    [House Hearing, 107 Congress]
    [From the U.S. Government Publishing Office]

                       CATASTROPHE BONDS: SPREADING RISK
    =======================================================================

                                    HEARING

                                   BEFORE THE

                                SUBCOMMITTEE ON
                          OVERSIGHT AND INVESTIGATIONS

                                     OF THE

                        COMMITTEE ON FINANCIAL SERVICES

                         U.S. HOUSE OF REPRESENTATIVES

                          ONE HUNDRED SEVENTH CONGRESS

                                 SECOND SESSION

                                   __________

                                OCTOBER 8, 2002

                                   __________

           Printed for the use of the Committee on Financial Services

                               Serial No. 107-86

                               U.S. GOVERNMENT PRINTING OFFICE
    84-418                         WASHINGTON : 2002
    ___________________________________________________________________________
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                     HOUSE COMMITTEE ON FINANCIAL SERVICES

                        MICHAEL G. OXLEY, Ohio, Chairman

    JAMES A. LEACH, Iowa                 JOHN J. LaFALCE, New York
    MARGE ROUKEMA, New Jersey, Vice      BARNEY FRANK, Massachusetts
        Chair                            PAUL E. KANJORSKI, Pennsylvania
    DOUG BEREUTER, Nebraska              MAXINE WATERS, California
    RICHARD H. BAKER, Louisiana          CAROLYN B. MALONEY, New York
    SPENCER BACHUS, Alabama              LUIS V. GUTIERREZ, Illinois
    MICHAEL N. CASTLE, Delaware          NYDIA M. VELAZQUEZ, New York
    PETER T. KING, New York              MELVIN L. WATT, North Carolina
    EDWARD R. ROYCE, California          GARY L. ACKERMAN, New York
    FRANK D. LUCAS, Oklahoma             KEN BENTSEN, Texas
    ROBERT W. NEY, Texas                 JAMES H. MALONEY, Connecticut
    BOB BARR, Georgia                    DARLENE HOOLEY, Oregon
    SUE W. KELLY, New York               JULIA CARSON, Indiana
    RON PAUL, Texas                      BRAD SHERMAN, California
    PAUL E. GILLMOR, Ohio                MAX SANDLIN, Texas
    CHRISTOPHER COX, California          GREGORY W. MEEKS, New York
    DAVE WELDON, Florida                 BARBARA LEE, California
    JIM RYUN, Kansas                     FRANK MASCARA, Pennsylvania
    BOB RILEY, Alabama                   JAY INSLEE, Washington
    STEVEN C. LaTOURETTE, Ohio           JANICE D. SCHAKOWSKY, Illinois
    DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
    WALTER B. JONES, North Carolina      CHARLES A. GONZALEZ, Texas
    DOUG OSE, California                 STEPHANIE TUBBS JONES, Ohio
    JUDY BIGGERT, Illinois               MICHAEL E. CAPUANO, Massachusetts
    MARK GREEN, Wisconsin                HAROLD E. FORD Jr., Tennessee
    PATRICK J. TOOMEY, Pennsylvania      RUBEN HINOJOSA, Texas
    CHRISTOPHER SHAYS, Connecticut       KEN LUCAS, Kentucky
    JOHN B. SHADEGG, Arizona             RONNIE SHOWS, Mississippi
    VITO FOSSELLA, New York              JOSEPH CROWLEY, New York
    GARY G. MILLER, California           WILLIAM LACY CLAY, Missouri
    ERIC CANTOR, Virginia                STEVE ISRAEL, New York
    FELIX J. GRUCCI, Jr., New York       MIKE ROSS, Arizona
    MELISSA A. HART, Pennsylvania
    SHELLEY MOORE CAPITO, West Virginia  BERNARD SANDERS, Vermont
    MIKE FERGUSON, New Jersey
    MIKE ROGERS, Michigan
    PATRICK J. TIBERI, Ohio

                 Terry Haines, Chief Counsel and Staff Director
                                     ------

                  Subcommittee on Oversight and Investigations

                         SUE W. KELLY, New York, Chair

    RON PAUL, Ohio, Vice Chairman        LUIS V. GUTIERREZ, Illinois
    PETER T. KING, New York              KEN BENTSEN, Texas
    ROBERT W. NEY, Texas                 JAY INSLEE, Washington
    CHRISTOPHER COX, California          JANICE D. SCHAKOWSKY, Illinois
    DAVE WELDON, Florida                 DENNIS MOORE, Kansas
    WALTER B. JONES, North Carolina      MICHAEL CAPUANO, Massachusetts
    JOHN B. SHADEGG, Arizona             RONNIE SHOWS, Mississippi
    VITO FOSSELLA, New York              JOSEPH CROWLEY, New York
    ERIC CANTOR, Virginia                WILLIAM LACY CLAY, Missouri
    PATRICK J. TIBERI, Ohio

                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on:
        October 8, 2002..............................................     1
    Appendix:
        October 8, 2002..............................................    29

                                   WITNESSES
                            Tuesday, October 8, 2002

    Brynjolfsson, John, Executive Vice President, PIMCO..............    16
    D'Agostino, Davi M., Director, Financial Markets and Community
      Investment, General Accounting Office (GAO) accompanied by Bill
      Shear..........................................................     4
    McGhee, Christopher M., Managing Director, Marsh & McLennan
      Securities Corporation on behalf of the Bond Market Association    14
    Moriarty, Michael, Director, Capital Markets Bureau, New York
      Department of Insurance on behalf of the National Association
      of Insurance Commissioners.....................................     6
    Ozizmir, Dan, Senior Managing Director and Head of Trading, Swiss
      Re Financial Products..........................................    18

                                    APPENDIX

    Prepared statements:
        Kelly, Hon. Sue W............................................    30
        Oxley, Hon. Michael G........................................    32
        Brynjolfsson, John...........................................    33
        D'Agostino, Davi M...........................................    56
        McGhee, Christopher M........................................    64
        Moriarty, Michael (with attachments).........................    72
        Ozizmir, Dan.................................................   215

                  Additional Material Submitted for the Record

    ``Catastrophe Insurance Risks'' The Role of Risk-Linked
      Securities and Factors Affecting Their Use, General Accounting
      Office Report..................................................   219

                       CATASTROPHE BONDS: SPREADING RISK

                                  ----------

                            Tuesday, October 8, 2002

                 U.S. House of Representatives,
           Subcommittee on Oversight and Investigation,
                               Committee on Financial Services,
                                                       Washington, D.C.
        The subcommittee met, pursuant to call, at 2:08 p.m., in
    Room 2128, Rayburn House Office Building, Hon. Sue Kelly
    [chairman of the subcommittee] presiding.
        Present: Representatives Weldon, Tiberi, and Inslee.
        Chairwoman Kelly. [Presiding.] Good afternoon. In the
    interest of time, I am going to go ahead and start this
    hearing. I understand there are other members that are on their
    way down, but I am going to go ahead and start because you have
    all come--a few from some distance, and I want to be able to
    get you fully heard before we end this hearing. So this hearing
    of the Financial Services Committee, Subcommittee on Oversight
    and Investigations will come to order. I want to thank all
    members of Congress who will be coming today. Without
    objection, all members present will participate fully in the
    hearing and all opening statements and questions will be made
    part of the official hearing record. The chair recognizes her
    self for a brief opening statement.
        Let me first say welcome to what will likely be the last
    hearing of the Financial Services Committee for the 107th
    Congress. It would be an understatement to say that this
    committee has been busy. I know our staff agrees, and I want to
    take this opportunity to publicly thank the remarkable and very
    professional staff of the Financial Services Committee for
    their work this year.
        They have done yeoman's work and we all appreciate it. The
    topic of discussion today is a new slant on an old problem. We
    only have to go back one Congress in the old banking committee
    to recall the numerous hours spent debating the creation of
    insurance capacity for disaster-prone areas. Individuals can
    disagree about the nature of the solution.
        The fact still remains that increasing capacity in our
    insurance markets is incredibly important. Whether you are a
    disaster-prone state like Florida or California, or from a
    state like mine, New York, with terrorist-targeted properties,
    it remains to be seen how much in the way of accumulated losses
    the private insurance and reinsurance market can absorb before
    the entire market is put at risk. As we see today, large
    insurers and reinsurers are being downgraded by rating agencies
    and markets continue to harden. When we last looked at the
    issue of natural disaster exposures, there was mention made of
    using the capital markets perhaps as a way to spread risk
    beyond the traditional insurance markets.
        Let me quote from 1999 testimony in front of this
    committee. "The potential capacity from the capital markets
    should not be ignored or underestimated during consideration of
    what was then Rick Lazio's federal disaster reinsurance bill.
    While still in its infancy, a lot of resources are being
    directed by capital markets intermediaries to encourage the
    development of the market." And further testimony stated, "The
    development of this risk-linked securities market would
    revolutionize catastrophe insurance funding and greatly expand
    the capacity of the U.S. insurance market."
        In other words, the private capital markets made sense then
    and probably make even more sense now. Last year, Chairman
    Oxley requested the General Accounting Office to look at the
    use of catastrophe bonds and their track record to date. Some
    in the private sector suggested that what was once counted as
    the next big financing instrument never really took off in the
    market as anticipated. The committee asked the GAO to find out
    why exactly that was. Specifically, the committee inquired, if
    it was a structural problem, meaning these instruments are too
    complicated or produce prohibitive transaction costs, or if it
    was because the market did not understand how to evaluate their
    underlying risk, or if it was because the traditional insurance
    market was soft and there was not a demonstrated need for new
    sources of capital.
        GAO appears before us today to discuss its findings, with
    an emphasis on the barriers and hurdles these instruments face.
    The team that put this report together is to be commended for
    their work in taking such a complicated topic and really
    boiling it down into its essential nuts and bolts. The
    committee greatly appreciates the GAO's work in this area and
    its cooperation with our committee staff in drawing its
    conclusions. Before I close, let me quickly make two points.
    The first is that this committee is looking to facilitate
    capacity creation in the insurance marketplace. In this case,
    we are examining catastrophe bonds. This is not to suggest that
    a booming market for these bonds should replace or be an
    alternative to traditional insurance financing such as risk-
    spreading by way of reinsurance.
        Second, in no way should anyone leave this room thinking
    the Financial Services Committee is creating a new class of
    government bond or government-backed security. This committee
    is simply looking at ways to possibly remove barriers that will
    bring about greater acceptance of an instrument that already
    exists in the marketplace today.
        With that, the chair will recognize the gentleman from
    Florida, my very good friend, Congressman Weldon. Congressman
    Weldon, have you an opening statement?
        [The prepared statement of Hon. Sue W. Kelly can be found
    on page 30 in the appendix.]
        Dr. Weldon. Yes, Madam Chairman. I apologize for being
    slightly late, Madam Chairman. I want to commend you for
    calling this hearing on a very important issue, not just for my
    congressional district in the State of Florida, but as well for
    the nation, and focusing the attention of the committee on the
    risks of catastrophic events. My state of Florida is wrestling
    with this very issue as it braces itself for the kinds of
    storms that just hit Louisiana.
        As is mentioned in the GAO study released today, the
    adequacy of the insurance industry's capacity to cover large
    catastrophes is a difficult question to answer. As you know, I
    have introduced legislation that addresses this capacity
    question by establishing the federal government as the insurer
    of last resort for mega-catastrophic events. The state of
    Florida experiences significant exposure to catastrophic
    events, yet people continue to relocate there, making it one of
    the fastest growing states in the country. Florida is also
    beset by litigation exposure, the complications of legislative
    and regulatory efforts and other factors such as sinkholes and
    mold.
        Whether capital markets can enhance the capacity of an
    industry affected by so many forces remains to be seen. Who
    must act to stimulate the trading of risk-linked securities.
    Can they generate the kind of resources necessary that would
    motivate both primary insurers and reinsurers to confidently
    write more policies in Florida? Earlier this year, Chairwoman
    Kelly convened a hearing looking at the risks associated by not
    passing federal terrorism insurance legislation. During that
    hearing, Alice Schroeder, senior U.S. non-life equity insurance
    analyst for Morgan Stanley, stated that, quote, "Insurance
    companies generally destroy, rather than create, value for
    their shareholders." I look forward to hearing from today's
    witnesses how risk-linked securities may overcome this dynamic,
    and I again thank you for calling this hearing.
        I yield back.
        Chairwoman Kelly. Thank you very much, Dr. Weldon.
        Since there are no more opening statements, we will begin
    with the witnesses on our first panel. Presenting the GAO
    report is Ms. Davi D'Agostino, the director of financial
    markets and community investment division from the General
    Accounting Office. Accompanying her is Mr. Bill Shear, also
    from the same division. Next we will turn to the first of our
    two witnesses from the great state of New York, and I would
    like to welcome Mr. Michael Moriarty who is the director of the
    capital market bureau for the New York Department of Insurance.
    Mr. Moriarty appears on behalf of the National Association of
    Insurance Commissioners and serves as the vice chair of the
    NAIC securitization committee.
        We thank you for joining us today to share your expertise
    on these issues. Without objection, your written statements
    will be made part of the record. Ms. D'Agostino has agreed that
    GAO will be given an extended period for its oral testimony,
    given the presentment of the report. All of our other witnesses
    will be recognized for a five minute summary of their
    testimony, and if you have not testified here before, at the
    end of the table there is a box that has different colored
    lights in it. Red lights mean stop; yellow light means you have
    one minute to sum up; and a green light obviously means go.
        With that, we turn to you, Ms. D'Agostino, and we greatly
    appreciate your presence here today.

