Philadelphia, PA (April 30, 2002
) — Demand for terrorism insurance coverage is one of the challenging ripple effects of September 11. As institutions consider the risks associated with possible future terrorist attacks, they are scrutinizing portfolios for geographic concentrations. Many banks are requiring commercial real estate borrowers to have terrorism insurance, but its availability and affordability are concerns, not only for bankers and property owners but also for analysts and investors.
On March 11, the six month anniversary of the attacks, RMA hosted an audioconference with a panel of speakers representing banks, insurers, rating agencies and investors who discussed terrorism risk, which was once considered a remote risk in the U.S.
Peter Haley, managing director and group credit executive for commercial real estate, JPMorganChase, said real estate practitioners, owners and lenders face many new risks and uncertainties since September 11, which are changing the risk equation of the portfolio.
"Taking all this risk is not the responsibility of the financial institution," said Haley. "We're not being paid to take that risk, nor is it appropriate for us to take it. We're clearly not pricing for it."
JPMorganChase has a large real estate portfolio spread around the country that offers some diversification, yet vigilance is still needed, said Haley. Before lending to large institutions with considerable real estate holdings, the bank must now examine more closely the borrower's portfolio concentrations and the inherent risk within those portfolios.
"We're reviewing our portfolio to understand what our concentrations are. But it's very difficult. We cannot be in the insurance underwriting business and try to estimate where and what the next terrorism event will be and how will it impact property."
Haley also noted that JPMorganChase is investigating portfolio or secured creditor insurance to cover calamity or uninsured risk as well as investigating parallels to earthquake risk, layering of coverage and self insurance.
Analysts Consider Various Approaches to Determine Ratings
Analysts from Standard and Poor's and Fitch Rating Service agreed that there was no probabilistic model they could use to determine ratings, and that the risk had to be accounted for in the rating. But they disagreed on how ratings could be determined.
Kim Diamond said Standard and Poor's is developing an approach that would apply a subscript to deals that would alert investors to terrorism risk. The subscript would be applied to indicate concentrations. It would be removed when the concentrations decreased. Single asset securitizations would be more likely to face the concentration issue than large diversified pools.
Fitch Ratings has a different perspective than S & P. "The risk of terrorism clearly was always included in ratings at all levels," said Susan Merrick, Fitch analyst. "We look at it as part of our ratings definition." She added, however, that the risk in the U.S. was considered so inconsequential that it did not affect the ratings. Insurers had a similar perception, she said, because insurers were willing to insure against this risk under an all risk policy. But since 9/11, cost prohibitive premiums and deductibles have made such insurance nonexistent.
In transactions involving commercial mortgage-backed securities (CMBS) without terrorism insurance, Fitch tests the effects of various scenarios to determine what would happen to Fitch-rated bonds at various rating categories. "Using a tiering methodology, we're trying to come up with a probable maximum loss (the type of analysis that's used mostly for earthquakes), for each transaction based on a number of identified factors," said Merrick. "If the transaction absorbs the PML with minimal impact, no rating adjustment is necessary. But if the PML is so significant that it would cause a default on the bonds, the ratings would be adjusted."
"We are grouping properties into low, medium or high risk levels and assigning an additional probability of default to the bonds, based on the assumption that this is a 100-year event," explained Merrick. Based on that second probability of default determination, Fitch would determine whether it's necessary to take rating action on the bond. Fitch has not yet formally adopted this rating policy.
AIG Leads Insurance Industry Efforts
AIG has been at the forefront of insurance industry effort to get some resolution of the issue of terrorism insurance. Richard Thomas, of AIG, said the insurance marketplace for terrorism coverage of commercial properties is in a dynamic state. "Currently, we believe that the limits capacity to insure buildings for terror coverage is around $300 million per property. And obviously that's not enough to cover many of the higher value structures that exist in this country, certainly in Manhattan and other major cities. The current pricing for that coverage ranges between 5% and 25% of total insured value. The deductible at the 5% level is usually between $1 million and $5 million and is usually geared around the scope of the business interruption coverage afforded for the building."
In offering the insurance coverage, Thomas said the issues are when and where the next event could occur. Since we can not predict with any certainty the frequency or severity of future events, the cost of insurance must reflect that uncertainty and the insurance company need to preserve its solvency.
In a telephone call a few days after the audio conference, Thomas told RMA that AIG had been approached by lenders seeking lender-only terrorism coverage. AIG is interested in providing such coverage and has spoken with a few banks about it. In developing such an insurance product, the key criteria would be that the lender would have to provide AIG with a specific schedule of the properties. While a blanket limit might be negotiated, the insurance limit could be restricted to only specifically identified properties in the portfolio.
A New Risk for B Note Investors
Terrorism is a new risk for B Note investors, although that risk is somewhat mitigated for those who purchase the B portion of large diversified pools because the bonds are typically comprised of a pool of 130 to 200 different loans, with an average loan size under $10 million.
The B Note investors will insist, however, that issuers include terrorism coverage as part of an all risk policy. "We don't want any language about 'commercially reasonable' says John Scheurer of Allied Capital. "We want an absolute requirement that they have it. And that there is nothing in the loan documents that would inhibit the lenders ability to require additional insurance."
Originators Worry About Insurance Renewals
Richard Jones of Dechert, which represents all parties from the originators to subordinate bondholders, said there are a wide range of approaches to the terrorism coverage issue. He is particularly concerned about what happens when the policy, assuming the borrower can procure coverage, comes up for renewal. "If we have a deal that can afford premiums of 5% to 20% of the value of the property, that may not be an issue," he said. "But for the rest of properties there are some unanswered questions. Will these policies stay in place if there's another attack? "Will coverage be terminated early or not renewed? If we have a broad effort to default borrowers who fail to procure coverage, how do we get a judge to find the borrower in default for failing to obtain something that can't be obtained?"
Jones said that ultimately the B piece buyers or the subordinate buyers will decide what the premium is for dealing with the absence of this terrorism provision. "In pools the answer is disclosure," said Jones.
"There are going to be some pools sold soon. And there's going to be terrorism risk in those pools. We'll see who buys and how widely the bonds are sold compared to pre-9/11 deals. "In general, the market is still holding its breath and hoping that some resolution will be developed that will allow the lenders to homogenize deal terms. Right now everyone's afraid they're at a competitive disadvantage they're afraid to book business."