    Catastrophe Insurance Risks: The Role of Risk-Linked Securities
    and Factors Affecting Their Use (24-SEP-02, GAO-02-941).

    Because of population growth, resulting real estate development,
    and using real estate values in hazard-prone areas, the nation is
    increasingly exposed to much higher property-casualty
    losses--both insured and uninsured--from natural catastrophes
    than in the past. In the 1990s, a series of natural disasters,
    (1) raised questions about the adequacy of the insurance
    industry's financial capacity to cover large catastrophes without
    limiting coverage or substantially raising premiums and (2)
    called attention to ways of raising additional sources of capital
    to help cover catastrophic risk. Catastrophe risk includes
    exposure to losses from natural disasters, such as hurricanes,
    earthquakes and tornadoes, which are infrequent events that can
    cause substantial financial loss but are difficult to reliably
    predict. The characteristics of natural disasters prompt most
    insurers to limit the amount and type of catastrophic risk they
    hold. Risk-linked securities that can be used to cover risk from
    natural catastrophes employ many structures and include
    catastrophic bonds and catastrophic options. GAO identified and
    analyzed several issues that might affect the use of risk-linked
    securities. First, the National Association of Insurance
    Commissioners and insurance industry representatives are
    considering revisions in the regulatory accounting treatment of
    risk transfer obtained from nonindemnity-based coverage that
    would allow credit to the insurer similar to that now afforded
    additional reinsurance. Such a revision has the potential to
    facilitate the use of risk-linked securities. Second, the
    Financial Accounting Standards Board is proposing a new U.S.
    Generally Accepted Accounting Principles interpretation, which
    would increase independent capital investment requirements that
    allow the sponsor to treat special purpose reinsurance vehicles
    (SPRV) and similar entities as independent entities and report
    SPRV assets and liabilities separately. Third, "pass-through" tax
    treatment--which eliminates taxation at the SPRV level--with
    favorable implementing requirements could facilitate expanded use
    of catastrophe bonds. Finally, catastrophe bonds, most of which
    are noninvestment-grade instruments, have not been sold to a wide
    range of investors beyond institutional investors.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-02-941
        ACCNO:   A05100
      TITLE:     Catastrophe Insurance Risks: The Role of Risk-Linked
    Securities and Factors Affecting Their Use
         DATE:   09/24/2002
      SUBJECT:   Bonds (securities)
    	     Insurance
    	     Insurance claims
    	     Insurance companies
    	     Insurance losses
    	     Risk management
    	     Securities
    	     Florida Hurricane Catastrophe Fund
    	     Hurricane Andrew
    	     Northridge Earthquake

    Catastrophe Insurance Risks: The Role of Risk-Linked Securities
    and Factors Affecting Their Use (24-SEP-02, GAO-02-941).

    Because of population growth, resulting real estate development,
    and using real estate values in hazard-prone areas, the nation is
    increasingly exposed to much higher property-casualty
    losses--both insured and uninsured--from natural catastrophes
    than in the past. In the 1990s, a series of natural disasters,
    (1) raised questions about the adequacy of the insurance
    industry's financial capacity to cover large catastrophes without
    limiting coverage or substantially raising premiums and (2)
    called attention to ways of raising additional sources of capital
    to help cover catastrophic risk. Catastrophe risk includes
    exposure to losses from natural disasters, such as hurricanes,
    earthquakes and tornadoes, which are infrequent events that can
    cause substantial financial loss but are difficult to reliably
    predict. The characteristics of natural disasters prompt most
    insurers to limit the amount and type of catastrophic risk they
    hold. Risk-linked securities that can be used to cover risk from
    natural catastrophes employ many structures and include
    catastrophic bonds and catastrophic options. GAO identified and
    analyzed several issues that might affect the use of risk-linked
    securities. First, the National Association of Insurance
    Commissioners and insurance industry representatives are
    considering revisions in the regulatory accounting treatment of
    risk transfer obtained from nonindemnity-based coverage that
    would allow credit to the insurer similar to that now afforded
    additional reinsurance. Such a revision has the potential to
    facilitate the use of risk-linked securities. Second, the
    Financial Accounting Standards Board is proposing a new U.S.
    Generally Accepted Accounting Principles interpretation, which
    would increase independent capital investment requirements that
    allow the sponsor to treat special purpose reinsurance vehicles
    (SPRV) and similar entities as independent entities and report
    SPRV assets and liabilities separately. Third, "pass-through" tax
    treatment--which eliminates taxation at the SPRV level--with
    favorable implementing requirements could facilitate expanded use
    of catastrophe bonds. Finally, catastrophe bonds, most of which
    are noninvestment-grade instruments, have not been sold to a wide
    range of investors beyond institutional investors.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-02-941
        ACCNO:   A05100
      TITLE:     Catastrophe Insurance Risks: The Role of Risk-Linked
    Securities and Factors Affecting Their Use
         DATE:   09/24/2002
      SUBJECT:   Bonds (securities)
    	     Insurance
    	     Insurance claims
    	     Insurance companies
    	     Insurance losses
    	     Risk management
    	     Securities
    	     Florida Hurricane Catastrophe Fund
    	     Hurricane Andrew
    	     Northridge Earthquake

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    GAO-02-941

                                           A

    Report to the Chairman, Committee on Financial Services, House of
    Representatives

    September 2002 CATASTROPHE INSURANCE RISKS The Role of Risk- Linked
    Securities and Factors Affecting Their Use

    GAO- 02- 941

    Letter 1 Results in Brief 3 Background 6 Insurance and Reinsurance Markets
    Provide Catastrophe Risk Coverage and Capital Markets Add to Industry
    Capacity 8

    Risk- Linked Securities Have Complex Structures 18 Regulatory, Accounting,
    Tax, and Investor Issues Might Affect Use of

    Risk- Linked Securities 22 Agency Comments and Our Evaluation 30

    Appendixes

    Appendix I: Scope and Methodology 33

    Appendix II: Catastrophe Options 36

    Appendix III: California and Florida Approaches to Catastrophe Risk 37
    California Earthquake Authority Provides Insurance 37 Florida Provides
    Residential Coverage for Windstorms and

    Supplements Insurance Capacity 38

    Appendix IV: Statutory Accounting Balance Sheet Implications of
    Reinsurance Contracts 41

    Appendix V: Comments from the National Association of Insurance
    Commissioners 44

    Appendix VI: Comments from the Reinsurance Association of America 46 GAO
    Comments 49

    Appendix VII: Comments from the Bond Market Association 50 GAO Comments 58

    Figures Figure 1: Catastrophic Risk in the United States: Earthquake,
    Hurricane, Tornado, and Hail 10

    Figure 2: Estimated Losses from Recent Large Catastrophes 12 Figure 3:
    Traditional Insurance, Reinsurance, and Retrocessional Transactions 13

    Figure 4: U. S. Reinsurance Prices, 1989- 2001 14 Figure 5: Special
    Purpose Reinsurance Vehicle 19 Figure 6: Current and Proposed California
    Earthquake Authority Financial Structure 38

    Figure 7: Effect on Ceding and Reinsurance Companies* Balance Sheets
    before and after a Reinsurance Transaction 42

    Abbreviations

    BMA Bond Market Association CBOT Chicago Board of Trade CEA California
    Earthquake Authority CFTC Commodity Futures Trading Commission EITF
    Emerging Issues Task Force FASB Financial Accounting Standards Board FASIT
    Financial Asset Securitization Investment Trust FHCF Florida Hurricane
    Catastrophe Fund FWUA Florida Windstorm Underwriting Association GAAP
    Generally Accepted Accounting Principles JUA Florida Residential Joint
    Underwriting Association LIBOR London Interbank Offered Rate NAIC National
    Association of Insurance Commissioners PCS Property Claim Services RAA
    Reinsurance Association of America REMIC Real Estate Mortgage Investment
    Conduit SEC Securities and Exchange Commission SPE special purpose entity
    SPRV special purpose reinsurance vehicles

    Lett er

    September 24, 2002 The Honorable Michael G. Oxley Chairman, Committee on
    Financial Services House of Representatives

    Dear Mr. Chairman: Because of population growth, resulting real estate
    development, and rising real estate values in hazard- prone areas, our
    nation is increasingly exposed to much higher property- casualty losses*
    both insured and uninsured* from natural catastrophes than in the past. 1
    In the 1990s, a series of natural disasters, including Hurricane Andrew
    and the Northridge earthquake, (1)

    raised questions about the adequacy of the insurance industry*s financial
    capacity to cover large catastrophes without limiting coverage or
    substantially raising premiums and (2) called attention to ways of raising
    additional sources of capital to help cover catastrophic risk. The
    nation*s exposure to higher property- casualty losses increases pressure
    on federal, state, and local governments; businesses; and individuals to
    assume everlarger

    liabilities for losses associated with natural catastrophes. Recognizing
    this greater exposure and responding to concerns about insurance market
    capacity, participants in the insurance industry and capital markets have
    developed new capital market instruments (hereafter called risk- linked
    securities) 2 as an alternative to traditional propertycasualty
    reinsurance, or insurance for insurers. Because of these concerns, you
    asked that we review the role of risk- linked

    securities in providing coverage for catastrophic risk and issues related
    to their expanded use. As agreed with your office, our objectives were to
    (1) describe catastrophe risk and how the insurance and capital markets

    provide for coverage against such risks; (2) describe how risk- linked
    securities, particularly catastrophe bonds, are structured; and (3)
    analyze how key regulatory, accounting, tax, and investor issues might
    affect the

    1 In this report, we use the term *catastrophe risk* to mean risk from
    natural catastrophes. For a discussion of insurance issues surrounding
    terrorism, see U. S. General Accounting Office, Terrorism Insurance:
    Alternative Programs for Protecting Insurance Consumers,

    GAO- 02- 175T (Washington, D. C.: Oct. 24, 2001). 2 In this report, we
    refer to capital market instruments that cover insured catastrophe risks
    as *risk- linked securities,* even though some of these instruments are
    not securities in the formal sense.

    use of risk- linked securities. Our overall objective was to provide the
    Committee with information and perspectives to consider as the Committee
    and Congress move forward in this important and complex area.

    Even though we did not have statutory audit or access to records authority
    with private- sector entities, we obtained extensive documentary and
    testimonial evidence from a large number of entities, including insurance
    and reinsurance companies, investment banks, institutional investors,
    rating agencies, firms that develop models to analyze catastrophe risks,
    regulators, and academic experts. We did not verify the accuracy of data
    provided by these entities. Some entities with whom we met voluntarily
    provided information they considered to be proprietary; therefore, we did

    not report details from such information. In other cases companies decided
    not to voluntarily provide proprietary information, and this limited our
    inquiry. For example, we did not obtain any reinsurance contracts
    representing either traditional reinsurance or reinsurance provided
    through the issuance of risk- linked securities.

    Although we identified factors that industry and capital markets experts
    believe might cause the use of risk- linked securities to expand or
    contract, we make no prediction about the future use of these securities*
    either under current accounting, regulatory, and tax policies or under
    changed

    policies. Nor are we taking a position that increased use of risk- linked
    securities is beneficial or detrimental. Appendix I provides a detailed
    discussion of our scope and methodology. We conducted our work between
    October 2001 and August 2002 in

    Washington, D. C.; Chicago, Ill.; New York, N. Y.; and various locations
    in California and Florida in accordance with generally accepted government
    auditing standards. Written comments on a draft of this report from the
    National Association of Insurance Commissioners (NAIC), 3 the Reinsurance
    Association of America (RAA), 4 and the Bond Market

    3 NAIC is a voluntary organization of the chief insurance regulatory
    officials of the 50 states, the District of Columbia, and four U. S.
    territories. 4 RAA is a national trade association representing property
    and casualty organizations that specialize in reinsurance.

