a

GAO

United States Government Accountability Office

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

GAO-05-199
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-05-199.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact William B. 

Shear at (202) 512-8678 or shearw@gao.gov.

Highlights of GAO-05-199, a 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 

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 

504

197

449

393

4.801

3.914

$7.885

4.153

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

Frances

Ivan

Charley

Jeanne

Estimated

insured losses

(dollars in billions)

Number of

claims reported

(in thousands)

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 taxdeductible 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. 
Page i GAO-05-199 Catastrophe Risk

Contents

Letter 1

Results in Brief 4

Background 8

Despite Enhancements to Insurer Capacity, Industry May Not Be 

Able to Address a Major Natural Catastrophe 10

Catastrophe Bonds and Tax-Deductible Reserves May Have the 

Potential to Enhance Insurers’ Capacity for Catastrophe Risk 25

European Countries Use a Mix of Approaches to Insure Natural 

Catastrophes, and Most Countries Studied Have National 

Terrorism Insurance Programs 31

Observations 52

Agency Comments and Our Evaluation 54

Appendixes

Appendix I: Objectives, Scope, and Methodology 56

Appendix II: TRIA Has Limited Insurers’ Financial Exposure to Terrorism 

Risk, but a Significant Portion of Catastrophic Risk Goes 

Uncovered 59

Appendix III: Tax, Regulatory, and Accounting Issues Might Have Affected 

the Development of the Catastrophe Bond Market 63

Appendix IV: GAO Contacts and Staff Acknowledgments 68

GAO Contacts 68

Acknowledgments 68

Glossary of Terms 69

Figures Figure 1: Insurance Industry Capital Levels, 1990-2003 12

Figure 2: The 2004 Hurricane Season Resulted in More Than $20 

Billion in Insured Losses in Florida 20

Figure 3: 2004 Hurricanes Did Not Trigger FHCF Payments to 

Citizens Property Insurance Corporation 21

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

2004 26

Figure 5: How Natural Catastrophe Insurance Is Covered in 

Selected European Countries 33

Figure 6: Countries with a National Terrorism Insurance Program 

Provide a State Guarantee 39
Contents

Page ii GAO-05-199 Catastrophe Risk

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

Page iii GAO-05-199 Catastrophe Risk

Abbreviations

ARC Accounting Regulatory Committee

CatNat Catastrophes Naturelles

CCR Caisse Centrale de Réassurance

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 Réassurance 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

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Page 1 GAO-05-199 Catastrophe Risk

United States Government Accountability Office

Washington, D.C. 20548

A

February 28, 2005 Letr

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 

1

Total estimated insured losses in the United States (including Alabama and other affected 

states) and the Caribbean range as high as $27 billion.

2

Property 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. 
Page 2 GAO-05-199 Catastrophe Risk

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 

3

Primary 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).

4

Defining 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.

5

See 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.
Page 3 GAO-05-199 Catastrophe Risk

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 

6

Catastrophe 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.

7

Under 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. 
Page 4 GAO-05-199 Catastrophe Risk

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 

8

See 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). 
Page 5 GAO-05-199 Catastrophe Risk

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:

• the establishment of state catastrophe authorities such as the Florida 

Hurricane Catastrophe Fund (FHCF) and the California Earthquake 

Authority (CEA);

• the establishment of stronger building codes in areas at risk for natural 

catastrophes;

• the development and use of computer programs to model insurers’ 

estimated losses from particular catastrophic scenarios and control 

exposures accordingly; 

• the implementation of higher deductibles that shift a greater share of the 

losses associated with natural catastrophes from insurers to 

policyholders; and

• 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 

9

Equity 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.
Page 6 GAO-05-199 Catastrophe Risk

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.
Page 7 GAO-05-199 Catastrophe Risk

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 
Page 8 GAO-05-199 Catastrophe Risk

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.
Page 9 GAO-05-199 Catastrophe Risk

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’ risk14GAO-02-941. 
Page 10 GAO-05-199 Catastrophe Risk

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 
Page 11 GAO-05-199 Catastrophe Risk

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.
Page 12 GAO-05-199 Catastrophe Risk

Figure 1: Insurance Industry Capital Levels, 1990-2003

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 

0

50

100

150

200

250

300

350

400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Dollars in billions

Sources: GAO analysis of ISO and AM Best data.
Page 13 GAO-05-199 Catastrophe Risk

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.
Page 14 GAO-05-199 Catastrophe Risk

State Governments and 

Insurers Have Taken Steps 

to Manage the Financial 

Consequences of Natural 

Catastrophes

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.

