2018-19 The Scheme

HOW ARPC’S TERRORISM INSURANCE SCHEME OPERATES

The Scheme was established on 1 July 2003 to provide eligible insurance contracts with terrorism cover for any Declared Terrorist Incident (DTI). Eligible insurance contracts are defined in the Terrorism Insurance Act 2003 (TI Act) and further refined through regulation.

The Minister, in consultation with the Attorney-General, determines whether a terrorist incident has occurred in Australia. They do so through the application of a consistent definition of terrorism, one used across Australian Government legislation, which draws on the meaning of a terrorist act contained in the Criminal Code. Once the Minister is satisfied that a terrorist act has occurred, the Minister must announce a DTI under section 6 of the TI Act. Upon that declaration, the provision of the TI Act in respect of eligible terrorism losses becomes effective and renders terrorism insurance exclusion clauses in eligible contracts of insurance invalid.

Through ARPC terrorism insurance coverage (the Scheme), insurers have three options. They can:

• carry the underwritten risk of terrorism losses following a DTI; or
• reinsure the risk through the commercial insurance market, paying terrorism reinsurance premiums; or
• reinsure the risk with ARPC by entering into a reinsurance contract and paying terrorism reinsurance premiums.

If an insurer chooses to reinsure the risk of claims for eligible terrorism losses following a DTI with ARPC, they do so by paying reinsurance premiums to ARPC. In most major economies similar arrangements exist, with some government involvement through terrorism reinsurance pools.

Commercial businesses that are insured with ARPC’s insurer customers and which hold eligible insurance policies are covered by the Scheme in the event of a DTI. Insurers are required to meet claims in accordance with the other terms and conditions of individual policies.

Scheme coverage excludes loss or liability arising from the hazardous properties of nuclear fuel, material or waste. Scheme coverage also excludes residential property not identified as eligible property. Farms can obtain cover if they hold insurance against business interruption.

Insurer and industry retentions (deductibles or excesses) apply before claiming against the Scheme. Claims against the Scheme will be met once an individual insurer’s retention is exhausted. In this way, and in line with good risk management practices, the Scheme requires insurers to retain the first portion of any loss.

ARPC’s pool of retained earnings is used to pay claims up to the agreed private retrocession deductible ($285 million for the 2019 calendar year). Above this point, an additional $3.315 billion of claims are funded by the retrocession program.

Once retrocession is exhausted, claims are paid by the Commonwealth guarantee. These claims may have a reduction percentage applied if claims in this layer exceed the $10 billion limit of the Commonwealth guarantee as legislated in the TI Act. If insurance companies are not reinsured with ARPC, then they are liable for the cost of claims resulting from the DTI on all eligible policies up to their pre-existing policy limits with no reduction percentage applied.

The Scheme funding capacity is the total value of the Scheme, which at 30 June 2019 totalled $13.6 billion. The Scheme’s benefits include efficient pooling of risk for terrorism catastrophe, particularly when capacity is limited and prices are high (which occurred following the terrorist attacks in the United States of America on 11 September 2001). Since then, ARPC has begun the gradual transfer of risk back to the global reinsurance market in line with incremental increases in global terrorism insurance capacity, thus reducing reliance on the Commonwealth guarantee in the event of a DTI.

In 2019, ARPC purchased an additional $250 million layer of retrocession at the top of the program from the global reinsurance market. This expanded the Scheme size and further protected the Commonwealth guarantee.

BACKGROUND TO THE SCHEME

Significant commercial and financial issues resulted from insurance and reinsurance companies’ withdrawal of coverage for terrorism risk following the events of 11 September 2001. With a large pool of assets uninsured for terrorism risk, financiers and investors faced uncertainty, which could have resulted in adverse economic circumstances, delayed commencement of investment projects and altered portfolio management decisions going forward. For these reasons, the Government’s response was to create the TI Act which attracted bipartisan support.

In July 2003, the TI Act stipulated a scheme that provides terrorism cover on eligible insurance contracts (the Scheme) and established the Australian Reinsurance Pool Corporation (ARPC) to administer it.

ARPC’s functions of corporation under section 10 of the TI Act are:

a) to provide insurance cover for eligible terrorism losses (whether by entering into contracts or by other means); and

b) any other functions that are prescribed by the regulations.

