    Catastrophe Insurance Risks: Status of Efforts to Securitize
    Natural Catastrophe and Terrorism Risk (24-SEP-03, GAO-03-1033).

    In addition to potentially costing hundreds or thousands of
    lives, a natural or terrorist catastrophe in the United States
    could place enormous financial demands on the insurance industry,
    businesses, and taxpayers. Given these financial demands,
    interest has been raised in bonds that are sold in the capital
    markets and thereby diversify catastrophe funding sources. GAO
    was asked to update a 2002 report on "catastrophe bonds" and
    assess (1) their progress in transferring natural catastrophe
    risks to the capital markets, (2) factors that may affect the
    issuance of catastrophe bonds by insurance companies, (3) factors
    that may affect investment in catastrophe bonds, and (4) the
    potential for and challenges associated with securitizing
    terrorism-related financial risks.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-03-1033
        ACCNO:   A08582
      TITLE:     Catastrophe Insurance Risks: Status of Efforts to
    Securitize Natural Catastrophe and Terrorism Risk
         DATE:   09/24/2003
      SUBJECT:   Bonds (securities)
    	     Financial analysis
    	     Financial management
    	     Insurance claims
    	     Insurance companies
    	     Risk management
    	     Strategic planning

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    GAO-03-1033

    United States General Accounting Office

    GAO

                           Report to Congressional Requesters

    September 2003

    CATASTROPHE INSURANCE RISKS

         Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk

                                           a

    GAO-03-1033

    Highlights of GAO-03-1033, a report to the Chairman, House Committee on
    Financial Services, the Chairman, Subcommittee on Capital Markets,
    Insurance, and Government Sponsored Enterprises, and House Members

    In addition to potentially costing hundreds or thousands of lives, a
    natural or terrorist catastrophe in the United States could place enormous
    financial demands on the insurance industry, businesses, and taxpayers.
    Given these financial demands, interest has been raised in bonds that are
    sold in the capital markets and thereby diversify catastrophe funding
    sources. GAO was asked to update a 2002 report on "catastrophe bonds" and
    assess (1) their progress in transferring natural catastrophe risks to the
    capital markets, (2) factors that may affect the issuance of catastrophe
    bonds by insurance companies, (3) factors that may affect investment in
    catastrophe bonds, and (4) the potential for and challenges associated
    with securitizing terrorism-related financial risks.

    GAO does not make any recommendations in this report.

    www.gao.gov/cgi-bin/getrpt?GAO-03-1033.

    To view the full product, including the scope and methodology, click on
    the link above. For more information, contact Davi M. D'Agostino at (202)
    512-8678 or dagostinod@gao.gov.

    September 2003

    CATASTROPHE INSURANCE RISKS

    Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk

    The market for catastrophe bonds, as discussed in our 2002 report, has
    transferred a small portion of natural catastrophe risk to the capital
    markets. From 1997 through 2002, a private firm has estimated that a total
    of 46 catastrophe bonds were issued or about 8 per year. Another firm
    estimated that the nearly $3 billion in catastrophe bonds outstanding for
    2002 (see figure) represented 2.5 to 3.0 percent of the worldwide
    catastrophe reinsurance market. Some insurance and reinsurance companies
    issue catastrophe bonds because they allow for risk transfer and may lower
    the costs of insuring against the most severe catastrophes. However, other
    insurers do not issue catastrophe bonds because their costs are higher
    than transferring risks to other insurers. Although some investors see
    catastrophe bonds as an attractive investment because they offer high
    returns and portfolio diversification, others believe that the bonds'
    risks are too high or too costly to assess. To date, no catastrophe bonds
    related to terrorism have been issued covering potential targets in the
    United States, and the general consensus of most experts GAO contacted is
    that issuing such securities would not be practical at this time due in
    part to the challenges of predicting the frequency and severity of
    terrorist attacks.

    Catastrophe Bond Issuance and Amount Outstanding (1997-2002)

    Dollars in millions

    3,000 2,943

    2,500

    2,000

    1,500

    1,000

    500

    0 1997 1998 1999 2000 2001 2002 Year

    Issued Outstanding from prior years

    Source: GAO, based on data provided by Swiss Re Capital Markets.

    Note: Totals shown in bold above each bar represent the amount outstanding
    at end of year.

    Contents

      Letter

    1 Results in Brief 4 Background 7 Catastrophe Bond Issuance Has Been
    Limited 14 Catastrophe Bonds Benefit Some Insurers, but Others Believe
    That

    the Bonds' Costs Are Too High 18 Institutional Investors Provided Mixed
    Views on Catastrophe

    Bonds 27 Securitizing Terrorism Risk Poses Significant Challenges 30
    Observations 34 Agency Comments and Our Evaluation 35

    Appendixes

    Appendix I: Appendix II:

    Appendix III:

    Appendix IV: Appendix V:

                                        Appendix VI: Appendix VII: Appendix VIII:

    Objectives, Scope, and Methodology

    Statutory Accounting Balance Sheet Implications of Reinsurance Contracts

    FASB Interpretation No. 46, Consolidation of Variable Interest Entities

    What is a VIE?

    Texas Windstorm Insurance Association

    Comments from the National Association of Insurance Commissioners

    GAO Comments

    Comments from the Bond Market Association

    GAO Comments

    Comments from the Reinsurance Association of America

    GAO Comments

    GAO Acknowledgments and Staff Contacts

    GAO Contacts Acknowledgments

                                           38

                                           40

                                         43 43

                                           45

                                         47 50

                                         51 59

                                         61 68

    70 70 70

                                Related GAO Products 71

    Figures Figure 1: Traditional Insurance, Reinsurance, and Retrocessional
    Transactions 8 Figure 2: Reinsurance Prices in the United States,
    1989-2002a 10

    Contents

    Figure 3: Special Purpose Reinsurance Vehicle 11 Figure 4: Annual Issuance
    of Catastrophe Bonds, 1997-2002 15 Figure 5: Catastrophe Bond Issuance and
    Amount Outstanding

    1997-2002 16 Figure 6: Type of Catastrophe Bond Issuer 1997-2002 17 Figure
    7: Residential Reinsurance Issuances 18 Figure 8: Effect on Ceding and
    Reinsurance Companies' Balance

    Sheets before and after a Reinsurance Transaction 41 Figure 9: Texas
    Windstorm Insurance Authority Financing 46

    Abbreviations

    BMA Bond Market Association
    CDO Collateralized Debt Obligation
    CEA California Earthquake Authority
    DEP Direct Earned Premium
    FASB Financial Accounting Standards Board
    FHCF Florida Hurricane Catastrophe Fund
    FIFA Federation Internationale de Football Association
    LIBOR London Interbank Offered Rate
    NAIC National Association of Insurance Commissioners
    RAA Reinsurance Association of America
    S&P Standard & Poors
    SEC Securities and Exchange Commission
    SPE special purpose entity
    SRPV special purpose reinsurance vehicle
    TRIA Terrorism Risk Insurance Act
    TWIA Texas Windstorm Insurance Association
    USAA United Services Automobile Association
    VIE variable interest entities

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

    A

    United States General Accounting Office Washington, D.C. 20548

    September 24, 2003

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

    The Honorable Richard H. Baker Chairman, Subcommittee on Capital Markets,
    Insurance, and Government Sponsored Enterprises House of Representatives

    The Honorable Steve Israel The Honorable Brad Sherman The Honorable Dave
    Weldon House of Representatives

    In addition to potentially costing hundreds or thousands of lives, a
    natural or terrorist catastrophe in the United States could place enormous
    financial demands on the insurance industry, businesses, and taxpayers.
    According to insurance industry estimates, a major hurricane striking
    densely populated regions of the United States could result in losses as
    high at $110 billion, a major earthquake could cause losses as high as
    $225 billion, and both types of events would generate serious financial
    difficulties for some insurance companies. Further, the September 11,
    2001, terrorist attacks resulted in an estimated $80 billion in
    losses-about half of which was insured----and another large scale attack
    or series of attacks has the potential for similar results. With the
    passage of the Terrorism Risk Insurance Act of 2002 (TRIA), the federal
    government assumed potential liability of $100 billion in
    terrorism-related losses annually (until the act expires in 2004, but may
    be extended through 2005).1

    Given the enormous financial losses associated with such catastrophes and
    concerns about the capacity of the insurance industry to cover

    1TRIA provides coverage for certified acts of terrorism. The program is
    triggered when there has been an act committed on behalf of any foreign
    person or foreign interest that results in at least $5 million in insured
    losses in the United States. In the event of an act of terrorism, the
    federal government, insurers, and policyholders share the risk of loss.
    The federal government is responsible for paying 90 percent of each
    insurer's primary property and casualty losses after an insurer's exposure
    exceeds 7 percent of its direct earned premium (DEP) in 2003, 10 percent
    of its DEP in 2004, or 15 percent of its DEP in 2005. Federal funds paid
    out under the program are capped at $100 billion for each program year.

    catastrophes without dramatic increases in premium prices or reductions in
    coverage, interest has been generated in transferring some of these risks
    to the capital markets, which had a total value of about $29 trillion as
    of the end of the first quarter of 2003.2 Since the mid-1990s, some
    insurance companies, reinsurance companies, and capital market
    participants have developed financial instruments called risk-linked
    securities that transfer various insurance-related risks to the capital
    markets. The largest category of these instruments are called catastrophe
    bonds and, due to their size in the marketplace, are the subject of this
    report.3 Risk-linked securities---such as catastrophe bonds-can offer a
    relatively high rate of return to investors who are willing to accept some
    of the substantial financial risks associated with such disasters. Last
    year we reported on the risks of natural catastrophes; the structure of
    risk-linked securities-particularly catastrophe bonds; and regulatory,
    accounting, tax, and investor factors potentially affecting the use of
    such securities.4

    Because of your continuing concerns about the potential costs to the
    federal government associated with natural and terrorist catastrophes and
    interest in diversifying the potential funding sources to cover such
    risks, you asked that we update our 2002 report. Specifically, you asked
    that we (1) assess the progress of catastrophe bonds in transferring
    natural catastrophe risks to the capital markets; (2) assess factors that
    may affect the issuance or sponsorship of catastrophe bonds by insurance
    and reinsurance companies, including a status report on accounting issues
    raised in our previous report; (3) assess factors that may affect
    investment

    2This figure represents the value of U.S. Treasury securities, agency
    securities, municipal securities, corporate and foreign bonds, and
    corporate equities as of March 31, 2003. The source is the Federal Reserve
    Flow of Funds data.

    3Catastrophe bonds are an example of a class of securities called
    risk-linked securities, which include quota share transactions, life
    insurance securities, catastrophe options, and other insurance related
    financial instruments. This report focuses on catastrophe bonds, which are
    privately placed securities sold to qualified institutional investors as
    defined under Securities and Exchange Commission Rule 144A. In general, a
    qualified institutional investor under Rule 144A owns and invests on a
    discretionary basis at least $100 million in securities of issuers that
    are not affiliated with the investor.

    4See U.S. General Accounting Office, Catastrophe Insurance Risks: The Role
    of Risk-Linked Securities and Factors Affecting Their Use, GAO-02-941
    (Washington, D.C.: Sept. 24, 2002) and U.S. General Accounting Office,
    Catastrophe Insurance Risks: The Role of Risk-Linked Securities,
    GAO-03-195T (Washington, D.C.: Oct. 8, 2002). These products focused
    primarily on catastrophe bonds but also mentioned other risk-linked
    securities.

    in catastrophe bonds, and (4) analyze the potential for and challenges
    associated with securitizing terrorism-related financial risks.5

    During our follow-up work, we contacted representatives from primary
    insurance companies and reinsurance companies, investment banks that
    underwrite catastrophe bonds, rating agencies, hedge funds that purchase
    catastrophe bonds, large mutual fund companies, accounting firms, firms
    that model natural catastrophe and terrorism risk, a state insurance
    regulator representing the National Association of Insurance Commissioners
    (NAIC), and state natural catastrophe authorities in Texas and
    California.6 We obtained data on the financial risks associated with
    natural catastrophes and terrorism as well as the issuance of catastrophe
    bonds from 1997 to 2002. We did not test the reliability of data we
    obtained from the private sector. We asked officials whom we contacted to
    provide their views on the development and potential of the market for
    catastrophe bonds. We conducted our work between March and August 2003 in
    New York, Massachusetts, Ohio, Illinois, Pennsylvania, Texas, and
    Washington, D.C. A more extensive discussion of our scope and methodology
    is in appendix I.

