Testimony

Before the Subcommittee on Oversight and

Investigations, Committee on Financial Services,

House of Representatives

United States General Accounting Office

GAO

For Release on Delivery

Expected at 2:00 p.m., EDT,

on Tuesday, October 8, 2002 CATASTROPHE

INSURANCE RISKS

The Role of Risk-Linked

Securities

Statement of Davi M. D’Agostino,

Director, Financial Markets and Community Investment

GAO-03-195T
Why GAO Did This Study

Because of population growth,

resulting real estate

development, and rising real

estate values in hazard-prone

areas, our nation is increasingly

exposed to higher property

casualty losses—both insured

and uninsured—from natural

catastrophes than in the past. In

the 1990s, a series of natural

disasters, including Hurricane

Andrew and the Northridge

earthquake, raised questions

about the adequacy of the

insurance industry’s financial

capacity to cover large

catastrophes without limiting

coverage or raising premiums.

Recognizing this greater

exposure and responding to

concerns about insurance market

capacity, participants in the

insurance industry and capital

markets have developed new

capital market instruments as an

alternative to traditional

property-casualty reinsurance, or

insurance for insurers. GAO’s

objectives were to (1) describe

catastrophe risk and how the

insurance and capital markets

provide coverage against such

risks; (2) describe how risklinked securities, particularly

catastrophe bonds, are

structured; and (3) analyze how

key regulatory, accounting, tax,

and investor issues might affect

the use of risk-linked securities.

October 2002

CATASTROPHE INSURANCE RISKS

The Role of Risk-Linked Securities

The full testimony is available at www.gao.gov/cgi-bin/getrpt?GAO-03-195T. For additional information about the testimony, contact Davi D'Agostino

(202-512-8678; dagostinod@gao.gov).

Highlights of GAO-03-195T, a testimony for the Subcommittee on Oversight and Investigations, House

Committee on Financial Services

United States General Accounting Office

What GAO Found

Natural catastrophes are infrequent events that cause severe losses. More

than 68 million Americans live in hurricane-vulnerable coastal areas, and

80 percent of Californians live near active earthquake faults. Insurance

companies who write property-casualty policies in these high-risk areas

try to spread the risks, traditionally through reinsurance. When

reinsurance prices or availability became problematic in the 1990s,

insurers turned to risk-linked securities as an alternative means to spread

catastrophe risk. Most risk-linked securities are catastrophe bonds,

which (1) have complicated structures, (2) are created offshore through

special purpose entities, and (3) generally receive noninvestment-grade

ratings. Key regulatory, accounting, tax, and investor issues pose

challenges to expanding the use of risk-linked securities, and GAO

discusses the advantages and disadvantages of potential changes.

Estimated Losses from Recent Large Catastrophes

Sources: Insurance Information Institute and other insurance industry sources.

G A O

Accountability Integrity Reliability

Highlights
Page 1 GAO-03-195T

Madame Chairwoman and Members of the Subcommittee:

I am pleased to be here today to discuss the results of our work on the

potential for risk-linked securities to address catastrophic risks arising

from natural events such as hurricanes and earthquakes. Population

growth, real estate development, and rising real estate values in hazardprone areas increasingly expose our nation to higher losses—both insured

and uninsured—from natural catastrophes than in the past. This exposure

increases pressure on businesses; individuals; and federal, state, and local

governments to assume ever-larger liabilities for losses associated with

natural catastrophes. A series of natural disasters in the 1990s, including

Hurricane Andrew and the Northridge earthquake, raised questions about

the financial capacity of the insurance industry to cover large catastrophes

without limiting coverage or substantially raising premiums, and called

attention to ways of raising additional sources of capital to help cover

catastrophe risk. Participants in the insurance industry and capital

markets developed new capital market instruments, risk-linked securities,

which both expand insurance and reinsurance capacity and provide an

alternative to traditional property-casualty reinsurance. We were asked to

analyze the role of risk-linked securities in the coverage of catastrophe

risk and factors affecting their use.

Today I will talk about (1) what catastrophe risk is and how the insurance

and capital markets provide coverage for such risks; (2) how risk-linked

securities, particularly catastrophe bonds, are structured; and (3) how key

regulatory, accounting, tax, and investor issues might affect the use of

these securities. Our overall objective is to provide the Committee with

information and perspectives to consider as it moves forward in this

important and complex area. For a fuller discussion of these points, I refer

you to our report entitled Catastrophe Insurance Risks: The Role of RiskLinked Securities and Factors Affecting Their Use (GAO-02-941), which

was released today at this hearing.