    Association (BMA) 5 appear in appendixes V, VI, and VII, respectively. We
    also obtained technical comments from the Department of the Treasury
    (Treasury), the Securities and Exchange Commission (SEC), the Commodities
    Futures Trading Commission (CFTC), NAIC, RAA, and BMA that have been
    incorporated where appropriate.

    Results in Brief Catastrophe risk includes exposure to losses from natural
    disasters, such as hurricanes, earthquakes, and tornadoes, which are
    infrequent events that can cause substantial financial loss but are
    difficult to reliably predict. The characteristics of natural disasters
    prompt most insurers to limit the

    amount and type of catastrophe risk they hold. For example,
    propertycasualty insurers that hold policies on their books that are
    overly concentrated in certain states, such as California and Florida,
    typically diversify and transfer risk through reinsurance. 6 Traditional
    reinsurance depends, in part, on well- developed contractual and business
    relationships

    between insurers and reinsurers. These relationships facilitate relatively
    low transaction costs and indemnity- based coverage, which compensates
    insurers for part or all of their losses from insured claims. 7 However,
    in the case of extremely large or multiple catastrophic events, insurers
    might not have purchased sufficient reinsurance, or traditional
    reinsurance providers might not have sufficient capital to meet their
    existing obligations. In any

    event, after a catastrophic loss, reinsurance capacity may be diminished
    and reinsurers might raise prices or limit availability of future
    catastrophic reinsurance coverage. In the 1990s, the combination of
    Hurricane Andrew

    and the Northridge earthquake along with reinsurance market conditions
    helped spur the development of capital market instruments and other
    alternatives to traditional reinsurance, such as state- run programs. Yet
    to date, risk- linked securities have represented a small share of the
    overall 5 BMA represents securities firms and banks that underwrite,
    distribute, and trade fixed

    income securities, both domestically and internationally. 6 Reinsurance is
    insurance for insurers that enables the insurer to transfer some of its
    risk to another insurer, called a reinsurer. 7 Indemnity coverage
    specifies a simple relationship that is based on the insurer*s actual
    incurred claims. For example, an insurer could contract with a reinsurer
    to cover half of all claims* up to $100 million in claims* from a
    hurricane over a specified time period in a specified geographic area. If
    a hurricane occurs where the insurer incurs $100 million or more in
    claims, the reinsurer would pay the insurer $50 million. In contrast,
    nonindemnity coverage specifies a specific event that triggers payment and
    payment formulas that are not directly related to the insurer*s actual
    incurred claims.

    property- casualty reinsurance market. According to the Swiss Reinsurance
    Company, in 2000, risk- linked securities represented less than 0.5
    percent of the worldwide catastrophe insurance.

    Risk- linked securities that can be used to cover risk from natural
    catastrophes employ many structures and include catastrophe bonds and
    catastrophe options. Currently, most risk- linked securities are
    catastrophe bonds. The cost of issuing catastrophe bonds includes the
    legal, accounting, and information costs necessary to issue securities and
    market them to investors who do not have contractual or business
    relationships with the insurance company receiving coverage. Although
    catastrophe

    bonds generally involve higher transaction costs than traditional
    reinsurance and most recently issued bonds have not been indemnitybased,
    they provide broader access to national and international capital markets.
    To provide catastrophe coverage via a catastrophe bond, an

    investment bank or insurance broker creates a special purpose reinsurance
    vehicle (SPRV) to issue bonds to the capital markets and to provide the
    sponsor organization* typically an insurance or reinsurance company* with
    reinsurance. The SPRVs are typically located offshore for tax, regulatory,
    and legal advantages. The SPRVs that issue catastrophe bonds receive
    payments in three forms (insurance premiums, interest payments,

    and principal payments); invest in Treasury securities and other highly
    rated securities; and pay investors in another form (interest). If the
    catastrophe occurs, principal that otherwise would be returned to the
    investors is used to fund the SPRV*s payments to the insurer. The
    investor*s reward for taking risk is a relatively high interest rate paid
    by the bonds. On the one hand, insurers prefer indemnity coverage, because
    the amount that the reinsurer pays will be directly linked to the insured
    claims actually

    incurred. However, that means the reinsurer has to pay more if the insurer
    underwrites (i. e., selects risks) poorly. On the other hand, investors
    cannot monitor the insurer*s behavior as well as the traditional reinsurer
    can, thus investors have greater exposure to risk from poor underwriting.
    Therefore,

    catastrophe bond issuers have developed nonindemnity- based bonds.
    Recently issued catastrophe bonds have been structured to make payments to
    the sponsor upon the occurrence of specified catastrophic events that

    can be objectively verified, such as an earthquake reaching 7. 2 or higher
    in moment magnitude. 8 8 Moment magnitude, a measure of earthquake
    intensity similar to the more commonly known Richter scale, has been used
    in catastrophe bonds securitizing earthquake risk.

    We identified and analyzed regulatory, accounting, tax, and investor
    issues that might affect the use of risk- linked securities. First, NAIC
    and insurance industry representatives are considering revisions in the
    regulatory accounting treatment of risk transfer obtained from
    nonindemnity- based coverage that would allow credit to the insurer
    similar to that now afforded traditional (indemnity- based) reinsurance.
    Such a revision, if adopted, has the potential to facilitate the use of
    risk- linked securities. Nevertheless, it is important yet difficult for
    U. S. insurance regulators to develop an effective measure to account for
    risk reduction for nonindemnity- based coverage so that insurance company
    filings with respect to risk evaluation and capital treatment both
    properly reflect the risk retained. Second, the Financial Accounting
    Standards Board (FASB) is proposing a new U. S. Generally Accepted
    Accounting Principles (GAAP) interpretation, which would

    increase independent capital investment requirements that allow the
    sponsor to treat SPRVs and similar entities as independent entities and
    report SPRV assets and liabilities separately. While the proposed guidance
    is intended to improve financial transparency in capital markets, it also
    could increase the cost of issuing catastrophe bonds and make them less
    attractive to sponsors. If the proposed rule were implemented, sponsors

    might turn to risk- linked securities such as catastrophe options that do
    not require an SPRV. 9 Third, *pass- through* tax treatment* which
    eliminates taxation at the

    SPRV level* with favorable implementing requirements could facilitate
    expanded use of catastrophe bonds, but such legislative actions may also
    create pressure from other industries for similar tax treatment. It is not
    clear if and when regulatory, accounting, and tax issues will be resolved.
    Fourth, catastrophe bonds, most of which are noninvestment- grade
    instruments, have not been sold to a wide range of investors beyond
    institutional investors. Investment fund managers whose portfolios include
    catastrophe bonds told us that these bonds comprise 3 percent or less of

    their portfolios. On the one hand, the managers appreciate the
    diversification aspects of catastrophe bonds because the risks are
    generally uncorrelated with the credit risks of other parts of the bond
    portfolio. On

    the other hand, the risks are difficult to assess and the bonds have a
    limited track record. If the ability of investors to evaluate the risks
    and rewards of risk- linked securities improves, or if catastrophe
    reinsurance price and availability becomes problematic, the risk- linked
    securities market has the potential to expand.

    9 See appendix II for a discussion of catastrophe options.

    This report does not contain any recommendations. We obtained comments on
    a draft of this report which are discussed on pages 30 to 32.

    Background Natural catastrophes have a low probability of occurrence, but
    when they do occur the consequences can be of high severity. Insurance
    companies

    face catastrophe risk associated with their provision of property-
    casualty insurance. Major reinsurers are insurance companies with global
    insurance and reinsurance operations. Insurers and reinsurers are subject
    to *moral hazard,* which is *the incentive created by insurance that
    induces those

    insured to undertake greater risk than if they were uninsured, because the
    negative consequences are passed through to the insurer.* Therefore,
    reinsurers have incentives to limit the possibility that ceding insurers
    take actions that would create negative consequences for the reinsurer.
    Indemnity reinsurance contracts have the potential to increase a
    reinsurer*s

    risk exposure to the extent that the reinsurer might be unaware of the
    underwriting and claims settlement practices of the ceding insurer.

    Traditional reinsurance is generally indemnity- based and tailored to the
    needs of the ceding company because traditional reinsurance depends, in
    part, on well- developed contractual and business relationships between

    insurers and reinsurers. When reinsurance coverage is not indemnitybased,
    the ceding insurer is exposed to basis risk* the risk that there may be a
    difference between the payment received from the reinsurance coverage and
    the actual accrued claims of the ceding insurance company. Property-
    casualty reinsurance agreements are typically single- event, excess of
    loss contracts. A single- event contract means that the reinsurer*s

    obligations are specific to an event, such as a hurricane in a
    contractually specified geographic area. Excess of loss means that the
    reinsurer makes payments that are based on a contractually specified share
    of claims in

    excess of a minimum amount, subject to a maximum claim payment.

    The financial industry has developed instruments through which primary
    financial products, such as lending or insurance, can be funded in the
    capital markets. Lenders and insurers continue to provide the primary
    products to the customers, but these financial instruments allow the
    funding of the products to be *unbundled* from the lending and insurance

    business; instead, the funding comes from securities sold to capital
    market investors. This process, called securitization, can give insurers
    access to the large financial resources of the capital markets. 10 With
    respect to funding catastrophe risk in property- casualty insurance, the
    risk of investing is tied to the potential occurrence of a specified
    catastrophic event and to the quality of underwriting by insurers and
    reinsurers. In evaluating risk, capital market investors face the issue of
    moral hazard because in the absence of well- developed contractual and
    business relationships with primary market insurers, capital market
    investors might be unable to monitor the primary insurance company*s
    underwriting and

    claims settlement practices that can act to increase risk.
    Nonindemnitybased coverage is a means to limit moral hazard for the
    investor by tying payment to industry loss indexes, parametric measures,
    and models of claims payments rather than actual claims that could be
    affected by lax

    underwriting standards or lax settlement of claims by the ceding insurer.
    However, such coverage introduces basis risk for the sponsoring insurance
    company. 11 Insurance companies are not regulated at the federal level but
    are to comply with the laws of the states in which they operate. The
    insurance regulators of the 50 states, the District of Columbia, and U. S.
    territories

    have created NAIC to coordinate regulation of multistate insurers. NAIC
    serves as a forum for the development of uniform policy, and its
    committees develop model laws and regulations governing the U. S.
    insurance industry. Although not required to do so, most states either
    adopt model laws or modify them to meet their specific needs and
    conditions.

    10 To illustrate the size of U. S. capital markets, we used Federal
    Reserve Board Flow of Funds data for the quarter ended March 31, 2002. Our
    calculation indicated that the size of the U. S. capital markets was about
    $31 trillion. We included outstanding levels of U. S. Treasury securities
    (excluding savings bonds), agency securities, municipal securities,
    corporate and foreign bonds, and corporate equities.

    11 Basis risk is the possibility that the value of a hedge will not move
    precisely with the value of the item being hedged. For catastrophe risk,
    basis risk is the risk that, for example, the value of a catastrophe
    option will not move precisely with the insurer*s catastrophe loss
    experience.

