United States General Accounting Office 

GAO Report to Congressional Requesters 

September 2003 CATASTROPHE 

INSURANCE RISKS 

Status of Efforts to 

Securitize Natural 

Catastrophe and 

Terrorism Risk 

GAO-03-1033


a
Highlights of GAO-03-1033, a report to the 

Chairman, House Committee on Financial 

Services, the Chairman, Subcommittee on 

Capital Markets, Insurance, and 

Government Sponsored Enterprises, and 

House Members 

In addition to potentially costing 

hundreds or thousands of lives, a 

natural or terrorist catastrophe in 

the United States could place 

enormous financial demands on the 

insurance industry, businesses, and 

taxpayers. Given these financial 

demands, interest has been raised 

in bonds that are sold in the capital 

markets and thereby diversify 

catastrophe funding sources. GAO 

was asked to update a 2002 report 

on “catastrophe bonds” and assess 

(1) their progress in transferring 

natural catastrophe risks to the 

capital markets, (2) factors that 

may affect the issuance of 

catastrophe bonds by insurance 

companies, (3) factors that may 

affect investment in catastrophe 

bonds, and (4) the potential for and 

challenges associated with 

securitizing terrorism-related 

financial risks. 

GAO does not make any 

recommendations in this report. 

www.gao.gov/cgi-bin/getrpt?GAO-03-1033. 

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Davi M. 

D'Agostino at (202) 512-8678 or 

dagostinod@gao.gov. 

September 2003 

CATASTROPHE INSURANCE RISKS 

Status of Efforts to Securitize Natural 

Catastrophe and Terrorism Risk 

The market for catastrophe bonds, as discussed in our 2002 report, has 

transferred a small portion of natural catastrophe risk to the capital markets. 

From 1997 through 2002, a private firm has estimated that a total of 46 

catastrophe bonds were issued or about 8 per year. Another firm estimated 

that the nearly $3 billion in catastrophe bonds outstanding for 2002 (see 

figure) represented 2.5 to 3.0 percent of the worldwide catastrophe 

reinsurance market. Some insurance and reinsurance companies issue 

catastrophe bonds because they allow for risk transfer and may lower the 

costs of insuring against the most severe catastrophes. However, other 

insurers do not issue catastrophe bonds because their costs are higher than 

transferring risks to other insurers. Although some investors see catastrophe 

bonds as an attractive investment because they offer high returns and 

portfolio diversification, others believe that the bonds’ risks are too high or 

too costly to assess. To date, no catastrophe bonds related to terrorism have 

been issued covering potential targets in the United States, and the general 

consensus of most experts GAO contacted is that issuing such securities 

would not be practical at this time due in part to the challenges of predicting 

the frequency and severity of terrorist attacks. 

Catastrophe Bond Issuance and Amount Outstanding (1997-2002) 

Dollars in millions 

3,000 2,943 

2,500 

2,000 

1,500 

1,000 

500 

0 

1997 1998 1999 2000 2001 2002 

Year 

69 

714 

306 

1,031 

725 

305 

825 

804 

1,122 

1,454 

967 

1,953 

990 

1,130 

1,926 

2,421 

783 

Issued Outstanding from prior years 

Source: GAO, based on data provided by Swiss Re Capital Markets. 

Note: Totals shown in bold above each bar represent the amount outstanding at end of year. 
Contents


Letter
 1 

Results in Brief 4 

Background 7 

Catastrophe Bond Issuance Has Been Limited 14 

Catastrophe Bonds Benefit Some Insurers, but Others Believe That 

the Bonds’ Costs Are Too High 18 

Institutional Investors Provided Mixed Views on Catastrophe 

Bonds 27 

Securitizing Terrorism Risk Poses Significant Challenges 30 

Observations 34 

Agency Comments and Our Evaluation 35 

Appendixes 

Appendix I: 

Appendix II: 

Appendix III: 

Appendix IV: 

Appendix V: 

Appendix VI: 

Appendix VII: 

Appendix VIII: 

Objectives, Scope, and Methodology 

Statutory Accounting Balance Sheet Implications of 

Reinsurance Contracts 

FASB Interpretation No. 46, Consolidation of Variable 

Interest Entities 

What is a VIE? 

Texas Windstorm Insurance Association 

Comments from the National Association of Insurance 

Commissioners 

GAO Comments 

Comments from the Bond Market Association 

GAO Comments 

Comments from the Reinsurance Association of America 

GAO Comments 

GAO Acknowledgments and Staff Contacts 

GAO Contacts 

Acknowledgments 

38 

40 

43 

43 

45 

47 

50 

51 

59 

61 

68 

70 

70 

70 

Related GAO Products 71


Figures Figure 1: Traditional Insurance, Reinsurance, and Retrocessional 

Transactions 8 

Figure 2: Reinsurance Prices in the United States, 1989-2002a 10 

Page i GAO-03-1033 Catastrophe Bond Follow-up 
Contents 

Figure 3: Special Purpose Reinsurance Vehicle 11 

Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002 15 

Figure 5: Catastrophe Bond Issuance and Amount Outstanding 

1997-2002 16 

Figure 6: Type of Catastrophe Bond Issuer 1997-2002 17 

Figure 7: Residential Reinsurance Issuances 18 

Figure 8: Effect on Ceding and Reinsurance Companies’ Balance 

Sheets before and after a Reinsurance Transaction 41 

Figure 9: Texas Windstorm Insurance Authority Financing 46 

Abbreviations 

BMA Bond Market Association


CDO Collateralized Debt Obligation


CEA California Earthquake Authority


DEP Direct Earned Premium


FASB Financial Accounting Standards Board


FHCF Florida Hurricane Catastrophe Fund


FIFA Federation Internationale de Football Association 


LIBOR London Interbank Offered Rate


NAIC National Association of Insurance Commissioners


RAA Reinsurance Association of America


S&P Standard & Poors


SEC Securities and Exchange Commission


SPE special purpose entity


SRPV special purpose reinsurance vehicle


TRIA Terrorism Risk Insurance Act


TWIA Texas Windstorm Insurance Association


USAA United Services Automobile Association


VIE variable interest entities


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Page ii GAO-03-1033 Catastrophe Bond Follow-up 
Page 1 GAO-03-1033 Catastrophe Bond Follow-up 

A

United States General Accounting Office 

Washington, D.C. 20548 

September 24, 2003


The Honorable Michael G. Oxley 


Chairman, Committee on Financial Services


House of Representatives


The Honorable Richard H. Baker 

Chairman, Subcommittee on Capital Markets, 

Insurance, and Government Sponsored Enterprises 

House of Representatives 

The Honorable Steve Israel 

The Honorable Brad Sherman 

The Honorable Dave Weldon 

House of Representatives 

In addition to potentially costing hundreds or thousands of lives, a natural 

or terrorist catastrophe in the United States could place enormous financial 

demands on the insurance industry, businesses, and taxpayers. According 

to insurance industry estimates, a major hurricane striking densely 

populated regions of the United States could result in losses as high at $110 

billion, a major earthquake could cause losses as high as $225 billion, and 

both types of events would generate serious financial difficulties for some 

insurance companies. Further, the September 11, 2001, terrorist attacks 

resulted in an estimated $80 billion in losses—about half of which was 

insured----and another large scale attack or series of attacks has the 

potential for similar results. With the passage of the Terrorism Risk 

Insurance Act of 2002 (TRIA), the federal government assumed potential 

liability of $100 billion in terrorism-related losses annually (until the act 

expires in 2004, but may be extended through 2005).1 

Given the enormous financial losses associated with such catastrophes and 

concerns about the capacity of the insurance industry to cover 

1

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, insurers, and policyholders share the risk of loss. The federal 

government is responsible for paying 90 percent of each insurer's primary property and 

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. 

Page 1 GAO-03-1033 Catastrophe Bond Follow-up 
catastrophes without dramatic increases in premium prices or reductions 

in coverage, interest has been generated in transferring some of these risks 

to the capital markets, which had a total value of about $29 trillion as of the 

end of the first quarter of 2003.2 Since the mid-1990s, some insurance 

companies, reinsurance companies, and capital market participants have 

developed financial instruments called risk-linked securities that transfer 

various insurance-related risks to the capital markets. The largest category 

of these instruments are called catastrophe bonds and, due to their size in 

the marketplace, are the subject of this report.3 Risk-linked securities---­

such as catastrophe bonds—can offer a relatively high rate of return to 

investors who are willing to accept some of the substantial financial risks 

associated with such disasters. Last year we reported on the risks of 

natural catastrophes; the structure of risk-linked securities—particularly 

catastrophe bonds; and regulatory, accounting, tax, and investor factors 

potentially affecting the use of such securities.

4 

Because of your continuing concerns about the potential costs to the 

federal government associated with natural and terrorist catastrophes and 

interest in diversifying the potential funding sources to cover such risks, 

you asked that we update our 2002 report. Specifically, you asked that we 

(1) assess the progress of catastrophe bonds in transferring natural 

catastrophe risks to the capital markets; (2) assess factors that may affect 

the issuance or sponsorship of catastrophe bonds by insurance and 

reinsurance companies, including a status report on accounting issues 

raised in our previous report; (3) assess factors that may affect investment 

2

This figure represents the value of U.S. Treasury securities, agency securities, municipal 

securities, corporate and foreign bonds, and corporate equities as of March 31, 2003. The 

source is the Federal Reserve Flow of Funds data. 

3

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. 

4

See U.S. General Accounting Office, Catastrophe Insurance Risks: The Role of RiskLinked Securities and Factors Affecting Their Use, GAO-02-941 (Washington, D.C.: Sept. 

24, 2002) and U.S. General Accounting Office, Catastrophe Insurance Risks: The Role of 

Risk-Linked Securities, GAO-03-195T (Washington, D.C.: Oct. 8, 2002). These products 

focused primarily on catastrophe bonds but also mentioned other risk-linked securities. 

Page 2 GAO-03-1033 Catastrophe Bond Follow-up 
in catastrophe bonds, and (4) analyze the potential for and challenges 

associated with securitizing terrorism-related financial risks.5 

During our follow-up work, we contacted representatives from primary 

insurance companies and reinsurance companies, investment banks that 

underwrite catastrophe bonds, rating agencies, hedge funds that purchase 

catastrophe bonds, large mutual fund companies, accounting firms, firms 

that model natural catastrophe and terrorism risk, a state insurance 

regulator representing the National Association of Insurance 

Commissioners (NAIC), and state natural catastrophe authorities in Texas 

and California.6 We obtained data on the financial risks associated with 

natural catastrophes and terrorism as well as the issuance of catastrophe 

bonds from 1997 to 2002. We did not test the reliability of data we obtained 

from the private sector. We asked officials whom we contacted to provide 

their views on the development and potential of the market for catastrophe 

bonds. We conducted our work between March and August 2003 in New 

York, Massachusetts, Ohio, Illinois, Pennsylvania, Texas, and Washington, 

D.C. A more extensive discussion of our scope and methodology is in 

appendix I. 

5

The financial industry has developed instruments through which primary financial 

products, such as lending or insurance, can be funded in the capital markets. Lenders and 

insurers continue to provide the primary products to the customers, but these financial 

instruments allow the funding of the products to be “unbundled” from the lending and 

insurance business; instead, the funding comes from securities sold to capital market 

investors. This process, called securitization, can give insurers access to the resources of 

the capital markets. 

6

Primary insurance companies can purchase insurance for some or all of their risks from 

reinsurance companies. Additionally, reinsurance companies can purchase insurance for 

some or all of their risks from other insurance companies (a process known as 

retrocessional coverage). In the securitization process, ratings agencies, such as Standard & 

Poors, Moody’s, and Fitch, typically assign ratings to securities that are sold to the public or 

in private placements. 

Page 3 GAO-03-1033 Catastrophe Bond Follow-up 
Results in Brief	 Private sector data indicate that the market for catastrophe bonds, as 

discussed in our 2002 report, has to date transferred a small portion of 

insurers’ natural catastrophe risk to the capital markets. According to 

Marsh and McLennan Securities, from 1997 through 2002, 46 catastrophe 

bonds were issued (about 8 per year).7 According to Swiss Reinsurance 

Company (Swiss Re) Capital Markets, there were nearly $3 billion in 

catastrophe bonds outstanding at the end of 2002. Swiss Re also estimated 

that outstanding catastrophe bonds represented about 2.5 to 3.0 percent of 

worldwide catastrophe reinsurance coverage in 2002.8 

Although catastrophe bonds played an important role for some insurance 

companies and reinsurance companies, representatives from other 

insurers and financial market participants said that the costs associated 

with the bonds and other factors have limited their use.9

 Some insurance 

and reinsurance companies used catastrophe bonds as a supplement to 

traditional approaches to managing natural catastrophe risks--such as 

reinsurance and limiting coverage in high-risk areas. Representatives from 

one insurance company also told us that the bonds lower the costs 

associated with providing coverage for the most severe types of 

catastrophic risks.10 However, representatives from two large insurance 

companies we contacted, two state authorities that offer natural 

catastrophe coverage, and financial market participants said that the total 

7

Our previous report stated that there had been some 70 risk-linked securities issued by 

August 2002. We report a lower number this time because our report focuses on catastrophe 

bonds. 

