Catastrophe Insurance Risks: The Role of Risk-Linked Securities  
(08-OCT-02, GAO-03-195T).					 
                                                                 
Because of population growth, resulting real estate development, 
and rising real estate values in hazard-prone areas, our nation  
is increasingly exposed to higher property casualty losses--both 
insured and uninsured--from natural catastrophes than in the	 
past. In the 1990s, a series of natural disasters, including	 
Hurricane Andrew and the Northridge earthquake, raised questions 
about the adequacy of the insurance industry's financial capacity
to cover large catastrophes without limiting coverage or raising 
premiums. Recognizing this greater exposure and responding to	 
concerns about insurance market capacity, participants in the	 
insurance industry and capital markets have developed new capital
market instruments as an alternative to traditional		 
property-casualty reinsurance, or insurance for insurers. GAO's  
objectives were to (1) describe catastrophe risk and how the	 
insurance and capital markets provide coverage against such	 
risks; (2) describe how risk-linked securities, particularly	 
catastrophe bonds, are structured; and (3) analyze how key	 
regulatory, accounting, tax, and investor issues might affect the
use of risk-linked securities.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-195T					        
    ACCNO:   A05258						        
  TITLE:     Catastrophe Insurance Risks: The Role of Risk-Linked     
Securities							 
     DATE:   10/08/2002 
  SUBJECT:   Bonds (securities) 				 
	     Insurance						 
	     Insurance companies				 
	     Risk management					 
	     Insurance claims					 
	     Insurance losses					 
	     Securities 					 

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GAO-03-195T

Testimony Before the Subcommittee on Oversight and Investigations,
Committee on Financial Services, House of Representatives

United States General Accounting Office

GAO For Release on Delivery Expected at 2: 00 p. m., EDT, on Tuesday,
October 8, 2002 CATASTROPHE

INSURANCE RISKS The Role of Risk- Linked Securities

Statement of Davi M. D*Agostino, Director, Financial Markets and Community
Investment

GAO- 03- 195T

Why GAO Did This Study

Because of population growth, resulting real estate development, and
rising real estate values in hazard- prone areas, our nation is
increasingly exposed to higher property casualty losses* both insured and
uninsured* from natural catastrophes than in the past. In the 1990s, a
series of natural disasters, including Hurricane Andrew and the Northridge
earthquake, raised questions about the adequacy of the insurance
industry*s financial capacity to cover large catastrophes without limiting
coverage or raising premiums. Recognizing this greater exposure and
responding to concerns about insurance market capacity, participants in
the insurance industry and capital markets have developed new capital
market instruments as an alternative to traditional property- casualty
reinsurance, or insurance for insurers. GAO*s objectives were to (1)
describe catastrophe risk and how the insurance and capital markets
provide coverage against such risks; (2) describe how risklinked
securities, particularly catastrophe bonds, are structured; and (3)
analyze how key regulatory, accounting, tax, and investor issues might
affect the use of risk- linked securities.

October 2002 CATASTROPHE INSURANCE RISKS The Role of Risk- Linked
Securities

The full testimony is available at www. gao. gov/ cgi- bin/ getrpt? GAO-
03- 195T. For additional information about the testimony, contact Davi
D'Agostino (202- 512- 8678; dagostinod@ gao. gov).

Highlights of GAO- 03- 195T, a testimony for the Subcommittee on Oversight
and Investigations, House Committee on Financial Services United States
General Accounting Office

What GAO Found

Natural catastrophes are infrequent events that cause severe losses. More
than 68 million Americans live in hurricane- vulnerable coastal areas, and
80 percent of Californians live near active earthquake faults. Insurance
companies who write property- casualty policies in these high- risk areas
try to spread the risks, traditionally through reinsurance. When
reinsurance prices or availability became problematic in the 1990s,
insurers turned to risk- linked securities as an alternative means to
spread catastrophe risk. Most risk- linked securities are catastrophe
bonds, which (1) have complicated structures, (2) are created offshore
through special purpose entities, and (3) generally receive noninvestment-
grade ratings. Key regulatory, accounting, tax, and investor issues pose
challenges to expanding the use of risk- linked securities, and GAO
discusses the advantages and disadvantages of potential changes.