    NAIC also has established statutory accounting standards, which are
    intended for use by insurance departments, insurers, and auditors when
    state statutes or regulations are silent. If not in conflict with state
    statutes and regulation, or in cases when the state statutes are silent,
    statutory accounting standards promulgated by NAIC are intended to apply.
    In addition to statutory accounting standards, insurers use GAAP, which
    are promulgated by FASB and are designed to meet the varying needs of both
    insurance and noninsurance companies. Although NAIC*s statutory accounting
    standards use the framework established by GAAP, GAAP

    stresses the measurement of earnings from period to period, while NAIC*s
    standards stress the measurement of ability to pay claims in the future.
    NAIC has also developed the Risk- Based Capital for Insurers Model Act,
    adopted in some form in all states, which imposes automatic requirements
    on insurers to file plans of action when their capital falls below minimum

    standards. Insurance and Natural catastrophes are infrequent events that
    can cause severe financial Reinsurance Markets

    losses. Traditional reinsurance helps insurance companies respond to
    severe losses by limiting their individual liability on specific risks and
    Provide Catastrophe

    thereby increases individual insurers* capacity. However, insurance Risk
    Coverage and companies have been faced with higher reinsurance premiums
    for certain Capital Markets Add to coverage following significant past
    natural catastrophes. Higher costs of reinsurance helped spur the
    development of risk- linked securities as an Industry Capacity alternative
    to traditional reinsurance. Natural Catastrophes Are

    Although natural catastrophes occur relatively infrequently compared with
    Infrequent Events but Cause

    other insured events, they can affect large numbers of persons as well as
    their property. The U. S. property and casualty insurance 12 industry has
    Severe Loss

    paid, on average, $9.7 billion in catastrophe- related claims per year
    from 1989 through 2001, and the amount of claims paid can be highly
    variable. More than 68 million Americans now live in hurricane- vulnerable
    coastal areas. Eighty percent of Californians live near active faults.
    When natural

    disasters occur they cause damage and destruction, which may or may not 12
    Property- casualty insurance protects individuals and commercial
    businesses against the risks associated with the loss of property from
    fire and other hazards, or loss deriving from liability for personal
    injury and damage to the property of others. Property- casualty insurance
    includes damage to real estate, automobiles, glass, and other items.

    be covered by insurance. The four most costly types of insured
    catastrophic perils in the United States are earthquakes, hurricanes,
    tornadoes, and hailstorms, although earthquakes and hurricanes pose the
    most significant catastrophe risk in insurance markets. Figure 1 shows the
    combined relative risk of these hazards across the United States.

    Figure 1: Catastrophic Risk in the United States: Earthquake, Hurricane,
    Tornado, and Hail

    Note: Risk is depicted as average annual loss at a given location from a
    broad range of catastrophic events. Losses from fires following
    earthquakes are not included. Because flood- related losses are largely
    covered by the National Flood Insurance Program, flooding and coastal
    storm surges are not included. Source: Risk Management Solutions.

    In August 1992, Hurricane Andrew swept ashore in Florida south of Miami
    and at the time set a new record for insured losses. As shown in figure 2,
    estimated losses from Andrew were about $30 billion, of which $15.5
    billion was insured. Payments of claims stemming from Andrew reduced the
    capital of affected insurance companies and sharply reduced their capacity
    to issue new policies. Some of Florida*s largest homeowner insurance

    companies had to be rescued by their parent companies and others had to
    tap their surpluses to pay claims. Eleven property- casualty insurance
    companies went into bankruptcy. In January 1994, an earthquake occurred
    about 20 miles northwest of downtown Los Angeles in the Northridge area of
    the San Fernando Valley. Also shown in figure 2, estimated losses from

    the Northridge earthquake were about $30 billion, of which approximately
    $12.5 billion was insured. Earthquake insurance coverage availability
    declined precipitously after the Northridge earthquake. Losses from the
    Kobe, Japan, earthquake and the September 11, 2001, terrorist attack on
    the World Trade Center also are included in figure 2 to illustrate the
    global nature of the insurance capacity problem and to provide perspective
    on the size of losses.

    Figure 2: Estimated Losses from Recent Large Catastrophes

    Note: Dollar figures are estimates of insured, uninsured, and total loss.
    Sources: Insurance Information Institute and other insurance industry
    sources.

    Catastrophe Risk Is Usually For many individuals and organizations,
    insurance is the most practical and

    Covered through Insurance, effective way of handling a major risk such as
    a natural catastrophe. By

    Reinsurance, and obtaining insurance, individuals and organizations spread
    risk so that no

    Retrocession single entity receives a financial burden beyond its ability
    to pay. But catastrophic loss presents special problems for insurers in
    that large

    numbers of those insured incur losses at the same time. Reinsurance helps
    insurance companies underwrite large risks, limit liability on specific
    risks, increase capacity, and share liability when claims overwhelm the
    primary insurer*s resources. In reinsurance transactions, one or more
    insurers agree, for a premium, to indemnify another insurer against all or
    part of the loss that an insurer may sustain under its policies. Figure 3
    illustrates traditional insurance, reinsurance, and retrocessional
    transactions. 13

    Figure 3: Traditional Insurance, Reinsurance, and Retrocessional
    Transactions

    Source: GAO.

    Reinsurance is a global business. According to RAA, almost half of all U.
    S. reinsurance premiums were paid to foreign reinsurance companies. 14 13
    Retrocessional coverage is reinsurance obtained by a reinsurance company
    when it transfers risk to another reinsurer. 14 According to RAA, in 2000
    U. S. insurance companies paid 53. 4 percent of their premiums to U. S.
    reinsurance companies and alien reinsurers received 46. 6 percent of
    reinsurance

    premiums. Premiums paid by U. S. insurance companies to offshore companies
    were most likely to go to reinsurance companies domiciled in Bermuda, the
    Cayman Islands, the United Kingdom, Germany, and Switzerland.

    Insurers Are Subject to Catastrophe reinsurance has experienced cycles in
    prices, both nationally

    Reinsurance Price Swings and in specific geographic areas. Figure 4
    presents a national reinsurance

    price index since 1989, which shows that, overall, reinsurance prices
    increased both before and after Hurricane Andrew and decreased after the
    Northridge earthquake. 15

    Figure 4: U. S. Reinsurance Prices, 1989- 2001

    Note: This figure creates a price index set equal to 100 in 1989
    normalized prices. We could not obtain information to assess the
    reliability of the price data. Source: Guy Carpenter & Company, Inc., a
    subsidiary of Marsh & McLennan Companies. 15 RAA commented that property
    catastrophe events have led to the creation of the Bermuda property
    reinsurance market that has played a major role in introducing new
    capacity into the marketplace after a major event.

    The price trend presented in figure 4 does not reflect the situations
    specific to Florida and California, where insurers refused to continue
    writing catastrophe coverage. In 1993, the Florida state legislature
    responded by establishing the Florida Hurricane Catastrophe Fund to
    provide reinsurance for insurance companies operating in Florida. 16 Also,
    the Northridge earthquake raised serious questions about whether insurers
    could pay earthquake claims for any major earthquake. In 1994, insurers
    representing about 93 percent of the homeowners insurance market in

    California severely restricted or refused to write new homeowners
    policies. In 1996, the California state legislature responded by
    establishing the California Earthquake Authority (CEA) to sell earthquake
    insurance to homeowners and renters. Appendix III more fully discusses the

    mechanisms established by Florida and California to deal with the risks
    posed by such catastrophes.

    In one comprehensive study analyzing the pricing of U. S. catastrophe
    reinsurance, 17 the authors concluded that a catastrophic event, such as a
    hurricane, reduced capital available to cover nonhurricane catastrophe

    reinsurance, thereby affecting reinsurance prices. This finding is
    consistent with the *bundled* nature of capital investment in traditional
    reinsurance (i. e., capital investors face both the risks associated with
    company management and the various perils covered by the insurance
    company). Therefore, the finding suggests that price and availability
    swings for catastrophe reinsurance covering one peril are affected by
    catastrophes

    involving all other perils. 18 Given the cyclic nature of the reinsurance
    market, investors have incentives to look for alternative capital sources.
    Hurricane Andrew and the Northridge earthquake provided an impetus for
    insurance companies and others to find different ways of raising capital
    to help cover 16 RAA commented that the private reinsurance market
    provides reinsurance to many primary companies in Florida. 17 Froot,
    Kenneth A. and Paul G. J. O*Connell, *The Pricing of U. S. Catastrophe
    Reinsurance,* in Kenneth A. Froot, ed., The Financing of Catastrophe Risk,
    National Bureau of Economic Research Project Report, (Chicago: Univ. of
    Chicago Press, 1999). We did not verify the reliability of the data used
    nor the authors* methodology. The authors relied on Guy Carpenter &
    Company pricing data for the years 1970 through 1994. 18 BMA commented
    that reinsurance prices in the United States are influenced by events in
    other parts of the world.

    catastrophic risk and helped spur the development of risk- linked
    securities and other alternatives to traditional reinsurance.

    Catastrophe Risk Can Be Catastrophe risk securitization began in 1992 with
    the introduction of Transferred to Capital

    index- linked catastrophe loss futures and options contracts by the
    Chicago Markets

    Board of Trade (CBOT). For more information on catastrophe options, see
    Appendix II. Other risk- linked securities, especially catastrophe bonds,
    were created and used in the mid- 1990s in the aftermath of Hurricane
    Andrew and the Northridge earthquake. During this time, traditional
    reinsurance prices were relatively high compared with other time periods.
    While the most direct means for insurance companies to raise capital in
    the capital market is issuing company stock, an investor in an insurance
    company*s stock is subject to the risks of the entire company. Therefore,
    an investor*s decision to purchase stock will depend on an assessment of
    the insurance company*s management, quality of operations, and overall
    risk exposures from all perils. In contrast, an investor in an indemnity-
    based, risk- linked security can face risk associated with the insurance
    company*s underwriting standards but does not take on the risk of the
    overall insurance (or reinsurance) company*s operations. The cost of
    issuing risklinked

    securities, such as catastrophe bonds, includes the legal, accounting, and
    information costs that are necessary to issue securities and market them
    to investors who do not have contractual and/ or business relationships
    with the insurance company receiving coverage. The market test for a
    securitized financial instrument, such as a catastrophe bond, depends, in
    part, on how well investors can evaluate the probability and severity of
    loss that may affect returns from the investment.

    However, the willingness of capital market investors to purchase
    instruments that securitize catastrophe risk, such as catastrophe bonds,
    and therefore the yields they will require, depends on a number of
    factors, including the investors* capacity to evaluate risk and the degree
    to which the investment can facilitate diversification of overall
    investment

    portfolios. 19 Demand for risk- linked securities by insurance and
    reinsurance company sponsors will depend, in part, on the basis risk faced
    and the ability of sponsors to hedge 20 this basis risk. Although issuance
    of risk- linked securities has been limited, many of the catastrophe bonds
    issued to date have provided reinsurance coverage for catastrophe risk
    with the lowest probability and highest financial severity. Insurance
    industry officials we interviewed told us that their use of risklinked
    securities has lowered the cost of some catastrophe protection. In
    addition, one official told us that the presence of risk- linked
    securities as a

    potential funding option has helped lower the cost of obtaining
    catastrophe protection covering low- probability, high- severity
    catastrophes from traditional reinsurers. According to the Swiss
    Reinsurance Company, in 2000, risk- linked

    securities represented less than 0.5 percent of worldwide catastrophe
    insurance and, according to estimates provided by Swiss Re and Goldman
    Sachs, between 1996 and August 2002, about $11 to $13 billion in
    risklinked securities had been issued worldwide. 21 As of August 2002,
    over 70 risk- linked securitizations had been done, according to Goldman
    Sachs. Risk- linked securities have covered perils that include
    earthquakes,

    19 BMA commented that there are often compelling reasons for sponsors of
    risk- linked securities to use nonindemnity- based structures, including
    that they (1) more effectively shield the confidentiality of the sponsor*s
    underwriting criteria, (2) may provide for more streamlined deal
    structuring and deal execution, and (3) may facilitate a more rapid payout
    in response to triggering events. 20 A hedge is a strategy used to offset
    risk. For example, investors can hedge against inflation

    by purchasing assets that they believe will rise in value faster than
    inflation. 21 Estimates of the number and dollar amount of risk- linked
    securities vary. These estimates are published by various industry
    sources, such as investment banks, insurance brokers, and rating agencies.
    The estimates differ because some of these data, such as those for
    privately placed catastrophe bonds, are not generally available and
    because the sources differ in how they define the instruments and
    transactions included as risk- linked securities. For example, an
    instrument called contingent equity may be included by some sources and
    not by other sources. BMA commented that about $6 to $7 billion in
    catastrophe- related, risk- linked securities were issued during this time
    period.

    hurricanes, and windstorms in the United States, France, Germany, and
    Japan.

