The Terrorism Risk Insurance Act which finally won passage through the US Senate last week has been criticised by ratings agency Standard & Poor’s for increasing the risks faced by insurance companies and casting a shadow on future industry ratings.

S&P’s said the law creates “pitfalls and grey areas” for insurers and this could see the negative outlook on the industry worsen.

Since the September 11 terrorist attacks, insurers have been largely avoiding providing terrorism cover. The new legislation effectively forces them to offer terrorism insurance, with some Federal Government backing.

S&P’s insurance ratings managing director Steven Dreyer said in New York that the legislation “amounts to a command from government” for insurers to get back into the pool of terror risk. He said this will create problems for insurers, who aren’t experienced in managing such risks.

“Compared to where they were, which was on dry land, the risk profile has to be worse with them in the water,” he said. “Although the legislation does much to ease anxiety among the insurance community, it cannot cure ignorance.

“Insurers do not know how to price terror risk and could use Government backing as a crutch for taking on exposure irresponsibly. Moreover, if insurers are pricing something they do not understand, they will tend to undercut each other.”

Mr Dreyer also criticised the terrorism pricing models as being “wildly exaggerated” and “bathed in an aura of invincibility. They are at best a blunt instrument that could nevertheless lull insurers into a false sense of security.”

He also noted that insurer deductibles under the law are calculated as a percentage of gross premiums, but companies that rely heavily on reinsurance base their capital on net premiums. This means companies get a much smaller number in deductibles and their liability under the law could represent an extremely large proportion of their capital.

The law also prohibits the use of public funds to cover any payments that insurers must make to reimburse punitive damages against their clients. However, it does not outlaw punitive damages altogether. “Insurers will therefore be entirely on the hook for these payouts, even though trial proceedings will be limited to federal court, where judgments tend to be smaller than in state courts,” Mr Dreyer said.

He also questioned how long it would take for the Government to reimburse insurers for their payouts. “Any delay could cause a devastating liquidity shortfall and threaten the solvency of some players.”