Estimated Losses from Recent Large Catastrophes

Sources: Insurance Information Institute and other insurance industry
sources. G A O Accountability Integrity Reliability

Highlights

Page 1 GAO- 03- 195T

Madame Chairwoman and Members of the Subcommittee: I am pleased to be here
today to discuss the results of our work on the potential for risk- linked
securities to address catastrophic risks arising from natural events such
as hurricanes and earthquakes. Population growth, real estate development,
and rising real estate values in hazardprone areas increasingly expose our
nation to higher losses* both insured and uninsured* from natural
catastrophes than in the past. This exposure increases pressure on
businesses; individuals; and federal, state, and local governments to
assume ever- larger liabilities for losses associated with natural
catastrophes. A series of natural disasters in the 1990s, including
Hurricane Andrew and the Northridge earthquake, raised questions about the
financial capacity of the insurance industry to cover large catastrophes
without limiting coverage or substantially raising premiums, and called
attention to ways of raising additional sources of capital to help cover
catastrophe risk. Participants in the insurance industry and capital
markets developed new capital market instruments, risk- linked securities,
which both expand insurance and reinsurance capacity and provide an
alternative to traditional property- casualty reinsurance. We were asked
to analyze the role of risk- linked securities in the coverage of
catastrophe risk and factors affecting their use.

Today I will talk about (1) what catastrophe risk is and how the insurance
and capital markets provide coverage for such risks; (2) how risk- linked
securities, particularly catastrophe bonds, are structured; and (3) how
key regulatory, accounting, tax, and investor issues might affect the use
of these securities. Our overall objective is to provide the Committee
with information and perspectives to consider as it moves forward in this
important and complex area. For a fuller discussion of these points, I
refer you to our report entitled Catastrophe Insurance Risks: The Role of
RiskLinked Securities and Factors Affecting Their Use (GAO- 02- 941),
which was released today at this hearing.

Even though we did not have statutory audit or access- to- records
authority with respect to the involved private- sector entities, we
obtained extensive documentary and testimonial evidence from various
groups, including insurance and reinsurance companies, investment banks,
investors, rating agencies, firms that develop models to analyze
catastrophic risks, regulators, and academic experts. However, we were not
able to verify the accuracy of data provided by these groups.

Our statement covers a number of issues affecting risk- linked securities,
but we make no recommendations. While we have identified factors that

Page 2 GAO- 03- 195T

industry and capital markets experts believe might cause the use of
risklinked securities to expand or contract, it is difficult to predict
the future use of these securities* either under current accounting,
regulatory, and tax policies or under changed policies. We do not take a
position on whether the increased use of risk- linked securities is
beneficial or detrimental.

In summary: Catastrophe risk is a global phenomenon and insurance and
reinsurance companies with global operations often provide coverage. We
focused on catastrophe risk in the United States. The map before you shows
the geographic distribution of catastrophe risk in the United States and
highlights areas that are the most likely to experience certain types of
natural catastrophes. The characteristics of natural disasters prompt most
insurers to limit the amount and type of catastrophe risk they hold. For
example, property- casualty insurers with too many policies concentrated
in California and Florida* states that are more subject to natural
catastrophes* need ways to diversify and transfer that risk. One key way
to transfer risk is through reinsurance. Traditional reinsurance provides
indemnity- based coverage, which compensates part or all of an insurer*s
losses as they are incurred, and depends on well- developed business
relationships between insurers and reinsurers, which facilitate relatively
low transaction costs. However, in a situation involving extremely large
or multiple catastrophic events, insurers might not have purchased
sufficient reinsurance or reinsurers might not have sufficient capital to
meet their existing obligations. Further, reinsurance capital is
diminished after a catastrophic loss, and reinsurers might raise prices or
limit the availability of future coverage. In the 1990s, the combination
of two extremely costly disasters* Andrew and Northridge* and conditions
in the reinsurance market helped spur the development of risk- linked
securities and other alternatives to traditional reinsurance. The
securities provided new access to national and international capital
markets. Yet to date, risk- linked securities represent a small share*
less than 0.5 percent* of worldwide catastrophe insurance, according to
the Swiss Reinsurance Company.