The activities that ARPC undertakes to support the functions of corporation include:

• maintaining, to the greatest extent possible, private sector involvement;
• appropriately pricing and compensating the Australian Government for risk transferred to it;
• allowing for the re-emergence of commercial markets for terrorism risk cover; and
• responding to global solutions.

SCHEME COVERAGE

The total capacity of the Scheme at 30 June 2019 stood at $13.6 billion including all sources of funding (see Figure 5.1, Scheme funding layers).

Contracts of insurance covered by the Scheme are those that provide insurance for:

• 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; or
  • inability to use eligible property, or part of eligible property, that is owned or occupied by the insured; and
• liability of the insured that arises out of the insured being the owner or occupier of eligible property.

Eligible property is property located in Australia comprising:

• buildings (including fixtures) or other structures or works on, in or under land (roads, tunnels, dams and pipelines are examples of eligible property);
• tangible property located in, or on, such property; and
• property prescribed by regulation.

Among the Scheme’s exclusions are:

• loss or liability arising from the hazardous properties of nuclear fuel, material or waste;
• residential property or the contents of residential property where the building has a sum insured less than $50 million;
• farms, unless they hold insurance against business interruption;
• life insurance policies that fall within the meaning of section 9 of the Life Insurance Act 1995; and
• contracts of insurance to the extent that they provide cover for loss arising from computer crime.

SCHEME FUNDING CAPACITY

As at 30 June 2019, ARPC provided insurers with an annual claims funding capacity of $13.6 billion in reinsurance capacity, comprising ARPC’s net assets, retrocession and the Commonwealth guarantee. Since 2009, ARPC has placed an annual retrocession program, purchasing more than $3 billion capacity through more than 70 reinsurers rated A- or better by Standard & Poor’s or AM Best, many of which are located overseas.

Figure 2.1*: ARPC funding layers for terrorism claims from all sources as at 30 June 2019

The funding order for terrorism claims against the Scheme is in layers, as follows:

1 policyholder deductible (the excess or retention stated in the underlying policy);

2 insurer retention (retention stated in ARPC’s reinsurance agreement with insurer customers) up to a maximum industry retention (total retention from all insurer customers involved in one event);

3 a $285 million ARPC retrocession deductible;

4 retrocession capacity of $3.315 billion; and

5 a Commonwealth guarantee of up to $10 billion.

REDUCTION PERCENTAGE

A reduction percentage must be specified if the Minister considers that, in the absence of a reduction percentage, the total amounts paid or payable by the Australian Government under section 35 of the TI Act (including amounts not related to the act or acts specified in the declaration) would be more than $10 billion.

By notice in the Australian Government Gazette, the Minister may vary the reduction percentage, but only by making it smaller and the percentage may be varied more than once. Once the reduction percentage is applied, insurers covered by ARPC would have no liability for any costs above their retention (regardless of sums insured) and eligible policyholders would receive a reduced claim payment from their insurer. After the reduction percentage figure announcement, the Australian Government can decide to revise this figure (to decrease it) which would increase claims payments to policyholders.

If an insurer is not reinsured with ARPC, that insurer is liable for the full costs of a DTI claim. They will not be protected by the reduction percentage and must pay claims to the limit of the policy sum insured, subject to the policy terms and conditions.

HOW THE SCHEME IS ADMINISTERED

Premiums

ARPC’s premium and investment income is used to:

• fund its operations;
• pay retrocession premiums;
• pay any fees and dividends to the Australian Government for the provision of the Commonwealth guarantee; and
• build the reserve available to meet claims.

The premium charged by ARPC for reinsurance is determined by Ministerial Direction. The tier rates charged by ARPC are shown below.

The premium tiers have been set by postcode, having regard to the population density in a postcode area. Figure 2.3 illustrates the breakdown of the three premium tiers and the broad geographical location to which they relate.

Reinsurance premiums payable by insurers to ARPC are calculated as a percentage of the premium processed by the insurer for eligible insurance contracts. The Scheme provides for tier rates to be adjusted following a claim on the Scheme, enabling ARPC to meet its outstanding claims liabilities and rebuild the claims reserve within an acceptable timeframe.

Retrocession placement

ARPC’s retrocession program continues to provide the following benefits:

• increases overall scheme capacity;
• positions the Commonwealth further away from the risk of terrorism losses under the Scheme;
• reduces the likelihood that a reduction percentage will be required;
• facilitates inflow of foreign funds to rebuild Australian assets following a terrorism incident; and
• encourages the return of the commercial terrorism insurance and reinsurance market for Australian risks.