    Risk- Linked Securities Catastrophe options offered by CBOT beginning in
    1995 were among the Have Complex

    first attempts to market risk- linked securities. The contracts covered
    exposures on the basis of a number of broad regional indexes that exposed
    Structures

    insurers to basis risk, and trading in CBOT catastrophe options ceased in
    1999 due to lower- than- expected demand (see app. II). 22 Insurance
    companies and investment banks developed catastrophe bonds, and the bonds
    are offered through the SPRVs. Recent catastrophe bonds have been
    nonindemnity- based to limit moral hazard; therefore, they expose the
    sponsor to basis risk. The SPRVs are usually established offshore to take

    advantage of lower minimum required levels of capital, favorable tax
    treatment, and a generally reduced level of regulatory scrutiny.

    Currently most risk- linked securities are catastrophe bonds. Most
    catastrophe bonds issued to date have been noninvestment- grade bonds. 23
    Catastrophe bonds achieved recognition in the mid- 1990s. They offered
    several advantages that catastrophe options did not, among them
    customizable offerings and multiyear pricing. Catastrophe bonds, to date,
    have been offered as private placements only to qualified institutional
    buyers. 24 A catastrophe bond offering is made through an SPRV that is
    sponsored by an entity that may be an insurance or reinsurance company. 25
    The SPRV provides reinsurance to a sponsoring insurance or reinsurance

    company and is backed by securities issued to investors. The SPRVs are
    similar in purpose to the special purpose entities (SPE) that banks and 22
    For a description of other capital market instruments used to manage
    catastrophe risk, see U. S. General Accounting Office, Insurers* Ability
    to Pay Catastrophe Claims, GAO/ GGD00- 57R (Washington, D. C.: Feb. 8,
    2000). 23 Some catastrophe bonds contain tranches that have received
    investment grade ratings. BMA commented that a small but growing
    percentage of newly issued, risk- linked securities have been investment
    grade.

    24 A private placement is a sale of a security to an institutional
    investor that does not have to be registered with SEC. Here, an
    institutional investor is defined by Rule 144A. This SEC rule provides an
    exemption for limited secondary market trading of privately placed
    securities. 25 A noninsurance business that has catastrophe exposure can
    also sponsor catastrophe bonds through a similar entity, a special purpose
    vehicle.

    other entities have used for years to obtain funding for their loans. 26
    These SPEs pay investors from principal and interest payments made by
    borrowers to the SPE. In contrast, the SPRVs that issue catastrophe bonds
    receive payments in three forms (premiums, principal, and interest);
    invest in securities; and pay investors in another form (interest). The
    SPRV returns the principal to the investor if the specified catastrophe
    does not occur. Figure 5 illustrates cash flows among the participants in
    a catastrophe bond.

    Figure 5: Special Purpose Reinsurance Vehicle

    Source: GAO.

    As shown in figure 5, the sponsoring insurance company enters into a
    reinsurance contract and pays reinsurance premiums to the SPRV to cover 26
    According to Federal Reserve Board Flow of Funds data, at the end of 2001,
    over $1. 8 trillion of loans outstanding were financed by asset- backed
    securities issued by such SPEs.

    The underlying loans were made to consumers, students, businesses, and
    homeowners exclusive of mortgage- backed securities guaranteed by
    government agencies, government corporations, and government- sponsored
    enterprises.

    specified claims. The SPRV issues bonds or debt securities for purchase by
    investors. The catastrophe bond offering defines a catastrophe that would
    trigger a loss of investor principal and, if triggered, a formula to
    specify the compensation level from the investor to the SPRV. The SPRV is
    to hold the funds raised from the catastrophe bond offering in a trust in
    the form of Treasury securities and other highly rated assets. 27 To avoid
    consolidation

    on the sponsor*s balance sheet, the trust also is to contain a minimum
    independent equity- capital investment of at least 3 percent of the SPRV*s
    assets, per GAAP. According to a rating agency official, the 3 percent
    equity capital is usually obtained from capital markets in the form of
    preferred stock. Typically, investors earn a return of the London
    Interbank Offered

    Rate (LIBOR) 28 plus an agreed spread. The SPRV deposits the payment from
    the investor as well as the premium from the company into a trust account.
    The premium paid by the insurance or reinsurance company and the
    investment income on the trust account provide the funding for the
    interest payments to investors and the costs of running the SPRV. Under
    the terms of nonindemnity- based catastrophe bonds, for the

    sponsoring insurance company to collect part or all of the investors*
    principal when the catastrophe occurs, an independent third party must
    confirm that the objective catastrophic conditions were met, such as an
    earthquake reaching 7.2 in moment magnitude as reported by the U. S.
    Geological Survey. Such nonindemnity bonds also allow the sponsor to
    continue to write new business without impacting the risk level of the
    bond and provide for faster reimbursement to the sponsor in the event of a
    catastrophe. The sponsor is exposed to basis risk because the claims on
    the investors* principal might not fully hedge the sponsor*s actual
    catastrophe exposure. However, the sponsor has minimal credit risk* the
    risk of nonpayment in the event of the covered catastrophe* because the
    bond is fully collateralized. The SPRVs are usually established offshore*
    typically in Bermuda or the Cayman Islands* to take advantage of lower
    minimum

    27 The fixed- rate interest payments are swapped for floating- rate
    interest payments from a highly rated swap counterparty. 28 LIBOR is the
    rate that the most creditworthy international banks charge each other for
    large loans. The SPRVs enter into interest rate swaps to exchange fixed-
    rate interest payments earned by funds invested in conservative
    instruments, such as U. S. government Treasury securities, for floating-
    rate interest payments, such as LIBOR.

    required levels of capital, favorable tax treatment, and a generally
    reduced level of regulatory scrutiny. 29 Bond rating agencies, such as
    Fitch, Moody*s, and Standard & Poors,

    provide bond ratings that are based on their assessment of loss
    probabilities and financial severity. Some SPRVs have issued catastrophe
    bonds in tranches having more than one risk structure. 30 The rating
    agencies rate the bonds according to expected loss. 31 Catastrophe bonds
    issued to date have generally received noninvestment- grade ratings
    because investors face a higher risk of loss of their principal. 32 The
    rating agencies rely, in part, on the risk assessments of three major
    catastrophemodeling

    firms* the same firms are used by traditional reinsurers to help them
    understand catastrophe risk. These modeling firms rely on large computing
    capacity; sophisticated mathematical modeling techniques; and very large
    databases containing information on past catastrophes, population
    densities, construction techniques, and other relevant information to
    assess loss probabilities and financial severities. Catastrophe bond-
    offering statements to investors include rating

    information and the results from the catastrophe modeling. One example of
    a catastrophe bond is Redwood Capital I, Ltd., which is linked to
    California earthquakes. Lehman Re, a reinsurance company, is the sponsor
    of the bond. Due to the catastrophe bond structure, investors are

    exposed to potential loss of principal of about $160 million. The contract
    provides insurance for 12 months beginning January 1, 2002, covering
    specified earthquake losses to property in California. The interest rates
    promised on the principal- at- risk variable rate notes and preference
    shares are LIBOR+ 5. 5 percent and LIBOR+ 7 percent. Investor losses are
    tied to 29 BMA commented that the principal reason risk- linked securities
    are organized offshore is to avoid entity- level taxation of those
    vehicles.

    30 Tranches are classes of a security that have different characteristics
    of risks and returns. The issuer of a security can split the security*s
    scheduled cash flows into separate classes known as tranches. Often, one
    tranche of an issue has greater exposure to risk than another tranche, and
    the different rates that investors can earn on these different tranches
    reflect their different risks. 31 There are some differences among rating
    agencies in their methodology for assigning ratings for some of the
    catastrophe risk structures. BMA commented that bonds are rated according
    to frequency of loss as well as expected loss. 32 Some catastrophe bonds
    contain tranches that have received investment- grade ratings and tranches
    with a noninvestment- grade rating.

    the Property Claim Services (PCS) index, an indicator of insured property
    losses for catastrophes. The issuer provides reinsurance coverage for the
    earthquake peril in California to Lehman Re, the sponsor, for triggering
    events causing industry losses that range from $22.5 billion to $31.5
    billion

    as estimated by PCS. Proceeds from the issuance of the securities are to
    be deposited into a collateral account and invested in securities that are
    guaranteed or insured by the U. S. government and in highly rated
    commercial paper and other securities. The securities have been offered
    only to qualified institutional buyers as defined by SEC Rule 144A.
    Moody*s rated the bond a Ba2 (i. e., a noninvestment- grade bond rating)
    on the basis of the determination that it is comparable to a Ba2- rated
    conventional bond of similar duration. The rating took into account the
    risk analysis of a catastrophe- modeling firm. Regulatory,

    We identified and analyzed regulatory, accounting, tax, and investor
    issues Accounting, Tax, and that might affect the use of risk- linked
    securities. Our analysis included (1) current accounting treatment of
    risk- linked securities and proposed Investor Issues Might

    changes to accounting treatment, (2) potential changes in equity Affect
    Use of RiskLinked requirements for the SPRVs, (3) a preliminary tax
    proposal by insurance

    Securities industry representatives to encourage domestic issuance of
    catastrophe bonds by creating *pass- through* tax treatment, and (4)
    reasons for limited

    investor participation in risk- linked securities. Regulators Are

    Under certain conditions, NAIC*s Statutory Accounting Principles allow an
    Reconsidering Accounting insurance company that obtains reinsurance to
    reflect the transfer of risk

    Treatment of Risk- Linked (effected by the purchase of reinsurance) on the
    financial statement it files

    Securities with state regulators. These regulatory requirements are
    designed to ensure that a true transfer of risk has occurred and the
    reinsurance company will be able to pay any claims. 33 In receiving
    *credit* for reinsurance, an insurance company may count the payments owed
    it from

    the reinsurance company on claims it has paid as an asset or as a
    deduction from liability. In doing so, a company can increase earnings
    reported on its 33 While such requirements have been promulgated, many
    insurance regulators hold the view

    that it is not within their oversight responsibility to police individual
    reinsurance business transactions between insurance companies, as such
    transactions are between sophisticated parties. See U. S. General
    Accounting Office, Summary of Reinsurance Activities and Rating Actions
    Tied to Selected Insurers Involved in the Failed *Unicover* Venture,
    GAO01- 977R (Washington, D. C.: Aug. 24, 2002).

    financial statement and lower the amount of capital it needs to meet
    riskbased capital requirements established by regulators. The ability to
    record an asset or to take a deduction from gross liability for
    reinsurance is consequent upon the transfer of risk and can strongly
    affect an insurance company*s financial condition.