    5The 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 resources of the capital markets.

    6Primary insurance companies can purchase insurance for some or all of
    their risks from reinsurance companies. Additionally, reinsurance
    companies can purchase insurance for some or all of their risks from other
    insurance companies (a process known as retrocessional coverage). In the
    securitization process, ratings agencies, such as Standard & Poors,
    Moody's, and Fitch, typically assign ratings to securities that are sold
    to the public or in private placements.

    Results in Brief	Private sector data indicate that the market for
    catastrophe bonds, as discussed in our 2002 report, has to date
    transferred a small portion of insurers' natural catastrophe risk to the
    capital markets. According to Marsh and McLennan Securities, from 1997
    through 2002, 46 catastrophe bonds were issued (about 8 per year).7
    According to Swiss Reinsurance Company (Swiss Re) Capital Markets, there
    were nearly $3 billion in catastrophe bonds outstanding at the end of
    2002. Swiss Re also estimated that outstanding catastrophe bonds
    represented about 2.5 to 3.0 percent of worldwide catastrophe reinsurance
    coverage in 2002.8

    Although catastrophe bonds played an important role for some insurance
    companies and reinsurance companies, representatives from other insurers
    and financial market participants said that the costs associated with the
    bonds and other factors have limited their use.9 Some insurance and
    reinsurance companies used catastrophe bonds as a supplement to
    traditional approaches to managing natural catastrophe risks--such as
    reinsurance and limiting coverage in high-risk areas. Representatives from
    one insurance company also told us that the bonds lower the costs
    associated with providing coverage for the most severe types of
    catastrophic risks.10 However, representatives from two large insurance
    companies we contacted, two state authorities that offer natural
    catastrophe coverage, and financial market participants said that the
    total

    7Our previous report stated that there had been some 70 risk-linked
    securities issued by August 2002. We report a lower number this time
    because our report focuses on catastrophe bonds.

    8The reinsurance market represents that portion of their exposure that
    primary insurance companies have decided to transfer from their books. In
    our previous report, we reported that Swiss Re estimated that catastrophe
    bonds accounted for 0.5 percent of the worldwide catastrophe market. The
    0.5 percent figure represented Swiss Re's estimate of the amount of
    reinsurance premiums that insurers dedicate to fund catastrophe bonds (see
    Background) as compared to the total amount of reinsurance premiums paid
    to cover catastrophe risks. Swiss Re officials said that the premium
    measure is also an appropriate measure of catastrophe bond's presence in
    the worldwide catastrophe insurance market and that the 0.5 percent figure
    had not changed as of December 31, 2002.

    9Although technically the initiator of the catastrophe bond
    transaction-the insurance company, reinsurance company, or noninsurance
    company-is different from the special purpose reinsurance vehicle that
    issues the catastrophe bond (see Background), for the purpose of
    simplicity, we use the terms "issue" or "issuer" in this report to
    describe organizations that initiate catastrophe bonds.

    10Natural catastrophes-such as hurricanes or earthquakes-of such severity
    that they are only expected to occur every 100 to 250 years.

    costs of catastrophe bonds-including relatively high rates of return paid
    to investors and administrative costs---significantly exceed the costs
    associated with purchasing reinsurance coverage. On the other hand, some
    financial market participants question the insurers' analysis of the costs
    associated with catastrophe bonds. For example, investment bank officials
    said that the insurers' analysis failed to account for the fact that many
    reinsurance companies have experienced financial difficulties and may not
    be able to meet their obligations if a catastrophe occurs.11

    We found that NAIC is still considering one statutory accounting issue
    discussed in our previous report that potentially affects the use of
    catastrophe bonds, while the potential effects of a separate accounting
    issue remain unclear. 12 The first issue concerned the differing statutory
    accounting standards that apply to traditional reinsurance and to certain
    financial instruments, which can include certain types of catastrophe
    bonds. 13 Current statutory accounting standards allow insurers that
    purchase traditional reinsurance to reflect the transfer of risk in
    financial reports that they file with state insurance regulators and
    thereby improve their stated financial condition, which may make the
    insurers more willing to write additional policies. However, this
    accounting treatment is not currently permitted for certain financial
    instruments-including certain catastrophe bonds-because these instruments
    have not been viewed as comparable to reinsurance. Although one NAIC
    committee has approved a proposal that would allow similar accounting
    treatment for these instruments under specified conditions, another NAIC
    committee has not

    11Due to the costs associated with the September 11, 2001, terrorist
    attacks and declines in worldwide stock markets, several reinsurance
    companies-particularly those headquartered in Europe--have experienced
    declining credit quality since 2000. Some financial analysts believe that
    potential reinsurer defaults during a catastrophe are costs that need to
    be considered in comparing catastrophe bonds to reinsurance.

    12NAIC establishes statutory accounting standards for insurance companies
    that may be adopted by states and their insurance regulators. Statutory
    accounting standards may differ from U.S. generally accepted accounting
    principles.

    13Current statutory accounting allows an insurance company that has
    obtained traditional reinsurance or issues indemnity based catastrophe
    bonds to reflect this transfer of risk on the financial statements that it
    files with state insurance regulators. By obtaining this accounting
    treatment, insurance companies may be more willing to write additional
    policies. However, current statutory accounting standards do not allow
    similar accounting treatment for nonindemnity based instruments that hedge
    insurance risk, which can include nonindemnity based catastrophe bonds,
    because such instruments have not been viewed as comparable to reinsurance
    or indemnity based catastrophe bonds. See this report and appendix II for
    a detailed discussion.

    approved the proposal.14 The second accounting issue-a 2002 proposal by
    the Financial Accounting Standards Board (FASB) that could have limited
    the appeal of catastrophe bonds---has been revised.15 Accounting firms and
    other financial market participants said that it was not clear (as of the
    date of this report) what effects FASB's revised guidance---would have on
    catastrophe bonds. Although the revised guidance could make catastrophe
    bonds less attractive to issuers and investors, it remains to be seen how
    the guidance will be interpreted and implemented.16

    Representatives from institutional investors-such as pension and mutual
    funds---we contacted provided mixed views on the purchase of catastrophe
    bonds. Some institutions favored catastrophe bonds because of their
    relatively high rates of return and usefulness in diversifying investment
    portfolios. However, because of the risks associated with catastrophe
    bonds, the institutions said that they limited their investments in the
    bonds to no more than 3.0 percent of their total portfolios.
    Representatives from several other institutional investors-such as some
    large mutual funds--said that they avoided purchasing catastrophe bonds
    altogether because of their perceived risks or because it would not be
    cost-effective for them to develop the technical capacity to analyze the
    risks of securities so different from the securities in which they
    currently invested. Some large mutual fund representatives also told us
    that they were not willing to purchase catastrophe bonds because of their
    relative illiquidity when compared with traditional bonds and equities.17

    Catastrophe bonds involving terrorism risks have not been issued by
    insurers to cover targets in the United States, and insurance industry and

    14NAIC is considering a proposal that would allow similar accounting
    treatment for financial instruments that effectively hedge insurers'
    risks. This issue is discussed in more detail in this report.

    15FASB is a private body that establishes accounting and auditing rules
    under generally accepted accounting principles. FASB's Interpretation No.
    46, clarifies accounting policy for special purpose entities to improve
    financial reporting and disclosure by companies using these entities. See
    this report and appendix III for a detailed discussion.

    16As discussed in this report, consolidation could make insurers less
    willing to issue catastrophe bonds. We note that while consolidation may
    be required under generally accepted accounting principles it is not
    required under NAIC's statutory accounting standards.

    17In an illiquid market, securities cannot be converted into cash easily
    or without incurring a substantial reduction in the price of the security.

    financial market participants we contacted noted that issuing such a
    security would be challenging. One challenge involves developing
    statistical models to predict with some certainty the frequency and
    severity of terrorist attacks. Developing such models would be difficult
    because terrorist attacks may be influenced by a wide variety of factors
    that may be difficult to quantify or predict. These factors include
    terrorist intentions, the ability of terrorists to enter the United
    States, target vulnerability, types of weapons that may be used, and the
    effectiveness of the efforts to prevent terrorist acts. Nevertheless,
    several modeling firms are developing models that were being used to
    assist insurers in providing terrorism insurance. However, the view of
    most financial market participants we contacted was that the models are
    too new and untested to support catastrophe bonds related to terrorism.
    Moreover, investor concerns about the risks associated with catastrophe
    bonds covering terrorism in the United States might also make the costs
    associated with issuing securities related to terrorism prohibitive. For
    example, investors might not believe that they have sufficient information
    about insurers' underwriting standards and efforts to limit the insurer's
    financial exposure to terrorism. Consequently, investors might demand a
    "risk-premium" to invest in a security related to terrorism that would be
    above the rate that insurance companies would be willing to pay.

    We are not making any recommendations in this report.

    We provided a draft of this report to NAIC, the Bond Market Association
    (BMA), and the Reinsurance Association of America (RAA), which are
    reprinted in appendixes V, VI, and VII respectively. We also received
    technical comments from these organizations, which have been incorporated
    where appropriate. In general, these organizations commented that the
    draft report provided a fair and useful analysis of efforts to securitize
    natural catastrophe and terrorism risks. However, BMA and RAA also
    disagreed with certain aspects of our analysis. Our evaluations of the
    NAIC, BMA, and RAA comments are discussed later in this report and in
    appendixes V, VI, and VII.

    Background	This section provides an overview of (1) insurance coverage for
    natural and terrorist catastrophe risk and (2) the complex structure of
    natural catastrophe bonds.

    Overview of Natural and Terrorist Catastrophe Insurance Coverage

    The insurance industry consists of primary and reinsurance companies,
    which provide coverage-including coverage for natural catastrophe and
    terrorism risk---to their customers through property-casualty, homeowners,
    automobile, and commercial policies among others (see fig. 1). Primary
    insurers typically write policies for residential and commercial customers
    and are responsible for reviewing customer claims and making payments if
    consistent with the customers' policies. Primary insurers, however, often
    hold more exposure to risk than management considers appropriate. For
    example, a primary property and casualty insurer may hold a large number
    of homeowners insurance policies along the Florida coast. If a
    catastrophic hurricane were to hit this area, the insurer would have to
    pay out on those policies, which could damage the company's financial
    condition. In order to transfer some of this risk, primary insurers
    purchase coverage from a reinsurance company. Reinsurers cover specific
    portions of the risk the primary insurer carries. For example, a reinsurer
    may cover events that cost the primary insurer more than $100 million.
    Likewise, reinsurers may also carry more risk exposure than they consider
    prudent and so they may contract with other reinsurers for coverage, which
    is a process referred to as retrocessional coverage.

    Figure 1: Traditional Insurance, Reinsurance, and Retrocessional
    Transactions

    Source: GAO.

    The insurance industry faces potentially significant financial exposure
    due to natural and terrorist catastrophes. Heavily populated areas along
    the coast in the Northeast, Southeast, Texas, and California have among
    the highest value of insured properties in the United States. Moreover,
    some of these areas also face the highest likelihood of major
    hurricanes-in the cases of the Northeast, Southeast, and Texas---and major
    earthquakes in the case of California. According to insurance industry
    estimates, a large hurricane in urban Florida or earthquake in urban
    California could cause

    up to $110 billion in insured losses with total losses as high as $225
    billion. We also note that a major earthquake in the central Mississippi
    Valley--which includes the New Madrid fault-could also result in
    significant loss of life and financial losses.18 Several states-including
    Florida, California, and Texas-have established authorities to help ensure
    that coverage is available in areas particularly prone to these events.19
    In addition, the insurance industry faces potentially large losses
    associated with terrorist attacks as demonstrated by the industry's $40
    billion in expected losses resulting from the September 11, 2001, attacks.
    With the passage of TRIA, the federal government also has substantial
    potential financial exposure to terrorist attacks.

