    Catastrophe Risk: U.S. and European Approaches to Insure Natural
    Catastrophe and Terrorism Risks (28-FEB-05, GAO-05-199).

    Natural catastrophes and terrorist attacks can place enormous
    financial demands on the insurance industry, result in sharply
    higher premiums and substantially reduced coverage. As a result,
    interest has been raised in mechanisms to increase the capacity
    of the insurance industry to manage these types of events. In
    this report, GAO (1) provides an overview of the insurance
    industry's current capacity to cover natural catastrophic risk
    and discusses the impacts of the 2004 hurricanes; (2) analyzes
    the potential of catastrophe bonds--a type of security issued by
    insurers and reinsurers (companies that offer insurance to
    insurance companies) and sold to institutional investors--and
    tax-deductible reserves to enhance private-sector capacity; and
    (3) describes the approaches that six European countries have
    taken to address natural and terrorist catastrophe risk,
    including whether these countries permit insurers to use
    tax-deductible reserves for such events. We provided a draft of
    this report to the Department of the Treasury and the National
    Association of Insurance Commissioners. Treasury provided
    technical comments that were incorporated as appropriate.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-05-199
        ACCNO:   A18316
      TITLE:     Catastrophe Risk: U.S. and European Approaches to Insure
    Natural Catastrophe and Terrorism Risks
         DATE:   02/28/2005
      SUBJECT:   Accounting standards
    	     Bonds (securities)
    	     Comparative analysis
    	     Emergency preparedness
    	     Foreign governments
    	     Insurance
    	     Insurance companies
    	     Insurance premiums
    	     Insurance regulation
    	     National preparedness
    	     Proposed legislation
    	     Risk management
    	     Terrorism
    	     Natural disasters
    	     Belgium
    	     Bermuda
    	     Florida
    	     Florida Hurricane Catastrophe Fund
    	     France
    	     Germany
    	     Italy
    	     Spain
    	     Switzerland
    	     United Kingdom

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    GAO-05-199

    United States Government Accountability Office

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

    February 2005

    CATASTROPHE RISK

     U.S. and European Approaches to Insure Natural Catastrophe and Terrorism Risks

                                           a

    GAO-05-199

    [IMG]

    February 2005

    CATASTROPHE RISK

    U.S. and European Approaches to Insure Natural Catastrophe and Terrorism Risks

      What GAO Found

    Despite steps that governments and insurers have taken in recent years to
    strengthen insurer capacity for catastrophic risk, the industry has not
    been tested by a major catastrophic event or series of events (at least
    $50 billion or more in insured losses). While insurers suffered losses of
    over $20 billion in Florida from the 2004 hurricanes, steps such as
    implementing stronger building codes and stricter underwriting standards
    may have limited market disruptions as compared with the aftermath of
    Hurricane Andrew in 1992. For example, in 2004, only 1 Florida insurance
    company failed in contrast to the 11 that failed after Hurricane Andrew in
    1992. However, a more severe catastrophic event or series of events could
    severely disrupt insurance markets and impose recovery costs on
    governments, businesses, and individuals.

    Some insurers and reinsurers benefit from catastrophe bonds because the
    bonds diversify their funding base for catastrophic risk. However, these
    bonds currently occupy a small niche in the global catastrophe reinsurance
    market and many insurers view the costs associated with issuing them as
    significantly exceeding traditional reinsurance. In addition, industry
    participants do not consider catastrophe bonds for terrorism risk feasible
    at this time. Authorizing insurers to establish tax-deductible reserves
    for potential catastrophic events has been advanced as a means to enhance
    industry capacity, but according to some industry analysts such reserves
    would lower federal tax receipts and not necessarily bring about a
    meaningful increase in capacity because insurers may substitute the
    reserves for other types of capacity.

    The six European countries GAO studied use a variety of approaches to
    address catastrophe risk. Some governments require insurers to provide
    natural catastrophe insurance and provide financial assistance to insurers
    in the wake of catastrophic events, while others generally rely on the
    private market. However, the majority of these governments have
    established national terrorism insurance programs. Although their
    approaches vary, insurers in all six countries were allowed to establish
    tax-deductible reserves for potential catastrophic events as of 2004.

    The 2004 Hurricanes Resulted in Over $20 Billion in Losses in Florida

    Sources: Risk Management Solutions (map); Florida Office of Insurance Regulation
                                        (data).

                     United States Government Accountability Office

    Contents

      Letter

    Results in Brief
    Background
    Despite Enhancements to Insurer Capacity, Industry May Not Be

    Able to Address a Major Natural Catastrophe Catastrophe Bonds and
    Tax-Deductible Reserves May Have the Potential to Enhance Insurers'
    Capacity for Catastrophe Risk

    European Countries Use a Mix of Approaches to Insure Natural Catastrophes,
    and Most Countries Studied Have National Terrorism Insurance Programs

    Observations
    Agency Comments and Our Evaluation

    1 4 8

    10

    25

    31 52 54

    Appendixes

    Appendix I: Appendix II:

    Appendix III: Appendix IV: Objectives, Scope, and Methodology

    TRIA Has Limited Insurers' Financial Exposure to Terrorism Risk, but a
    Significant Portion of Catastrophic Risk Goes Uncovered

    Tax, Regulatory, and Accounting Issues Might Have Affected the Development
    of the Catastrophe Bond Market

    GAO Contacts and Staff Acknowledgments

    GAO Contacts Acknowledgments 56

    59

    63

    68 68 68

    Glossary of Terms

    Figures	Figure 1: Figure 2:

    Figure 3:

    Figure 4:

    Figure 5:

    Figure 6:

    Insurance Industry Capital Levels, 1990-2003 12
    The 2004 Hurricane Season Resulted in More Than $20
    Billion in Insured Losses in Florida 20
    2004 Hurricanes Did Not Trigger FHCF Payments to
    Citizens Property Insurance Corporation 21
    Catastrophe Bond Amount Outstanding, Year-end 1997-
    2004 26
    How Natural Catastrophe Insurance Is Covered in
    Selected European Countries 33
    Countries with a National Terrorism Insurance Program
    Provide a State Guarantee 39

    Contents

    Figure 7: GAREAT 2004 Financing Structure Involves Insurers,
    Reinsurers, and the State 41
    Figure 8: Extremus 2004 Financing Structure Caps German

    Government Payments 43
    Figure 9: Reserve Policies in Selected European Countries 47
    Figure 10: Potential Consumer Motivations in Choosing to Forego

    Earthquake Insurance Include Belief That They Are Not
    at Risk 61
    Figure 11: Special Purpose Reinsurance Vehicle Structure and
    Payment Flows 64

    Contents

    Abbreviations

    ARC Accounting Regulatory Committee
    CatNat Catastrophes Naturelles
    CCR Caisse Centrale de Reassurance
    CEA California Earthquake Authority
    DEP Direct Earned Premiums
    EFRAG European Financial Reporting Advisory Group
    EU European Union
    FASB Financial Accounting Standards Board
    FEMA Federal Emergency Management Administration
    FHCF Florida Hurricane Catastrophe Fund
    FSA Financial Services Authority
    GAAP Generally Accepted Accounting Principles
    GAPP FER Swiss Financial Reporting Standards of the Swiss Accounting

    and Reporting Recommendations GAREAT Gestion de l'Assurance et de la
    Reassurance des Risques

    Attentats et Actes de Terrorisme IASB International Accounting Standards
    Board IFRS 4 International Financial Reporting Standard 4 ISO Insurance
    Services Office JUA Florida Residential Joint Underwriting Association
    NAIC National Association of Insurance Commissioners OECD Organization for
    Economic Cooperation and Development PCS Property Claim Services SAP
    Statutory Accounting Principles SEC Securities and Exchange Commission SPE
    special purpose entity SPRV special purpose reinsurance vehicle TRIA
    Terrorism Risk Insurance Act VIE variable interest entity

    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 Government Accountability Office Washington, D.C. 20548

    February 28, 2005

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

    Dear Mr. Chairman:

    Natural catastrophes and terrorist attacks can place enormous financial
    demands on households, businesses, and the insurance industry, in addition
    to causing significant loss of life. For example, the four hurricanes that
    primarily affected Florida in 2004 caused over $20 billion in insured
    losses in the state due to property destruction, and Congress appropriated
    approximately $16 billion to assist victims of the hurricanes and repair
    public infrastructure such as roads and military bases.1 Moreover, natural
    catastrophes and terrorist attacks pose unique challenges to
    propertycasualty insurers.2 Forecasting the timing and severity of such
    events is difficult and the large losses associated with catastrophes can
    threaten insurer solvency. Insurers frequently respond to catastrophic
    events by cutting back coverage significantly or substantially increasing
    premiums for policyholders. After Hurricane Andrew crossed southern
    Florida in 1992, many insurance and reinsurance companies (insurers that
    offer insurance to other insurance companies) raised premiums or stopped
    offering catastrophic coverage in the state. Similar reactions took place
    in the California insurance market after the Northridge earthquake of 1994
    and worldwide insurance markets after the September 11, 2001, terrorist

    1Total estimated insured losses in the United States (including Alabama
    and other affected states) and the Caribbean range as high as $27 billion.

    2Property insurance includes the loss or damage to real estate and
    personal property because of perils such as fire. Casualty insurance is a
    broad field of insurance and covers whatever is not covered by fire,
    marine, and life insurers. For example, automobile, liability, and workers
    compensation insurance are included in casualty insurance. In this report,
    the term insurer refers to property-casualty insurers. In addition, while
    the term catastrophe is most often associated with natural events (such as
    hurricanes or earthquakes), it can also be used when there is widespread
    damage from man-made disasters (such as fires, pollution, or nuclear
    fallout). The term catastrophe in this report refers to natural events or
    terrorist attacks. Insurers may face the risk of catastrophic losses from
    other types of manmade events. For example, asbestos-related losses could
    reach as much as $65 billion for the U.S. insurance industry. However,
    these risks are outside the scope of this report.

    attacks (September 11 attacks).3 To the extent that insurers are unable or
    unwilling to insure against catastrophic events, a subsequent lack of
    affordable coverage in the marketplace could impede economic recovery and
    development.

    In response to such insurance market disruptions, governments and the
    private sector have taken steps to enhance the "capacity" of the insurance
    industry to address catastrophic risk. Although there are several
    definitions of industry capacity, we define the term to mean the ability
    of property-casualty insurers to pay customer claims in the event of a
    catastrophic event and their willingness to make catastrophic coverage
    available to their customers, particularly subsequent to catastrophes.4
    Several states-including Florida and California-have established
    authorities to compensate insurers for certain natural catastrophe-related
    losses and help ensure that catastrophe coverage is available.
    Additionally, with the passage of the Terrorism Risk Insurance Act (TRIA),
    the federal government required primary insurance companies to make
    terrorism coverage available to their commercial customers and provides
    substantial compensation to the companies in the event of a foreign
    terrorist attack in the United States.5 Insurance companies have made
    significant changes in their approaches to providing coverage for natural
    catastrophes-as

    3Primary insurance companies may be able to purchase insurance for some or
    all of their risks from reinsurance companies. Additionally, reinsurance
    companies may be able to purchase insurance for some or all of their risks
    from other insurance companies (a process known as retrocessional
    coverage).

    4Defining insurance capacity is difficult and the concept itself is
    subject to differing interpretations. The definition used in this report
    is based on our previous work and subsequent analysis of insurance
    markets. See GAO, Insurers' Ability to Pay Catastrophe Claims,
    GAO/GGD-00-57R (Washington, D.C.: Feb. 8, 2000). On the other hand, some
    insurers we contacted defined capacity as the total amount of dollar
    coverage that a company will write for particular risks, such as natural
    catastrophes or terrorism, or in terms of insurers obtaining the amount of
    reinsurance that they wished to purchase at consistent prices.

    5See GAO, Terrorism Insurance: Implementation of the Terrorism Risk
    Insurance Act of 2002, GAO-04-307 (Washington, D.C.: Apr. 23, 2004). TRIA
    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, primary insurers, and policyholders share the risk of
    loss. The federal government is responsible for paying 90 percent of each
    insurer's primary property-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.
    TRIA will expire on December 31, 2005.

    discussed in this report-and some insurance and reinsurance companies and
    capital market participants have developed catastrophe bonds, which are a
    type of security that may be purchased by institutional investors and
    cover certain insurer natural catastrophic risks.6 Proposals have also
    been made that Congress and regulatory agencies take additional steps to
    increase the capacity of the insurance industry to address catastrophe
    risk. For example, a proposal has been made to change U.S. tax laws and
    accounting standards to allow insurers to set aside funds on a
    taxdeductible basis to establish reserves for potential future natural
    catastrophes or terrorist attacks.7

    Because of your continuing concerns about the costs and consequences of
    natural catastrophes and interest in minimizing the federal government's
    potential financial exposure, you asked us to provide information on a
    range of issues that would assist the committee in its oversight of the
    insurance industry. Specifically, our report (1) provides an overview of
    the property-casualty insurance industry's current capacity to cover
    natural catastrophic risk and discusses the impacts that the four
    hurricanes in 2004 had on the industry; (2) analyzes the potential of
    catastrophe bonds and permitting insurance companies to establish
    tax-deductible reserves to cover catastrophic risk to enhance
    private-sector capacity; and (3) describes the approaches six selected
    European countries-France, Germany, Italy, Spain, Switzerland, and the
    United Kingdom-have taken to address natural and terrorist catastrophe
    risk, including whether these countries permit insurers to use
    tax-deductible reserves for such events.

    To address our three reporting objectives, we contacted primary and
    reinsurance companies in the United States, Europe, and Bermuda. We also

    6Catastrophe 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.

    7Under U.S. accounting standards, reserves for future losses can be
    accrued in liability accounts on the balance sheet if the losses are
    probable and reasonably estimable. In general, this means that an event
    such as a hurricane has already occurred and an insurance company is in
    the process of estimating its potential losses. Insurers are not permitted
    to set aside reserves on a tax-deductible basis for events that have not
    occurred and the losses from which are not probable and reasonably
    estimable, such as potential natural catastrophes or terrorist attacks.

    interviewed officials from rating agencies, modeling firms, accounting
    firms, insurance industry associations, a consumer group, the National
    Association of Insurance Commissioners (NAIC), state natural catastrophe
    authorities in California, Florida, and Texas, a state insurance
    regulator's office, and we spoke with academics. We also updated our
    previous work on catastrophe bonds.8 In the six European countries we
    studied, we obtained documents and interviewed officials representing
    insurance supervisory authorities, insurance companies, insurance and
    business associations, accounting firms, national catastrophe insurance
    programs, and international and regional organizations. We asked officials
    whom we contacted to provide their views on the insurance industry's
    ability to cover, and strategies to manage, catastrophe risk. We also
    obtained data on the financial risks associated with natural catastrophes
    and terrorism, and European insurance markets.

    We conducted our work between February 2004 and January 2005 in Florida,
    New York, Washington, D.C., Belgium, France, Germany, Spain, Switzerland,
    and the United Kingdom. Our work was done in accordance with generally
    accepted government auditing standards. A more extensive discussion of our
    scope and methodology appears in appendix I. In addition, our report
    provides information on insurers' financial exposure to terrorist attacks
    under TRIA and the extent to which natural catastrophe and terrorism risks
    are uncovered in the United States. These issues are discussed in appendix
    II. The report also includes a glossary of insurancerelated terms. We
    provided a draft of this report to the Department of the Treasury and the
    National Association of Insurance Commissioners. Treasury provided
    technical comments on the report that were incorporated as appropriate.

    Results in Brief	Although insurers and state governments have taken steps
    to enhance the industry's capacity to address natural catastrophe risk, a
    major event or series of events surpassing the over $20 billion in losses
    in Florida resulting from the 2004 hurricane season could severely disrupt
    insurance markets and impose substantial recovery costs on governments,
    businesses, and individuals. Insurers increased their equity capital-the
    financial resources

    8See GAO, Catastrophe Insurance Risks: Status of Efforts to Securitize
    Natural Catastrophe and Terrorism Risk, GAO-03-1033 (Washington, D.C.:
    Sept. 24, 2003) and GAO, Catastrophe Insurance Risks: The Role of
    Risk-Linked Securities and Factors Affecting Their Use, GAO-02-941
    (Washington, D.C.: Sept. 24, 2002).

    available to cover catastrophic and other types of claims that exceed
    premium and investment income-from 1990 through 2003.9 However, this
    measure has several limitations. For example, insurers may also face
    significant financial exposure in risk-prone areas, which could partially
    offset the increase in equity capital. Additionally, insurers' equity
    capital may be required for other types of claims besides claims involving
    catastrophic risk.10 Therefore, it is not clear from reviewing equity
    capital alone that the industry is in a relatively better position to
    withstand catastrophic events. According to insurers, regulators, and
    analysts we contacted, the following government and industry actions also
    have the potential to mitigate insurer losses and maintain insurance
    availability after natural catastrophes:

    o 	the establishment of state catastrophe authorities such as the Florida
    Hurricane Catastrophe Fund (FHCF) and the California Earthquake Authority
    (CEA);

    o 	the establishment of stronger building codes in areas at risk for
    natural catastrophes;

    o 	the development and use of computer programs to model insurers'
    estimated losses from particular catastrophic scenarios and control
    exposures accordingly;

    o 	the implementation of higher deductibles that shift a greater share of
    the losses associated with natural catastrophes from insurers to
    policyholders; and

    o 	the creation of new reinsurance companies in Bermuda that specialize in
    catastrophic risk.