8

The reinsurance market represents that portion of their exposure that primary insurance 

companies have decided to transfer from their books. In our previous report, we reported 

that Swiss Re estimated that catastrophe bonds accounted for 0.5 percent of the worldwide 

catastrophe market. The 0.5 percent figure represented Swiss Re’s estimate of the amount of 

reinsurance premiums that insurers dedicate to fund catastrophe bonds (see Background) 

as compared to the total amount of reinsurance premiums paid to cover catastrophe risks. 

Swiss Re officials said that the premium measure is also an appropriate measure of 

catastrophe bond’s presence in the worldwide catastrophe insurance market and that the 

0.5 percent figure had not changed as of December 31, 2002. 

9

Although technically the initiator of the catastrophe bond transaction—the insurance 

company, reinsurance company, or noninsurance company—is different from the special 

purpose reinsurance vehicle that issues the catastrophe bond (see Background), for the 

purpose of simplicity, we use the terms “issue” or “issuer” in this report to describe 

organizations that initiate catastrophe bonds. 

10Natural catastrophes—such as hurricanes or earthquakes—of such severity that they are 

only expected to occur every 100 to 250 years. 

Page 4 GAO-03-1033 Catastrophe Bond Follow-up 
costs of catastrophe bonds—including relatively high rates of return paid 

to investors and administrative costs---significantly exceed the costs 

associated with purchasing reinsurance coverage. On the other hand, some 

financial market participants question the insurers’ analysis of the costs 

associated with catastrophe bonds. For example, investment bank officials 

said that the insurers’ analysis failed to account for the fact that many 

reinsurance companies have experienced financial difficulties and may not 

be able to meet their obligations if a catastrophe occurs.11 

We found that NAIC is still considering one statutory accounting issue 

discussed in our previous report that potentially affects the use of 

catastrophe bonds, while the potential effects of a separate accounting 

issue remain unclear. 12 The first issue concerned the differing statutory 

accounting standards that apply to traditional reinsurance and to certain 

financial instruments, which can include certain types of catastrophe 

bonds. 13 Current statutory accounting standards allow insurers that 

purchase traditional reinsurance to reflect the transfer of risk in financial 

reports that they file with state insurance regulators and thereby improve 

their stated financial condition, which may make the insurers more willing 

to write additional policies. However, this accounting treatment is not 

currently permitted for certain financial instruments—including certain 

catastrophe bonds—because these instruments have not been viewed as 

comparable to reinsurance. Although one NAIC committee has approved a 

proposal that would allow similar accounting treatment for these 

instruments under specified conditions, another NAIC committee has not 

11Due to the costs associated with the September 11, 2001, terrorist attacks and declines in 

worldwide stock markets, several reinsurance companies—particularly those 

headquartered in Europe--have experienced declining credit quality since 2000. Some 

financial analysts believe that potential reinsurer defaults during a catastrophe are costs 

that need to be considered in comparing catastrophe bonds to reinsurance. 

12NAIC establishes statutory accounting standards for insurance companies that may be 

adopted by states and their insurance regulators. Statutory accounting standards may differ 

from U.S. generally accepted accounting principles. 

13Current statutory accounting allows an insurance company that has obtained traditional 

reinsurance or issues indemnity based catastrophe bonds to reflect this transfer of risk on 

the financial statements that it files with state insurance regulators. By obtaining this 

accounting treatment, insurance companies may be more willing to write additional 

policies. However, current statutory accounting standards do not allow similar accounting 

treatment for nonindemnity based instruments that hedge insurance risk, which can include 

nonindemnity based catastrophe bonds, because such instruments have not been viewed as 

comparable to reinsurance or indemnity based catastrophe bonds. See this report and 

appendix II for a detailed discussion. 

Page 5 GAO-03-1033 Catastrophe Bond Follow-up 
approved the proposal.14 The second accounting issue—a 2002 proposal by 

the Financial Accounting Standards Board (FASB) that could have limited 

the appeal of catastrophe bonds---has been revised.15 Accounting firms and 

other financial market participants said that it was not clear (as of the date 

of this report) what effects FASB’s revised guidance---would have on 

catastrophe bonds. Although the revised guidance could make catastrophe 

bonds less attractive to issuers and investors, it remains to be seen how the 

guidance will be interpreted and implemented.

16 

Representatives from institutional investors—such as pension and mutual 

funds---we contacted provided mixed views on the purchase of catastrophe 

bonds. Some institutions favored catastrophe bonds because of their 

relatively high rates of return and usefulness in diversifying investment 

portfolios. However, because of the risks associated with catastrophe 

bonds, the institutions said that they limited their investments in the bonds 

to no more than 3.0 percent of their total portfolios. Representatives from 

several other institutional investors—such as some large mutual funds--­

said that they avoided purchasing catastrophe bonds altogether because of 

their perceived risks or because it would not be cost-effective for them to 

develop the technical capacity to analyze the risks of securities so different 

from the securities in which they currently invested. Some large mutual 

fund representatives also told us that they were not willing to purchase 

catastrophe bonds because of their relative illiquidity when compared with 

traditional bonds and equities.17 

Catastrophe bonds involving terrorism risks have not been issued by 

insurers to cover targets in the United States, and insurance industry and 

14NAIC is considering a proposal that would allow similar accounting treatment for financial 

instruments that effectively hedge insurers’ risks. This issue is discussed in more detail in 

this report. 

15FASB is a private body that establishes accounting and auditing rules under generally 

accepted accounting principles. FASB’s Interpretation No. 46, clarifies accounting policy for 

special purpose entities to improve financial reporting and disclosure by companies using 

these entities. See this report and appendix III for a detailed discussion. 

16As discussed in this report, consolidation could make insurers less willing to issue 

catastrophe bonds. We note that while consolidation may be required under generally 

accepted accounting principles it is not required under NAIC’s statutory accounting 

standards. 

17In an illiquid market, securities cannot be converted into cash easily or without incurring a 

substantial reduction in the price of the security. 

Page 6 GAO-03-1033 Catastrophe Bond Follow-up 
financial market participants we contacted noted that issuing such a 

security would be challenging. One challenge involves developing 

statistical models to predict with some certainty the frequency and severity 

of terrorist attacks. Developing such models would be difficult because 

terrorist attacks may be influenced by a wide variety of factors that may be 

difficult to quantify or predict. These factors include terrorist intentions, 

the ability of terrorists to enter the United States, target vulnerability, types 

of weapons that may be used, and the effectiveness of the efforts to prevent 

terrorist acts. Nevertheless, several modeling firms are developing models 

that were being used to assist insurers in providing terrorism insurance. 

However, the view of most financial market participants we contacted was 

that the models are too new and untested to support catastrophe bonds 

related to terrorism. Moreover, investor concerns about the risks 

associated with catastrophe bonds covering terrorism in the United States 

might also make the costs associated with issuing securities related to 

terrorism prohibitive. For example, investors might not believe that they 

have sufficient information about insurers’ underwriting standards and 

efforts to limit the insurer’s financial exposure to terrorism. Consequently, 

investors might demand a “risk-premium” to invest in a security related to 

terrorism that would be above the rate that insurance companies would be 

willing to pay. 

We are not making any recommendations in this report. 

We provided a draft of this report to NAIC, the Bond Market Association 

(BMA), and the Reinsurance Association of America (RAA), which are 

reprinted in appendixes V, VI, and VII respectively. We also received 

technical comments from these organizations, which have been 

incorporated where appropriate. In general, these organizations 

commented that the draft report provided a fair and useful analysis of 

efforts to securitize natural catastrophe and terrorism risks. However, BMA 

and RAA also disagreed with certain aspects of our analysis. Our 

evaluations of the NAIC, BMA, and RAA comments are discussed later in 

this report and in appendixes V, VI, and VII. 

Background	 This section provides an overview of (1) insurance coverage for natural and 

terrorist catastrophe risk and (2) the complex structure of natural 

catastrophe bonds. 

Page 7 GAO-03-1033 Catastrophe Bond Follow-up 
Overview of Natural and 

Terrorist Catastrophe 

Insurance Coverage 

The insurance industry consists of primary and reinsurance companies, 

which provide coverage—including coverage for natural catastrophe and 

terrorism risk---to their customers through property-casualty, homeowners, 

automobile, and commercial policies among others (see fig. 1). Primary 

insurers typically write policies for residential and commercial customers 

and are responsible for reviewing customer claims and making payments if 

consistent with the customers’ policies. Primary insurers, however, often 

hold more exposure to risk than management considers appropriate. For 

example, a primary property and casualty insurer may hold a large number 

of homeowners insurance policies along the Florida coast. If a catastrophic 

hurricane were to hit this area, the insurer would have to pay out on those 

policies, which could damage the company’s financial condition. In order to 

transfer some of this risk, primary insurers purchase coverage from a 

reinsurance company. Reinsurers cover specific portions of the risk the 

primary insurer carries. For example, a reinsurer may cover events that 

cost the primary insurer more than $100 million. Likewise, reinsurers may 

also carry more risk exposure than they consider prudent and so they may 

contract with other reinsurers for coverage, which is a process referred to 

as retrocessional coverage. 

Figure 1: Traditional Insurance, Reinsurance, and Retrocessional Transactions 

Reinsurer 

#1 

Reinsurer 

#2 

Loss payments 

Premium 

Reinsurance 

coverage 

Insurance 

coverage 

Retrocessional 

coverage 

Primary Premium Premium 

insurer 

Firm 

Loss payments Loss payments 

Source: GAO. 

The insurance industry faces potentially significant financial exposure due 

to natural and terrorist catastrophes. Heavily populated areas along the 

coast in the Northeast, Southeast, Texas, and California have among the 

highest value of insured properties in the United States. Moreover, some of 

these areas also face the highest likelihood of major hurricanes—in the 

cases of the Northeast, Southeast, and Texas---and major earthquakes in 

the case of California. According to insurance industry estimates, a large 

hurricane in urban Florida or earthquake in urban California could cause 

Page 8 GAO-03-1033 Catastrophe Bond Follow-up 
up to $110 billion in insured losses with total losses as high as $225 billion. 

We also note that a major earthquake in the central Mississippi Valley--­

which includes the New Madrid fault—could also result in significant loss 

of life and financial losses.18 Several states—including Florida, California, 

and Texas—have established authorities to help ensure that coverage is 

available in areas particularly prone to these events.19 In addition, the 

insurance industry faces potentially large losses associated with terrorist 

attacks as demonstrated by the industry’s $40 billion in expected losses 

resulting from the September 11, 2001, attacks. With the passage of TRIA, 

the federal government also has substantial potential financial exposure to 

terrorist attacks. 

The costs associated with providing insurance coverage for natural 

catastrophes helped generate the market for risk-linked securities---such as 

catastrophe bonds—as an alternative means of risk transfer for primary 

insurance companies and reinsurance companies. As shown in figure 2, 

reinsurance prices increased significantly in 1992, which was the year that 

Hurricane Andrew struck Florida. Reinsurance prices may increase after 

major catastrophes as reinsurance companies attempt to restore their 

financial condition through higher revenues or coverage restrictions. 

Because of the increase in reinsurance prices and restricted coverage in the 

mid 1990s, some insurance companies developed catastrophe bonds with 

the view that the capital markets would be able to provide coverage for 

some natural catastrophes at a lower cost than reinsurers. We note that 

after declining in the mid-to-late 1990’s, reinsurance prices increased from 

1999 to 2002 due to several factors including losses associated with 

hurricanes, adverse loss development on business written in 1997 through 

2000, adverse loss development relating to asbestos, the declining credit 

quality of some European reinsurers due to declining stock prices, the 

18The New Madrid seismic zone lies within the central Mississippi Valley, extending from 

northeast Arkansas, through southeast Missouri, western Tennessee, and western Kentucky 

to southern Illinois. Historically, this area has been the site of some of the largest 

earthquakes in North America. Between 1811 and 1812, four catastrophic earthquakes, with 

magnitudes greater than 7.0 occurred during a 3-month period. Since 1974 when seismic 

instruments were installed around this area, more than 4,000 earthquakes have been 

located, most of which were too small to be felt. The probability for an earthquake of 

magnitude 6.0 or greater is significant in the near future. A quake with a magnitude equal to 

that of the 1811-1812 quakes could result in great loss of life and property damage in the 

billions of dollars. 

19Our 2002 report provided information on the Florida Hurricane Catastrophe Fund and the 

California Earthquake Authority. This report provides information about the Texas 

Windstorm Insurance Association. See appendix IV. 

Page 9 GAO-03-1033 Catastrophe Bond Follow-up 
declining investment income due to decreased interest rates, and the costs 

associated with the September 11, 2001, terrorist attacks. 

Figure 2: Reinsurance Prices in the United States, 1989-2002a 

0 

50 

100 

150 

200 

250 

300 

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Dollars 

Year 

Source: Guy Carpenter & Company, Inc., a subsidiary of Marsh & McLennan Companies. 