    The costs associated with providing insurance coverage for natural
    catastrophes helped generate the market for risk-linked securities---such
    as catastrophe bonds-as an alternative means of risk transfer for primary
    insurance companies and reinsurance companies. As shown in figure 2,
    reinsurance prices increased significantly in 1992, which was the year
    that Hurricane Andrew struck Florida. Reinsurance prices may increase
    after major catastrophes as reinsurance companies attempt to restore their
    financial condition through higher revenues or coverage restrictions.
    Because of the increase in reinsurance prices and restricted coverage in
    the mid 1990s, some insurance companies developed catastrophe bonds with
    the view that the capital markets would be able to provide coverage for
    some natural catastrophes at a lower cost than reinsurers. We note that
    after declining in the mid-to-late 1990's, reinsurance prices increased
    from 1999 to 2002 due to several factors including losses associated with
    hurricanes, adverse loss development on business written in 1997 through
    2000, adverse loss development relating to asbestos, the declining credit
    quality of some European reinsurers due to declining stock prices, the

    18The New Madrid seismic zone lies within the central Mississippi Valley,
    extending from northeast Arkansas, through southeast Missouri, western
    Tennessee, and western Kentucky to southern Illinois. Historically, this
    area has been the site of some of the largest earthquakes in North
    America. Between 1811 and 1812, four catastrophic earthquakes, with
    magnitudes greater than 7.0 occurred during a 3-month period. Since 1974
    when seismic instruments were installed around this area, more than 4,000
    earthquakes have been located, most of which were too small to be felt.
    The probability for an earthquake of magnitude 6.0 or greater is
    significant in the near future. A quake with a magnitude equal to that of
    the 1811-1812 quakes could result in great loss of life and property
    damage in the billions of dollars.

    19Our 2002 report provided information on the Florida Hurricane
    Catastrophe Fund and the California Earthquake Authority. This report
    provides information about the Texas Windstorm Insurance Association. See
    appendix IV.

    declining investment income due to decreased interest rates, and the costs
    associated with the September 11, 2001, terrorist attacks.

             Figure 2: Reinsurance Prices in the United States, 1989-2002a

      aThis figure shows a price index set equal to 100 in 1989 normalized prices.

    Catastrophe Bonds Employ Complex Structures

    As discussed in our previous report, risk-linked securities-including
    catastrophe bonds-have complex structures. Figure 3 illustrates the cash
    flows among the participants in a catastrophe bond. Typically, a
    catastrophe bond offering is made through an entity called a special
    purpose reinsurance vehicle (SPRV) that may be sponsored by an insurance
    or reinsurance company.20 The insurance company enters into a reinsurance
    contract and pays reinsurance premiums to the SPRV to cover specified
    claims. The SPRV issues bonds or debt or debt securities for purchase by
    investors. The catastrophe bond offering defines a catastrophe

    20SPRVs are a type of special purpose entity. Most SPRVs are based
    offshore for tax, regulatory, and legal purposes.

    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 from the catastrophe bond offering in a
    trust in the form of Treasury securities and other highly rated assets.
    The SPRV deposits the payment from the investor as well as the premium
    income 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. If no event occurs that triggers the bond's
    provisions and it matures, the SPRV is responsible for paying investors
    the principal and interest that they are owed.

                     Figure 3: Special Purpose Reinsurance Vehicle

    Source: GAO.

    Catastrophe bonds also have the following characteristics:

    1.	The bonds are typically only offered to qualified institutional
    investors under Securities and Exchange Commission (SEC) Rule 144A and are
    not available for direct purchase by retail investors.

    2.	The bonds typically offer a return to investors based on the London
    Interbank Offered Rate (LIBOR) plus an agreed spread.21 The return to
    investors on catastrophe bonds is relatively high, either equaling or
    exceeding the returns on some comparable fixed-rate investments, such as
    high-yield corporate debt.22 Under some catastrophe bond structures,
    however, investors may face the risk of losing all or substantially all of
    their principal if a catastrophe triggering the bond's provisions
    occurs.23

    3.	The bonds typically receive noninvestment grade ratings from bond
    ratings agencies such as Fitch, Moody's, and Standard & Poors (S&P)
    because bond holders face potentially large losses on the securities. The
    ratings agencies rely in part on three major modeling firms to help
    understand the risks associated with specific catastrophe bonds. The
    modeling firms use sophisticated computer systems and large databases of
    past natural catastrophes to assess loss probabilities and financial
    severities.

    4.	The bonds typically cover risks that are considered the lowest
    probability and highest severity. That is, the bonds typically cover
    hurricanes or earthquakes that are expected to occur no more than once
    every 100 to 250 years. The bonds do not typically provide

    21LIBOR is the rate most international creditworthy banks charge one
    another for large loans.

    22Cochran, Caronia Securities LLC reports that catastrophe bonds returned
    on average 9.07 percent in 2002, 9.45 percent in 2001, and 11.42 percent
    in 2000. The 9.07 percent return in 2002 exceeded selected fixed-income
    sector returns for high-yield (or noninvestment grade) corporate debt.
    According to the Bond Market Association, the yields on catastrophe bonds
    have been comparable to the yields on noninvestment grade corporate debt.

    23However, some catastrophe bonds have been structured to contain
    different risk tranches having varying probabilities of loss occurrence.
    If the probability of loss occurrence for a bond tranche is very low, such
    as might occur if the bond's payout provisions could be triggered only
    upon the occurrence of a third consecutive specified catastrophic event
    within a set time period, the bond tranche could even receive a triple-A
    investment-grade rating.

    coverage for events expected to occur more frequently than once every 100
    years.

    5.	To offset investors' lack of information about insurer underwriting
    practices, the bonds are typically nonindemnity rather than
    indemnity-based and specify industry loss estimates or parametric triggers
    (such as wind speed during a hurricane or ground movement during an
    earthquake) as the events that trigger the bonds' provisions.24 By tying
    payment to an estimate of industry losses or an objective measure such as
    wind speed, investors do not have to completely understand an individual
    company's underwriting practices.25

    24Indemnity 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 period for a 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 is not related to actual or incurred claims. The
    provisions of a catastrophe bond, for example, may provide $100 million in
    coverage to the issuing insurance company if a hurricane or earthquake of
    a specified magnitude occurs or established insurance industry formulas
    estimate that a catastrophe causes industry wide losses of a specified
    amount.

    25One factor that may limit investors' understanding of an insurers'
    underwriting practices is moral hazard, which means that two parties to a
    contract change their behavior because of that contract. Due to moral
    hazard, the potential exists that an insurer would increase its
    risk-taking, such as by providing coverage for properties more vulnerable
    to natural catastrophes or in paying claims without adequate review. Moral
    hazard may be present in other insurance arrangements-besides catastrophe
    bonds-such as in the case of an insurer providing coverage for natural
    catastrophe risk through residential or business policies. Because
    reinsurers have established business relationships with insurers, they may
    be able to better monitor insurer underwriting practices than investors.

    Catastrophe Bond Issuance Has Been Limited

    Private sector data indicate that the catastrophe bond market accounts for
    a small share of the worldwide reinsurance market for catastrophe risk.26
    According to Marsh & McLennan Securities, between 1997 and 2002, a total
    of 46 catastrophe bonds were issued, or about 8 per year as shown in
    figure 4.27 Figure 5 shows that the annual dollar volume of catastrophe
    bond issuance remained relatively stable between 1997 and 2002, with 2000
    representing the highest volume with a total of $1.1 billion in total
    issuance.28 Between 1997 and 2002, the total value of outstanding
    catastrophe bonds increased more than three-fold from about $800 million
    to $2.9 billion. However, outstanding catastrophe bonds accounted for only
    2.5 to 3.0 percent of worldwide catastrophe reinsurance coverage.29 As of
    September 2003, no natural catastrophe had occurred that would have
    triggered one of the 46 bonds' provisions and resulted in payments to
    issuers to cover their losses.30

    26Organizations involved in the catastrophe bond market may also report
    additional figures for other risk-linked securities or methods that
    transfer catastrophe risk or other insurance risk to securities markets.
    Such other securities and methods include collateralized debt obligations
    (CDO), quota share arrangements, swaps, options, and contingent capital. A
    catastrophe-related CDO is a portfolio of already issued catastrophe bonds
    and other risk-linked securities. Investors in securitized quota share
    arrangements share directly in the performance of a reinsurance portfolio,
    sharing losses as well as gains.

    27Marsh & McLennan Securities did not report catastrophe bond issuance
    prior to 1997. However, available data indicate that three bonds were
    issued in the period 1994-96. We chose to report catastrophe bond issuance
    starting in 1997 (through 2002) because this is the first year that the
    market expanded to include a number of issuers. According to securities
    market participants, a total of four catastrophe bonds were issued in 2003
    through July.

    28In 2002, Swiss Re introduced "shelf issuance" of catastrophe bonds,
    which allows them to periodically issue bonds over a several year period
    based on one offering statement to investors. Marsh & McLennan reported
    Swiss Re's three quarterly issuances of this bond as one issuance in 2002.

    29Estimates obtained from Swiss Re and Fermat Capital Management.

    30According to an investment bank we contacted, the payout provisions of
    one catastrophe bond issued in 1996 have been triggered.

    Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002
    Number of issuances
    10

    8

    6

    4

    2

    0
    1997 1998 1999 2000 2001 2002
    Year

    Source: GAO, based on data provided by Marsh & McLennan Securities.

    Figure 5: Catastrophe Bond Issuance and Amount Outstanding 1997-2002

    Dollars in millions 3,000 2,943

    2,500

    2,000

    1,500

    1,000

    500

    0 1997 1998 1999 2000 2001 2002 Year

    Issued
    Outstanding from prior years
    Source: GAO, based on data provided by Swiss Re Capital Markets.

    Note: Total shown by figure at top of bar is amount outstanding at year
    end.

    Figure 6 shows that insurance and reinsurance companies have issued almost
    all catastrophe bonds. Insurance companies accounted for 22 of the 46
    catastrophe bonds issued in 1997 through 2002, reinsurers accounted for
    22, and two commercial companies--Oriental Land and Vivendi, SA-issued the
    other two securities. Figure 7 provides a recent example of a catastrophe
    bond issuance. The following section provides reasons why some insurance
    and reinsurance companies use catastrophe bonds while others do not.

    Figure 6: Type of Catastrophe Bond Issuer 1997-2002

    Number of issuances

                                           4%

    Noninsurance

    companies............ 2

    Insurers.............. 22

    Reinsurers.......... 22

    Total: 46

    Source: GAO, based on data provided by Marsh & McLennan Securities.

                      Figure 7: Residential Reinsurance Issuances

    One example of a catastrophe bond is a $125 million of variable rate notes
    issued by Residential Reinsurance 2002 Limited, a special purpose
    reinsurance company, for the ultimate benefit of United Services
    Automobile Association (USAA). Offered only to qualified institutional
    buyers as defined by SEC Rule 144A, these bonds were privately placed by
    Goldman, Sachs & Co., Lehman Brothers, and Merrill Lynch & Co. These bonds
    were sold to investors with a coupon of 3-month LIBOR plus 4.9 percent
    during the loss occurrence period and received ratings of Ba3 from Moody's
    and BB+ from S&P, both noninvestment grade ratings.a The ratings reflect
    the expected loss to note holders, calculated by a catastrophe-modeling
    firm, relative to the promise of receiving the present value of the
    required interest and principal payments as provided by the governing
    documents.

    The issuer provides reinsurance coverage for 3 years to USAA against
    hurricane losses in the East and Gulf Coast states of the United States
    and in Hawaii beginning June 1, 2002. Losses to investors are tied to
    actual losses experienced by USAA due to qualified hurricanes affecting
    its portfolio of exposures in the covered areas at any time during the
    risk period. Qualified hurricanes are those classified on the
    Saffir-Simpson scale as a Category 3, 4, or 5.b If more than one
    qualifying event were to occur in any given year, only one event, at the
    discretion of USAA, will be considered in calculating losses to the notes.
    An independent third party is to review loss payout. The proceeds from
    issuance of the bonds were deposited into a trust account and invested in
    high quality-rated commercial paper or money market instruments and
    investment-grade securities.

    In 2003, Residential Reinsurance issued another $160 million of variable
    rate notes, its seventh consecutive placement of catastrophic risk for the
    benefit of USAA. The bonds provided aggregate coverage for USAA's
    hurricane and earthquake risk in the United States, including the risk of
    loss caused by fire following an earthquake. This issue was the first
    catastrophe bond to include Alaska and Hawaii earthquake risk. The bonds
    were sold with a coupon of 3-month LIBOR plus 4.95 percent and received
    noninvestment grade ratings of Ba2 (Moody's) / BB+ (S&P). The bonds were
    privately placed by Goldman Sachs and BNP Paribas.

