Insurers' Ability to Pay Catastrophe Claims (Correspondence, 02/08/2000,
GAO/GGD-00-57R).

Pursuant to a congressional request, GAO provided information on the
insurance industry's capacity to pay natural catastrophe claims,
focusing on: (1) comparing available data on industry financial
resources to estimates of potential insured losses that would result
from natural catastrophes of various magnitudes; (2) two recent studies
of capacity; and (3) factors that may affect the stability of insurer
capacity over time.

GAO noted that: (1) the insurance industry's financial resources have
grown substantially since 1990 and are large relative to the natural
catastrophe claims estimated to arise from a single major disaster; (2)
however, not all of those resources would be available to pay claims
from any single catastrophe because individual insurance companies, not
the industry as a whole, pay disaster claims; (3) because any analysis
of insurers' capacity requires making assumptions about both the level
of their available resources and the timing, location, and size of
catastrophes, any estimate is subject to potentially serious
limitations; (4) to estimate how insurers might be affected by a
particular catastrophe, GAO compared estimates made by a catastrophe
modelling firm of potential losses from a major catastrophe in the 10
states that the firm estimated would face the largest losses in such a
catastrophe to the net worth of insurers that operate in each of those
states; (5) the results of GAO's analysis suggest that some insurers
might lose a significant share of their assets to a major catastrophe;
(6) catastrophes can disrupt insurance markets and harm insurance
companies and consumers even in cases where all claims are paid; (7)
therefore, determining whether insurance companies have resources to pay
all claims arising from a given natural catastrophe may ignore other
important aspects of insurer capacity; (8) the two recent studies of
capacity GAO reviewed found that the insurance industry as a whole,
implicitly including reinsurance, possesses the financial resources
needed to support its natural catastrophe risk; (9) one study found that
the catastrophes it modelled--a $100-billion catastrophe and a
$20-billion Florida hurricane--would cause a number of insurer
insolvencies; (10) the other study noted that it could not account for
differences in individual insurers' capital adequacy; (11) neither study
evaluated in detail the degree of insurance market disruption that a
major catastrophe might cause; (12) although it appears the insurance
industry as a whole may be able to pay for most or all claims arising
from a 1-in-100-year loss, the current level of insurer resources to pay
catastrophe claims is unlikely to be stable over time; (13) a
catastrophe loss greater than a 1-in-100-year loss or a closely spaced
series of smaller disasters could temporarily deplete insurer resources,
including the supply of reinsurance; and (14) such disasters could lead
to a larger number of insurer insolvencies, or reduce the availability
of insurance in catastrophe-prone areas of the country.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-00-57R
     TITLE:  Insurers' Ability to Pay Catastrophe Claims
      DATE:  02/08/2000
   SUBJECT:  Property damage claims
	     Comparative analysis
	     Property losses
	     Insurance companies
	     Insurance cost control
	     Insurance losses
	     Financial analysis
IDENTIFIER:  Florida
	     California
	     Hurricane Andrew
	     Northridge Earthquake

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United States General Accounting Office
GAO

GAO/GGD-00-57R

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B-284252
Page 13GAO/GGD-00-57R Insurers' Ability to Pay Catastrophe Cla
ims
B-284252

February 8, 2000

The Honorable Ed Royce
House of Representatives
 
The Honorable Paul E. Kanjorski
House of Representatives
 
The Honorable Rick Hill
House of Representatives
 
Subject: Insurers' Ability to Pay Catastrophe Claims

The Homeowners' Insurance Availability Act of 1999 (H.R. 21)
would establish a federal program to sell reinsurance1 (1) to
state government programs and (2) at auction to cover some
insured losses associated with certain natural disasters. The
bill requires that the federal program not displace or compete
with the private insurance or reinsurance markets, or compete
in the capital markets. However, conflicting claims have been
made concerning private insurers' capacity to handle such
disasters.

You asked us to evaluate current industry capacity to pay
natural catastrophe2 claims. To address this issue, we (1)
compared available data on industry3 financial resources to
estimates of potential insured losses that would result from
natural catastrophes of various magnitudes, (2) considered two
recent studies of capacity,4 and (3) evaluated factors that
may affect the stability of insurer capacity over time.

Results in Brief

The industry's financial resources have grown substantially
since 1990 and currently are large relative to the natural
catastrophe claims estimated to arise from a single major
disaster. However, not all of those resources would be
available to pay claims from any single catastrophe because
individual insurance companies, not the industry as a whole,
pay disaster claims. Because any analysis of insurers'
capacity requires making assumptions about both the level of
their available resources and the timing, location, and size
of catastrophes, any estimate is subject to potentially
serious limitations. Nevertheless, to estimate how insurers
might be affected by a particular catastrophe, we compared
estimates made by a catastrophe modeling firm of potential
losses from a major catastrophe (one that would cause a "1-in-
100-year" loss1) in the 10 states that the firm estimated
would face the largest losses in such a catastrophe to the net
worth of insurers that operate in each of those states.

The results of our analysis suggest that some insurers might
lose a significant share of their assets to a major
catastrophe. However, among other limitations, our analysis
did not take into account reinsurance or capital market
products that might be available to insurers to pay
catastrophe claims. We also did not assess the extent to which
a major catastrophe could have long-term effects on insurers
and consumers of insurance. Catastrophes can disrupt insurance
markets and harm insurance companies and consumers even in
cases where all claims are paid. Therefore, determining
whether insurance companies have resources to pay all claims
arising from a given natural catastrophe may ignore other
important aspects of insurer capacity.

The two recent studies of capacity that we reviewed found that
the insurance industry as a whole, implicitly including
reinsurance, possesses the financial resources needed to
support its natural catastrophe risk. Still, one study found
that the catastrophes it modeled (a $100-billion catastrophe
and a $20-billion Florida hurricane) would cause a number of
insurer insolvencies. The other study noted that it could not
account for differences in individual insurers' capital
adequacy. Neither study evaluated in detail the degree of
insurance market disruption that a major catastrophe might
cause.

Although it appears that the insurance industry today as a
whole may be able to pay for most or all claims arising from a
1-in-100-year catastrophe loss, the current level of insurer
resources to pay catastrophe claims is unlikely to be stable
over time. A catastrophe loss greater than a 1-in-100-year
loss or a closely spaced series of smaller disasters could
temporarily deplete insurer resources, including the supply of
reinsurance. Such disasters could lead to a larger number of
insurer insolvencies than would result from a 1-in-100-year
loss, or reduce the availability of insurance in catastrophe-
prone areas of the country. Other developments also could
shrink insurer capacity. For example, after adjusting for
taxes on realized capital gains on insurers' stock and bond
holdings, more than three-quarters of the growth in the
insurance industry's financial capital (known as surplus)
since 1995 was from capital gains. As a result, insurer
resources could change with major changes in equities prices
or interest rates.

Background

Measuring an insurer's ability to pay catastrophic losses
requires information about the financial resources the company
has available to pay claims as well as the potential losses it
may face. Some information on an insurer's resources is
available from the regulatory financial reports prepared
annually by each insurer. For example, the annual financial
statements reveal an insurer's surplus at a particular point
in time but not the value of the reinsurance that would be
recoverable in any particular catastrophe.

Measuring potential losses also requires a great deal of
information, both about the individual insurer as well as
about future catastrophes. Determining an insurer's exposure
to catastrophes requires detailed information about the
insurance that it has sold in catastrophe-prone areas. Some of
this information is proprietary, that is, known only to the
specific insurance company.

Predicting catastrophes is both difficult and imprecise.
However, to understand losses that would result from a
catastrophe, one would need to predict precisely the timing,
the severity, and the exact location of future catastrophic
events. Since this is impossible, a common strategy has been
to evaluate the industry's current ability to pay the losses
that would occur if an historical catastrophic event were to
happen today. In the past few years, another strategy has been
developed. Using sophisticated computers, advanced
mathematical modeling techniques, and very large databases
containing information on past catastrophes, population
densities, construction techniques, and other relevant
information, catastrophe modeling firms run thousands of
scenarios to predict the probable financial effects of
catastrophes. Although this science is still in its infancy,
it has the potential to be a significant improvement over
previous approaches.