Hurricane Andrew 

Northridge earthquake 

September 11 

terrorist attacks 

a

This figure shows a price index set equal to 100 in 1989 normalized prices. 

Catastrophe Bonds Employ 

Complex Structures 

As discussed in our previous report, risk-linked securities—including 

catastrophe bonds—have complex structures. Figure 3 illustrates the cash 

flows among the participants in a catastrophe bond. Typically, a 

catastrophe bond offering is made through an entity called a special 

purpose reinsurance vehicle (SPRV) that may be sponsored by an 

insurance or reinsurance company.

20 The insurance company enters into a 

reinsurance contract and pays reinsurance premiums to the SPRV to cover 

specified claims. The SPRV issues bonds or debt or debt securities for 

purchase by investors. The catastrophe bond offering defines a catastrophe 

20SPRVs are a type of special purpose entity. Most SPRVs are based offshore for tax, 

regulatory, and legal purposes. 

Page 10 GAO-03-1033 Catastrophe Bond Follow-up 
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 is 

to hold the funds from the catastrophe bond offering in a trust in the form 

of Treasury securities and other highly rated assets. The SPRV deposits the 

payment from the investor as well as the premium 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 is responsible for paying investors the principal and 

interest that they are owed. 

Figure 3: Special Purpose Reinsurance Vehicle 

Premium 

Reinsurance cover 

Special purpose 

reinsurance vehicle 

Investors 

Trust 

Principal and interest 

Principal and investment income 

Insurer or reinsurer 

Principal 

Principal 

Source: GAO. 

Page 11 GAO-03-1033 Catastrophe Bond Follow-up 
Catastrophe bonds also have the following characteristics: 

1.	 The bonds are typically only offered to qualified institutional investors 

under Securities and Exchange Commission (SEC) Rule 144A and are 

not available for direct purchase by retail investors. 

2.	 The bonds typically offer a return to investors based on the London 

Interbank Offered Rate (LIBOR) plus an agreed spread.21 The return to 

investors on catastrophe bonds is relatively high, either equaling or 

exceeding the returns on some comparable fixed-rate investments, 

such as high-yield corporate debt.22 Under some catastrophe bond 

structures, however, investors may face the risk of losing all or 

substantially all of their principal if a catastrophe triggering the bond’s 

provisions occurs.23 

3.	 The bonds typically receive noninvestment grade ratings from bond 

ratings agencies such as Fitch, Moody’s, and Standard & Poors (S&P) 

because bond holders face potentially large losses on the securities. 

The ratings agencies rely in part on three major modeling firms to help 

understand the risks associated with specific catastrophe bonds. The 

modeling firms use sophisticated computer systems and large 

databases of past natural catastrophes to assess loss probabilities and 

financial severities. 

4.	 The bonds typically cover risks that are considered the lowest 

probability and highest severity. That is, the bonds typically cover 

hurricanes or earthquakes that are expected to occur no more than 

once every 100 to 250 years. The bonds do not typically provide 

21LIBOR is the rate most international creditworthy banks charge one another for large 

loans. 

22Cochran, Caronia Securities LLC reports that catastrophe bonds returned on average 9.07 

percent in 2002, 9.45 percent in 2001, and 11.42 percent in 2000. The 9.07 percent return in 

2002 exceeded selected fixed-income sector returns for high-yield (or noninvestment grade) 

corporate debt. According to the Bond Market Association, the yields on catastrophe bonds 

have been comparable to the yields on noninvestment grade corporate debt. 

23However, some catastrophe bonds have been structured to contain different risk tranches 

having varying probabilities of loss occurrence. If the probability of loss occurrence for a 

bond tranche is very low, such as might occur if the bond's payout provisions could be 

triggered only upon the occurrence of a third consecutive specified catastrophic event 

within a set time period, the bond tranche could even receive a triple-A investment-grade 

rating. 

Page 12 GAO-03-1033 Catastrophe Bond Follow-up 
coverage for events expected to occur more frequently than once every 

100 years. 

5.	 To offset investors’ lack of information about insurer underwriting 

practices, the bonds are typically nonindemnity rather than indemnitybased and specify industry loss estimates or parametric triggers (such 

as wind speed during a hurricane or ground movement during an 

earthquake) as the events that trigger the bonds’ provisions.24 By tying 

payment to an estimate of industry losses or an objective measure such 

as wind speed, investors do not have to completely understand an 

individual company’s underwriting practices.25 

24Indemnity coverage specifies a simple relationship that is based on the insurer’s actual 

incurred claims. For example, an insurer could contract with a reinsurer to cover half of all 

claims—up to $100 million in claims—from a hurricane over a specified period for a 

geographic area. If a hurricane occurs where the insurer incurs $100 million or more in 

claims, the reinsurer would pay the insurer $50 million. In contrast, nonindemnity coverage 

is not related to actual or incurred claims. The provisions of a catastrophe bond, for 

example, may provide $100 million in coverage to the issuing insurance company if a 

hurricane or earthquake of a specified magnitude occurs or established insurance industry 

formulas estimate that a catastrophe causes industry wide losses of a specified amount. 

25One factor that may limit investors’ understanding of an insurers’ underwriting practices is 

moral hazard, which means that two parties to a contract change their behavior because of 

that contract. Due to moral hazard, the potential exists that an insurer would increase its 

risk-taking, such as by providing coverage for properties more vulnerable to natural 

catastrophes or in paying claims without adequate review. Moral hazard may be present in 

other insurance arrangements—besides catastrophe bonds—such as in the case of an 

insurer providing coverage for natural catastrophe risk through residential or business 

policies. Because reinsurers have established business relationships with insurers, they may 

be able to better monitor insurer underwriting practices than investors. 

Page 13 GAO-03-1033 Catastrophe Bond Follow-up 
Catastrophe Bond 

Issuance Has Been 

Limited 

Private sector data indicate that the catastrophe bond market accounts for 

a small share of the worldwide reinsurance market for catastrophe risk.

26 

According to Marsh & McLennan Securities, between 1997 and 2002, a total 

of 46 catastrophe bonds were issued, or about 8 per year as shown in figure 

4.27 Figure 5 shows that the annual dollar volume of catastrophe bond 

issuance remained relatively stable between 1997 and 2002, with 2000 

representing the highest volume with a total of $1.1 billion in total 

issuance.28 Between 1997 and 2002, the total value of outstanding 

catastrophe bonds increased more than three-fold from about $800 million 

to $2.9 billion. However, outstanding catastrophe bonds accounted for only 

2.5 to 3.0 percent of worldwide catastrophe reinsurance coverage.

29 As of 

September 2003, no natural catastrophe had occurred that would have 

triggered one of the 46 bonds’ provisions and resulted in payments to 

issuers to cover their losses.

30 

26Organizations involved in the catastrophe bond market may also report additional figures 

for other risk-linked securities or methods that transfer catastrophe risk or other insurance 

risk to securities markets. Such other securities and methods include collateralized debt 

obligations (CDO), quota share arrangements, swaps, options, and contingent capital. A 

catastrophe-related CDO is a portfolio of already issued catastrophe bonds and other risklinked securities. Investors in securitized quota share arrangements share directly in the 

performance of a reinsurance portfolio, sharing losses as well as gains. 

27Marsh & McLennan Securities did not report catastrophe bond issuance prior to 1997. 

However, available data indicate that three bonds were issued in the period 1994-96. We 

chose to report catastrophe bond issuance starting in 1997 (through 2002) because this is 

the first year that the market expanded to include a number of issuers. According to 

securities market participants, a total of four catastrophe bonds were issued in 2003 through 

July. 

28In 2002, Swiss Re introduced “shelf issuance” of catastrophe bonds, which allows them to 

periodically issue bonds over a several year period based on one offering statement to 

investors. Marsh & McLennan reported Swiss Re’s three quarterly issuances of this bond as 

one issuance in 2002. 

29Estimates obtained from Swiss Re and Fermat Capital Management. 

30According to an investment bank we contacted, the payout provisions of one catastrophe 

bond issued in 1996 have been triggered. 

Page 14 GAO-03-1033 Catastrophe Bond Follow-up 
Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002


Number of issuances


10


8


6


4


2


0


1997 1998 1999 2000 2001 2002


Year 

Source: GAO, based on data provided by Marsh & McLennan Securities. 

Page 15 GAO-03-1033 Catastrophe Bond Follow-up 
Figure 5: Catastrophe Bond Issuance and Amount Outstanding 1997-2002 

Dollars in millions 

3,000 2,943 

2,500 

2,000 

1,500 

1,000 

500 

0 

1997 1998 1999 2000 2001 2002 

Year 

69 

714 

306 

1,031 

725 

305 

825 

804 

1,122 

1,454 

967 

1,953 

990 

1,130 

1,926 

2,421 

783 

Issued


Outstanding from prior years


Source: GAO, based on data provided by Swiss Re Capital Markets. 

Note: Total shown by figure at top of bar is amount outstanding at year end. 

Page 16 GAO-03-1033 Catastrophe Bond Follow-up 
Figure 6 shows that insurance and reinsurance companies have issued 

almost all catastrophe bonds. Insurance companies accounted for 22 of the 

46 catastrophe bonds issued in 1997 through 2002, reinsurers accounted for 

22, and two commercial companies--Oriental Land and Vivendi, SA—issued 

the other two securities. Figure 7 provides a recent example of a 

catastrophe bond issuance. The following section provides reasons why 

some insurance and reinsurance companies use catastrophe bonds while 

others do not. 

Figure 6: Type of Catastrophe Bond Issuer 1997-2002 

Number of issuances 

4% 

48% 48% 

Noninsurance 

companies............ 2 

Insurers.............. 22 

Reinsurers.......... 22 

Total: 46 

Source: GAO, based on data provided by Marsh & McLennan Securities. 

Page 17 GAO-03-1033 Catastrophe Bond Follow-up 
Figure 7: Residential Reinsurance Issuances 

One example of a catastrophe bond is a $125 million of variable rate notes issued by 

Residential Reinsurance 2002 Limited, a special purpose reinsurance company, for the ultimate 

benefit of United Services Automobile Association (USAA). Offered only to qualified institutional 

buyers as defined by SEC Rule 144A, these bonds were privately placed by Goldman, Sachs & 

Co., Lehman Brothers, and Merrill Lynch & Co. These bonds were sold to investors with a 

coupon of 3-month LIBOR plus 4.9 percent during the loss occurrence period and received 

ratings of Ba3 from Moody's and BB+ from S&P, both noninvestment grade ratings.

a

 The ratings 

reflect the expected loss to note holders, calculated by a catastrophe-modeling firm, relative to 

the promise of receiving the present value of the required interest and principal payments as 

provided by the governing documents. 

The issuer provides reinsurance coverage for 3 years to USAA against hurricane losses in the 

East and Gulf Coast states of the United States and in Hawaii beginning June 1, 2002. Losses 

to investors are tied to actual losses experienced by USAA due to qualified hurricanes affecting 

its portfolio of exposures in the covered areas at any time during the risk period. Qualified 

hurricanes are those classified on the Saffir-Simpson scale as a Category 3, 4, or 5.b

 If more 

than one qualifying event were to occur in any given year, only one event, at the discretion of 

USAA, will be considered in calculating losses to the notes. An independent third party is to 

review loss payout. The proceeds from issuance of the bonds were deposited into a trust 

account and invested in high quality-rated commercial paper or money market instruments and 

investment-grade securities. 

In 2003, Residential Reinsurance issued another $160 million of variable rate notes, its seventh 

consecutive placement of catastrophic risk for the benefit of USAA. The bonds provided 

aggregate coverage for USAA's hurricane and earthquake risk in the United States, including 

the risk of loss caused by fire following an earthquake. This issue was the first catastrophe 

bond to include Alaska and Hawaii earthquake risk. The bonds were sold with a coupon of 3-

month LIBOR plus 4.95 percent and received noninvestment grade ratings of Ba2 (Moody's) / 

BB+ (S&P). The bonds were privately placed by Goldman Sachs and BNP Paribas. 

Source: GAO analysis based on information from Moody's Investors' Service, Residential Reinsurance 2002 


Limited Catastrophe Linked Notes, Structured Finance New Isue Report, July 30, 2002 and Marsh & McLennan Securities, 


Market Update: The Catastrophe Bond Market at Year-End 2002.


a

Libor is the rate that creditworthy international banks generally change each other for large loans. 

b

The Saffir-Simpson Hurricane Scale is a 1-5 rating based on the hurricane’s intensity. This is used to 

give an estimate of the potential property damage and flooding expected along the coast from a 

hurricane landfall. Wind speed is the determining factor in the scale, as storm surge values (used to 

estimate flooding) are highly dependent on the slope of the continental shelf in the landfall region. 