    Source: GAO analysis based on information from Moody's Investors' Service,
    Residential Reinsurance 2002
    Limited Catastrophe Linked Notes, Structured Finance New Isue Report, July
    30, 2002 and Marsh & McLennan Securities,
    Market Update: The Catastrophe Bond Market at Year-End 2002.

    aLibor is the rate that creditworthy international banks generally change
    each other for large loans.

    bThe Saffir-Simpson Hurricane Scale is a 1-5 rating based on the
    hurricane's intensity. This is used to give an estimate of the potential
    property damage and flooding expected along the coast from a hurricane
    landfall. Wind speed is the determining factor in the scale, as storm
    surge values (used to estimate flooding) are highly dependent on the slope
    of the continental shelf in the landfall region.

    Catastrophe Bonds Representatives from some insurance and reinsurance
    companies told us

    that catastrophe bonds served a useful role in their overall approach
    toBenefit Some Insurers, managing their natural catastrophe risk exposures
    and that such bonds but Others Believe lowered the costs associated with
    the most severe types of catastrophe That the Bonds' Costs risk. However,
    representatives from two large insurers and two state

    authorities said that the total costs associated with the bonds were
    highAre Too High compared with traditional reinsurance and affected their
    willingness to

    issue the bonds.31 Other financial market participants believed that
    insurers' comparisons of the prices of catastrophe bonds and traditional
    reinsurance do not fully account for important factors, such as the credit
    quality of reinsurers. This section also provides information on the
    status of two accounting issues that potentially affect the use of
    catastrophe bonds and which we discussed in our previous report.

    Some Insurance and Reinsurance Companies Identified Benefits of
    Catastrophe Bonds

    Representatives from some large insurers and reinsurers we contacted said
    that catastrophe bonds were a complement to several other basic risk
    management tools: raising more equity capital by selling more company
    stock, transferring risks to the reinsurance markets, and limiting risks
    through the underwriting and asset management process. Representatives
    from one insurance company said that of the natural catastrophe exposure
    that was transferred by their company, 76 percent was sold to traditional
    reinsurance companies and 24 percent was transferred through catastrophe
    bonds. Company representatives said that while reinsurance accounted for
    most risk transfer needs, catastrophe bonds were also beneficial in this
    regard. Representatives from a reinsurance company said that catastrophe
    bonds allowed the company to transfer a portion of its natural catastrophe
    exposures to the capital markets rather than retaining the exposure on its
    books or retroceding the risks to other reinsurers.

    As discussed in our 2002 report, catastrophe bonds can play a role in
    lowering the costs of reinsuring catastrophe risks. According to various
    financial market representatives, because of the larger amount of capital
    that traditional reinsurers need to hold for lower probability and higher
    financial severity areas of catastrophe risk---such as the risk of
    hurricanes in Florida or earthquakes in California expected to occur only
    once every 100 to 250 years---these reinsurers limit their coverage and
    charge increasingly higher premiums for these risks. Many of the
    catastrophe bonds issued to date have provided coverage for such severe
    catastrophe risks. Representatives from one insurance company said that
    the company cannot obtain the amount of reinsurance it needs in this risk
    category from traditional reinsurers at reasonable prices. As a result,
    the company has

    31As discussed in our previous report, one of these authorities-the
    California Earthquake Authority (CEA)-also does not issue catastrophe
    bonds because they are based offshore. While CEA has not issued
    catastrophe bonds through SPRVs, some of its catastrophe risks have been
    included in catastrophe bonds issued by a reinsurer with whom CEA has a
    business relationship.

    obtained some of its reinsurance coverage in this risk category from
    catastrophe bonds. The officials said that they believed that the
    catastrophe bond market has had a moderating effect on reinsurance prices,
    which, as shown in figure 2, increased from 1999 through 2002. Other
    market participants also said that the presence of catastrophe bonds as an
    alternative means of transferring natural catastrophe risk may have
    prevented reinsurance prices from increasing any faster than they did.

    We note that two noninsurance corporations-Oriental Land and Vivendi- have
    issued catastrophe bonds to address some of the risks facing their
    properties from hurricanes and earthquakes. Oriental Land-the operator of
    Tokyo Disneyland---sponsored the Concentric, Ltd. security that provides
    $100 million in coverage for an earthquake or earthquakes in a particular
    region of Japan over a 5-year period ending in 2004. The transaction
    allows Oriental Land to directly insure against certain earthquake risks.
    Vivendi sponsored a $175 million catastrophe bond to provide coverage for
    certain earthquakes affecting Southern California.32

    Several Insurers Said That Catastrophe Bonds Were More Expensive Than
    Traditional Natural Catastrophe Reinsurance

    Although some insurance and reinsurance companies have found catastrophe
    bonds to be cost-effective for some of their catastrophe coverage,
    representatives from two large insurance companies and two state
    authorities, as well as other market participants, said that the costs
    associated with catastrophe bonds could be significantly higher than the
    costs of buying traditional reinsurance coverage. The insurance company
    and state authority representatives said that they monitored the costs
    associated with catastrophe bonds by reviewing price information provided
    by investment banks and comparing these prices to quotes offered on
    reinsurance contracts. Some insurance company officials and state
    authority representatives estimated that the total costs associated with
    catastrophe bonds could be as much as twice as high as traditional
    reinsurance. In addition, representatives from two investment banks that
    have participated in many catastrophe bond transactions, insurance brokers
    that monitor the market, and other market participants said that
    catastrophe bond costs typically exceeded the cost of reinsurance for many
    insurers.

    32Vivendi Universal, S.A. did this transaction through its affiliated
    company, Gulfstream Insurance Ltd., located in Ireland. Gulfstream
    Insurance entered into a reinsurance contract with Swiss Re, which, in
    turn, entered into a retrocessional contract with Studio Re Ltd., the
    special purpose reinsurer that issued the catastrophe bonds and preference
    shares.

    One of the costs associated with catastrophe bonds are the interest costs
    that insurers must pay to compensate investors for purchasing securities
    that involve a substantial risk of loss of principal. As discussed
    previously, the yields on catastrophe bonds have generally equaled or
    exceeded the yields on some risky fixed-income investments, such as
    high-yield corporate debt. Representatives from two large insurers and a
    state authority told us that quotes that they received from investment
    banks on the interest costs associated with catastrophe bonds exceeded the
    costs of comparable reinsurance. Additionally, representatives from two
    large insurance companies said that the insurance rates they develop to
    cover their expected losses on natural catastrophes and operating expenses
    and then file with state regulators are frequently denied as being too
    high. As a result, a representative of one of the insurers said that the
    company did not earn sufficient premium income to cover the costs
    associated with catastrophe bonds and tended to restrict coverage in
    states that do not allow for adequate premium increases. NAIC commented
    that the process of determining appropriate insurance rates is complex and
    that insurers and state regulators can reasonably disagree on the proper
    rate to charge for a specific insurance product.

    Insurance industry representatives as well as other market participants
    cited administrative and transaction costs as another reason for the
    relatively high costs associated with catastrophe bonds as compared to
    reinsurance. Representatives from a state authority estimated that
    transaction costs represented 2 percent of the total coverage provided by
    a catastrophe bond (for example, $2 million for a security providing $100
    million in coverage). These costs include:

    o  underwriting fees charged by investment banks;

    o 	fees charged by modeling firms to develop models to predict the
    frequency and severity of the event-such as the hurricane or
    earthquake-that is covered by the security;

    o 	fees charged by the rating agencies to assign a rating to the
    securities; and

    o 	legal fees associated with preparing the provisions of the security and
    preparing disclosures for investors.

    The price of a reinsurance contract would not typically include such
    additional fees.

    Insurers' preference for traditional reinsurance as compared to
    catastrophe bonds may also be explained by their long-standing business
    relationships with reinsurance companies and the general nature of
    reinsurance contracts. Reinsurance contracts often cover a range of a
    primary insurer's risks including natural catastrophe and other risks, and
    the insurer's premium payments to the reinsurer cover all potential losses
    to the insurance company after some initial retention of risk by the
    insurer. Moreover, reinsurance contracts typically cover an insurer's
    losses, such as those resulting from hurricanes in a specified area up to
    a specified dollar limit, such as $100 million. In contrast, catastrophe
    bonds focus on one type of risk (for example, natural catastrophe) and can
    be highly customized (for example, the development of parametric triggers)
    which may add to their administrative costs and require a greater
    commitment of management time to develop, particularly the first time that
    they are used.

    Some Financial Market Participants Questioned Insurers' Analysis of the
    Costs Associated with Catastrophe Bonds

    Some financial market participants that supported the use of catastrophe
    bonds-such as investment banks-and some insurers questioned other
    insurers' analysis of cost differences between catastrophe bonds and
    traditional reinsurance. These representatives said that catastrophe bonds
    may be cost-competitive with traditional reinsurance for high severity and
    low probability risks, for retrocessional coverage, and for larger-sized
    transactions. The representatives also said that insurers tended to
    undervalue the risk that-due to credit deterioration-reinsurers might not
    be able to honor their reinsurance contracts if a natural catastrophe were
    to occur. They said catastrophe bonds, on the other hand, pose no or
    minimal credit risk to insurers because the funds are immediately
    deposited into a trust account upon the bonds' issuance to investors.
    Representatives from insurers we contacted said that while they recognized
    that some reinsurers' credit quality had declined, they have established
    credit standards for the companies with whom they do business and
    continually monitored their financial condition.33

    33In addition, when dealing with a reinsurer with poorer credit quality, a
    representative of one insurer that purchases a large amount of reinsurance
    also said that his company and other firms put the reinsurance premiums
    into a "funds held" account, paying the reinsurer only interest on the
    premium funds held for the duration of the reinsurance contract. However,
    this method collateralizes only the premiums paid, not the full amount of
    the insurance coverage. Another method used is to obtain a letter of
    credit up to the full amount of the exposure that is ceded.

    Some financial market participants also said that various provisions in
    reinsurance contracts-such as deductibles, termination clauses, and
    reinstatement premiums-may also raise their costs and should be factored
    into the cost comparison between catastrophe bonds and reinsurance costs.
    Furthermore, they said that because catastrophe bond funds were held in
    trust accounts, insurers would likely be able to quickly claim the funds
    to cover natural catastrophe losses. In contrast, the representatives said
    that reinsurance contracts frequently involved litigation over whether
    insurer claims should be paid. RAA disagreed with this statement and said
    that reinsurance contracts rarely involve litigation and that the
    contracts typically include arbitration clauses. RAA said that arbitration
    typically settles disputes more quickly than does litigation. RAA also
    commented that because the provisions of catastrophe bonds have never been
    triggered, it is not clear that such bond payments would not be subject to
    litigation.34

    One reinsurance company has developed a method of issuing catastrophe
    bonds that may lower issuance costs. The reinsurer-Swiss Re-issued a
    security known as Pioneer in June 2002. Pioneer's structure contains six
    separate "tranches," or individual bonds, that cover five types of perils-
    hurricanes in the North Atlantic, windstorms in Europe, earthquakes in
    California, earthquakes in the central United States, earthquakes in
    Japan-and one that covers all of the five perils. Pioneer is also an
    "off-the-shelf" security, which means that Swiss Re can issue the security
    to investors over a period of time as necessary to meet its business needs
    and the demand of investors. By covering multiple perils and allowing
    risks to be transferred over time, market participants said that the
    security could pay a lower yield because the market would not have to
    absorb a relatively larger issuance in a shorter time span. In addition,
    it would lower administrative costs because most of the paperwork and
    disclosures to issue the security would already be in place, which means
    they do not have to be recreated, as is the case with other catastrophe
    bonds.

    34Although none of the 46 catastrophe bonds issued from 1997 through 2002
    have generated investor losses, one investment bank told us that the
    payout provisions of a catastrophe bond issued in 1996 had been triggered
    and generated investor losses.

    Some Insurers Noted That Catastrophe Bonds Were Not Cost-Effective for
    Natural Catastrophes That Were More Likely to Occur or for Lower Coverage
    Amounts

    Besides cost, some insurance company and state authority representatives
    we contacted cited other reasons why they did not choose to issue
    catastrophe bonds. They said that they were not attracted to catastrophe
    bonds' traditional focus on covering events with the lowest frequency and
    the highest severity (for example, hurricanes or earthquakes expected to
    occur every 100 to 250 years). Rather, the representatives said that their
    coverage needs were for less severe events expected to take place more
    frequently than every 100 years. In addition, they and other market
    representatives said that it is not cost-effective to issue catastrophe
    bonds below a certain level. They estimated that this this level ranged
    from $100 million to $800 million. Some insurers said that they typically
    bought reinsurance for smaller amounts and might be more willing to issue
    catastrophe bonds if they were offered coverage in amounts less than $100
    million. BMA commented that catastrophe bonds have been issued in smaller
    denominations than $100 million.