Estimating the "capacity" of the insurance industry to pay
future catastrophic losses thus requires collecting and
aggregating information from several sources as well as using
assumptions to estimate elements of both total insurer
resources available and total potential losses. Because of
this, all estimates are approximations.

Moreover, comparing the total available resources of the
insurance industry to total potential catastrophe losses may,
itself, not be the best way to measure capacity. A more
thorough evaluation of the insurance industry's catastrophe
capacity would also take account of the extent to which
hypothetical disasters would erode the financial health of
insurance companies and the degree to which individual
insurers would react to those losses by restricting the supply
of insurance after the event occurs. Historically, large
natural catastrophes have disrupted insurance markets and
harmed insurers and consumers. For example, in 1992, Hurricane
Andrew caused more insured losses than any other catastrophe
in U.S. history. Even though more than $15 billion in claims
eventually were paid and few insurers became insolvent,
insurance companies then restricted the supply of certain
types of insurance-notably homeowners' insurance-in
catastrophe-prone areas. Some state government insurance and
reinsurance programs were created to (1) replace reduced
private-sector supply in catastrophe-prone areas or (2) help
to maintain that supply.

Catastrophes can affect the supply of insurance because, in
the wake of a catastrophe loss, some insurance companies'
managers may decide to reevaluate the catastrophe risk that
their firms face or should face and may stop renewing or
selling new policies in areas they perceive as prone to
catastrophes. In some cases, a firm may lose so much of its
capital to a major catastrophe that its state regulators may
require it to reduce the amount of insurance it sells to
continue to meet minimum risk-based capital levels.6

Therefore, the insurance industry's capacity to handle natural
disasters might be defined as insurers' ability to pay
catastrophe claims before unduly harming the health of the
insurance industry or consumer interests. Defining "unduly" is
challenging, of course, in part because public policy
decisions are involved, such as the weighing of insurer versus
consumer interests when insurers request rate increases in the
wake of a disaster. In general, however, catastrophe losses
that result in a greater than 20-percent reduction in surplus
are significant. Officials from A.M. Best Company, a firm that
rates the financial health of insurance companies, told us
that a single, unanticipated catastrophe loss of that
magnitude likely would trigger a review by Best of an
insurer's financial rating, which might result in a rating
downgrade-meaning that there had been a significant increase
in the probability of failure.

Scope and Methodology

To estimate the property and casualty industry's current
ability to pay claims from major natural catastrophes, we
compared data on the net assets of all property and casualty
insurance companies that operate in 10 catastrophe-prone
states to estimates of potential catastrophe losses as
determined by an independent, private, catastrophe modeling
company. We generally defined a major natural catastrophe as
one that would generate a 1-in-100-year loss. However, the
approach we used had important limitations. For example, it
did not factor in any reinsurance that insurance companies
might have held because we were not able to obtain such
information. Omitting reinsurance might lead us to
underestimate capacity. On the other hand, our analysis may
have overestimated capacity because it included the surpluses
of some firms that either were in the same corporate family7
or that do not sell property insurance.

We reviewed the two studies of capacity to determine their
methodologies, key assumptions used, and limitations. To
evaluate the factors that may affect the stability of insurer
capacity over time, we reviewed insurance industry financial
data and studies of the industry.

We shared a draft of this letter with organizations that
supplied us with data. These organizations confirmed that we
had accurately presented their information. They and the U.S.
Department of the Treasury also provided us with technical
suggestions that we incorporated where appropriate.

We did our work from October 1999 to January 2000 in
accordance with generally accepted government auditing
standards.

Insurance Industry Resources Appear to Exceed Potential Claims
From a Single Major Catastrophe

The resources available to insurance companies to pay claims
have grown substantially since 1990. Our comparison of
insurers' financial capital to catastrophe loss estimates
suggests that they probably would be able to pay all or most
claims arising from a single 1-in-100-year catastrophe loss
that strikes 1 of the 10 states we studied. However, important
limitations reduce the usefulness of the results.

Industry Resources Have Grown Substantially in the 1990s

The resources that the insurance industry has available to pay
claims arising from natural catastrophes clearly have grown
substantially in the last 10 years. They consist of insurance
companies' surpluses as well as reinsurance and capital market
products to the extent that insurance companies have
transferred some of their natural catastrophe risk to those
sources. Industry surplus has more than doubled in the 1990s,
and the amount of reinsurance that insurers buy has grown
since the mid-1990s.

Insurer Surplus

The combined surplus of all U.S. insurance companies has grown
substantially in the 1990s. According to the National
Association of Insurance Commissioners (NAIC)8 and the
Insurance Services Office, Inc. (ISO), between 1990 and 1998,
total industry surplus grew by about 140 percent in current
dollars and about 93 percent in inflation-adjusted dollars.
According to NAIC, the nominal increase was from about $177
billion in 1990 to about $427 billion in 1998, with almost all
of the growth due to an increase in the capital of existing
insurance companies, rather than from the formation of new
companies. ISO cited a smaller total industry surplus than
NAIC because ISO used information provided by A.M. Best, a
private company that rates insurance companies. A.M. Best
consolidates surplus data to avoid double counting the
surpluses of separate insurers that are part of the same
insurance group, and Best does not collect data on every
insurance company in the industry. According to ISO, between
1990 and 1998, the total consolidated industry surplus grew in
nominal terms from $138.4 billion to $333.5 billion.

In our view, growth in the entire insurance industry's surplus
is a fairly crude measure of its natural catastrophe claims-
paying capacity because the insurance industry as a whole does
not pay catastrophe insurance claims. Instead, individual
insurance companies pay claims on the basis of the damage that
particular catastrophes inflict on the properties they insure.
For any given catastrophe, only a portion of the industry's
surplus (and its other resources, such as catastrophe
reinsurance) is available to pay disaster claims.

To get a better idea of the surplus available to insurance
companies to pay natural catastrophe claims, we obtained data
from NAIC on the surpluses of property and casualty insurers
that operated in 10 catastrophe-prone U.S. states during 1990-
98. We found that the surpluses of the insurers that operated
in each of those 10 states more than doubled during this
period in nominal terms, and that insurers operating in 6
states experienced an increase of 150 percent or more.9

The state-by-state surplus figures cannot be added together
because doing so would at least partially double count insurer
surpluses since many insurers-including those with the largest
surpluses-operate in more than one state. Also, once an
insurer uses a portion of its surplus to pay claims from one
catastrophe, those resources are no longer available to pay
subsequent insurance claims in the same state or other states
where the firm insures property.

Reinsurance

Another resource that insurance companies can use to pay
natural catastrophe claims is reinsurance. Recent estimates of
reinsurance available to finance catastrophic losses indicate
that reinsurance coverage has increased significantly since
the mid-1990s. Two leading reinsurance firms estimated that
about $13 billion to $15 billion of catastrophe, excess-of-
loss10 reinsurance is in force in the United States per region
(Northeast, Southeast, Gulf states and Texas, California, and
the Midwest New Madrid fault-line states), per type of
catastrophic event. These estimates are about twice the amount
of reinsurance that they estimated was available in 1994. In
addition, these two leading reinsurance firms estimated that
an additional $5 billion to $6 billion of reinsurance capacity
is available from other forms of reinsurance11 that were not
included in the estimates. The estimates were prepared for the
Reinsurance Association of America and submitted for the
record by the Association at a hearing of the House Banking
and Financial Services Committee in July 1999.2

We could not independently verify these estimates of
reinsurance capacity because the data on which the estimates
were based are not publicly reported and are proprietary in
nature. Still, these estimates have certain limitations that
must be understood so that their meanings are not
misconstrued. First, regional figures should not be added
together to obtain multiregional or national totals. This is
because insurance companies tend to buy reinsurance to cover
some share of their catastrophe exposure regardless of where
the catastrophes occur. Therefore, a catastrophe in any one
region would reduce the amount of reinsurance available to pay
for additional catastrophes in that region or other regions.

Second, these estimates are for the value of the reinsurance
purchased by insurers, not the surpluses of the reinsurance
companies supplying the reinsurance; that is, not for the
resources that back up the reinsurance contracts. An ISO
official said that, in a major catastrophe, some reinsurance
companies might become insolvent before they fully honor their
reinsurance commitments. Therefore, the actual amount of
reinsurance that would be used to cover insurer losses in a
major catastrophe could be less than the estimates provided by
the two reinsurance companies. Finally, these estimates are
for a particular point in time. The price and availability of
reinsurance have varied widely during the last 10 years.
Nevertheless, as of January 2000 when we completed our review,
it was generally agreed that reinsurance was widely available
and that prices were low relative to historical levels.