     STATEMENT OF DAVI D'AGOSTINO, DIRECTOR, FINANCIAL MARKETS AND
            COMMUNITY INVESTMENT, GENERAL ACCOUNTING OFFICE

        Ms. D'Agostino. Thank you very much, Madam Chairwoman.
    Madam Chairwoman and members of the subcommittee, I am pleased
    to be here today before you to discuss our work on how risk-
    linked securities are used to address catastrophic risks.
        These risks arise from natural events such as hurricanes
    and earthquakes. Population growth, real estate development and
    rising real estate values in hazard-prone areas increasingly
    expose the nation to higher losses from natural disasters than
    in the past. More than 68 million Americans live in hurricane-
    vulnerable coastal areas and 80 percent of Californians live
    near active earthquake faults. A series of natural disasters in
    the 1990s, including Hurricane Andrew and the Northridge
    earthquake raised questions about the financial capacity of the
    insurance industry to cover large disasters--these are
    important words-- without limiting coverage or substantially
    raising premiums.
        They also called attention to ways of raising additional
    sources of capital to help cover catastrophic risk. The
    insurance industry and capital markets developed risk-linked
    securities which both supplement the insurance industry's
    capacity and do provide an alternative to traditional property
    casualty reinsurance, which is insurance for insurers. Today, I
    will talk about one, how the insurance and capital markets
    provide coverage for catastrophic risk; two, how risk-linked
    securities, specifically catastrophe bonds, are structured and
    how they work; and three, how regulatory, accounting, tax and
    investor issues might affect the use of these securities and
    the advantages and disadvantages of potential changes.
        First, catastrophe risk is a global phenomenon, and
    insurance and reinsurance companies with global operations
    often provide coverage. The color map before you on the screen,
    as well as in our report, highlights the areas of the United
    States that are most likely to experience certain types of
    natural catastrophes. Most insurance companies try to limit the
    amount and type of catastrophe risk they hold on their books.
        For example, if property casualty insurers have written too
    many policies concentrated in California or Florida, they need
    ways to diversify and transfer that risk. One way is through
    reinsurance, where for all or part of the premiums collected,
    the reinsurer agrees to compensate all or part of an insurer's
    claims as they are incurred. When reinsurance prices or
    availability became problematic in the mid-1990s, insurers
    turned to risk-linked securities as an alternative way to
    spread catastrophe risk. Now, I will turn to the second area of
    my statement, which is how risk-linked securities are
    structured and how they actually work.
        If you turn to page three of the written statement, you
    will see a graphic that will help you walk through how they are
    set up, at least in basic terms. Most risk-linked securities
    are catastrophe bonds these days, and they have complicated
    structures, as you can see, that are created off-shore. And
    they are created through special purpose entities which
    generally receive non-investment grade ratings. To develop a
    catastrophe bond, a sponsor, which is usually an insurance or
    reinsurance company, creates a special purpose reinsurance
    vehicle or an SPRV, which you will see in the graphic before
    you, to provide reinsurance to the sponsor and to issue bonds
    to the securities market. SPRVs, which are typically located
    off-shore for tax and other advantages, receive payments in the
    form of insurance premiums, interest, and investor principal;
    invest in Treasury and other highly rated securities; and pay
    out to the investors in the form of interest.
        The reinsurance provided to the sponsor through catastrophe
    bonds is different from that provided through traditional
    reinsurance contracts. Most of the recently issued catastrophe
    bonds are non-indemnity based. This means that they are
    structured to make payments to the sponsor upon the verified
    occurrence of specified catastrophic events. The payments are
    also based on pre-agreed financial formulas. The payments from
    the investor's principal to the insurer/sponsor are not
    directly related to the insurer's actual claims, and they are
    triggered by an event that meets an objective index or measure
    such as wind speed in the case of a hurricane. In this way, the
    investors avoid exposure to the risk that the sponsor or
    primary insurer has poor underwriting or claims settlement
    practices.
        This very point is important to understanding some of the
    issues that were identified by industry observers to us and the
    third area of my testimony, the regulatory, accounting, tax and
    other investor issues that challenge catastrophe bonds.
    Accounting treatment for risk transfers occurring through non-
    indemnity-based catastrophe bonds is a challenge for
    regulators. With traditional indemnity-based reinsurance, an
    insurer gets credit for reinsurance on its balance sheet in the
    form of a deduction from liability for the risk transferred to
    the reinsurer, and can reduce the amount of regulatory risk-
    based capital required. Credit for reinsurance is designed to
    ensure that a true transfer of risk has occurred, and that any
    recoveries from reinsurance are collectible.
        Calculating the credit with indemnity-based coverage is
    fairly straightforward. In contrast, it is very complicated to
    value the true amount of risk transferred to determine credit
    for reinsurance with nonindemnity-based coverage. The National
    Association of Insurance Commissioners is considering revising
    accounting treatment to accurately calculate and recognize
    nonindemnity-based reinsurance.
        While these changes could facilitate the use of catastrophe
    bonds, it is very important that the credit accurately reflect
    the true risk transferred. Another development that could
    affect the use of catastrophe is a proposed change being
    considered by the Financial Accounting Standards Board to
    address consolidation of certain special purpose entities on a
    sponsor's balance sheet. The proposed guidance may increase the
    outside equity capital investment required and add other tests
    for a sponsor to treat an SPRV as ``off balance sheet''.
        While the proposed guidance is intended to improve
    financial transparency in capital markets and to stem potential
    abuses of special purpose entities, it could also increase the
    cost of issuing catastrophe bonds. We also explored some of the
    tax issues raised by industry representatives. These
    representatives are considering a legislative proposal that
    would encourage domestic issuance of catastrophe bonds by
    eliminating U.S. taxation of the SPRV. If special tax treatment
    were legislated, expanded use of catastrophe bonds might occur.
        On the other hand, under certain conditions, the federal
    government could experience tax revenue losses and other
    industry sectors might pressure the government for similar tax
    treatment. Also, some elements of the insurance industry
    believe such legislation would create an uneven playing field
    for domestic reinsurance companies.
        Finally, unlike other bonds, catastrophe bonds, most of
    which are non-investment grade, have not been sold to a wide
    range of investors. While investment fund managers we
    interviewed appreciated the diversification aspects of
    catastrophe bonds, the risks are difficult to assess and
    investors are concerned about the bonds' limited liquidity and
    track record. Madam Chairwoman, members of the subcommittee,
    that concludes my oral summary and I would be happy to answer
    questions.
        [The prepared statement of Davi D'Agostino can be found on
    page 56 in the appendix.]
        Chairwoman Kelly. Thank you very much, Ms. D'Agostino.
        Mr. Shear, do you have anything you want to add to that?
        Mr. Shear. No, I do not think so.
        Chairwoman Kelly. All right, thank you.
        Mr. Moriarty? Before you start, let me just say that we
    have for the audience facing this direction, you may not have
    seen the map that the GAO had up on the back screen. I wonder
    if we could put that map back up. I do not know how many people
    saw that. You may be interested in taking a look at that. Can
    we leave it up there for a little bit?
        Good. Thank you.
        I am sorry, Mr. Moriarty. Please go on.