    RAA commented that nonindemnity based catastrophe bonds may not be
    appealing to insurers because of basis risk, which is the risk to the
    insurer that the payment from the catastrophe bond will not cover all of
    its losses. Traditional reinsurance and indemnity based catastrophe bonds
    mitigate basis risk. In addition, RAA said that catastrophe bonds may not
    appeal to insurers because they do not adequately cover "tail risk," which
    is the risk to the insurer that it will take a protracted period (perhaps
    years) to settle all of the claims associated with a natural catastrophe.
    RAA stated that traditional reinsurance remains an "open account" to
    settle such claims when they come due while catastrophe bond contracts
    typically require that all claims be quickly settled (perhaps within 2
    years). RAA commented that the insurer could ultimately become responsible
    for any claims filed after the catastrophe bond cut-off period.

    Impact of Accounting Issues Potentially Affecting the Use of Catastrophe
    Bonds Still Unclear

    Our previous report stated that NAIC's current statutory accounting
    requirements might affect insurers' use of nonindemnity-based catastrophe
    bonds. 35 Under statutory accounting, an insurance company that buys
    traditional indemnity-based reinsurance or issues an indemnity based
    catastrophe bond can reflect the transfer of risk (effected by the
    purchase of reinsurance) on the financial statements that it files with
    state regulators. As a result of the risk transfer, the insurance company
    can improve its stated financial condition and it may be willing to write
    additional insurance policies. However, statutory accounting rules
    currently do not allow insurance companies to obtain a similar credit for
    using nonindemnity based financial instruments that hedge insurance
    risk-which can include nonindemnity-based catastrophe bond structures-and
    may therefore limit the appeal of these types of catastrophe bonds to
    potential issuers. Statutory accounting standards have differed because
    unlike traditional reinsurance, instruments that are nonindemnity-based
    have not been viewed as providing a true transfer of insurers' risks.
    However, during 2003, NAIC's Securitization Working Group approved a
    proposal that would establish criteria for allowing reinsurance like
    accounting treatment for such instruments---including nonindemnitybased
    catastrophe bonds-that provide a highly effective hedge against insurer
    losses. The proposal must still be considered by NAIC's Statutory
    Accounting Committee, which must give final approval before the accounting
    treatment is put into effect. According to an NAIC official, if NAIC were
    to ultimately approve a reinsurance credit for financial instruments that
    effectively hedge insurer losses, it could take about 1 year for the new
    standards to be implemented. See appendix II for a detailed discussion of
    this accounting issue.

    35NAIC is currently considering the appropriate accounting treatment for
    nonindemnity based financial instruments that hedge insurance risk, which
    could include nonindemnitybased catastrophe bonds. 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
    catastrophe bond contract must be closely correlated to the insurance
    risks being hedged so that the pay-off is expected to be consistent with
    the expected claims, even though there is some risk that it will not
    (referred to as "basis risk"). This correlation is known as "hedge
    effectiveness" and NAIC is currently considering how it should be
    measured. Should NAIC determine a hedge-effectiveness measure, statutory
    accounting standards could be changed so that a fair value measure of the
    catastrophe bond contract could be calculated and recognized as an offset
    to insurance losses, hence allowing credit to the insurer similar to that
    granted for reinsurance. If nonindemnity-based catastrophe bonds are
    accepted as an effective hedge of underwriting results, they could become
    more attractive to potential issuers. We note that the process for
    developing an effective measure to account for risk reduction through the
    issuance of nonindemnity-based coverage is difficult and complex.

    In September 2002, we also reported that FASB was considering a new
    approach for accounting for special purpose entities (SPE)-special purpose
    reinsurance vehicles (SPRV) used to issue catastrophe bonds are a type of
    SPE---that had the potential to raise the costs associated with issuing
    catastrophe bonds and make them less attractive to issuers.36 The proposal
    was considered in response to the problems at Enron Corporation, which
    raised questions about the accounting for SPEs. FASB's proposed
    interpretation could have, among other things, (1) required the primary
    beneficiary of an SPE to consolidate the assets and liabilities of the SPE
    in its financial statements and (2) set a presumptive equity investment
    requirement for SPEs at 10 percent as compared to the previous standard of
    3 percent.

    In January 2003, FASB issued Interpretation No. 46, Consolidation of
    Variable Interest Entities (FIN 46), which revised the guidance under
    consideration in 2002. FIN 46 is quite complex and does not expressly
    discuss reinsurance, but provides criteria to determine if consolidation
    is required.37 FIN 46 introduces "variable interest entities" (VIE), a new
    term that encompasses most SPEs. A VIE is broadly defined as an entity
    which meets either of two conditions: (1) equity investors have not
    invested enough for the entity to stand on its own (insufficiency is
    presumed if the equity investment is less than 10 percent of the equity's
    total assets) or (2) equity investors lack any of the characteristics of a
    controlling financial interest (the risks or rewards of ownership). If an
    entity is deemed a VIE, then it is evaluated for possible consolidation
    according to the new risk and reward approach in FIN 46. Accounting firm
    officials that we contacted said that most catastrophe bond structures
    likely qualify as VIEs because most SPRVs do not meet the ten percent
    equity threshold. Moreover, an accounting firm official said that
    insurance companies may be less likely to issue catastrophe bonds if they
    were required to consolidate SPRV assets and liabilities on their balance
    sheets. The official said that insurance companies do not typically
    believe that they "own" SPRV assets or "owe" SPRV liabilities. The
    official said that insurance companies may decide that the costs
    associated with issuing confusing and potentially misleading financial
    statements would outweigh the benefits of issuing catastrophe bonds
    through SPRVs.

    36Companies have used SPEs for many years to carry out specific financial
    transactions.

    37FIN 46 is applicable under U.S. generally accepted accounting principles
    and has no direct application to insurance company financial statements
    prepared according to statutory accounting principles or accounting
    principles outside the United States.

    However, accounting firm and insurance officials also told us that FIN 46
    is very complex and that it is not yet certain whether it would require
    issuers of catastrophe bonds to consolidate the SPRVs on their financial
    statements.38 The officials said the potential exists that FIN 46 could
    require investors in catastrophe bonds to consolidate the bonds on their
    balance sheets or it may not require consolidation by either issuers or
    investors. FIN 46 is currently in effect for VIEs created after January
    31, 2003, and is effective for existing VIEs beginning in the first fiscal
    year or quarter beginning after June 15, 2003. Because FIN 46 became
    effective during 2003 and each transaction could be structured
    differently, it remains to be seen how FIN 46 will affect future
    catastrophe bond transactions. Additional information should be available
    after December 2003, when insurers that issue catastrophe bonds evaluate
    the substance of their catastrophe bonds for purposes of reporting their
    year-end financial statements. See appendix III for additional information
    about FIN 46.

    Institutional Investors Representatives from some institutional investors
    told us that catastrophe

    bonds served a useful but limited role in their overall approach to
    managingProvided Mixed Views their investment portfolios by often
    providing higher yields than traditional on Catastrophe Bonds investments
    and diversification. Other institutional investors said that the

    risks of catastrophe bonds were too high or not worth the costs associated
    with assessing the risks. Some institutional investors also said that they
    had decided not to purchase catastrophe bonds because they were illiquid.

    Some Institutions Invested in Catastrophe Bonds for High Yields and
    Portfolio Diversification

    The relatively high rates of return offered by catastrophe bonds make them
    attractive to some institutional investors, such as pension funds, hedge
    funds, and mutual funds-including mutual funds that specialize in
    catastrophe bond investments. As discussed previously, catastrophe bonds
    carry noninvestment-grade ratings and, during certain time periods, high
    spreads relative to alternative fixed-income investments, such as
    high-yield

    38Determining whether consolidation is required under FIN 46 requires an
    analysis of what entity-either the issuer or investor in catastrophe
    bonds-bears the majority of the expected risks and expected rewards. An
    accounting firm official we contacted said that in his view it is unlikely
    that insurers would be required to consolidate under FIN 46 because they
    do not bear the risks associated with catastrophe bonds. Rather, the
    accounting firm official said that an investor in the bonds may be
    required to consolidate if it holds more than half of the outstanding
    bonds in a particular issuance. Determining whether consolidation by an
    investor is necessary under FIN 46 could require an analysis of the
    percentage of outstanding bonds held by particular investors.

    corporate bonds. Officials from one large pension fund said that
    catastrophe bonds were attractive because they often paid higher rates
    than similarly rated instruments. Representatives from a hedge fund said
    that since September 11, 2001, the rate of return on catastrophe bonds has
    been high and the demand for the bonds has exceeded the supply.

    Another reason that some large institutional investors---such as pension
    funds---purchased catastrophe bonds is that they were uncorrelated with
    other credit risks in their bond portfolios and help diversify their
    investment risks. In general, institutional investors attempt to invest in
    equities and debt from a wide range of companies, industries, and
    geographic locations to minimize their exposure to any particular risk in
    the event of an economic downturn. Representatives from some institutional
    investors told us that catastrophe bonds complemented their general
    diversification strategy. The securities were tied to the occurrence of
    hurricanes and earthquakes rather than the performance of the economy.
    That is, investors might realize a relatively high rate of return on
    catastrophe bonds during an economic downturn, while other assets were
    performing poorly (assuming that no natural catastrophe occurred to
    trigger the securities' provisions). However, due to the potential risks
    associated with catastrophe bonds, the institutional investor
    representatives said that they confined their investments to no more than
    3 percent of their total portfolios. We note that some specialized
    institutional investors---such as hedge funds and mutual funds that focus
    on catastrophe bond investments---may assign a greater percentage of their
    investment portfolios to catastrophe bonds than large institutions.

    Some Institutional Investors As discussed in our previous report, the
    investor market for catastrophe Cited High Risks, Lack of bonds is not
    broad and some institutional investors-such as mutual Analytical Capacity,
    and funds-did not purchase them.39 Representatives from three large mutual

    funds we contacted for our follow-up work said they did not
    purchaseIlliquidity as Primary catastrophe bonds because of their
    perceived risks. The mutual fund Reasons for Not Purchasing officials said
    that their traditional approach to investing in high-yield debtCatastrophe
    Bonds involved assessing a company's business strategy, management talent,

    39In testimony before the House Financial Services Committee on October 8,
    2002, representatives from Swiss Re-one of the largest issuers of
    risk-linked securities-said that lack of interest by many money managers
    was the primary reason that the market has not expanded. See The
    Risk-Linked Securities Market: Testimony before the House Financial
    Services Committee, Subcommittee on Oversight and Investigations, U.S.
    House of Representatives. (Oct. 8, 2002).

    assets, and cash flow to justify risking customer assets in purchasing the
    company's debt. Even if a company failed, one mutual fund official said
    that as creditors they might be able to take over the business, insert new
    management, sell assets, and turn the company around. In contrast, a
    mutual fund official said that catastrophe bonds differed substantially
    from their traditional company-oriented approach and posed unacceptably
    high risks of loss to customer funds. The official also expressed doubt
    about the accuracy of models that have been developed to predict
    hurricanes and earthquakes or said that they lacked the technical
    expertise to analyze the models. The official said that insurance
    companies were in the best position to assess the risks associated with
    their natural catastrophe exposures and that they were not interested in
    purchasing risks that the companies did not want to keep on their books.
    Further, a mutual fund official said that if a natural catastrophe
    occurred and the provisions of catastrophe bonds were activated, creditors
    would have no opportunities to minimize their losses as occurs when
    companies go into bankruptcy. BMA commented that it is not inevitable that
    investors will lose all of their principal if a catastrophe bond is
    triggered (as discussed previously, some bond structures minimize the
    chances that investors will lose all of their principal).

    Mutual fund representatives also said that it was not cost-effective for
    them to develop the technical expertise necessary to analyze catastrophe
    bonds and determine if they represent a sound investment. First, a mutual
    fund official said that it was much safer to simply buy the stocks and
    bonds of insurance companies if the fund believed the management of such
    companies had the skills necessary to profitably manage their natural
    catastrophe and other exposures. Second, a mutual fund official said that
    there were alternative investments-such as high-yield corporate debt- that
    offered comparable returns and risks that firm officials understood.
    Third, a mutual fund official said that given the small size of the
    catastrophe bond market, it did not make sense to hire experts in
    hurricanes or earthquakes to monitor the market. A mutual fund
    representative did say, however, if the market for catastrophe bonds
    expanded, the company would reconsider employing experts to better
    understand these securities.

