As a result of the events of September 11 2001, the collapse of HIH and the hardening of the insurance and reinsurance market worldwide, reinsurance for terrorism events have become either unavailable or prohibitively expensive.
Consequently, insurers in Australia have progressively been adding terrorism exclusions to their policies, thereby excluding cover for loss or damage to property caused by acts of terrorism. This saw a good proportion of commercial property inadequately covered when reinstatement and business interruption policies were renewed in 2002.
Significant commercial and financial difficulties resulted from the withdrawal of such coverage mostly because of the uncertainty created by having large pools of assets uninsured for terrorism risk. The uncertainty meant that the commencement of projects was delayed or abandoned, especially commercial development in our cities that were perceived to be high risk. There is evidence of the value of transactions being downgraded because credit rating agencies did not have confidence that terrorism insurance would be available at all if there were to be another major terrorist attack. There has been an identifiable trend towards fringe CBD or suburban office locations which are seen as having a lower risk profile coupled with lower occupancy costs.
In response, the Commonwealth government established a temporary programme of reinsurance (and compulsory insurance) of terrorism events pending the recovery of the terrorism reinsurance market. The new scheme operates under the Terrorism Insurance Act 2003 (Cth). The scheme targets commercial property, related business interruption and public liability risks and is designed to provide comfort to business that damage to commercial buildings and other tangible property will be insured in the event of a terrorism act in Australia.
The scheme is compulsory – all classes of commercial property owners who purchase insurance under an eligible contract are required to take terrorism cover, whether or not they consider their property to be at risk from terrorism.
Operation Eligible contracts, eligible property and eligible terrorism loss
The Act operates on two levels:
> To deem terrorism exclusions in eligible insurance contracts to be inoperative to the extent to which the loss or liability is an eligible terrorism loss. Insurers cannot opt out of this aspect of the Act
> To establish the Australian Reinsurance Corporation Pool (ARPC) which will provide terrorism reinsurance to insurers until the terrorism reinsurance market recovers. Insurers can choose whether or not to reinsure with ARPC.
Eligible insurance contracts are those in place as at 1 July 2003 and entered into after that date which covers:
> loss of, or damage to, eligible property that is owned by the insured
> business interruption and consequential loss arising from:
– loss of, or damage to, eligible property that is owned or occupied by the insured
– inability to use eligible property, or part of eligible property, that is owned or occupied by the insured
> Liability of the insured that arises out of the insured being the owner or occupier of eligible property.
The various heads of insurance do not need to be provided in the one insurance contract to be captured by the scheme. Business interruption and liability insurance contracts that are written separately to the property damage insurance contract will be eligible.
Eligible property means the following property that is located in Australia:
> buildings (including fixtures) or other structures or works on, in or under land
> tangible property that is located in, or on, those buildings and other structures
> Any other property prescribed by the regulations.
This definition would extend to:
> contracts taken out by owners or construction project consortia for buildings (and fixtures and fittings) and infrastructure (for example, toll roads, dams, power plants, sewerage works, pipelines)
> Insurance contracts taken out by owners or tenants of real property for equipment, office furniture and the like that is contained within the property.
The property affected is largely that covered by industrial special risks (including associated business interruption), commercial property and contract works policies.
The Terrorism Insurance Regulations 2003 list the contracts excluded from the coverage of the Act. Generally, a contract of insurance that has no connection with real property will not be covered, nor will government or domestic property.
An eligible terrorism loss is a loss or liability arising from a declared terrorist incident. An incident can only be declared a terrorist incident by the Treasurer, after consultation with the Attorney General, if a terrorist act has happened in Australia after 1 July 2003. An action or threat of action made with the intention of advancing a political, religious or ideological cause with the intention of coercion, intimidation of the government or public is not a terrorist act. Nor is an act of war a terrorist act.
We are only dealing here with policies protecting owners against damage to their real property, and consequential loss or liability claims flowing out of damage to that property, inability to use that property and by virtue of ownership of that property. If there is an incident outside Australia that causes a loss in Australia, it will not be covered.
Premiums
The reinsurance pool will be capitalised by property insurance premiums levied through postcode areas on the basis of urban concentration, with the areas of highest risk (perceived to be CBD properties in Sydney and Melbourne) attracting the highest rates.
For commercial property and associated business interruption, an initial reinsurance premium of 2% of the underlying base premium will generally apply (Tier C). Rates of 12% and 4% would apply to properties located in most Capital City CBDs (Tier A) and other urban areas (Tier B), respectively, with Tier A and Tier B to be designated by postcodes. There are no initial premiums for public liability cover.
While the Act allows the ARPC to set the level of reinsurance premiums, the premiums charged by insurers to policy holders will not be so controlled. The additional premiums to be paid by policy holders will not necessarily be equal to the reinsurance charge the insurer pays because the insurers will want to recoup administration expenses, and they will also need to factor in the $1 million risk the insurer has to retain when reinsuring with the ARPC.