Capital Market Products

A third financial resource-but by far the smallest-that
insurance companies can use to transfer catastrophe risk is
capital market products. These specialized products transfer
some of insurers' catastrophe risk to investors. Some sources
with whom we talked told us that the potential for using
capital market products may be great, but actual use of these
products by the insurance and reinsurance industries has been
very modest to date. For example, a few insurers have used
catastrophe bonds, which are similar to corporate bonds except
that, in the event of a catastrophe, payments of all interest
or principle can be canceled or deferred if actual catastrophe
losses pass a specified amount.

According to ISO, about $2.6 billion in catastrophe bonds have
been issued since 1994, compared to industry catastrophe
exposures in the hundreds of billions of dollars. This $2.6
billion figure somewhat overstates the amount of catastrophe
risk transferred to the capital markets because most bonds are
not multiyear bonds. Therefore, this 6-year figure does not
show the current amount of securitized catastrophe risk. In
addition, the total face value of the bonds somewhat
overstates the total amount of catastrophe risk laid-off to
the bond market because, depending on the individual terms of
the bonds, not all of the bonds' principal may be at risk.

Enclosure I provides more information on the insurance
industry's past use of capital market products to transfer
natural catastrophe risk and their future potential.

We Estimated Insurers' Ability to Pay Catastrophe Claims in 10
States

We obtained data on insurer resources from NAIC and compared
these data to estimates of potential catastrophe losses in
those states provided by a private catastrophe modeling
company. The results of our analysis suggest that insurers
likely could pay most or all claims from a single 1-in-100-
year catastrophe loss that strikes a single state. However,
some insurers might lose a substantial share of their assets
to such a disaster.

Loss Estimates

We obtained catastrophe loss estimates from two firms: EQE
International (EQE)3 and Applied Insurance Research, Inc.
(AIR).4 EQE provided estimates of expected insured property
losses for the 50 states, the District of Columbia, and Puerto
Rico for 1-in-100-year, 1-in-250-year, 1-in-500-year, and 1-in-
1,000-year losses. EQE's catastrophe model includes
earthquakes, fire following earthquakes, and windstorms with
sustained speeds of greater than 74 miles per hour. Table 1
shows EQE's estimates of the 1-in-100-year and 1-in-250-year
catastrophe losses for the 10 states that EQE estimated face
the largest 1-in-100-year losses.

Table 1: Estimated Insured Losses for 10 States for the 1-in-
100-Year and 1-in-250-Year Catastrophic Losses
Dollars in                                        
billions
Ranking among   State              1-in-100-year  1-in-250-year
the 50 statesa                    expected loss  expected loss
1               Florida                    $42.8          $71.5
2               California                  20.3           30.2
3               Texas                       11.6           19.1
4               New York                     9.8           19.1
5               Louisiana                    6.8           10.5
6,              Massachusetts                4.8            8.1
7               North Carolina               3.4            5.5
8               South Carolina               3.0            4.5
9               New Jersey                   2.8            5.2
10              Mississippi                  2.6            4.3
Notes:
(1) These estimates are for insured losses, that is, losses
paid or reimbursed by an insurance company. Other losses may
include those paid by the federal, state, or local governments
or losses retained by home or business owners through
insurance policy terms such as deductibles.
(2) State totals cannot be added.
aPuerto Rico would rank second with expected insured losses of
$27.1 billion and $44.1 billion for the 1-in-100-year and 1-in-
250-year losses, respectively.
Source: EQE International.

AIR's loss estimates, which were on a regional, rather than a
state-by-state basis, are in enclosure II.

Comparing Potential Losses to Insurer Resources

To estimate the insurance industry's capacity to pay claims
from a major natural catastrophe, we compared EQE's estimates
of potential losses in each of the 10 states that EQE
estimated to have the largest 1-in-100-year catastrophe losses
to the surpluses of the individual insurers that operated in
each of those states. We obtained, from NAIC, data on the
market share held by each insurance company in each of the 10
states, then we estimated how much surplus each firm might
lose to 1-in-100-year statewide loss by assuming that each
insurer would have to pay a proportion of those catastrophe
losses that was equal to its market share. For example, if a
company wrote 10 percent of the insurance premiums in a state
in 1998, we assumed that the company would have to pay 10
percent of any 1-in-100-year disaster loss that occurred
anywhere within that state that year. This method allowed us
to estimate roughly the financial "bite" that a major
catastrophe might have on each insurer in a state.

The results of our analysis suggest that some insurers' claims
from a single major catastrophe in a single state could be
large relative to their surplus. As table 2 indicates, in four
states (Florida, California, Texas, and New York) more than 20
percent of insurance companies might have claims that exceed
20 percent of their surpluses, the level of surplus loss from
a catastrophe that could trigger a rating review by A.M. Best
Co.

Table 2:  Proportion of Insurers in 10 States Whose Claims
Might Exceed 20 Percent of Their Surpluses in a 1-in-100-Year
Catastrophe Loss, Excluding Reinsurance
State                       Percentage of    Percentage of 1998
                                 insurers      statewide market
                       whose claims might   share of firms with
                                   exceed   claims exceeding 20
                      20 percent of their    percent of surplus
                                  surplus
Florida                             45.0 %                61.8 %
Californiaa                         30.5                 61.9  
Texas                               22.7                 48.8  
New York                            20.8                 39.3  
Louisiana                           15.0                 37.1  
Massachusetts                       11.5                 46.5  
North Carolina                       1.1                  3.2  
South Carolina                       4.0                 27.8  
New Jersey                           8.0                 24.3  
Mississippi                          7.7                 32.1  
Notes:
(1) Assumes that firms would incur losses in proportion to
their statewide market share of insurance premiums written in
1998. In reality, the effect any catastrophe would have on an
insurer would depend on the affect of that disaster on the
specific properties insured by the firm.
(2) The 10 states are those that EQE estimated would face the
largest 1-in-100-year catastrophe losses among the 50 states.
aExcludes most earthquake insurance sold in California. Most
such insurance is provided by the California Earthquake
Authority. See enclosure III for more details on this
organization.
Source: GAO calculations using EQE International loss estimate
data and NAIC surplus and premium data.

To the extent that these losses were not replaced, for
example, by reinsurance payments, some of these companies
could face serious financial difficulty. Moreover, the
insurance markets in these states could also be disrupted if
insurers reduced the number of policies they issued after the
event, as happened in the aftermath of Hurricane Andrew in
1992 and other past major catastrophes.

Table 2 also shows the statewide market shares of the
insurance companies whose claims might exceed 20 percent of
their surpluses in one major catastrophe. As the table
indicates, in some cases, these insurers had insured a
substantial share of all the insured property in the
state-more than 60 percent in Florida and California. It would
seem likely that most of these companies would offset a
portion-possibly a major portion-of those losses through
reinsurance agreements. However, if firms holding a
significant market share were impaired to this degree, then
insurance markets might be significantly disrupted in the
aftermath of such an event. Historically, many insurance
companies have sought regulators' permission to charge higher
insurance rates and/or reduce the supply of insurance they
offered in the state where a major disaster occurred.

Our Analysis Has Substantial Limitations

The above analysis suggests that, in the 10 states we studied,
most insurance companies should be able to handle a major
catastrophe, but that some firms could incur significant
financial harm in paying their claims. However, this analysis
has important limitations. In reality, the effect any
catastrophe would have on an insurer would depend on the
affect of that disaster on the specific properties insured by
the firm. Some insurers might incur large losses, while others
might not incur any losses. Our market share approach assumed
that each insurer in a state had (1) sold policies with the
same geographic distribution as every other insurer in the
state; (2) insured properties of the same value, construction,
and other characteristics as every other insurer; (3) sold
policies with the same deductible and other features as every
other insurers' policies; and (4) priced the policies it had
sold identically to every other insurer. Because these
assumptions are likely to be inconsistent with actual
experience, our analysis cannot predict which specific
insurers, if any, would have trouble paying their claims after
a catastrophe.