Catastrophe Bonds Representatives from some insurance and reinsurance companies told us 

that catastrophe bonds served a useful role in their overall approach to Benefit Some Insurers, managing their natural catastrophe risk exposures and that such bonds 

but Others Believe lowered the costs associated with the most severe types of catastrophe 

That the Bonds’ Costs risk. However, representatives from two large insurers and two state 

authorities said that the total costs associated with the bonds were high Are Too High compared with traditional reinsurance and affected their willingness to 

Page 18 GAO-03-1033 Catastrophe Bond Follow-up 
issue the bonds.31 Other financial market participants believed that 

insurers’ comparisons of the prices of catastrophe bonds and traditional 

reinsurance do not fully account for important factors, such as the credit 

quality of reinsurers. This section also provides information on the status 

of two accounting issues that potentially affect the use of catastrophe 

bonds and which we discussed in our previous report. 

Some Insurance and 

Reinsurance Companies 

Identified Benefits of 

Catastrophe Bonds 

Representatives from some large insurers and reinsurers we contacted said 

that catastrophe bonds were a complement to several other basic risk 

management tools: raising more equity capital by selling more company 

stock, transferring risks to the reinsurance markets, and limiting risks 

through the underwriting and asset management process. Representatives 

from one insurance company said that of the natural catastrophe exposure 

that was transferred by their company, 76 percent was sold to traditional 

reinsurance companies and 24 percent was transferred through 

catastrophe bonds. Company representatives said that while reinsurance 

accounted for most risk transfer needs, catastrophe bonds were also 

beneficial in this regard. Representatives from a reinsurance company said 

that catastrophe bonds allowed the company to transfer a portion of its 

natural catastrophe exposures to the capital markets rather than retaining 

the exposure on its books or retroceding the risks to other reinsurers. 

As discussed in our 2002 report, catastrophe bonds can play a role in 

lowering the costs of reinsuring catastrophe risks. According to various 

financial market representatives, because of the larger amount of capital 

that traditional reinsurers need to hold for lower probability and higher 

financial severity areas of catastrophe risk---such as the risk of hurricanes 

in Florida or earthquakes in California expected to occur only once every 

100 to 250 years---these reinsurers limit their coverage and charge 

increasingly higher premiums for these risks. Many of the catastrophe 

bonds issued to date have provided coverage for such severe catastrophe 

risks. Representatives from one insurance company said that the company 

cannot obtain the amount of reinsurance it needs in this risk category from 

traditional reinsurers at reasonable prices. As a result, the company has 

31As discussed in our previous report, one of these authorities—the California Earthquake 

Authority (CEA)—also does not issue catastrophe bonds because they are based offshore. 

While CEA has not issued catastrophe bonds through SPRVs, some of its catastrophe risks 

have been included in catastrophe bonds issued by a reinsurer with whom CEA has a 

business relationship. 

Page 19 GAO-03-1033 Catastrophe Bond Follow-up 
obtained some of its reinsurance coverage in this risk category from 

catastrophe bonds. The officials said that they believed that the 

catastrophe bond market has had a moderating effect on reinsurance 

prices, which, as shown in figure 2, increased from 1999 through 2002. 

Other market participants also said that the presence of catastrophe bonds 

as an alternative means of transferring natural catastrophe risk may have 

prevented reinsurance prices from increasing any faster than they did. 

We note that two noninsurance corporations—Oriental Land and Vivendi— 

have issued catastrophe bonds to address some of the risks facing their 

properties from hurricanes and earthquakes. Oriental Land—the operator 

of Tokyo Disneyland---sponsored the Concentric, Ltd. security that 

provides $100 million in coverage for an earthquake or earthquakes in a 

particular region of Japan over a 5-year period ending in 2004. The 

transaction allows Oriental Land to directly insure against certain 

earthquake risks. Vivendi sponsored a $175 million catastrophe bond to 

provide coverage for certain earthquakes affecting Southern California.32 

Several Insurers Said That 

Catastrophe Bonds Were 

More Expensive Than 

Traditional Natural 

Catastrophe Reinsurance 

Although some insurance and reinsurance companies have found 

catastrophe bonds to be cost-effective for some of their catastrophe 

coverage, representatives from two large insurance companies and two 

state authorities, as well as other market participants, said that the costs 

associated with catastrophe bonds could be significantly higher than the 

costs of buying traditional reinsurance coverage. The insurance company 

and state authority representatives said that they monitored the costs 

associated with catastrophe bonds by reviewing price information 

provided by investment banks and comparing these prices to quotes 

offered on reinsurance contracts. Some insurance company officials and 

state authority representatives estimated that the total costs associated 

with catastrophe bonds could be as much as twice as high as traditional 

reinsurance. In addition, representatives from two investment banks that 

have participated in many catastrophe bond transactions, insurance 

brokers that monitor the market, and other market participants said that 

catastrophe bond costs typically exceeded the cost of reinsurance for many 

insurers. 

32Vivendi Universal, S.A. did this transaction through its affiliated company, Gulfstream 

Insurance Ltd., located in Ireland. Gulfstream Insurance entered into a reinsurance contract 

with Swiss Re, which, in turn, entered into a retrocessional contract with Studio Re Ltd., the 

special purpose reinsurer that issued the catastrophe bonds and preference shares. 

Page 20 GAO-03-1033 Catastrophe Bond Follow-up 
One of the costs associated with catastrophe bonds are the interest costs 

that insurers must pay to compensate investors for purchasing securities 

that involve a substantial risk of loss of principal. As discussed previously, 

the yields on catastrophe bonds have generally equaled or exceeded the 

yields on some risky fixed-income investments, such as high-yield 

corporate debt. Representatives from two large insurers and a state 

authority told us that quotes that they received from investment banks on 

the interest costs associated with catastrophe bonds exceeded the costs of 

comparable reinsurance. Additionally, representatives from two large 

insurance companies said that the insurance rates they develop to cover 

their expected losses on natural catastrophes and operating expenses and 

then file with state regulators are frequently denied as being too high. As a 

result, a representative of one of the insurers said that the company did not 

earn sufficient premium income to cover the costs associated with 

catastrophe bonds and tended to restrict coverage in states that do not 

allow for adequate premium increases. NAIC commented that the process 

of determining appropriate insurance rates is complex and that insurers 

and state regulators can reasonably disagree on the proper rate to charge 

for a specific insurance product. 

Insurance industry representatives as well as other market participants 

cited administrative and transaction costs as another reason for the 

relatively high costs associated with catastrophe bonds as compared to 

reinsurance. Representatives from a state authority estimated that 

transaction costs represented 2 percent of the total coverage provided by a 

catastrophe bond (for example, $2 million for a security providing $100 

million in coverage). These costs include: 

• underwriting fees charged by investment banks; 

•	 fees charged by modeling firms to develop models to predict the 

frequency and severity of the event—such as the hurricane or 

earthquake—that is covered by the security; 

•	 fees charged by the rating agencies to assign a rating to the securities; 

and 

•	 legal fees associated with preparing the provisions of the security and 

preparing disclosures for investors. 

The price of a reinsurance contract would not typically include such 

additional fees. 

Page 21 GAO-03-1033 Catastrophe Bond Follow-up 
Insurers’ preference for traditional reinsurance as compared to catastrophe 

bonds may also be explained by their long-standing business relationships 

with reinsurance companies and the general nature of reinsurance 

contracts. Reinsurance contracts often cover a range of a primary insurer’s 

risks including natural catastrophe and other risks, and the insurer’s 

premium payments to the reinsurer cover all potential losses to the 

insurance company after some initial retention of risk by the insurer. 

Moreover, reinsurance contracts typically cover an insurer’s losses, such as 

those resulting from hurricanes in a specified area up to a specified dollar 

limit, such as $100 million. In contrast, catastrophe bonds focus on one 

type of risk (for example, natural catastrophe) and can be highly 

customized (for example, the development of parametric triggers) which 

may add to their administrative costs and require a greater commitment of 

management time to develop, particularly the first time that they are used. 

Some Financial Market 

Participants Questioned 

Insurers’ Analysis of the 

Costs Associated with 

Catastrophe Bonds 

Some financial market participants that supported the use of catastrophe 

bonds—such as investment banks—and some insurers questioned other 

insurers’ analysis of cost differences between catastrophe bonds and 

traditional reinsurance. These representatives said that catastrophe bonds 

may be cost-competitive with traditional reinsurance for high severity and 

low probability risks, for retrocessional coverage, and for larger-sized 

transactions. The representatives also said that insurers tended to 

undervalue the risk that—due to credit deterioration—reinsurers might not 

be able to honor their reinsurance contracts if a natural catastrophe were 

to occur. They said catastrophe bonds, on the other hand, pose no or 

minimal credit risk to insurers because the funds are immediately 

deposited into a trust account upon the bonds’ issuance to investors. 

Representatives from insurers we contacted said that while they 

recognized that some reinsurers’ credit quality had declined, they have 

established credit standards for the companies with whom they do 

business and continually monitored their financial condition.

33 

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 reinsurer 

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 22 GAO-03-1033 Catastrophe Bond Follow-up 
Some financial market participants also said that various provisions in 

reinsurance contracts—such as deductibles, termination clauses, and 

reinstatement premiums—may also raise their costs and should be 

factored into the cost comparison between catastrophe bonds and 

reinsurance costs. Furthermore, they said that because catastrophe bond 

funds were held in trust accounts, insurers would likely be able to quickly 

claim the funds to cover natural catastrophe losses. In contrast, the 

representatives said that reinsurance contracts frequently involved 

litigation over whether insurer claims should be paid. RAA disagreed with 

this statement and said that reinsurance contracts rarely involve litigation 

and that the contracts typically include arbitration clauses. RAA said that 

arbitration typically settles disputes more quickly than does litigation. RAA 

also commented that because the provisions of catastrophe bonds have 

never been triggered, it is not clear that such bond payments would not be 

subject to litigation.34 

One reinsurance company has developed a method of issuing catastrophe 

bonds that may lower issuance costs. The reinsurer—Swiss Re—issued a 

security known as Pioneer in June 2002. Pioneer’s structure contains six 

separate “tranches,” or individual bonds, that cover five types of perils— 

hurricanes in the North Atlantic, windstorms in Europe, earthquakes in 

California, earthquakes in the central United States, earthquakes in 

Japan—and one that covers all of the five perils. Pioneer is also an “off-theshelf” security, which means that Swiss Re can issue the security to 

investors over a period of time as necessary to meet its business needs and 

the demand of investors. By covering multiple perils and allowing risks to 

be transferred over time, market participants said that the security could 

pay a lower yield because the market would not have to absorb a relatively 

larger issuance in a shorter time span. In addition, it would lower 

administrative costs because most of the paperwork and disclosures to 

issue the security would already be in place, which means they do not have 

to be recreated, as is the case with other catastrophe bonds. 

34Although none of the 46 catastrophe bonds issued from 1997 through 2002 have generated 

investor losses, one investment bank told us that the payout provisions of a catastrophe 

bond issued in 1996 had been triggered and generated investor losses. 

Page 23 GAO-03-1033 Catastrophe Bond Follow-up 
Some Insurers Noted That 

Catastrophe Bonds Were 

Not Cost-Effective for 

Natural Catastrophes That 

Were More Likely to Occur 

or for Lower Coverage 

Amounts 

Besides cost, some insurance company and state authority representatives 

we contacted cited other reasons why they did not choose to issue 

catastrophe bonds. They said that they were not attracted to catastrophe 

bonds’ traditional focus on covering events with the lowest frequency and 

the highest severity (for example, hurricanes or earthquakes expected to 

occur every 100 to 250 years). Rather, the representatives said that their 

coverage needs were for less severe events expected to take place more 

frequently than every 100 years. In addition, they and other market 

representatives said that it is not cost-effective to issue catastrophe bonds 

below a certain level. They estimated that this this level ranged from $100 

million to $800 million. Some insurers said that they typically bought 

reinsurance for smaller amounts and might be more willing to issue 

catastrophe bonds if they were offered coverage in amounts less than $100 

million. BMA commented that catastrophe bonds have been issued in 

smaller denominations than $100 million. 

RAA commented that nonindemnity based catastrophe bonds may not be 

appealing to insurers because of basis risk, which is the risk to the insurer 

that the payment from the catastrophe bond will not cover all of its losses. 

Traditional reinsurance and indemnity based catastrophe bonds mitigate 

basis risk. In addition, RAA said that catastrophe bonds may not appeal to 

insurers because they do not adequately cover “tail risk,” which is the risk 

to the insurer that it will take a protracted period (perhaps years) to settle 

all of the claims associated with a natural catastrophe. RAA stated that 

traditional reinsurance remains an “open account” to settle such claims 

when they come due while catastrophe bond contracts typically require 

that all claims be quickly settled (perhaps within 2 years). RAA commented 

that the insurer could ultimately become responsible for any claims filed 

after the catastrophe bond cut-off period. 