Florida and California 

Established Catastrophe 

Authorities to Stabilize Markets 

and Maintain or Increase 

Capacity

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.
Page 15 GAO-05-199 Catastrophe Risk

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 

Strengthened Building Codes in 

Areas at Risk for Natural 

Catastrophes 

In 1994, in the wake of Hurricane Andrew, Miami-Dade and Broward 

counties enacted a revised South Florida Building Code to ensure that 

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).
Page 16 GAO-05-199 Catastrophe Risk

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 

to Monitor Catastrophe 

Exposure and Better Manage 

Their Risk Exposures

According to insurance market participants, many, if not all, insurance 

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. 
Page 17 GAO-05-199 Catastrophe Risk

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 

Higher Deductibles to Shift a 

Greater Share of Losses from 

Insurers to Policyholders

Insurers have increased policyholder deductibles for certain natural 

catastrophe risks in risk-prone areas. For example, prior to Hurricane 

Andrew in 1992, insurers in Florida generally required homeowners to pay 

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.
Page 18 GAO-05-199 Catastrophe Risk

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.
Page 19 GAO-05-199 Catastrophe Risk

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.
Page 20 GAO-05-199 Catastrophe Risk

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 MidSized Hurricanes Striking Florida 

Rather Than One Major Storm 

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. 

Four hurricanes made landfall in the United States within a 6-week period in 2004. The storms caused an 

estimated $27 billion in insured losses in the United States and the Caribbean. As a whole, the 2004 

hurricane season is the second most expensive insurance event in U.S. history, behind the September 11, 

2001, terrorist attacks. The chart below details the impact of the four storms on Florida.

Sources: Benfield Group Limited, Florida Insurance Council, Florida Office of Insurance Regulation, Guy Carpenter, Swiss Re, and Risk

Management Solutions (map).

Charley

Frances

Ivan

Jeanne

Saffir-Simpson

Hurricane Scale

Number of

claims reported

(in thousands)

Estimated

insured losses

(in billions)

Date of

landfall

13

Aug. Sept.

5

Aug. Sept.

16

Aug. Sept.

25

Aug. Sept.

1 2 3 4 5

1 2 3 4 5

1 2 3 4 5

1 2 3 4 5

4.801

3.914

$7.885

4.153

504

197

449

393
Page 21 GAO-05-199 Catastrophe Risk

Figure 3: 2004 Hurricanes Did Not Trigger FHCF Payments to 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 

Citizens’ claims paying resources for the wind-only policies it writes in designated coastal areas include a surplus 

of $1.1 billion, an estimated $3.3 billion in FHCF recoveries, and pre-event financing in excess of $2 billion. 

Citizens also has the ability to assess the insurance industry for $750 million if it incurs a deficit. 

As with traditional reinsurance, the allocation of losses between primary insurers, such as Citizens, and 

reinsurance from FHCF depends not on the aggregate insured loss from all events, but on the insured losses 

from each event. Florida law specifies an insurance industry aggregate retention of $4.5 billion before FHCF 

coverage is triggered; however, this is distributed to each insurer based on its FHCF premium. Once insurers’ 

losses meet this specified retention level they can recover funds from FHCF up to a specified limit. Citizens’ 

individual retention level is $950 million for its coastal area wind-only policies. That is, its losses would have to 

exceed $950 million before coverage from the FHCF was triggered, and Citizens would have to pay all losses 

below this amount. 