    Traditional reinsurance pays off on an indemnity trigger* that is, payment
    is based on the actual claims incurred by the insurance company. Some
    risk- linked securities have also provided payments from principal on an
    indemnity basis, and, under insurance accounting principles, these
    risklinked securities have enabled the SPRVs to provide reinsurance that
    has received what is called *underwriting accounting treatment,* thereby

    allowing the SPRV sponsor to gain credit for reinsurance. In other cases,
    recovery under a catastrophe bond may not be indemnity based and may rely
    on a financial model of the insured claims of the insurance company rather
    than on the actual claims of the company. In these cases, there is a risk
    that the modeled claims will not equal the insurance company*s actual
    claims. There are also risks that the financial model will produce a
    recovery less or greater than the companies* incurred claims. Current
    accounting guidance requires that the contract must indemnify the company
    against loss or liability associated with insurance risk in order to
    qualify for reinsurance accounting.

    However, NAIC is currently reconsidering the appropriate statutory
    accounting treatment of nonindemnity- based insurance, which would include
    risk- linked securities. 34 Both exchange- traded instruments and over-
    the- counter instruments can be used to hedge underwriting results (i. e.,
    to offset risk). The triggering event on a risk- linked contract must be
    closely related to the insurance risks being hedged so that the payoff is
    expected to be consistent with the expected claims, even though some

    basis risk may still exist. This correlation is known as *hedge

    effectiveness.* NAIC is currently considering how hedge effectiveness
    should be measured. Should NAIC determine a hedge- effectiveness measure,
    statutory insurance accounting standards could be changed so that a fair
    value of the contract could be calculated and recognized as an offset to
    insurance losses, hence allowing a credit to the insurer similar to 34 A
    white paper on the subject written by members of NAIC*s securitization
    subcommittee specifically addressed treatment of nonindemnity- based
    insurance derivatives, such as catastrophe options. However, NAIC is
    addressing this issue as it relates more broadly to risk- linked
    securities.

    that granted for reinsurance. If nonindemnity- based, risk- linked
    securities are accepted by insurance regulators as an effective hedge of
    underwriting results, they could help make such contracts more appealing
    to insurance companies by providing treatment similar to that afforded
    traditional reinsurance. Nevertheless, it is important yet difficult for
    U. S. insurance regulators to develop an effective measure to account for
    risk reduction for nonindemnity- based coverage so that insurance company
    reporting on

    both risk evaluation and capital treatment properly reflects the risk
    retained. Appendix IV contains a discussion of credit for reinsurance
    accounting treatment and the balance sheet implications of such treatment.

    Proposed Rule on Equity An SPE is created solely to carry out an activity
    or series of transactions Requirements Could Affect

    directly related to a specific purpose. The use of an SPE (or more
    Catastrophe Bonds specifically an SPRV) in a catastrophe bond
    securitization transaction involves a number of complex financial
    accounting issues in the United States. Current FASB guidance generally
    provides that the sponsor of an SPE report all assets and liabilities of
    the SPE in its financial statements, unless all of the following criteria
    are met:

    1. Independent third- party owner*s( s*) investment in the SPE is at least
    3 percent of the SPE*s total debt and equity or total assets. 2. The
    independent third- party owner( s) has a controlling financial

    interest in the SPE (generally meaning that the owner holds more than 50
    percent of the voting interest of the SPE).

    3. Independent third- party owners must possess the substantive risk and
    rewards of its investment in the SPE (generally meaning that the owner*s
    investment and potential return are *at risk* and not guaranteed by
    another party). 35

    In response to issues arising from Enron*s use of SPEs, FASB is currently
    considering a new approach to accounting for SPEs. The new FASB
    interpretation would require the primary beneficiary of an SPE to
    consolidate (list assets and liabilities of) the SPE in its financial
    statements, unless the SPE has *economic substance* sufficient not to be
    consolidated; that is, the SPE would have to have the ability to fund or
    finance its

    35 See Emerging Issues Task Force (EITF), Topic Number D- 14, Transactions
    Involving Special Purpose Entities and other related EITF issues.

    operations without assistance from or reliance on any other party involved
    in the SPE. In turn, the SPE would have that ability if it had independent
    third- party owners who have substantive voting equity investment at risk,
    exposure to variable returns, and the ability to make decisions and manage
    the SPE*s activities. A presumption is set that substantive equity
    investment in an SPE should be at least 10 percent of the SPE*s total
    assets throughout the life of the SPE. Therefore, according to information
    provided by FASB,

    many existing SPEs would probably be consolidated on the sponsors*
    financial statements under the new requirement. The potential revision for
    equity requirements is intended to improve transparency in capital
    markets. According to rating agency officials, the current 3 percent
    independent equity requirements in recent catastrophe bond transactions

    have been met by issuing preferred stock. Our work did not determine the
    extent to which the 3 percent independent equity requirement is currently
    being met by the insurance industry.

    Bond market representatives told us that the proposed FASB equity
    requirements also have the potential to create a substantial hurdle to
    structuring catastrophe bond SPEs because few investors would be willing
    to purchase preferred shares because of the difficulties in understanding
    the risks. These representatives argue that risk- linked securitizations
    are different from other securitizations using SPEs because the insurer
    does not control the funds held by the SPE, and therefore, should not be
    subject to the new 10 percent equity investment requirement. The proposed
    new FASB interpretation also considers who bears the

    largest potential risks of the SPE when determining whether to consolidate
    with the primary beneficiary. Should the primary beneficiary bear the
    largest dollar loss if the SPE should fail, then consolidation would be
    required with the primary beneficiary. According to one FASB

    representative, one issue that needs to be considered is whether the
    insurer or the investors should be responsible for reporting or
    consolidating the assets and liabilities of the SPE in financial
    statements depending on who bears the largest potential risks of the SPE.
    If an insurer must consolidate the assets and liabilities of the SPE onto
    its own balance sheet, the insurer will also lose part of the benefit of
    the reinsurance contract that it enters into with the SPE.

    While the proposed guidance is intended to improve financial transparency
    in capital markets, it could also increase the cost of issuing catastrophe
    bonds and make them less attractive to sponsors. If the proposed rule were

    implemented, sponsors might turn to risk- linked securities that do not
    require an SPE, such as catastrophe options.

    Insurance Industry NAIC is concerned that offshore SPRVs reduce economic
    efficiency and

    Representatives Have limit the oversight ability of insurance regulators.
    To further encourage the

    Proposed Pass- Through Tax use of onshore SPRVs, NAIC*s working group on
    securitization has Treatment of Risk- Linked

    interacted with a group of insurance industry representatives that is
    considering how to structure a legislative proposal to make onshore SPRVs
    Securities

    tax- exempt entities. The SPRVs have been established in offshore tax
    haven jurisdictions, where the SPRV itself is not subject to any income or
    other tax; the SPRVs also usually operate in a manner intended to help
    ensure that they avoid U. S. taxation by conducting most activities
    outside of the United States. 36 Taxation of the U. S. holders of SPRV-
    issued

    securities depends upon whether the securities are characterized as debt
    or equity. This characterization in turn depends upon a number of factors,
    including the likelihood of loss of principal, the relative degree of
    subordination of the instrument in the SPRV*s capital structure, and the
    accounting treatment of the instrument. Although almost all SPRVs have
    been established offshore, there has been interest in facilitating the
    creation of onshore transactions because it is argued that onshore SPRVs
    would lessen transactional costs and afford

    regulators greater scrutiny of the SPRVs* activities. NAIC has already
    approved a model state insurance law that allows for the creation of an
    onshore SPRV. Under the model law, an onshore SPRV would be an entity
    domiciled in and organized under state law for a limited purpose.
    Insurance

    regulators* scope of authority would be limited for the SPRVs, which would
    be required to be minimally capitalized, and the domiciliary state*s laws
    on insolvency would apply to the SPRV.

    However, it is likely that the onshore SPRV would be subject to federal
    income taxation, making the transaction more expensive. To further 36 The
    status of the SPRV for U. S. federal income tax purposes is dependent upon
    a number of factual issues. If the SPRV were determined to be engaged in a
    U. S. trade or business, it could be subject to U. S. income tax at a rate
    of up to 35 percent, and to a 30 percent branch profits tax on its income,
    resulting in an effective U. S. federal tax rate of up to 54. 5 percent.
    This tax rate would substantially reduce the return to investors. The
    SPRVs are generally characterized as passive foreign investment companies
    and treat the bonds that they issue

    as equity for federal income tax purposes. See Bertil Lundqvist,
    Securitization of Risk of Loss from Future Events, 829 PLI/ Comm 875,
    2001.

    encourage the use of onshore SPRVs, a group of industry attendees at the
    NAIC*s insurance securitization working group is considering a legislative
    proposal to make the onshore SPRVs tax- exempt. Currently, the industry
    representatives are considering using a structure that would receive tax
    treatment similar to the treatment received by an issuer of asset- or

    mortgage- backed securities. Issuers of asset- backed securities are
    generally not subject to tax on the income from underlying assets as they
    pass through the issuer to the investors in the securities. It would not
    be economical for an SPE to issue an asset- backed security if the SPE

    incurred material tax costs on the payments collected and paid over to the
    investors as taxable income. Securitizations address the problem of taxes
    in one of two ways: First, if an asset- backed security is considered debt
    for tax purposes, deductions are allowed for the interest expense, and the
    tax

    burden is shifted to the investors. Second, if the securities are not
    classified as debt, tax is avoided by treating the SPE as a pass- through
    entity with income allocated and taxed to its owners. 37 The current
    proposal by the industry representatives would create a

    structure similar to a Real Estate Mortgage Investment Conduit (REMIC) 38
    or a Financial Asset Securitization Investment Trust (FASIT). REMICs and
    FASITs are pools of real property mortgages or debt instruments that issue
    multiple classes, or tranches, of financial payments among investors. The
    REMIC and FASIT legislation adopt two approaches to avoiding an issuer
    tax: They treat the issuer as a pass- through entity and classify regular

    interest as debt for purposes of allowing an interest deduction to the
    issuer. The proposal would mimic REMICs and FASITs by providing pass-
    through treatment for the onshore SPRV and ensuring that the regular
    payments in the SPRV are classified as debt. To the extent that domestic
    SPRVs gained

    business at the expense of taxable entities, the federal government could
    experience tax revenue losses. The statutory and regulatory requirements
    used to implement any such legislation would also affect tax revenue.

    37 The principal types of mortgage or other asset- backed securities
    currently available are pass- through certificates, pay- through bonds,
    equity interests in domestic issuers of paythrough bonds, pass- through
    debt certificates, and Real Estate Mortgage Investment Conduits and
    Financial Asset Securitization Investment Trusts interests. Offshore
    corporations also are used to issue some asset- backed securities. See
    David Nirenberg, Tax

    Developments in Securitization, 829 PLI/ Comm 411, 2001. 38 Several
    concerns with the use of pass- through certificates and pay- through bonds
    arose, including the inability of a grantor trust to issue pass- through
    certificates that are divided into multiple classes with staggered
    maturities. To address some of these concerns, the Tax Reform Act of 1986
    enacted the REMIC rules.

    Expanded use of catastrophe bonds might occur with favorable implementing
    requirements, but such legislative actions may also create pressure from
    other industry sectors for similar tax treatment.

    Also, some elements of the insurance industry believe that any
    consideration of changes to the tax treatment of domestic SPRVs would have
    to take into account the taxation of domestic reinsurance companies.