Page 24 GAO-03-1033 Catastrophe Bond Follow-up 
Impact of Accounting Issues 

Potentially Affecting the 

Use of Catastrophe Bonds 

Still Unclear 

Our previous report stated that NAIC’s current statutory accounting 

requirements might affect insurers’ use of nonindemnity-based catastrophe 

bonds. 35 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 that it files with state 

regulators. As a result of the risk transfer, the insurance company can 

improve its stated financial condition and it 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 bond 

structures—and may therefore limit the appeal of these types of 

catastrophe bonds to potential issuers. Statutory accounting standards 

have differed because unlike traditional reinsurance, instruments that are 

nonindemnity-based have not been viewed as providing a true transfer of 

insurers’ risks. However, during 2003, NAIC’s Securitization Working Group 

approved a proposal that would establish criteria for allowing reinsurance 

like accounting treatment for such instruments---including nonindemnitybased catastrophe bonds—that provide a highly effective hedge against 

insurer losses. The proposal must still be considered by NAIC’s Statutory 

Accounting Committee, which must give final approval before the 

accounting treatment is put into effect. According to an NAIC official, if 

NAIC were to ultimately approve a reinsurance credit for financial 

instruments that effectively hedge insurer losses, it could take about 1 year 

for the new standards to be implemented. See appendix II for a detailed 

discussion of this accounting issue. 

35NAIC is currently considering the appropriate accounting treatment for nonindemnity 

based financial instruments that hedge insurance risk, which could include nonindemnitybased catastrophe bonds. Both exchange-traded instruments and over-the-counter 

instruments can be used to hedge underwriting results (i.e., 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 (referred to as “basis risk”). This correlation is 

known as “hedge effectiveness” and NAIC is currently considering how it should be 

measured. Should NAIC determine a hedge-effectiveness measure, statutory accounting 

standards could be changed so that a fair value measure of the catastrophe bond contract 

could be calculated and recognized as an offset to insurance losses, hence 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. 

Page 25 GAO-03-1033 Catastrophe Bond Follow-up 
In September 2002, we also reported that FASB was considering a new 

approach for accounting for special purpose entities (SPE)—special 

purpose reinsurance vehicles (SPRV) used to issue catastrophe bonds are a 

type of SPE---that had the potential to raise the costs associated with 

issuing catastrophe bonds and make them less attractive to issuers.36 The 

proposal was considered in response to the problems at Enron 

Corporation, which raised questions about the accounting for SPEs. FASB’s 

proposed interpretation could have, among other things, (1) required the 

primary beneficiary of an SPE to consolidate the assets and liabilities of the 

SPE in its financial statements and (2) set a presumptive equity investment 

requirement for SPEs at 10 percent as compared to the previous standard 

of 3 percent. 

In January 2003, FASB issued Interpretation No. 46, Consolidation of 

Variable Interest Entities (FIN 46), which revised the guidance under 

consideration in 2002. FIN 46 is quite complex and does not expressly 

discuss reinsurance, but provides criteria to determine if consolidation is 

required.37 FIN 46 introduces “variable interest entities” (VIE), a new term 

that encompasses most SPEs. A VIE is broadly defined as an entity which 

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. Accounting firm officials that we contacted 

said that most catastrophe bond structures likely qualify as VIEs because 

most SPRVs do not meet the ten percent equity threshold. Moreover, an 

accounting firm official said that insurance companies may be less likely to 

issue catastrophe bonds if they were required to consolidate SPRV assets 

and liabilities on their balance sheets. The official said that insurance 

companies do not typically believe that they “own” SPRV assets or “owe” 

SPRV liabilities. The official said that insurance companies may decide that 

the costs associated with issuing confusing and potentially misleading 

financial statements would outweigh the benefits of issuing catastrophe 

bonds through SPRVs. 

36Companies have used SPEs for many years to carry out specific financial transactions. 

37FIN 46 is applicable under U.S. generally accepted accounting principles and has no direct 

application to insurance company financial statements prepared according to statutory 

accounting principles or accounting principles outside the United States. 

Page 26 GAO-03-1033 Catastrophe Bond Follow-up 
However, accounting firm and insurance officials also told us that FIN 46 is 

very complex and that it is not yet certain whether it would require issuers 

of catastrophe bonds to consolidate the SPRVs on their financial 

statements.38 The officials said the potential exists that FIN 46 could require 

investors in catastrophe bonds to consolidate the bonds on their balance 

sheets or it may not require consolidation by either issuers or investors. 

FIN 46 is currently in effect for VIEs created after January 31, 2003, and is 

effective for existing VIEs beginning in the first fiscal year or quarter 

beginning after June 15, 2003. Because FIN 46 became effective during 2003 

and each transaction could be structured differently, it remains to be seen 

how FIN 46 will affect future catastrophe bond transactions. Additional 

information should be available after December 2003, when insurers that 

issue catastrophe bonds evaluate the substance of their catastrophe bonds 

for purposes of reporting their year-end financial statements. See appendix 

III for additional information about FIN 46. 

Institutional Investors Representatives from some institutional investors told us that catastrophe 

bonds served a useful but limited role in their overall approach to managing Provided Mixed Views their investment portfolios by often providing higher yields than traditional 

on Catastrophe Bonds investments and diversification. Other institutional investors said that the 

risks of catastrophe bonds were too high or not worth the costs associated 

with assessing the risks. Some institutional investors also said that they 

had decided not to purchase catastrophe bonds because they were illiquid. 

Some Institutions Invested 

in Catastrophe Bonds for 

High Yields and Portfolio 

Diversification 

The relatively high rates of return offered by catastrophe bonds make them 

attractive to some institutional investors, such as pension funds, hedge 

funds, and mutual funds—including mutual funds that specialize in 

catastrophe bond investments. As discussed previously, catastrophe bonds 

carry noninvestment-grade ratings and, during certain time periods, high 

spreads relative to alternative fixed-income investments, such as high-yield 

38Determining whether consolidation is required under FIN 46 requires an analysis of what 

entity—either the issuer or investor in catastrophe bonds—bears the majority of the 

expected risks and expected rewards. An accounting firm official we contacted said that in 

his view it is unlikely that insurers would be required to consolidate under FIN 46 because 

they do not bear the risks associated with catastrophe bonds. Rather, the accounting firm 

official said that an investor in the bonds may be required to consolidate if it holds more 

than half of the outstanding bonds in a particular issuance. Determining whether 

consolidation by an investor is necessary under FIN 46 could require an analysis of the 

percentage of outstanding bonds held by particular investors. 

Page 27 GAO-03-1033 Catastrophe Bond Follow-up 
corporate bonds. Officials from one large pension fund said that 

catastrophe bonds were attractive because they often paid higher rates 

than similarly rated instruments. Representatives from a hedge fund said 

that since September 11, 2001, the rate of return on catastrophe bonds has 

been high and the demand for the bonds has exceeded the supply. 

Another reason that some large institutional investors---such as pension 

funds---purchased catastrophe bonds is that they were uncorrelated with 

other credit risks in their bond portfolios and help diversify their 

investment risks. In general, institutional investors attempt to invest in 

equities and debt from a wide range of companies, industries, and 

geographic locations to minimize their exposure to any particular risk in 

the event of an economic downturn. Representatives from some 

institutional investors told us that catastrophe bonds complemented their 

general diversification strategy. The securities were tied to the occurrence 

of hurricanes and earthquakes rather than the performance of the 

economy. That is, investors might realize a relatively high rate of return on 

catastrophe bonds during an economic downturn, while other assets were 

performing poorly (assuming that no natural catastrophe occurred to 

trigger the securities’ provisions). However, due to the potential risks 

associated with catastrophe bonds, the institutional investor 

representatives said that they confined their investments to no more than 3 

percent of their total portfolios. We note that some specialized institutional 

investors---such as hedge funds and mutual funds that focus on catastrophe 

bond investments---may assign a greater percentage of their investment 

portfolios to catastrophe bonds than large institutions. 

Some Institutional Investors As discussed in our previous report, the investor market for catastrophe 

Cited High Risks, Lack of bonds is not broad and some institutional investors—such as mutual 

Analytical Capacity, and funds—did not purchase them.39 Representatives from three large mutual 

funds we contacted for our follow-up work said they did not purchase Illiquidity as Primary catastrophe bonds because of their perceived risks. The mutual fund 

Reasons for Not Purchasing officials said that their traditional approach to investing in high-yield debt

Catastrophe Bonds involved assessing a company’s business strategy, management talent, 

39In testimony before the House Financial Services Committee on October 8, 2002, 

representatives from Swiss Re—one of the largest issuers of risk-linked securities—said 

that lack of interest by many money managers was the primary reason that the market has 

not expanded. See The Risk-Linked Securities Market: Testimony before the House 

Financial Services Committee, Subcommittee on Oversight and Investigations, U.S. 

House of Representatives. (Oct. 8, 2002). 

Page 28 GAO-03-1033 Catastrophe Bond Follow-up 
assets, and cash flow to justify risking customer assets in purchasing the 

company’s debt. Even if a company failed, one mutual fund official said that 

as creditors they might be able to take over the business, insert new 

management, sell assets, and turn the company around. In contrast, a 

mutual fund official said that catastrophe bonds differed substantially from 

their traditional company-oriented approach and posed unacceptably high 

risks of loss to customer funds. The official also expressed doubt about the 

accuracy of models that have been developed to predict hurricanes and 

earthquakes or said that they lacked the technical expertise to analyze the 

models. The official said that insurance companies were in the best 

position to assess the risks associated with their natural catastrophe 

exposures and that they were not interested in purchasing risks that the 

companies did not want to keep on their books. Further, a mutual fund 

official said that if a natural catastrophe occurred and the provisions of 

catastrophe bonds were activated, creditors would have no opportunities 

to minimize their losses as occurs when companies go into bankruptcy. 

BMA commented that it is not inevitable that investors will lose all of their 

principal if a catastrophe bond is triggered (as discussed previously, some 

bond structures minimize the chances that investors will lose all of their 

principal). 

Mutual fund representatives also said that it was not cost-effective for them 

to develop the technical expertise necessary to analyze catastrophe bonds 

and determine if they represent a sound investment. First, a mutual fund 

official said that it was much safer to simply buy the stocks and bonds of 

insurance companies if the fund believed the management of such 

companies had the skills necessary to profitably manage their natural 

catastrophe and other exposures. Second, a mutual fund official said that 

there were alternative investments—such as high-yield corporate debt— 

that offered comparable returns and risks that firm officials understood. 

Third, a mutual fund official said that given the small size of the 

catastrophe bond market, it did not make sense to hire experts in 

hurricanes or earthquakes to monitor the market. A mutual fund 

representative did say, however, if the market for catastrophe bonds 

expanded, the company would reconsider employing experts to better 

understand these securities. 

Another reason mutual fund representatives said that they did not purchase 

catastrophe bonds was that they were illiquid. One mutual fund 

representative said that the company preferred investments—such as 

mortgage-backed securities, credit card receivables, and government 

debt—that had large numbers of buyers and sellers, stable prices, and 

Page 29 GAO-03-1033 Catastrophe Bond Follow-up 
narrow bid-ask spreads.40 A liquid market allows investors to sell securities 

for cash without accepting a substantial discount in price. One mutual fund 

representative said that catastrophe bonds “trade by appointment,” and 

that the fund’s policies did not allow for the purchase of such illiquid 

securities. Another mutual fund representative also commented that their 

company policies did not allow for the purchase of illiquid securities. BMA 

disagreed with these statements and commented that the liquidity of the 

catastrophe bond market is comparable to similar securities. 

Securitizing Terrorism 

Risk Poses Significant 

Challenges 

The general consensus of insurance and financial market participants we 

contacted was that insuring against terrorism risk would be difficult and 

that developing bonds covering potential targets against terrorism attacks 

in the United States was not feasible at this time. Although, several 

modeling firms were developing terrorism models that were 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 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. 

The Complexity of 

Forecasting Terrorist 

Attacks Makes Insuring 

against Terrorism Risk 

Difficult 

According to insurance industry representatives, insuring against natural 

catastrophe risk, despite its challenges, is considered more practical than 

insuring against or securitizing terrorism risk. To establish their exposures 

and to price insurance premiums, companies need to be able to predict 

with some reliability the frequency and severity of insured event risks. 

Although difficult, risk-modeling firms and insurance companies have 

developed models to predict the frequency and severity of natural 

catastrophes such as hurricanes and earthquakes. Representatives from 

these firms said that there was a substantial amount of historical data on, 

for example, hurricane frequency and paths as well as earthquake faults 

and severity. Using data on natural catastrophe frequency and severity, 

insurers can gauge their exposures in particular areas and more accurately 

price their coverage. For example, an insurer could estimate the impact to 

40A bid-ask spread is the difference between the price asked for a security and the price 

paid. 

Page 30 GAO-03-1033 Catastrophe Bond Follow-up 
the insurance company of a Category 5 hurricane in Miami, given the 

number of policies that the insurer has written in the city as well as the 

value of insured property.

41 Within pricing constraints established by 

insurance regulators, the company would set premiums at a level designed 

to compensate it for predicted losses while allowing for a reasonable rate 

of return. The development of models to predict the frequency and severity 

of natural catastrophe risks are considered crucial to any market growth 

that has thus far taken place for catastrophe bonds. 