    Preliminary information suggests that several of these changes generally
    have facilitated the industry's ability to absorb losses associated with
    the

    9Equity capital, also referred to as insurers' surplus, is defined as net
    worth under the Statutory Accounting Principles (SAP) promulgated by NAIC.
    As such, equity capital or surplus is the difference between assets and
    liabilities valued according to SAP.

    10This report also identifies other limitations in the insurer equity
    capital measure that complicate assessments of insurer capacity. For
    example, not all of the reported industry capital would necessarily be
    available in the event of a catastrophe. In particular, only those
    companies whose policies are affected, not the industry as a whole, would
    pay claims resulting from a particular event.

    2004 hurricanes as compared with losses from Hurricane Andrew in 1992.11
    Because of significant losses, particularly from property claims in
    Florida, some companies have restricted coverage in certain areas of the
    state, and some companies have requested rate increases. However, only 1
    company failed in 2004 in contrast to 11 companies that failed after
    Andrew. Nevertheless, the estimated $20 billion in combined losses in
    Florida from the four hurricanes is far below potential losses associated
    with a major event or series of events (hurricanes or earthquakes of such
    magnitude that they have a 1 percent to .4 percent chance of occurring
    annually), which could be $50 billion or more.12 Such an event could
    exhaust the available financial resources of impacted state authorities,
    generate higher premiums, and likely result in the failures of some
    companies.

    While several insurance and reinsurance companies currently use
    catastrophe bonds to enhance their capacity to address the most severe
    types of natural catastrophes, the bonds occupy a small niche in the
    global catastrophe reinsurance market. By raising funds from the capital
    markets through the issuance of catastrophe bonds, these insurers
    diversified their funding base for the transfer of catastrophic risk,
    which traditionally involves purchasing reinsurance or retrocessional
    coverage. The appeal of catastrophe bonds to these insurers, as well as
    certain institutional investors that value the bonds for their relatively
    high rates of return and importance in portfolio diversification, was
    evidenced by the reported 50 percent growth of the market from year-end
    2002 to year-end 2004 to a total of $4.3 billion in bonds outstanding
    worldwide. However, that amount was still small compared with industry
    catastrophe exposures, and the bonds have not yet achieved widespread
    insurance industry acceptance. Some state catastrophe authorities we
    contacted and many insurers choose not to issue catastrophe bonds because
    of their relatively high costs compared with traditional reinsurance.
    These costs include the transaction costs- such as legal fees-necessary to
    issue catastrophe bonds. In addition, catastrophe bonds have not been
    issued to address terrorism risk in the United States, and according to
    industry participants such bonds are not

    11Industry losses were comparable on an inflation-adjusted basis. Losses
    from Hurricane Andrew were $20 billion, adjusted to 2004 dollars.

    12An event with a 1 percent chance of occurring annually is referred to as
    a 1-in-100 year event. An event with a .4 percent chance of occurring
    annually is referred to as a 1-in-250 year event. In this report, we refer
    to the probability of these occurrences in annual percentage terms because
    these events could occur in any given year.

    considered feasible at this time given the uncertainties associated with
    forecasting the timing and severity of terrorist attacks.

    Another means to increase capacity-authorizing U.S. insurance companies to
    establish tax-deductible reserves to cover the financial risks associated
    with potential natural catastrophes and terrorist attacks-is
    controversial. Some analysts believe that establishing tax-deductible
    reserves (as is currently permitted in European countries as described
    next) would increase private-sector capacity and lower premiums. However,
    according to industry analysts we contacted, permitting these reserves
    would reduce federal tax receipts, and Department of the Treasury staff
    and reinsurance association officials we contacted, said that the proposed
    changes may not bring about a meaningful increase in the insurance
    industry's ability to pay claims. For example, reinsurance association
    officials and an industry analyst said that since reinsurance premiums are
    already tax deductible, insurers may reduce the amount of reinsurance
    coverage that they purchase.

    Among the six European countries we studied, we found a mix of government
    and private-sector approaches to providing natural catastrophe insurance,
    while most of the countries have national terrorist insurance programs.
    For example, natural catastrophe coverage is mandatory in France and Spain
    and the national governments are explicitly committed to providing
    financial support to insurers through state-backed entities and state
    guarantees. Other governments, such as Germany, neither require natural
    catastrophe insurance nor provide explicit financial commitments. To cover
    terrorism risk, four of the European national governments we studied
    (France, Spain, Germany, and the United Kingdom) provide financial
    guarantees similar to those provided in the United States under TRIA. In
    some countries, such as Spain, a state-owned entity administers the
    terrorism insurance program. In other countries, such as the United
    Kingdom, the government provides a state guarantee to an otherwise private
    terrorism insurance program.

    Finally, unlike the United States, as of 2004, accounting standards and
    tax laws in each of the six countries we studied allowed insurance
    companies to establish tax-deductible reserves for future catastrophic
    events, although there can be significant differences in the reserving
    approaches used in each country. For example, in two of the six countries
    (Germany and the United Kingdom) insurers must follow established
    standards in determining the amount of money that can be added to the
    reserves each year and the conditions under which the money may be
    withdrawn to cover

    catastrophe losses. In contrast, insurers in the other four countries have
    more discretion to determine the level of contributions to the reserves
    and when the funds may be used. However, under a new international
    accounting standard designed to improve the transparency of insurer
    financial statements that became effective in 2005, insurance groups are
    no longer allowed to include catastrophe reserves in their consolidated
    financial statements. Nevertheless, European insurers and regulators we
    contacted said that countries may allow the subsidiaries or affiliates of
    insurance groups to continue using the reserves for tax purposes.

    Background	While insurers assume some risk when they write policies, they
    employ various strategies to manage overall risks so that they may earn
    profits, limit potential financial exposures, and build
    capacity-generally, equity capital that would be used to pay claims. For
    example, they charge premiums for the coverage provided and establish
    underwriting standards such as (1) refusing coverage to customers who may
    represent unacceptable levels of risk or (2) limiting coverage offered in
    particular areas. Establishing underwriting standards also allows insurers
    to minimize the adverse consequences of "moral hazard," which is "the
    incentive created by insurance that induces those insured to undertake
    greater risk than if they were uninsured, because the negative
    consequences are passed to the insurer."

    To manage potential financial exposures and also enhance their capacity,
    insurance companies may also purchase reinsurance.13 Reinsurers generally
    cover specific portions of the risk the primary insurer carries. For
    example, a reinsurance contract could cover 50 percent of all claims
    associated with a single event up to $100 million from a hurricane over a
    specified time period in a specified geographic area. This type of
    contract, which specifies payments based on the insurer's actual incurred
    claims, is called indemnity coverage. In turn, reinsurers act to limit
    their risks and moral hazard on the part of primary insurers by charging
    premiums, establishing underwriting standards, and maintaining close
    business

    13Some large national insurance companies generally do not purchase
    private reinsurance. These companies are able to retain their risk because
    they have large capital bases and are well-diversified. In addition, an
    official from one state authority said that the organization purchases
    reinsurance to manage the risk of an event with a 1 percent chance of
    occurring annually, but not for the risk of an event with a .4 percent
    chance of occurring annually because of the high cost for reinsurance at
    the higher level and the low risk of such an event occurring in the state.

    relationships with insurers that generally have been maintained over a
    long period.

    In contrast to other types of insurance risks, catastrophic risk poses
    unique challenges for primary insurers and reinsurers. To establish their
    exposures and price insurance and reinsurance premiums, insurance
    companies need to be able to predict with some reliability the frequency
    and severity of insured losses. For example, the incidence of most
    property insurance claims, such as automobile insurance claims, is fairly
    predictable, and losses generally do not occur to large numbers of
    policyholders at the same time. However, catastrophes are infrequent
    events that may affect many households, businesses, and public
    infrastructure across large areas and thereby result in substantial losses
    that can impair insurer capital levels. Given the higher levels of capital
    that reinsurers must hold to address major catastrophic events (for
    example, hurricanes or earthquakes with expected annual occurrences of no
    more than 1 percent), reinsurers generally charge higher premiums and
    restrict coverage for such events. Further, as previously noted, in the
    wake of catastrophic events reinsurers and insurers may sharply increase
    premiums and significantly restrict coverage.

    The reinsurance market disruptions associated with the Andrew and
    Northridge catastrophes provided an impetus for insurance companies and
    others to find different ways of raising capital to help cover
    catastrophic risk. The mid-1990s saw the development of catastrophe bonds,
    a capital market alternative to reinsurance (in the sense that other
    parties assume some of the insurer's risks).14 Catastrophe bonds generally
    (1) are sold to qualified institutional investors such as pension or
    mutual funds; (2) provide coverage for relatively severe types of events
    such as hurricanes with an annual expected occurrence of 1 percent; and
    (3) pay relatively high rates of interest and have less than
    investment-grade ratings (because in some cases, investors may risk all of
    their principal if a specified catastrophe occurs). Catastrophe bonds also
    potentially expose investors to moral hazard because, absent the business
    relationships that typically characterize primary insurers and reinsurers,
    investors may lack information on insurer underwriting standards or the
    claims payment process. That is, an insurer that has issued a catastrophe
    bond may have incentives to lower its underwriting standards and offer
    coverage to riskier insureds because investors have less ability to
    monitor the insurers' risk

    14GAO-02-941.

    taking than would a reinsurer with whom the insurer has done business for
    years. To minimize moral hazard, most catastrophe bonds are triggered by
    objective measures (also referred to as "nonindemnity" based coverage)
    such as wind speed during a hurricane or ground movement during an
    earthquake rather than insurer loss experience (indemnity-based). However,
    nonindemnity based coverage exposes insurers to "basis risk," which is the
    risk that the proceeds from the catastrophe bond will not be related to
    the insurer's loss experience. For example, if a hurricane with a
    specified wind speed occurs, the insurer would automatically receive the
    proceeds of the catastrophe bond, which may be either higher or lower than
    its actual losses. See appendix III for additional information on the
    structure of catastrophe bonds.

    Because insurance markets have been severely disrupted by catastrophic
    events, state and federal governments also have taken a variety of steps
    to enhance the capacity of insurers to address catastrophic risk. For
    example, Florida established FHCF to address hurricane risk, and
    California established CEA to address earthquake risk. Although these
    programs cover different risks and use different strategies as described
    in this report, they share a similar goal in ensuring that insurers can
    withstand catastrophic events and continue to make coverage available.
    Similarly, Congress enacted TRIA in 2002 to ensure the continued
    availability of terrorism insurance subsequent to the September 11
    attacks. TRIA was designed as a temporary program that would remain in
    place until the end of 2005, when it was expected that insurers and
    reinsurers would have had time to establish a market for terrorism
    insurance. However, Congress is currently considering extending the 2005
    deadline due to concerns about whether insurers will offer terrorism
    insurance after the act's expiration. See appendix II for more information
    about TRIA.

    Despite Enhancements to Insurer Capacity, Industry May Not Be Able to
    Address a Major Natural Catastrophe

    Despite steps taken in recent years to strengthen insurer capacity for
    catastrophic risk, the industry has not yet been tested by a major
    catastrophic event or series of events. Overall, insurers increased their
    equity capital-financial resources available to cover catastrophic and
    other types of claims that exceed premium and investment income-from 1990
    through 2003, but this measure of capacity has limitations, and therefore,
    the extent to which capacity has increased is not clear. For example,
    insurers' exposures in risk-prone coastal and other areas have also
    increased over time, which could partially offset the increase in equity
    capital. However, state governments and insurers have taken other steps to
    enhance industry capacity for catastrophic risk such as establishing state

    authorities, implementing stronger building codes, and reportedly
    implementing stronger underwriting standards. Several of these changes
    appear to have facilitated the industry's ability to withstand the 2004
    hurricanes better than the impacts of Hurricane Andrew in 1992, but a more
    severe catastrophe or catastrophes could have significant financial
    consequences for insurers and their customers.

    Equity Capital Can Measure Insurance Industry Capacity, but the Data Are
    Subject to Several Limitations

    The insurance industry's equity capital levels commonly are used to assess
    capacity to cover catastrophic risk. As shown in figure 1, the Insurance
    Services Office, Inc. (ISO) found that from 1990 through 2003 industry
    equity capital increased from $194.8 billion to $347 billion on an
    inflationadjusted basis.15 After steadily increasing for 18 years,
    insurers' equity capital actually declined from 1999 to 2002 before
    rebounding in 2003. Capital levels declined for a variety of reasons
    including a series of natural catastrophes in the late 1990s, declining
    stock prices that particularly affected the investments of large European
    reinsurers, and the losses associated with the September 11 attacks.
    Insurer capital increased in 2003 for several reasons that include lower
    losses associated with natural catastrophes. According to information from
    ISO, the industry's capital level did not decline in 2004 even though
    insurers experienced significant losses associated with the 2004 hurricane
    season.

    15ISO provides information about the property-casualty insurance business,
    including statistical and actuarial information. Equity capital figures
    are in 2003 dollars adjusted for inflation and include all private U.S.
    property-casualty insurers and reinsurers that file statutory financial
    statements with state insurance regulators as well as the U.S.
    subsidiaries and affiliates of foreign insurers, as long as those
    subsidiaries and affiliates are required to file statutory financial
    statements with state regulators.

    Figure 1: Insurance Industry Capital Levels, 1990-2003 Dollars in billions

    400 350 300 250 200 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997
    1998 1999 2000 2001 2002 2003

    Sources: GAO analysis of ISO and AM Best data.

    Although insurers' equity capital has generally increased over time, it is
    difficult to determine whether the growth in insurer equity capital has
    resulted in a material increase in the industry's relative capacity to pay
    claims. Insurers may also face significant financial exposure in areas
    prone to natural catastrophes such as the southeastern United States,
    which could partially offset the increase in insurer capital over the
    years. However, individual insurers do not make publicly available
    specific information about the extent to which they write policies in
    risk-prone areas, the terms offered on these policies, or the level of
    reinsurance that they purchase to help cover these risks, which
    complicates assessments of insurer capacity.

    We have also identified other limitations to using equity capital as a
    measure of insurance industry capacity. First, in any given catastrophe,
    only a portion of the industry's capital (and its other resources, such as
    catastrophe reinsurance) is available to pay disaster claims because the
    insurance industry as a whole does not pay catastrophe claims. Instead,
    individual insurance companies pay claims on the basis of the damage that
    particular catastrophes inflict on the properties they insure. An insurer
    writing policies only in one state would not have to pay any claims if a

    catastrophe occurred in another state. Second, only a portion of equity
    capital would be available to cover catastrophe claims because the capital
    may also be needed to pay claims from all of the other types of risk that
    insurers have assumed should the experience of those risks prove
    unfavorable.

    To better understand insurers' capacity to address natural catastrophe
    risks, we contacted two rating agencies that monitor the insurance
    industry. According to one rating agency official, most insurance
    companies the agency rated in 2003 were financially secure. The rating
    agency determines the financial strength of insurance companies and their
    ability to meet ongoing obligations to policyholders by analyzing
    companies' balance sheets, operating performance, and business profiles.
    According to officials from one rating agency, when establishing an
    insurance company's rating, the agency considers an insurer secure if the
    company would have enough capital after a catastrophic event to maintain
    the same rating. In other words, to maintain a secure rating, insurers
    must demonstrate that they are able to absorb losses from a hurricane with
    a 1 percent chance of occurring annually or an earthquake with a .4
    percent chance of occurring annually. Officials from one rating agency
    told us that of the 1,058 ratings it issued in 2003, 904 companies
    obtained secure ratings, meaning that they would be able to meet ongoing
    obligations to policyholders and withstand adverse economic conditions,
    such as major catastrophes, over a long period of time. Conversely, 164
    insurance companies obtained vulnerable ratings, meaning that they might
    have only a current ability to pay claims or not be able to meet the
    current obligations of policyholders at all. Although this rating agency's
    analysis concludes that nearly 90 percent of insurers would remain
    financially secure under major catastrophe scenarios, other information
    suggests that such events could result in significant insurance market
    disruptions and the inability of insurers to meet their financial
    obligations to policyholders.16 This information is discussed in a later
    section.

    16The rating agency's analysis focuses on hurricanes with an expected
    annual occurrence of no more than 1 percent. The potential exists that a
    hurricane with an expected annual occurrence of .4 percent would generate
    higher losses and financial difficulties for affected insurers.

    State Governments and Insurers Have Taken Steps to Manage the Financial
    Consequences of Natural Catastrophes

    Florida and California Established Catastrophe Authorities to Stabilize
    Markets and Maintain or Increase Capacity

    While independently assessing insurer capacity for catastrophic risk is
    challenging due to limitations associated with the equity capital measure
    and the lack of key data-such as insurers' reinsurance purchases-state
    governments and insurance companies have taken steps that have the
    potential to mitigate insurer losses and enhance industry capacity. We
    discuss several of the measures that were initiated to strengthen the
    insurance industry's capacity to respond to catastrophic events, including
    the creation of state-run programs, changes to building codes, shifts in
    underwriting, and market innovations.