With the occurrence of four moderately sized hurricanes, primary insurers bear a much greater proportion of the 

insured loss than reinsurers. Primary insurers, including Citizens, will have to pay losses up to their retention level 

on their FHCF coverage and private reinsurance policies, if they purchase it, for each event. As shown in the 

chart, Citizens’ losses from the wind-only policies did not meet its individual retention level for any of the 2004 

hurricanes. Since Citizens’ estimated losses from each of the four hurricanes is lower than its retention level, 

recoveries from the FHCF will not be triggered. If Citizens’ losses exceed available funding, Citizens may levy an 

assessment on the insurance industry. Since claims were still being reported and settled at the time of our 

review, Citizens was unable to predict whether it would incur a deficit for 2004, thereby needing to assess the 

industry. As of January 2005, Citizens had received over 74,000 claims from policyholders with wind-only 

coverage and estimated its losses from these claims to be approximately $1.45 billion.

Source: Citizens Property Insurance Corporation.

Citizens' FHCF Retention

Level and Potential Recoveries

FHCF recoveries

$3.3 billion

FHCF retention

$950 million

Charley

Frances

Jeanne

Ivan

543 456

253 192

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.
Page 22 GAO-05-199 Catastrophe Risk

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

Revised Building Codes May 

Have Mitigated Losses

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. 

Steps Industry Took Based on 

Catastrophe Model Estimates 

Viewed as Mitigating 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).
Page 23 GAO-05-199 Catastrophe Risk

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. 

Insurers Increased Deductibles 

to Mitigate Losses, but Multiple 

Deductibles Have Raised 

Concerns

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 That 

Specialize in Catastrophe Risk 

Are Expected to Meet Their 

Obligations from the 2004 

Hurricanes 

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 
Page 24 GAO-05-199 Catastrophe Risk

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. 
Page 25 GAO-05-199 Catastrophe Risk

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.
Page 26 GAO-05-199 Catastrophe Risk

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

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 

Dollars in millions

Source: GAO analysis of Swiss Re Capital Markets data.

1997 1998 1999 2000 2001 2002 2003 2004

4,260 4,388

2,376

1,881

1,005 878

2,898

714

0

1,000

2,000

3,000

4,000

5,000
Page 27 GAO-05-199 Catastrophe Risk

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. 
Page 28 GAO-05-199 Catastrophe Risk

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.
Page 29 GAO-05-199 Catastrophe Risk

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. 
Page 30 GAO-05-199 Catastrophe Risk

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). 
Page 31 GAO-05-199 Catastrophe Risk

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 
Page 32 GAO-05-199 Catastrophe Risk

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.
Page 33 GAO-05-199 Catastrophe Risk

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

Natural Catastrophe Programs in 

France and Spain Involve 

Mandatory Coverage, Statebacked Entities, and Unlimited 

State Guarantees

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 Réassurance 

(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 

France

National program

Catastrophes Naturelles

(CATNAT) 1982

Year started Natural catastrophes covered Program overview

Includes floods, mud slides, landslides, 

drought, earthquakes, tidal waves, and 

avalanches

All policyholders pay premium surcharge set by the 

government. Unlimited state guarantee. Insurers 

may reinsure their natural catastrophe risk with the 

state-backed reinsurer. 

Italy None N/A

Insurance for natural catastrophes is optional and 

available from private insurers for an additional 

premium.

Spain

Consorcio de 

Compensacion de

Seguros (Consorcio)

1954

Earthquakes, tsunamis, extraordinary 

floods, volcanic eruptions, atypical 

cyclonic storms, and meteorites

All policyholders pay a premium surcharge set by the 

state-run entity providing direct coverage for natural 

catastrophes. Insurers collect the surcharge and 

transfer it to the Consorcio. Unlimited state guarantee.

Switzerland Elementarschadenpool

(Elemental Pool) 1953

High waters, floods, windstorms, 

hail, avalanches, snow pressure, 

falling rocks, and landslides

All policyholders pay a premium surcharge set by 

the pool. Members of the pool transfer natural 

catastrophe losses into the pool. The pool provides 

limited coverage based on members' size.

