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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GAO United States General Accounting Office

Page i GAO- 02- 941 Risk- Linked Securities

Contents

Contents

Page ii GAO- 02- 941 Risk- Linked Securities

Page 1 GAO- 02- 941 Risk- Linked Securities United States General
Accounting Office

Washington, D. C. 20548 Page 1 GAO- 02- 941 Risk- Linked Securities

A

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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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