The retrocession program renews on 1 January each year. The 2019 placement includes approximately $3 billion of capacity written on a multi-year agreement, up from $2 billion written on a multi-year agreement in 2018, to reduce pricing volatility for ARPC and its retrocessionaires. The multi-year agreement allows adjustment if ARPC’s portfolio changes by more than 10 per cent year-on-year or cancellation if ARPC’s audited forecast premium income¹ reduces by 10 per cent or more.

There are currently 71 participants in the retrocession program drawn from the Australian market and from the Lloyds, European, Bermudian, USA and Asian markets. Figure 2.5 illustrates the split of retrocessionaires by their Standard & Poor’s credit rating.

Figure 2.5: Retrocession program counterparty credit rating CY 2019

The 2019 $3.315 billion (2018: $3.065 billion) retrocession program was placed in four layers in excess of $285 million (2018: $285 million). Losses in excess of the retrocession program are covered by the Commonwealth guarantee.

Retrocession is placed on a calendar year basis from 1 January. The retrocession premium expense incurred for the 12 months to 30 June 2019 totalled $64.8 million gross (compared with $62.4 million in 2017-18). The total retrocession commission income recognised by ARPC for 2018-19 was $5.1 million (2017-18: $6 million).

ARPC MODELLING CAPABILITIES

ARPC has access to world class modelling through its collaboration with Geoscience Australia (GA), Australia’s public-sector geoscience organisation.

Three-dimensional blast model

ARPC uses its insurer customers’ sum insured aggregate figures and building sum insured surveys in the three-dimensional (3D) blast model, developed in collaboration with GA. ARPC’s 3D blast model is intended to accurately analyse pressure waves and resulting damage from blasts in all Tier A locations.

The blast model includes the most built-up CBD areas of Sydney, Melbourne, Brisbane, Adelaide and Perth, with multi-location analysis conducted in those cities to review expected losses from different sized charges.

Plume model

ARPC, in collaboration with GA, maintains its capability to analyse exposure and potential damage from the release of a biological or chemical agent in Sydney and Melbourne CBDs. This capability draws on the expertise of several government agencies including GA, the Bureau of Meteorology, Defence Science and Technology Group and the Australian Federal Police, as well as external consultants.

ARPC regularly analyses various plume scenarios including mobile drone delivery systems of selected agents in Sydney and Melbourne.

GA forms an integral part of ARPC’s blast and plume analytical capability. ARPC has entered a three-year maintenance and development program for 2018-21 to keep both models current and fulfil ARPC’s needs.

Geospatial model

During 2018-19, ARPC has been working with Risk Frontiers on a two-dimensional (2D) blast model that will cover all mainland locations in Australia. This geospatial model is based on the original 2D blast model developed by Risk Frontiers in 2007 and is due for completion in late 2019.

Exposure risk management

A key Australian Government expectation is that ARPC will be able to advise the responsible Minister of the estimated insured losses (under the Scheme) in the event of a DTI. This estimate will be used to inform the calculation of an appropriate reduction percentage.

To address this issue, ARPC implemented a strategy to develop its capability to:

• analyse aggregate sum insured information;
• estimate its probable losses in the event of a DTI; and
• provide evidence-based advice to the responsible Minister on an appropriate reduction percentage.

GLOBAL TERRORISM REINSURANCE POOLS

Many foreign governments and insurance markets have introduced insurance pools with government participation. Some were created in response to the events of 9/11, while others were established in response to specific terrorist or war threats within each country.

Terrorism insurance pools are the global standard approach to providing cost effective reinsurance for terrorism catastrophe. There are 23 pools around the world offering similar arrangements. Figure 2.6 lists the international terrorism insurance pools in place today.

INSURER CUSTOMER REVIEW PROGRAM

ARPC undertakes insurer customer reviews on a regular basis. These reviews verify that insurer customers are meeting their obligations under ARPC’s reinsurance agreement. The following table details the number of reviews conducted over the past four years.