    After Hurricane Andrew, the State of Florida established FHCF to act as a
    reinsurance company for insurers that offer property-casualty insurance in
    the state. According to officials from FHCF, Florida insurance regulators,
    and insurance companies that offer coverage in the state, FHCF enhances
    industry capacity by (1) offering reinsurance at lower rates than private
    reinsurers for catastrophic risk, thereby increasing the number of primary
    companies willing to write policies in the state; (2) ensuring that
    primary companies will be compensated up to specified levels when a
    catastrophic hurricane occurs; and (3) continuing to offer reinsurance at
    relatively stable rates in the immediate aftermath of hurricanes.
    Residential property insurers are required by state law to participate in
    the FHCF program. Coverage from FHCF is triggered when participating
    companies' losses meet their share of an aggregate industry retention
    level of $4.5 billion, and coverage is capped at $15 billion.17 FHCF is
    financed from three sources: actuarially-based premiums charged to
    participating insurers, investment earnings, and emergency assessments on
    Florida insurance companies if needed.18 FHCF may also issue bonds to meet
    its obligations. In 2002, Florida also established Citizens Property
    Insurance Corporation (Citizens), a state-run, tax-exempt primary insurer
    that offers coverage for a premium to homeowners who cannot obtain
    property insurance from

    17Each company has an individual retention, or deductible, which is its
    proportionate share of the industry aggregate of $4.5 billion. An insurer
    taking unusually heavy losses from a smaller storm from which aggregate
    industry losses do not meet $4.5 billion could qualify for FHCF
    reimbursement, while the industry overall might not. For example, the fund
    paid about $13 million to a few insurers after Hurricanes Erin and Opal in
    1995 even though the combined losses from these two storms only reached
    about $1.7 billion.

    18FHCF premiums are based in part on hurricane catastrophe models, which
    are discussed later in this report.

    private companies.19 Citizens writes full residential coverage in all 67
    Florida counties and wind-only coverage in the coastal areas of 29
    counties. Citizens' claims paying resources include premiums, assessments
    on the industry if its financial resources fall to specified levels, and
    reinsurance from FHCF.

    After the Northridge earthquake, the State of California established CEA
    to provide residential earthquake insurance. Insurers that sell
    residential property insurance in California must offer their
    policyholders separate earthquake insurance. Companies can offer a private
    earthquake policy or a CEA policy, but most choose the CEA policy. Only
    insurance companies that participate in CEA can sell CEA policies. The
    funds to pay claims come from premiums, contributions from and assessments
    on member insurance companies, borrowed funds, reinsurance, and the return
    on invested funds. As discussed in appendix II, about 15 percent of
    eligible customers in California purchase earthquake insurance in part
    because apparently many potential customers believe that premiums and
    deductibles are too high.

    States and Counties Have In 1994, in the wake of Hurricane Andrew,
    Miami-Dade and Broward Strengthened Building Codes in counties enacted a
    revised South Florida Building Code to ensure that

    Areas at Risk for Natural Catastrophes

    buildings would be designed to withstand both the strong wind pressures
    and impact of wind-borne debris experienced during a hurricane. In March
    2002, Florida instituted a statewide building code that implemented
    similar requirements and replaced a complex system of 400 local codes. The
    Florida Building Code was based on a national model code, which was
    amended where necessary to address Florida's specific needs for added
    hurricane protection requirements. The code also created a High Velocity
    Hurricane Zone to continue use of the South Florida Building Code's design
    and construction measures for the highly vulnerable Miami-Dade and Broward
    counties. Local jurisdictions may amend the code to make it more stringent
    when justified and are responsible for administering and enforcing it.
    According to a 2002 study, building codes have the potential to
    significantly reduce the damage caused by hurricanes.20 The study found

    19After Hurricane Andrew, Florida created FHCF as well as another
    organization, the Florida Residential Joint Underwriting Association
    (JUA). JUA provided residential coverage in specifically designated areas
    most vulnerable to windstorm damage. In 2002, JUA merged with the Florida
    Windstorm Underwriting Association to form Citizens.

    20Applied Insurance Research, Inc., in collaboration with the Institute
    for Business & Home Safety, "Impact of Building Code Developments on
    Potential Hurricane Losses in Florida," (May 2002).

    that residential losses from Hurricane Andrew would have been about $8.1
    billion lower if all South Florida homes had met the current Miami-Dade
    and Broward code.

    In California, there is no statewide building code, but certain counties
    did implement stronger building codes after the Northridge earthquake in
    1994. For example, Los Angeles County made its building code stronger
    after Northridge and has implemented several updates since then. According
    to a CEA official, the California legislature has tried to enact a
    statewide building code since 1996, but has been unable to reach a
    consensus. Florida and California officials we contacted said that while
    stronger building codes have been implemented, many older structures that
    have not been retrofitted remain vulnerable to hurricane or earthquake
    damage.

    Insurers Use Statistical Models According to insurance market
    participants, many, if not all, insurance

    to Monitor Catastrophe Exposure and Better Manage Their Risk Exposures

    companies and state authorities currently use computer programs offered by
    several modeling firms to estimate the financial consequences of various
    natural catastrophe scenarios and manage their financial exposures. To
    generate the loss estimates, the computer programs use large databases
    that catalog the past incidence and severity of natural catastrophes as
    well as proprietary insurance company data on policies written in
    particular states or areas. Using the estimates provided by these computer
    programs, insurers can attempt to manage their exposures in particularly
    high-risk areas. For example, an insurer could estimate the impact to the
    company of a hurricane with specified wind speeds striking Miami, given
    the number of policies that the insurer has written in the city as well as
    the value of insured property. Based on these types of estimates,
    companies can manage their risk and control their exposures (for example,
    by limiting the number and volume of policies written in a particular area
    or purchasing reinsurance if available on favorable terms) so that their
    losses are not expected to exceed a particular threshold, such as a
    specified percentage of their existing equity capital (a commonly used
    measure is from 10 to 20 percent of capital). According to industry
    officials we contacted, insurance and reinsurance companies generally use
    the computer programs to have greater confidence that they would have
    sufficient capital remaining to meet their obligations to customers and
    remain in business even in the aftermath of a major event. Whether
    individual companies are successful in managing their losses should such
    an event occur will depend in part on the accuracy of the estimates and
    the quality of the company's risk management practices.

    Although the use of models and other revised underwriting standards may
    enhance insurers' ability to control the financial consequences they
    experience from natural catastrophes, an effect may be reduced insurance
    availability. To the extent that private insurers reduce their exposures
    in risk-prone areas, consumers only may be able to obtain property
    insurance offered by state authorities. For example, according to Citizens
    officials, the organization provides 70 percent or more of the wind
    coverage in sections of Palm Beach, Broward, and Dade counties.21 Although
    state authorities can ensure that coverage is available in risk-prone
    areas, such insurers are generally not able to diversify their insurance
    portfolios and may suffer disproportionate losses when catastrophes occur.

    Insurers Have Implemented Insurers have increased policyholder deductibles
    for certain natural

    Higher Deductibles to Shift a catastrophe risks in risk-prone areas. For
    example, prior to Hurricane

    Greater Share of Losses from Andrew in 1992, insurers in Florida generally
    required homeowners to pay

    Insurers to Policyholders	a standard deductible of $500 for wind-related
    damage and would cover remaining losses to specified limits. After
    Hurricane Andrew, the Florida legislature instituted percentage hurricane
    deductibles. For homes valued at $100,000 or more, insurers may now
    establish deductibles from 2 to 5 percent of the policy limits for
    hurricane damage.22 According to an insurance association, 2 percent is
    the most common deductible level, although 5 percent deductibles are
    widespread on higher-priced dwellings. The new deductible is much higher
    than the previous deductible and to some extent limits insurers' financial
    exposures due to increases in property values resulting from inflation,
    since the dollar value of the 2 percent deductible increases as property
    values increase. General deductibles-usually $500-still apply to all
    homeowner policies for nonhurricane losses, including tornadoes, severe
    thunderstorms, and fire. Moreover, according to information from insurance
    market participants, percentage deductibles are now standard in risk-prone
    areas throughout the United States.

    21Private-sector insurers provide coverage to some of the remaining 30
    percent of properties in these counties.

    22For homes valued under $100,000, the insurer must offer a hurricane
    deductible no lower than $500 and no higher than 2 percent of policy
    limits. For homes valued above $100,000, the insurer may offer a policy
    that contains up to a 2 percent deductible if the insurer guarantees that
    it will renew the policy for another year. The maximum allowable
    deductible is 2 percent for homes valued under $100,000, 5 percent for
    homes valued between $100,000 and $500,000, and there is no maximum limit
    for homes valued in excess of $500,000. There are also separate provisions
    for mobile homes.

    Development of Bermuda Reinsurance Market Reportedly Has Expanded Capacity

    Insurers and analysts we contacted said that the growth of the Bermuda
    reinsurance market over the past 15 years has enhanced the industry's
    capacity to withstand natural catastrophes. According to an industry
    report, many reinsurance companies were incorporated in Bermuda after
    Hurricane Andrew in 1992 and the September 11 attacks to take advantage of
    the high global premium rates for catastrophic coverage, and many
    specialize in catastrophe risk. Additionally, regulatory and industry
    officials we contacted said that Bermuda's favorable tax environment (no
    corporate income or capital gains taxes), a flexible regulatory
    environment that permits companies to be created more quickly than in
    other jurisdictions, and a concentration of individuals with insurance
    expertise have contributed to the growth of the Bermuda insurance market.

    According to a Bermuda insurance industry association, Bermuda reinsurers
    currently provide a total of 50 percent of all Florida reinsurance. One
    large primary company we contacted said that Bermuda companies are of
    critical importance to its overall risk management strategy. In addition,
    one state authority official reported buying reinsurance from companies in
    Bermuda. Other industry participants noted that Bermuda companies have
    diversified the worldwide reinsurance market. Moreover, some Bermuda
    companies specialize in providing reinsurance to about 30 primary
    companies that were established to "take out" policies from Citizens.23
    Citizens pays bonuses to primary companies, called take out companies, as
    an incentive to assume the liability on polices that are taken out for 3
    years. The bonuses are based on a percentage of the premiums for the
    policies taken out of Citizens.24 According to Florida insurance
    regulators, many of the take out companies, therefore, have substantial
    exposure to hurricane risk.

    23Some U.S. reinsurers also provide coverage to take out companies.

    24According to a Citizens official, take out companies are required to
    take a minimum number of policies and also write a minimum number of those
    policies including wind coverage in Dade, Broward, and Palm Beach counties
    in order to receive the bonus amounts.

    We note that some analysts have questioned the extent to which the Bermuda
    market has enhanced insurer capacity since some of the capital raised by
    Bermuda insurers may represent funds invested by existing insurance
    companies.25

    2004 Hurricane Season Tested Measures Implemented to Better Manage Natural
    Catastrophes

    The four hurricanes that struck within a 6-week period in 2004 provided
    the first test of the steps the state and the insurance industry have
    taken to enhance industry capacity since Hurricane Andrew (see fig. 2). As
    of the end of 2004, they had generated an estimated 1.5 million claims
    from property owners with over $20 billion in insured losses in Florida-
    equating to losses with an expected annual occurrence from 2 to 5 percent
    (that is, a 1-in-20 to a 1-in-45 year loss). Although many insurers
    incurred significant losses, 1 take out company failed, and some insurers
    are restricting coverage and requesting rate increases, industry
    participants and state officials generally agreed that the steps taken
    after Hurricane Andrew in 1992 helped the industry better absorb the
    hurricane losses and provided stability in the insurance markets. For
    example, only 1 company failed in 2004 in contrast to 11 that failed after
    Andrew. According to one modeling firm official, while the hurricane
    losses are significant, insurers typically plan to absorb more than double
    the losses experienced in these four events. However, some of the steps
    taken after Andrew were designed to manage losses from a single storm
    similar to Andrew, rather than the unusual occurrence of four hurricanes
    making landfall in the United States and causing major damage in the same
    general area.26 Therefore, state officials and insurers are considering
    further changes to better address the potential for a future hurricane
    season with similar events.

    25In 2001, 10 new Bermuda companies were formed. In some cases, the
    sources of the capital came from established industry players. For
    example, the principal sponsors of one of these new companies were three
    existing insurance and reinsurance companies.

    26According to two insurance broker reports, there have been 4 years with
    four hurricanes making landfall in the United States since 1900 (1906,
    1909, 1964, and 2004), 1 year with five hurricanes (1933), and 2 years
    with six hurricanes (1916 and 1985). A hurricane rating 3, 4, or 5 on the
    Saffir Simpson scale is considered a major hurricane. There has not been a
    year where four major hurricanes made landfall in the United States in
    over 105 years. Moreover, the year 1886 was the last time more than three
    landfalls occurred in one state.

    Figure 2: The 2004 Hurricane Season Resulted in More Than $20 Billion in Insured
                                   Losses in Florida

    FHCF and Reinsurers Losses Limited Due to Multiple Mid-Sized Hurricanes
    Striking Florida Rather Than One Major Storm

    Sources: Benfield Group Limited, Florida Insurance Council, Florida Office
    of Insurance Regulation, Guy Carpenter, Swiss Re, and Risk Management
    Solutions (map).

    FHCF's payments to its members were limited due to the fact that four
    relatively mid-sized hurricanes struck Florida rather than one major storm
    such as Andrew. As previously discussed, FHCF payments to its members are
    generally triggered when members' losses from a particular storm reach
    $4.5 billion (a company may receive FHCF payments if its losses exceed its
    individual retention level-or deductible-even if overall industry losses
    are less than $4.5 billion). According to an FHCF official, all four
    storms are expected to trigger FHCF recoveries totaling about $2 billion
    in payments to 123 of about 230 participating insurers. FHCF members that
    did not receive payments, including Citizens, did not have losses that
    reached their individual retention levels (see fig. 3). As a result of the
    2004 hurricanes, Florida officials are considering changes to FHCF, such
    as lowering the industry retention level from the current $4.5 billion,
    lowering the retention after the second hurricane in a season, or applying
    a single hurricane season retention, rather than the per hurricane
    retentions currently in place.

    Figure 3: 2004 Hurricanes Did Not Trigger FHCF Payments to Citizens
    Property Insurance Corporation

    Source: Citizens Property Insurance Corporation.

    Reinsurance company officials, except for Bermuda companies described in a
    subsequent section, said that their losses from the 2004 hurricanes were
    also limited for the same general reasons as FHCF. That is, reinsurance
    contracts typically require primary companies to retain a specified
    percentage of the losses associated with hurricanes and are written on a
    per occurrence basis. The reinsurance company officials said that each of
    the four hurricanes generally did not result in losses that exceeded the
    primary companies' retention levels.27 Additionally, reinsurers' exposures
    may have been limited because primary companies only purchased reinsurance
    for one or two storms and may not have

    27Primary insurance companies in Florida are required to purchase
    reinsurance from FHCF, which provides a layer of reinsurance coverage
    below what is typically offered by reinsurers. That is, FHCF provides
    coverage for storms with an expected annual occurrence of about 2 percent
    annually (approximately the 1-in-50 year storm). Primary companies may
    purchase reinsurance for catastrophes that exceed the FHCF levels (such as
    storms with an expected annual occurrence of less than 2 percent-for
    example, a 1-in-100 year storm). Since each of the four hurricanes had an
    expected annual occurrence of greater than 2 percent and FHCF payments
    were minimized as a result, reinsurance contracts were frequently not
    triggered.

    Revised Building Codes May Have Mitigated Losses

    Steps Industry Took Based on Catastrophe Model Estimates Viewed as
    Mitigating Losses

    purchased reinsurance coverage for a third or fourth storm. Because, in
    general, many reinsurance companies were not significantly affected by the
    2004 hurricane season, insurance market analysts generally do not expect
    significant increases in reinsurance premiums similar to those that took
    place after Hurricane Andrew in 1992.28

    Although it is too early for definitive conclusions, insurers, a Florida
    regulatory official, and a consumer representative we contacted said that
    the state's revised building codes may have mitigated insurer losses from
    the 2004 hurricanes. For example, a recent study of damage caused by
    Hurricanes Charley, Frances, and Ivan found that structures built
    according to the new building codes fared better than structures built
    under older building codes.29 However, in some cases, insurance market
    participants said that newer structures sustained damage despite the
    revised building codes. For example, the officials said that materials
    blown off of older structures struck newer buildings causing damage such
    as shattered windows. In addition, Florida officials reported that some
    builders of structures subject to revised codes did not use proper
    materials or techniques, which resulted in damage and losses.

    Overall, insurance companies and other industry participants reported that
    steps insurers took based on information generated by computer models of
    exposures mitigated their losses during the 2004 hurricane season;
    however, some insurers noted that the models did not accurately estimate
    their actual losses. According to two modeling firm representatives, the
    purpose of catastrophe modeling is not to predict exact losses from
    specific storms but to anticipate the likelihood and severity of potential
    future events so that companies can prepare accordingly.

    Insurers and other industry participants also reported some aspects of the
    models that could be improved. Insurance industry officials noted that the
    models did not take into account the increased cost of labor and
    construction materials after the hurricanes, or demand surge. In addition,
    companies noted that the models did not take into account the impact of

    28Reinsurance premiums were reportedly declining prior to the 2004
    hurricane season. As a result of losses incurred by reinsurers, insurance
    market analysts we contacted said they do not expect reinsurance premiums
    to decline as rapidly as prior to the advent of the four hurricanes.