Issues for property owners, tenants and financiers
Extent of cover
> the relevant policy will act as it would have prior to the introduction of the Act; there is no new or additional cover so limits of liability, excesses or deductions that apply to the particular policy remain unaffected.
> cover will only be available for risks otherwise insured against in current policies. For example, a policy holder whose cover does not extend to flood will not be covered for losses incurred due to a flood caused by a terrorist act.
> policy holders should consider whether or not any existing cover or other covers they may have sought for a terrorism liability needs to be adjusted. Consider:
– will the owner’s amount of cover or the length of the period of protection nominated under a business interruption policy be sufficient in the event of a terrorist act?
– are time limits imposed for reinstatement long enough?
Compulsory scheme
> in the US, while insurers are obliged to offer terrorism coverage, property owners who want to insure are not obliged to take that cover. Under the Australian scheme, policy holders don’t have the option to reject cover and therefore avoid the additional premium if they want to insure their property.
> does the compulsory nature of the scheme means that owners of properties at low risk of terrorist attack or those who are willing to wear the risk are subsidising the owners of high risk properties? Businesses may feel that their existing risk management schemes are adequate.
> or is it more important to ensure that the cost of any incident is spread across a broad base – otherwise the additional premiums would be even higher.
Cost
> is there a danger of price exploitation in relation to the introduction of compulsory cover or will competitive forces in the insurance market to ensure insurance companies don’t use the fact that policy holders will be required to take out terrorism cover to dramatically increase premiums?
> will it mean more affordable terrorism cover for owners than was available via those few stand alone policies offered in the period after most other terrorism cover had been withdrawn?
> the additional premiums charged by insurers will be subject to government charges of stamp duty, GST, and, in some States, the fire services levy. There is a view that the cascading effect of imposing stamp duty on the total premium and other taxes, including GST, will provide windfall benefits to the States.
> Possible consequences of the increase in insurance costs:
– a negative impact on property values, given the reduction in property operating cash flow and associated depression of capitalised net operating income.
– owners deciding that they will reduce coverage in an effort to save costs, with the risk that businesses will not be insuring at prudent levels or even insuring at all.
– costs being taken away from the implementation of other security measures, like the development of evacuation plans or works to ensure the protection of crucial IT systems.
Landlords
> landlords should check their leases to make sure that their terms allow recovery of that part of the premium attributable to terrorism cover.
> generally speaking, recovery clauses are quite broad so recovery should not be an issue. Recovery under leases would have been more complicated had the Government opted for a ‘terrorism tax’ or levy.
> Owners with gross leases, where there is not separate variable outgoings component, will need to wear the cost and factor in the increased occupancy cost when setting new rents.
> for semi gross arrangements, landlords will pick up the increased costs when adjustments from the base year are made at the end of the relevant outgoings year.
Tenants > owners will seek to pass additional insurance costs on to their tenants.
> the Act will apply to the tenant’s own eligible insurance contracts – tenants also have an insurable interest in the property as the owner of the leasehold estate.
> tenants will be affected by the Act in its application to cover taken out for tenant’s fixtures, business interruption and public liability.
Financiers
> investments will now have a certain degree of protection because borrowers will have cover in the event of property damage caused by a terrorist act.
> financiers may need to assess whether the level of cover they require borrowers to take out will be sufficient in light of the terrorist threat and whether their finance documentation requires borrowers to insure on appropriate terms.
> is the type of cover held by banks and other lenders to protect themselves in the event that a borrower is not adequately protected by general insurance cover is included in the compulsory scheme? Mortgage insurance is specifically excluded.
Off shore insurers
> the scheme applies to all eligible policies regardless of whether the insurer is an authorised or foreign insurer.
> Policy holders need to check with their overseas insurers that they understand the effect of the Act and the insurer’s obligations under it.
Mixed use property
> Policies covering domestic property are excluded from the eligible insurance contract definition.
> what about residential property in buildings that also have commercial or retail tenants?
> The ARPC and the Insurance Council of Australia have developed a protocol to be followed to determine whether a building is residential or not.
Recovery after a terrorist incident
How will the way the scheme works affect policy holders and their disaster recovery after a terrorist incident? Consider:
> whether an incident qualifies as a terrorist act under the legislation, and the inevitable delays in a decision being made.
> the declaration of an incident will not be sufficient. There may still be disputes between owners and their insurers about claims, although insurers will have to investigate and pay claims before they are reimbursed out of the scheme.
> whether the pool of $10 billion will be enough to cover the losses. If the funds in the pool are insufficient to meet the losses incurred as a result of a terrorist incident, then there will be a pro rata reduction in claim payments.
What to ask your insurer
> Is the insurer going to reinsure with the ARPC?
> If not, what reinsurance is held and will this affect the ability of the insurer to pay out a claim?
> What relationship does the increased premium the you are being required to pay bear to the reinsurance premium the insurer is paying to the ARPC?
> Does your overseas insurer understand the effect of the Act and its obligations under it?
*Jane Baddeley is a Senior Associate with Phillips Fox lawyers.