Insurer customers review trends

Most insurer customers were found to have high levels of compliance. ARPC has observed and addressed the following items in some reviews:

• out of date postcode tables;
• back-calculation of gross written premium (GWP);
• terrorism exclusion clauses that are ambiguous or which could have unintended consequences;
• incorrectly considering insurance contracts which contain a terrorism sub-limit to be ineligible under the TI Act;
• not recognising pollution and contamination exclusions as terrorism exclusion clauses for the purposes of the TI Act;
• incorrect calculation of premium that contain broker commission which results in over or under payment of premium;
• incorrect calculation on premium that contains Withholding Tax (WHT) resulting in over or under payment of premium;
• staff turnover within the insurer customer, leading to a lack of understanding of ARPC processes.

ARPC is committed to working with insurer customers to reduce the incidence of these issues.

STATISTICS

Active insurer customers’ reinsurance agreements

ARPC’s active reinsurance agreements (or treaties) with insurer customers decreased to 220 in 2018-19, compared to 235 in 2017-18.

The percentage split between each of the categories is illustrated in Figure 2.8 below:

Figure 2.8: Active client reinsurance agreements*

The Gross Written Premium (GWP) trend reported by insurer customers is measured by insurer customer type, premium by tier, premium by state and premium by business class. Figure 2.9 illustrates the GWP by insurer customer type.

Figure 2.9: ARPC gross written premium by insurer customer type
The following tables show that GWP by tier, state and business class (between 2014 and 2019) has remained stable, with most exposure observed in Tier B, followed by Tier C.

Insurance premium report

Figure 2.13 shows that the annual change in ARPC premium revenue is directly related to the change in insurer customer GWP and is linked to the aggregate sum insured. The overall growth is indicative of the market change in premiums for commercial risks over time, while the increase in premium as a percentage of insurer customer GWP shows the impact of the rate change implemented by Ministerial Direction in early 2016.

Figure 2.14 shows the breakdown of premium income and sum insured by tier, indicating that ARPC’s exposure is mostly located within Tier B, closely followed by Tier C. This is consistent with ARPC’s portfolio being mainly ‘business package’ risks located in suburban areas followed by ISR policies in rural areas.

Figure 2.15 indicates that the vast majority of ARPC’s exposure is in New South Wales, Victoria and Queensland. Much of the premium income is derived from NSW, followed by Victoria, owing to the higher volume of risks located in Tier B.

Aggregate sum insured reports

ARPC’s reinsurance agreement requires each insurer customer to provide an annual aggregate sum insured report by 31 August each year. The report summarises the aggregate sums insured amounts at postcode level for all postcodes and at street address level for the five main central business district Tier A locations as at 30 June. The information is uploaded by insurer customers directly into ARPC’s RISe system, which enables ARPC to analyse the distribution of exposure risk across Australia. The analysis includes the ability to report aggregate sum insured exposures.

Figure 2.16, 2.17 and 2.18 provide an overview of ARPC’s total exposure based on information provided by insurer customers as at 30 June 2018.

Figure 2.17: Percentage of aggregate sum insured held by tier 2017-2018

Figure 2.19: Percentage of aggregate sum insured by state 2017-2018

The exposure report by state allows ARPC to identify the correlation between state exposures and collected premiums and the relative size of assets in each state.

2018 TRIENNIAL REVIEW

Given global market uncertainty at the time of ARPC’s establishment, a requirement was written into the TI Act that the Minister provide a report every three years reviewing the need for the TI Act to continue. Under the terms of reference for each review, the Treasury was to seek submissions from, and consult widely with, ARPC’s key stakeholders.

To date, there have been five reviews undertaken and published, each examining the operation of the TI Act in the context of contemporary market trends and how governments of other countries have responded to this market failure.

In December 2018, the Treasury published the 2018 Triennial Review. The review made the following recommendations and findings:

• That the Act remains in force.
• That ARPC pay an additional temporary dividend of $10 million a year for three years commencing in 2018-19 and terminating in 2020-21, with the Government to consider the appropriate level of payments when this dividend ceases.
• The current structure of pricing for the range of risks currently covered by the Act and the approach to declaring a terrorism incident remains appropriate.
• Cyber terrorism is an emerging risk and there is yet to be a clear and evident market failure in relation to physical property damage from cyber terrorism requiring government intervention through the Act at this time.
• Coverage is broad for domestic terrorism causing death or serious injury to Australians. There is an array of government schemes under which they could claim some form of compensation or funding, depending on their circumstances. There are also widely available insurance products that do not contain exclusions for terrorism incidents.