Germany None N/A

Insurance for natural catastrophes is optional and 

available from private insurers for an additional 

premium.

United

Kingdom None N/A

N/A

N/A

N/A

Insurance for floods is generally included in 

standard property insurance policies and is 

available from private insurers.

Sources: GAO analysis based on information from the Organization for Economic Cooperation and Development (OECD),

Guy Carpenter, American Insurance Association, and interviews of insurance industry participants and insurance supervisory

authority officials in each country; Nova Development (maps).
Page 34 GAO-05-199 Catastrophe Risk

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 Compensación 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. 
Page 35 GAO-05-199 Catastrophe Risk

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.
Page 36 GAO-05-199 Catastrophe Risk

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 

Mandates Natural Catastrophe 

Coverage, It Provides No 

Government Guarantee and the 

Industry Administers Its Own 

Pool

Swiss law requires insurers to include coverage for natural catastrophes as 

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

Insurers first integrated natural catastrophe coverage into fire insurance 

policies on a voluntary basis in 1953 after severe damage caused by 

avalanches. Since it was too expensive to insure those who lived in areas at 

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.
Page 37 GAO-05-199 Catastrophe Risk

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.

National Governments in Italy, 

Germany, and the United 

Kingdom Are Not Involved in 

Natural Catastrophe Insurance

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.
Page 38 GAO-05-199 Catastrophe Risk

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. 
Page 39 GAO-05-199 Catastrophe Risk

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

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 Réassurance des Risques 

Attentats et Actes de Terrorisme (GAREAT) pool, a nonprofit organization, 

France

National

program

Gestion de

l'Assurance et

de la Reassurance

des Risques

Attentats et Actes

de Terrorisme

2002

Program overview

All acts of terrorism, based on the French Criminal 

Code, including nuclear, biological, and chemical.

Insurers transfer a proportion of their terrorism risk 

to the GAREAT pool. Unlimited state guarantee on 

reinsurance provided by CCR.

Majority of insurers are excluding terrorism from 

general coverage. Limited coverage available from 

private insurers for additional premiums.

Terrorism excluded from general coverage above 10 

million Swiss francs. Joint reinsurance coverage above 

10 million Swiss francs available in limited capacity 

through agreement between private insurers' 

association and an international group of reinsurers.

Mutual insurance company that provides its 

members reinsurance for terrorism risk. Unlimited 

state guarantee.

Year

started Definition of terrorism

Italy None N/A

All policyholders pay premium surchage, collected by 

insurers, for coverage provided by the state-owned 

Consorcio. Unlimited state guarantee. Spain

Consorcio de 

Compensacion

de Seguros

1954

Acts with social repercussions: terrorism, rebellion, 

insurrection, riots, civil commotion, acts or actions of 

the Armed Forces or Security Services in peacetime.

Switzerland None N/A

Violent acts or the threat of violence for achieving 

political, religious, ethnic, or ideological aims. The 

violent acts or threat of violence are such as to spread 

fear and anxiety among the population or sections of 

the population or exert influence on a government or 

state institutions. Does not include civil unrest.

Acts of persons acting on behalf of, or in connection 

with, any organization, which carries out activities 

directed towards the overthrowing or influencing, by 

force or violence, of the government in the UK or any 

other government de jure or de facto.

Specialized insurance company formed by insurers 

to provide terrorism coverage. Capped state 

guarantee.

Acts by persons or groups of persons committed for 

political, religious, ethnic or ideological purposes 

suitable to create fear in the population or any section 

of the population and thus to influence a government or 

public body.