Our analysis has other limitations as well. Two of these
limitations may have led us to underestimate and two to
overestimate insurance companies' capacity to pay catastrophe
claims.

We Excluded Reinsurance From Our Analysis

We were unable to obtain data on individual companies'
reinsurance and, thus, could not estimate the degree to which
reinsurance companies would cover the losses that the
insurance companies would incur in a 1-in-100-year catastrophe
loss. All recoveries would increase insurers' capacity to pay
claims. As previously mentioned, we also could not determine
the total amount of catastrophe reinsurance available to the
entire insurance industry. However, two leading reinsurance
firms estimated that about $13 billion to $15 billion of
catastrophe excess-of-loss reinsurance is in force in the
United States for each region and type of catastrophic event.

We Excluded State Government Insurance Programs From Our
Analysis

In the time we had to do our work, we were unable to take into
account that state government-supported insurance or
reinsurance programs exist in two of the 10 states.5 These
programs increase the private sector's ability to handle
natural disasters because they would absorb some catastrophe
losses that private insurers or reinsurers otherwise might
have to incur. A Florida government fund provides catastrophe
reinsurance to insurance companies. In California, the
California Earthquake Authority directly provides most of the
residential earthquake insurance sold in the state. Enclosure
III provides more information on the Earthquake Authority's
role in California insurance markets.

We Analyzed the Effects of One, Single-state Catastrophe

Our analysis only considered the impact that a single
catastrophe that strikes a single state would have on insurer
surpluses. In reality, insurance companies often must deal
with catastrophes that cause damage in more than one state or
that occur within a short span of time. To the extent this
happens, our analysis overestimated capacity. In fact, EQE
estimated that the 1-in-100-year catastrophe loss for the
entire United States is $154.6 billion; that is, each year
there is a 1-percent chance that all of the catastrophes that
EQE models (earthquakes, fire following earthquakes, and
windstorms with sustained speeds of greater than 74 miles per
hour) will inflict insured losses of this magnitude in the
United States.

We Included Some Insurer Surpluses That May Not Be Available
to Pay Catastrophe Claims

The assets of an insurance firm include the value of all of
its subsidiaries, including any other insurers that it owns.
The NAIC data we used did not consolidate insurer surplus data
to take into account the surpluses of separate insurers that
are part of the same corporate family.  Therefore, some double-
counting of surpluses probably occurred. Also, we did not
obtain data that distinguished firms that sell property
insurance from those that provide solely casualty insurance.
According to an ISO official, a company that provides mainly
or exclusively casualty insurance is unlikely to incur
significant losses in a catastrophe because those policies are
not affected by a catastrophe.

Two Recent Studies Concluded That Insurers Have Sufficient
Resources to Support Their Catastrophe Exposure

The findings of two recent analyses of the U.S. property and
casualty insurance industry indicate that the industry
currently possesses the resources to pay all or most claims
from a single, major catastrophe. However, neither study
estimated the potential harm that a major disaster could
inflict on the financial health of the insurance industry and
consumers. The two studies used different approaches to
estimate capacity. A July 1999 study by the Risk and Decision
Process Center of the University of Pennsylvania's Wharton
School,6 measured the insurance industry's capacity to finance
major catastrophe property losses at 1991 and 1997
capitalization levels for both the industry as a whole and for
those insurers that did business in Florida to assess the
capacity of the industry to handle a Florida hurricane.7

The Wharton study estimated that in 1997, the insurance
industry as a whole had more than adequate capacity to pay for
the catastrophes that it studied and that capacity increased
dramatically between 1991 and 1997. However, the study also
concluded that a significant number of insolvencies would
result. According to the study, the insurance industry as a
whole in 1997 could have paid at least 99 percent of a $20
billion natural catastrophe and at least 93 percent of a $100
billion catastrophe, while the 1997 industry capacity on the
basis of 1991 capitalization levels would have been only 95
percent and 80 percent, respectively. The insurance companies
that operated in Florida in 1997 could have paid at least 99
percent of a $20 billion Florida hurricane or at least 90
percent of a $100 billion Florida hurricane, compared to 94
percent and 72 percent at 1991 capitalization levels. The
Wharton study did not specify how likely catastrophe losses of
these magnitudes were to occur. However, by way of comparison,
EQE estimated that catastrophe losses with a 1-percent
probability of occurring for the entire United States and
Florida are $154.6 billion and $42.8 billion, respectively.
The Wharton study implicitly took into account the effect that
reinsurance would have on companies' ability to pay disaster
claims because the company-by-company loss data it used to
construct its model were net of reinsurance.

The Wharton analysis also found that, even if the insurance
industry as a whole could pay all or most claims arising from
catastrophes of these magnitudes, a significant number of
insolvencies would result. For example, Wharton estimated that
(1) a $100 billion catastrophe would cause either 30 corporate
family or 136 individual insurance company insolvencies
nationwide (depending on the assumptions used) and (2) a $100
billion Florida hurricane would cause either 10 corporate
family or 34 individual insurer insolvencies. The Wharton
study concluded that these insolvencies would disrupt the
normal functioning of the insurance market, not only for
property insurance but also for other types of insurance.
However, Wharton did not discuss in detail how such
catastrophes would affect the financial health of the
remaining solvent portion of the insurance industry nor the
effect on the public of a reduced supply of insurance coverage
that could occur after the catastrophe.

Moreover, the Wharton study's model may overstate insurance
industry capacity for two reasons. First, as our analysis did,
the study assumed that the total resources of all property and
casualty insurers in the respective samples would be available
to pay catastrophic loss claims, even though some of those
companies do not write policies that likely would be triggered
by a catastrophe (such as firms that write only liability
insurance). Second, according to the Wharton study, most
catastrophes that are currently being projected by insurers
and modeling firms are localized in one or a few states and
only a subset of insurers are licensed in any given state.
Thus, the actual amount of money that would be forthcoming
from the insurance industry to fund any given catastrophic
loss would be smaller than that projected by the Wharton
analysis.

A second 1999 study8 by a catastrophe modeling firm and a
financial company also found that the insurance industry
currently has sufficient capital to support its catastrophe
risk. The study used a different methodology for estimating
capacity, however, and considered resources other than firms'
surpluses to be available to support catastrophe risk. This
"economic capital" was comprised of a company's surplus and
other sources of capital, such as unrealized gains on bond
holdings and real estate appreciation. The catastrophe model
the study used also accounted for reinsurance. The study
employed a "value-at-risk approach" in which a company's value
at risk is the amount of money it could lose under extremely
adverse circumstances. The difference between the value at
risk and the total economic capital that an insurer (and the
industry) actually possesses determines an insurer's (and
industry's) capacity.

This study found that the one-third of the insurance
industry's economic capital that is devoted to catastrophe
risk is more than sufficient to support that risk. In fact,
the study concluded that the largest risk that the industry as
a whole faces is investment risk, not catastrophe risk.9 The
study noted, however, that these observations relate to the
average industry capitalization level, and that the capital
adequacy of individual insurance companies in relation to
their catastrophe and other risks varies from firm to firm.

The Ability of Insurers to Pay Catastrophe Claims Is Unlikely
to Be Stable Over Time

Although it appears that insurance companies today may be able
to pay for most or all claims arising from a 1-in-100-year
catastrophe, insurers' current capacity may not be stable over
time. Insurance companies remain heavily exposed to
catastrophe losses despite efforts to reduce their potential
losses. A single, very large catastrophe or a series of
smaller but still costly catastrophes could temporarily
decrease insurer resources, including reinsurance. Other
events that could affect insurers' surpluses, notably a large
stock market correction or rise in interest rates, also could
reduce insurers' ability to pay catastrophe claims.

Insurers Remain Exposed to Catastrophes

The U.S. property and casualty insurance industry continues to
be vulnerable to natural catastrophe losses, despite efforts
to contain potential losses since the early 1990s. According
to the Insurance Information Institute, insurers in many
states now use percentage deductibles, rather than dollar
deductibles, to limit their exposure to catastrophic losses
from natural disasters. In addition, many insurers (1) are
limiting their homeowners insurance business in windstorm
vulnerable areas of East and Gulf coast states to reduce their
maximum loss from a major storm, and (2) have substantially
increased premiums. The Institute said that these actions have
reduced some insurers' exposure to catastrophe losses.