We focused on catastrophe bonds because they currently comprise the
largest share of risk- linked securities, which also include other

Page 3 GAO- 03- 195T

instruments such as options. 1 To develop a catastrophe bond, a sponsor,
usually an insurance or reinsurance company, creates a special purpose
reinsurance vehicle (SPRV) to provide reinsurance to the sponsor and to
issue bonds to the securities market. SPRVs are similar in purpose to the
special purpose entities that banks and others have used to securitize
their loans. These special purpose entities *pass through* principal and
interest from borrowers to investors. In contrast, SPRVs, which are
typically located offshore for tax, regulatory, and legal advantages,
receive payments in three forms (insurance premiums, interest, and
principal), invest in Treasury securities and other highly rated
securities, and pay investors in another form (interest). Figure 1
illustrates cash flows among the participants in a catastrophe bond.

Figure 1: Cash Flows for a Special Purpose Reinsurance Vehicle

Source: GAO.

The sponsoring insurance company enters into a reinsurance contract and
pays reinsurance premiums to the SPRV to cover specified claims. The SPRV
issues bonds or debt securities for purchase by investors. The catastrophe
bond offering defines a catastrophe that would trigger a loss

1 Catastrophe options were offered by the Chicago Board of Trade in 1995
and were delisted in 2000 due to lower- than- expected demand. The
purchaser of a catastrophe option paid the seller a premium, and the
seller provided the purchaser with a cash payment if an index measuring
insurance industry catastrophe losses exceeded a certain level. If the
catastrophe loss index remained below a specified level for the prescribed
time period, the option expired worthless, and the seller kept the
premium.

Page 4 GAO- 03- 195T

of investor principal and, if triggered, a formula to specify the
compensation level from the investor to the SPRV. The SPRV is to hold the
funds raised from the catastrophe bond offering in a trust in the form of
Treasury securities and other highly rated assets. The SPRV deposits the
payment from the investor as well as the premium from the company into the
trust account. The premium paid by the SPRV sponsor 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 a predefined
catastrophe occurs, principal that otherwise would be returned to the
investors is used to fund the SPRV*s payments to the insurer or sponsor.
The investor*s reward for taking this risk is a relatively high interest
rate paid by the bonds.

Recently issued catastrophe bonds have been nonindemnity- based* that is,
structured to make payments to the sponsor upon the verified occurrence of
specified catastrophic events. Indemnity- based reinsurance coverage
compensates insurers for part or all of their losses from insured claims.
2 Although insurers prefer indemnity- based coverage because reinsurance
payments are directly linked to claims actually incurred, reinsurers face
the risk of paying more if the insurer underwrites or selects risks
poorly, or has poor claims- settlement practices. With an indemnitybased
catastrophe bond, investors would have greater exposure to risks from poor
underwriting and claims settlement practices because investors might not
be able to monitor the insurer*s behavior. As a result, investors prefer
nonindemnity- based bonds because they are tied to an objective index or
measure that is unrelated to the insurance company*s management.

In addition to looking at the characteristics and coverage of catastrophe
risk and the structure of risk- linked securities, we identified and
analyzed regulatory, accounting, tax, and investor issues that might
affect the use of risk- linked securities:

2 Indemnity coverage specifies a simple relationship that is based on the
insurer*s actual incurred claims. For example, an insurer could contract
with a reinsurer to cover half of all claims* up to $100 million in
claims* from a hurricane over a specified time period in a certain
geographic area. If a hurricane occurs where the insurer incurs $100
million or more in claims, the reinsurer would pay the insurer $50
million. In contrast, nonindemnity coverage specifies a specific event
that triggers payment and payment formulas that are not directly related
to the insurer*s actual incurred claims.