    Another reason mutual fund representatives said that they did not purchase
    catastrophe bonds was that they were illiquid. One mutual fund
    representative said that the company preferred investments-such as
    mortgage-backed securities, credit card receivables, and government
    debt-that had large numbers of buyers and sellers, stable prices, and

    narrow bid-ask spreads.40 A liquid market allows investors to sell
    securities for cash without accepting a substantial discount in price. One
    mutual fund representative said that catastrophe bonds "trade by
    appointment," and that the fund's policies did not allow for the purchase
    of such illiquid securities. Another mutual fund representative also
    commented that their company policies did not allow for the purchase of
    illiquid securities. BMA disagreed with these statements and commented
    that the liquidity of the catastrophe bond market is comparable to similar
    securities.

    Securitizing Terrorism Risk Poses Significant Challenges

    The general consensus of insurance and financial market participants we
    contacted was that insuring against terrorism risk would be difficult and
    that developing bonds covering potential targets against terrorism attacks
    in the United States was not feasible at this time. Although, several
    modeling firms were developing terrorism models that were being used by
    insurance companies to assist in their pricing of terrorism exposure, most
    experts we contacted said these models were too new and untested to be
    used in conjunction with a bond covering risks in the United States.
    Furthermore, potential investor concerns-such as a lack of information
    about issuer underwriting practices or the fear that terrorists would
    attack targets covered by catastrophe bonds---could make the costs
    associated with issuing terrorism-related securities prohibitive.

    The Complexity of Forecasting Terrorist Attacks Makes Insuring against
    Terrorism Risk Difficult

    According to insurance industry representatives, insuring against natural
    catastrophe risk, despite its challenges, is considered more practical
    than insuring against or securitizing terrorism risk. To establish their
    exposures and to price insurance premiums, companies need to be able to
    predict with some reliability the frequency and severity of insured event
    risks. Although difficult, risk-modeling firms and insurance companies
    have developed models to predict the frequency and severity of natural
    catastrophes such as hurricanes and earthquakes. Representatives from
    these firms said that there was a substantial amount of historical data
    on, for example, hurricane frequency and paths as well as earthquake
    faults and severity. Using data on natural catastrophe frequency and
    severity, insurers can gauge their exposures in particular areas and more
    accurately price their coverage. For example, an insurer could estimate
    the impact to

    40A bid-ask spread is the difference between the price asked for a
    security and the price paid.

    the insurance company of a Category 5 hurricane in Miami, given the number
    of policies that the insurer has written in the city as well as the value
    of insured property.41 Within pricing constraints established by insurance
    regulators, the company would set premiums at a level designed to
    compensate it for predicted losses while allowing for a reasonable rate of
    return. The development of models to predict the frequency and severity of
    natural catastrophe risks are considered crucial to any market growth that
    has thus far taken place for catastrophe bonds.

    In contrast, insuring against terrorism risk poses challenges because it
    requires the insurer to measure with some reliability the frequency and
    severity of terrorist acts. Experts we contacted said such analyses were
    extremely difficult because they involved attempts to forecast terrorist
    behavior, which were very difficult to quantify. The frequency of attacks
    would be subject to a range of factors including terrorist intentions, the
    ability of terrorists to enter the United States, target vulnerability,
    and the effectiveness of the war on terrorism. One market participant told
    us that even if the severity of losses at different targets given
    specified weapons were able to be modeled, it would be difficult to
    forecast losses for particular attacks given the variety of weapons that
    could be used by terrorists.

    Recent experience illustrates the difficulties associated with insuring
    against terrorism risks. After the September 11, 2001, terrorist attacks,
    many primary insurance companies refused to renew terrorism coverage in
    their general property and casualty policies for commercial customers and
    reinsurance companies stopped providing coverage for terrorism to primary
    insurers.42 Although TRIA subsequently required primary insurance
    companies to offer terrorism insurance to clients, insurers set the
    premiums. While insurance companies did not publish data on how many of
    their clients accepted offers of terrorism coverage, one insurer we
    contacted said that the overall acceptance rate was about 25 percent.

    41A Category 5 hurricane is defined by winds greater than 155 mph, storm
    surge generally greater than 18 feet above normal, complete roof failure
    on many residences and industrial buildings, and some complete building
    failures with small utility buildings blown over or away.

    42In GAO testimony before the House Subcommittee on Oversight and
    Investigations, Committee on Financial Services we stated that many
    insurers consider terrorism an uninsurable risk because it is not possible
    to estimate the frequency and severity of terrorist attacks. See Terrorism
    Insurance: Rising Uninsured Exposure Heightens Potential Economic
    Vulnerabilities. GAO-02-472T. Washington, D.C.: February 27, 2002.

    Terrorism Models under Development Considered by Some as Too New and
    Untested to Support Catastrophe Bonds

    Representatives from the three major risk-modeling firms said that they
    have developed terrorism risk models. The models differ in the method they
    employ to model risk but are similar in that they rely on the ability of
    terrorism experts to forecast the frequency and severity of terrorist
    attacks. One firm uses the Delphi method, another uses game theory, and
    the third uses a combination of the two. The models account for subjective
    information such as the particular terrorist organization that is carrying
    out the attack and the resources available to them; the political
    situation; and when, where, and how the attack might occur. The Delphi
    method, for example, analyzes various threats posed by domestic
    extremists, formal international and state-sponsored terrorist
    organizations, and loosely affiliated extremist networks. The game theory
    model analyzes the potential actions of terrorists based on the actions of
    security forces and counter-terrorism measures.

    Modeling firm officials and insurance industry representatives said that
    insurers, reinsurers, group life insurers, and corporations were currently
    using terrorism models. Some insurance companies were using the models to
    help them determine their exposure to terrorism and price this risk. For
    example, some life insurance companies were using the models to ensure
    that they did not have a high concentration of life insurance policies in
    properties that might be particularly vulnerable to terrorist attacks.

    Representatives from reinsurance companies we contacted, however, said
    that the models were not reliable in predicting the frequency of terrorist
    attacks, although they provided useful information on the potential
    severity of attacks. Moreover, officials from ratings agencies we
    contacted said that they were not convinced about the reliability of the
    terrorism models at this point and that they would not be willing to rate
    a catastrophe bond covering targets in the United States based on the
    models. According to one of the major rating firms, for example, the
    estimates derived from the three models for predicting the frequency and
    severity of terrorist attacks could vary by 200 percent or more. Another
    rating firm official said that investors currently would not believe that
    the terrorism models adequately reflected the risk. Without acceptance of
    the models by major ratings agencies and investors, the officials said
    that the issuance of catastrophe bonds related to terrorism coverage in
    the United States would be highly unlikely. We note that NAIC officials
    commented that while developing catastrophe bonds to cover terrorism is
    very difficult and may not occur in the medium-term, the potential exists
    that such bonds will be issued.

    Investor Concerns Could Impede the Development of a Market for
    Terrorism-Related Securities

    Investor concerns about catastrophe bonds related to terrorism could also
    make the costs to insurers of issuing such bonds prohibitive. In the
    absence of well-developed and contractual business relationships with the
    primary insurer, investors might not believe they had sufficient
    information about the extent to which an insurance company offered
    terrorism coverage to properties that were potentially highly vulnerable
    to a terrorist attack or the quality of an issuer's underwriting practices
    and claims payment processes. Because of investors' potential lack of
    information about insurer practices, they might demand a significantly
    higher rate of return before they would purchase a security that covered
    terrorism risks. Some insurance companies already have decided not to
    issue catastrophe bonds for natural catastrophes due to their relatively
    high costs. Given the uncertainties associated with forecasting the
    frequency and severity of terrorist attacks, it is likely that the costs
    associated with issuing terrorism-related bonds would be even higher.

    Investors might also demand high returns on terrorist-related securities
    because of concerns about strategic behavior by terrorists. Investors
    might be concerned that terrorists would learn about the conditions that
    would activate the provisions of a catastrophe bond, and plan attacks on
    the basis of that knowledge. Although it is not clear that terrorists
    would make attacks based on such reasoning, investors fear that they would
    increase the risk premium demanded of such securities.

    While developing a catastrophe bond to cover terrorism risks in the United
    States may be difficult, we note that in August 2003 a bond was developed
    to cover such risks---and other risks---in Europe. The Federation
    Internationale de Football Association (FIFA), the world governing body of
    association football-called soccer in the United States-and organizer of
    the FIFA World Cup developed a catastrophe bond to protect its investment
    in the 2006 World Cup in Germany. The bond is rated investment grade and
    covers natural and terrorist catastrophic events that result in the
    cancellation of the final World Cup game. Representatives from the rating
    agency that rated the bond said they were able to provide an investment
    grade rating because the bond's provisions make it highly unlikely that

    investors will lose their principal.43 For example, the officials said
    that it would require extraordinary circumstances for the final game to be
    cancelled. Under the bond's provisions, FIFA also has the flexibility to
    reschedule the final game and, if necessary, hold the event in another
    country. While the rating agency official said that the firm relied on
    natural catastrophe models to help assign a rating to the bond, the firm
    did not rely on terrorism models because terrorism is impossible to
    predict. Instead, the rating firm used an analytical approach developed by
    one of the modeling firms to analyze potential terrorist threats to the
    2006 World Cup.44 It remains to be seen how well the bond is accepted by
    investors and whether it will result in similar issuances.

    Observations	Although catastrophe bonds to date have not transferred a
    significant portion of insurers' natural catastrophe risk exposures to the
    capital markets, the bonds do play a useful role for some companies and
    institutional investors. For some companies, catastrophe bonds supplement
    traditional reinsurance and may lower the costs associated with covering
    low-probability, high severity events. For some institutional investors,
    catastrophe bonds are attractive in limited quantities because of their
    relatively high rate of return and usefulness in portfolio risk
    diversification. However, the lack of interest by other large insurance
    companies and institutional investors may have been factors in limiting
    the broader expansion of the market for catastrophe bonds. Some large
    insurers and state natural catastrophe authorities viewed the bonds as too
    expensive compared to traditional reinsurance and large institutional
    investors view the bonds as too risky, not worth the costs of
    understanding the risks, and illiquid. Whether the catastrophe bond market
    expands in the future beyond the useful but limited role that it currently
    serves would likely depend upon changing the views of additional large
    insurance companies and institutional investors about the bonds' utility.

    43The structure of the bond rated investment grade guarantees that
    investors will recover at least 25 percent of their principal. Other
    provisions in the bond do not provide such protection to investors and
    were not rated. The rating agency also said that investor losses were not
    likely because Germany is not prone to natural disasters, the World Cup
    tournament is spread over many venues, and German security measures are
    stringent.

    44The rating agency's analysis concluded that terrorism is unlikely to
    affect the 2006 World Cup because, among other reasons, "...there is less
    involvement by the U.S. and greater sympathy for football in general."

    The general view of insurance industry officials and financial market
    participants is that the development of a bond market covering terrorism
    risks in the United States would be challenging at this time. Although
    statistical models have been developed to assist insurance companies in
    providing terrorism insurance, the models appear to be too new and
    untested to use in conjunction with a bond related to terrorism.
    Developing such models is considered extremely challenging due to the
    complexity of attempting to predict the frequency and severity of
    terrorist attacks. Investors' lack of complete information about issuer
    underwriting practices and concerns about strategic behavior by
    terrorists, may make insurers' costs of issuing bonds covering terrorism
    prohibitive.

    Agency Comments and Our Evaluation

    We received written comments on a draft of this report from NAIC, BMA, and
    RAA. We also received technical comments from these organizations, which
    we have incorporated into the report text where appropriate.