However, other factors have worked against these efforts to
contain insurer costs. According to ISO, the U.S. property and
casualty insurance industry incurred $99.5 billion in
catastrophe losses in 1998 dollars during the 10 years from
1989 to 1998, more than twice the $48.8 billion in 1998-dollar
catastrophe losses during the 39 years from 1950 to 1988.
Population growth and the increase in the number and value of
insured properties in areas exposed to catastrophes have
contributed to this rise in catastrophe losses. The coastal
populations of the four southeastern states that, according to
ISO, are at highest risk-Florida, Georgia, and North and South
Carolina-increased by 36 percent from 9 million in 1980 to
more than 12.2 million in 1993. Demographic projections
indicate that this growth will continue. A study by the
Insurance Research Council found that insured residential
property values along the Gulf and Atlantic states had
increased by 166 percent from 1988 to 1993, and that insured
commercial values had risen by 193 percent during the same
period.

Insurers' Ability to Pay Catastrophe Losses Depends on the
Size and Number of Previous Losses

Insurance companies' capacity to pay catastrophe claims can be
affected by the occurrence of past catastrophes. In the event
of a very large natural disaster or of multiple major
disasters, insurer resources, including reinsurance, could be
temporarily depleted. This occurred in the mid-1990s after
Hurricane Andrew and the Northridge, CA, earthquake. Hurricane
Andrew accounted for $15.5 billion in catastrophe losses in
1992 and Northridge for $12.5 billion in 1994, the two most
costly years for catastrophes. After these events, reinsurance
availability was both restricted and expensive. Consumer
access to insurance, particularly homeowners insurance, was
affected by these catastrophes and could again be affected by
other major disasters. Homeowners may experience difficulty in
obtaining insurance or may have to accept insurance with
reduced policy coverages and increased premiums.

Moreover, historically, the property and casualty insurance
business has been cyclical in nature. That is, the industry
has experienced periods of low profitability followed by
periods of improved operating results. A major catastrophe or
series of catastrophes could occur near the peak of a cycle,
when both demand for insurance and insurance premiums were
high by historical standards. According to an ISO official, in
such a case, consumers could be harmed more than if the
catastrophe were to occur during a period when insurance was
readily available and prices were low.

Insurer Capacity Is Vulnerable to Events Other Than
Catastrophes

Factors other than large catastrophes could affect insurers'
capacity to handle catastrophe losses. About 53 percent of the
growth in the insurance industry's surplus in the last 4 years
was from unrealized capital gains on insurers' bond and stock
portfolios.10 After adjusting for taxes on realized capital
gains, almost 78 percent of the growth in surplus since 1995
was from capital gains. Much of this growth has come from the
industry's holdings of common stock, which appreciated at a
compound annual rate of 20.1 percent during 1995-98. These
facts suggest that major downward changes in equities prices
could decrease the resources insurers have to pay catastrophe
losses. Rising interest rates could also affect insurer
resources adversely, since two-thirds of the industry's cash
and invested assets are in bonds and a rise in interest rates
reduces the bonds' value.11

While other indicators suggest that the insurance industry's
financial condition has improved in recent years, industry
analysts caution about the interpretation of these indicators.
According to ISO, two commonly used ratios to measure the
insurance industry's financial strength and stability, the
ratio of premiums written to surplus and the ratio of loss and
loss adjustment expense12 reserves to surplus, have steadily
declined in recent years. Both of these ratios would have a
tendency to fall as surplus increased. Other things being
equal, the lower the ratios, the more sound insurers may be.
However, ISO cautioned that the ratios also could be an
indication of inadequate premium volume or inadequate loss
reserves, rather than solely financial strength. Declines in
the industry's premium to surplus ratio may reflect increased
competition and depressed premium growth or, on the other
hand, positive operating results and growing capital.
Similarly, deterioration in the adequacy of the industry's
loss reserves may have contributed to declines in the ratio of
loss and loss adjustment expense reserves to surplus.

Conclusions

Both the surplus of insurance companies and the amount of
reinsurance they purchase have increased substantially during
recent years. However, only a portion of these resources would
be available to pay claims from any single catastrophe. Our
analysis of insurance industry data suggested that the
surpluses of insurance companies that operated in 1998 in each
of the 10 states in our review exceeded likely losses they
would incur from a single 1-in-100-year natural catastrophe.
However, a simple comparison of the industry's total resources
available to pay catastrophe claims with the estimated losses
that could result from a large catastrophe ignores the
importance of maintaining functioning insurance markets in the
aftermath.

Two recent studies we reviewed found that the insurance
industry as a whole possesses the financial resources needed
to support its natural catastrophe risk. Both studies
implicitly factored in reinsurance. However, neither study
evaluated in detail the degree of insurance market disruption
that major disasters might cause, although one study found
that a major catastrophe would cause a number of insurer
insolvencies.

The insurance industry's current capacity to pay disaster
claims is not likely to be stable over time. A major
catastrophe loss or a series of smaller disasters could
temporarily deplete insurer resources, including the supply of
reinsurance, as happened in the mid-1990s after large
catastrophes occurred in Florida and California. Other
developments also could shrink insurer capacity, such as a
major change in equities prices or interest rates that would
reduce the value of insurers' stock and bond holdings.

As agreed with your offices, we plan no further distribution
of this report until 10 days from the date of this letter
unless you publicly release its contents earlier. We will then
send copies to the Honorable Lawrence Summers, the Secretary
of the Treasury; the Honorable Jim Leach and the Honorable
John J. LaFalce, Chairman and Ranking Minority Member of the
House Committee on Banking and Financial Services; the
Honorable Rick A. Lazio and the Honorable Barney Frank,
Chairman and Ranking Minority Member of the Housing and
Community Opportunity Subcommittee of the House Committee on
Banking and Financial Services; and George Nichols, III,
President of NAIC. We will also make copies available to
others upon request.

Please contact me or Lawrence D. Cluff on (202) 512-8678 if
you or your staff have any questions. Key contributors to this
report are acknowledged in enclosure IV.