       STATEMENT OF MICHAEL MORIARTY, DIRECTOR, CAPITAL MARKETS
      BUREAU, NEW YORK DEPARTMENT OF INSURANCE, ON BEHALF OF THE
            NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS

        Mr. Moriarty. Thank you, Madam Chairwoman. It is a pleasure
    to be here today to provide the subcommittee with an update on
    the state regulatory practices that deal with reinsurance and
    the related use of securities to transfer insurance risk. You
    have my written testimony, and I will try to use this allotted
    time to summarize the major points. State regulators are
    responsible for supervising activities of insurance companies
    that sell products here in the United States.
        One of our main tasks is monitoring the financial condition
    of these insurance companies to ensure that they are able to
    honor the obligations to their policyholders and to claimants.
    Insurers that write policies here in the United States for the
    public invariably transfer some of the risk written to other
    entities in the insurance marketplace, primarily via the use of
    reinsurance. Like other financial services, companies and
    insurers try to spread and diversify risk among many of the
    market participants.
        Because a primary insurer is under obligation to honor
    these direct or original insurance contracts, it is critical to
    their financial well being that reinsurers are able to
    reimburse a ceding company for losses that are incurred. Hence
    it is incumbent upon regulators to effectively supervise the
    reinsurer and any other form of risk transfer. License
    reinsurers are subject to financial regulation similar to
    direct writing insurers.
        Transactions with unlicensed reinsurers, especially those
    based abroad, are subject to regulation that focuses on
    securing collateral. A detailed explanation of the manner in
    which state regulators supervise reinsurance is included in my
    written testimony. Insurance securitization is another means to
    transfer insurance risk. Instead of transferring risk to the
    insurance marketplace, it is transferred directly to capital
    markets investors.
        The NAIC formed a working group on insurance securitization
    in 1998 to determine our regulatory response to developments in
    insurance securitization. The NAIC's position is that U.S.
    regulators should encourage the development of alternative
    sources of capacity such as insurance securitizations, provided
    adequate standards governing these transactions are applied.
    Further deliberations of the working group at the NAIC led to a
    determination that it will be preferable if insurance
    securitizations could be done here in the United States instead
    of off-shore.
        To further that position, the NAIC has adopted separate
    model acts to facilitate on-shore securitization using two
    different methods--protected cells and special purpose
    reinsurance vehicles. Under the protected cell method, a
    segregated unit of the insurance company would issue the debt
    securities. The funds taken in from the sales of these bonds
    would be kept separate from the insurer's general fund. If
    there is a loss to the insurance company or a triggering event,
    money can be kept by the insurance company. If not, it is paid
    back with interest to the bondholders.
        The second method is the establishment of a special purpose
    reinsurance vehicle. This vehicle's only purpose is to transfer
    insurance risk to the capital markets via investment
    securities.
        As Ms. D'Agostino indicated, it is our understanding that
    an impediment to the utility of both of these options here in
    the United States is tax uncertainty. Both of these methods
    depend on certain tax treatment which may require amendments to
    the tax code. The special purpose reinsurance vehicle needs a
    pass-through tax treatment. The protected cell needs to be
    recognized as part of the insurance company. The majority of
    the securitizations to date have been done off-shore. Many
    states do not have the laws to enable securitization vehicles
    and, as I indicated before, there are tax disadvantages or at
    least some uncertainty when doing these deals on-shore.
        From a regulatory perspective, doing these deals on-shore
    would provide more transparency and better oversight. Even with
    traditional catastrophe reinsurance, coverage placed with non-
    U.S. reinsurers entails a certain amount of credit risk to the
    United States ceding companies. U.S. laws require collateral,
    but only of incurred losses. The sufficiency of collateral
    provided by off-shore reinsurers can only be known for certain
    after a catastrophic loss has occurred. Credit and collateral
    risk are clearly reduced by the use of securitization since
    they are required under the model laws to be fully funded.
        Due to that security, companies that transfer risk via
    securitization now get credit on the balance sheet and income
    statement for the transfer of risk. Insurers' underwriting
    accounts, which measure the profit and loss for insurance
    transactions are adjusted accordingly for these indemnity-based
    transactions. The use of index-based triggers on non-indemnity
    transactions is more challenging. It is important that the
    basis risk in these types of transactions be measured or
    managed by the ceding company, and the NAIC is working with the
    industry on developing means to both measure and manage this
    basis risk. In conclusion, the NAIC supports creating an
    environment that facilitates a more fluid transfer of insurance
    risk to the capital markets.
        Given the amount of capital in the property and casualty
    industry, a major catastrophe or series of catastrophes could
    strain the ability of the industry to respond to its customers.
    Capital markets have the capacity and apparent willingness to
    take on insurance risk. Capital markets also have precedence in
    the securitization of other risks such as mortgages, credit
    card receivables and other types of cash flows. The
    securitization of insurance risk is not a cure-all for the
    funding of catastrophe risk. We see it as an addition, rather
    than a replacement to traditional reinsurance. We cannot gauge
    the appetite of capital markets investors for these securities.
        However, the NAIC believes it is important to enable the
    marketplace to make that determination. Other initiatives to
    address capacity needs for catastrophe and for other types of
    coverage should continue to be explored.
        This concludes my oral summary and I would be happy to
    address any questions the subcommittee may have.
        Thank you.
        [The prepared statement of Michael Moriarty can be found on
    page 72 in the appendix.]
        Chairwoman Kelly. Thank you, Mr. Moriarty. Ms. D'Agostino,
    in your report you break down the analysis of cat bonds into
    four main areas--regulatory accounting treatment,
    capitalization requirements, taxation and assessing the
    investment risk. Based on your analysis, can you rank the
    relative order of importance of these areas and offer
    recommendations to address them?
        Ms. D'Agostino. I think that it would be very difficult to
    rank them in order of importance. Some of them hinge upon each
    other and some of them are totally unrelated to each other. The
    accounting and tax treatment are mainly issues pertaining to
    whether these SPRVs come on-shore or not, and also in terms of
    the Financial Accounting Standards Board proposal, there are
    arguments that say that if the 10 percent outside equity
    capital requirement applied to these vehicles, then they would
    probably go away.
        We are not sure about that, but we know that they would
    become a lot more expensive to issue and create. One of the key
    areas I think that really has an impact, and I think some of
    the people who will talk later will talk to this even more, is
    the investor-related issues. These are relatively new
    securities instruments so they do not have a great track
    record, and people are looking for a track record. There are
    some attractive elements to the bonds, especially the fact that
    they do not correlate with other risks in a portfolio.
        At the same time, very few are issued, there is limited
    liquidity in them, and it is very difficult for people to
    evaluate the risk or get a comfort level with the risks in the
    catastrophe bonds. Further, some people who have not bought
    these--because we did try to find out from people who have not
    bought catastrophe bonds why they have not bought--and there
    were some concerns raised about their suitability for a certain
    element of investors in, say, a mutual fund--the more moderate
    income investors. I think that is a pretty important challenge
    to overcome.
        Even if you took care of some of the other issues, you
    still would have that hurdle to deal with--trying to educate
    investors and make them more comfortable with purchasing
    catastrophe bonds and finding a place in their portfolio for
    them.
        Chairwoman Kelly. Ms. D'Agostino, have you any
    recommendations for creating or helping people have some sense
    that these instruments are worthy of investment?
        Ms. D'Agostino. No, I do not. These instruments are very
    high-risk and high-return-type instruments, and they are
    noninvestment-grade bonds, not that that is a deterrent in and
    of itself, but GAO is not in the business of recommending bonds
    and the like. We do not have any recommendations for this,
    otherwise our report would have included them. I think our
    whole point of doing the work for you was to present the
    information to you and allow the policymakers to decide on
    where to go with this. We feel that we have gone as far as we
    can go in this area.
        Chairwoman Kelly. Thank you. I thought it was worth a try.
        [Laughter.]
        Mr. Moriarty, I believe that the NAIC and possibly you have
    seen a draft of this report, and I wanted to know if you would
    care to comment, either for yourself or for the NAIC?
        Mr. Moriarty. We have not reviewed it at the NAIC level, so
    I will just give you my preliminary comments, Madam Chairwoman.
    I think the GAO did a very good job in setting out the issues,
    certainly from a regulatory perspective. With respect to the
    appetite of the marketplace, the investor concerns and even the
    tax issues there are outside of the purview of insurance
    regulators. I do not mean to operate in a vacuum here, but just
    looking at the financial solvency of the ceding companies, we
    think the biggest issue is with the non-indemnity-based
    transactions, which I think the capital marketplace would buy
    more of, so to speak, than the indemnity-based. I do think,
    though, that the basis risk can be addressed.
        There are not best practices in terms of the insurance
    industry in measuring basis risk, partly because there have not
    been these transactions out there before and they have not had
    to measure it. But nonetheless, there is a great deal of talent
    in the industry in measuring and managing this risk, and we do
    think that disclosure of how companies measure basis risk when
    using these instruments can provide the regulators with a good
    basis to determine whether there has been in fact transfer of
    risk.
        But again, going back to the report, we think it does state
    all of the issues that have been out there over the past four
    or five years in an accurate manner.
        Chairwoman Kelly. Thank you very much. I am out of time.
        Dr. Weldon, any questions?
        Dr. Weldon. Yes, thank you very much, Madam Chairman.
        Ms. D'Agostino, maybe you cannot answer this, but I will
    ask it anyway, how much capacity for coverage of natural
    disasters is likely to be added through risk-linked securities
    in the near future?
        Ms. D'Agostino. We did not undertake to try to project the
    future market for risk-linked securities. They have been
    covering a growing segment of reinsurance and catastrophe
    reinsurance, but I do not think that we are in a position to--
        Dr. Weldon. I think your report, correct me if I am wrong,
    indicates it is one-half of one percent?
        Ms. D'Agostino. That is according to a Swiss Re report.
        Dr. Weldon. So you say it is growing--it went from zero to
    one-half of one percent?
        Ms. D'Agostino. Well, it is growing in real dollar terms as
    well, into the billions of dollars.
        Dr. Weldon. Is that right?
        Ms. D'Agostino. Yes. And actually catastrophe bonds have
    been written to cover Florida hurricanes as well as California
    earthquake perils.
        Dr. Weldon. Okay. Would you agree it is kind of hard to
    speculate at this time the potential performance in the future,
    even though the real dollar amounts may be growing? As a
    percentage of risk, it is still quite negligible?
        Ms. D'Agostino. It is very difficult to project, for us
    anyway.
        Dr. Weldon. You did not look at all at the rate of growth?
    Is it linear? And is it affected by economic variables at all?
        Ms. D'Agostino. Bill, do you want to take that?
        Dr. Weldon. I know we did not ask you to study all these
    things, so I am not--I am just trying to get answers to some of
    these questions.
        Mr. Shear. The growth has been relatively unlevel, and you
    would expect that because one of the major determinants is the
    price and availability of reinsurance through traditional
    reinsurers. So it has largely been dependent on certain events