    29Institute for Business & Home Safety, "Preliminary Damage Observations,
    Hurricanes Charley, Frances & Ivan 2004," (2004).

    Insurers Increased Deductibles to Mitigate Losses, but Multiple
    Deductibles Have Raised Concerns

    Bermuda Reinsurers That Specialize in Catastrophe Risk Are Expected to
    Meet Their Obligations from the 2004 Hurricanes

    damage caused to the same properties by storms with overlapping tracks.
    Officials from the modeling firms told us that since the models are based
    on historical data, they do factor in the possibility of multiple events
    in 1 year. However, one firm noted that the models assume that the damage
    caused by each event is independent. Representatives from three modeling
    firms told us that the companies will incorporate meteorological and
    claims data from the 2004 hurricane season into their models and consider
    other improvements in future upgrades.

    Insurance company and other industry officials we contacted said that
    using percentage-based deductibles mitigated losses associated with the
    2004 hurricanes. However, Florida insurance regulatory officials told us
    that some consumers complained that they were surprised by the high amount
    of their deductibles. In addition, with multiple storms sometimes crossing
    the same paths, paying multiple deductibles became an issue of consumer
    fairness. According to state regulatory officials, some insurance
    companies have decided to apply a single deductible to all their policies.
    Some insurers we interviewed said that they are deciding on a case-by-case
    basis whether multiple deductibles should apply. For example, one insurer
    told us that if the claims adjuster could not determine what damage was
    caused by what storm, generally only one deductible would be applied.
    According to state regulatory officials, there are approximately 29,000
    cases of multiple deductibles. On December 16, 2004, the state legislature
    passed legislation to reimburse policyholders who had to pay multiple
    deductibles. According to the new law, up to $150 million will be borrowed
    from FHCF to provide grants of up to $10,000 to policyholders subject to
    two deductibles and up to $20,000 for policyholders subject to three or
    more deductibles. Funds borrowed from FHCF will be repaid by increasing
    insurers' FHCF premiums beginning in 2006. For policies issued or renewed
    on or after May 1, 2005, the new law also permits insurers to apply a
    single deductible for each hurricane season. When the deductible is
    exhausted, the deductible for other perils-generally $500-will be applied
    to claims for damage from subsequent storms.

    Bermuda reinsurers are expected to pay a significant amount of reinsurance
    losses compared with other reinsurance companies because of their
    specialization in catastrophe risk (such as providing reinsurance to take
    out companies). A Bermuda insurance industry association representative
    estimated that Bermuda reinsurers will pay about $2.6 billion in losses
    from the four hurricanes, or about 10 percent of the total losses. These
    losses could exhaust from 25 to 40 percent of companies' earnings for
    2004. The Bermuda insurance industry association official

    noted that no Bermuda companies are expected to fail as a result of these
    losses and that the ratings of Bermuda companies have not been affected by
    the hurricane losses. The association official also said that these
    companies are well capitalized and have had several years with low
    catastrophe losses.

    A Severe Natural Catastrophe or Series of Catastrophes Could Generate
    Major Insurance Market Disruptions

    While state government and insurer measures initiated since the 1990s
    likely facilitated insurers' ability to respond to the 2004 hurricane
    season, an event with losses representing an expected annual occurrence of
    no more than 1 percent to .4 percent could have major consequences for
    insurers and insurance availability. Neither the 2004 hurricane season, as
    discussed previously, nor Hurricane Andrew or the Northridge earthquake
    qualified as an event with losses representing a 1 percent expected annual
    occurrence, yet many insurers experienced significant losses and some
    restricted coverage as a result of these catastrophes.30 It follows that a
    more severe hurricane (or series of hurricanes) or earthquake with
    estimated losses of $50 billion or more would have even more severe
    consequences. For example, FHCF's total available financial resources of
    $15 billion are intended to cover losses from a hurricane with an
    estimated occurrence of about 2 percent annually (approximately a 1-in-50
    year event). If a more severe hurricane or series of hurricanes struck
    Florida, FHCF would likely impose assessments on the insurance industry to
    cover the costs of bonds issued to meet its obligations and its financial
    resources would be exhausted. Insurers, in turn, might impose higher
    premiums on policyholders to cover the cost of these assessments.
    Moreover, a severe hurricane would likely impose much higher losses on the
    reinsurance industry than did the 2004 hurricane season, particularly
    because primary insurers' losses may exceed the retention levels specified
    in their reinsurance contracts.

    Our previous work, as well as recent discussions with NAIC officials, also
    indicates that a catastrophe with an expected occurrence of no more than 1
    percent annually would likely cause a significant number of insurer
    insolvencies among companies with high exposures to such events and
    inadequate risk management practices.31 Several assessments by state

    30The $19 to $20 billion in losses from Hurricane Andrew and the
    Northridge earthquake generally qualify as losses with a 2 percent annual
    occurence (1-in-50 year loss) or more.

    31See GAO/GGD-00-57R.

    catastrophe authorities, such as FHCF and Citizens, and state guaranty
    funds (described next) could reduce insurers' equity capital, which would
    already be strained by significant losses. Insurers that experience
    substantial losses and declines in equity capital would likely face rating
    downgrades from the rating agencies. Consequently, such companies might no
    longer be able to meet their obligations to their customers and state
    authorities could intervene to ensure that some claims were paid. All
    states have established so-called guaranty funds, which are financed by
    assessments on the insurance industry for this purpose.32 However, it is
    not clear that the state guaranty funds would have sufficient resources to
    withstand the failures of many insurers associated with a major
    catastrophic event or series of events.

    Catastrophe Bonds and Tax-Deductible Reserves May Have the Potential to
    Enhance Insurers' Capacity for Catastrophe Risk

    Insurers' reactions to past catastrophic events-for example, restrictions
    on reinsurance coverage and higher reinsurance premiums-and the potential
    consequences for insurers from an even more severe catastrophe have
    generated financial instruments and proposals designed to enhance industry
    capacity for both natural events and terrorist attacks. Catastrophe bonds
    serve as a potential means for insurers to tap the large financial
    resources of the capital markets to cover the large exposures associated
    with potential catastrophes. In fact, several insurance and reinsurance
    companies currently use catastrophe bonds to enhance their capacity to
    cover low probability, high severity natural events, although catastrophe
    bonds have not been issued yet to cover terrorism risk in the United
    States. However, catastrophe bonds are not widely used in the insurance
    industry due to their relatively high cost compared with reinsurance,
    among other factors. Some insurance market analysts have also advocated
    changing U.S. tax laws and accounting standards to permit insurers to set
    aside reserves on a tax-deductible basis to increase their capacity for
    both natural catastrophes and terrorist attacks. However, tax-deductible
    reserves involve tradeoffs such as lower federal revenues and some
    analysts believe that the reserves would not materially enhance capacity
    because insurers might substitute reserves for existing reinsurance
    coverage, the cost of which is tax deductible.

    32The lines of insurance covered by guaranty funds and the maximum amount
    paid on any claims vary from state to state.

    Catastrophe Bond Market Has Grown Significantly but Is Still Small
    Compared with Overall Catastrophe Exposure

    According to private-sector data, the value of outstanding catastrophe
    bonds increased substantially from 1997 through 2004 (see fig. 4). The
    value of outstanding catastrophe bonds worldwide increased about 50
    percent from year-end 2002 to year-end 2004 to $4.3 billion. However, at
    $4.3 billion, the value of outstanding catastrophe bonds was small
    compared with industry catastrophe exposures. For example, a major
    hurricane striking densely populated regions of Florida alone could cause
    more than an estimated $50 billion in insured losses.

    Figure 4: Catastrophe Bond Amount Outstanding, Year-end 1997- 2004

    Dollars in millions

    5,000

    4,388

    4,000

    3,000

    2,000

    1,000

    0 1997 1998 1999 2000 2001 2002 2003 2004

    Source: GAO analysis of Swiss Re Capital Markets data.

    Note: The data include catastrophe bonds issued and amounts outstanding
    from prior years. These data represent the most current estimates
    available as of the end of 2004 and are based on voluntary submissions.
    According to two private-sector sources, industry participants agree that
    the data are generally consistent.

    As discussed in our previous reports, some insurance and reinsurance
    companies view catastrophe bonds as an important means of diversifying
    their overall strategy for transferring catastrophe risks, which
    traditionally involves purchasing reinsurance or retrocessional coverage.
    By raising funds from investors through the issuance of catastrophe bonds,
    insurers can expand the pool of capital available to cover the transfer of
    catastrophic risk. In addition, most of the catastrophe bonds issued
    provide

    coverage for catastrophic risk with high financial severity and low
    probability (such as events with an expected occurrence of no more than 1
    percent annually). Consequently, none of the bonds issued to date that
    include coverage of U.S. wind risk were triggered by the 2004 hurricane
    season. According to various financial market representatives, because of
    the larger amount of capital that traditional reinsurers need to hold for
    high severity and lower-probability events, reinsurers limit their
    coverage and charge increasingly higher premiums for these risks.
    Representatives from one insurance company said that the company cannot
    obtain the amount of reinsurance it needs for the highest risks at
    reasonable prices and has obtained some of its reinsurance coverage in
    this risk category from catastrophe bonds as a result. This firm and other
    market participants said that the presence of catastrophe bonds as an
    alternative means of transferring risk may have moderated reinsurance
    premium increases over the years.

    Some insurers also find catastrophe bonds beneficial because they pose
    little or no credit risk. That is, financial market participants told us
    that insurers can be exposed to the credit risk of reinsurers not being
    able to honor their reinsurance contracts if a natural catastrophe were to
    occur. Catastrophe bonds, on the other hand, create little or no credit
    risk for insurers because the funds are immediately deposited into a trust
    account upon bond issuance to investors. Representatives from some
    insurers we contacted said that while they recognize that some reinsurers'
    credit quality had declined in recent years, they guarded against credit
    risks by establishing credit standards for the companies with whom they do
    business and continually monitoring their financial condition.33

    Some institutional investors we contacted also expressed positive views
    about catastrophe bonds. Some investors said that the bonds offered an
    attractive yield compared with traditional investments. These
    institutional investors also said that they purchased catastrophe bonds
    because they were uncorrelated with other risks in bond portfolios and
    helped diversify their portfolios.

    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 reinsurers 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.

    Various Factors May Have Limited the Expansion of the Catastrophe Bond
    Market

    Although catastrophe bonds benefit some insurers and institutional
    investors, others we contacted said they do not issue or purchase
    catastrophe bonds for a number of reasons, which may have limited the
    expansion of the market. Some state authorities we contacted and many
    insurers view the total costs of catastrophe bonds-including transaction
    costs such as legal fees-as significantly exceeding the costs of
    traditional reinsurance. Insurer and state authority officials also said
    that they were not attracted to catastrophe bonds because they generally
    covered events with the lowest frequency and the highest severity. Rather,
    the officials said that they would prefer to obtain coverage for less
    severe events expected to take place more frequently. In addition, a
    recent study concluded that the fact that most catastrophe bonds are
    issued on a nonindemnity basis has limited the growth of the market
    because such bonds expose insurers to basis risk (the risk that the
    provisions that trigger the catastrophe bond will not be highly correlated
    with the insurer's loss experience).34

    Representatives from some institutional investors said that the risks
    associated with catastrophe bonds were too high or not worth the costs
    associated with assessing the risks. Some institutional investors also
    said that they decided not to purchase catastrophe bonds because they were
    considered illiquid. However, capital market participants we contacted
    said that the liquidity of the catastrophe bond market has improved.

    Moreover, the catastrophe bond market has generally been limited to
    coverage of natural disasters because the general consensus of insurance
    and financial market participants we contacted was that developing
    catastrophe bonds to cover potential targets against terrorism attacks in
    the United States was not feasible at this time. In contrast to natural
    catastrophes, where a substantial amount of historical data on the
    frequency and severity of events exists, terrorism risk poses challenges
    because it is extremely difficult to reliably model the frequency and
    severity of terrorist acts.35 Although several modeling firms are
    developing terrorism models that are 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

    34Sylvie Bouriaux, Ph.D., and William L. Scott, Ph.D., "Capital Market
    Solutions to Terrorism Risk Coverage: A Feasibility Study," Journal of
    Risk and Finance Vol. 5, No. 4 (2004): 33-44.

    35See GAO-03-1033.

    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.

    Our previous work also identified certain tax, regulatory, and accounting
    issues that might have affected the use of catastrophe bonds. We have
    updated this work and discuss it in detail in appendix III.

    Permitting Tax-Deductible Catastrophe Reserves Is Controversial

    Tax-deductible reserves could confer several potential benefits, according
    to advocates of the proposal, but others argue that reserves would not
    bring about a meaningful increase in industry capacity. First, supporters
    of tax-deductible reserves argue they would provide insurers with
    financial incentives to increase their capital and thereby expand their
    capacity to cover catastrophic risks and avoid insolvency. Supporters also
    argue that they would lower the costs associated with providing
    catastrophic coverage and encourage insurers to charge lower premiums,
    which would increase catastrophic coverage among policyholders. Moreover,
    as mentioned in our discussion of catastrophe bonds, the risk exists that
    reinsurers might not be able to honor their reinsurance contracts if a
    natural catastrophe were to occur. Allowing insurers to establish
    taxdeductible reserves could help ensure that funds are available to pay
    claims if a catastrophe were to take place. Finally, information from NAIC
    states that under current accounting rules, insurers are not required to
    fully disclose the financial risks that they face from natural
    catastrophes and that these risks are not accounted for on insurers'
    balance sheets. By requiring insurers to establish a mandatory reserve on
    their balance sheets and disclose it in the footnotes of the financial
    statements, the NAIC officials argue that the insurers' financial
    statements would be more transparent and provide better information about
    the potential catastrophic risks that they face.

    An NAIC committee has made a catastrophe reserve proposal-which the NAIC
    has not officially endorsed-that would require insurers to gradually build
    up industrywide catastrophe reserves of a total of $40 billion over a
    20-year period, or not more than $2 billion per year.36 The NAIC
    committee's proposal would make such reserves mandatory to promote the
    safety and soundness of the insurance industry. The committee's proposal
    would also stipulate that specified events-such as an earthquake, wind,
    hail, or volcanic eruption-could trigger a drawdown from the reserves- and
    that the President of the United States or Property Claim Services would
    have to declare that a catastrophe had occurred.37 The proposal would
    specify that either insurers' losses reach a certain level or that
    industry catastrophe losses exceed $10 billion for insurers to make a
    drawdown on the reserve.

    However, there are potential tradeoffs associated with allowing insurers
    to establish tax-deductible reserves for potential catastrophes. In
    particular, permitting tax-deductible reserves would result in lower
    federal tax receipts according to industry analysts we contacted. Although
    supporters counter that permitting reserves would enhance industry
    capacity and thereby reduce the federal government's catastrophe-related
    costs over the long term, the size of any such benefit is unknown. In
    addition, Treasury staff said that there would be no guarantee that
    insurance companies would actually increase the capital available to cover
    catastrophic risks. Rather, the officials said that insurers might use the
    reserves to shield a portion of their existing capital (or retained
    earnings) from the corporate income tax. Furthermore, reinsurance
    association officials said that insurance companies could inappropriately
    use tax-deductible reserves to manage their financial statements. That is,
    insurers could increase the

    36The proposal was made by NAIC's Catastrophe Insurance Working Group to
    NAIC's Property and Casualty Committee in 2000. See NAIC Catastrophe
    Working Group, "Summary of the NAIC Catastrophe Reserve Proposal," NAIC
    Research Quarterly 6, no. 2 (Summer 2000). According to an NAIC official,
    the NAIC will not adopt the proposal beyond the working group level unless
    the tax laws are changed to allow insurance companies to establish
    reserves for future catastrophic events on a tax-deductible basis.

    37The ISO's Property Claim Services (PCS) provides widely used data on
    insured property losses from catastrophes in the United States, Puerto
    Rico, and the U.S. Virgin Islands. PCS investigates reported disasters and
    determines the extent and type of damage, dates of occurrence, and
    geographic areas affected. PCS is the only insurance industry resource for
    compiling and reporting estimates of insured property losses resulting
    from catastrophes. For each catastrophe, the PCS loss estimate represents
    anticipated industrywide insurance payments for property lines of
    insurance covering fixed property, building contents, business
    interruption losses, vehicles, and inland marine (diverse goods and
    properties).

    reserves during good economic times and decrease them in bad economic
    times. In addition, Treasury staff expressed skepticism about the
    reliability of models used to predict the frequency and severity of
    catastrophes. Without reliable models, Treasury staff said that it would
    be difficult to determine the appropriate size of the catastrophe
    reserves. We note that insurers have developed sophisticated models to
    predict the frequency and severity of natural catastrophes such as
    hurricanes and that these models are currently considered more reliable
    than terrorism models.

    Finally, reinsurance association officials and an insurance industry
    analyst who supports tax-deductible reserves said that some insurers might
    reduce the amount of reinsurance coverage that they purchased if they were
    allowed to establish reserves. Because reserving would also convey tax
    advantages, some insurers might feel that they could limit the expense of
    purchasing reinsurance. To the extent that insurers reduced their
    reinsurance coverage in favor of tax-deductible reserves, the industry's
    overall capacity would not necessarily increase. We also note that
    reinsurance is a global business and that reinsurers in other countries,
    particularly European countries and Bermuda, provide a significant amount
    of reinsurance for U.S. insurers. Since many European insurers in the
    countries we studied are already permitted to establish tax-deductible
    reserves (as described in the next section) and Bermuda reinsurers are not
    subject to an income tax, any potential enhancement of insurer capacity
    associated with granting U.S. insurers the authority to establish such
    reserves may be limited.