Germany Extremus 2002

United

Kingdom Pool Re 1993

N/A

Sources: GAO analysis based on information from the Organization for Economic Cooperation and Development (OECD),

Guy Carpenter, American Insurance Association, and interviews of insurance industry participants and insurance supervisory

authority officials in each country; Nova Development (maps).
Page 40 GAO-05-199 Catastrophe Risk

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. 
Page 41 GAO-05-199 Catastrophe Risk

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

State

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

Unlimited state cover through CCR

400M

0

2,000M

Second layer:

Reinsurers and insurers

Third layer:

CCR/State

First layer:

Insurers

Euros

Source: GAO analysis of information from GAREAT.
Page 42 GAO-05-199 Catastrophe Risk

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. 
Page 43 GAO-05-199 Catastrophe Risk

Figure 8: Extremus 2004 Financing Structure Caps German Government Payments

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

• the perception of many insureds that they were at a low risk of a 

terrorism attack and that Extremus coverage would not be costeffective; 

Reinsurance

Reinsurance

Limited state guarantee

1,500M

2,000M

0

10,000M

Second layer: International insurers and reinsurers

Third layer:

State

First layer:

Domestic insurers

and reinsurers

Euros

Source: GAO analysis of information from Extremus.
Page 44 GAO-05-199 Catastrophe Risk

• gaps in Extremus coverage (for example, Extremus only covers 

properties within Germany and excludes liability coverage); and 

• 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.
Page 45 GAO-05-199 Catastrophe Risk

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 £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 

£612 million (about $1.2 billion) and currently has about £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 £262 million 

(about $509 million). 

Italy and Switzerland Have Not 

Implemented National Terrorism 

Insurance Programs

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

availability of terrorism insurance is limited. According to a study 

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 £150 million in 2005 and to £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).
Page 46 GAO-05-199 Catastrophe Risk

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. 
Page 47 GAO-05-199 Catastrophe Risk

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: 

• 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.

France

Standards governing

contributions and

withdrawals from 

reserve

Catastrophe and equalization reserves can be used for 

storms, hail, nuclear, pollution, aviation, and terrorism 

Overview of reserve

Sources: GAO analysis of interviews with insurance industry officials in each country; Nova Development (maps).

No

Spain

Catastrophe reserve can be used for natural 

catastrophes and terrorism risks.

Equalization reserve can be used for other liability risk 

such as automobile risk.

No

Catastrophe reserve is required for nuclear, 

pharmaceutical liability, and terrorism risks.

Equalization reserve is required for other natural 

catastrophes.

Germany Yes

Equalization reserve is required for property and other 

types of insurance. 

United

Kingdom Yes

Italy

Catastrophe reserve is required for nuclear risk and natural 

catastrophes such as earthquakes and volcanic eruptions.

Equalization reserve is required for hail and other climate

risks.

No

Switzerland

Catastrophe reserve is allowed in Switzerland for all 

types of catastrophes provided the Swiss insurance 

supervisory authority approves a justification of the 

reserve.

No
Page 48 GAO-05-199 Catastrophe Risk

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.

• 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. 

• 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. 

• 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 
Page 49 GAO-05-199 Catastrophe Risk

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. 

• 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 
Page 50 GAO-05-199 Catastrophe Risk

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

• 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.
Page 51 GAO-05-199 Catastrophe Risk

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.
Page 52 GAO-05-199 Catastrophe Risk

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: 

• 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. 

• 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. 

• 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.
Page 53 GAO-05-199 Catastrophe Risk

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 
Page 54 GAO-05-199 Catastrophe Risk

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 

Our Evaluation

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. 

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 
Page 55 GAO-05-199 Catastrophe Risk

available to others on request. In addition, the report will be available at no 

charge on GAO’s Web site at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me 

at (202) 512-8678 or shearw@gao.gov or Wesley M. Phillips, Assistant 

Director, at phillipsw@gao.gov. GAO staff who made major contributions to 

this report are listed in appendix IV.

Sincerely yours,

William B. Shear

Director, Financial Markets and

Community Investment
Page 56 GAO-05-199 Catastrophe Risk

Appendix I

Objectives, Scope, and Methodology ApApenednxidexiIs

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

Page 57 GAO-05-199 Catastrophe Risk

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

Page 58 GAO-05-199 Catastrophe Risk

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.
Page 59 GAO-05-199 Catastrophe Risk

Appendix II

TRIA Has Limited Insurers’ Financial 

Exposure to Terrorism Risk, but a Significant 

Portion of Catastrophic Risk Goes Uncovered ApendxiI

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

Page 60 GAO-05-199 Catastrophe Risk

(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. 