    that affect the pricing of traditional reinsurance.
        Dr. Weldon. Mr. Moriarty, in your estimation are we
    currently facing a capacity crisis? You say yes, is that right?
        Mr. Moriarty. Well, I think in terms of looking at the
    availability and the affordability of reinsurance, it has
    clearly spiked in the last year or year and a half. Throughout
    the 1990s, resinsurance was by all measurements very available
    and very affordable.
        Certain events--certainly when you talk about the events of
    9-11 with respect to terrorism coverage, and the availability
    of capital in the insurance industry, it is a hard market. So
    it has become more difficult to get insurance, and one would
    think that this would be the marketplace where alternatives
    such as insurance securitization would see a spike in activity.
    Whether it is an availability and affordability crisis, at this
    point I do not think so, but again clearly it is becoming more
    difficult to get reinsurance on terms that are favorable to
    ceding companies.
        Dr. Weldon. Do either of you from GAO, Mr. Shear and Ms.
    D'Agostino want to add to that at all? Do you disagree or
    agree?
        Mr. Shear. I do not disagree that recently it appears from
    the information we analyze that there have been increases in
    prices in certain types of reinsurance, and reduced
    availability. Part of the question which again we do not want
    to forecast, is how large the response would be to catastrophe
    bonds and potentially other forms of risk-linked securities.
        Dr. Weldon. Mr. Moriarty, would you characterize the crisis
    as national or regional? Is it based on the nature of the risk?
        Mr. Moriarty. I would characterize the increasing prices
    and the increasing lack of coverage to be national.
    Anecdotally, I have heard that it is becoming more difficult in
    certain catastrophe-prone areas to secure reinsurance, but that
    is more anecdotal. But clearly, across the board the prices of
    reinsurance and the terms that ceding companies have been able
    to secure are becoming more difficult across the board.
        Dr. Weldon. And you do not see a specific impact of a
    certain kind of peril on that availability at all? It is across
    the board, nationwide, and not affected by the peril being
    insured for?
        Mr. Moriarty. On a very broad basis, I think commercial
    reinsurance is more difficult to secure, and clearly terrorism
    coverage stands by itself on the side as being very unavailable
    and very unaffordable.
        Dr. Weldon. Thank you, Madam Chairman.
        Chairwoman Kelly. Thank you, Dr. Weldon. I would like to go
    back to you, Ms. D'Agostino. The GAO's report states that SPRVs
    are typically located off-shore for tax, regulatory and legal
    advantages. Wouldn't consumers be better advantaged if we
    improved our tax and regulatory treatment and bring the SPRVs
    back into the country, both for capital investment and for
    regulatory control?
        Ms. D'Agostino. I think arguments can and have been made on
    both sides. With every action one could take to improve the
    conditions for domestic SPRVs and catastrophe bonds on-shore,
    there could be a co-related trade-off. I mean, everything
    involves trade-offs. It is really up to the Congress to weigh
    those trade-offs and decide for itself as a matter of policy
    and law which direction it wants to take.
        Chairwoman Kelly. That is a very interesting answer.
        Thank you.
        Mr. Moriarty, how soon can we expect the NAIC to revise its
    accounting treatment for risk transfer to help facilitate
    securitization of disaster risk?
        And once the NAIC adopts the changes, who has to promulgate
    the changes in order to have them be effective?
        Mr. Moriarty. I will separate that into two responses. With
    respect to the indemnity-based transactions which reimburse the
    ceding company on a dollar-for-dollar basis, the NAIC has
    already promulgated accounting standards to allow, or have
    accounting standards in place with respect to special purpose
    vehicles, to allow companies to take credit for this transfer
    of risk. With respect to the model laws that allow the
    formation of protected cells, I believe that seven states thus
    far have enacted that model. With respect to special purpose
    reinsurance vehicles, two states have adopted the model.
        The other part of the answer with respect to the non-
    indemnity-based triggers, my sense is that the NAIC would be in
    a position next year to promulgate accounting guidance with
    respect to index-based securitization transactions. Being an
    accounting standard, it need not be adopted on a state-by-state
    basis. Most state statutes adopt the NAIC codification of
    statutory accounting principles once they are adopted by the
    NAIC, although states have the option of not adopting NAIC-
    specific principles. So I think we are looking at next year to
    finalize the accounting rules with respect to nonindemnity-
    based transactions.
        Chairwoman Kelly. Thank you. Mr. Moriarty. What concerns do
    you have with the use of off-shore SPRVs? Do you share a
    similar concern with traditional reinsurance provided by off-
    shore entities?
        Mr. Moriarty. Well, the securitization deals that have been
    done off-shore have been done by a select number of either
    companies or investment banks who have been more than willing
    to share information with us. Nonetheless, the fact that they
    are done off-shore could lead to a concern for transparency
    when looking at a transaction.
        We think that there would be a lot of benefit in terms of
    sheer transparency if they were done on-shore, if they were
    subject to review by state regulators. Clearly, that would
    enhance our ability to get all the details should there be a
    concern sometime in the future. But that being said, the deals
    that have been done off-shore, they are not inherently bad.
    Just from a pure transparency viewpoint, regulators would be
    better served if they were done on-shore.
        Chairwoman Kelly. Thank you. I would like to ask you both,
    based on your discussions with private sector people, what
    segment of the market is most likely to use these risk-linked
    securities? Can you give me a reason why? I have a follow-up
    question to that, but I would like to hear your answer to this.
    Can you give me--either one of you--just please answer that one
    question. Ms. D'Agostino, do you want to start?
        Ms. D'Agostino. If you are talking about the investment
    side, it is institutional investors. Part of that is driven by
    the nature of the catastrophe bonds, and part of it is driven
    by how they are issued under a specific type of rule, 144b,
    that the SEC is in charge of. If you are talking about from the
    issuance side, mostly insurance companies and reinsurance
    companies issue them. The other interesting fact is that
    insurance companies and reinsurance companies also buy them. So
    it is just--it is an interesting area.
        We have learned a lot, and some of the things I cannot
    explain, like why a part of the industry that both buys them
    and issues them might feel uncomfortable with risk-linked
    securities coexisting in the marketplace with regular
    reinsurance.
        Chairwoman Kelly. Would transparency help? Would increased
    transparency help, as Mr. Moriarty pointed out?
        Ms. D'Agostino. I am really not sure. I think the
    transparency might make certain investors more comfortable with
    them.
        Chairwoman Kelly. Mr. Moriarty, would you like to answer
    that question? MORIARTY: Sure, Madam Chairwoman. From the
    insurance industry point of view, most of the deals done to
    date have been securitization of the very high level
    catastrophe risk, and we would see that trend continue in view
    of the apparently increasing price for reinsurance coverage as
    the return to investors in a securitization deal would better
    match the risk that they are undertaking. Again, I have heard
    from the investor's viewpoint, I think establishing those is
    correct.
        These have been big institutional investors and you will
    hear from one of them this afternoon--and there apparently is
    some attractiveness to these types of securities in terms of
    their non-correlation to the rest of their investment
    portfolio, as the happening of a catastrophe has nothing to do
    with the sliding real estate market or concerns in the equity
    of the bond market. But again, the utility of these bonds and
    these deals to date have been to provide the upper layers of
    catastrophe covers, and I would think that they would continue
    along those lines. Conceptually, I think it could cover any
    high level type of risk.
        Chairwoman Kelly. Thank you. Dr. Weldon, have you another
    question?
        Dr. Weldon. I just have one or two more questions, Madam
    Chairman. For the GAO witnesses, could you expand on the fact
    that risk-linked securities are considered non-investment-
    grade, and do they help diversify a portfolio? Could these
    securities be considered a hedge to help investors reduce
    market risk? Is that the proper way to describe them? Do they
    therefore then become not an investment of first choice?
        Ms. D'Agostino. Where do we begin?
        Mr. Shear. Yes, where do we begin?
        Ms. D'Agostino. Maybe the--
        Dr. Weldon. Mr. Moriarty, you are free to comment on that.
        Mr. Shear. The noninvestment-grade bonds--as we know, there
    are fairly large transparent markets for noninvestment-grade
    bonds generally. These are different types of noninvestment-
    grade bonds. They have the advantage of not being correlated
    with other forms of credit risk. In terms of some of the
    questions with transparency, by definition a bond market is
    going to have greater transparency than the traditional
    insurance market, which is governed by private contracts.
        To some degree in terms of talking about where this could
    go and why we are so uncomfortable projecting where these would
    go, the extent to which any changes along tax or regulatory
    fronts, other types of fronts, could facilitate use of risk-
    linked securities, there are advantages to the greater
    transparency that could occur. There could be more discovery in
    the marketplace. But this could be a circular argument in the
    sense that we say there is limited liquidity which limits their
    attractiveness, yet that limited liquidity in a sense is
    searching for a larger market.
        So that becomes the big question. We are not quite sure
    what the response would be to any legislative or other changes.
    But by the same token, the hope of the market--I think you will
    hear more on that from the second panel--would be if liquidity
    could be increased, you might have greater transparency and
    perhaps a larger investment base.
        Dr. Weldon. Did you want to add to that at all, Mr.
    Moriarty, or would you rather steer away from the issue?
        Mr. Moriarty. Again, they are generally noninvestment-grade
    securities, but there are many noninvestment-grade securities
    out in the marketplace. Rating agencies review these securities
    and they assign a rating based upon the probability of default.
    These bonds have a probability of default, i.e. of a
    catastrophe happening, the same as any other noninvestment-
    grade bond. When we look at insurance company portfolios, we
    look at their credit quality; we look at diversification.
        To the extent that a life insurance company would hold a
    catastrophe bond would not alarm us any more than they would
    hold any other noninvestment-grade bond. Clearly, if they made
    up a large part of their portfolio or if they did not have the
    capital to support it, it would cause a concern. But again, I
    do not think these stand out there as a class by themselves in
    comparison to all the other noninvestment-grade-type
    securities.
        Dr. Weldon. Thank you very much, Madam Chairman.
        Chairwoman Kelly. Thank you, Dr. Weldon. If there are no
    further questions, the chair notes that some members may have
    additional questions that they may wish to submit in writing.
    Without objection, the hearing record will remain open for 30
    days for members to submit written questions to these witnesses
    and to place their responses in the record. The first panel is
    excused, with this committee's great appreciation for your
    time.
        If the second panel will take their seats at the witness
    table, I will begin the introductions. On our second panel, we
    will begin with Mr. Christopher M. McGhee, who is the managing
    director of the Marsh and McLennan Securities Corporation,
    testifying on behalf of the Bond Market Association. Next, we
    will hear from Mr. John Brynjolfsson, who is the executive vice
    president of PIMCO, the Pacific Investment Management Company,
    one of the world's largest fixed-income managers with over $270
    billion in fixed income investments.
        Finally, we will hear from Mr. Dan Ozizmir, who is the
    senior managing director of trading for the Swiss Re Financial
    Products Corporation, whose American headquarters is located in
    Armonk, New York. I want to thank you all for taking time out
    of your busy schedule, and I really appreciate the fact that
    you are with us today. So without objection, your written
    statements will be made part of the record.
        You will each be recognized in turn for a five-minute
    summary of your testimony. If you are ready, Mr. McGhee, we
    would like to begin with you.