    European Countries Use a Mix of Approaches to Insure Natural Catastrophes,
    and Most Countries Studied Have National Terrorism Insurance Programs

    European countries also face significant risks associated with natural
    catastrophes and terrorist attacks, and have developed a range of
    approaches to enhance insurers' capacity to address catastrophic risks.
    For example, the six European countries we studied-France, Germany, Italy,
    Spain, Switzerland, and the United Kingdom-have developed a mix of
    government and private-sector approaches to covering natural catastrophe
    risk. In three of the countries, standard homeowner policies include
    mandatory coverage for natural catastrophes, and the government provides
    an explicit financial guarantee to pay claims in two of these three
    countries. The other three countries generally rely on insurance markets
    to provide natural catastrophe coverage. Concerning terrorism coverage,
    four of the six countries have established national terrorism programs,
    two of which are mandatory, wherein the national governments provide
    explicit financial guarantees to address the financial risks associated
    with terrorist attacks while the two remaining countries generally rely on
    insurance

    markets. As of the time of our review, all six countries allowed insurers
    to establish tax-deductible reserves to cover the costs associated with
    potential catastrophes, but there are significant variations in each
    country's approach. Further, a new international accounting standard
    designed to prohibit the use of such catastrophe reserves may have a
    limited effect due to the way it is being implemented in Europe.

    Europeans Use a Mix of Government and Privatesector Approaches to Insure
    Natural Catastrophes

    Insurance for natural catastrophes in the six European countries we
    studied encompass a range of structures-from mandatory coverage with
    state-backed guarantees to wholly private-sector coverage. Figure 5
    provides an overview of how natural catastrophes are insured in the six
    selected European countries. In summary, France and Spain have developed
    national programs with mandatory coverage and unlimited state guarantees.
    Switzerland mandates natural catastrophe coverage, but the government does
    not provide an explicit financial commitment. Germany, Italy, and the
    United Kingdom do not offer national insurance programs for natural
    catastrophes.

    Figure 5: How Natural Catastrophe Insurance Is Covered in Selected
    European Countries

    Guy Carpenter, American Insurance Association, and interviews of insurance
    industry participants and insurance supervisory authority officials in
    each country; Nova Development (maps).

    In France, the Catastrophes Naturelles (CatNat) program was started in
    1982 in response to serious flooding in southern France. French law
    requires standard property insurance policies to include coverage for
    natural catastrophes. According to information from the French government,
    between 95 and 98 percent of the population has taken out this
    comprehensive insurance and thus benefits from CatNat coverage. To cover
    natural catastrophe risk, insurers collect a government-determined 12
    percent premium surcharge from policyholders. Insurers may then choose to
    forgo reinsurance for natural catastrophes or purchase reinsurance from
    the private market or the Caisse Centrale de Reassurance (CCR), a
    state-backed company authorized by law to reinsure natural catastrophe
    risk. CCR offers unlimited reinsurance coverage that is guaranteed by the
    French government in the event that CCR exhausts its

    Natural Catastrophe Programs in France and Spain Involve Mandatory
    Coverage, Statebacked Entities, and Unlimited State Guarantees

    resources. However, a CCR official noted that insurance companies must
    transfer half of their natural catastrophe risk to CCR in order to be
    covered under the state guarantee. According to one insurance broker and a
    French Treasury official, most insurers in France reinsure their natural
    catastrophe risk through CCR to obtain the state guarantee coverage.

    Under the French program, the government must declare that an event
    qualifies as a natural disaster.38 According to information from the
    French government and a CCR official, the program is set up so that
    insurers manage policyholders' claims because they have the best
    claims-paying experience and expertise. Coverage from CCR takes effect
    after insureds pay a certain deductible.39 Since the program was started
    in 1982, France has declared 110,000 natural disasters and paid
    �6.4 billion (about $8.6 billion) in compensation, over half of
    which was for floods.40 In 2001, the government introduced a program to
    encourage cities to implement loss prevention measures by increasing
    deductibles in the event of repeated natural disasters, such as floods,
    for cities without a prevention plan.

    In Spain, a state-owned entity called the Consorcio de Compensacion de
    Seguros (Consorcio) provides coverage for natural catastrophe risks.41
    Originally established to provide indemnity to victims from the Spanish
    Civil War, the Consorcio now provides coverage for catastrophic risks not
    specifically covered under private-sector insurance policies or when an

    38There is no real definition of a natural disaster (either of covered or
    noncovered risks) in the law establishing the French program. The only
    triggering point is that an event be uninsurable and of abnormal
    intensity. A nonexhaustive list of qualifying events includes floods and
    mudslides, earthquakes, tidal waves, avalanches, and landslides.

    39CCR's coverage for natural disasters is unlimited because of the state
    guarantee. The deductible under the CCR reinsurance contract, therefore,
    represents the maximum amount that an insurer will have to bear in the
    course of a year, regardless of how many losses occur.

    40For the exchange rate from euros to dollars, we used the daily 12 noon
    buying rate as certified by the New York Federal Reserve Bank on December
    6, 2004, which was 1.3431. This rate is quoted in U.S. dollars per foreign
    currency unit.

    41While state owned, the Consorcio operates as a private company and must
    follow the same regulations and standards as private companies. The
    Consorcio's resources for coverage of catastrophic risk come from
    surcharges paid by policyholders, and not from the state's budget. As
    discussed in the next section, the Consorcio also covers risks such as
    terrorism, civil commotion, and riot.

    insurance company cannot fulfill its obligations.42 According to a
    Consorcio official, natural catastrophe coverage is mandatory and
    automatically included in standard policies, and although Spanish law does
    not require the purchase of standard property insurance policies, most
    people do have insurance because banks require it as a condition of
    mortgages. As a result, most property is covered for natural catastrophes.
    The Consorcio uses data from private insurers and its own claims data to
    calculate the standard surcharge rate for different types of properties
    (such as housing, offices, industrial sites, and public works). As in
    France, insurers collect this surcharge from all policyholders' property
    insurance premiums. Unlike in France, where insurers may use the surcharge
    collected to purchase reinsurance coverage from CCR or private reinsurers
    (or to cover the costs associated with retaining natural catastrophe
    risk), Spanish insurers must transfer the surcharge to the Consorcio on a
    monthly basis and in return receive a 5 percent collection commission that
    is tax deductible. The Consorcio's catastrophe coverage protects the same
    property or persons to at least the same level as risks covered under the
    primary insurance policy from the private insurer. The Spanish government
    provides an unlimited guarantee in the event that the Consorcio's
    resources are exhausted; however, the government guarantee has never been
    triggered.

    According to Consorcio and Spanish insurance industry officials, the
    Consorcio provides nearly all the natural catastrophe coverage in Spain.
    Even though private insurers have been allowed to provide natural
    catastrophe coverage since 1990 few, if any, do so. Because their risks
    would not be as geographically diversified as the Consorcio's (since it
    provides coverage to policyholders across the country), private insurers
    would not be able to charge rates competitive with the Consorcio. In
    addition, a Consorcio official said that even if insurers provided
    policyholders with natural catastrophe coverage, the insurers would still
    have to pay the Consorcio surcharge. Unlike France, no official government
    declaration of a disaster is required for this coverage to take effect.
    Coverage from the Consorcio is automatic whenever any of the specified
    catastrophes occurs. The Spanish system also differs from the French
    system in that, according to a Consorcio official, the Consorcio
    compensates policyholders directly for their losses. In 2003, the
    Consorcio

    42The Consorcio also operates as a guarantee fund and would indemnify
    policyholders if an insurance company covered a natural catastrophe risk,
    but subsequently filed for bankruptcy, suspended payments, or become
    insolvent.

    paid about �143 million (about $192 million) in catastrophe losses.
    As in France, floods represent the highest percentage of the total natural
    catastrophe claims.

    While the Swiss Government Swiss law requires insurers to include coverage
    for natural catastrophes as

    Mandates Natural Catastrophe an extension to all fire insurance contracts
    on buildings and contents.

    Coverage, It Provides No Insurers first integrated natural catastrophe
    coverage into fire insurance

    Government Guarantee and the policies on a voluntary basis in 1953 after
    severe damage caused by

    Industry Administers Its Own avalanches. Since it was too expensive to
    insure those who lived in areas at

    Pool	high risk for avalanches, the insurance industry packaged all natural
    catastrophe risks together and attached this package to fire insurance
    policies. The natural catastrophe coverage became a requirement in law in
    1992. In addition, Switzerland now has regulations controlling building in
    areas such as avalanche zones and flood plains. As in France and Spain,
    all policyholders pay a uniform premium rate for natural catastrophe
    coverage, which is part of the fire insurance premium. The standard
    premium amount, calculated by an actuarially based methodology, is also
    written into law but has not been revised or adjusted since 1993. Most
    property owners in Switzerland are required to have building insurance for
    fire and natural catastrophes.43 As a result of this mandatory coverage,
    most buildings in Switzerland are covered for these events. Coverage for
    building contents is generally optional in Switzerland, but according to
    Swiss insurance industry and government officials, most people also have
    this coverage.44 An insurance association official told us that earthquake
    risk was not originally included in the natural catastrophe package
    because at that time, earthquakes were considered uninsurable. According
    to a Swiss Insurance Association official, coverage for earthquakes is
    available from insurers in Switzerland as an additional optional policy,
    but not many people buy it.

    43Building insurance is not compulsory in 4 of Switzerland's 26 cantons-or
    states. 44Coverage for building contents is compulsory in 2 cantons.

    National Governments in Italy, Germany, and the United Kingdom Are Not
    Involved in Natural Catastrophe Insurance

    Although the Swiss government does not provide a state guarantee to cover
    losses from a major catastrophe, as is the case in France and Spain, Swiss
    insurers have developed programs to share catastrophe losses. In some
    areas of Switzerland, state-run insurers provide building insurance.45
    These state-run insurers have established a specialized reinsurance
    company to manage their natural catastrophe risk. According to Swiss
    government officials, the state-run insurers may purchase reinsurance
    coverage from the private market or this specialized reinsurance company.
    Providing coverage to only the state-run insurers, an insurance industry
    official said that this company retains some of the risk and also
    purchases retrocessional coverage from the private market. Similarly,
    private insurers created the Elementarschadenpool, or Swiss Elemental
    Pool, to spread their natural catastrophe risk.46 A Swiss insurance
    association official said that the pool has also obtained reinsurance
    coverage for losses that exceed specified levels. As in France and Spain,
    the pool's flood losses have exceeded the losses for other natural perils,
    according to an industry report.

    The governments in Italy, Germany, and the United Kingdom do not mandate,
    provide, or financially guarantee natural catastrophe insurance. In Italy
    and Germany, coverage for natural catastrophes, such as floods, is
    optional and only available from private insurers for additional premiums.
    According to an Italian insurance supervisory official, the property of
    private citizens is generally not covered by any kind of natural
    catastrophe insurance. The official also said that some medium and
    large-sized businesses and, to a lesser extent, small businesses are
    covered against this risk in Italy. In Germany, regulatory and insurance
    officials said that coverage for a wide variety of natural catastrophes is
    generally available from private insurers in additional policies. However,
    the officials also said that few policyholders choose to purchase it and
    it may be difficult to obtain flood insurance, particularly in areas prone
    to repeated flooding. In the United Kingdom, coverage for a range of
    natural perils, including flood

    45State-run insurers established by cantonal building insurance offices
    have a monopoly on providing property insurance in 19 cantons. These
    insurers are not allowed to offer any other type of insurance (except
    state-run insurers in two cantons that are allowed to also offer contents
    insurance). According to an industry official, the state-run insurers
    offer the same natural catastrophe coverage as private insurers and charge
    the same risk premium as the private insurers. Some of the state-run
    insurers also cover earthquake risk.

    46According to a Swiss insurance industry official, private insurers
    provide building insurance in areas of the country not served by public
    insurers and provide contents insurance in the whole country.

    insurance, is generally included in standard property insurance policies;
    however, the premiums and terms of the policy reflect the property's flood
    risk. According to British insurance association officials, insurance for
    natural perils is generally available from the private market and 99
    percent of homeowners have coverage, including coverage for flood.47
    Although Italy, Germany, and the United Kingdom do not have national
    catastrophe programs, according to industry and government officials, each
    country has discussed developing such programs in recent years largely in
    the context of providing enhanced flood coverage. However, no final
    decisions had been reached at the time of our review.

    Most European Countries Have National Terrorism Insurance Programs

    Four of the six European countries we studied provide terrorism insurance
    that is backed by government guarantees (see fig. 6). Specifically,
    France, Spain, Germany, and the United Kingdom have established national
    programs in conjunction with the insurance industry to provide terrorism
    coverage. In contrast, Italy and Switzerland do not have national
    terrorism insurance programs and private companies provide the limited
    coverage that is available.

    47The insurance industry agreed to provide flood insurance in
    three-quarters of the United Kingdom's floodplains after the government
    agreed to implement certain flood prevention measures. In locations where
    the insurance industry association considers the risk of flooding to be
    unacceptably high, there may be some limitations on the availability of
    coverage, especially if no flood prevention measures are planned.

    Figure 6: Countries with a National Terrorism Insurance Program Provide a
    State Guarantee

    France, Spain, Germany, and the United Kingdom Offer State Guarantees for
    Terrorism Coverage

    Guy Carpenter, American Insurance Association, and interviews of insurance
    industry participants and insurance supervisory authority officials in
    each country; Nova Development (maps).

    In France, primary insurers that offer property insurance are required by
    law to provide terrorism insurance and coverage is generally included in
    standard insurance policies, which means that all commercial properties
    are covered. However, after the September 11 attacks, reinsurers cancelled
    terrorism coverage and many primary insurers that could not obtain
    reinsurance chose to stop offering commercial property insurance to avoid
    the mandatory terrorism coverage. According to French insurance industry
    officials, the French government responded to this situation by
    temporarily requiring the extension of all contracts, but immediately
    began negotiations with the insurance industry to develop a more permanent
    solution. The Gestion de l'Assurance et de la Reassurance des Risques
    Attentats et Actes de Terrorisme (GAREAT) pool, a nonprofit organization,

    was created based on the existing administrative structures of the
    insurance associations and the natural catastrophe program already in
    place in France.48 Completed on December 28, 2001, GAREAT was the first
    national terrorism pool organized with state support after the September
    11 attacks. In 2002, GAREAT paid two regional terrorism claims resulting
    from attacks on buildings to influence state policy totaling �7
    million (about $9.4 million). Claims in 2003 amounted to �0.25
    million (about $336,000).

    GAREAT reinsures terrorism and business interruption risks for commercial
    properties that exceed �6 million (about $8 million) in insured
    value.49 The two insurance associations in France require their members to
    participate in GAREAT. Over 100 companies participate in the pool.50
    Members of GAREAT must transfer a certain percentage of their terrorism
    risk into the pool. Insurers may charge policyholders whatever premium
    they consider appropriate, then the insurers pay 6, 12, or 18 percent of
    this premium depending on the size of the risks insured to obtain
    reinsurance coverage from the pool.51 In 2003, GAREAT earned �210
    million (about $282 million) in premiums on 80,000 policies.52 In the
    event of a terrorist act that meets the definition in the French Criminal
    Code, the French state has agreed to provide an unlimited state guarantee
    after a certain industry retention level through the end of 2006 (see fig.
    7). The unlimited state guarantee is provided through the same
    government-backed reinsurer that guarantees natural catastrophe claims,
    CCR.

    48According to a GAREAT official, GAREAT employees are on loan from their
    insurance companies. The cost of running GAREAT is 0.25 percent of the
    premium. The board is made up of representatives from insurance and
    reinsurance companies and CCR (representing the state).

    49Properties under �6 million may be ceded to the pool on a
    voluntary basis.

    50Around 70 nonlife insurance companies that are members of the two
    insurance associations are involved in the pool. Membership is optional
    for any company authorized to carry out direct insurance operations in
    France or certain other insurers that cover French industrial risks.
    Around 35 of these companies are involved in the pool.

    51A scale of reinsurance rates applies to property premiums for three risk
    categories: 6 percent for insured values under �20 million; 12
    percent for insured values between �20-50 million; and 18 percent
    for insured values above �50 million.

    52This number includes coinsurance, where two or more insurance companies
    provide partial coverage for one property. Without counting coinsurance
    policies, the estimated number of properties insured by the pool is almost
    34,000, about 74 percent of which are for policies insured for sums
    between �6-20 million.

    Figure 7: GAREAT 2004 Financing Structure Involves Insurers, Reinsurers,
    and the State

    Source: GAO analysis of information from GAREAT.

