Terrorism Insurance: The economic impact on commercial real estate lending

July 13, 2002 Published Work
Connecticut Business Magazine, June/July 2002

Before September 11th, the risk of a terrorist attack destroying commercial real estate was borne by the insurance industry. While "all risk" insurance was required by lenders, the cost of providing such coverage was not overly significant.
In the wake of September 11th, insurance commissioners in 45 states have approved broad exclusions from coverage for terrorism, war and military action, and the use of nuclear, biological or chemical materials.
At the same time, insurance companies have dramatically increased their premiums on average between 100 percent and 300 percent since September 11th, and traditional carriers are exiting the real estate insurance market altogether.
These events are having a dramatic effect on real estate owners and developers who cannot afford their current insurance or the newly required increases in coverage. It may also have potentially far-reaching effects on the lending, construction and banking industries.
Property owners' search for terrorism coverage has been motivated by a combination of fear of other terrorist attacks and lender requirements in loan documentation.
Standard "non-recourse" real estate loan agreements typically contain "recourse carve-outs" which provide that the entire loan becomes recourse to the borrower in the event of certain defaults. Failure to maintain adequate insurance coverage is typically one of those "recourse carve-out" defaults.
Many lenders have begun notifying borrowers with properties considered at risk for terrorism that they are now required now to carry insurance for such risk. If borrowers cannot obtain the requisite terrorism coverage (which is often not available), lenders may find them in violation of their loan covenants.
Lenders and investors are now being faced with a dilemma of either allowing their risk exposure to increase or acting to terminate existing loan agreements because terrorism coverage is not available to satisfy insurance covenants in the loan agreement.
This scenario, however unlikely it may have been in the past, is becoming increasingly real for many real estate owners.
In addition to jeopardizing already existing loans, recent insurance increases make it impossible to close many new loans. Some insurers will not consider any loan in excess of $50 million without full terrorism insurance coverage and they are scrutinizing all loans in excess of $20 million.
Lack of adequate insurance coverage has delayed or prevented many financing transactions and development projects. Developers, financiers and industry observers note that both lenders and investors are reluctant to commit resources to projects that cannot be insured against terrorist attacks.
Many projects, particularly those in high-rise office buildings in high-profile cities such as New York, Washington, Chicago and Los Angeles, will be extremely difficult to finance without terrorism coverage.
The impact, however, is not limited to the financing of high-risk properties and trophy assets. It may also have a far-reaching effect on the economy as a whole since the property taxes alone provide almost half of all local government funding and more than 70 percent of the local tax base throughout the country.
The ripple effect could extend to the mortgage security market, the second-largest source of financing of real estate projects. Pension funds and life insurance companies have significant amounts of their investors' capital tied up in commercial real estate holdings and commercial mortgage-backed securities (CMBS").
What was a routine task in the pre-September 11th days has turned into a tortuous process, particularly for owners who cannot obtain or afford new expanded insurance requirements.
Companies servicing this market are responsible for ensuring that the real estate securing mortgage bonds has adequate insurance coverage. The rating agencies are keeping a watchful eye on the servicing companies to ensure compliance with their requirements.
What was a routine task in the pre-September 11th days has turned into a tortuous process, particularly for owners of well-located properties who either cannot obtain or cannot afford the newly expanded insurance requirements. If the same coverage is not available when insurance policies are up for annual renewal, servicing companies may declare the CMBS in technical default.
While so far there have been no reported cases, if a servicing company does not declare a default and the property is damaged or destroyed in a terrorist attack, the bondholders may have legal claims against the servicing company.
Bondholders may also have the option of selling the bonds back to the issuer. A massive sale-back of these mortgage bonds could have a profound effect on the soundness of the banking industry, given the fact that during 2001 new CMBS issuance totaled $97 billion.
Many servicers of CMBS have already expressed their concerns about insurance coverage on existing securities.
GMAC Commercial Mortgage, the biggest servicer of securitized commercial mortgages, in taking a hard-line approach and gearing up to transfer loans with inadequate coverage into special servicing pools or to force borrowers to accept coverage required by GMAC.
The insurance industry and certain real estate groups have petitioned the federal government to provide backstop insurance coverage against terrorism. However, plans for governmental intervention have cooled off considerably since they were first introduced immediately after September 11th.
Clearly, real estate owners, developers and borrowers will have to shoulder the burden of these exorbitant insurance premiums in the short term. Owners will most likely attempt to pass-through much of the increased costs to tenants as common area/maintenance charges through tenant leases.
However, savvy real estate attorneys are already crafting and negotiating complex solutions with lenders in order to ensure that their clients are protected in the future.
John J. Ginley III, is a partner in the real estate practice group of the law firm of Wiggin & Dana in Stamford. Ginley can be reached at 203-363-7610 or [email protected]