FINANCE AND TERRORISM RISK

TERRORISM RISK THREAT TO LENDERS 
The building finance community 
distinguishes between two major areas of 
lending activity: single-family residential and 
commercial/multifam-ily. The residential 
sector is less affected by terrorism risk 
considerations. However, since the WTC 
attack federal officials have issued specific 
warnings for elevated terrorism risk in 
shopping malls, banks, and multifamily 
housing. 
Building Finance Community 
While many owners are unwilling to make the extra 
expenditure now required for terrorism risk insurance, 
lenders prefer to require adequate cover for all relevant 
perils. To date, apartment lenders have taken the most 
relaxed view because it is most difficult for apartment 
owners to pass through the added insurance costs to 
tenants. Exposed owners might perceive risk, but most 
owners do not voluntarily want to pay for the insurance. 
Commercial building owners and lenders take a stricter 
view. They issue temporary waivers, but require insurance 
when loan balances are over a certain threshold (e.g., $10 
million) and for trophy properties or properties that are 
identified as having higher risk due to location, building 
tenant, or historic/national recognition. 
Each sector consists of its own array of financial interests: 
. _ Loan originators 
. _ Loan servicers 
. _ Secondary markets 
. _ Bond markets 

The commercial/multifamily sector includes: loan 
originators, loan servicers, life insurance companies, 
pension funds, the multifamily secondary market (Fannie 
Mae and Freddie Mac), Wall Street, and financial 
institutions as direct lenders. 
Lenders Concerns 
Building lenders and loan servicers are concerned about the adequacy of property 
insurance to cover potential loss of the asset and the potential default of the borrower. 
Lenders are also concerned with other types of insuranceÑworkersÕ compensation, 
liability, and business interruptionÑas they relate to the solvency of the borrower. 
Both assets and borrower solvency are threatened by terrorism risk. The terrorist acts 
of September 11, 2001 resulted in pervasive uncertainty in the insurance markets 
regarding insurance associated with future terrorist attacks. The commercial/multi-
family real estate industry is very concerned about the availability of terrorism risk 
coverage as it relates to the asset value and financial health of borrowers. The 
Terrorism Risk Insurance Act of 2002 ensures the current availability of basic 
terrorism insurance, but significant questions remain as to the comprehensiveness of 
the coverage and whether a viable terrorism insurance market will develop in the 
future. 
Terrorism Impact 
The potential impact of terrorism risk for the real estate finance industry lies in six 
key areas: 
Loss of asset (collateral). The traditional approach to asset risk on the part of lenders 
is to require the borrower to purchase adequate insurance cover for all relevant 
perils. The terrorism risk exclusions following the WTC attack presented a major 
problem for lenders. Their profit is based on extending more loans but without 
insurance cover new loans also expand their credit risk. 
Default of borrower. The primary concern of the lender is the ability of the borrower 
to meet the conditions of the loan. Protection of the underlying asset is of key 
importance to maintaining the business operation of the borrower in addition to 
providing collateral for the loan. Terrorism risk includes modes of attack that will 
directly damage the building such as bomb blast and arson as well as those that may 
not physically damage the building such as biological, chemical, or radiological attack. 
Such Ônon-
FINANCE AND TERRORISM RISK

buildingÕ threats can destroy the borrowers ability to pay and can deny access to the 
asset for extended periods of time. Even without physical damage, asset value can be 
destroyed. 
Rating of securities. In the case of mortgage backed securities for both residential and 
commercial real estate the value of the security is influenced by the evaluation of 
rating agencies. These ratings take into account a range of risks, which will necessarily 
include terrorism risk. The exposure of the underlying assets to terrorist attack and 
the extent of related insurance coverage will influence securities ratings. Perception of 
portfolio risk affects rating of securities: securities based on a single asset in a "high 
risk" location will receive a lower rating. Securities based on multiple or dispersed 
assets are generally less negatively affected by terrorism risk. Aside from New York City 
and Washington DC, the cities of greatest concern for terrorism are Los Angeles, Se-
attle, Chicago, Houston, and Atlanta. 
Retained risk. In the aftermath of the WTC attack and the terrorism risk exclusions, 
many lenders chose to temporarily waive insurance requirements. This action was 
deemed necessary to continue real estate financing and to foster new construction in 
the economy. However, waiving the terrorism insurance requirement left the lenders 
exposed to an as yet undefined risk. Lenders have traditionally relied on the insurance 
industry to price and provide coverage for such risks. In this case the lack of consensus 
on terrorism risk pricing and the withdrawal of the reinsurance industry have left 
lenders in an awkward position. Even with TRIA, lenders remain concerned with risks 
related to domestic terrorism, attacks involving chemical, biological, or radiological 
materials and the designation of terrorism events by the Secretary of the Treasury. 
Cost of capital. One approach to dealing with increased risk has been to "cover" the 
risk with increased interest rates. This increase in the cost of capital is not desirable 
because it impacts the volume of lending and who receives a loan if terrorism is not 
covered or the cost is prohibitive. 
Regulation. Financial institutions and lending institutions are subject to regulation 
regarding standards for lending and management of risk, including terrorism risk. 
Banks and financial institutions must meet the regulatory standards of the Comptrol-
ler of the Currency and the Securities and Exchange Commission.


