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