    STATEMENT OF CHRISTOPHER M. MCGHEE, MANAGING DIRECTOR, MARSH &
     MCLENNAN SECURITIES CORPORATION, ON BEHALF OF THE BOND MARKET
                              ASSOCIATION

        Mr. McGhee. Good afternoon. On behalf of the Bond Market
    Association, I would like to thank the committee for holding
    this hearing on risk-linked securities. My name is Christopher
    McGhee and I am a Managing Director of Marsh and McLennan
    Securities Corporation in New York. I also serve as chairman of
    the Risk-Linked Securities Committee of the Bond Market
    Association. This committee includes representatives of
    securities firms that are active in the primary distribution
    and secondary trading of risk-linked securities.
        I should note that my firm is an affiliate of Marsh and
    McLennan Companies, a global professional services firm whose
    operating companies include the world's leading insurance and
    reinsurance brokers.
        I have submitted a statement for the record that includes a
    diagram of standard catastrophe bonds transactions. I will
    summarize my written statement here and will be happy to answer
    any questions the committee may have at the end of testimony.
        Risk-linked securities developed in the wake of the major
    catastrophes of the 1990s. Following Hurricane Andrew in 1992
    and the Northridge quake in 1994, catastrophe reinsurance
    prices more than doubled and became much more difficult to
    obtain. Risk securitization had been discussed in years
    preceding the natural disasters of the 1990s, but it really
    took the capacity crunch and price spike caused by Andrew and
    Northridge for securitization to be seen as a realistic risk-
    transfer mechanism. Risk securitization has the potential to
    generate significant sources of catastrophe risk-taking
    capacity on the part of insurers and reinsurers.
        This would, in turn and most importantly, enable insurers
    to assume greater amounts of catastrophe risk from their
    policyholders. Much as the secondary mortgage market brought
    the cost of home finance down significantly, we hope that
    insurance securitization could make catastrophe protection more
    broadly and more cheaply available to policyholders.
        We hope that such an increase in coverage would
    substantially reduce the burden on the federal government to
    provide emergency disaster relief to uninsured homeowners
    following a natural catastrophe. Bear in mind, at the end of
    2001 only 17 percent of Californians had earthquake insurance.
        Since 1997, 45 catastrophe bond transactions have been
    completed, with a total risk limit securitized of almost $6
    billion. While this figure is not insubstantial, it could be
    larger.
        We do believe there are certain actions which could be
    taken which would facilitate the development of this
    marketplace. These include, first, permitting reinsurance
    special purpose entities to be treated as flow-through vehicles
    from a tax perspective. As in all securitizations, repackaging
    risk requires the use of a special purpose entity. Establishing
    the SPE in the jurisdiction of the U.S. tax code would subject
    the RLS transaction to two layers of U.S. federal tax and
    perhaps even state taxes, making the transaction more costly
    for issuers and less attractive to investors. As a result, the
    bulk of all these transactions today take place off-shore in
    jurisdictions with no entity-level tax.
        To fix this problem, Congress could permit reinsurance SPEs
    to be treated as flow-through vehicles that would not be
    taxable at the entity level. This has already been done with
    mortgage-backed securities under REMICs and FCTs This would
    encourage risk securitization to come on-shore and as such
    would be less costly and less complicated to transact. We
    believe that this would result in an increase in transactions
    overall, and as noted, policyholders would be the ultimate
    beneficiary of this new risk capacity.
        This issue is, of course, a matter involving the tax code
    and as such we recognize that this is not subject to the
    jurisdiction of this committee, but rather than of the
    Committee on Ways and Means. Therefore, we mention this here
    only so that we can be complete on the issues facing the
    marketplace.
        The second action would be to ensure that the economic
    substance of all these transactions are taken into account
    under the pending accounting rules concerning the consolidation
    of SPEs. In short and in general, we do not believe that any
    entity other than the SPRV should be made to consolidate the
    risk-linked security onto its balance sheet, specifically
    neither the sponsor of the transaction or any investor should
    be required to consolidate the full transaction.
        Accounting consolidation we think would produce misleading
    financial statements because the consolidation does not reflect
    the economic exposure of the parties to the transaction.
        Let me conclude with these final points on behalf of the
    association. First, risk-linked securities are beneficial to
    policyholders as they can help expand the availability of
    competitively priced catastrophe insurance. Second, the RLS
    market can relieve pressure on governments to insure
    catastrophe risk.
        Third, flow-through tax treatment of RLS would bring
    transactions on-shore and we believe would encourage the
    further development of this marketplace. Again, we recognize
    that any action on this matter is within the purview of the
    Committee on Ways and Means.
        Fourth and finally, the proposed FASB accounting rule as
    currently contemplated should not require consolidation of the
    SPE's balance sheet in the financial statement of any party
    involved in the transaction.
        A contrary result would be severely detrimental to the
    development of the RLS marketplace. Thank you for providing the
    Bond Market Association the opportunity to testify.
        [The prepared statement of Christopher M. McGhee can be
    found on page 64 in the appendix.]
        Chairwoman Kelly. Thank you very much, Mr. McGhee.
        Mr. Brynjolfsson?

