Risk Managers’ Forum
By Michael T. Scott
CAPTIVE INSURANCE: TERRORISM VS. PANDEMIC COVERAGE
With a federal backstop in place, pandemic risks can become insurable
Captive insurance is a type of alternative risk transfer in which a business forms its own insurance company to insure its risks. Since the 9/11 terrorist attacks, there has been an increase in the formation of captive insurance companies that cover their owners’ terrorism risk.
For example, according to the 2016 Marsh Captive Benchmarking Report, over the previous three years almost 40 captives were formed by Marsh clients to cover risks excluded from conventional terrorism policies and/or to provide access to reinsurance to cover the potential gap under the Terrorism Risk Insurance Act (TRIA). In 2018, Marsh released a report titled The 2018 Terrorism Risk Insurance Report that indicated that in 2017, the number of Marsh-managed captives with programs that accessed the federal terrorism insurance backstop had increased by 44%, from 115 in 2016 to 166. In general, captive insurers have been used to offer more comprehensive terrorism coverage than the commercial markets may provide and to allow organizations access to the TRIA backstop.
If a federal backstop is created, captive insurance has a place. If not, other avenues exist for captives to help their owners deal with future pandemics.
TRIA was originally signed into law on November 26, 2002, by President George W. Bush and created the Terrorism Risk Insurance Program (TRIP). On December 20, 2019, President Trump signed into law the fourth reauthorization of TRIP (TRIPRA). The new authorization extended the terrorism backstop through December 21, 2027. The 2019 reauthorization set the reimbursement level for covered terrorism losses that exceed the statutorily established deductible at a fixed 80%, set the coverage limit at a $100 billion program cap, set the captive deductible at 20% of the prior year direct earned premium, and set the triggering event threshold at $200 million.
Under TRIPRA, a U.S.-domiciled captive is required to offer terrorism insurance in its primary policies. TRIPRA provides organizations with captive insurance structures several benefits that ultimately may reduce premiums and enhance terrorism coverage. These include:
- Captives can offer broader coverage than is available from commercial insurers, including coverage for chemical, biological, radiological and nuclear risks (CBRN), cyber risks and contingent time element
- Captives provide flexibility and allow customization in policy wording
- Captives provide improved capacity, especially where commercial terrorism capacity is limited
- Captives provide premium savings when there are no losses (i.e., no certified terrorism events) during the policy period, because premiums are paid and retained by the captive
Let’s look at an example of how a captive would respond to a certified act of terrorism under TRIPRA that caused loss only to the captive’s owner. Assume a $400 million insured certified terrorism loss and a prior year direct earned premium in the captive of $4 million. The 20% captive deductible would be $800,000. The total loss after the deductible would be $399,200,000. The captive’s share would be 20% or $79,840,000, while the federal government’s share would be $319,360,000. Thus, using a captive to access the federal backstop could turn a $400 million uninsured terrorist loss into a recovery from the federal backstop of $319,360,000.
TRIPRA is considered by many to be a model public-private partnership. Many in the insurance industry believe that without TRIP, commercial insurers would not be able to provide sufficient limits of terrorism coverage and that terrorism insurance would not be commercially viable in the United States.
Fast forward to December 2020, one year after the fourth reauthorization of TRIP was enacted, and the world is a vastly different place. While we are still cognizant of terrorism risks, we are engulfed in dealing with COVID-19 and the risks that arise out of a global pandemic. According to the annual Systemic Risk Barometer published by the Depository Trust & Clearing Corporation (DTCC), the COVID-19 pandemic is the greatest threat to global financial stability in 2021. The report also states that close to one-third of respondents cited the pandemic as the number one risk, while 67% included it in their top five. The question that now arises is whether captive insurance companies can be used to address pandemic risks and whether the federal government should establish a program like TRIA for pandemic risks.
Some companies, in response to MERS in 2012, H1N1 in 2009, the Avian flu in 2005, and SARS in 2003, had the foresight to place pandemic coverage in their captives. These companies are the exception, not the rule. The pandemic has certainly heightened the awareness of using a captive to deal with pandemic losses. This is especially true because many businesses thought they were covered for business interruption arising out of the pandemic and government shutdowns, only to learn that their existing policies excluded the losses.
Insurers generally rely on two grounds to deny these claims. First, standard business interruption coverage requires physical loss to property to trigger a claim, and a shutdown caused by a pandemic is not physical damage. Second, after the SARS outbreak of 2003, many insurers added exclusions for bacterial or viral infections. In the United States, most of the litigation surrounding these claim denials has been won by the insurers.
One reason a business might use a captive insurer is to obtain coverages that are not available in the commercial markets. Some ways that a captive could provide pandemic coverage to its owners going forward are:
- Administrative or regulatory actions coverage. For businesses in highly regulated industries such as healthcare or finance, a captive can write a policy that covers the business for losses that arise out of changed regulation or regulatory action. Considering the varied governmental responses to COVID-19, this coverage could be valuable.
- Enhanced cybersecurity coverage. Many businesses are relying heavily on remote workers and are dealing with customers and clients using technologies such as Zoom. The increased risk of cybercrime caused by COVID-19 could be dealt with in a captive.
- Coverage for loss of income caused by loss of key suppliers, customers, or employees. Some businesses will not survive COVID-19 while others will be shut down for some time. This makes it likely that a company’s supply chain could be disrupted by loss of a key supplier or customer. Moreover, a key employee could become a victim of COVID-19. These risks could be covered in a captive.
- Reputation coverage. Virtually any kind of business can experience a reputation event that arises out of COVID-19. This is especially true for service businesses such as retail establishments, restaurants, and gyms.
