Nigel Allen assesses the implications for the captives industry of the Terrorism Risk Insurance Act

The Terrorism Risk Insurance Act of 2002 (TRIA) was a piece of knee-jerk legislation, drawn up in the aftermath of the events of September 11 to provide a financial prop to the commercial property and casualty insurance market and to ensure the availability of terrorism coverage at a price cedants could afford. Signed into law on 26 November 2002 with immediate effect, the Act saw the US Government become the largest terrorism risk reinsurer in the world - at least temporarily. Addressing members of Congress, the then Treasury Secretary Paul O'Neill said: "This legislation is a critical element in our economic recovery. It reduces the economic risks and economic consequences associated with the threat of future terrorist attacks. It will help restore insurance capacity to the marketplace, which will promote new construction and spur economic activity."The efforts of the US Department of Treasury were applauded by insurers, which had urged the Government to provide a 'hand-up' to a marketplace unable to right itself. However, the ink had not dried on the Act before industry practitioners and regulators were circling terms and phrases included in the legislation with red pen, and the Treasury began the task of issuing guidelines, interpretive letters and final rules, a task which is still going on today. As Wayne Abernathy, Assistant Secretary for Financial Institutions at the US Treasury, explained: "The statute was drawn up in haste. We have discovered in the implementation process that a number of elements simply do not work." He added: "The definition of 'control' was taken from a banking statute. And it was only learned in the process afterwards that it didn't fit terribly well in the insurance world."Clarification was demanded on a number of issues, including what constituted a "certified act of terrorism", how insurers covered by the Act should calculate their deductibles, what was meant by the phrase "make available" in relation to terrorism cover, and what should be the scope of the insurance coverage to be provided. But perhaps most significantly, many believed that the legislation failed to adequately clarify the term "insurer", and in particular whether the term encompassed captive insurance companies and risk retention groups.The uncertainty as to the inclusion of captives stemmed from Section 103(f) of the Act, which stated: "The Secretary may, in consultation with the NAIC or the appropriate state regulatory authority, apply the provisions of this title, as appropriate, to other classes or types of captive insurers and other self-insurance arrangements by municipalities and other entities ..." Many practitioners took this to mean that, while the general definition of insurers provided in the Act could include captive insurers and risk retention groups, the addition of this clause suggested that at the time of enactment such entities were excluded until further notice. In a special edition of its captive newsletter (December 2002), Vermont-based law firm Primmer & Piper suggested that the inclusion of the word "other" might have been a "drafting error", stating that: "In Conference Report 107-779, the Joint Explanatory Statement of the Committee of Conference omitted the word 'other' in explaining that Section 103(f) gives the Secretary the discretion to apply the Act to 'various' classes of captives."The US Treasury moved quickly to clear up this confusion, releasing interim guidance on, among other things, the definition of 'insurer', on 18 December 2002. The guidance left the captive insurance community in no doubt as to its mandatory participation in the Act. "The definition of 'insurer' in Section 102(6)(A)(v) also includes captive and self-insurance arrangements, not otherwise covered in clauses (i)-(iv) above, to the extent provided in rules issued by Treasury under this Section 103(f)," it stated. "If you are in the P&C business," explained Mr Abernathy, "and you provide commercial P&C coverage, you are in - even if you only provide it to one company."