    STATEMENT OF JOHN BRYNJOLFSSON, EXECUTIVE VICE PRESIDENT, PIMCO

        Mr. Brynjolfsson. Madam Chair and members of the Committee
    on Financial Services, I welcome this opportunity to share my
    expertise and recommendations. This testimony is offered in my
    capacity as an individual with extensive experience relating to
    risk-linked securities, and not in my official capacity as an
    officer of PIMCO.
        I believe that the risk-linked securities market holds
    great promise for your constituents and our nation more
    generally. I therefore am strongly supportive of your efforts
    to foster the unfettered development of this market. The
    committee has forwarded to me six questions, four of which I
    will answer now orally. Question one, what attracts investors
    to risk-linked securities?
        Risk-linked securities can provide investors with a
    handsome yield in exchange for absorbing a small amount of
    risk. I will give an example. Five years ago in 1997 and every
    year since, PIMCO, my employer, has participated in a
    transaction known as residential reinsurance. This risk-linked
    security allowed USAA, one of the nation's largest insurers of
    military personnel, to cede $400 million of super-catastrophic
    risk to the capital markets. PIMCO purchased 17 percent of that
    transaction, representing $69 million of catastrophic hurricane
    risk.
        In particular, the risk-linked security PIMCO bought was
    only exposed to the most catastrophic of hurricanes--for
    example, a category five hurricane passing directly over Miami,
    where a large number of retired and active military personnel
    reside, would have triggered a loss on this bond. In contrast,
    a category four hurricane passing 20 miles south of Miami, as
    Hurricane Andrew did in 1993, would not have triggered a loss.
    Despite a relatively handsome yield, the risk of loss on these
    bonds could be quantified as a once in 100-year event.
        Question two, what factors have limited your investment in
    risk-linked securities? One factor that has limited our use of
    risk-linked securities is that our competitors rarely use them.
    As a result, upon the first serious loss, our use of risk-
    linked securities may become a lightning rod for journalists
    and lawyers who would be quick to second-guess our decision.
        Question three, should individuals invest in risk-linked
    securities? The risk-linked securities market is by no means
    appropriate for the direct participation of individual
    investors. Generally, all risk-linked securities issued in the
    U.S. have been issued under the framework of regulation 144(a)
    that limits participation to qualified professional asset
    managers. Individuals can and do, however, appropriately access
    the risk-linked securities market in a very small dose through
    broadly diversified mutual funds managed by competent
    professionals.
        Question four, what does the future hold? I would suggest
    that the risk-linked securities market is currently struggling
    to get any notice whatsoever. This is temporary and simply
    caused by the substantial turmoil that the equity and corporate
    bond market are currently experiencing. Ultimately, the risk-
    linked securities market will likely develop into an
    instrumental part of the global reinsurance infrastructure.
        Before I conclude, allow me to more concretely and
    specifically highlight for you how I think the development of
    the risk-linked securities market will impact your
    constituents.
        First, the risk-linked securities market has the potential
    to substantially and dramatically increase the capacity and
    lower the cost of capacity in the reinsurance market. This is
    particularly true in the case of capacity relating to super-
    catastrophic risks--those once in a hundred-year events that
    inevitably occur and fill the pages of Life magazine.
        Increasing this capacity frees up the limited capacity
    reinsurance companies have to address more complex risks such
    as terrorism. Ultimately of course, expanding capacity benefits
    both individual and small business consumers of insurance
    services. Your constituents may benefit a second time when the
    premiums the insurance industry charges are passed through in
    the form of interest on bonds to your constituents' pension
    plans, mutual funds and other investment vehicles.
        One last constituent is the IRS, whose revenues have the
    potential to benefit from the development of a robust risk-
    linked securities market. As the risk-linked securities market
    develops, premiums traditionally earned by distantly domiciled
    insurance companies will begin to be earned instead by
    taxpayers. I commend this committee for its proven success in
    making the U.S. financial markets more competitive globally.
        Specifically with respect to risk-linked securities, I am
    supportive of your efforts to firstly lower barriers to
    development of the risk-linked securities market; two, to
    encourage the understanding and foster prudent use; three, to
    enhance market efficiency by promoting increased transparency
    and risk disclosure; four, solidify the contractual nature of
    risk-linked securities; five, streamline regulation and enable
    on-shore domiciling of special purpose reinsurance vehicles;
    six, standardize the fragmented nature of state insurance
    regulations. Most distinguished members of this committee,
    thank you for your interest. I am of course available to answer
    your questions.
        [The prepared statement of John Brynjolfsson can be found
    on page 33 in the appendix.]
        Chairwoman Kelly. Thank you very much, Mr. Brynjolfsson.
        Mr. Ozizmir?