- Defense costs and legal expense reimbursement coverage. A business might be the subject of litigation that arises out of COVID-19. The claims made against the business may not be covered by commercial insurance. In that case the business will have to cover the costs of defense itself. A captive can provide coverage that reimburses the business for those defense costs.
- Business interruption/event cancellation coverage. A captive could write a property policy for its owners that covers business interruption with language that does not require physical damage or that does not contain a virus exclusion.
- Finite risk/loss portfolio transfer. Captives may be able to retroactively write coverages for areas where their owners have gaps in coverage. This approach would require a captive with access to excess-surplus markets and would entail a lot of actuarial work to establish the appropriate premium.
A proposed solution that has been introduced in Congress is the creation of a federal pandemic backstop. Such an approach would cap insurance industry losses from pandemics, would encourage commercial insurers to write pandemic coverage, and would be similar to how the government has addressed terrorism risk through TRIA.
Specifically, in May 2020, Rep. Carolyn B. Maloney (D-N.Y.) introduced a bill that would create a federal pandemic risk backstop. Titled the Pandemic Risk Insurance Act of 2020 (PRIA), the bill would create the Pandemic Risk Reinsurance Program (PRRP). Like TRIP, PRRP would create a system of shared public and private compensation for business interruption losses that resulted from future pandemics.
As introduced, PRIA would require insurers to offer business interruption coverage for pandemics. The goal of PRRP is to provide a backstop that ideally will ensure sufficient insurance capacity to cover losses and protect the U.S. economy against a future pandemic. One key difference between PRIA and TRIA is that under PRIA insurer participation in the program would be voluntary, with insurers electing to sign up on an annual basis. If an insurer chooses to participate, it would be required to provide business interruption policies, including event cancellation, that cover pandemics. Another key difference from TRIA is that PRIA lacks a recoupment mechanism.
The PRRP backstop would be triggered when aggregate insured losses for a covered public health emergency exceed $250 million. Once the backstop is triggered, the federal government would pay 95% of insured losses that exceed the insurer’s deductible. The backstop would have a $750 billion program cap for federal compensation. The bill authorizes the Treasury secretary to determine the pro rata share of federal compensation if losses exceed the cap.
Of course, with a federal backstop in place, there could be a role for captive insurance companies to participate similar to the way they have participated in TRIA. Captive participation would depend on whether PRIA allows it.
The question becomes whether PRIA is a feasible solution to pandemic risk. First, insurers typically don’t cover pandemic risk because pandemics don’t meet the requirements of an insurable loss.
According to the Center for Infectious Disease Research and Policy department at the University of Minnesota in a 2007 article, an influenza pandemic will occur every 30 to 35 years. An analysis of business interruption by the American Property Casualty Insurance Association (APCIA) estimates that “closure losses for small businesses with fewer than 100 employees, across the U.S., are between $255 billion and $431 billion per month. U.S. home, auto, and business insurers have about $800 billion surplus to pay all future losses.” APCIA also estimates that “between 60 and 90 percent of businesses will be impacted by COVID-19.” Harvard economists David Cutler and Lawrence Summers published a paper in JAMA estimating the total cost of the COVID-19 pandemic to be $16 trillion or 90% of US GDP. Finally, according to an article in the Insurance Journal by L.S. Howard, “the world’s property/casualty insurers would have to collect business interruption insurance premiums for 150 years in order to absorb the estimated US$4.5 trillion global output loss inflicted by COVID-19 and its handling in 2020.” The article goes on to say that “P-C insurers currently collect US $1.6 trillion in annual premiums for all policies, with just US$30 billion of that total for business interruption policies, which represent less than 2% of the global P-C insurance market, according to a report from the Geneva Association titled ‘An Investigation into the Insurability of Pandemic Risk.’”
In comparison with the terrorist attacks of 9/11, losses from the COVID-19pandemic dwarf that event in sheer dollars of loss. According to the Institute for the Analysis of Global Security, losses from 9/11 were around $100 billion. According to the Insurance Information Institute, total losses from the September 11 attacks were $200 billion while insured losses were “$35.9 billion as of May 2007, including property, life and liability insurance claim costs.” The Insurance Information Institute also cited a 2005 study by the American Academy of Actuaries that explored the insured losses that chemical, biological, radiological and nuclear incidents might give rise to in four U.S. cities. That study indicated that in New York, a large CBRN event could cost insurers as much as $778.1 billion.
It is clear that pandemic exposures are not insurable in the commercial markets because of the size of the loss potential and the fact that the losses occur to a large number of insureds at once. Others may argue that these exposures are not insurable because many of the losses are not random or independent. The question becomes: Who should or could cover these kinds of events? Obviously, public-private solutions such as PRIA should be explored, but even PRIA’s $750 billion cap represents only approximately one month of COVID-19 losses. If a federal backstop is created, captive insurance has a place. If not, other avenues exist for captives to help their owners deal with future pandemics.
Michael T. Scott is an attorney and partner at Allison & Mosby-Scott, where he heads the firm’s business law, estate planning, and personal injury practices. He also serves as president of Allison & Mosby-Scott Risk Management, the firm’s risk management consulting practice. Before joining the firm, Scott was vice president of insurance and risk management at Archer Daniels Midland Company (ADM) and president and general counsel of Agrinational Insurance Company, the captive insurer of ADM. Michael is a frequent speaker on risk management, insurance, and captives and is a published author who has served on many boards. He is also a faculty member of The National Alliance for Insurance Education & Research. In addition to being licensed to practice law in the States of Illinois and Vermont, Scott holds the CPA, CRM, CPCU, CLU, ChFC, FLMI, ARM, ARC, AIC, AMIM, ARe, AIAF, AU, and CGMA designations.