    Domestic reinsurance companies are taxed under the special rules of
    Subchapter L of the Internal Revenue Code. Under these rules, all
    insurance companies are taxed as corporations. Premiums earned by a
    domestic reinsurance company, after deducting premiums paid for
    retrocessional insurance coverage, are taxable. Investment income earned
    by the reinsurer is also taxable. A ceding commission paid by a reinsurer
    to an insurer to cover costs, including marketing and sale of the premium,
    is taxable to the ceding insurance company. However, many reinsurers are

    either incorporated offshore or are affiliated with companies created
    offshore to take advantage of reduced levels of taxation. Payments to an
    offshore reinsurer may be subject to an excise tax. 39 In addition,
    because of

    the potential for abuses, the Secretary of the Treasury has special
    statutory authority to reallocate deductions, assets, and income between
    unrelated parties when a reinsurance transaction has a significant tax
    avoidance effect. 40

    RAA officials expressed concerns about the impact of NAIC*s model act
    creating an onshore SPRV. RAA objects to both the special regulatory
    treatment in the model act and the tax advantages proposed for the onshore
    SPRV. RAA argues that the NAIC model act creates a new class of

    reinsurer that will operate under regulatory and tax advantages not
    afforded to existing U. S. licensed and taxed reinsurance companies. RAA
    maintains that the SPRV will act as a reinsurer and yet not be subject to
    insurance regulation, thus endangering solvency regulation and creating an

    uneven playing field for reinsurers. 39 26 U. S. C. S:4371.

    40 26 U. S. C. S:845.

    Risk- Linked Securities Do Catastrophe bonds have not attracted a wide
    range of investors beyond

    Not Have Broad Investor institutional investors. Investor participation in
    risk- linked securities is Participation limited in part because the risks
    of these securities are difficult to assess.

    Investment bank representatives and investment advisors we interviewed
    noted that catastrophe bonds have thus far been issued only to
    sophisticated institutional investors and a small number of large

    investment fund managers for inclusion in bond portfolios that include
    noninvestment- grade bonds. Most catastrophe bonds carry
    noninvestmentgrade bond ratings from the rating agencies, but a low rating
    by itself has not been a barrier to active investor interest in other
    types of bonds, such as corporate bonds. The investment fund managers told
    us that catastrophe

    bonds comprise 3 percent or less of the portfolios in which they are
    included. On the one hand, the managers like the diversification aspects
    of catastrophe bonds because the risks are generally uncorrelated with the
    credit risks of other parts of the bond portfolio. On the other hand,
    managers stated that they have concerns about the limited liquidity and
    track record of catastrophe bonds as well as the lack of in- house
    expertise to understand the perils, indexes, and other features of the
    bonds. 41

    As requested, we explored the potential for individual investors to
    purchase shares in mutual funds that purchase catastrophe bonds for
    inclusion with other securities in a mixed asset fund. We analyzed the SEC
    rules governing catastrophe bond issuance and mutual fund composition and
    confirmed with SEC that these rules and regulations do not preclude mutual
    funds from purchasing catastrophe bonds. One of the investment advisors we
    interviewed told us that his firm included a small amount of catastrophe
    bonds in mutual funds sold to the public. However, a mutual fund industry
    association official told us that the mutual fund companies

    that the association surveyed* including three of the largest* have not
    included catastrophe bonds in funds available to individual investors
    because the companies lack the capacity to evaluate the risks. The mutual
    fund industry official also raised the issue of whether the risk
    associated

    with risk- linked securities would be appropriate or suitable for
    investments by a broad range of investors, including moderate- income
    investors. 41 The September 9, 2002, comment letter from RAA notes that no
    catastrophe bond contracts have been triggered by catastrophic events.

    Agency Comments and We received written comments on a draft of this report
    from NAIC, RAA,

    Our Evaluation and BMA. We also obtained technical comments from Treasury,
    SEC, CFTC, NAIC, RAA, and BMA that have been incorporated where

    appropriate. NAIC commented that it supports developing alternative
    sources of reinsurance capacity, the securitizing of catastrophic risk
    within the United States, and subjecting SPRVs to U. S. insurance
    regulation. As stated in our report, a group of insurance industry
    representatives interacting with NAIC*s working group on securitization is
    considering how to structure a legislative proposal to make the onshore
    SPRV a tax- exempt entity. Our report also indicates that such legislation
    also could result in tax revenue losses and other potential costs. NAIC
    stated that SPRVs, however, would be subject to onshore supervision by U.
    S. regulators, but it is not clear to us how risk- linked securities would
    actually be regulated once brought onshore. 42

    RAA commented that our report provides an excellent summary on the use of
    risk- linked securities in providing coverage for catastrophes. However,
    RAA took exception to (1) our characterization of reinsurance industry
    capacity and (2) our description of risk- linked securities as an
    alternative

    to reinsurance. RAA noted that in recent occurrences of major catastrophic
    events in the United States, insurers and reinsurers had sufficient
    capital to meet their obligations and added that most of the California
    and Florida market was underwritten by insurers that relied very little,
    if at all, on reinsurance capacity. First, we note that while the
    reinsurance industry has been able to meet its obligations from recent
    events with existing capacity, the industry*s capacity must be considered
    along with issues related to (1) the price and availability of
    catastrophic reinsurance in high- risk areas and (2) its ability to handle
    multiple, sequential catastrophes. Some insurers who self- reinsure might
    do so partially because they believe that the price

    of reinsurance to cover their exposure to catastrophic events is not
    attractive. Second, RAA asked that we characterize risk- linked securities
    as a supplement to reinsurance rather than as an alternative because of
    the relatively small amount of reinsurance coverage currently provided
    through risk- linked securities. We agree, and our report states that
    risklinked securities add to or supplement reinsurance capacity, but we
    also 42 In one case, companies experienced an estimated $1 to $2 billion
    in losses in reinsuring the

    occupational accident portion of workers* compensation insurance policies.
    See GAO- 01- 977T.

    note that sponsors of catastrophe bonds view these securities as
    alternatives to traditional reinsurance when they are more cost-
    effective. BMA stated that our report was accurate and well- researched
    and commented on several policy issues raised in the report. Their letter
    raised several concerns with our discussion of tax treatment, accounting

    treatment, and investor interest in risk- linked securities. First, BMA
    disagreed with concerns cited in our report that pass- through tax
    treatment for risk- linked securities could result in (1) tax revenue
    losses and (2) regulatory and tax advantages that are not afforded to
    existing U. S. licensed and taxed reinsurance companies. BMA commented
    that because a large percentage of entities that provide reinsurance
    coverage is based

    outside of the United States, including all reinsurance companies
    established since September 11, 2001, the tax impact would not be
    dramatic. In addition, BMA noted that any potential loss of U. S. tax
    revenue must be weighed against the policy benefits associated with
    creating

    additional private- sector capacity to absorb and distribute insurance
    risk. We agree that many reinsurance entities are not U. S.- based, but
    the potential tax revenue losses would depend on a number of factors,
    including business lost by taxable entities and the regulatory
    requirements used to implement such legislation. We also agree that many
    considerations must be weighed in the policy decision to grant special tax
    treatment for onshore SPRVs, including potential tax revenue losses and
    the extent to which an uneven playing field is created for domestic
    reinsurance

    companies. Second, BMA commented that our description of FASB*s SPE
    consolidation proposal was not based on the final exposure draft and that
    they interpret the proposal to allow SPRVs to apply only a variable
    interests approach and not satisfy a particular outside equity threshold.
    Our draft report discussion of the FASB proposal was based on the final
    exposure draft. While we did not evaluate BMA*s interpretation of the FASB
    proposal, we included their position in our report. Finally, BMA commented
    that our discussion of reasons for the lack of broader investor
    participation in risk- linked securities was incomplete and somewhat
    inaccurate. They noted that

    several mutual funds have purchased risk- linked securities as part of
    their overall portfolios, that mutual fund managers are well- equipped to
    evaluate the risk associated with these securities, and that lack of
    broader investor participation may be due to limited issuance. We agree
    that some mutual

    funds have purchased risk- linked securities and that lack of broader
    participation may be attributed to some degree to limited issuance of
    risklinked securities. However, information we obtained indicates that
    some of

    the largest mutual fund companies did not include risk- linked securities
    in their mutual fund portfolios mainly because of their unusual and
    unfamiliar risk characteristics. Unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days from
    the date of this letter. At that time, we will send copies of this report
    to the Ranking Minority Member of the House Committee on Financial
    Services and the Chairmen and Ranking

    Minority Members of the Senate Committee on Banking, Housing and Urban
    Affairs; and the House Committee on Ways and Means. We also will make
    copies available to others upon request. In addition, this report will be
    available for no charge on GAO*s Internet home page at http:// www. gao.
    gov. Please contact Bill Shear, Assistant Director, or me at (202) 512-
    8678 if you or your staff have any questions concerning this report. Key
    contributors to this work were Rachel DeMarcus, Lynda Downing, Patrick
    Dynes, Christine

    Kuduk, and Barbara Roesmann. Sincerely yours,

    Davi M. D*Agostino Director, Financial Markets and

    Community Investment

    Appendi Appendi xes x I

    Scope and Methodology You asked us to report on the potential for risk-
    linked securities to cover catastrophic risks arising from natural events.
    As agreed with your office, our objectives were to (1) describe
    catastrophe risk and how insurance and capital markets provide for
    insurance against such risks; (2) describe how risk- linked securities,
    particularly catastrophe bonds, are structured; and (3) analyze how key
    regulatory, accounting, tax, and investor issues might affect the use of
    risk- linked securities.

    Even though we did not have audit or access- to- records authority with
    the private- sector entities, we obtained extensive documentary and
    testimonial evidence from a large number of entities, including insurance
    and reinsurance companies, investment banks, institutional investors,
    rating agencies, firms that develop models to analyze catastrophic risks,
    regulators, and academic experts. However, we did not verify the accuracy
    of data provided by these entities. Some entities we met with voluntarily
    provided information they considered to be proprietary, and therefore we

    did not report details from such information. In other cases, companies
    decided not to provide proprietary information, and this limited our
    inquiry. For example, we did not obtain any reinsurance contracts
    representing

    either traditional reinsurance or reinsurance provided through issuance of
    risk- linked securities. To describe catastrophe risk and how insurance
    and capital markets provide for insurance against such risks, we examined
    a variety of documents, including books on insurance and reinsurance;
    academic articles and essays; and analyses done by the Insurance
    Information

    Institute, the Insurance Services Office, modeling firms, and the
    Congressional Budget Office. We also interviewed officials from insurance
    companies, reinsurance companies, the California Earthquake Authority
    (CEA), the Florida Hurricane Catastrophe Fund (FHCF), modeling firms, and
    university finance departments and schools.

    To describe how risk- linked securities, particularly catastrophe bonds,
    are structured, we examined catastrophe bond- offering circulars,
    investment bank documents, reinsurance company analyses, rating agency
    reports,

    academic studies, futures exchange documents, and analyses prepared by the
    American Academy of Actuaries. We also met with officials of investment
    banks, insurance companies, reinsurance companies, rating agencies,
    modeling firms, a futures exchange, investment advisors, and the American
    Academy of Actuaries.