Richard J. Hillman
Associate Director, Financial Institutions
 and Markets Issues
_______________________________
1Reinsurance is insurance for insurance firms. Under a
reinsurance contract, in return for a share of the premium it
collects, an insurer is able to transfer a portion of its risk
to a reinsurance entity, which, in turn, is obligated to
reimburse the insurance company for an agreed-upon share of
covered losses.
1The Insurance Services Office, Inc., a company that provides
information on the insurance industry, defines a catastrophe
as an event that causes at least $25 million in insured
property losses and affects a significant number of property
and casualty insurers and policyholders. Although some
catastrophes are not nature-related (e.g., riots), this report
focuses on natural catastrophes.
1The U.S. insurance industry can be divided into (1) an
accident, life, and health insurance industry and (2) a
property and casualty (liability) insurance industry.  This
report deals with the property and casualty insurance industry
only.
1The studies are (1) Can Insurers Pay for the "Big One?"
Measuring the Capacity of the Insurance Market to Respond to
Catastrophic Losses (Wharton School, University of
Pennsylvania), July 14, 1999; and (2) P&C RAROC: A Catalyst
for Improved Capital Management in the Property and Casualty
Industry (Risk Management Solutions, Inc., and Oliver, Wyman,
and Company), Fall 1999.
1A 1-in-100-year loss is the most costly natural disaster
expected to occur in a century. Stated another way, a
catastrophe that would generate a 1-in-100-year loss has a 1-
percent annual probability of occurring. A 1-in-100-year
catastrophe loss could occur more or less than once in a
century but would be expected to occur on average only once
during such a period.
1Under risk-based capital, an insurance company must maintain
a minimum level of capital to support all of the risks it
assumes, including any catastrophe risk. In most cases,
insurers voluntarily maintain higher capital levels than
required. However, when an insurer's capital approaches its
minimum risk-based capital level, state insurance regulators
have the authority to intervene in the company's operations to
ensure that adequate capital is maintained. Regulatory action
may be required even if an insurer is solvent from an
accounting perspective.
1The assets of an insurance firm include the value of all of
its subsidiaries, including any other insurers that it owns.
Because the data we used did not consolidate surplus data to
take into account the surpluses of separate insurers that are
part of the same corporate family, some double-counting of
surpluses is likely to have occurred.
1NAIC is a membership organization of state insurance
commissioners.
1The states are Florida (152 percent), California (145
percent), Texas (156 percent), New York (157 percent),
Louisiana (147 percent), Massachusetts (155 percent), North
Carolina (157 percent), South Carolina (150 percent),
Mississippi (128 percent), and New Jersey (141 percent).
1Under an excess-of-loss reinsurance contract, the insurer
pays the amount of each claim for each risk up to a limit
determined in advance, and the reinsurer pays the amount of
the claim above the limit to a specific sum.
1Other forms of reinsurance include facultative, proportional,
and treaty. Facultative reinsurance involves the reinsurance
of all or part of an individual risk. Under proportional
reinsurance, the reinsurer shares losses in the same
proportion as it shares premium and policy amounts with the
insurer. Treaty reinsurance is an agreement between an insurer
and reinsurer that covers a class or classes of business.
2"Statement," Franklin W. Nutter, Reinsurance Association of
America, before the Committee on Banking and Financial
Services, U. S. House of Representatives, July 30, 1999.
3The Internet address for EQE is as follows:
http://www.eqe.com.
4The Internet address for AIR is as follows: http://www.air-
boston.com.
5These states are Florida and California.  Also, Hawaii has a
state government fund to pay hurricane claims of residential
policyholders.
6Can Insurers Pay for the "Big One?" Measuring the Capacity of
the Insurance Market to Respond to Catastrophic Losses
(Wharton School, University of Pennsylvania), July 14, 1999. A
copy of the study may be found at
http://fic.wharton.upenn.edu/fic/wfic/riskinfo.html.
7Insurers doing business in Florida represent almost 80
percent of the total industry equity, according to the Wharton
study. Therefore, the capacity of the Florida sample to
withstand Florida hurricanes is close to the entire industry's
capacity to do so.
8P&C RAROC: A Catalyst for Improved Capital Management in the
Property and Casualty Industry (Risk Management Solutions,
Inc., and Oliver, Wyman, and Company), Fall 1999. A copy of
the study may be found at
http://www.riskinc.com/rms/products/consulting/pcraroc/.
9Investment risk is the variability in the value of an
insurer's assets due to changes in the market price of
securities or changes in interest rates that would affect the
value of an insurer's bond holdings and thus its capital.
10Unrealized capital gains are the appreciation in the value of
unsold assets plus an offset for the capital gains realized on
assets sold during the period.
11Even recent increases in interest rates have had some effect
on the value of insurers' assets and surplus. Sharper
increases could potentially have major consequences.
12Loss adjustment expense is the cost involved in an insurance
company's adjustment of losses under a policy. That is, they
are additional expenses related to the claim settlement
process, including the fees paid for defending insureds
against third-party claims.

Enclosure 1
The Insurance Industry's Use of Capital Market
Products to Manage Catastrophe Risk
Page 22GAO/GGD-00-57R Insurers' Ability to Pay Cat
astrophe Claims
Since the early 1990s, the insurance industry has
to a limited extent increased its capacity to pay
natural disaster claims by using new, specialized
products that transfer some of insurers' natural
catastrophe risk to the capital markets. Use of
these products-catastrophe bonds, swaps, options,
and contingent surplus notes-has been limited for
a variety of reasons. One reason has been that the
price of reinsurance, which is the main
alternative to these capital market products, has
dropped substantially since it peaked in 1993.
Some experts believe that, eventually, use of
capital market insurance products will take off
and substantially increase the insurance
industry's capacity to handle large natural
disasters. However, it is unclear how quickly the
many perceived cost, legal, regulatory, and other
barriers to increased use of these instruments
will be overcome.

Efforts to Develop an Alternative to Catastrophe
Reinsurance
In the aftermath of Hurricane Andrew in 1992, the
price of traditional catastrophe reinsurance
increased substantially, and its supply contracted
sharply, which led the insurance industry to
search for alternatives to the traditional
reinsurance of catastrophe risk. The price of
reinsurance has been falling since its peak in
1993, as a result of several factors, including
increased retention (i.e., deductible) levels,
reduced exposure, and competition. However, one
analyst estimated that the price of catastrophe
reinsurance, adjusted for changes in retention and
exposure, is still above pre-Hurricane Andrew
levels.

The search for new capacity has led to the
creation of new financial products to transfer
insurance risks. These new products include
securities and derivatives. Insurance securities,
such as catastrophe-linked bonds, are created by
the process of securitization. This process
creates tradable securities that are
collateralized by a pool of assets that are not,
in and of themselves, readily tradable. An
emerging insurance derivatives1 market has
accompanied the insurance securitization market.
This market comprises swap transactions and the
catastrophe options traded on exchanges, such as
the Chicago Board of Trade (CBOT). These new
financial products have the effect of turning
insurance risks into securities and derivatives
that investors can include in an investment
portfolio with traditional assets, such as stocks
and bonds.

Catastrophe Bonds
Catastrophe bonds are similar to corporate bonds
except that when a catastrophe occurs, there can
be a cancellation or deferment of some or all
payments of interest or principal if catastrophe
losses surpass a specified amount, or trigger
level. When that happens, the insurer or reinsurer
can pay claims with the funds that would otherwise
have gone to the bondholders. The assets backing a
catastrophe bond issue consist of a pool of one or
more reinsurance contracts and any contract
collateral. However, in the event of large
underwriting losses to the reinsurance contracts
in the pool, bondholders are exposed to the loss
of some or all of their investment, depending on
the structure of the pool.

Although a primary insurer can issue catastrophe
bonds directly to investors, many catastrophe
bonds are issued by a separate company, known as a
special purpose vehicle. The primary insurer
places reinsurance contracts or pools of contracts
with this special purpose vehicle, which is
established in a convenient domicile for the
specific purpose of writing the contracts and
lasting until they expire. The special purpose
vehicle then issues catastrophe bonds to investors
and, in turn, sells reinsurance to the originating
insurers. This structure has several advantages
for the primary insurer. For example, the credit
risk underlying the bond is independent from that
of the insurer. This independence can increase the
bond's marketability. In addition, the primary
insurer can account for the bond obligation as
traditional reinsurance, thereby removing risk
from its balance sheet. Many special purpose
vehicles are incorporated in the Cayman Islands
and Bermuda to obtain optimal tax benefits.

In 1994, insurance companies began issuing
catastrophe bonds; however, most issues were not
very successful due to the lack of time to fully
educate investors about how to price the
underlying risk. In 1997, when rating agencies
began rating the bonds, the United Service
Automotive Association, a Texas-based insurer,
issued catastrophe bonds totaling $477 million,
the largest single securitized risk transfer to
date. The offer was oversubscribed in the market
primarily because the bonds were rated. By rating
catastrophe bonds, the rating agencies have
assisted investors in evaluating the underlying
risk and comparing this risk with other
noncatastrophe bond offerings. Investment banks
now consider a rating essential for large bond
transactions. From 1994, through December 1999,
about $2.6 billion in catastrophe bonds have been
issued. However, this figure somewhat overstates
the amount of catastrophe risk transferred to the
capital markets because most bonds are not
multiyear bonds. Therefore, this 6-year figure
does not show the current amount of securitized
catastrophe risk. In addition, the total face
value of the bonds somewhat overstates the total
amount of catastrophe risk laid-off to the bond
market because, depending on the individual terms
of the bond, not all of the bond's principal may
be at risk.

Over-the-counter Catastrophe Swaps
Swaps are a financial contract used to transfer
risks between two parties. In a catastrophe
insurance swap insurers may exchange policies from
one region of the country for policies in another
region. Each swap is a reciprocal agreement
between the two insuring entities. Swapping
policies allows insurers to diversify their
portfolios. If an insurer has a concentrated book
of business in a catastrophe-prone area, it can
swap a portion of that business for a book of
business in an area where it is less exposed to
the same risk. In an alternative swap approach, an
insurance company can exchange a series of fixed
predefined payments for a series of floating
payments whose values depend on the occurrence of
an insured catastrophic event. That is, if a
catastrophic event occurs, the insurance company
receives a higher cash flow from the floating
payment stream, which helps pay the claim
settlements. Swap instruments offer several price
advantages over catastrophe bonds and generally
are easier to conduct.

