United States: Terrorism Insurance Alert

By Fred L. Pillon and Kristin Buff

Prior to September 11, 2001, standard property insurance policies included full coverage for losses produced by terrorist events, under the assumption that the United States was an unlikely target. The radical change in risk calculus brought on by the events of September 11 has caused insurance providers to limit or entirely exclude losses caused by terrorist acts from coverage. With increased risk to their investments, many lenders now require commercial real estate borrowers to obtain terrorism insurance. Limited capacity to insure, increased demand for insurance and exorbitant costs combine to create uncertainty and uninsured risks - characteristics that threaten commercial real estate investments individually and liquidity in the real estate market in general. A recent survey conducted by the Mortgage Bankers Association of America found that thus far in 2002, inadequate terrorism coverage proved fatal to $3.7 billion in deals and detrimentally affected the timing and pricing of another $4.5 billion.

Early and decisive action by both Congress and the Senate raised hopes for a quick solution. However, differences between the House and Senate sponsored bills foreclosed the possibility of a reconciliation prior to the August recess. With Congress back in session on September 3, and President Bush's continued press for federal backstop legislation, movement towards a terrorism insurance bill appears to be gaining momentum.

Many lenders have created rough guidelines for assessing risk and determining which investments to pursue. One prominent lender employs a three-tiered system with Tier 1 presenting the highest level of risk and Tier 3 the lowest. Tier 1 consists of a very limited number of "trophy" assets that are well known regionally or nationally, and may also include buildings immediately surrounding trophy properties. Lenders are reluctant, and some flatly refuse, to enter bids to originate debt for properties in the first tier. Tier 2 assets are large, central business districts, major regional shopping malls and large multi-family residence buildings in major cities. Lenders demand some coverage for second-tier assets, depending on the specific risk factors the asset presents. Tier 3 assets include all properties not classified as Tier 1 or Tier 2 and are at little risk for terrorist acts. Lenders may not even require that such assets have terrorism coverage, and in the event that coverage is needed, the cost of coverage will be relatively low due to the limited risk involved.

To insure their properties against terrorism, some owners have purchased multiple policies and layer them to cover varying levels of exposure. Obtaining multiple policies can take several months and can cost from 40% to 500% more than pre-9/11 policies. To the extent that such expenses are not capped by their leases, owners may shift the increase in costs to their tenants. Even when terrorism insurance can be procured, it may not be available for the full investment value. Experts estimate that the limit capacity for terrorism coverage is around $300 million per property - not enough to cover many of the highly valued assets in major cities across the country.

Lenders currently require full coverage for the debt they have invested. When full coverage is not available at the acquisition stage, potential owners have been walking away from the transactions. Owners trying to meet requirements of an existing loan do not have that option, creating a situation in which the Lender demands more coverage than the owner is able or willing to provide. The two primary responses to the impasse have been to negotiate or litigate.

In order to continue lending capital while protecting their investments, some lenders have relaxed their requirements in one way or another, exchanging diminished coverage levels for the right to make additional demands on the owners should new coverage options arise. Recently, the equity investor in the Mall of America in Minnesota failed to find adequate terrorism coverage at an acceptable price. The lender holding the debt on the asset purchased insurance to protect its investment and charged the expense to the owner. The owner filed an injunction to prevent the lender from forcing it to pay for the insurance. The parties settled the matter, agreeing that the owner purchase $100 million in terrorism insurance (less than the lender originally required) for the mall and a separate $100 million for the remainder of its portfolio.

Lenders and owners will not always be able to agree on the appropriate cost and level of coverage. In April, La Salle National Bank, holder of the mortgage on Four Times Square in New York, informed the owner, the Durst Organization, that it was in default for failure to obtain terrorism insurance. Durst filed for and received a temporary restraining order to prevent the bank from seizing $3.2 million for payment on a one-year policy. In May, a Manhattan Supreme Court Justice modified the restraining order, giving La Salle access to rent payments made to Durst because the potential harm in not obtaining coverage outweighed the cost of purchasing the policy while the court considered the merits of the case. Durst got a temporary stay of the modification from the Appellate Division, 1st Department. On September 3, 2002, the appellate court again ruled in Durst's favor, preventing Cigna Investments, the manager of the mortgage on the property, from diverting revenue from the building's rental income to purchase terrorism insurance.

While the court considers its ruling, alternative insurance strategies are emerging. One possibility is a form of self-insurance. To mitigate risk associated with an asset, owners could permit recourse through a "terrorism indemnity" to an investment-grade sponsor to the extent that terrorism insurance is unavailable or coverage is insufficient. The viability of this strategy is limited by the risk that destruction of the asset would eliminate the capital of the sponsor. Also, such an indemnity must not affect the operation or efficacy of necessary non-consolidation opinions.

Insurers and lenders are also working to create alternative insurance structures. Recently, AIG reported that it had been contacted by lenders seeking lender-only terrorism coverage. AIG is interested in providing such a product and continues to speak to banks and lenders about developing it. In the absence of legislative action, such a solution may be the most logical response to the terrorism insurance crunch. We will have more on how such an approach might be strucutred in a subsequent article.

Copyright © 2002 Gibson, Dunn & Crutcher LLP