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 [email protected].

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
Factors Affecting Their Use. GAO-02-941. Washington, D.C.: September 24,
2002.

Terrorism Insurance: Rising Uninsured Exposure to Attacks Heightens
Potential Economic Vulnerabilities. GAO-02-472T. Washington, D.C.:
February 27, 2002.

Terrorism Insurance: Alternative Programs for Protecting Insurance
Consumers. GAO-02-199T. Washington, D.C.: October 24, 2001.

Insurance Regulation: The NAIC Accreditation Program Can Be Improved.
GAO-01-948. August 31, 2001.

Regulatory Initiatives of the National Association of Insurance
Commissioners. GAO-01-885R. Washington, D.C.: July 6, 2001.

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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