keep it in place until the entire package expires at the end of 2005.

This issue has captured the attention of everyone involved in retail real estate finance, from the developers to the insurers themselves.

Premiums could go up, said Adam Ifshin, president of Tarrytown, N.Y.–based DLC Management Corp., as he awaited Treasury’s decision. The firm, which owns and builds malls, power centers and grocery-anchored neighborhood centers, is currently shopping around for coverage.

Treasury Secretary John W. Snow extended the provision by issuing a letter of administrative action. He had until Sept. 1, 2004, to do so. This deadline, falling as it did three months before the provision’s expiration date, gave executives in the insurance and real estate industries time to plan accordingly.

At ICSC’s Strategic Leadership Summit, in Washington, D.C., in March, ICSC members and executives met with the Treasury secretary, and they also lobbied members of Congress to put additional pressure on Snow. Further, the House Financial Services Subcommittee heard testimony from ICSC members about the issue.

Insurance companies, too, had lobbied for an extension of the provision, even though it obligates them to offer the coverage. They wanted the whole package preserved because if the act were allowed to expire, it would have disrupted the financial markets, says Matt Campbell, vice president and general counsel at Whitehouse Station, N.J.–based Chubb Commercial Insurance, a major provider of primary insurance to real estate companies.

Another reason insurers wanted the law left intact was that most states require them to cover workers’ compensation and fire claims arising from terrorism. If the act had expired, the industry would have faced obligations from the various states to provide coverage with no backstop of any kind.

More companies appear to be buying terrorism insurance than before. Figures released by Marsh Inc., a unit of Marsh & McLennan Cos., show that 52 percent of commercial real estate owners bought or renewed coverage in the first quarter, up from 28.1 percent in the fourth quarter of 2003. The company atributes the rise to falling rates.

Most insurance industry analysts estimate that the U.S. property and casualty insurance industry has a $300 billion surplus. About $150 billion of this is earmarked for homeowners’ and auto insurance claims, says Campbell. The remaining $150 billion would have to support terrorism claims — plus payouts stemming from natural disasters, such as hurricanes or floods. But another terrorist attack could suddenly wipe out these reserves, insurance insiders point out.

Not everyone shares the views of insurers and developers. The Consumer Federation of America insists there is no case for a federal government safety net beyond 2005 because the insurance industry is financially sound. Indeed, The Insurance Information Institute reported strong financial results for the property and casualty industry in 2003. Thanks to a 9.8 percent rise in premiums, 85 percent fewer underwriting losses and an $8.1 billion increase in capital gains, the industry realized a 9.4 percent return on equity, its best profitability benchmark since 1997. That was “nothing short of phenomenal,” said Robert P. Hartwig, senior vice president and chief economist of the Insurance Information Institute, in the report, which was published in April.

The insurance side counters that not even these healthy results enable the industry to take on the costs of terrorism.

“This risk is different from any other,” said Peter Bisbecos, director of legal and regulatory affairs for the National Association of Mutual Insurance Companies, in a recent article published by Advisen.

To be sure, the amounts are staggering. Before reinsurance recovery, Chubb’s Sept. 11 losses amounted to about $3.2 billion. Reinsurance payouts brought that down to about $645 million.

Some still question whether renewing the act was really as crucial as proponents say.

“An important consideration here is that in the past, when insurance has disappeared, alternatives have quickly sprung up,” said Bradford. A consortium of shopping center developers and other industry participants could form a “captive” terrorism insurance company to share the risks, for instance. Farmers and doctors have done it, Bradford notes. In the mid-1980s, when there was a shortage of malpractice insurance for medical practitioners, state medical associations formed such entities for their members. Similarly, many states have a mutual insurance agency to provide coverage for farmers, he says.

That is exactly what the insurance act was supposed to do: give the insurance industry breathing room until it could come up with market-based solutions to the terrorism insurance problem. But no such solutions have surfaced, says Daniel Rubock, vice president and senior analyst of commercial-mortgage-backed securities at Moody’s Investors Service.

At press time, the Treasury Department was conducting a study of the demand for and the costs of terrorism coverage for companies of every size. The department is also looking at alternative means of financing terrorism costs and at ways to mitigate the risk of attacks. But the results won’t be available until next June.

The Rand Corp., a nonprofit research and analysis firm with headquarters in Santa Monica, Calif., is studying the efficacy of the make-available provision. That study is to be released sometime this summer.

Memories of the way real estate finance slowed down in 2002 linger in the minds of many. Single-asset commercial-mortgage-backed securitizations used to be a routine method of financing trophy malls and other real estate properties. But after the attacks, the volume of these deals dropped dramatically, from about 25 deals in 2001 to four in 2002. In 2003 there was just one such single-asset deal, the C$335 million ($246 million) securitization of the West Edmonton Mall, in Edmonton, Alberta.

The terror insurance act hasn’t encouraged any comeback of single-asset CMBS deals, but market participants don’t want uncertainty to choke off other forms of CMBS transactions.

Moody’s and other bond-rating agencies began downgrading certain triple-A-rated CMBS deals. Normally, triple-A deals maturing over 10 years (a common period in the CMBS market) have a tiny default rate, about 0.01 percent, according to a report titled “Moody’s Approach to Terrorism Insurance after the Federal Backstop.” With insurers refusing to provide coverage on certain assets, however, Moody’s could not ignore the possibility, however remote, that an attack could destroy a prized asset and throw its financing into default. In the third quarter of 2002, Moody’s downgraded primarily the triple-A classes of high-profile, single-asset CMBS deals, along with any deals not diversified by a large number of loans.

There are very few examples in U.S. history of the government interjecting itself in this way, says Chubb’s Campbell. But terrorist activity presents some stubborn problems from an insurance perspective. “Terrorism is an uninsurable event,” said Campbell. “It is based on an enemy’s motivation, and it is unpredictable in terms of timing, location and magnitude.”

And that’s why some see government’s role as an absolute necessity.

“Terrorism is a national security issue,” said Julie Gackenbach, assistant vice president of government relations for Property Casualty Insurers Association of America. “It’s not appropriate to expect a single industry to bear the responsibility.”

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