Exchange-traded Catastrophe Instruments
Catastrophe index options contracts have been
trading at the CBOT since 1992. Exchange-traded
options allow insurers to tailor their risk
exposure using the capital markets, without the
issuance of securities. Catastrophe options track
the industry catastrophic loss results during a
specified time period and allow companies to
insure themselves against a self-determined level
of loss. To facilitate trading, these contracts
are standardized in terms of the regions and
states covered and in the period during which the
losses must occur. Insurers can adjust their risk
exposures in different regions by buying contracts
covering risk in a region where they prefer to
reduce exposure and investing in contracts
covering risk in regions where they prefer to
increase exposure. Generally, exchange-traded
catastrophe options differ from reinsurance and
cash-flow swaps in that they are more standardized
and backed by the credit of the exchange, rather
than the credit of the reinsurer or swap
counterparty. The value of these options is
determined on the trading floor. Trading in CBOT
options has been slow.

Another initiative includes the Catastrophe Risk
Exchange (CATEX), which began operation as a
reinsurance intermediary in 1996. CATEX is
essentially an electronic bulletin board on which
insurance companies (CATEX subscribers) can list
risks that they want to cede or to swap against
other risks. However, in contrast to the trading
with insurance derivatives on the CBOT, there is
no direct flow of additional capacity from the
financial markets into the insurance industry
through the CATEX exchange. There is an increase
in the surplus available to pay claims from a
catastrophe because more insurance companies bear
the risk. Increased risk diversification occurs
through the swap so the insurance industry's risk
capital is used more efficiently.

By April 1998, use of CATEX catastrophe options
contracts by the insurance industry was
negligible. One disadvantage of catastrophe
options compared with traditional reinsurance is
the difference in tax deductibility. Insurers can
deduct reinsurance premiums from their taxable
income, immediately lowering their income tax
bills.2 However, insurers cannot deduct the cost
of buying standardized catastrophe options until
they calculate their capital gains or losses when
the options settle.

Contingent Surplus Notes
Contingent surplus notes are instruments that give
the insurer the right to issue notes in the future
at preset terms to investors in exchange for cash
or liquid assets. The contingent part of the
surplus note is that the investors agree to accept
the surplus notes not when the deal is struck, but
when a particular event, such as a catastrophic
event, occurs. Under Statutory Accounting
Practices, surplus notes are added to an insurer's
net worth or surplus. In general, an insurer needs
a regulator's approval to issue surplus notes and
to make related payments of interest and
principal. Insurers can use the proceeds from
issuing surplus notes to pay catastrophe losses or
for any other purpose. Surplus notes generally
oblige the issuer to repay the funds on a fixed
schedule. As a result, these transactions do not
transfer risk since catastrophe event losses are
still borne by the company and its equity holders.
Contingent surplus notes are basically debt
instruments that for regulatory purposes may be
treated as capital.3 Only a few companies have
issued contingent surplus notes.

Future Trends in Insurance Securitization
Research on future trends in the use of insurance
securitization and derivative products has been
minimal, and the results are often conflicting.
For example, in 1996, on the basis of calculations
in a portfolio optimization model and a survey of
investment banks and potential investors, a large
reinsurer (Swiss Re) estimated that in the long
term, capital markets would provide $30 billion to
$40 billion in additional capacity to cover
catastrophe risks.4 The study emphasized that
success in the short term will require that
potential investors have a clear understanding of
the pricing process. In contrast, 86 percent of
insurance executives polled in 1997 by New York's
Insurance Information Institute, a trade group,
said that selling insurance risks to investors in
the financial markets would prove to be a fad.  In
addition, a Harvard University business school
professor suggested that there are structural
shortcomings slowing the entry of capital markets
into the insurance business, such as the need to
standardize and package investor risk so it does
not have to be analyzed repeatedly.5

Several factors that may influence the future use
of insurance securitization include:

ï¿½    A principal barrier to increased insurance
 securitization is the cost of catastrophe
 reinsurance, currently low by historical
 standards. This situation could change rapidly,
 however, since pricing in the reinsurance market
 is extremely cyclical--premiums for the same risks
 can vary substantially as has occurred over the
 past several years.
 
ï¿½    Insurers issuing catastrophe bonds faced high
transaction costs because of the complexity of a
securitization transaction and the need to provide
significant amounts of information to multiple
investors. Transaction costs, however, are
declining. For the initial issuances of
catastrophe bonds, investment bankers were
charging fees of up to 75-basis points6 and legal
expenses of up to $1 million. Banking fees for
recent securitizations have dropped to about 25
basis points, and legal expenses are at or below
$100,000 per issue.7
ï¿½    Some investors are not confident that they
understand how to analyze and price insurance and
reinsurance risk. Since 1997, rating agencies have
begun to rate insurance risk securities. By
translating the scale of insurance risks into
their bond market equivalent, the rating agencies
have played a crucial part in helping investment
banks and other arrangers open up a substantial
investor base. However, even with comparable
ratings, investors still require higher yields on
catastrophe bonds than on noncatastrophe bonds.
According to a 1997 report, the yields on
catastrophe bonds have been 3 to 4 percentage
points more than on comparably rated
noncatastrophe bonds. However, as investors have
become more confident in evaluating catastrophe
bond risk, the spread between yields on
catastrophe bonds and other comparably risky
noncatastrophe bonds has narrowed.
ï¿½    The development of computer modeling of
natural catastrophes and the growing understanding
of catastrophe risk among institutional investors
are increasing market capacity.
ï¿½    Catastrophe bonds permit portfolio
diversification across all financial assets, since
the occurrence of a catastrophe is independent of
economic conditions.
ï¿½    Perceived regulatory, accounting, and tax
barriers may deprive many potential users of the
benefits of insurance securitization. For example,
only three states have expressly addressed an
insurance company's authority to engage directly
in exchange-traded insurance derivatives.8 In each
of these jurisdictions, such authority has been
limited to hedging transactions. Furthermore, the
National Association of Insurance Commissioners
(NAIC) does not treat catastrophe contracts like
reinsurance for accounting purposes. To alleviate
some of these regulatory and accounting barriers
and gain certain tax advantages, many insurers
have used offshore special purpose vehicle
reinsurers for insurance securitization. In
response, and to encourage more onshore insurance
securitization, NAIC has adopted a Special Purpose
Vehicle Model Act that would allow insurers to
create protected cells that function
semiautonomously within a company to retain
favorable tax and accounting advantages while
protecting investors from losses incurred by the
parent company. The Model Act would serve as a
model for laws that individual states could enact
to allow creation of protected cells by insurers.
In the long run, the growth momentum of insurance
derivatives and securitized catastrophe risks will
not evolve independently from future catastrophe
events and the general investment environment.
Securitizing catastrophe risk will succeed only if
the transactions give insurers a more cost-
effective means of financing catastrophe risk
while enhancing the performance of investors'
portfolios.

_______________________________
1 Derivatives are financial products whose value
is determined from an underlying reference
(interest rates, foreign currency exchange rates);
index (reflects the collective value of various
financial products); or asset (stocks, bonds, or
commodities).  Derivatives can be (1) traded
through central locations, called exchanges, where
buyers and sellers, or their representatives, meet
to determine prices or (2) privately negotiated by
the parties off the exchanges or over the counter.
2 Financing Catastrophe Risk: Capital Market
Solutions, Insurance Services Office, Inc.,
January 1999, p. 5.
3 The Evolving Market for Catastrophic Event Risk,
Marsh & McLennan Securities Corp., August 1998, p.
13.
4 "Insurance Derivatives and Securitization: New
Hedging Perspectives for the U.S. Catastrophe
Insurance Market?", Swiss Re, Sigma No. 5/1996, p.
3.
5 Cited in reprinted article from National
Underwriter: Property  & Casualty/Risk & Benefits
Management Edition, January 20, 1997.
6 A basis point is 1/100th of a percentage point.
7 "Beyond Catastrophes," Best's Review: Property &
Casualty, April 1999, p. 76.
8 Statement of Sylvia Bouraux, Chicago Board of
Trade, House Banking Committee, April 23, 1998, p.
4.