Page 5 GAO- 03- 195T

 First, accounting treatment for risk transfers occurring through
nonindemnity- based, risk- linked securities is a challenge for
regulators. In traditional reinsurance* that is, indemnity- based*
transactions, where an insurer is compensated for part or all of its
losses from insured claims, the insurer gets credit on its balance sheet
in the form of a deduction from liability for the risk transferred to the
reinsurer and can reduce the amount of regulatory risk- based capital
required. Credit for reinsurance is designed to ensure that a true
transfer of risk has occurred and that the reinsurance company will be
able to pay any claims. In nonindemnity transactions using catastrophe
bonds, payments may be triggered by an index or independently measurable
value, such as wind speed, and are not directly related to incurred
claims. When a catastrophic event triggers a catastrophe bond, payment
formulas determine the reduction of the investors* principal that will
compensate the insurance company sponsor. As a result, it is difficult to
value the true amount of risk transferred to determine credit for
reinsurance. The National Association of Insurance Commissioners and
interested insurance industry parties are considering revisions in the
regulatory accounting treatment of risk transfer obtained through
nonindemnity- based coverage. If insurance accounting standards were
changed so that the value of the risk transfer could be accurately
calculated and recognized as an offset to potential insurance losses, the
insurer could get credit for reinsurance for risk transfers occurring
through nonindemnity- based catastrophe bonds. Such changes, if adopted,
could facilitate the use of risk- linked securities. However, it is
important that credit for nonindemnity- based reinsurance accurately
reflect the true risk transferred so that insurance company reporting on
both risk evaluation and capital treatment properly reflects the risks
retained.

 Second, the Financial Accounting Standards Board is proposing a new
interpretation addressing consolidation of certain special purpose
entities on a sponsor*s balance sheet. Under current guidance, a sponsor
could avoid consolidating an SPRV as a liability on its balance sheet if
the SPRV has at least 3 percent independent equity capital investment. The
proposal may increase the independent capital investment required for a
sponsor to treat an SPRV as independent to 10 percent of total assets. The
proposal also contemplates other tests for consolidation of certain
special purpose entities. While the proposed guidance is intended to
improve financial transparency in capital markets and stem potential
abuses of special purpose entities, it could also increase the cost of
issuing catastrophe bonds. If the proposed interpretation requires
consolidation, sponsors might turn to risk- linked securities, such as
catastrophe options, that do not require an SPRV.

Page 6 GAO- 03- 195T

 Third, insurance industry representatives are considering a legislative
proposal to help expand the use of domestically issued, or onshore,
catastrophe bonds. SPRVs are typically located offshore, in part, to avoid
U. S. taxes. By allowing special *pass- through* tax treatment, the
proposal would eliminate U. S. taxation at the SPRV level. The pass-
through treatment would be similar to that already provided to Real Estate
Mortgage Investment Conduits and Financial Asset Securitization Investment
Trusts. To the extent that domestic SPRVs gained business at the expense
of taxable entities, including reinsurance companies, the federal
government could experience tax revenue losses. Expanded use of
catastrophe bonds might occur with favorable implementing requirements,
but such legislative actions might also create pressure from other
industry sectors for similar tax treatment. Some elements of the insurance
industry believe that any consideration of changes to the tax treatment of
domestic SPRVs would have to take into account the taxation of domestic
reinsurance companies. Specifically, the Reinsurance Association of
America argues that if special tax treatment is provided to domestic
SPRVs, they would operate under tax advantages not afforded to existing U.
S. licensed and taxed reinsurance companies.

 Fourth, unlike other bonds, catastrophe bonds, most of which are
noninvestment- grade instruments, have not been sold to a wide range of
investors beyond institutional investors. Investment fund managers who
included catastrophe bonds in their portfolios told us that catastrophe
bonds comprised 3 percent or less of those portfolios. On the one hand,
the managers appreciate the diversification aspects of catastrophe bonds
because the risks are generally uncorrelated with the credit risks of
other parts of the bond portfolio. On the other hand, the risks are
difficult to assess and investors are concerned about the limited
liquidity and track record of the bonds.

Madame Chairwoman, Members of the Subcommittee, that concludes my prepared
statement. I would be happy to answer any questions at this time.

(250091)
*** End of document. ***