CURRENT FINANCE SITUATION 
Following the WTC attack and the withdrawal of the insurance industry from provision 
of terrorism risk cover, real estate finance institutions faced a serious dilemma. In the 
absence of available or reasonably priced reinsurance, investments and lending in 
major projects (those over $30 Ð $50 million) were delayed in what were believed to be 
the primary target cities of New York and Washington. Difficulty in acquiring 
insurance for recognized trophy buildings also impacted refinancing in some cases. 
The key concern for lenders is borrower insurance coverage, so they also have a keen 
interest in the TRIA. The continued health of the real estate sector of the economy 
requires adequate and affordable property and liability insurance coverage against ter-
rorism risk. The enactment of TRIA is an important milestone for the real estate 
finance industry because it ensures the availability of basic insurance coverage. 
However, the real estate finance industry has several serious concerns with the federal 
program created under the statute: 
. _	Acts of domestic terrorism are not covered. 
. _	It is not clear whether or how carriers will cover terrorist acts with 
aggregate losses below $5 million that are not reinsured under TRIA. 
. _	Carriers are not required to notify lenders if a borrower rejects coverage 
under TRIA, either by affirmative statement or by failing to pay any premium for such 
coverage imposed by the carrier. 

FINANCE AND TERRORISM RISK

_	Carriers are not required to offer terrorism coverage for nuclear, chemical or 
biological attacks if they do not typically offer property and liability insurance for 
nuclear, chemical and biological perils. 
Following TRIA, lenders have many borrowers out of compliance with loan insurance 
requirements. Lender and servicer procedures vary. Some large servicers have 
instituted a requirement for mandatory terrorism risk coverage. 
Following TRIA there have been limited reports of substantial premium increases, 
particularly in Manhattan and Washington DC. For the most part post-TRIA rate 
increases for required terrorism risk coverage have been in the 0% Ð 10% range, but 
some have been much higher. 
The terrorist threat is a dynamic phenomenon. Government and commercial 
response to the threat is also dynamic in ways independent of the underlying 
phenomenon. For these reasons change is inevitable. More experience is needed to 
understand the nature of the threat and more time is needed to understand the 
implications of market and policy responses to the threat. 
Key real estate finance industry associations suggest that several factors must be 
monitored over time: 
. _	The Department of the Treasury rule-making process for TRIA relating 
to the acceptance and rejection of terrorism risk insurance by owners, and the 
availability of insurance for acts of terrorism not covered by TRIA. 
. _	The declining financial strength ratings for some insurers
that have produced difficulties for borrowers in obtaining
coverage that complies with underlying loan documents.

. _	The development of a useable insurance certificate that provides an 
accurate and comprehensive summary for lenders and servicers of the coverage 
afforded by the underlying insurance policy. 

What happens after TRIA? It is important to see if the insurance market for terrorism 
risk cover does in fact stabilize over the three year period stipulated in the Act. If the 
market does not find an acceptable means to price terrorism risk there may need to 
be a longer term federal role in this area.


LENDER RISK MANAGEMENT MODELS 
As mentioned above the traditional practice of lenders has been to rely on required 
insurance purchase by borrowers of adequate cover for relevant perils. The 
breakdowns in terrorism insurance availability and risk pricing by insurers have 
necessitated the temporary intervention of the federal government pending the 
stabilization of the insurance market. Lenders are dependent on the insurance 
industry to transfer terrorism risk. In lieu of an insurance solution the real estate 
finance industry will have to consider alternative approaches to terrorism risk 
management. These may include addressing questions of risk identification and risk 
reduction directly. Tools for the assessment of terrorism vulnerability of specific 
buildings may be developed and introduced into the standard process of due 
diligence and property condition assessment, as discussed further in Chapter 5. 
Each sector of the real estate finance industry (originators, servicers, secondary 
markets, and bond markets) may assess its exposure to terrorism risk in a particular 
way. Useful analogies may be found in considering how these sectors address other 
building risks, such as natural disasters and environmental hazards. 
Each sector of the real estate finance industry should also consider terrorism risk in 
relation to the risks traditionally covered by the various lines of insurance. 
As standards for building siting, construction, and property management are 
developed to address terrorism risk reduction, it will become possible for both 
insurers and lenders to rate buildings in terms or their exposure to terrorism. 
FINANCE AND TERRORISM RISK


FUTURE DEVELOPMENTS 
The real estate finance industry needs tools for the evaluation of building vulnerability 
and for the evaluation of physical and operational measures for risk reduction. These 
include: 
. _	Rapid screening methods for the evaluation of portfolios of properties 
. _	Detailed guidelines for due diligence on individual buildings 
. _	Legally accepted standards for risk reduction measures and 
management practices related to terrorism risk