Enclosure II
Regional Catastrophe Loss Estimates by Applied
Insurance Research, Inc.
Page 24GAO/GGD-00-57R Insurers' Ability to Pay Cat
astrophe Claims
We asked Applied Insurance Research, Inc. (AIR), a
catastrophe modeling company, to provided
estimates of insured losses that would result from
natural catastrophes of various types and
magnitudes in six U.S. regions (Alaska was
excluded).  The estimates are shown in table II.1.
The types of disasters included in the estimates
are combined losses from earthquake, fire
following earthquake, hurricanes, hailstorms,
tornadoes, and straight-line wind.  The magnitudes
are expressed in terms of loss-return periods,
which are the time spans within which a single
catastrophe loss of a given size is expected to
occur.

As the table shows, expected catastrophe losses
for the 1-in-100-year return period range from
$2.8 billion in the 13-state Great Plains region,
to $35.2 billion for the 5-state Gulf region that
includes both Florida and Texas. The West region,
which includes California, had a $31.2 billion 1-
in-100-year expected loss.

Table II.1:  Estimated Insured Losses for
Different Return Periods for Six U.S. Regions
Dollars in                                  
billions
Rank among                                          
the six            States              1-in-     1-in-
U.S.       Region  comprising    100-year   250-year
regionsa          region                   
                               expected   expected
                              loss       loss
1          Gulf    AL, FL, LA,       $35.2     $47.3
                 MS, TX
2          West    AZ, CA, HI,        31.2      44.6
                 ID, NV, OR,
                 UT, WA
3          Northea CT, DE, MD,        12.0      21.6
          st      ME, MA, NH,
                 NJ, NY, PA,
                 RI, VT,
                 Washington,
                 D.C.
4          Southea GA, NC, SC,         7.3       9.4
          st      VA, WV
5          New     AR, IL, IN,         4.8      13.3
          Madrid  KY, MO, OH,
                 TN
6          Great   CO, IA, KS,         2.8       3.6
          Plains  MI, MN, MT,
                 NE, NM, ND,
                 OK, SD, WI,
                 WY
Notes
(1) Regions are ranked according to losses
expected for a 1-in-100-year catastrophe loss.
(2) Includes losses from earthquake, fire
following earthquake, and windstorms.
(3) These estimates are for insured losses; that
is, losses paid or reimbursed by an insurance
company.  Other losses may include those paid by
federal, state, or local governments or losses
retained by home or business owners through policy
terms, such as deductibles.
(4) Alaska is not included in any of the regions
because none of the perils are modeled for Alaska.
The estimate for Hawaii does not include
earthquakes.
(5) Region totals cannot be added to generate a
countrywide number.
aA Caribbean region comprising Puerto Rico and the
U.S. Virgin Islands would rank fourth among U.S.
regions with estimated 1-in-100-year and 1-in-250-
year insured losses of $8.6 billion and $12.8
billion, respectively.
Source: Applied Insurance Research, Inc.

     AIR also provided estimates for the 1-in-500-
year and 1-in-1,000-year return period, and the
largest possible loss that the company modeled.
AIR estimated that 1-in-500-year losses ranged
from $4.6 billion for the Great Plains region to
$57.9 billion for the West region.  Expected
losses for the 1-in-1,000-year loss ranged from
$5.2 billion for the Great Plains region to $84.4
billion for the West region.  The largest single
natural catastrophe loss modeled by AIR was a
$227.9 billion loss in the West region.  Finally,
AIR provided countrywide estimates for the perils
modeled.  The countrywide estimates were $47.3
billion for the 1-in-100-year loss and $70.8
billion for the 1-in-1,000-year loss.

     An NAIC official told us that loss estimates
made by catastrophe modeling firms sometimes vary
widely.  The estimates provided to us by AIR and
another catastrophe modeling firm, EQE
International (EQE), show some variation.
Notably, EQE's estimate of $42.8 billion for the 1-
in-100-year loss for Florida exceeds AIR's
estimate of $35.2 billion for the 1-in-100-year
loss for the entire Gulf region, which includes
Florida and four other states.  Part of this
variation is due to differences in the types of
catastrophes the two firms model.

Enclosure III
California Earthquake Authority
Page 26GAO/GGD-00-57R Insurers' Ability to Pay Cat
astrophe Claims
After paying a large number of claims that
resulted from the 1994 Northridge, CA, earthquake,
many insurance companies stopped selling
homeowners' insurance or notified existing
policyholders that their insurance would not be
renewed. The California Earthquake Authority (CEA)
was established by law in 1996 to address the
homeowners' insurance availability crisis
following the earthquake by offering residential-
only earthquake insurance policies through
insurers that joined the CEA program. The
legislation also capped potential liability for
losses under the program for those companies that
elected to participate in the program.

A governing board comprising elected officials or
their designees administers the CEA. No public
funds are available to pay for losses incurred by
CEA policyholders, although the Authority,
according to the CEA's Chief Executive Officer,
has tax-exempt status on both the state and
federal levels. The funds available to pay claims
come from premiums, contributions from
participating insurance companies, and reinsurance
purchased by the CEA. The CEA's insurance coverage
is significantly less than the insurance coverage
that was available in the California market before
the Northridge earthquake-the basic policy
includes higher deductibles, reduced coverage, and
higher premiums. As a result, policyholders will
be responsible for more of the costs associated
with earthquake damage. In addition, some costs
may be transferred to the federal government
through the tax exemption and federal disaster
relief.

The CEA's enabling legislation required that
insurers representing at least 70 percent of the
state's homeowners' earthquake insurance market
agree to participate in the CEA program. Insurers
representing approximately 72 percent of the
market initially joined in the program by January
1997. The participating insurers were required to
make an initial capital contribution totaling
approximately $717 million that was based on their
individual shares of the residential earthquake
insurance market. The insurers are also subject to
two additional, one-time assessments that cap
their maximum contingent liability for CEA claims
payments at about $3.6 billion. According to
information provided by CEA representatives, the
Authority's claim-paying capacity consists of
several sources of funding.

ï¿½    Working capital.  This layer consists of the
 initial insurance companies' contributions,
 policyholder premiums, and income from
 investments. By law, the working capital must be
 maintained at no less than $350 million.
 
ï¿½    Assessment on participating insurers.  The
first assessment on insurers would be made in the
event that CEA's available capital falls below the
$350 million minimum level. This assessment is
limited to $2.15 billion, and CEA's authority to
make the assessment is to be eliminated after 12
years.
ï¿½    Reinsurance. CEA has obtained reinsurance
providing for $1.433 billion coverage in excess of
the working capital and the first assessment on
participating insurers.
ï¿½    Debt financing.  This layer provides for $717
million in additional funding in the event that
the previous levels were exhausted.
ï¿½    Reinsurance.  A second layer of reinsurance
provides an additional $1.075 billion in claims-
paying capacity.
ï¿½    Finally, in the event all previous funding
layers are expended, the CEA can assess
participating insurers up to $1.434 billion to pay
outstanding claims and/or return the CEA's capital
to the $350 million minimum. The amount of this
assessment is to be gradually reduced if the CEA's
available working capital exceeds $6 billion. In
the event that loss claims exceed all layers of
available funding, outstanding claims payments
would be prorated.
The CEA, as a state-run catastrophe insurance
program, would have access to the reinsurance
contracts that would be available under H.R. 21.
CEA representatives told us that while the
Authority has not taken a formal position on the
bill, any federal involvement in providing
catastrophe reinsurance should not interfere with
the private sector's ability to handle
catastrophes. In this respect, these officials
said that the trigger points of such a reinsurance
program should be set high enough (perhaps at a 1-
in-250-year rather than at the 1-in-100-year loss)
to prevent this. The representatives said the CEA
has been successful in obtaining the reinsurance
coverage that it needs.  The initial reinsurance
placement of $2 billion was purchased at a rate
that was somewhat less than initially estimated.
Since then, CEA has renewed coverage at
substantially reduced rates primarily because both
it and the reinsurance industry have been
profitable in recent years. Moreover, indicative
of the current excess capacity in the catastrophe
reinsurance market, CEA, in 1999, received offers
for more reinsurance coverage than it required.

Enclosure IV
GAO Contacts and Staff Acknowledgements
Page 29GAO/GGD-00-57R Insurers' Ability to Pay Cat
astrophe Claims
GAO Contacts
Richard J. Hillman (202) 512-8678
Lawrence D. Cluff (202) 512-8678

Acknowledgments
     In addition to the persons named above, David
Genser, Thomas Givens, and John Strauss made key
contributions to the report.

*** End of Document ***