In contrast, insuring against terrorism risk poses challenges because it 

requires the insurer to measure with some reliability the frequency and 

severity of terrorist acts. Experts we contacted said such analyses were 

extremely difficult because they involved attempts to forecast terrorist 

behavior, which were very difficult to quantify. The frequency of attacks 

would be subject to a range of factors including terrorist intentions, the 

ability of terrorists to enter the United States, target vulnerability, and the 

effectiveness of the war on terrorism. One market participant told us that 

even if the severity of losses at different targets given specified weapons 

were able to be modeled, it would be difficult to forecast losses for 

particular attacks given the variety of weapons that could be used by 

terrorists. 

Recent experience illustrates the difficulties associated with insuring 

against terrorism risks. After the September 11, 2001, terrorist attacks, 

many primary insurance companies refused to renew terrorism coverage in 

their general property and casualty policies for commercial customers and 

reinsurance companies stopped providing coverage for terrorism to 

primary insurers.42 Although TRIA subsequently required primary 

insurance companies to offer terrorism insurance to clients, insurers set 

the premiums. While insurance companies did not publish data on how 

many of their clients accepted offers of terrorism coverage, one insurer we 

contacted said that the overall acceptance rate was about 25 percent. 

41A Category 5 hurricane is defined by winds greater than 155 mph, storm surge generally 

greater than 18 feet above normal, complete roof failure on many residences and industrial 

buildings, and some complete building failures with small utility buildings blown over or 

away. 

42In GAO testimony before the House Subcommittee on Oversight and Investigations, 

Committee on Financial Services we stated that many insurers consider terrorism an 

uninsurable risk because it is not possible to estimate the frequency and severity of terrorist 

attacks. See Terrorism Insurance: Rising Uninsured Exposure Heightens Potential 

Economic Vulnerabilities. GAO-02-472T. Washington, D.C.: February 27, 2002. 

Page 31 GAO-03-1033 Catastrophe Bond Follow-up 
Terrorism Models under 

Development Considered by 

Some as Too New and 

Untested to Support 

Catastrophe Bonds 

Representatives from the three major risk-modeling firms said that they 

have developed terrorism risk models. The models differ in the method 

they employ to model risk but are similar in that they rely on the ability of 

terrorism experts to forecast the frequency and severity of terrorist 

attacks. One firm uses the Delphi method, another uses game theory, and 

the third uses a combination of the two. The models account for subjective 

information such as the particular terrorist organization that is carrying out 

the attack and the resources available to them; the political situation; and 

when, where, and how the attack might occur. The Delphi method, for 

example, analyzes various threats posed by domestic extremists, formal 

international and state-sponsored terrorist organizations, and loosely 

affiliated extremist networks. The game theory model analyzes the 

potential actions of terrorists based on the actions of security forces and 

counter-terrorism measures. 

Modeling firm officials and insurance industry representatives said that 

insurers, reinsurers, group life insurers, and corporations were currently 

using terrorism models. Some insurance companies were using the models 

to help them determine their exposure to terrorism and price this risk. For 

example, some life insurance companies were using the models to ensure 

that they did not have a high concentration of life insurance policies in 

properties that might be particularly vulnerable to terrorist attacks. 

Representatives from reinsurance companies we contacted, however, said 

that the models were not reliable in predicting the frequency of terrorist 

attacks, although they provided useful information on the potential severity 

of attacks. Moreover, officials from ratings agencies we contacted said that 

they were not convinced about the reliability of the terrorism models at this 

point and that they would not be willing to rate a catastrophe bond 

covering targets in the United States based on the models. According to 

one of the major rating firms, for example, the estimates derived from the 

three models for predicting the frequency and severity of terrorist attacks 

could vary by 200 percent or more. Another rating firm official said that 

investors currently would not believe that the terrorism models adequately 

reflected the risk. Without acceptance of the models by major ratings 

agencies and investors, the officials said that the issuance of catastrophe 

bonds related to terrorism coverage in the United States would be highly 

unlikely. We note that NAIC officials commented that while developing 

catastrophe bonds to cover terrorism is very difficult and may not occur in 

the medium-term, the potential exists that such bonds will be issued. 

Page 32 GAO-03-1033 Catastrophe Bond Follow-up 
Investor Concerns Could 

Impede the Development of 

a Market for TerrorismRelated Securities 

Investor concerns about catastrophe bonds related to terrorism could also 

make the costs to insurers of issuing such bonds prohibitive. In the absence 

of well-developed and contractual business relationships with the primary 

insurer, investors might not believe they had sufficient information about 

the extent to which an insurance company offered terrorism coverage to 

properties that were potentially highly vulnerable to a terrorist attack or 

the quality of an issuer’s underwriting practices and claims payment 

processes. Because of investors’ potential lack of information about 

insurer practices, they might demand a significantly higher rate of return 

before they would purchase a security that covered terrorism risks. Some 

insurance companies already have decided not to issue catastrophe bonds 

for natural catastrophes due to their relatively high costs. Given the 

uncertainties associated with forecasting the frequency and severity of 

terrorist attacks, it is likely that the costs associated with issuing terrorismrelated bonds would be even higher. 

Investors might also demand high returns on terrorist-related securities 

because of concerns about strategic behavior by terrorists. Investors might 

be concerned that terrorists would learn about the conditions that would 

activate the provisions of a catastrophe bond, and plan attacks on the basis 

of that knowledge. Although it is not clear that terrorists would make 

attacks based on such reasoning, investors fear that they would increase 

the risk premium demanded of such securities. 

While developing a catastrophe bond to cover terrorism risks in the United 

States may be difficult, we note that in August 2003 a bond was developed 

to cover such risks---and other risks---in Europe. The Federation 

Internationale de Football Association (FIFA), the world governing body of 

association football—called soccer in the United States—and organizer of 

the FIFA World Cup developed a catastrophe bond to protect its investment 

in the 2006 World Cup in Germany. The bond is rated investment grade and 

covers natural and terrorist catastrophic events that result in the 

cancellation of the final World Cup game. Representatives from the rating 

agency that rated the bond said they were able to provide an investment 

grade rating because the bond’s provisions make it highly unlikely that 

Page 33 GAO-03-1033 Catastrophe Bond Follow-up 
investors will lose their principal.43 For example, the officials said that it 

would require extraordinary circumstances for the final game to be 

cancelled. Under the bond’s provisions, FIFA also has the flexibility to 

reschedule the final game and, if necessary, hold the event in another 

country. While the rating agency official said that the firm relied on natural 

catastrophe models to help assign a rating to the bond, the firm did not rely 

on terrorism models because terrorism is impossible to predict. Instead, 

the rating firm used an analytical approach developed by one of the 

modeling firms to analyze potential terrorist threats to the 2006 World 

Cup.44 It remains to be seen how well the bond is accepted by investors 

and whether it will result in similar issuances. 

Observations	 Although catastrophe bonds to date have not transferred a significant 

portion of insurers’ natural catastrophe risk exposures to the capital 

markets, the bonds do play a useful role for some companies and 

institutional investors. For some companies, catastrophe bonds 

supplement traditional reinsurance and may lower the costs associated 

with covering low-probability, high severity events. For some institutional 

investors, catastrophe bonds are attractive in limited quantities because of 

their relatively high rate of return and usefulness in portfolio risk 

diversification. However, the lack of interest by other large insurance 

companies and institutional investors may have been factors in limiting the 

broader expansion of the market for catastrophe bonds. Some large 

insurers and state natural catastrophe authorities viewed the bonds as too 

expensive compared to traditional reinsurance and large institutional 

investors view the bonds as too risky, not worth the costs of understanding 

the risks, and illiquid. Whether the catastrophe bond market expands in the 

future beyond the useful but limited role that it currently serves would 

likely depend upon changing the views of additional large insurance 

companies and institutional investors about the bonds’ utility. 

43The structure of the bond rated investment grade guarantees that investors will recover at 

least 25 percent of their principal. Other provisions in the bond do not provide such 

protection to investors and were not rated. The rating agency also said that investor losses 

were not likely because Germany is not prone to natural disasters, the World Cup 

tournament is spread over many venues, and German security measures are stringent. 

44The rating agency’s analysis concluded that terrorism is unlikely to affect the 2006 World 

Cup because, among other reasons, “...there is less involvement by the U.S. and greater 

sympathy for football in general.” 

Page 34 GAO-03-1033 Catastrophe Bond Follow-up 
The general view of insurance industry officials and financial market 

participants is that the development of a bond market covering terrorism 

risks in the United States would be challenging at this time. Although 

statistical models have been developed to assist insurance companies in 

providing terrorism insurance, the models appear to be too new and 

untested to use in conjunction with a bond related to terrorism. Developing 

such models is considered extremely challenging due to the complexity of 

attempting to predict the frequency and severity of terrorist attacks. 

Investors’ lack of complete information about issuer underwriting 

practices and concerns about strategic behavior by terrorists, may make 

insurers’ costs of issuing bonds covering terrorism prohibitive. 

Agency Comments and 

Our Evaluation 

We received written comments on a draft of this report from NAIC, BMA, 

and RAA. We also received technical comments from these organizations, 

which we have incorporated into the report text where appropriate. 

NAIC commented that U.S. insurance regulators should encourage the 

development of alternative sources of capacity, such as insurance 

securitizations and risk-linked securities, so long as such developments are 

consistent with NAIC’s overriding goal of consumer protection. NAIC also 

made several other points in its comment letter. First, NAIC stated that 

SPRVs should be brought on-shore and be subject to U.S. regulation, which 

could lower the costs associated with catastrophe bonds. Second, NAIC 

stated that the removal of any uncertainty regarding the tax treatment of 

catastrophe bonds could encourage the use of such bonds. We note that the 

tax treatment of catastrophe bonds was outside the scope of our review for 

this report but we discussed the issue in detail in our previous report on 

risk-linked securities. Third, NAIC concurred with our report finding on the 

difficulty in securitizing terrorism risk, however, NAIC also commented 

that some insurers are writing terrorism risk, and if it can be priced, then it 

can be securitized. In addition, NAIC objected to a reference in the draft 

report to insurance company representatives implying that state insurance 

regulators set premium levels below levels that the insurer believed were 

necessary to cover their expected losses on natural catastrophes and 

operating expenses. We have revised the report text to more accurately 

describe the procedures for setting insurance premiums and reflected 

NAIC’s views in the report. 

BMA commented that the draft report provided a timely and helpful 

assessment of the progress of catastrophe bonds in transferring natural and 

terrorism catastrophe risk to the capital markets. However, BMA 

Page 35 GAO-03-1033 Catastrophe Bond Follow-up 
commented that while some insurers believe that catastrophe bonds are 

more expensive than reinsurance, other factors—such as reinsurer credit 

risk—must also be considered. In particular, BMA stated that that the 

relative attractiveness of catastrophe bonds depends upon whether the 

particular risk is truly a “peak peril” of the type that has typically been 

addressed by catastrophe bonds, which can include Japanese earthquakes, 

California earthquakes, and Florida hurricanes. BMA stated that 

reinsurance companies charge higher premiums to cover these types of 

perils. 

As stated in the report, reinsurance companies may limit coverage or 

charge increasingly higher premiums for low probability and high severity 

events, such as hurricanes or earthquakes expected to occur no more than 

once ever 100 to 250 years. Some insurance companies have concluded that 

catastrophe bonds serve as a useful risk transfer mechanism for such risks 

and as an effective supplement to traditional reinsurance. Some insurance 

company officials also stated that catastrophe bonds can serve a role in 

lowering the costs of insuring against such risks. Other insurance 

companies and state authorities we contacted do provide coverage for such 

events as Florida hurricanes and California earthquakes. However, officials 

from these organizations said that catastrophe bonds are not cost-effective 

as compared to reinsurance for the severity of events that they are willing 

to insure against. For example, some insurance companies believe that 

reinsurance offers more cost-effective coverage for events expected to 

occur more frequently that once every 100 years. 

RAA commented that our draft report provided a generally fair summary of 

the effort to securitize natural catastrophe risks and provides a very good 

overview of differing views on the utility of such bonds. However, RAA 

took exception to our draft report’s characterization of NAIC statutory 

accounting requirements for reinsurance as favorable compared to NAIC 

accounting requirements for certain catastrophe bonds. We have changed 

the language in the report to more clearly distinguish between the current 

grant of credit for traditional reinsurance and indemnity-based catastrophe 

bonds and NAIC’s review of potential changes to statutory accounting 

standards that would grant similar accounting treatment for nonindemnity 

based financial instruments that hedge insurance risk (including 

nonindemnity based catastrophe bonds). Such changes would allow credit 

to instruments that effectively hedge insurance risk because they are highly 

correlated with the issuer’s actual losses. We note that traditional 

reinsurance does not need hedge accounting treatment because it already 

receives credit for risk transfer. 