      STATEMENT OF DAN OZIZMIR, SR. MANAGING DIRECTOR OF TRADING,
                SWISS RE FINANCIAL PRODUCTS CORPORATION

        Mr. Ozizmir. I would like to thank Chairwoman Kelly and
    Chairman Oxley for holding this hearing on risk-linked
    securities, an important and growing segment of the fixed-
    income and reinsurance markets. My name is Dan Ozizmir. I am
    the senior managing director and head of trading with Swiss Re
    Financial Products, a subsidiary of Swiss Re, the largest
    reinsurer in North America and second largest in the world.
    Swiss Re is also a member of the Reinsurance Association of
    America and the Bond Market Association. Swiss Re has an
    interest in this market from two primary perspectives.
        We structure and underwrite new risk-linked securities and
    we access the risk-linked securities market as an alternative
    source of capital. Insurer motivation--to make sure it can pay
    claims after a catastrophe, an insurer can do the following:
    raise more equity capital by selling company stock; transfer
    risks to the reinsurance markets; limit risks by underwriting
    and asset management process. While not a perfect substitute
    for any of these approaches, transferring risks to the risk-
    linked securities market is a useful, fixed-cost, multi-
    accompaniment to these other tools for certain peak
    catastrophic risks to the insurance industry, such as east
    coast hurricanes and California earthquakes.
        As an aside, an insurer needs to hold significantly more
    equity to underwrite peak exposures, like a Florida hurricane
    and California earthquake, than it does to underwrite non-peak
    exposures such as a single house fire or an auto accident. In
    fact, equity is an extremely efficient source of capital for
    non-peak exposures, as we can use the same dollar of capital to
    underwrite many dollars of coverage.
        The lower the cost of capital to insurers, the greater the
    availability of affordable insurance to policyholders. Making
    affordable insurance more available has important public policy
    implications. For example, as of the end of 2001, only 17
    percent of California homeowners had earthquake insurance.
        Presumably if earthquake coverage were less expensive, more
    consumers would obtain coverage. This in turn would reduce the
    potential burden on the government to provide emergency
    disaster relief following a major catastrophe. Investor
    motivation--generally, bond investors buy risk-linked
    securities, often known to them as cat bonds, to diversify
    their investment portfolios.
        Adding risk-linked securities to a fixed-income portfolio
    reduces the expected standard deviation for the portfolio. In
    other words, the returns stay similar, but the portfolio risk
    goes down. This occurs because defaults on corporate bonds and
    natural disasters are not correlated. Given these
    diversification benefits, an obvious question is, why have many
    significant fund investors stayed on the sidelines. I have a
    more complete response in my written testimony, but the short
    answer is that some professional investors take the time to
    learn about the sector and get comfortable, while others have
    not yet done so. Mr. Brynjolfsson from PIMCO today is an
    exception.
        The risk-linked securities market current status and future
    directions--at present for our company, risk-linked securities
    represent a relatively small, but strategically important
    source of capital. At present, we believe that while some low-
    rate insurers and reinsurers might face capital strain from the
    equivalent of two natural catastrophes on the order of
    Hurricane Andrew, yet industry as a whole remains capable of
    meeting its obligations. Note that notwithstanding the
    estimated insured losses from September 11, which were greater
    than Hurricane Andrew and the Northridge earthquake combined,
    reinsurance remains readily available.
        A major exception, of course, to this rule is terrorism
    coverage, which is either not available or extremely expensive.
    On the whole, we expect the risk-linked securities market to
    continue to grow in several ways. First, we would anticipate
    the absolute amount of securities outstanding to continue to
    grow as new investors begin to participate and existing
    investors devote more capital to the sector. Second, we
    anticipate that over time, innovation will gradually broaden
    the types of risk securitized. On the second point, I would
    note in particular that the risk-linked securities market is
    not a near-term solution for providing capacity for terrorism
    risk. Terrorism risk cannot be quantified.
        We believe that the only solution to this important and
    difficult problem is passage of a government backstop. In
    conclusion, we believe that the risk-linked security market
    plays a useful role in providing additional capital to the
    reinsurance and insurance industry. To the extent that it
    succeeds, it can also help increase the availability of
    affordable insurance to policyholders exposed to peak perils
    and therefore reduce the amount of uninsured losses from
    natural catastrophes. This concludes my testimony. Thank you
    very much.
        [The prepared statement of Dan Ozizmir can be found on page
    215 in the appendix.]
        Chairwoman Kelly. Thank you very much, Mr. Ozizmir.
        I have a question for you, Mr. McGhee.
        If the FASB adopts new rules governing SPRVs to increase
    their equity requirements, how would that affect your
    securitization efforts to help protect consumers against
    natural disasters?
        Mr. McGhee. We think it would clearly inhibit the growth of
    that sector. It would add expense, certainly. The equity
    component of a transaction would need to be paid more than they
    currently are under the fixed-income approach, so there would
    be an expense component there.
        But in addition, there is a challenge in finding equity
    investors for these kinds of transactions. This is
    traditionally been a fixed-income market for fixed-income
    investors. Finding equity investors for this transaction we
    think is complicated and difficult. So we actually believe it
    would be a significant impediment to the growth of this
    marketplace.
        Chairwoman Kelly. Thank you. Mr. Brynjolfsson, how can we
    facilitate the acceptance of natural disaster bonds by the
    investment marketplace? Do you think we need to help
    standardize information parameters or to improve the disclosure
    requirements? I asked this question of the prior panel. I would
    be interested in what you have to say.
        Mr. Brynjolfsson. Sure. At our firm, we have done
    everything that we can do to, let's say, maximize disclosure;
    and to actually limit these securities strictly to portfolios
    where the clients have previously acknowledged that we have the
    authority to invest in these bonds. Even there, we are still
    somewhat concerned about liability associated with our
    investing in these types of bonds.
        It may just be a matter of education. What the committee is
    doing today in the form of publicizing, in effect, the GAO
    report and having hearings on this topic may help move the
    market in the direction of acceptance. Investors quite
    appropriately are concerned about the risk in their portfolios,
    now more so than ever. We have invested time and effort in
    developing the expertise to invest in these bonds.
        To some extent, I have tried to facilitate our competitors'
    developing expertise by speaking at the Bond Market Association
    conferences on these topics and so on. But ultimately, my job
    is to take care of my investors and I hope others do the same
    for their investors.
        Chairwoman Kelly. How would you assess the current market
    for these risk instruments?
        Mr. Brynjolfsson. Well, we have been an aggressive
    purchaser of these bonds, sometimes buying 25 percent or even
    30 or 40 percent of individual transactions that have come to
    market over the past five years. In the past 12 months or so,
    we have been a little bit less aggressive. Part of the reason
    for that is the appetite for risk among the capital markets has
    been waning.
        We have to some extent anticipated that, to some extent
    just been a victim of it. But the whole purpose of integrating
    the reinsurance market with the capital markets is to bring the
    reinsurance markets away from the reinsurance cycle that you
    may be aware of where reinsurance rates harden and soften and
    harden and soften. Unfortunately, capital markets also have a
    cycle where capital market investors get driven by fear and
    greed and then fear and then greed. Right now, fear is the
    dominant sentiment in capital markets.
        Chairwoman Kelly. I have another question for you, and that
    is, do you really need a Ph.D. in physical sciences in order to
    understand this risk?
        Mr. Brynjolfsson. You know, I have spent the past 12 years
    intensely focusing on the financial markets. Obviously, these
    securities are by and large a financial security. The firms
    that model the risk of this will have a dozen or more than
    that--50 or 60--Ph.D. scientists all evaluating the latest
    theories in earthquake, hurricane and so forth. Having some
    credentials in the physical sciences at least gives me some
    confidence that I can, let's say, read the reports that these
    scientists publish. I do not know if I would want to write
    them.
        Chairwoman Kelly. Our hat is off to the GAO, I guess. I
    have run out of time here, so I am going to turn to
        Dr. Weldon. Dr. Weldon, have you questions?
        Dr. Weldon. Yes, thank you, Madam Chairman. I have got a
    question for Mr. McGhee and maybe Mr. Brynjolfsson, you can
    comment on it, too. There was some discussion--Mr.
    Brynjolfsson, you purchased a bond for a category five
    hurricane going over Miami.
        Mr. Brynjolfsson. Correct.
        Dr. Weldon. Let me start with you, Mr. McGhee. What do you
    think would be the impact on the market if that were to happen?
        Mr. McGhee. If there were an event like that?
        Dr. Weldon. Next week.
        Mr. McGhee. We have talked a lot about that question. The
    concern has always been that a big loss occurs and as a result
    investors exit the market. Our sense is that the investor
    universe in this particular category is extremely well
    informed. They understand the risks they are running, and we
    believe that it is unlikely that they would immediately exit
    the marketplace.
        We think in fact that this might draw more investors in
    because the opportunities to buy more bonds at increased prices
    or increased yields we think would be available. So our sense
    is that investors would not cut and run; that they would
    actually stay there. We think this marketplace does have
    staying power.
        Dr. Weldon. Do you agree with that, Mr. Brynjolfsson?
        Mr. Brynjolfsson. Well, there are two parts to that
    question. One is will the capacity we provide be there when an
    event occurs. As a major hurricane occurs, market participants
    start to get white knuckles and start to brace. Trading
    activity, pricing of the risk may occur. Bond prices may fall.
        However, our firm is not really well positioned to monitor
    the minute-to-minute development of hurricanes. As a result, we
    are essentially buying these bonds ahead of time with the
    belief and plans to hold them throughout any disaster. Then we
    will see how the sword falls, and I hope avoid dying by the
    sword, if you will.
        So what that means is that the capacity that is provided is
    there and will be there for the event that occurs. The second
    part of the question implicitly is, on subsequent events, would
    we necessarily step up and provide additional capacity.
        As Mr. McGhee suggested, probably not unless the price were
    even more attractive than initially. There is actually a market
    for what we call second event bonds, and we do participate in
    the second event bond market. That is a market where we are
    actually paid a premium in order to absorb the possibility of
    two major catastrophic events occurring.
        The second event market is really a good example of how the
    capital markets can step in to provide not just backup
    capacity, but backup capacity to the backup capacity.
        Dr. Weldon. I was not aware of this. This is a developing
    market, you are saying?
        Mr. Brynjolfsson. Well, it is part of the risk-linked
    securities market, and just as you have wind-risk bonds,
    earthquake-risk bonds, hailstorm bonds and so forth, you have
    something called a second event bond, which would not trigger
    on the first category five hurricane that hit Miami, but the
    second one would trigger it.
        And they are usually structure so that you would need two
    smaller events like two category four hurricanes to hit in the
    same season, which again we can probabilistically model.
        Dr. Weldon. Mr. McGhee, based on the diagram on page four
    of your testimony, the issuance of catastrophe bonds has
    decreased or flattened--is that true? Do you feel that it is a
    tax issue that is causing it to happen? Why do you think it is
    flattening out?
        Mr. McGhee. It is hard to speculate, because I think there
    are a series of things that are feeding into why this
    marketplace has stayed relatively flat. The central issue is
    that catastrophe bonds are perceived by the potential sponsors
    of the transactions--insurance companies and reinsurance
    companies--as still relatively expensive as risk transfer
    mechanisms.
        So essentially it is a cost issue. There is a certain large
    fixed cost component to issuing cat bonds. That relatively
    large fixed transaction cost means that there are a relatively
    small number of potential issuers because they must be issuing
    large transactions to spread that cost over the large
    transaction size. So it is essentially a cost issue, and if
    those costs could be brought down, we think that the capacity
    being sought in the capital markets would increase. So it is
    really a cost issue.
        Mr. Brynjolfsson. I would also add that it is my sense, and
    I do not have the data to back this up but perhaps one of the
    other panelists could verify what I am going to presume and
    that is, that recent transactions have tended to be multi-year
    transactions. This means that for any given amount of capacity,
    or for any given amount of issuance, rather than covering one
    year of risk, it is covering, say, three years of risk. From a
    capacity point of view you could multiply these reported
    numbers by a factor of three, because new bonds do not have to
    be reissued as frequently just to cover the same risk.
        Mr. Ozizmir. In fact, I believe the number right now of the
    outstanding capacity in the market is on the order of about
    $2.5 billion. So even as a dimension, if you issue $1 billion a
    year and they are multi-year transactions, over time the actual
    capacity that exists in the market that the reinsurance and
    insurance companies can take advantage of is in excess of that.
        Dr. Weldon. I believe my time has expired. Madam Chairman,
    I did have a follow-up question.
        Chairwoman Kelly. Go ahead and ask your follow-up question.
        Dr. Weldon. In the GAO report, they have got on page 12,
    figure 2, Hurricane Andrew was $30 billion, with about $15
    billion being insured and a little less than half uninsured.
    Northridge was $30 billion.
        Then they show the World Trade Center, $80 billion--again
    about half is insured, half is not insured. It is very
    interesting--they have Kobe, Japan, the 1995 earthquake there,
    $147 billion of which $142.9 billion was uninsured. The
    impression I get is that relative to the amount of risk we have
    out there, this may be a growing segment and in dollar amounts
    it may be growing.
        This is really a drop in the bucket relative to the amount
    of risk that is out there. Is that an accurate statement? It
    sounds like a good way to try to address the risk, and I am not
    in any way trying to knock the industry, but it is not covering
    a lot of risk.
        Mr. Brynjolfsson. Looking at just these four events and the
    decade or more they cover, if we were just to average the
    annual loss per year, we would be looking at something that
    appears in the neighborhood of $30 billion. As pointed out,
    this market is $2 billion or more. The capital markets in total
    are typically seen measured in terms of $30 trillion. So the
    capital markets clearly have the ability to absorb $2 billion,
    as they currently are, or $4 billion or $8 billion or $12
    billion of catastrophic risk. Any of those numbers is not just
    a noticeable fraction, but a substantial fraction of
    catastrophic risk.
        Dr. Weldon. So you think the market could absorb the risk--
