CMBS Spreads and Terrorism Risk Insurance Joseph B. Nichols and Amy Cunningham

1. Discussion Mario Ugoletti U.S. Treasury Department CMBS Spreads and Terrorism Risk InsuranceJoseph B. Nichols and Amy Cunningham

2. Borrowing Costs and the Terrorism Risk Insurance Act (TRIA)‏ • Pre 9/11 Backdrop • Prior to 9/11 insurers generally did not charge for terrorism risk insurance. • Post 9/11 • Post 9/11 insurers sought to exclude terrorism risk insurance from policies. • Key justification for the passage of TRIA • Lack of terrorism risk insurance would lead to a slowdown in overall economic activity. • Without adequate terrorism risk insurance, access to credit would be limited or prohibitively expensive.

3. TRIA Background • TRIA passed in 2002 • Temporary program through 12/31/3005. • Based on the concept of insurance company deductible and excess loss sharing with the Federal government above the deductible. • Insurer deductibles increased from 7% of previous year’s direct earned premium in 2003, to 10% in 2004, to 15% in 2005. • Insurer loss sharing above the deductible set at 10%. • 2005 Extension • TRIA extended for 2 years until December 31, 2007. • Insurer deductibles increased to 17.5% in 2006, and 20% in 2007. • Insurer loss sharing above the deductible set at 15%. • Program trigger increased from $5 million event size to $50 million in 2006 and $100 million in 2007. • 2007 Extension • TRIA extended for 7 years until December 31, 2014. • Insurer deductibles, loss sharing, and program triggers maintained. • Domestic terrorism included.

4. Nichols/Cunningham CMBS Spread Model Results • Overall Model Results • Impact of key variables relatively consistent with expectations. • Impact of TRA • Focus on event windows of post-9/11 and post-TRIA. • Results seem mixed. • On-the-run BBB spread model finds no post-9/11 increase and a post-TRIA increase in spreads. • Some at issuance AAA spread model results show a decrease in post-9/11 spreads. • Some at issuance BBB spread model results show a post-9/11 increase with a slight reduction post-TRIA. • At issuance BBB spread model finds post-9/11 large loan premium disappears post-TRIA.

5. Some Issues to Consider • Model Specification • Large Loan Variable: presence or proportion? • Geography: overlay with large loan and other variables, but might be worth exploring. • TRIA Coverage was not Universal • While TRIA-take up rates were likely higher in the CMBS market, Treasury surveys showed initial take-up rates of 40% in 2003 rising to 54% in 2004. • Initially, much confusion on adequacy of terrorism risk insurance coverage in the commercial mortgage market. • TRIA “make available” requirement. • Other TRIA coverage gaps.

6. Other TRIA Issues - Coverage for Nuclear, Biological, Chemical, and Radioactive (NBCR) Risks • Coverage for NBCR Risks • TRIA’s “make available” requirement only applies on the same terms and conditions as other coverage that is provided in the policy. • In general, this implies that since coverage for NBCR risks are generally excluded from insurance policies, NBCR coverage for terrorism risk is not required to be offered under TRIA. • Overall, the provision of NBCR terrorism coverage has been very low. • If there was a clear relationship between financing and terrorism risk insurance, the lack of NBCR coverage would seem to be important. • Lack of importance likely related to other factors, such as expectations of additional government assistance in the event of a NBCR terrorism attack.

7. Remaining TRIA Policy Issues • Coverage for NBCR • The 2006 extension for 7 years put to rest some of the near-term policy discussions on changes to the TRIA program. • One key remaining issue is the lack of NBCR coverage. • Bills introduced prior to the 2007 extension suggested various ways to broaden NBCR coverage (e.g., lowering insurer retentions). • Whether or not these types of risks should be covered in private insurance contracts, or be more explicitly covered by the Federal government will likely receive additional attention over the next few years.