    NAIC commented that U.S. insurance regulators should encourage the
    development of alternative sources of capacity, such as insurance
    securitizations and risk-linked securities, so long as such developments
    are consistent with NAIC's overriding goal of consumer protection. NAIC
    also made several other points in its comment letter. First, NAIC stated
    that SPRVs should be brought on-shore and be subject to U.S. regulation,
    which could lower the costs associated with catastrophe bonds. Second,
    NAIC stated that the removal of any uncertainty regarding the tax
    treatment of catastrophe bonds could encourage the use of such bonds. We
    note that the tax treatment of catastrophe bonds was outside the scope of
    our review for this report but we discussed the issue in detail in our
    previous report on risk-linked securities. Third, NAIC concurred with our
    report finding on the difficulty in securitizing terrorism risk, however,
    NAIC also commented that some insurers are writing terrorism risk, and if
    it can be priced, then it can be securitized. In addition, NAIC objected
    to a reference in the draft report to insurance company representatives
    implying that state insurance regulators set premium levels below levels
    that the insurer believed were necessary to cover their expected losses on
    natural catastrophes and operating expenses. We have revised the report
    text to more accurately describe the procedures for setting insurance
    premiums and reflected NAIC's views in the report.

    BMA commented that the draft report provided a timely and helpful
    assessment of the progress of catastrophe bonds in transferring natural
    and terrorism catastrophe risk to the capital markets. However, BMA

    commented that while some insurers believe that catastrophe bonds are more
    expensive than reinsurance, other factors-such as reinsurer credit
    risk-must also be considered. In particular, BMA stated that that the
    relative attractiveness of catastrophe bonds depends upon whether the
    particular risk is truly a "peak peril" of the type that has typically
    been addressed by catastrophe bonds, which can include Japanese
    earthquakes, California earthquakes, and Florida hurricanes. BMA stated
    that reinsurance companies charge higher premiums to cover these types of
    perils.

    As stated in the report, reinsurance companies may limit coverage or
    charge increasingly higher premiums for low probability and high severity
    events, such as hurricanes or earthquakes expected to occur no more than
    once ever 100 to 250 years. Some insurance companies have concluded that
    catastrophe bonds serve as a useful risk transfer mechanism for such risks
    and as an effective supplement to traditional reinsurance. Some insurance
    company officials also stated that catastrophe bonds can serve a role in
    lowering the costs of insuring against such risks. Other insurance
    companies and state authorities we contacted do provide coverage for such
    events as Florida hurricanes and California earthquakes. However,
    officials from these organizations said that catastrophe bonds are not
    cost-effective as compared to reinsurance for the severity of events that
    they are willing to insure against. For example, some insurance companies
    believe that reinsurance offers more cost-effective coverage for events
    expected to occur more frequently that once every 100 years.

    RAA commented that our draft report provided a generally fair summary of
    the effort to securitize natural catastrophe risks and provides a very
    good overview of differing views on the utility of such bonds. However,
    RAA took exception to our draft report's characterization of NAIC
    statutory accounting requirements for reinsurance as favorable compared to
    NAIC accounting requirements for certain catastrophe bonds. We have
    changed the language in the report to more clearly distinguish between the
    current grant of credit for traditional reinsurance and indemnity-based
    catastrophe bonds and NAIC's review of potential changes to statutory
    accounting standards that would grant similar accounting treatment for
    nonindemnity based financial instruments that hedge insurance risk
    (including nonindemnity based catastrophe bonds). Such changes would allow
    credit to instruments that effectively hedge insurance risk because they
    are highly correlated with the issuer's actual losses. We note that
    traditional reinsurance does not need hedge accounting treatment because
    it already receives credit for risk transfer.

    As agreed with your offices, unless you publicly announce the contents of
    this report earlier, we plan no further distribution of this report until
    30
    days from the report date. At that time, we will provide copies of this
    report
    to the Chairman and Ranking Minority Member, Senate Committee on
    Banking, Housing, and Urban Affairs and the Ranking Minority Members,
    House Committee on Financial Services and its Subcommittee on Capital
    Markets, Insurance, and Government Sponsored Enterprises. Copies will
    also be provided to NAIC, BMA, RAA, and other interested parties. In
    addition, the report will be available at no charge on GAO's home page at
    http://www.gao.gov.

    If you or your staff have any questions regarding this report, please
    contact
    Mr. Wesley M. Phillips or me at (202) 512-8678. GAO staff that made major
    contributions to this report are listed in appendix VIII.

    Davi M. D'Agostino
    Director, Financial Markets and

    Community Investment

    Appendix I

                           Objectives, Scope, and Methodology

    You asked us to update our September 2002 report on the role of
    catastrophe bonds and factors affecting their use and to report on the
    potential for terrorism risk to be securitized. As agreed with your
    offices, our objectives were to (1) assess the progress of catastrophe
    bonds in transferring natural catastrophe risks to the capital markets;
    (2) assess factors that affect the issuance or sponsorship of catastrophe
    bonds by insurance and reinsurance companies, including a status report on
    accounting issues raised in our previous report; (3) assess factors that
    affect investment in catastrophe bonds, and (4) analyze the potential for
    and challenges associated with securitizing terrorism-related financial
    risks.

    Our general methodology involved meeting with a range of private-sector
    and regulatory officials to obtain diverse viewpoints on the status of
    efforts to securitize natural catastrophe and terrorism risks. We met with
    (1) three large insurers or reinsurers that currently issue catastrophe
    bonds and two insurers who currently do not, (2) two state authorities
    that currently do not issue catastrophe bonds through SPRVs, (3) three
    institutional investors-including a large pension fund and two hedge
    funds-that purchase catastrophe bonds and three large mutual funds that do
    not purchase catastrophe bonds, (4) investment banks that underwrite
    catastrophe bonds and monitor the market, (5) three large ratings
    agencies, (6) three modeling firms, (7) two large accounting firms, (8)
    two firms that engage in insurance and reinsurance brokerage, (9) the
    National Association of Insurance Commissioners (NAIC), (10) the Bond
    Market Association, and (11) the Reinsurance Association of America.
    Because of our reporting deadlines, we selected a judgmental sample of
    organizations to contact. We also reviewed our previous work on
    catastrophe bonds and insurance (see Related GAO Products) and data and
    reports provided by private-sector sources.1

    Even though we did not have audit or access-to-records authority for the
    private-sector entities, we obtained extensive testimonial and documentary
    evidence from them. However, we did not verify the accuracy of the data
    from these entities. We note that there is no central source of
    information on key issues, such as the number of catastrophe bonds issued
    or the

    1One of the insurance companies with whom we met does not currently issue
    catastrophe bonds, but did issue one such bond several years ago. One of
    the state authorities does not issue catastrophe bonds through SPRVs, but
    some risks that it had transferred to a reinsurer were included in a
    catastrophe bond issued by that reinsurer.

    Appendix I
    Objectives, Scope, and Methodology

    amount of catastrophe bonds outstanding. In such cases, we used
    professional judgment to determine how to present the data and what period
    of time to report.

    To respond to the first objective, we reviewed data on catastrophe bond
    issuance from 1997 through 2002 provided by a firm that specializes in
    these securities. We also obtained data from a large reinsurer that
    collects data on the size of the catastrophe bond market relative to the
    worldwide reinsurance market and a firm that collects data on reinsurance
    prices. We also obtained data from the firm on the issuance of catastrophe
    bonds by large insurers and reinsurers.

    To respond to the second objective, we asked insurance and reinsurance
    companies that issue or have issued catastrophe bonds why they had done so
    and what role the bonds played for their companies. We also asked other
    large insurance companies and two state catastrophe authorities that do
    not currently issue catastrophe bonds the basis for that decision. In
    addition, we asked financial market participants that support the use of
    catastrophe bonds-such as an investment bank and hedge fund-for their
    views on the costs associated with catastrophe bonds as opposed to
    reinsurance contracts. To update accounting issues raised in our 2002
    report, we reviewed FIN 46 and interviewed officials from accounting
    firms, insurers, and NAIC.

    To respond to the third objective, we spoke with three institutional
    investors that purchased catastrophe bonds and discussed their reasons for
    doing so. We also contacted representatives from three large mutual funds
    that had not purchased catastrophe bonds to obtain their views. We also
    obtained data comparing the returns on catastrophe bonds to other
    fixed-income investments, such as high-yield bonds.

    To respond to objective four, we contacted insurance and reinsurance
    companies, modeling firms, rating agencies, investment banks, and NAIC. We
    reviewed a variety of documents including academic studies, insurance
    company and reinsurance company articles on terrorism and terrorism
    insurance, modeling firm and rating firm publications, and offering
    circulars.

    We conducted our work between March and August 2003 in New York,
    Massachusetts, Ohio, Illinois, Pennsylvania, Texas, and Washington, D.C.

    Appendix II

    Statutory Accounting Balance Sheet Implications of Reinsurance Contracts

    Over the duration 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 the National Association of
    InsuranceCommissioners (NAIC), but also by the Securities and Exchange
    Commission and the Financial Accounting Standards Board. 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.

    To illustrate, 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

    Appendix II
    Statutory Accounting Balance Sheet
    Implications of Reinsurance Contracts

    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 8
    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.

    Figure 8: Effect on Ceding and Reinsurance Companies' Balance Sheets
    before and after a Reinsurance Transaction

    Source: Insurance Accounting Systems Association.

    Appendix II
    Statutory Accounting Balance Sheet
    Implications of Reinsurance Contracts

    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 a special purpose
    reinsurance vehicle (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.

    Appendix III

    FASB Interpretation No. 46, Consolidation of Variable Interest Entities

    In January 2003, the Financial Accounting Standard Board (FASB) released
    Interpretation No. 46 with the objective of improving financial reporting
    by entities involved in variable interest entities (VIE)-an entity subject
    to consolidation according to the provisions of the Interpretation---and
    not to restrict the use of VIEs.1 The goal is to help financial statement
    users understand the financial statements of VIE primary beneficiaries
    that consolidate as well as those with a significant variable interest
    that do not consolidate. Interpretation No. 46 states that to faithfully
    represent the total assets that an enterprise controls and liabilities for
    which an enterprise is responsible, assets and liabilities of the VIE for
    which the enterprise is the primary beneficiary must be included in an
    enterprise's consolidated financial statements.

    What is a VIE?	The interpretation explains how to identify VIEs, which are
    entities that, by design, have one or both of the following
    characteristics:

    1.	The total equity investment at risk is not sufficient (insufficiency is
    presumed if the equity investment is less than 10 percent of the equity's
    total assets, but this presumption may be rebutted) to permit the entity
    to finance its activities without additional subordinated financial
    support from other parties. In other words, the equity investment at risk
    is not greater than the expected losses of the entity. Such subordinated
    financial support may be provided through other interests (including
    ownership, contractual, or other pecuniary interests) that will absorb
    some or all of the expected losses of the entity.

    2.	The equity investors lack one or more of the following essential
    characteristics of a controlling financial interest:

    o 	The direct or indirect ability to make decisions about the entity's
    activities through voting rights or similar rights;

    o 	The obligation to absorb the expected losses of the entity if they
    occur, which makes it possible for the entity to finance its activities;
    or

    1This analysis of FIN 46 is based on existing interpretations by
    private-sector analysts and publications. See, for example, Michael J.
    Pinsel. "Impact of FIN 46 on Insurance Industry Transactions." Insurance
    and Financial Services Report (Second Quarter Issue, 2003).

                                      Appendix III
                      FASB Interpretation No. 46, Consolidation of
                               Variable Interest Entities

    o 	The right to receive the expected residual returns of the entity if
    they occur, which is the compensation for the risk of absorbing the
    expected losses.

    Consolidate or Not?	The interpretation also gives guidance on how an
    enterprise assesses its interests in a VIE to consolidate that entity.
    FASB says that if a business enterprise has a controlling financial
    interest in a VIE, the assets, liabilities, and results of the activities
    of the VIE should be included in consolidated financial statements of the
    business enterprise. A direct or indirect ability to make decisions that
    significantly affect the results of the activities of a VIE is a strong
    indication that an enterprise has one or both of the characteristics that
    would require consolidation of the variable interest entity.

    Primary Beneficiaries Must The interpretation requires existing
    unconsolidated VIEs to be

    Consolidate	consolidated by their primary beneficiaries if the entities do
    not effectively disperse risks among parties involved. A primary
    beneficiary is the party that absorbs a majority of the VIE's expected
    losses if they occur, receives a majority of its expected residual returns
    if they occur, or both. The primary beneficiary of the VIE is required to
    disclose (1) the nature, purpose, and size of the VIE; (2) the carrying
    amount and classification of consolidated assets that are collateral; and
    (3) any lack of recourse by creditors.