    more of the risk, substantially more?
        Mr. Brynjolfsson. Yes.
        Dr. Weldon. But as I understand your testimony, and all of
    your testimony, the two principal stumbling blocks are the tax
    treatment and the nature of the market. It is very complicated
    to get into and there are a lot of people in the industry who
    do not have the expertise or the willingness to get acquainted
    with the complexity of this type of investment instrument.
        Mr. Ozizmir. Let me add a couple of things to what you said
    there. I would add that marginal cost is important. I mean, we
    discussed the fact that the risk-linked securities market is
    relatively small percentage. But in any market, I think the
    marginal cost is often what defines the overall price. So I
    think that we need to look at the growth of this market in the
    context of that.
        The second thing that I would like to talk about is, we are
    talking about a lot of knowledge here from the point of view of
    investors. We at Swiss Re and many other participants in this
    market are really not focusing just on knowledge to the
    investors, but also to the potential sedants or the insurers
    who are using this product.
        I think that that is something that also needs to grow as
    well. For example, there were some conversations here about the
    NAIC looking very carefully at how to define basis risk, when
    it is acceptable and when it is not. That is the same process
    that we and other insurers go through when they look at these
    parametric structures, because since we are not able to sell
    indemnity risk into the capital markets as well for the obvious
    reasons of transparency and disclosure and objectivity, it is
    important that the knowledge is not just on the investor side,
    but also on the user side.
        Dr. Weldon. I thank you, Madam Chairman.
        Chairwoman Kelly. Thank you. Mr. Ozizmir, how do you relate
    the current situation with terrorism to the potential use of
    the risk-based securities? You mentioned terrorism before.
        Mr. Ozizmir. Yes. Our view at Swiss Re is that the critical
    element of this market is developing knowledge, objectivity and
    transparency in how transactions are structured. We feel that
    terrorism risk, even away from the securitization process, is
    not quantifiable.
        So if it is not quantifiable in the traditional insurance
    and reinsurance market, we do not see anything in the near term
    that would permit the risk-linked securities market to transfer
    risk in the terrorism market.
        Mr. McGhee. May I just add to that?
        Chairwoman Kelly. By all means.
        Mr. McGhee. I would say that there are a lot of very smart
    people with lots of initials after their names, like Ph.D.,
    that are working very hard on exactly this problem of
    terrorism. There are modeling firms that have all recently come
    out with early, early issues of models that try to assess the
    probability of loss of terror attacks.
        If those models were to become generally accepted, and we
    believe this will take some time, then it is possible, we
    think, that with time securitization of terror risk is a
    possibility. But, I should stress, this is very early days in
    this marketplace, though there are many people who are working
    very hard on this issue.
        Chairwoman Kelly. Thank you, Mr. McGhee. I really
    appreciate that. We have worked very hard on terrorism and
    trying to address the situation, and both of you have shed some
    light that may help us along our way, so thank you very much.
        I would like to go back to you, Mr. Ozizmir. According to
    the Institutional Investor last month, several European
    insurers are now seriously considering securitization as an
    alternative source of capital to fund their underwriting
    capacity. How can reinsurers take advantage of their unique
    ability to analyze high-level risk and work with the securities
    market and investors to bring confidence into these deals? What
    do you think Congress can do to facilitate this?
        Mr. Ozizmir. I will start with the whole issue, and go back
    to the initial issue of knowledge. It is critical that there is
    transparency in the transactions. I think it has been mentioned
    that bringing the transactions on-shore has various benefits,
    and we do agree with that. That said, we do believe that the
    transactions, the parametric structures that are currently
    being done are adequate from a transparency point of view in
    terms of how the risks are modeled and how the risks are
    disclosed.
        The critical thing that a reinsurance company needs to do
    if they decide to access the capital markets is recognize a few
    things. One is that since this is a new market, the cost of
    getting coverage in the capital markets is high. In some cases,
    it is higher than traditional reinsurance; in some cases, it is
    about the same; and in some cases slightly lower. But the fact
    is, it is not a lower cost of coverage. So a reinsurance
    company needs to make sure that they control and manage the
    basis risk.
        This is a very, very critical issue. The investors, again,
    are going to accept transparent modeled objective structures.
    The reinsurer or the insurer is going to have their own book of
    business which may change in a multi-year period of time. For
    example, if you do a four-year structure, much of the
    reinsurance or insurance you have written is a one-year
    contract. So a reinsurer will have to anticipate how their book
    of business may change over time.
        They are also going to have to look very carefully at where
    their risk is. We talk about category four hurricanes, category
    five hurricanes. In the case of Europe, it would be what would
    be called a European windstorm would be the predominant risk,
    such as Lothar that hit France a few years ago. So the
    reinsurer needs to, with the help of the modeling agencies and
    their own internal analytics, determine at a certain wind speed
    what their losses would be. This is a very, very complicated
    process, but something that needs to be done.
        Chairwoman Kelly. I would like to thank you.
        I would like to, Mr. Ozizmir, ask you another question. In
    your testimony, you state, reinsurance remains readily
    available. It seems to me that any discussion that we have here
    on reinsurance capacity ought to cover catastrophic events,
    ought to include a discussion of the price of covering
    catastrophic events because price may mean that reinsurance is
    not readily available. So I would like to have you discuss that
    a bit.
        Mr. Ozizmir. Okay. One of the reasons we do support the
    development of this market is we agree that prices have
    increased over the last few years and in spite of the fact that
    they increased from a relatively low level in the late 1990s,
    clearly capacity coming into the market will reduce the cost.
        We think that that is good for primarily all constituents
    here in terms of having greater coverage. That said, the
    capital markets, as I said, are not providing distinctly
    different prices than what is available in the reinsurance
    markets right now.
        Chairwoman Kelly. We may give you a written question to
    follow-up on that. I am out of time. Dr. Weldon, have you any
    other questions?
        Dr. Weldon. Yes, I just have one more follow-up question.
    Mr. Brynjolfsson, let's go back to Miami, category five comes
    over the city. Does the catastrophic bonds that we have been
    talking about that cover that type of event do anything to help
    the people who are living, say, 20 miles south or 20 miles
    north of the city?
        Mr. Brynjolfsson. Sure. The example I gave is actually not
    specifically part of the contractual nature of the bond. The
    way the contract that is written for the specific bond that I
    was describing is that if USAA lost more than $1 billion, then
    the cat bond would in effect indemnify that insurance company
    for losses of greater than $1 billion.
        The firms that I alluded to that do the modeling of
    catastrophic risks were able to quantify for us relatively
    objectively that $1 billion was high enough a threshold that
    the insurance company itself could cover those losses out of
    the first $1 billion of coverage through its general operating
    reserves and the like, and that in order to have more than $1
    billion of losses, either one large hurricane hitting a
    metropolitan area would have to occur, or alternately a smaller
    hurricane that hit successively three or four or five
    communities would have to occur.
        For example, if a hurricane went up the coast, it could
    trigger $1 billion or more in losses. So there is no exclusion
    of any particular homeowner or anything like that. It is more
    just a function of how the industry works. Now, more generally,
    obviously the way an insurance company works is they try to
    write as many premiums as they can without exceeding certain
    capital constraints. Any cat bond that helps relieve their
    capital usage frees up capital to underwrite in other areas.
        The capital markets are, I believe, best equipped to
    protect against super-catastrophic risks, meaning those one in
    one-hundred year events that I alluded to, and also relatively
    generic risks which I as a bond manager can contemplate,
    understand and have modeling firms advise me on. Very specific
    risks relating to the intricacies of workman's compensation or
    intricacies of business liability or for that matter even
    intricacies of terrorism coverage, at this stage I am not ready
    to contemplate. I am not saying that I would never contemplate
    anything along those lines. However, I do know on the other
    hand that I am comfortable contemplating straightforward simple
    risks like massive hurricanes and massive earthquakes.
        Dr. Weldon. Go ahead.
        Mr. McGhee. I was just going to add to that if I could. It
    touches back on your question about the size of the cat bond
    market relative to reinsurance, and it plays in here as well.
    As Mr. Brynjolfsson said, the cat bond market really plays in
    that sort of super-cat layer, that area in excess of the one in
    one hundred year return period.
        One of the things that my firm has done is that we have
    been looking at the size of risk transfer capacity bought from
    the cat bond market and from the reinsurance market in this
    very remote area. We believe that there is a relatively small
    amount purchased from reinsurance for those super-cat events.
    It may be as little as $3 billion in total capacity. If that is
    the case, then catastrophe bonds may represent about 40 percent
    of the overall risk transfer market in that segment right now.
    It is a little-understood fact that cat bonds are a very
    important part of this super-cat marketplace, We think cat
    bonds could actually add significantly to the synthetic capital
    that is being created for insurance companies and reinsurance
    companies that can be then used to provide more coverage to
    their policyholders.
        Dr. Weldon. I just want to make sure I come away from this
    hearing properly understanding this issue. It is a very complex
    issue. We have taken testimony that there is a capacity crisis
    and then we have taken testimony that there is plenty of
    capacity out there. Could you, Mr. Brynjolfsson or Mr. McGhee,
    answer that question for me?
        Mr. Brynjolfsson. Sure. I would be happy to address that.
    In the area of super-catastrophic risk in the area of hurricane
    risk and the area of earthquake risk, there clearly is not a
    capacity crisis. We have been looking to buy catastrophe bonds
    at spreads that were previously available that are no longer
    being offered to us because to some extent there is capacity
    for those types of risk.
        On the other hand, and I do not want to get excessively
    anecdotal, but when it comes to very specific types of risk
    that I am not involved in at PIMCO, then there clearly are
    problems, even in the area of, well, workman's comp, other
    things that were directly brought to the industry's attention
    by the disasters at the World Trade Center.
        For example, the idea that 6,000 people could
    simultaneously have their lives put at risk was not something
    that typical workman's comp policies had contemplated or life
    insurance policies prior to 9-11. My understanding is that air
    frame and aircraft insurance similarly has become almost
    unavailable.
        Mr. McGhee. May I add to that?
        Dr. Weldon. Yes.
        Mr. McGhee. I think you might not characterize it as a
    crisis, but it may be a crisis that people do not yet recognize
    as a crisis, if I can put it that way. In California, only 17
    percent of homeowners have earthquake insurance. In Florida, as
    you know, there is a state-sponsored government entity, the
    Florida Hurricane Cat Fund, that exists because of the need to
    intercede and provide some quasi-governmental support to make
    homeowners insurance for hurricanes more readily and cost-
    effectively available.
        So our sense is that there could be much more insurance
    being sold to consumers were it available at a competitive
    cost. We think that this marketplace could help encourage
    that--perhaps not solve all the problems, but could encourage
    the availability of more and cheaper capacity.
        Chairwoman Kelly. Mr. Ozizmir, I would like you to answer
    that question as well, if you do not mind.
        Mr. Ozizmir. Okay. In terms of relating capacity to the
    impact of the risk-linked securities market, I would like to
    basically agree with what my panel members said. One thing I
    would highlight here is that again we are talking about
    quantifiable, objective and transparent risks.
        Now, for that reason, if you look at the actual secondary
    market trading or the spread of new issues on California
    earthquake, Florida windstorm, European windstorm and even
    Tokyo earthquake risks in the market, and if you observe that
    the trading levels over the last few years, what you will see
    is that rates have been pretty much stable, except for the
    fourth quarter of last year, after September 11.
        What that tells me is that in the types of risks that can
    be specifically addressed by the risk-linked securities market,
    there are capacity issues possibly, but it is not showing up in
    the trading of those instruments. Where we are seeing in
    general the greatest price increases are the non-quantifiable
    risks like terrorism, if it is even available; hull insurance
    and other things like that for planes--those have increased
    dramatically. So again, in the risks that this market can
    address, we are not seeing as significant an increase in price
    or as great a dearth of capacity.
        Chairwoman Kelly. Thank you. Mr. Inslee, do you have any
    questions for this panel?
        Mr. Inslee. I do. This may be on the periphery of this
    hearing, but I wanted to ask about the sort of general
    assessment of risk for weather-related losses, and whether the
    global warming phenomena is causing any concern, any thoughts
    in the industry in general.
        We see these relatively rapid loss patterns from weather-
    related events, and I just wonder, is the industry concerned
    about global warming and how it affects catastrophic losses in
    that regard? Or is that something you all can comment on? That
    is a question to anyone who cares to--if anyone wants to tackle
    it.
        Mr. McGhee. Well, I can jump in there. It is absolutely
    clear that the reinsurance industry is thinking about just
    these issues, and certain large reinsurance companies in Europe
    have in fact done some studies with respect to the impact of
    global warming on the incidence of natural catastrophe and the
    severity of natural catastrophe.
        I do not think anybody has drawn a firm conclusion as to
    what the result will be, but certainly because the reinsurance
    and insurance industries, they take the hits when they happen,
    are concerned about this and trying to assess the potential
    risks associated with global warming.
        Mr. Inslee. Thank you. Thank you, Madam Chair.
        Chairwoman Kelly. Thank you, Mr. Inslee. If there are no
    further questions, the chair notes that some members may have
    additional questions they may wish to submit in writing.
    Without objection, the hearing record will remain open for 30
    days for members to submit written questions to these witnesses
    and place their responses in the record.
        This panel is excused with the committee's great thanks and
    great appreciation for your time. This hearing is adjourned.
        [Whereupon, at 3:48 p.m., the subcommittee was adjourned.]

                                A P P E N D I X

                                October 8, 2002

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