Why not include captives?On 8 July 2003, the US Treasury announced that it had received six comments relating to the inclusion of captives under the terms of TRIA, most of which objected to their mandatory participation. Captives and risk retention groups, it was argued, occupied a unique position outside the commercial insurance industry, falling into the category of alternative risk transfer vehicles and enabling policyholders to bypass the traditional insurance route in favour of a self-insurance option, and therefore should not be included under the term of 'insurer'. It was also cited that the requirements of the Act could be a disincentive to the establishment of captives in the US. Under the terms, captives, whether providing policyholders with terrorism coverage or not, would, in the event of a terrorist attack, be forced to pay a recoupment charge to the US Government imposed on all participants in the programme. This would involve imposing up to a 3% surcharge on premiums paid by policyholders.Furthermore, as the Act only applies to US-domiciled captives, this could result in a move offshore, as companies sought to avoid TRIA, a concern which was raised by regulators in Vermont. In addition, Vermont legislation also states that should a captive wish to offer policyholders an additional product, approval may be required from the Vermont Department of Banking, Insurance, Securities and Health Care Administration, which will decide whether the captive possesses sufficient liquidity levels to cover any losses resulting from this particular line - in the case of TRIA the deductible (7% in 2003, 10% in 2004 and 15% in 2005) in addition to the 10% retention of the primary insurer. By making such coverage mandatory, this could result in a captive being forced into run-off.To overcome these problems, it was suggested that captive insurers be provided an 'opt in/opt out' clause, allowing them the choice of whether to avail of the protection afforded by TRIA or not.The Treasury rejected the opt in/opt out clause, stating that it would "create the potential for adverse selection within the Program as those captive insurers that perceived themselves to have higher risk to terrorism would likely opt-in to the Program while other with lower perceived risks would likely opt-out of the Program.""The government would end up with all of the bad risk," Mr Abernathy explained, adding that such an option would result in "a cherry-picking scenario", which could leave the taxpayer "exposed". The Treasury also said that such a policy would have a negative impact on the recoupment base, potentially increasing the cost on other policyholders of mandatory participants. A lack of exposure to terrorism risk was not considered a valid reason for non-participation.With regard to the definition of 'insurer', the Treasury stated that it was clear from the details of the Act that participation was mandatory for state licensed or admitted captive insurers, as for all other state licensed or admitted insurance entities, other than those specifically excluded from the Act. It went on to comment on the suggestion that the inclusion of the word 'other' in Section 103(f) was an "error", saying that: "If the words of a statute can be construed as having a rational meaning, then the rules of statutory construction preclude an interpretation that they were enacted by Congress in error."On 1 December 2003, the US Treasury announced a proposed regulation under TRIA in relation to claims procedures. Under the proposals, an insurer covered by the Act, in the event of a claim being made resulting from a terrorist event, would be required to pay the full amount of the losses prior to submitting a claim to the Treasury. Commenting on the claims procedure, Jeffrey Bragg, Executive Director of the Terrorism Risk Insurance Program, said: "Treasury seeks to establish operational procedures that suitably emulate the best practices of the reinsurance industry. Our goal is to respond quickly to insurer claims for payment while maintaining appropriate financial controls over the use of taxpayer funds."Mr Abernathy explained that the reason behind the decision to place the financial burden on the insurer before allowing them to tap the federal fund, was "to make sure that the taxpayers' funds are going to compensate actual payments by the insurance industry and not being put up in front in place of them. One of the key elements to verifying the bona fides of the claims," he continued, "is we felt that if the insurance company has to put up its money first it is going to do a good job in verifying the bona fides of the claim." However, while the relationship which exists between a primary insurer and a reinsurer might allow for such a financial hit to be taken on the chin, the relationship between the reinsurer and the captive would not.In a letter to Mr Bragg dated 23 December 2003, Molly Lambert, President of the Vermont Captive Insurance Association, raised deep concerns regarding the potentially crippling effect of such a claims procedure on the solvency of captive insurance companies and other entities with a limited capital base. Ms Lambert described the potential financial impact of such a procedure as being of "epic proportions", stating that it could place captive insurers in "the position of offering insurance for risks which may be beyond their financial capabilities."The relationship between the reinsurer and the captive was described as being one based on "simultaneous payments" whereby the reinsurer will pay up at exactly the same time as the captive pays out to its policyholders, thereby ensuring that the captive can maintain adequate capital levels to remain solvent.Such a relationship, Ms Lambert pointed out, also influences the capital levels required of captives by state regulators, with the security provided by its reinsurance programme being factored into the capital adequacy equations applied to such entities. The proposed claims procedures could therefore have a detrimental impact on the capital adequacy requirements for captives, as they would not be able to rely upon instantaneous payment to cover claims paid out.To overcome this, Ms Lambert proposed a compromise, which would be "to carve out an exception to the proposed rules for aggregate losses, which exceed a given percentage of the surplus of the insurer. In the event that aggregate losses exceeded such an amount, Treasury would agree to a simultaneous payment arrangement or indeed pay on behalf of insurers for such an event."It is still uncertain as to whether the claims proposal will be implemented. However, the implications for the captive insurance industry of such a procedure in the event of a terrorist attack could be devastating.

One size fits allTRIA was not built to last. From the beginning it was made clear that this would be a temporary piece of legislation with a fixed life expectancy.That it should have caused so many headaches for the insurance industry, and in particular for captive managers, is perhaps not surprising. "Because we were creating legislation in a hurry for a temporary purpose Congress created something which had some what would become long-term inequities if they persisted," said Mr Abernathy, "but were expedients that we needed to rely upon." The Government, he added, was not seeking to incorporate into the legislation the various nuances between different types of insurance company. "Rather than put in the statute those types of gradations that might, over time, make a lot of sense, the statute was written to get everyone in." The US Treasury has made it clear that captives are included in the Act, and appears unwilling or unable to make any exceptions for such entities. The 'one size fits all' attitude has certainly been brought to bear on TRIA.