Page 36 GAO-03-1033 Catastrophe Bond Follow-up 
As agreed with your offices, unless you publicly announce the contents of


this report earlier, we plan no further distribution of this report until 30 


days from the report date. At that time, we will provide copies of this report 


to the Chairman and Ranking Minority Member, Senate Committee on 


Banking, Housing, and Urban Affairs and the Ranking Minority Members,


House Committee on Financial Services and its Subcommittee on Capital 


Markets, Insurance, and Government Sponsored Enterprises. Copies will 


also be provided to NAIC, BMA, RAA, and other interested parties. In 


addition, the report will be available at no charge on GAO’s home page at 


http://www.gao.gov.


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


Mr. Wesley M. Phillips or me at (202) 512-8678. GAO staff that made major 


contributions to this report are listed in appendix VIII.


Davi M. D’Agostino


Director, Financial Markets and


Community Investment


Page 37 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix I 

Objectives, Scope, and Methodology


You asked us to update our September 2002 report on the role of 

catastrophe bonds and factors affecting their use and to report on the 

potential for terrorism risk to be securitized. As agreed with your offices, 

our objectives were to (1) assess the progress of catastrophe bonds in 

transferring natural catastrophe risks to the capital markets; (2) assess 

factors that affect the issuance or sponsorship of catastrophe bonds by 

insurance and reinsurance companies, including a status report on 

accounting issues raised in our previous report; (3) assess factors that 

affect investment in catastrophe bonds, and (4) analyze the potential for 

and challenges associated with securitizing terrorism-related financial 

risks. 

Our general methodology involved meeting with a range of private-sector 

and regulatory officials to obtain diverse viewpoints on the status of efforts 

to securitize natural catastrophe and terrorism risks. We met with (1) three 

large insurers or reinsurers that currently issue catastrophe bonds and two 

insurers who currently do not, (2) two state authorities that currently do 

not issue catastrophe bonds through SPRVs, (3) three institutional 

investors—including a large pension fund and two hedge funds—that 

purchase catastrophe bonds and three large mutual funds that do not 

purchase catastrophe bonds, (4) investment banks that underwrite 

catastrophe bonds and monitor the market, (5) three large ratings agencies, 

(6) three modeling firms, (7) two large accounting firms, (8) two firms that 

engage in insurance and reinsurance brokerage, (9) the National 

Association of Insurance Commissioners (NAIC), (10) the Bond Market 

Association, and (11) the Reinsurance Association of America. Because of 

our reporting deadlines, we selected a judgmental sample of organizations 

to contact. We also reviewed our previous work on catastrophe bonds and 

insurance (see Related GAO Products) and data and reports provided by 

private-sector sources.1 

Even though we did not have audit or access-to-records authority for the 

private-sector entities, we obtained extensive testimonial and documentary 

evidence from them. However, we did not verify the accuracy of the data 

from these entities. We note that there is no central source of information 

on key issues, such as the number of catastrophe bonds issued or the 

1

One of the insurance companies with whom we met does not currently issue catastrophe 

bonds, but did issue one such bond several years ago. One of the state authorities does not 

issue catastrophe bonds through SPRVs, but some risks that it had transferred to a reinsurer 

were included in a catastrophe bond issued by that reinsurer. 

Page 38 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix I


Objectives, Scope, and Methodology


amount of catastrophe bonds outstanding. In such cases, we used 

professional judgment to determine how to present the data and what 

period of time to report. 

To respond to the first objective, we reviewed data on catastrophe bond 

issuance from 1997 through 2002 provided by a firm that specializes in 

these securities. We also obtained data from a large reinsurer that collects 

data on the size of the catastrophe bond market relative to the worldwide 

reinsurance market and a firm that collects data on reinsurance prices. We 

also obtained data from the firm on the issuance of catastrophe bonds by 

large insurers and reinsurers. 

To respond to the second objective, we asked insurance and reinsurance 

companies that issue or have issued catastrophe bonds why they had done 

so and what role the bonds played for their companies. We also asked other 

large insurance companies and two state catastrophe authorities that do 

not currently issue catastrophe bonds the basis for that decision. In 

addition, we asked financial market participants that support the use of 

catastrophe bonds—such as an investment bank and hedge fund—for their 

views on the costs associated with catastrophe bonds as opposed to 

reinsurance contracts. To update accounting issues raised in our 2002 

report, we reviewed FIN 46 and interviewed officials from accounting 

firms, insurers, and NAIC. 

To respond to the third objective, we spoke with three institutional 

investors that purchased catastrophe bonds and discussed their reasons for 

doing so. We also contacted representatives from three large mutual funds 

that had not purchased catastrophe bonds to obtain their views. We also 

obtained data comparing the returns on catastrophe bonds to other fixedincome investments, such as high-yield bonds. 

To respond to objective four, we contacted insurance and reinsurance 

companies, modeling firms, rating agencies, investment banks, and NAIC. 

We reviewed a variety of documents including academic studies, insurance 

company and reinsurance company articles on terrorism and terrorism 

insurance, modeling firm and rating firm publications, and offering 

circulars. 

We conducted our work between March and August 2003 in New York, 

Massachusetts, Ohio, Illinois, Pennsylvania, Texas, and Washington, D.C. 

Page 39 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix II 

Statutory Accounting Balance Sheet 

Implications of Reinsurance Contracts 

Over the duration of insurance policies, premiums that an insurance 

company collects are expected to pay for any insured claims and 

operational expenses of the insurer while providing the insurance company 

with a profit. The amount of projected claims that a single insurance policy 

may incur is estimated on the basis of the law of averages. An insurance 

company can obtain indemnification against claims associated with the 

insurance policies it has issued by entering into a reinsurance contract with 

another insurance company, referred to as the reinsurer. The original 

insurer, referred to as the ceding company, pays an amount to the reinsurer, 

and the reinsurer agrees to reimburse the ceding company for a specified 

portion of the claims paid under the reinsured policy. 

Reinsurance contracts can be structured in many different ways. 

Reinsurance transactions over the years have increased in complexity and 

sophistication. Reinsurance accounting practices are influenced not only 

by state insurance departments through the National Association of 

InsuranceCommissioners (NAIC), but also by the Securities and Exchange 

Commission and the Financial Accounting Standards Board. If an insurer 

or reinsurer engages in international insurance, both government 

regulatory requirements and accounting techniques will vary widely among 

countries. 

Statutory accounting principles promulgated by NAIC allow an insurance 

company that obtains reinsurance to reflect the transfer of risk for 

reinsurance on the financial statements that it files with state regulators 

under certain conditions. The regulatory requirements for allowing credit 

for reinsurance are designed to ensure that a true transfer of risk has 

occurred and any recoveries from reinsurance are collectible. By obtaining 

reinsurance, ceding companies are able to write more policies and obtain 

premium income while transferring a portion of the liability risk to the 

reinsurer. 

To illustrate, under many reinsurance contracts, a commission is paid by 

the reinsurer to the ceding company to offset the ceding company’s initial 

acquisition cost, premium taxes and fees, assessments, and general 

overhead. For example, if an insurer would like to receive reinsurance for 

$10 million and negotiates a 20 percent ceding commission, then the 

insurer will be required to pay the reinsurer $8 million ($10 million 

premiums ceded, less $2 million ceding commission income). The effect of 

this transaction is to reduce the ceding company’s assets by the $8 million 

paid for reinsurance, while reducing the company’s liability for unearned 

Page 40 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix II


Statutory Accounting Balance Sheet 


Implications of Reinsurance Contracts


premiums by the $10 million in liabilities transferred to the reinsurer. The 

$2 million is recorded by the ceding company as commission income. 

This type of transaction results in an economic benefit for the ceding 

company because the ceding commission increases equity. The reinsurer 

has assumed a $10 million liability and would basically report a mirror 

entry that would have the opposite effects on its financial statements. 

Figure 8 shows the effects of the reinsurance transaction on both the 

ceding insurance company and reinsurance company’s balance sheets and 

is intended to show how one transaction increases and decreases assets 

and liabilities. 

Figure 8: Effect on Ceding and Reinsurance Companies’ Balance Sheets before and 

after a Reinsurance Transaction 

Liabilities/ 

Equity 

Cash 

Unearned premium 

reserve 

Policyholders' 

surplus 

Total 

$25,000,000 

$25,000,000 

$20,000,000 

$25,000,000 

5,000,000 

$17,000,000 

$17,000,000 

$10,000,000 

$17,000,000 

7,000,000 

After 

Assets Liabilities/ 

Equity 

Before 

Assets 

Liabilities/ 

Equity 

Cash 

Total 

$30,000,000 

$30,000,000 

$25,000,000 

$30,000,000 

5,000,000 

$38,000,000 

$38,000,000 

$35,000,000 

$38,000,000 

3,000,000 

After 

Assets Liabilities/ 

Equity 

Before 

Assets 

Reinsurance company 

Ceding company 

Unearned premium 

reserve 

Policyholders' 

surplus 

Source: Insurance Accounting Systems Association. 

Page 41 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix II


Statutory Accounting Balance Sheet 


Implications of Reinsurance Contracts


Reinsurance contracts do not relieve the ceding insurer from its obligation 

to policyholders. Failure of reinsurers to honor their obligations could 

result in losses to the ceding insurer. 

An insurer may also obtain risk reduction from a special purpose 

reinsurance vehicle (SPRV) that issues an indemnity-based, risk-linked 

security; the recovery by the insurer would be similar to a traditional 

reinsurance transaction. However, if an insurer chooses to obtain risk 

reduction from sponsoring a nonindemnity-based, risk-linked security 

issued through an SPRV, the recovery could differ from the recovery 

provided by traditional reinsurance. Even though the insurer is reducing its 

risk, the accounting treatment would not allow a reduction of liability for 

the premiums. 

Page 42 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix III 

FASB Interpretation No. 46, Consolidation of 

Variable Interest Entities 

In January 2003, the Financial Accounting Standard Board (FASB) released 

Interpretation No. 46 with the objective of improving financial reporting by 

entities involved in variable interest entities (VIE)—an entity subject to 

consolidation according to the provisions of the Interpretation---and not to 

restrict the use of VIEs.

1 The goal is to help financial statement users 

understand the financial statements of VIE primary beneficiaries that 

consolidate as well as those with a significant variable interest that do not 

consolidate. Interpretation No. 46 states that to faithfully represent the 

total assets that an enterprise controls and liabilities for which an 

enterprise is responsible, assets and liabilities of the VIE for which the 

enterprise is the primary beneficiary must be included in an enterprise’s 

consolidated financial statements. 

What is a VIE?	 The interpretation explains how to identify VIEs, which are entities that, by 

design, have one or both of the following characteristics: 

1.	 The total equity investment at risk is not sufficient (insufficiency is 

presumed if the equity investment is less than 10 percent of the equity’s 

total assets, but this presumption may be rebutted) to permit the entity 

to finance its activities without additional subordinated financial 

support from other parties. In other words, the equity investment at 

risk is not greater than the expected losses of the entity. Such 

subordinated financial support may be provided through other interests 

(including ownership, contractual, or other pecuniary interests) that 

will absorb some or all of the expected losses of the entity. 

2.	 The equity investors lack one or more of the following essential 

characteristics of a controlling financial interest: 

•	 The direct or indirect ability to make decisions about the entity’s 

activities through voting rights or similar rights; 

•	 The obligation to absorb the expected losses of the entity if they 

occur, which makes it possible for the entity to finance its activities; 

or 

1

This analysis of FIN 46 is based on existing interpretations by private-sector analysts and 

publications. See, for example, Michael J. Pinsel. “Impact of FIN 46 on Insurance Industry 

Transactions.” Insurance and Financial Services Report (Second Quarter Issue, 2003). 

Page 43 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix III


FASB Interpretation No. 46, Consolidation of 


Variable Interest Entities


•	 The right to receive the expected residual returns of the entity if they 

occur, which is the compensation for the risk of absorbing the 

expected losses. 

Consolidate or Not?	 The interpretation also gives guidance on how an enterprise assesses its 

interests in a VIE to consolidate that entity. FASB says that if a business 

enterprise has a controlling financial interest in a VIE, the assets, liabilities, 

and results of the activities of the VIE should be included in consolidated 

financial statements of the business enterprise. A direct or indirect ability 

to make decisions that significantly affect the results of the activities of a 

VIE is a strong indication that an enterprise has one or both of the 

characteristics that would require consolidation of the variable interest 

entity. 

Primary Beneficiaries Must The interpretation requires existing unconsolidated VIEs to be 

Consolidate	 consolidated by their primary beneficiaries if the entities do not effectively 

disperse risks among parties involved. A primary beneficiary is the party 

that absorbs a majority of the VIE’s expected losses if they occur, receives a 

majority of its expected residual returns if they occur, or both. The primary 

beneficiary of the VIE is required to disclose (1) the nature, purpose, and 

size of the VIE; (2) the carrying amount and classification of consolidated 

assets that are collateral; and (3) any lack of recourse by creditors. 