    In Spain, coverage for terrorism risk is handled in the same way as
    natural catastrophe risk-it is included in standard property insurance
    policies and all policyholders pay a premium surcharge on their primary
    insurance contracts to fund coverage for both risks.53 Spain's state-owned
    company, the Consorcio, provides policyholders direct compensation for
    terrorism losses as well as natural catastrophe losses. The state offers
    an unlimited guarantee, which has never gone into effect, if claims exceed
    the Consorcio's resources. Between 1987 and 2003, terrorism claims
    represented 9.9 percent of all losses paid by the Consorcio. The Consorcio
    is in the process of paying claims resulting from the terrorist attack on
    a Madrid commuter train on March 11, 2004. According to information from
    the Consorcio, as of January 2005, �35 million (about $47 million)
    in claims

    53Indemnification from the Consorcio is automatically linked to insurance
    policies from any primary insurance company in the market for the
    following classes: property, motor damage, theft, machinery breakdown,
    information technology, construction and assembly, business interruption,
    and personal accident. The coverage for extraordinary risks is mandatory
    for all of these classes.

                                                          Reinsurance
                                                       Industry retention

    had been paid, including benefits for deaths, permanent disability, and
    property damage.

    Germany also has a national terrorism insurance program with a state
    guarantee, although it differs from the Spanish and French programs in
    that insureds have the option of purchasing the coverage and the state
    guarantee is limited. After the September 11 attacks, most insurance
    companies excluded terrorism coverage from their commercial policies and
    the German government came under pressure from businesses as well as
    insurance companies to find a solution to the lack of terrorism insurance,
    according to insurance officials we contacted. One official said that
    industry representatives feared that German businesses were at a
    competitive disadvantage because terrorism insurance was available in
    other European countries. As a result, the German government, insurance
    industry, and business groups collaborated to form Extremus
    Versicherungs-AG (Extremus), a specialized insurance company that covers
    only terrorism risk. Extremus provides voluntary coverage for commercial
    and industrial properties and business interruption losses in Germany with
    an insured value above �25 million (about $34 million). The premium
    rate for coverage from Extremus is a standard rate based on the value of
    the property insured, with no differentiation according to risk or
    location of the property. Unlike the French and Spanish programs, the
    guarantee from the German government is capped at �8 billion (about
    $10.7 billion) and would take effect after insurers and reinsurers had
    absorbed �2.0 billion (about $2.7 billion) in losses (see fig. 8).
    The total capacity of the program therefore is �10 billion (about
    $13 billion). According to an Extremus official, the state guarantee was
    limited to 3 years, and the government will have to decide whether to
    continue the guarantee after 2005.

    Figure 8: Extremus 2004 Financing Structure Caps German Government
    Payments

                                Limited state guarantee
                                      Reinsurance
                                      Reinsurance

    Source: GAO analysis of information from Extremus.

    Demand for terrorism coverage from Extremus has been much lower than
    expected, according to Extremus officials. In the first year of business,
    Extremus had a goal of collecting �300 million (about $403 million)
    in premiums, which was increased to �500 million (about $671
    million) in the following years, but collected only �105 million in
    premiums (about $141 million). In addition, many of the contracts were
    from smaller businesses. As a result, Extremus renegotiated its
    reinsurance contracts and the level of the state guarantee was reduced in
    March 2004. Extremus originally planned to phase out the state guarantee
    by building up sufficient reserves to handle potential claims. However,
    premium income has been too low to build a substantial reserve. Extremus
    continues to struggle to meet its goals, as five large clients did not
    renew their policies in 2004. Representatives from an organization
    representing German businesses told us that several factors may have
    contributed to low demand, including

    o 	the perception of many insureds that they were at a low risk of a
    terrorism attack and that Extremus coverage would not be costeffective;

    o 	gaps in Extremus coverage (for example, Extremus only covers properties
    within Germany and excludes liability coverage); and

    o 	competition from other international insurers and reinsurers that could
    offer coverage similar to Extremus. 54

    An official from Extremus told us that the company is considering making
    changes to its underwriting based on these concerns-such as covering
    business interruption risks for subsidiaries of German companies located
    in other European Union countries if an attack occurred in one of these
    countries.

    In the United Kingdom, the Pool Reinsurance Company, Limited (Pool Re)
    provides terrorism coverage, which is similar to the French and Spanish
    programs in that the state provides an unlimited guarantee but also
    similar to the German system in that participation by insureds is
    voluntary. Pool Re was established in 1993 by the insurance market with
    support from the British government in response to restrictions on the
    availability of reinsurance following several terrorism incidents in
    London related to the situation in Northern Ireland at that time. Pool Re
    is a mutual insurance company that operates to provide reinsurance
    coverage for only commercial property damage and business interruption as
    a result of a terrorist act. While terrorism coverage is optional in the
    United Kingdom and membership in Pool Re is voluntary, Pool Re members are
    required to provide terrorism coverage to policyholders if requested, and
    members must reinsure all of their terrorism coverage with Pool Re.
    Similarly, insureds cannot select which properties in the United Kingdom
    are insured for terrorism. If they choose to purchase terrorism insurance,
    they must insure either all of their properties or none of them. According
    to one Pool Re official, this policy prevents adverse selection from
    occurring (that is, the risk that Pool Re's portfolio would include only
    the riskiest properties and not be diversified). Pool Re's rates are
    determined by geographic zone in the United Kingdom. For example, rates
    are higher for properties located in London than for properties in other
    parts of the country. Business interruption coverage is offered at a
    standard rate throughout the country. Members are free to set their own
    terrorism premiums for their underlying policies. Prior to the September
    11 attacks, Pool Re coverage was limited to acts of terrorism resulting in
    fire and explosion, according to a Pool Re official. However, after the
    September 11 attacks, reinsurers began

    54None of the pools currently in operation provide international coverage.

    excluding damage caused by perils other than fire and explosion. As a
    result, Pool Re agreed, in consultation with the U.K. Treasury, members,
    and insurance industry participants, to expand its coverage to include
    other conventional perils beyond fire and explosion and also the risk of
    nuclear, biological, and chemical attacks.

    In the event of an attack, the British government issues a certificate
    determining the event to be an act of terrorism. Coverage from Pool Re
    takes effect after members pay individual retention levels, which are
    calculated as proportions of an industrywide figure based on the degree of
    members' participation in Pool Re. For 2004, the industrywide retention
    level is -L-100 million (about $194 million).55 If the resources of Pool
    Re are exhausted, the British government provides an unlimited guarantee.
    Pool Re pays the government a premium for this guarantee and would have to
    repay the Treasury any amount received from the guarantee. This guarantee
    has never been triggered. Since 1993, Pool Re has paid a total of -L-612
    million (about $1.2 billion) and currently has about -L-1.5 billion in
    reserves (about $2.9 billion). The largest event for which Pool Re paid
    claims occurred in 1993, and resulted in payments totaling -L-262 million
    (about $509 million).

    Italy and Switzerland Have Not Italy and Switzerland do not have national
    terrorism programs, and the

    Implemented National Terrorism availability of terrorism insurance is
    limited. According to a study

    Insurance Programs	commissioned by the Organization for Economic
    Cooperation and Development (OECD), the majority of insurance policies
    covering damage to high-value properties in Italy exclude terrorism
    risk.56 The OECD report also noted that additional terrorism insurance is
    fairly restricted and very expensive. According to a Swiss insurance
    association official, terrorism risk is excluded from standard fire
    insurance policies above a certain value

    55The reinsurance cover provided to members of Pool Re is subject to an
    individual retention per event combined with an annual industrywide limit.
    The annual industrywide retention level will increase to -L-150 million in
    2005 and to -L-200 million in 2006. For the exchange rate from pounds to
    dollars, we used the daily 12 noon buying rate in New York as certified by
    the New York Federal Reserve Bank on December 6, 2004, which was 1.9423.
    This rate is quoted U.S. dollars per foreign currency unit.

    56John Cooke, "The Coverage of Terrorism Risks at the National Level,"
    Organization for Economic Cooperation and Development, Conference on
    Catastrophic Risks and Insurance, (Paris: November 2004).

    in Switzerland (set at 10 million Swiss francs or about $8.8 million).57
    Each of these countries has considered the necessity for a national
    terrorism insurance program. For example, the Italian National Insurance
    Companies Association submitted a proposal to the government in 2003 to
    create an insurance/reinsurance pool, but it was later withdrawn.

    Insurance Companies in European Countries We Studied Are Permitted to
    Establish Tax-Deductible Reserves for Future Catastrophic Events

    As of 2004, regulations, tax law, and accounting standards in the six
    European countries we reviewed allowed insurance companies to establish
    tax-deductible reserves for potential losses associated with catastrophic
    events. These tax-deductible reserves are often called catastrophe or
    equalization reserves.58 However, each country differs in the way it
    allows reserves to be set-up and used (see fig. 9).

    57For the exchange rate from Swiss francs to dollars, we used the daily 12
    noon buying rate as certified by the New York Federal Reserve Bank on
    December 6, 2004, which was 1.1381. This rate is quoted in foreign
    currency units per U.S. dollar.

    58Catastrophe reserves are generally built up over the years from premium
    income, sometimes following a prescribed formula, until a specific limit
    is reached. Catastrophe reserves are intended to be used for future
    catastrophic losses covered by current or future contracts for events such
    as nuclear accidents and terrorism. Equalization reserves are intended to
    cover random fluctuations of claim expenses for some types of insurance
    contracts such as hail insurance, using a formula based on multiyear
    claims experience.

    Figure 9: Reserve Policies in Selected European Countries

    Following are brief descriptions of each European country's approach for
    establishing and maintaining catastrophe and equalization reserves:

    o 	According to an insurance industry official, French accounting
    standards and tax law allow insurance companies to establish both
    catastrophe and equalization reserves.59 A French insurance industry
    participant told us that these reserves can be used for natural events

    59French accounting standards are a subset of the French basic business
    law, and consequently every business entity is required to comply with
    them. French business law incorporates different sources of law, such as
    European Union directives and French regulatory texts including decrees
    and regulations.

    such as storms and hail, but also for nuclear, pollution, aviation, and
    terrorism risks. The industry officials also said that under French
    accounting standards and tax law, the maximum limit on the taxdeductible
    amount that can be put into these reserves is 75 percent of the income for
    each year, provided that the total amount of the reserve does not exceed
    300 percent of annual income. The funds reserved each year are released
    after 10 years if not used. However, neither the regulator nor the French
    accounting standards provides guidance on when money can be withdrawn from
    the reserves.

    o 	German commercial law requires insurance companies to establish
    catastrophe and equalization reserves for catastrophic risk, according to
    German accounting firm officials. These officials said that catastrophe
    reserves cover losses from nuclear, pharmaceutical liability, and
    terrorism risks but cannot be used for natural catastrophes. Instead,
    insurance companies can use equalization reserves to manage losses from
    natural catastrophes. To prevent abuse of the reserves, the accounting
    firm officials said that German accounting standards contain specific
    guidance for calculating the additions, withdrawals, and limits on both
    catastrophe and equalization reserves for different lines of businesses.
    The officials also said that under German tax law, these reserves are tax
    deductible.

    o 	According to an Italian government official, the insurance supervisory
    authority in Italy requires insurance companies to establish catastrophe
    reserves for nuclear risk and natural catastrophes such as earthquakes and
    volcanic eruptions, but reserves are not permitted for terrorism risk. The
    official also said that equalization reserves are required for hail and
    other climate risks. Under Italian accounting standards and tax law, the
    government official said that catastrophe and equalization reserves are
    built through tax-deductible contributions. In addition, the official
    noted that although there are specific limits on the total amount
    companies can hold in reserve for each type of risk, currently there are
    no regulations for determining the amounts of additions and withdrawals
    for these reserves.

    o 	According to Spanish government and insurance industry officials,
    Spanish insurance regulators allow the state-owned insurer, the Consorcio,
    and private insurance companies to establish catastrophe reserves for
    catastrophic events and equalization reserves for other liability risks
    such as automobile. However, as previously discussed, the Consorcio
    effectively handles all natural catastrophe and terrorism

    risks, and therefore, insurance industry officials told us that private
    insurers do not need catastrophe reserves. According to Spanish tax law
    and accounting standards, catastrophe reserves are tax deductible and are
    accrued in the liability accounts on the balance sheet. Spanish accounting
    firm officials said that the funds in the Consorcio's catastrophe reserve
    are tax deductible to a certain limit. Once the reserved funds exceed this
    limit, they are taxed. The accounting firm officials also said that there
    is no regulation controlling the amount of funds the Consorcio has to
    maintain in its reserve and no formula for contributions to and
    withdrawals from the reserve. However, a Consorcio official told us that
    the Consorcio's general practice is to maintain an amount in reserve equal
    to three times the highest amount of claims it had ever paid in a year.

    o 	According to a Swiss accounting firm official, under Swiss tax and
    accounting standards, insurance companies are allowed to establish
    taxdeductible catastrophe reserves provided the Federal Office of Private
    Insurance (the Swiss insurance supervisory body) approves a justification
    of the reserve. The official said that currently, there are no explicit
    regulations on how the contributions, withdrawals, or total amount of
    reserves should be calculated. Instead, the Swiss supervisory body
    provides guidance on a case-by-case basis on how to increase and withdraw
    reserves. According to government officials, the insurance supervisory
    authority is currently developing new solvency standards, which include
    more explicit rules to ensure consistency and standardization in
    calculating contributions and balances of the reserves. Although Swiss tax
    and accounting standards generally allow catastrophe reserves and Swiss
    insurance companies could establish these reserves on the individual
    company level, insurance industry officials said that not many companies
    that are organized into insurance groups have them on a consolidated level
    (for example, the reserves are not included in the combined financial
    statements of an insurance group, which may have individual affiliates or
    subsidiaries in many different countries). According to the accounting
    firm official, these

    reserves would be eliminated on the consolidated level if Swiss GAAP FER
    or another internationally accepted accounting framework that prohibits
    such reserves is used.60

    o 	In the United Kingdom, the Financial Services Authority (FSA), the
    regulatory body for the financial services industry, requires insurance
    companies to establish equalization reserves for property and other types
    of insurance, according to a British accounting firm official. This
    official said that under U.K. accounting standards and tax law, these
    reserves are tax deductible and are accrued in the liability accounts of
    the balance sheet. The Interim Prudential Sourcebook for Insurers,
    published by FSA, contains detailed accounting rules for the calculation
    of the reserve, including the contributions, withdrawals, and maximum
    balances of the equalization reserves. However, the accounting firm
    official said that U.K. accounting standards do not permit a separate
    catastrophe reserve.

    In March 2004, as part of an effort to achieve global convergence of
    accounting standards, the International Accounting Standards Board (IASB)
    issued International Financial Reporting Standard 4 Insurance Contracts
    (IFRS 4), which includes guidance that effectively prohibits the use of
    catastrophe and equalization reserves.61 Under the new international
    accounting standards, loss reserves can only be accrued if the event has
    occurred and the related losses are estimable. IFRS 4 presents several
    arguments in favor of prohibiting the use of reserves for future
    catastrophic events. For example, provisions for such reserves do not
    necessarily qualify as liabilities because the losses have not occurred
    yet and treating

    60Swiss GAAP FER stands for Swiss Financial Reporting Standards of the
    Swiss Accounting and Reporting Recommendations. Internationally accepted
    accounting frameworks that prohibit such reserves include International
    Financial Reporting Standard 4 (IFRS 4) or U.S. GAAP.

    61IFRS 4 has two phases. Phase I was completed on March 31, 2004, with the
    goal of introducing improved disclosures and recognition and measurement
    practices for insurance companies, as well as providing better information
    for financial statements users. The second phase of IFRS 4 will address
    broader conceptual and practical issues related to insurance accounting
    and is currently under development. The Phase II standards will be in
    effect by 2007. IASB is an independent, privately funded accounting
    standard setter committed to developing, in the public interest, a single
    set of high quality, global accounting standards that require transparent
    and comparable information in general purpose financial statements. In
    pursuit of this objective, IASB cooperates with national accounting
    standard-setters to achieve convergence in accounting standards around the
    world.

    them as if they had could diminish the relevance and reliability of an
    insurer's financial statements. As previously mentioned, some analysts
    argue that reserves would ensure funds were available to pay claims in the
    event of a catastrophe. However, IASB argues that the general purpose of
    financial reporting is not to enhance solvency, but to provide information
    that is useful to a wide range of users for economic decisions.

    In November 2004, the European Union (EU) endorsed IFRS 4, and specified
    that only companies listed on their respective national stock exchanges,
    as well as companies with listed debt, be required to prepare their
    consolidated financial statements (for example, the combined financial
    statements of an insurance group, which may have individual affiliates or
    subsidiaries in many different countries) in accordance with IFRS 4.62
    However, the EU gives member states the option of permitting or requiring
    these individual affiliates or subsidiaries to follow IFRS 4 requirements
    in preparing their individual financial statements. EU countries also have
    the option of allowing unlisted companies to follow these standards. For
    example, according to government and Consorcio officials, Spanish
    insurance regulators have decided to exercise this option and prohibit the
    Consorcio-an unlisted company-from following IFRS 4. According to the EU
    regulation, the designated insurance companies are required to follow IFRS
    4, starting with financial statements prepared on or after January 1,
    2005.