    To analyze how key regulatory, accounting, tax, and investor issues might
    affect the use of risk- linked securities, we examined a variety of
    documents, including books on insurance accounting and taxation, the
    Financial Accounting Standards Board*s (FASB) proposed consolidation
    principles for special- purpose entities, accounting firm publications,
    the National Association of Insurance Commissioners* (NAIC) Statutory
    Accounting Principles, and the proceedings of NAIC*s Working Group on

    Securitization. We met with officials from many organizations, including
    NAIC*s Working Group on Securitization, the Bond Market Association (BMA),
    the Reinsurance Association of America, the Investment Company Institute*
    a mutual fund company association, and FASB. We also met with officials
    from the Securities and Exchange Commission (SEC), the

    Commodity Futures Trading Commission (CFTC), and the Department of the
    Treasury (Treasury). We faced a number of limitations in our work. We did
    not verify the accuracy of data provided by the various entities we
    contacted. While we obtained publicly available data on U. S. reinsurance
    prices, we could not obtain information to assess the reliability of the
    price data nor the methodology used to construct the reported price index.
    We obtained offering statements for some catastrophe bond offers. However,
    we could not determine whether the offering statements were representative
    of the universe of catastrophe bond offers, and we relied on summary
    information on the various offers provided to us by bond rating agencies.

    We also faced limitations in identifying the specific financing
    arrangements made to provide independent capital investments to special
    purpose reinsurance vehicles (SPRV) used to avoid consolidation with the
    sponsor*s balance sheet. In addition, without access to reinsurance
    contracts, we could not determine the extent to which insurance and
    reinsurance

    companies received credit for reinsurance, including those companies that
    relied, in part, on risk- linked securities to transfer catastrophe risk.
    Although we identified factors that industry and capital markets experts
    believe might cause the use of risk- linked securities to expand or
    contract, it was not within the scope of our work to forecast increased or
    reduced future use of these securities* either under current accounting,
    regulatory, and tax policies or under changed policies. It also was not
    within the scope of our work to take a position on whether the increased
    use of risk- linked securities is beneficial or detrimental.

    We conducted our work between October 2001 and August 2002 in Washington,
    D. C.; Chicago, Ill.; New York, N. Y.; and various locations in

    California and Florida, in accordance with generally accepted government
    auditing standards.

    Appendi x II

    Catastrophe Options Catastrophe options were offered by the Chicago Board
    of Trade (CBOT) in 1995. These options contracts were among the first
    attempts to market natural disaster- related securities. Catastrophe
    options offered the advantage of standardized contracts with low
    transaction costs traded over an exchange. Specifically, the purchaser of
    a catastrophe option paid the seller a premium, and the seller provided
    the purchaser with a cash payment if an index measuring insurance industry
    catastrophe losses exceeded a certain level. If the catastrophe loss index
    remained below a

    specified level for the prescribed time period, the option expired
    worthless, and the seller kept the premium. The option might have been
    purchased by an insurance company that wanted to hedge its catastrophe
    risk and might have been sold by firms that would do well in the event of
    a catastrophe*

    for example, homebuilders* or by investors looking for a chance to
    diversify outside of traditional securities markets.

    Catastrophe option contracts were revised several times and covered
    exposures on national, regional, and state bases. On the one hand, because
    the payouts on the contracts were based on an index of insurance industry
    catastrophe losses, 43 the transactions did not expose the investor to
    moral hazard or adverse selection 44 risk. The indexes used were the
    Property Claim Services 45 (PCS) catastrophe loss indexes. 46 On the other
    hand, the contracts created basis risk for purchasers* the differences in
    the claim patterns between an individual insurer*s portfolio and the
    industry index.

    The options were to have offered minimal credit risk because the CBOT
    clearinghouse guaranteed the transactions. However, low trading volumes on
    options also raised questions about liquidity risk. Trading in CBOT

    catastrophe options ceased in 1999 due to lower- than- expected demand;
    CBOT delisted catastrophe options in 2000.

    43 The payouts varied with industry catastrophe losses, limited to certain
    maximums. 44 Adverse selection is the tendency of persons with a higher-
    than- average chance of loss to seek reinsurance at average rates, which,
    if not controlled by underwriting, results in higherthan- expected loss
    levels. 45 PCS, a unit of the Insurance Services Office, provides
    estimates of insured losses related to catastrophes incurred by the
    insurance industry. 46 The indexes track PCS*s estimates of the insurance
    industry*s aggregate direct property losses as a result of catastrophes.

    California and Florida Approaches to

    Appendi x II I Catastrophe Risk The insurance markets in California and
    Florida illustrate the difficulties that the catastrophe insurance
    industry has faced nationally. Because California and Florida are markets
    with high catastrophe risk, these states have developed programs to
    increase insurer capacity in these markets. The Northridge earthquake
    raised serious questions about whether insurers could pay earthquake
    claims for any major earthquake. In 1994, insurers representing about 93
    percent of the homeowners insurance market in California severely
    restricted or refused to write new homeowner policies because the insurers
    grew concerned that another

    earthquake would exhaust their resources. Florida experienced a similar
    insurance crisis after Hurricane Andrew in 1992. In response, the state
    created two organizations to provide primary insurance coverage and
    additional reinsurance capacity.

    California Earthquake In 1996, the California legislature established CEA
    as a privately funded

    Authority Provides and publicly managed entity to help residents protect
    themselves against earthquake loss. CEA sells earthquake insurance to
    homeowners, including Insurance

    condominium owners and renters. Insurers doing business in California must
    offer earthquake insurance in their homeowners insurance policies, whether
    a CEA policy or their own. The basic CEA policy carries a deductible of 15
    percent on the home*s insured value, provides up to $5,000 to replace
    contents and personal possessions, and up to $1, 500 for emergency living
    expenses. In 2001, the average policy for a house cost $560, but costs
    were several times higher in areas with high seismic risk.

    While companies must offer earthquake insurance, there is no state
    requirement that consumers purchase earthquake insurance or that mortgage
    lenders require it. About 16 percent of California residences had
    earthquake insurance at the end of 2001, and CEA insured 65 percent of
    those with earthquake insurance.

    As of January 2002, CEA had more than 814,000 policies and a claims paying
    capacity of more than $7 billion against an exposure from all policies of
    about $175 billion. Their claims paying capacity consisted of layers of
    capital, insurance company assessments, and reinsurance and a

    line of credit. Recent external and internal reviews* conducted by the
    California State Auditor, CEA staff, and others* of CEA*s finances have
    focused on its claims paying capacity. The common concern of these

    reviews has been the heavy dependence on the reinsurance market* some 40
    percent of CEA*s $7. 2 billion claims paying capacity. Reviewers recommend
    that some of CEA*s claims paying capacity be converted to catastrophe
    bonds. Such a conversion would make CEA the largest

    catastrophe bond issuer in the world. As shown in figure 6, CEA is
    currently exploring catastrophe bond placements on two layers for $400
    million and $338 million. Recently the CEA*s Governing Board decided not
    to support CEA issuance of catastrophe bonds because catastrophe bonds are
    done in offshore tax havens. A CEA official told us that the Governing
    Board would revisit the issue when catastrophe bonds can be done

    onshore.

    Figure 6: Current and Proposed California Earthquake Authority Financial
    Structure

    Source: California Earthquake Authority.

    Florida Provides Following Hurricane Andrew in 1992, there was a property
    insurance crisis, Residential Coverage and the Florida state legislature
    created two organizations to provide

    coverage and additional capacity* the Florida Residential Joint for
    Windstorms and Underwriting Association (JUA) and the FHCF. JUA provides
    residential

    Supplements Insurance coverage in specifically designated areas that are
    most vulnerable to Capacity

    windstorm damage. Qualified recipients are property owners who could not
    obtain coverage from private insurers after Hurricane Andrew. The JUA

    had 68,000 policyholders and an $11 billion exposure as of January 2001.
    Rates charged by the JUA in each county must be at least as high as the
    highest rate charged by the 20 largest private insurance companies in
    Florida. The JUA*s capacity to pay claims was $1. 9 billion as of January
    2001; claims would be paid by drawing down its surplus, private

    reinsurance, assessments of members, pre- event notes, a line of credit,
    and reimbursements from the state*s catastrophe fund. In March 2002, the
    Florida legislature approved a plan to merge JUA with the Florida
    Windstorm Underwriting Association (FWUA), thereby forming an organization
    called the Citizen*s Property Insurance Corporation. 47 The FHCF was
    created as a source of reinsurance capacity to supplement

    what was available from private sources. The FHCF is run by Florida and
    was set up to encourage insurers to stay in the Florida marketplace in the
    aftermath of Hurricane Andrew, when reinsurance became more difficult to
    obtain. The FHCF reimburses insurers for a portion of their claims from
    future severe hurricanes. Unlike California, where catastrophe coverage is
    voluntary, Florida homeowners* policies must include hurricane coverage.
    The FHCF is the world*s largest hurricane reinsurer, and Florida*s two
    residential pools (JUA and FWUA) and private insurers depend on it.
    Participation by the state*s insurers is mandatory, but insurers may
    choose different levels of coverage (45 percent, 75 percent, or 90
    percent) above a

    high- retention or deductible level for the participating insurers. The
    fund is financed by (1) about 260 property insurers doing business in the
    state on the basis of their exposure to hurricane loss and (2) bonding
    secured by emergency assessments on other insurers. If the FHCF cash
    balance is not sufficient to reimburse covered losses, it can issue tax-
    exempt revenue bonds, which are financed by an emergency assessment of all
    property- casualty insurers excluding workers* compensation writers.
    Premiums paid relative to coverage purchased are significantly below those
    in the privatesector.

    The FHCF*s capacity is currently $11 billion against an exposure of over
    $1 trillion. The $11 billion capacity comprises approximately $4. 9
    billion in cash and $6.1 billion in borrowing capacity. FHCF is also
    exempt from federal income tax. Although no major claims have occurred
    since Hurricane Andrew, the FHCF is designed to handle a $16.3 billion
    ground up residential property loss, which would include its $11 billion

    47 The FWUA was created in the 1970s to provide wind coverage to property
    owners who cannot obtain hurricane and windstorm coverage from private
    insurance companies. It has 430,000 policies with an exposure exceeding
    $90 billion.

    current capacity limit along with an aggregate insurance industry
    retention of $3. 8 billion and an aggregate copayment by insurers of about
    $1. 5 billion.

    Florida has not announced plans to use risk- linked securities to address
    capacity issues.

    Statutory Accounting Balance Sheet

    Appendi x I V

    Implications of Reinsurance Contracts Over the term of insurance policies,
    premiums that an insurance company collects are expected to pay for any
    insured claims and operational expenses of the insurer while providing the
    insurance company with a profit. The amount of projected claims that a
    single insurance policy may incur is estimated on the basis of the law of
    averages. An insurance company can obtain indemnification against claims
    associated with the insurance policies it has issued by entering into a
    reinsurance contract with another insurance company, referred to as the
    reinsurer. The original insurer, referred to as the ceding company, pays
    an amount to the reinsurer, and the reinsurer agrees to reimburse the
    ceding company for a specified portion of the claims paid under the
    reinsured policy. Reinsurance contracts can be structured in many
    different ways.

    Reinsurance transactions over the years have increased in complexity and
    sophistication. Reinsurance accounting practices are influenced not only
    by state insurance departments through NAIC, but also by SEC and FASB. If
    an insurer or reinsurer engages in international insurance, both
    government regulatory requirements and accounting techniques will vary
    widely among countries.