Page 44 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix IV 

Texas Windstorm Insurance Association


In 1971, the Texas Legislature established the Texas Windstorm Insurance 

Association (TWIA) as a mechanism to provide wind and hail coverage to 

residents of 14 counties along the coast and portions of 1 additional county 

who are unable to obtain insurance in the voluntary market. The 

legislature’s action was in response to insurance market constrictions 

along the Texas Gulf Coast after several hurricanes in the late 1960s and 

Hurricane Celia, which struck Corpus Christi in August 1970. TWIA is a 

pool of property and casualty insurance companies authorized to write 

coverage in Texas. Since its inception, the legislature has made it clear that 

TWIA was to write limited coverage for wind and hail in order to provide 

for the “orderly economic growth of the Coastal counties.” 

Residential and commercial rates for the TWIA are controlled by statute. 

The average residential policy costs more than $500. There is an annual 

rate increase or decrease cap on both residential and commercial rates of 

10 percent, except under unusual circumstances following a catastrophe or 

series of catastrophes, when the Commissioner of Insurance—after a 

public hearing—has the authority to lift the cap. Currently, it is estimated 

that TWIA provides 20 percent of the residential coverage for wind and hail 

and 50 percent of the seaward coverage in Texas. 

As of June 30, 2003, TWIA had more than 89,000 residential and commercial 

policies and a claims paying capacity of more than $1.1 billion. TWIA’s total 

liability on these residential and commercial policies was more than $17 

billion. The organization’s claims paying capacity consists of layers of 

assessment of their pool of insurers, the Catastrophe Trust Fund, and 

reinsurance. As shown in figure 9, for the bottom level of financing ($0 to 

$100 million) and the highest probability of occurrence (one in every 9 

years), TWIA has coverage through its pool of insurers. For the next level 

of financing ($100 to $200 million) and probability of occurrence of once 

every 9 to 15 years, coverage comes from the Catastrophe Trust Fund. 

Page 45 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix IV


Texas Windstorm Insurance Association


Figure 9: Texas Windstorm Insurance Authority Financing 

0 

$100M 

$200M 

$400M 

$700M 

$800M 

$1.1B 

$1B 

9 years 

15 years 

27 years 

54 years 

67 years 

102 years 

125 years 

$100M Assessment of pool of insurers 

$200M Assessment of pool of insurers 

Unlimited assessment of pool of insurers 

$100M Catastrophe Trust Fund 

Reinsurance of $100% of $100M in excess of $1B 

$100M Catastrophe Trust Fund 

$100M Catastrophe 

Trust Fund 

Reinsurance of 

50% of $200M 

in excess of $200M 

Reinsurance of 100% of $300M 

in excess of $400M 

Lowest probability 

of occurrence 

Highest probability 

of occurrence 

Source: TWIA. 

The Catastrophe Trust Fund consists of funds originally provided by 

cancellation of a multiyear reinsurance contract. Coverage comes from the 

Catastrophe Trust Fund and reinsurance for the next layer of financing at 

($200 to $400 million) and with a probability of occurrence of once every 15 

to 27 years. The Catastrophe Trust Fund covers $100 million of this layer 

while reinsurance covers an additional $100 million. The next layer of 

financing is $300 million of reinsurance and covers events occurring once 

every 27 to 54 years. The next layer of financing is $100 million in coverage 

from the Catastrophe Trust Fund and covers events that occur once every 

54 to 67 years. The next layer up of financing is a $200 million assessment 

of its pool of insurers and covers events occurring once every 67 to 102 

years. The next level of financing comes from $100 million in reinsurance 

coverage. For any losses above this point, there is an unlimited assessment 

of TWIA’s pool of insurers. 

Page 46 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix V 

Comments from the National Association of 

Insurance Commissioners 

Note: GAO comments 

supplementing those in 

the report text appear 

at the end of this 

appendix. 

Page 47 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix V


Comments from the National Association of 


Insurance Commissioners


See comment 1. 

See comment 2. 

Page 48 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix V


Comments from the National Association of 


Insurance Commissioners


Page 49 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix V


Comments from the National Association of 


Insurance Commissioners


The following are GAO's comments on the National Association of 

Insurance Commissioner's letter dated September 5, 2003. 

GAO Comments 1. We have reflected NAIC's views in the report. 

2. We have revised the text and reflected NAIC's views in the report. 

Page 50 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI 

Comments from the Bond Market Association


Note: GAO comments 

supplementing those in 

the report text appear 

at the end of this 

appendix. 

Page 51 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


See comment 1. 

See comment 2. 

See comment 3. 

Page 52 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


See comment 4. 

Page 53 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


See comment 5. 

See comment 6. 

See comment 7. 

See comment 8. 

Page 54 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


See comment 9. 

See comment 10. 

See comment 11. 

See comment 12. 

See comment 13. 

See comment 14. 

Page 55 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


See comment 15. 

See comment 16. 

See comment 17. 

Page 56 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


Page 57 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


Page 58 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


The following are GAO's comments on the Bond Marketing Association's 

(BMA) letter dated September 5, 2003. 

GAO Comments 1. 

2. 

3. 

4. 

5. 

6. 

7. 

The two insurance companies that we discussed in this section of the 

report as well as one state authority cover Florida hurricanes or 

California earthquakes ("peak perils" as defined by BMA). Officials 

from each of these organizations said that they have compared the 

costs associated with catastrophe bonds to traditional reinsurance and 

did not consider catastrophe bonds cost-effective for their catastrophe 

reinsurance needs for the level of risks that they insure against 

(although they may have other reasons for not using catastrophe bonds 

including the fact that most SPRVs are based offshore). The other state 

authority does not cover either Florida hurricanes or California 

earthquakes but considers catastrophe bonds as not cost-effective 

compared with traditional reinsurance for its business. 

While multi-year fixed pricing may be a factor in catastrophe bonds' 

favor, none of the insurers or state authorities we contacted who 

currently do not issue catastrophe bonds cited it in our discussions. 

The BMA is correct in its statement that catastrophe bond transaction 

costs decline as a percentage of the (coverage) limit provided as deal 

size and bond maturity increase. However, some insurance company 

and state authority representatives said that it was not cost-effective 

for them to issue catastrophe bonds in amounts large enough to offset 

the transaction costs. 

We have clarified the language in the report with respect to the 

potential effects that consolidation would have for potential 

catastrophe bond issuers. 

We have reflected BMA's position in the report. We note that BMA's 

position differs from that of several large mutual fund companies we 

contacted who said that catastrophe bonds are illiquid. 

The mutual fund companies that we contacted offer high-yield bond 

funds to their investors. 

We have clarified language in the report stating that investors do not 

always face total losses if catastrophe bond provisions are triggered. 

Page 59 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VI


Comments from the Bond Market Association


8. We have clarified the language in the report. 

9.	 We have added language to the report that provides additional reasons 

that most SPRVs are based offshore. 

10. We have made revisions to the figure. 

11. We agree that there are different approaches to comparing the returns 

on different types of financial instruments and have clarified language 

in the report. The data we obtained suggest that catastrophe bonds 

have had a higher return than high-yield corporate debt in 2002. The 

scope of our work did not involve identifying or assessing other 

measures, although we note that BMA believes that catastrophe bonds 

yields are comparable to high-yield corporate debt. 

12. As discussed in this report, many catastrophe bonds have covered 

events expected to take place no more than once every 100 to 250 

years. It remains to be seen whether a greater number of catastrophe 

bonds covering events expected to take place more frequently than 

once every 100 years will occur. 

13. As noted in the report, some insurers issue or have issued indemnitybased catastrophe bonds. 

14. We have revised the figure in the report. 

15. We agree that some insurers find that catastrophe bonds serve as an 

important supplement to traditional means of managing risk, such as 

reinsurance or limiting coverage in high-risk areas. 

16. We have reflected BMA's position in the report. 

17. A Fitch representative we contacted said that the report cited in the 

draft report had not been updated since 2001. We revised the text and 

stated BMA's position. 

Page 60 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII 

Comments from the Reinsurance Association 

of America 

Note: GAO comments 

supplementing those in 

the report text appear 

at the end of this 

appendix. 

See comment 1. 

Page 61 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


See comment 2. 

Page 62 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


See comment 3. 

Page 63 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


See comment 4. 

See comment 5. 

See comment 6. 

See comment 7. 

See comment 8. 

Page 64 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


See comment 9. 

See comment 10. 

See comment 11. 

See comment 12. 

See comment 13. 

See comment 14. 

Page 65 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


See comment 15. 

See comment 16. 

See comment 17. 

See comment 18. 

Page 66 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


See comment 19. 

See comment 20. 

See comment 21. 

Page 67 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


The following are GAO's comments on the Reinsurance Association of 

America's (RAA) letter dated September 3, 2003. 

GAO Comments 1. 

2. 

3. 

4. 

5. 

6. 

7. 

8. 

9. 

In this report, we have revised the text to clarify that current statutory 

accounting standards differ for traditional indemnity reinsurance 

contracts—including indemnity based catastrophe bonds—and 

nonindemnity based instruments that hedge insurance risk, such as 

nonindemnity catastrophe bonds. Where appropriate, we have also 

revised the text to make clear why the accounting standards differ. That 

is, traditional reinsurance results in risk transfer while nonindemnity 

based instruments have not been viewed as providing a comparable 

risk transfer. We note that NAIC is considering a proposal that would 

allow similar accounting treatment for nonindemnity based 

instruments that effectively hedge insurance company risks. 

See comment 1. We note that traditional reinsurance does not need 

hedge accounting treatment afforded an effective hedge because it 

already receives credit for risk transfer. 

See comment 1. 

We have altered the report text to indicate that reinsurance contracts 

may involve litigation over whether insurer claims should be paid. We 

also state RAA's position in the report. 

We have added language to the report stating RAA's positions. 

We agree that reinsurance and indemnity based catastrophe bonds 

receive identical accounting treatment and have revised the text to 

make this point clear. However, we note that this statutory accounting 

treatment differs from the accounting treatment that applies to 

nonindemnity based instruments, such as nonindemnity catastrophe 

bonds, and this point has also been clarified in the text. 

See comment 1. 

See comment 1. 

See comment 1. 

Page 68 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VII


Comments from the Reinsurance Association 


of America


10. See comment 1. We think that insurance statutory accounting rules are 

primarily the concern of issuers and not investors—who would not be 

subject to such rules. 

11. We have revised the report text. 

12. We have revised the report text. 

13. We have revised the text to avoid confusion with other discussions in 

this report. 

14. We have revised the report text. 

15. We have changed the text so that "frequently" is replaced by "may." We 

have also added RAA's views on the prevalence of insurance litigation. 

16. We have added language to the report as suggested by RAA concerning 

additional reasons reinsurance prices increased during the 1999-2002 

period. 

17. We have added language to the report on the issue of basis risk 

presented by nonindemnity based catastrophe bonds. 

18. We have added the text on tail risk suggested by RAA stating that 

reinsurance contracts may continue to address tail risk while 

catastrophe bonds may not allow claims after several years. 

19. See comment 10. 

20. We have made some revisions to the report text. 

21. We have revised the report language so that the Florida Hurricane 

Catastrophe Fund is properly identified. 

Page 69 GAO-03-1033 Catastrophe Bond Follow-up 
Appendix VIII 

GAO Acknowledgments and Staff Contacts


GAO Contacts	 Davi M. D'Agostino (202) 512-8678 

Wesley M. Phillips (202) 512-5660 

Acknowledgments	 In addition to those named above, Lynda Downing, Patrick S. Dynes, 

Christine Kuduk, Marc Molino, Rachel DeMarcus, and Rachel Seid made 

key contributions to this report. 

Page 70 GAO-03-1033 Catastrophe Bond Follow-up 
Related GAO Products


Insurance Regulation: Preliminary Views on States' Oversight of 

Insurers' Market Behavior. GAO-03-738T. Washington, D.C.: May 6, 2003. 

Catastrophe Insurance Risks: The Role of Risk-Linked Securities. GAO03-195T. Washington, D.C.: October 8, 2002. 

Catastrophe Insurance Risks: The Role of Risk-Linked Securities and 

Factors Affecting Their Use. GAO-02-941. Washington, D.C.: September 24, 

2002. 

Terrorism Insurance: Rising Uninsured Exposure to Attacks Heightens 

Potential Economic Vulnerabilities. GAO-02-472T. Washington, D.C.: 

February 27, 2002. 

Terrorism Insurance: Alternative Programs for Protecting Insurance 

Consumers. GAO-02-199T. Washington, D.C.: October 24, 2001. 

Insurance Regulation: The NAIC Accreditation Program Can Be 

Improved. GAO-01-948. August 31, 2001. 

Regulatory Initiatives of the National Association of Insurance 

Commissioners. GAO-01-885R. Washington, D.C.: July 6, 2001. 

Disaster Assistance: Issues Related to the Development of FEMA's 

Insurance Requirements. GGD/OGC-00-62. Washington, D.C.: February 25, 

2000. 

Insurers' Ability to Pay Catastrophe Claims. GGD-00-57R. Washington, 

D.C.: February 8, 2000. 

FCIC: Catastrophic Risk Protection Endorsement and Federal Crop 

Insurance Reform, Insurance Implementation. OGC-98-69. Washington, 

D.C.: August 17, 1998. 

(250134) Page 71 GAO-03-1033 Catastrophe Bond Follow-up 
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