    European officials we contacted in some cases expressed differing views on
    the elimination of catastrophe and equalization reserves under IFRS 4. A
    European Commission official indicated that European insurance companies
    should be able to cope with the elimination of catastrophe and
    equalization reserves because individual companies could still establish
    and maintain the reserves for tax purposes, but the reserves would be
    eliminated in the financial statements on a consolidated level.63 In the

    62According to EU regulation 1606/2002, all listed EU companies, as well
    as companies with listed debt, should present financial reports following
    the endorsed international accounting standards as of January 1, 2005. The
    international accounting standards were endorsed at the EU level by the
    Accounting Regulatory Committee (ARC) after recommendation from the
    European Financial Reporting Advisory Group (EFRAG).

    63The European Commission is an operating arm of the EU. It proposes
    legislation, administers policies, enforces EU law, and negotiates
    international agreements. One of the activities of the European Commission
    is to promote a single insurance market to achieve economic efficiency and
    market integration, allowing insurers to operate throughout the EU and
    establish and provide services freely.

    consolidation for financial reporting, the reserves would be moved from
    liabilities to equity. Representatives from a large German accounting firm
    said that German insurance companies would most likely prepare two sets of
    financial statements. One would exclude reserves and comply with the
    international accounting standards, and the other would include the
    reserves and be submitted to the taxation authorities, similar to U.S.
    practices.64 However, insurance industry participants in some of the
    European countries that we reviewed expressed the following concerns about
    the provision eliminating reserves:

    o 	Insurance industry officials in France stated that reserving is
    essential as a precaution for coverage of natural catastrophe risks. In
    addition, representatives from a large German accounting firm said that
    reserves provide transparency in financial reporting and help users of
    financial statements to better understand insurers' risk management
    practices.

    o 	One insurance industry representative expressed concern that having two
    sets of financial statements would result in complexities and ambiguities
    in financial reporting and national tax regulations and policies.

    o 	Other officials said they are concerned that the local taxation
    authorities might follow IFRS 4 and change their policies to discontinue
    the use of tax-deductible reserves. Insurers might have to respond by
    purchasing reinsurance in order to obtain coverage for catastrophic risks,
    which the reserves would have provided.

    As of the time of this review we were not aware of any changes in these
    countries' regulations or tax laws regarding the use of catastrophe
    reserves for tax purposes.

    Observations	The insurance industry may not be able to withstand major
    catastrophic events without federal government intervention. Although the
    industry has improved its ability to respond to the losses associated with
    natural catastrophes-at least those on the scale of the 2004 hurricane
    season- without widespread market disruptions, industry capacity has not
    yet been tested by a major catastrophe (such as an event with an expected
    annual

    64U.S. corporations prepare financial statements for tax purposes, which
    may differ from public financial statements prepared under U.S. GAAP.

    occurrence of no more than 1 percent to .4 percent). Such a catastrophe or
    series of catastrophes could result in significant disruptions to
    insurance markets. In addition, it is not clear how state governments and
    insurers would react to such a scenario, restore stability to insurance
    markets, and ensure the continued availability of critical insurance
    coverage, or whether they would have the capacity to do so. Moreover,
    because of the federal government's size and financial resources, it could
    be called upon to provide financial assistance to insurers and
    policyholders in addition to traditional obligations, such as repairing
    public facilities and providing temporary assistance to affected
    individuals.

    It is also not yet clear the extent to which the catastrophe bond market
    or authorizing insurers to establish tax-deductible reserves has the
    potential to materially enhance industry capacity and thereby mitigate
    financial risks to the federal government and others. Although several
    insurers use catastrophe bonds to address the most severe types of
    catastrophic risk, the bonds are not yet widely accepted in the insurance
    industry due to cost and other factors. In addition, some industry
    participants question the viability of the catastrophe bond market because
    no catastrophe bond has ever been triggered, even by the 2004 hurricane
    season. Further, industry participants do not consider catastrophe bonds
    feasible for terrorism risks at this time. Although supporters believe
    that authorizing tax-deductible reserves could enhance industry capacity,
    such a policy change would also reduce federal tax revenue and may not
    materially enhance capacity since the reserves may substitute for
    reinsurance.

    In response to the financial and market risks associated with natural
    catastrophes and terrorism attacks, major European countries have, with
    important exceptions, generally adopted policies that rely on national
    government intervention to enhance industry capacity to a greater extent
    than is the case in the United States. France, Spain, and to some extent
    Switzerland (but not Germany, the United Kingdom, and Italy) have adopted
    national programs to address a range of natural catastrophe risk, whereas
    the United States government does not have a comparable program (although
    it does have a flood insurance program as discussed in app. II). Further,
    all six countries we studied use their tax codes to encourage insurers to
    establish reserves for potential catastrophic events. A key similarity
    between Europe and the United States is that four of the six countries we
    reviewed have adopted national programs to address terrorism risk similar
    in many respects to TRIA. One important difference is that TRIA was
    designed as a temporary program that was expected to be discontinued when
    a private market for terrorism insurance could be

    established, whereas the European programs are generally not expected to
    be discontinued.

    European approaches to addressing natural catastrophe and terrorism risks
    illustrate benefits and drawbacks that may be useful for consideration by
    policymakers. The mandatory national programs for natural catastrophe risk
    in Spain and France, for example, help ensure that coverage is widely
    available for such risks, particularly in the wake of catastrophic events.
    However, such programs also involve significant government intervention in
    insurance markets, such as setting premium rates, which may not be
    actuarially based. Consequently, the capability of governments and
    insurers to control risk-taking by policyholders and minimize potential
    government liabilities may be limited, although some governments have
    tried to minimize this liability by implementing loss prevention programs.
    Concerning terrorism insurance, the mandatory national programs in France
    and Spain ensure that most policyholders have such coverage, although
    these programs also involve government intervention in setting premium
    rates and in monitoring risk-taking as is the case for natural catastrophe
    risk. In contrast, the purely voluntary national terrorism program in
    Germany and the private sector approaches in Switzerland and Italy have
    not yet been successful in ensuring that policyholders have terrorism
    coverage. Many policyholders choose not to purchase terrorism coverage
    because they view their risks as acceptably low or the premiums for
    terrorism coverage as too high (see app. II for a similar discussion
    regarding TRIA).

    Agency Comments and 	We provided a draft of this report to the Department
    of the Treasury and the National Association of Insurance Commissioners.
    Treasury provided

    Our Evaluation	technical comments on the report that were incorporated as
    appropriate. NAIC's Chief Financial Officer commented that the report was
    informative and accurate. In addition, we provided the relevant sections
    of a draft of this report to government and industry contacts in each of
    the European countries we studied and incorporated their comments where
    appropriate.

    As agreed with your office, unless you publicly announce the contents of
    this report earlier, we plan no further distribution of this report until
    30 days after the report date. At that time, we will provide copies of
    this report to the Department of the Treasury, the National Association of
    Insurance Commissioners, and other interested parties. We will also make
    copies

    available to others on request. In addition, the report will be available
    at no charge on GAO's Web site at http://www.gao.gov.

    If you or your staff have any questions about this report, please contact
    me at (202) 512-8678 or shearw@gao.gov or Wesley M. Phillips, Assistant
    Director, at phillipsw@gao.gov. GAO staff who made major contributions to
    this report are listed in appendix IV.

    Sincerely yours,

    William B. Shear Director, Financial Markets and Community Investment

    Appendix I

                           Objectives, Scope, and Methodology

    This report provides information on a range of issues to assist the
    committee in its oversight of the insurance industry, particularly in
    light of the Terrorism Risk Insurance Act's (TRIA) pending expiration. Our
    objectives were to (1) provide an overview of the property-casualty
    insurance industry's current capacity to cover natural catastrophic risk
    and discuss the impacts that four hurricanes in 2004 had on the industry;
    (2) analyze the potential of catastrophe bonds and permitting insurance
    companies to establish tax-deductible reserves to cover catastrophic risk
    to enhance private-sector capacity; and (3) describe the approaches six
    selected European countries-France, Germany, Italy, Spain, Switzerland,
    and the United Kingdom-have taken to address natural and terrorist
    catastrophe risk, including whether these countries permit insurers to use
    tax-deductible reserves for such events. We also provide information on
    insurers' financial exposure to terrorist attacks under TRIA and the
    extent to which catastrophe risks are not covered in the United States.
    These issues are discussed in appendix II.

    Our general methodology involved meeting with a range of private-sector
    and regulatory officials to obtain diverse viewpoints on the capacity of
    the insurance industry, status of efforts to securitize catastrophe risks,
    and the approaches taken in European countries to address catastrophe
    risk. We met with or received written responses from representatives of
    (1) the U.S. Department of Treasury; (2) the National Association of
    Insurance Commissioners (NAIC); (3) a state insurance regulator; (4) state
    catastrophe insurance and fund authorities including the California
    Earthquake Authority, Florida Hurricane Catastrophe Fund, and the Texas
    Windstorm Insurance Association; (5) national finance or economic
    ministries in Europe; (6) national insurance regulators in Europe; (7) the
    European Commission; (8) the Bermuda Monetary Authority; (9) the
    International Accounting Standards Board; (10) large insurers and
    reinsurers based in the United States, Europe, and Bermuda; (11) Citizens
    Property Insurance Corporation, (12) ratings agencies; (13) modeling
    firms; (14) law firms; (15) academics; (16) the American Academy of
    Actuaries; (17) the Insurance Services Office; (18) U.S. insurance and
    reinsurance trade associations; (19) global accounting firms; (20)
    European insurance associations and a Bermuda insurance association; (21)
    European business or property associations; (22) European catastrophe
    insurance programs; (23) the Organization for Economic Cooperation and
    Development; (24) the International Chamber of Commerce; (25) Lloyd's; and
    (26) a consumer group. We also reviewed our previous work on insurance and
    catastrophe bonds and data and reports provided by private-sector and
    European government sources. Even though we did not have audit or
    access-to-

    Appendix I
    Objectives, Scope, and Methodology

    records authority for the private-sector entities or foreign organizations
    and governments, we obtained extensive testimonial and documentary
    evidence. We also obtained estimates of the insured losses and claims
    resulting from the 2004 hurricanes from the Florida Office of Insurance
    Regulation. We obtained data on the issuance and outstanding value of the
    catastrophe bond market from Swiss Re Capital Markets. We did not verify
    the accuracy of data obtained from these organizations, but corroborated
    the information where possible with other sources. The information on
    foreign law in this report does not reflect our independent legal
    analysis, but is based on interviews and secondary sources.

    To respond to the first objective, we obtained data on insurance industry
    capacity from the Insurance Services Office and A.M. Best, the leading
    sources for data on the insurance industry. We asked these organizations
    and U.S. insurance companies, reinsurance companies, domestic and foreign
    insurance trade associations, rating agencies, state catastrophe
    authorities, and academic experts their views on insurance industry
    capacity, the difficulties of measuring insurance industry capacity, the
    implications and limitations of industry surplus data, the role of the
    Bermuda insurance market and state insurance funds and authorities in
    providing catastrophic insurance coverage, and the impact the 2004
    hurricanes had on the insurance industry in Florida, and other issues. We
    also reviewed our previous report on insurance industry capacity.

    To respond to the second objective, we asked a reinsurance company and an
    insurance broker for the latest numbers on the kinds and amounts of
    catastrophe bonds issued and outstanding. We also talked to various
    organizations about the extent to which they use or do not use catastrophe
    bonds and why, the portion of the market for catastrophe risk that is
    covered by catastrophe bonds, and other methods of transferring
    catastrophe risk. Further, we obtained information about developing
    catastrophe bonds to cover terrorism risk; regulatory, tax, and accounting
    influences on catastrophe bonds; and views on the advantages and
    disadvantages of tax-deductible catastrophe reserves. We also reviewed our
    previous reports on catastrophe bonds.

    To respond to the third objective, we interviewed representatives of
    various national, regional, international, private, and public-sector
    organizations in the six countries we studied. We gathered documentary and
    testimonial evidence on laws, regulations, and practices related to
    catastrophe insurance and catastrophe reserving in each country and
    compared and contrasted information obtained from each country. We also

    Appendix I
    Objectives, Scope, and Methodology

    interviewed international and regional organizations and asked
    representatives to assess the impact of International Accounting Standards
    on European countries' reserving policies. We did not determine the effect
    of tax-deductibility on the overall tax burden imposed on insurance
    companies in these countries, or whether the deductibility provided
    incentives to create reserves.

    We conducted our work between February 2004 and January 2005 in Florida,
    New York, Washington, D.C., Belgium, France, Germany, Spain, Switzerland,
    and the United Kingdom. Our work was done in accordance with generally
    accepted government auditing standards.

    Appendix II

    TRIA Has Limited Insurers' Financial Exposure to Terrorism Risk, but a
    Significant Portion of Catastrophic Risk Goes Uncovered

    This appendix provides information from our previous reports and other
    sources on (1) insurers' financial exposures to terrorist attacks under
    the Terrorism Risk Insurance Act (TRIA) and (2) the extent to which
    natural catastrophe and terrorism risks may be uncovered in the United
    States.

    TRIA Has Limited Insurers' Financial Exposure from Terrorist Attacks

    Congress enacted TRIA in 2002 to ensure the continued availability of
    terrorism insurance in the United States after the September 11 attacks.
    Under TRIA, the Department of the Treasury (Treasury) would reimburse
    insurers for a large share of the losses associated with certain acts of
    foreign terrorism that occur during the term of the act. TRIA caps the
    federal government's and the industry's exposure to terrorist attacks at
    $100 billion annually. TRIA also requires that all insurers selling
    commercial lines of property-casualty insurance make available coverage
    for certain terrorist events and defines make available to mean that the
    coverage must be offered for insured losses arising from certified
    terrorist events and not differ materially from the terms, amounts, and
    limitations applicable to coverage for other insured losses. The act's
    provisions are set to expire on December 31, 2005, but Congress is
    currently considering proposals to extend that date.

    Under TRIA, primary insurers have assumed responsibility for the financial
    consequences of terrorist attacks up to the levels specified in the act
    while the federal government is responsible for 90 percent of losses above
    those levels up to $100 billion annually. In 2005, primary insurers'
    financial exposure is limited to 15 percent of their direct earned
    premiums (DEP), and they are responsible for 10 percent of losses above
    that amount while the federal government is responsible for the remaining
    90 percent. Determining individual insurer's financial exposures depends
    upon varying scenarios of the potential costs associated with terrorist
    attacks (for example, to what extent the cost of the attack would exceed
    15 percent of an insurer's DEP and the insurer's 10 percent share of any
    losses beyond that amount).

    Since TRIA's make available provisions do not apply to reinsurers, these
    companies have discretion in deciding how much terrorism coverage to offer
    to primary companies. As we have previously reported, available evidence
    indicates that reinsurers have cautiously reentered the market for
    terrorism insurance and are offering coverage up to the deductible

    Appendix II TRIA Has Limited Insurers' Financial Exposure to Terrorism Risk, but
               a Significant Portion of Catastrophic Risk Goes Uncovered

    (percentage of DEP) limits and 10 percent share specified in TRIA.1
    However, we have previously reported that available evidence also suggests
    that few primary companies are buying this reinsurance to cover
    deductibles and co-pays because-as discussed next-many of their customers
    choose not to buy terrorism insurance or the primary companies consider
    reinsurance premiums to be too high.

    In the absence of TRIA, we have reported that reinsurers may not return to
    the terrorism insurance market, thereby further limiting their liability.
    Insurers we contacted stated that they cannot estimate potential losses
    from terrorism without a pricing model that can estimate both the
    frequency and severity of terrorist attacks. Reinsurance officials said
    that current models of risks for terrorist events do not have enough
    historical data to dependably forecast timing and severity, and therefore,
    are not reliable.

    Significant Percentage of Individuals and Businesses Lack Coverage for
    Some Catastrophic Events Even When Protection Is Available

    A significant percentage of individuals and businesses lack coverage for
    some catastrophic events, even though protection is available from a
    variety of sources. For example, the California Earthquake Authority (CEA)
    estimates that about 15 percent of California residents purchase
    earthquake insurance. As shown in figure 10, an Insurance Services Office
    (ISO) study found that consumers have expressed a number of reasons for
    deciding not to purchase earthquake insurance in California, including the
    beliefs that they are not at risk, premiums and deductibles are too high,
    and the federal government would provide financial assistance in the event
    of a disaster. Insurers with whom we spoke expressed similar views on why
    their customers do not purchase certain types of catastrophic coverage. We
    note that earthquake insurance is voluntary in California, whereas
    participation in the Florida Hurricane Catastrophe Fund (FHCF) is
    mandatory for Florida insurers and mortgage lenders require that
    homeowners and businesses purchase wind protection. Consequently, most
    homeowners and businesses in Florida have wind coverage.

    1See GAO-04-307.

    Appendix II TRIA Has Limited Insurers' Financial Exposure to Terrorism Risk, but
               a Significant Portion of Catastrophic Risk Goes Uncovered

                           Source: Insurance Services Office.

    Further, a significant percentage of flood risk in the United States
    remains uncovered, although, the National Flood Insurance Program was
    enacted to increase the availability of insurance for homeowners in areas
    at high risk for floods.2 The Federal Emergency Management Administration
    (FEMA), which administers the program, estimates that one-half to
    twothirds of structures in special flood hazard areas do not have flood
    insurance coverage because the uninsured owners either are unaware that
    homeowners insurance does not cover flood damage or do not perceive the
    flood risk to which they are exposed as serious. Flood insurance is
    required for some of these properties, but the level of noncompliance with
    this

    2In 1968, in recognition of the increasing amount of flood damage, the
    lack of readily available insurance for property owners, and the cost to
    the taxpayer for flood-related disaster relief, Congress enacted the
    National Flood Insurance Act (P.L. 90-448) that created the National Flood
    Insurance Program.