    Appendix IV

                         Texas Windstorm Insurance Association

    In 1971, the Texas Legislature established the Texas Windstorm Insurance
    Association (TWIA) as a mechanism to provide wind and hail coverage to
    residents of 14 counties along the coast and portions of 1 additional
    county who are unable to obtain insurance in the voluntary market. The
    legislature's action was in response to insurance market constrictions
    along the Texas Gulf Coast after several hurricanes in the late 1960s and
    Hurricane Celia, which struck Corpus Christi in August 1970. TWIA is a
    pool of property and casualty insurance companies authorized to write
    coverage in Texas. Since its inception, the legislature has made it clear
    that TWIA was to write limited coverage for wind and hail in order to
    provide for the "orderly economic growth of the Coastal counties."

    Residential and commercial rates for the TWIA are controlled by statute.
    The average residential policy costs more than $500. There is an annual
    rate increase or decrease cap on both residential and commercial rates of
    10 percent, except under unusual circumstances following a catastrophe or
    series of catastrophes, when the Commissioner of Insurance-after a public
    hearing-has the authority to lift the cap. Currently, it is estimated that
    TWIA provides 20 percent of the residential coverage for wind and hail and
    50 percent of the seaward coverage in Texas.

    As of June 30, 2003, TWIA had more than 89,000 residential and commercial
    policies and a claims paying capacity of more than $1.1 billion. TWIA's
    total liability on these residential and commercial policies was more than
    $17 billion. The organization's claims paying capacity consists of layers
    of assessment of their pool of insurers, the Catastrophe Trust Fund, and
    reinsurance. As shown in figure 9, for the bottom level of financing ($0
    to $100 million) and the highest probability of occurrence (one in every 9
    years), TWIA has coverage through its pool of insurers. For the next level
    of financing ($100 to $200 million) and probability of occurrence of once
    every 9 to 15 years, coverage comes from the Catastrophe Trust Fund.

    Appendix IV
    Texas Windstorm Insurance Association

    Figure 9: Texas Windstorm Insurance Authority Financing

    Source: TWIA.

    The Catastrophe Trust Fund consists of funds originally provided by
    cancellation of a multiyear reinsurance contract. Coverage comes from the
    Catastrophe Trust Fund and reinsurance for the next layer of financing at
    ($200 to $400 million) and with a probability of occurrence of once every
    15 to 27 years. The Catastrophe Trust Fund covers $100 million of this
    layer while reinsurance covers an additional $100 million. The next layer
    of financing is $300 million of reinsurance and covers events occurring
    once every 27 to 54 years. The next layer of financing is $100 million in
    coverage from the Catastrophe Trust Fund and covers events that occur once
    every 54 to 67 years. The next layer up of financing is a $200 million
    assessment of its pool of insurers and covers events occurring once every
    67 to 102 years. The next level of financing comes from $100 million in
    reinsurance coverage. For any losses above this point, there is an
    unlimited assessment of TWIA's pool of insurers.

    Appendix V

    Comments from the National Association of Insurance Commissioners

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

    Appendix V
    Comments from the National Association of
    Insurance Commissioners

                                     See comment 1.

                                     See comment 2.

    Appendix V
    Comments from the National Association of
    Insurance Commissioners

    Appendix V
    Comments from the National Association of
    Insurance Commissioners

    The following are GAO's comments on the National Association of Insurance
    Commissioner's letter dated September 5, 2003.

    GAO Comments 1. We have reflected NAIC's views in the report.

    2. We have revised the text and reflected NAIC's views in the report.

                                      Appendix VI

                       Comments from the Bond Market Association

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

    Appendix VI
    Comments from the Bond Market Association

                                     See comment 1.

                                     See comment 2.

                                     See comment 3.

    Appendix VI
    Comments from the Bond Market Association

                                     See comment 4.

    Appendix VI
    Comments from the Bond Market Association

                                     See comment 5.

                                     See comment 6.

                                     See comment 7.

                                     See comment 8.

    Appendix VI
    Comments from the Bond Market Association

                                     See comment 9.

                                    See comment 10.

                                    See comment 11.

                                    See comment 12.

                                    See comment 13.

                                    See comment 14.

    Appendix VI
    Comments from the Bond Market Association

                                    See comment 15.

                                    See comment 16.

                                    See comment 17.

    Appendix VI
    Comments from the Bond Market Association

    Appendix VI
    Comments from the Bond Market Association

                                      Appendix VI
                       Comments from the Bond Market Association

    The following are GAO's comments on the Bond Marketing Association's (BMA)
    letter dated September 5, 2003.

    GAO Comments 1.

    2.

    3.

    4.

    5.

    6.

    7.

    The two insurance companies that we discussed in this section of the
    report as well as one state authority cover Florida hurricanes or
    California earthquakes ("peak perils" as defined by BMA). Officials from
    each of these organizations said that they have compared the costs
    associated with catastrophe bonds to traditional reinsurance and did not
    consider catastrophe bonds cost-effective for their catastrophe
    reinsurance needs for the level of risks that they insure against
    (although they may have other reasons for not using catastrophe bonds
    including the fact that most SPRVs are based offshore). The other state
    authority does not cover either Florida hurricanes or California
    earthquakes but considers catastrophe bonds as not cost-effective compared
    with traditional reinsurance for its business.

    While multi-year fixed pricing may be a factor in catastrophe bonds'
    favor, none of the insurers or state authorities we contacted who
    currently do not issue catastrophe bonds cited it in our discussions.

    The BMA is correct in its statement that catastrophe bond transaction
    costs decline as a percentage of the (coverage) limit provided as deal
    size and bond maturity increase. However, some insurance company and state
    authority representatives said that it was not cost-effective for them to
    issue catastrophe bonds in amounts large enough to offset the transaction
    costs.

    We have clarified the language in the report with respect to the potential
    effects that consolidation would have for potential catastrophe bond
    issuers.

    We have reflected BMA's position in the report. We note that BMA's
    position differs from that of several large mutual fund companies we
    contacted who said that catastrophe bonds are illiquid.

    The mutual fund companies that we contacted offer high-yield bond funds to
    their investors.

    We have clarified language in the report stating that investors do not
    always face total losses if catastrophe bond provisions are triggered.

    Appendix VI
    Comments from the Bond Market Association

    8. We have clarified the language in the report.

    9.	We have added language to the report that provides additional reasons
    that most SPRVs are based offshore.

    10. We have made revisions to the figure.

    11. We agree that there are different approaches to comparing the returns
    on different types of financial instruments and have clarified language in
    the report. The data we obtained suggest that catastrophe bonds have had a
    higher return than high-yield corporate debt in 2002. The scope of our
    work did not involve identifying or assessing other measures, although we
    note that BMA believes that catastrophe bonds yields are comparable to
    high-yield corporate debt.

    12. As discussed in this report, many catastrophe bonds have covered
    events expected to take place no more than once every 100 to 250 years. It
    remains to be seen whether a greater number of catastrophe bonds covering
    events expected to take place more frequently than once every 100 years
    will occur.

    13. As noted in the report, some insurers issue or have issued
    indemnity-based catastrophe bonds.

    14. We have revised the figure in the report.

    15. We agree that some insurers find that catastrophe bonds serve as an
    important supplement to traditional means of managing risk, such as
    reinsurance or limiting coverage in high-risk areas.

    16. We have reflected BMA's position in the report.

    17. A Fitch representative we contacted said that the report cited in the
    draft report had not been updated since 2001. We revised the text and
    stated BMA's position.

    Appendix VII

    Comments from the Reinsurance Association of America

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

    See comment 1.

    Appendix VII
    Comments from the Reinsurance Association
    of America

                                     See comment 2.

    Appendix VII
    Comments from the Reinsurance Association
    of America

                                     See comment 3.

    Appendix VII
    Comments from the Reinsurance Association
    of America

                                     See comment 4.

                                     See comment 5.

                             See comment 6. See comment 7.

                                     See comment 8.

    Appendix VII
    Comments from the Reinsurance Association
    of America

                                     See comment 9.

                                    See comment 10.

                                    See comment 11.

                                    See comment 12.

                                    See comment 13.

                                    See comment 14.

    Appendix VII
    Comments from the Reinsurance Association
    of America

                                    See comment 15.

                                    See comment 16.

                                    See comment 17.

                                    See comment 18.

    Appendix VII
    Comments from the Reinsurance Association
    of America

                                    See comment 19.

                                    See comment 20.

                                    See comment 21.

                                      Appendix VII
                       Comments from the Reinsurance Association
                                       of America

    The following are GAO's comments on the Reinsurance Association of
    America's (RAA) letter dated September 3, 2003.

    GAO Comments 1.

    2.

    3.

    4.

    5.

    6.

    7.

    8.

    9.

    In this report, we have revised the text to clarify that current statutory
    accounting standards differ for traditional indemnity reinsurance
    contracts-including indemnity based catastrophe bonds-and nonindemnity
    based instruments that hedge insurance risk, such as nonindemnity
    catastrophe bonds. Where appropriate, we have also revised the text to
    make clear why the accounting standards differ. That is, traditional
    reinsurance results in risk transfer while nonindemnity based instruments
    have not been viewed as providing a comparable risk transfer. We note that
    NAIC is considering a proposal that would allow similar accounting
    treatment for nonindemnity based instruments that effectively hedge
    insurance company risks.

    See comment 1. We note that traditional reinsurance does not need hedge
    accounting treatment afforded an effective hedge because it already
    receives credit for risk transfer.

    See comment 1.

    We have altered the report text to indicate that reinsurance contracts may
    involve litigation over whether insurer claims should be paid. We also
    state RAA's position in the report.

    We have added language to the report stating RAA's positions.

    We agree that reinsurance and indemnity based catastrophe bonds receive
    identical accounting treatment and have revised the text to make this
    point clear. However, we note that this statutory accounting treatment
    differs from the accounting treatment that applies to nonindemnity based
    instruments, such as nonindemnity catastrophe bonds, and this point has
    also been clarified in the text.

    See comment 1.

    See comment 1.

    See comment 1.

    Appendix VII
    Comments from the Reinsurance Association
    of America

    10. See comment 1. We think that insurance statutory accounting rules are
    primarily the concern of issuers and not investors-who would not be
    subject to such rules.

    11. We have revised the report text.

    12. We have revised the report text.

    13. We have revised the text to avoid confusion with other discussions in
    this report.

    14. We have revised the report text.

    15. We have changed the text so that "frequently" is replaced by "may." We
    have also added RAA's views on the prevalence of insurance litigation.

    16. We have added language to the report as suggested by RAA concerning
    additional reasons reinsurance prices increased during the 1999-2002
    period.

    17. We have added language to the report on the issue of basis risk
    presented by nonindemnity based catastrophe bonds.

    18. We have added the text on tail risk suggested by RAA stating that
    reinsurance contracts may continue to address tail risk while catastrophe
    bonds may not allow claims after several years.

    19. See comment 10.

    20. We have made some revisions to the report text.

    21. We have revised the report language so that the Florida Hurricane
    Catastrophe Fund is properly identified.

    Appendix VIII

                         GAO Acknowledgments and Staff Contacts

    GAO Contacts	Davi M. D'Agostino (202) 512-8678 Wesley M. Phillips (202)
    512-5660

    Acknowledgments	In addition to those named above, Lynda Downing, Patrick
    S. Dynes, Christine Kuduk, Marc Molino, Rachel DeMarcus, and Rachel Seid
    made key contributions to this report.

    Related GAO Products

    Insurance Regulation: Preliminary Views on States' Oversight of Insurers'
    Market Behavior. GAO-03-738T. Washington, D.C.: May 6, 2003.

    Catastrophe Insurance Risks: The Role of Risk-Linked Securities.
    GAO-03-195T. Washington, D.C.: October 8, 2002.

    Catastrophe Insurance Risks: The Role of Risk-Linked Securities and
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    Terrorism Insurance: Rising Uninsured Exposure to Attacks Heightens
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    Terrorism Insurance: Alternative Programs for Protecting Insurance
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    Insurance Regulation: The NAIC Accreditation Program Can Be Improved.
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    Regulatory Initiatives of the National Association of Insurance
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    Disaster Assistance: Issues Related to the Development of FEMA's Insurance
    Requirements. GGD/OGC-00-62. Washington, D.C.: February 25, 2000.

    Insurers' Ability to Pay Catastrophe Claims. GGD-00-57R. Washington, D.C.:
    February 8, 2000.

    FCIC: Catastrophic Risk Protection Endorsement and Federal Crop Insurance
    Reform, Insurance Implementation. OGC-98-69. Washington, D.C.: August 17,
    1998.

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