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
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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 [email protected] or Wesley M. Phillips, Assistant
Director, at [email protected]. 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.

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