    Appendix II TRIA Has Limited Insurers' Financial Exposure to Terrorism
    Risk, but a Significant Portion of Catastrophic Risk Goes Uncovered

    requirement is unknown.3 However, as we have previously reported, there
    are indications that some level of noncompliance exists.4 For example, an
    August 2000 study by FEMA's Office of Inspector General examined
    noncompliance for 4,195 residences in coastal areas of 10 states and found
    that 416-10 percent-were required to have flood insurance but did not.

    Finally, despite availability of terrorism coverage due to TRIA, limited
    industry data suggest that a significant percentage of commercial
    policyholders are not buying terrorism insurance, perhaps because they
    perceive their risk of losses from a terrorist act as being relatively
    low. Limited, but consistent results from industry surveys suggest from 10
    to 30 percent of commercial policyholders are purchasing terrorism
    insurance. However, a more recent study estimates that nearly 50 percent
    of commercial property owners purchased terrorism insurance mid-2004.
    According to industry experts, many policyholders with businesses or
    properties not located near major urban centers or in possible high-risk
    locations are not buying terrorism insurance because they perceive
    themselves at low risk for terrorism and thus view any price for terrorism
    insurance as high relative to their risk exposure. Some industry experts
    are concerned that adverse selection-where those most at risk from
    terrorism are generally the only ones buying terrorism insurance-may be
    occurring. The potential negative effects of low purchase rates would
    become evident only in the aftermath of a terrorist attack and could
    include more difficult economic recovery for affected businesses without
    terrorism coverage.

    3Flood insurance is mandatory for properties in participating communities
    for the life of mortgage loans made or held by federally regulated lending
    institutions, guaranteed by federal agencies, or purchased by
    government-sponsored enterprises.

    4See GAO, Flood Insurance: Challenges Facing the National Flood Insurance
    Program, GAO-03-606T (Washington, D.C.: Apr. 1, 2003).

    Appendix III

    Tax, Regulatory, and Accounting Issues Might Have Affected the Development
    of the Catastrophe Bond Market

    This appendix describes the structure of catastrophe bonds and certain
    tax, regulatory, and accounting issues that might have affected the use of
    catastrophe bonds as described in our previous reports.1 We have also
    updated some of the information from those reports.

    As discussed in our previous reports, a catastrophe bond offering is
    typically made through a special purpose reinsurance vehicle (SPRV) that
    may be sponsored by an insurance or reinsurance company (see fig. 11).2
    The SPRV issues bonds or debt securities for purchase by investors. The
    catastrophe bond offering defines a catastrophe that would trigger a loss
    of investor principal and, if triggered, a formula to specify the
    compensation level from the investor to the SPRV. The SPRV holds the funds
    from the catastrophe bond offering in a trust in the form of Treasury
    securities and other highly rated assets. The SPRV then deposits the
    payments from the investors 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 pays investors the principal and interest that they are owed.

    1See GAO-02-941 and GAO-03-1033.

    2SPRVs are a type of special purpose entity (SPE). Companies have used
    SPEs for many years to carry out specific financial transactions.

    Appendix III Tax, Regulatory, and Accounting Issues Might Have Affected
    the Development of the Catastrophe Bond Market

                                      Source: GAO.

    Catastrophe bonds also

    o 	typically are offered only to qualified institutional investors under
    Securities and Exchange Commission (SEC) Rule 144A;

    o 	produce relatively high returns, either equaling or exceeding the
    returns on some comparable fixed-rate investments such as high-yield
    corporate debt;

    o 	typically do not receive investment-grade ratings because bondholders
    face potentially large losses on the securities; and typically cover event
    risks that are considered the lowest probability and highest severity.3

    3According to the Bond Market Association, the yields on catastrophe bonds
    have been comparable to the yields on noninvestment-grade corporate debt.

    Appendix III Tax, Regulatory, and Accounting Issues Might Have Affected
    the Development of the Catastrophe Bond Market

    Most catastrophe bonds are issued through SPRVs located offshore-in
    jurisdictions such as Bermuda-rather than in the United States. Unlike the
    United States, several of these jurisdictions exempt SPRVs from income or
    other taxes, which provides financial incentives for insurers to issue
    catastrophe bonds offshore. The National Association of Insurance
    Commissioners (NAIC) and some insurance industry groups have argued that
    insurers should be encouraged to issue catastrophe bonds onshore to lessen
    transaction costs and afford regulators greater scrutiny of SPRV
    activities. Some insurance industry groups have advocated that Congress
    change U.S. tax laws so that SPRVs would not be subject to income tax but
    instead receive "pass-through" treatment similar to that afforded
    mortgagebacked securities. In other words, the SPRV would not be taxed on
    the investment income from the trust account, and the tax would be passed
    on to the investor. Eliminating taxation at the SPRV level with
    pass-through treatment might facilitate expanded use of catastrophe bonds,
    but such legislative actions might also create pressure from other
    industries for similar tax treatment. In addition, to the extent that
    domestic SPRVs gained business at the expense of taxable entities, the
    federal government could lose tax revenue.

    Our previous reports also stated that NAIC's current statutory accounting
    requirements might affect insurers' use of nonindemnity-based financial
    instruments such as many catastrophe bonds.4 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

    4See GAO-02-941 and GAO-03-1033. NAIC is currently considering the
    appropriate accounting treatment for nonindemnity-based financial
    instruments that hedge insurance risk, which could include
    nonindemnity-based catastrophe bonds. Both exchange-traded instruments and
    over-the-counter instruments can be used to hedge underwriting results
    (that is, 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 be (referred to as "basis
    risk"). This correlation is known as "hedge effectiveness" and NAIC is
    currently considering how it should be measured. Should NAIC create a
    hedge-effectiveness measure, statutory accounting standards could be
    changed so that a fair value measure (the current quoted market price) of
    the catastrophe bond contract could be calculated and recognized as an
    offset to insurance losses, 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.

    Appendix III Tax, Regulatory, and Accounting Issues Might Have Affected
    the Development of the Catastrophe Bond Market

    that it files with state regulators.5 As a result of the risk transfer,
    the insurance company can improve its stated financial condition and 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
    bonds-and may therefore limit the appeal of these types of catastrophe
    bonds to potential issuers. Statutory accounting standards treat
    indemnityand nonindemnity-based products differently because instruments
    that are nonindemnity-based have not been viewed as providing a true risk
    transfer. Although NAIC's Securitization Working Group has approved a
    proposal that would allow reinsurance-like accounting treatment for such
    instruments, NAIC's Statutory Accounting Committee must give final
    approval. The committee met in June 2004, but has not yet made a decision
    on this issue.

    Finally, we reported in 2003 that the Financial Accounting Standards Board
    (FASB) had issued guidance under GAAP that had the potential to limit the
    appeal of catastrophe bonds.6 Specifically, under the provisions of FASB
    Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
    46), variable interest entities, which include most catastrophe bond
    structures, were subject to consolidation on issuers' financial
    statements.7 This provision had the potential to raise the costs
    associated with issuing catastrophe bonds and make them less attractive to
    issuers. Our September 2003 report stated that the impact of FIN 46 on the
    use of catastrophe bonds was unclear because insurers and financial market
    participants were not certain whether it would require insurers or
    investors to consolidate catastrophe bond assets and liabilities on their
    financial statements. In

    5NAIC establishes statutory accounting standards that may be adopted by
    states and their insurance regulators. Statutory accounting standards may
    differ from U.S. generally accepted accounting principles (GAAP).

    6See GAO-03-1033.

    7FIN 46 introduced the variable interest entity (VIE), a new term that
    encompasses most special purpose entities (SPE). A VIE is broadly defined
    as an entity that 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. Most catastrophe bond structures likely qualify as VIEs because
    most SPRVs do not meet the 10 percent equity threshold.

    Appendix III Tax, Regulatory, and Accounting Issues Might Have Affected
    the Development of the Catastrophe Bond Market

    December 2003, FASB issued FIN 46R, revised guidance that eliminated some
    of the requirements for consolidation.8 One large issuer of catastrophe
    bonds we contacted consolidated some of its SPRVs in its financial
    statements under the criteria set in FIN 46R. However, another large
    issuer decided not to consolidate any of its SPRVs after evaluation of the
    criteria set in FIN 46R.

    8The revised interpretation, FIN 46R, requires the consolidation of a VIE
    by an enterprise if that enterprise either absorbs a majority of the VIE's
    expected losses or receives a majority of the VIE's expected residual
    returns as a result of ownership, contractual, or other financial
    interests in the VIE. This enterprise is defined as a primary beneficiary
    in the guidance.

    Appendix IV

                         GAO Contacts and Staff Acknowledgments

    GAO Contacts	William B. Shear (202) 512-8678 Wesley M. Phillips (202)
    512-5660

    Acknowledgments	In addition to those named above, Patrick S. Dynes, Jill
    M. Johnson, Matthew Keeler, Wing Lam, Marc Molino, and Barbara Roesmann
    made key contributions to this report.

    Glossary of Terms

    1 in 100 year event A catastrophic event with a 1 percent chance of
    occurring annually.

    Adverse Selection	The tendency of those exposed to a higher risk to seek
    more insurance coverage than those at a lower risk.

    Balance Sheet	Provides a snapshot of a company's financial condition at
    one point in time. It shows assets, including investments and reinsurance,
    and liabilities, such as loss reserves to pay claims in the future, as of
    a certain date. It also states a company's equity, which for insurance
    companies is known as policyholder surplus. Changes in that surplus are
    one indicator of an insurer's financial standing.

    Basis Risk	The risk that the proceeds from a financial instrument-such as
    a nonindemnity based catastrophe bond-will not be related to the insurer's
    loss experience.

    Capacity	The ability of property-casualty insurers to pay customer claims
    in the event of a catastrophic event and their willingness to make
    catastrophic coverage available to their customers, particularly
    subsequent to catastrophes.

    Catastrophe	Term used for statistical recording purposes to refer to a
    single incident or a series of closely related incidents causing severe
    insured property losses totaling more than a given amount.

    Catastrophe Bonds	Risk-based securities that pay relatively high interest
    rates and provide insurance companies with a form of reinsurance to pay
    losses from a catastrophe such as those caused by a major hurricane. They
    allow insurance risk to be sold to institutional investors in the form of
    bonds, thus spreading the risk.

                                   Glossary of Terms

    Catastrophe Model	Using computers, a method to mesh long-term disaster
    information with current demographic, building, and other data to
    determine the potential cost of natural disasters and other catastrophic
    losses for a given geographic area.

    Deductible	The amount of loss paid by the policyholder. Either a specified
    dollar amount, a percentage of the claim amount, or a specified amount of
    time that must elapse before benefits are paid. The bigger the deductible,
    the lower the premium charged for the same coverage.

    Equity Capital	Equity capital, or insurers' surplus, is defined as net
    worth under the Statutory Accounting Principles (SAP) promulgated by the
    National Association of Insurance Commissioners. As such, surplus is the
    difference between assets valued according to SAP and liabilities valued
    according to SAP.

    Generally Accepted Generally accepted accounting principles (GAAP) refers
    to the

    Accounting Principles	conventions, rules, and procedures that define
    acceptable accounting practices at a particular time. These practices form
    the framework for financial statement preparation.

    Guaranty Fund	The mechanism by which solvent insurers ensure that some of
    the policyholder and third-party claims against insurance companies that
    fail are paid. Such funds are required in all 50 states, the District of
    Columbia, and Puerto Rico, but the type and amount of claims covered by
    the fund varies from state to state. Some states pay policyholders'
    unearned premiums-the portion of the premium for which no coverage was
    provided because the company was insolvent. Some have deductibles. Most
    states have no limits on workers compensation payments. Guaranty funds are
    supported by assessments on insurers doing business in the state.

    Homeowners Insurance The typical homeowners insurance policy covers the
    house, the garage, and

    Policy	other structures on the property, as well as personal possessions
    inside the house such as furniture, appliances, and clothing, against a
    wide variety of perils including windstorms, fire, and theft. The extent
    of the perils covered

                                   Glossary of Terms

    depends on the type of policy. An all-risk policy offers the broadest
    coverage. This covers all perils except those specifically excluded in the
    policy. Homeowners insurance also covers additional living expenses. Known
    as "loss of use," this provision in the policy reimburses the policyholder
    for the extra cost of living elsewhere while the house is being restored
    after a disaster. Coverage for flood and earthquake damage is excluded and
    must be purchased separately.

    Indemnity Coverage	Coverage with a simple relationship that is based on
    the insurer's actual incurred claims. For example, an insurer could
    contract with a reinsurer to cover half of all claims-up to $100 million
    in claims-from a hurricane over a specified time period in a specified
    geographic area. If a hurricane occurs where the insurer incurs $100
    million or more in claims, the reinsurer would pay the insurer $50
    million.

    Insolvency	Insurer's inability to pay debts. Insurance insolvency
    standards and the regulatory actions taken vary from state to state. When
    regulators deem an insurance company is in danger of becoming insolvent,
    they can take one of three actions: place a company in conservatorship or
    rehabilitation if the company can be saved or liquidation if salvage is
    deemed impossible. The difference between the first two options is one of
    degree-regulators guide companies in conservatorship but direct those in
    rehabilitation. Typically the first sign of problems is an inability to
    pass the financial tests regulators administer as a routine procedure.

    Institutional Investor	An organization such as a bank or insurance company
    that buys and sells large quantities of securities.

    Joint Underwriting Insurers that join together to provide coverage for a
    particular type of risk

    Association	or size of exposure, when there are difficulties in obtaining
    coverage in the regular market, and share in the profits and losses
    associated with the program.

    Moral Hazard	The incentive created by insurance that induces those insured
    to undertake greater risk than if they were uninsured, because the
    negative consequences are passed to the insurer.

                                   Glossary of Terms

    Nonindemnity Coverage	Coverage that specifies a specific event that
    triggers payment and payment formulas that are not directly related to the
    insurer's actual incurred losses. Payment could be tied to industry loss
    indexes, parametric measures such as wind speed during a hurricane or
    ground movement during an earthquake, or models of claims payments rather
    than actual claims.

    Peril	A specific risk or cause of loss covered by an insurance policy,
    such as a fire, windstorm, flood, or theft. A named-peril policy covers
    the policyholder only for the risks named in the policy in contrast to an
    all-risk policy, which covers all causes of loss except those specifically
    excluded.

    Premium	The price of an insurance policy typically charged annually or
    semiannually.

    Property-Casualty Covers damage to or loss of policyholders' property and
    legal liability for

    Insurance	damages caused to other people or their property.
    Property-casualty insurance, which includes auto, homeowners, and
    commercial insurance, is one segment of the insurance industry. The other
    sector is life/health. Outside the United States, property-casualty
    insurance is referred to as nonlife or general insurance.

    Rating Agency	Six major credit agencies determine insurers' financial
    strength and viability to meet claims obligations. They are A.M. Best Co.;
    Duff & Phelps Inc.; Fitch, Inc.; Moody's Investors Services; Standard &
    Poor's Corp.; and Weiss Ratings, Inc. Ratings agencies consider factors
    such as company earnings, capital adequacy, operating leverage, liquidity,
    investment performance, reinsurance programs, and management ability,
    integrity, and experience.

    Reinsurance	Reinsurance is insurance for insurers. A reinsurer assumes
    part of the risk and part of the premium originally taken by the primary
    insurer. Reinsurers reimburse insurers for claims paid. The business is
    global and some of the largest reinsurers are based abroad.

                                   Glossary of Terms

    Reserves A company's best estimate of what it will pay for claims.

    Retention The amount of risk retained by an insurance company that is not
                                       reinsured.

    Retrocession The reinsurance bought by reinsurers to protect their
    financial stability.

    Risk The chance of loss of the person or entity that is insured.

    Risk Management	Management of the varied risks to which a business firm or
    association might be subject. It includes analyzing all exposures to gauge
    the likelihood of loss and choosing options to better manage or minimize
    loss. These options typically include reducing and eliminating the risk
    with safety measures, buying insurance, and self-insurance.

    Securitization of Insurance Using the capital markets to expand and
    diversify the assumption of

    Risk	insurance risk. The issuance of bonds or notes to third-party
    investors directly or indirectly by an insurance or reinsurance company as
    a means of raising money to cover risks.

    Solvency	Insurance companies' ability to pay the claims of policyholders.
    Regulations to promote solvency include minimum capital and surplus
    requirements, statutory accounting conventions, limits to insurance
    company investment and corporate activities, financial ratio tests, and
    financial data disclosure.

    Statutory Accounting Accounting principles that are required by law. In
    the insurance industry,

    Principles (SAP)	these standards are more conservative than GAAP and are
    intended to emphasize the present solvency of insurance companies. SAP is
    directed toward measuring whether the company will have sufficient funds
    readily available to meet anticipated insurance obligations by recognizing
    liabilities earlier or at a higher value than GAAP and assets later or at
    a

    Glossary of Terms

    lower value. For example, SAP requires that selling expenses be recorded
    immediately rather than amortized over the life of the policy.

    GAO's Mission	The Government Accountability Office, the audit, evaluation
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