1

See GAO-04-307.
Appendix II

TRIA Has Limited Insurers’ Financial 

Exposure to Terrorism Risk, but a Significant 

Portion of Catastrophic Risk Goes Uncovered

Page 61 GAO-05-199 Catastrophe Risk

Figure 10: Potential Consumer Motivations in Choosing to Forego Earthquake Insurance Include Belief That They Are Not at 

Risk

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 

Earthquake

insurance

Belief that

premiums too

high or risks

too low; no

requirement

to do so; ...

Consumer motivations in forgoing earthquake insurance

• Homeowners think "it" will not happen to them.

• They focus on up-front expenses without considering long-term benefits.

• They perceive the premiums and deductibles as too high.

• They do not regard insurance and loss reduction as good investments.

• They have a "regional chauvinism" that rationalizes familiar dangers and magnifies others, so 

 they become desensitized to dangers in their own area.

• They assume the federal government will come to their aid with a relief package in the event of 

 a disaster.

• Those who do purchase earthquake coverage after a quake do not renew the insurance a year 

 or two later, because they believe the risk has passed.

• Banks do not require borrowers to purchase earthquake insurance to secure a loan.

• Insurers do not push earthquake coverage, because it appears underpriced compared with the 

 potential losses.

• Earthquake policies normally limit payments.

Source: Insurance Services Office.

2

In 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

Page 62 GAO-05-199 Catastrophe Risk

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.

3

Flood 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.

4

See GAO, Flood Insurance: Challenges Facing the National Flood Insurance Program, 

GAO-03-606T (Washington, D.C.: Apr. 1, 2003).
Page 63 GAO-05-199 Catastrophe Risk

Appendix III

Tax, Regulatory, and Accounting Issues Might 

Have Affected the Development of the 

Catastrophe Bond Market ApendxiI

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.

1

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

2

SPRVs 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

Page 64 GAO-05-199 Catastrophe Risk

Figure 11: Special Purpose Reinsurance Vehicle Structure and Payment Flows

Catastrophe bonds also

• typically are offered only to qualified institutional investors under 

Securities and Exchange Commission (SEC) Rule 144A;

• produce relatively high returns, either equaling or exceeding the returns 

on some comparable fixed-rate investments such as high-yield 

corporate debt;

• 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

Premium

Reinsurance cover

Special purpose

reinsurance vehicle

Investors

Trust

Principal and interest

Principal and investmentincome

Insurer or reinsurer

Principal

Principal

Source: GAO.

3

According 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

Page 65 GAO-05-199 Catastrophe Risk

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 

4

See 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

Page 66 GAO-05-199 Catastrophe Risk

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 

5

NAIC 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).

6

See GAO-03-1033.

7

FIN 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

Page 67 GAO-05-199 Catastrophe Risk

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.

8

The 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. 
Page 68 GAO-05-199 Catastrophe Risk

Appendix IV

GAO Contacts and Staff Acknowledgments ApendxiIV

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.
Page 69 GAO-05-199 Catastrophe Risk

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

Page 70 GAO-05-199 Catastrophe Risk

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 

Accounting Principles

Generally accepted accounting principles (GAAP) refers to the 

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 

Policy

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

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

Page 71 GAO-05-199 Catastrophe Risk

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 

Association

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

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

Page 72 GAO-05-199 Catastrophe Risk

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 

Insurance

Covers damage to or loss of policyholders’ property and legal liability for 

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

Page 73 GAO-05-199 Catastrophe Risk

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 

Risk

Using the capital markets to expand and diversify the assumption of 

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 

Principles (SAP)

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

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

Page 74 GAO-05-199 Catastrophe Risk

lower value. For example, SAP requires that selling expenses be recorded 

immediately rather than amortized over the life of the policy.

(250190)
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