    Statutory Accounting Principles promulgated by NAIC allow an insurance
    company that obtains reinsurance to reflect the transfer of risk for
    reinsurance on the financial statements that it files with state
    regulators under certain conditions. The regulatory requirements for
    allowing credit for reinsurance are designed to ensure that a true
    transfer of risk has

    occurred and any recoveries from reinsurance are collectible. By obtaining
    reinsurance, ceding companies are able to write more policies and obtain
    premium income while transferring a portion of the liability risk to the
    reinsurer. Under many reinsurance contracts, a commission is paid by the
    reinsurer to the ceding company to offset the ceding company*s initial
    acquisition cost, premium taxes and fees, assessments, and general
    overhead. For example, if an insurer would like to receive reinsurance for
    $10 million and negotiates a 20 percent ceding commission, then the

    insurer will be required to pay the reinsurer $8 million ($ 10 million
    premiums ceded, less $2 million ceding commission income). The effect of
    this transaction is to reduce the ceding company*s assets by the $8
    million

    paid for reinsurance, while reducing the company*s liability for unearned
    premiums by the $10 million in liabilities transferred to the reinsurer.
    The $2 million is recorded by the ceding company as commission income.
    This type of transaction results in an economic benefit for the ceding
    company because the ceding commission increases equity. The reinsurer has
    assumed a $10 million liability and would basically report a mirror entry

    that would have the opposite effects on its financial statements. Figure 7
    shows the effects of the reinsurance transaction on both the ceding
    insurance company and reinsurance company*s balance sheets and is intended
    to show how one transaction increases and decreases assets and
    liabilities. 48

    Figure 7: Effect on Ceding and Reinsurance Companies* Balance Sheets
    before and after a Reinsurance Transaction

    Source: Insurance Accounting Systems Association.

    48 Whereas it appears that the ceding company increases its policyholders*
    surplus, this transaction does not include the effects of other normal
    business transactions that will cause the surplus to decrease.

    Reinsurance contracts do not relieve the ceding insurer from its
    obligation to policyholders. Failure of reinsurers to honor their
    obligations could result in losses to the ceding insurer.

    An insurer may also obtain risk reduction from an SPRV that issues an
    indemnity- based, risk- linked security; the recovery by the insurer would
    be similar to a traditional reinsurance transaction. However, if an
    insurer chooses to obtain risk reduction from sponsoring a nonindemnity-
    based, risk- linked security issued through an SPRV, the recovery could
    differ from the recovery provided by traditional reinsurance. Even though
    the insurer

    is reducing its risk, the accounting treatment would not allow a reduction
    of liability for the premiums.

    Comments from the National Association of

    Appendi x V

    Insurance Commissioners NAIC

    NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS Ms. Davi M. D Agostino
    Director, Financial Institutions and Community Investment United States
    General Accounting Office

    EX CUTIVE HEADQUARTERS

    Washington, DC 20548

    2301 MCGEE STRE T SUITE 800

    September 9, 2002

    KANSAS CITY MO 64108- 2662

    Dear Ms. D Agostino:

    VOICE 816- 842- 3600 FAX 816- 783- 8175

    Thank you for giving the NAIC the opportunity to comment on the report
    Catastrophe Insurance Risks: the Role of Risk- Linked Securities and
    Factors Affecting Their Use .

    FEDERAL AND INTERNATIONAL

    The National Association of Insurance Commissioners ( NAIC) is a voluntary

    R LATIONS

    organization of the chief insurance regulatory officials of the 50 states,
    the

    HALL OF THE STAT S

    District of Columbia and four U. S. territories. The association s
    overriding

    444 NORTH CAPITOL ST NW

    objective is to assist state insurance regulators in protecting consumers
    and

    SUITE 701 WASHINGTON DC

    helping maintain the financial stability of the insurance industry by
    offering

    20001- 1509

    financial, actuarial, legal, computer, research, market conduct and
    economic

    VOICE 202- 624- 7790 FAX 202- 624- 8579

    expertise. The NAIC formed a working group on Insurance Securitization in
    1998 to investigate whether there needs to be a regulatory response to
    continuing

    SECURITIES

    developments in insurance securitization, including the use of non- U. S.
    special

    VALUATION

    purpose vehicles and to prepare educational material for regulators. As a
    result

    OFFICE

    of its deliberations, the NAIC has taken the position that U. S. insurance

    1411 BROADWAY

    regulators should encourage the development of alternative sources of
    capacity

    9 TH FLOOR

    such as insurance securitizations and risk linked securities as long as
    such

    NEW YORK NY 10018- 3402

    developments are commensurate with the overriding goal of the NAIC

    VOICE 212- 398- 9000

    membership of consumer protection. As such, the NAIC believes that one
    goal

    FAX 212- 382- 4207

    should be to encourage and facilitate securitizations within the United
    States. If transactions that are currently performed offshore were brought
    back to the United States, they would be subject to on- shore supervision
    by U. S. regulators. Both the NAIC s Special Purpose Reinsurance Vehicle
    Model Act and the

    WORLD

    Protected Cell Company Model Act would require that at least one U. S.

    WIDE W B

    insurance commissioner would review each transaction in depth and set the

    www. naic. or

    appropriate standards. In addition, an NAIC member chairs the
    International Association of Insurance Supervisors Subgroup on Insurance
    Securitization and fully agrees with these views.

    At present, off- shore insurance securitizations are not subject to U. S.
    regulation, and the NAIC members are concerned about the appropriate use
    of Special

    Purpose Vehicles. The recent events at Enron have demonstrated how
    inappropriate use of special purpose vehicles can endanger solvency. The
    NAIC membership believes that, properly used and structured, Special
    Purpose Reinsurance Vehicles may provide extra capacity, more competition,
    and may reduce the overall costs of insurance for the public. The NAIC
    membership therefore believes that on- shore SPRVs, regulated by U. S.
    insurance regulators, would be preferable to the current situation where
    most securitizations are conducted off- shore.

    Again, we thank you for the opportunity to review and comment on the
    report. Sincerely,

    Therese M. Vaughan President, NAIC Iowa Insurance Commissioner

    Comments from the Reinsurance Association

    Appendi x VI

    of America Note: GAO comments supplementing those in the report text
    appear at the end of this appendix.

    See comment 1. See comment 2. See comment 3. Now on p. 5. See comment 4.

    Now on p. 18. See comment 5.

    The following are GAO*s comments on the Reinsurance Association of
    America*s letter dated September 9, 2002. GAO Comments 1. In appendix III
    of the draft report we had already noted that the Florida

    Hurricane Catastrophe Fund provides reinsurance to supplement that
    available from private sources. We added a footnote on page 15 to note
    that reinsurance is also available from private sources for property and
    casualty insurance companies doing business in Florida. 2. We agree and
    have added a footnote on page 29 to state that no

    catastrophe bond contracts have been triggered by an actual event. 3. We
    agree and have added a footnote on page 14 on the creation of the Bermuda
    reinsurance market and its role in introducing new capacity into the
    marketplace after a major event. 4. This issue is covered on pages 24
    through 26.

    5. Bankruptcy remoteness is among the reasons that the special purpose
    entities are established, whether domestically or offshore.

    Appendi x VII

    Comments from the Bond Market Association Note: GAO comments supplementing
    those in the report text appear at the end of this appendix.

    See comment 1.

    See comment 2.

    See comment 3.

    Now on p. 17. See comment 4.

    Now on p. 4. See comment 5.

    Now on pp. 5 and 18. See comment 6.

    Now on p. 17. See comment 7.

    Now on p. 17. See comment 8.

    Now on p. 18. See comment 9.

    Now on p. 21. See comment 10.

    Now on pp. 37 and 38. See comment 11.

    The following are GAO*s comments on the Bond Market Association*s letter
    dated September 10, 2002.

    GAO Comments 1. Our report does not assign relative weights to the factors
    that lead to risk- linked securities being established offshore. We have
    added a

    footnote on page 21 to indicate that BMA believes that the principal
    reason risk- linked securities are organized offshore is to avoid
    taxation.

    2. In contrast to BMA*s view, we state that a primary reason for limited
    investor participation in risk- linked securities is that the risks of
    these securities are difficult to assess. Also, the risks of risk- linked
    securities and mortgage- backed securities are assessed differently. For
    example, the risk of loss from a natural catastrophic event, such as an
    earthquake in a specified geographic area over a specified time period, is
    often based on events that will only happen once over a long- time horizon
    and in some cases as long as an 100- year period. Therefore, investors
    must rely heavily on complex scientific analysis of the likelihood of the

    event, rather than statistical modeling. In contrast, the risk of loss
    from events such as defaults on home mortgage payments by borrowers occurs
    frequently, and extensive statistics are available to assess such risks.
    3. We agree and our draft report discussed the relationship between

    reinsurance prices and interest in risk- linked securities as alternatives
    to traditional reinsurance. We also agree and have added a footnote on
    page 15 to indicate that U. S. reinsurance prices are influenced by
    catastrophic events outside of the United States.

    4. We did not order by relative importance the reasons insurance companies
    stated for their interest in risk- linked securities.

    5. We have changed the text on page 4 by inserting the word *generally.*

    6. In our analysis, we relied on information provided by rating agencies
    for our discussion of credit ratings. Our draft report indicated that some
    catastrophe bonds contain tranches that have received investment- grade
    ratings. We added language to a footnote on page 18 to note BMA*s
    statement that some newly issued, risk- linked securities have been
    investment grade.

    7. We have added language to a footnote on page 17 to note BMA*s statement
    that about $6 to $7 billion in catastrophe related, risk- linked
    securities were issued during this time period.

    8. We have added a footnote on page 17 that states BMA*s view that there
    are often compelling reasons for sponsors of risk- linked securities to
    use nonindemnity- based structures. 9. On the basis of information we
    obtained from the CBOT and market participants, our draft report stated
    that the options were to have

    offered minimal credit risk because the Board of Trade Clearing
    Corporation guaranteed the transactions. There were several reasons why
    catastrophe options had limited appeal, including daily marking to market,
    difficulties in accounting for options trading in insurance company
    accounting, basis risk, the unfamiliarity of locals with the product, lack
    of insurance company membership at CBOT, lack of investment by CBOT, the
    structure of the contract, lack of liquidity, and other factors. 10. We
    have added language to a footnote on page 21 saying that bonds are

    rated according to frequency of loss as well as expected loss. As stated
    in our draft report, rating agencies provide bond ratings on the basis of
    their assessment of loss probabilities and financial severity. We use the
    term expected loss to mean the outcome from analyzing frequency of loss
    and expected loss when it occurs. 11. We added language in appendix III
    that the Governing Board of the California Earthquake Authority has not
    authorized use of catastrophe

    bonds because of concerns about the appearance of being involved in
    offshore transactions in tax havens.

    (250053)

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    a

    GAO United States General Accounting Office

    Page i GAO- 02- 941 Risk- Linked Securities

    Contents

    Contents

    Page ii GAO- 02- 941 Risk- Linked Securities

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    Appendix I

    Appendix I Scope and Methodology

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    Appendix I Scope and Methodology

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    Appendix II

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    Appendix III

    Appendix III California and Florida Approaches to Catastrophe Risk

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    Appendix III California and Florida Approaches to Catastrophe Risk

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    Appendix III California and Florida Approaches to Catastrophe Risk

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    Appendix IV

    Appendix IV Statutory Accounting Balance Sheet Implications of Reinsurance
    Contracts

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    Appendix IV Statutory Accounting Balance Sheet Implications of Reinsurance
    Contracts

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    Appendix V

    Appendix V Comments from the National Association of Insurance
    Commissioners

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    Appendix VI

    Appendix VI Comments from the Reinsurance Association of America

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    Appendix VI Comments from the Reinsurance Association of America

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    Appendix VI Comments from the Reinsurance Association of America

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    Appendix VII

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    Appendix VII

    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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    Appendix VII Comments from the Bond Market Association

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