Even though we did not have statutory audit or access-to-records

authority with respect to the involved private-sector entities, we obtained

extensive documentary and testimonial evidence from various groups,

including insurance and reinsurance companies, investment banks,

investors, rating agencies, firms that develop models to analyze

catastrophic risks, regulators, and academic experts. However, we were

not able to verify the accuracy of data provided by these groups.

Our statement covers a number of issues affecting risk-linked securities,

but we make no recommendations. While we have identified factors that
Page 2 GAO-03-195T

industry and capital markets experts believe might cause the use of risklinked securities to expand or contract, it is difficult to predict the future

use of these securities—either under current accounting, regulatory, and

tax policies or under changed policies. We do not take a position on

whether the increased use of risk-linked securities is beneficial or

detrimental.

In summary:

Catastrophe risk is a global phenomenon and insurance and reinsurance

companies with global operations often provide coverage. We focused on

catastrophe risk in the United States. The map before you shows the

geographic distribution of catastrophe risk in the United States and

highlights areas that are the most likely to experience certain types of

natural catastrophes. The characteristics of natural disasters prompt most

insurers to limit the amount and type of catastrophe risk they hold. For

example, property-casualty insurers with too many policies concentrated

in California and Florida—states that are more subject to natural

catastrophes—need ways to diversify and transfer that risk. One key way

to transfer risk is through reinsurance. Traditional reinsurance provides

indemnity-based coverage, which compensates part or all of an insurer’s

losses as they are incurred, and depends on well-developed business

relationships between insurers and reinsurers, which facilitate relatively

low transaction costs. However, in a situation involving extremely large or

multiple catastrophic events, insurers might not have purchased sufficient

reinsurance or reinsurers might not have sufficient capital to meet their

existing obligations. Further, reinsurance capital is diminished after a

catastrophic loss, and reinsurers might raise prices or limit the availability

of future coverage. In the 1990s, the combination of two extremely costly

disasters—Andrew and Northridge—and conditions in the reinsurance

market helped spur the development of risk-linked securities and other

alternatives to traditional reinsurance. The securities provided new access

to national and international capital markets. Yet to date, risk-linked

securities represent a small share—less than 0.5 percent—of worldwide

catastrophe insurance, according to the Swiss Reinsurance Company.

We focused on catastrophe bonds because they currently comprise the

largest share of risk-linked securities, which also include other
Page 3 GAO-03-195T

instruments such as options.1 To develop a catastrophe bond, a sponsor,

usually an insurance or reinsurance company, creates a special purpose

reinsurance vehicle (SPRV) to provide reinsurance to the sponsor and to

issue bonds to the securities market. SPRVs are similar in purpose to the

special purpose entities that banks and others have used to securitize their

loans. These special purpose entities “pass through” principal and interest

from borrowers to investors. In contrast, SPRVs, which are typically

located offshore for tax, regulatory, and legal advantages, receive

payments in three forms (insurance premiums, interest, and principal),

invest in Treasury securities and other highly rated securities, and pay

investors in another form (interest). Figure 1 illustrates cash flows among

the participants in a catastrophe bond.

Figure 1: Cash Flows for a Special Purpose Reinsurance Vehicle

Source: GAO.

The sponsoring insurance company enters into a reinsurance contract and

pays reinsurance premiums to the SPRV to cover specified claims. The

SPRV issues bonds or debt securities for purchase by investors. The

catastrophe bond offering defines a catastrophe that would trigger a loss

 1

Catastrophe options were offered by the Chicago Board of Trade in 1995 and were delisted

in 2000 due to lower-than-expected demand. The purchaser of a catastrophe option paid

the seller a premium, and the seller provided the purchaser with a cash payment if an index

measuring insurance industry catastrophe losses exceeded a certain level. If the

catastrophe loss index remained below a specified level for the prescribed time period, the

option expired worthless, and the seller kept the premium.
Page 4 GAO-03-195T

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 raised 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 from the company into

the trust account. The premium paid by the SPRV sponsor 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 a

predefined catastrophe occurs, principal that otherwise would be returned

to the investors is used to fund the SPRV’s payments to the insurer or

sponsor. The investor’s reward for taking this risk is a relatively high

interest rate paid by the bonds.

Recently issued catastrophe bonds have been nonindemnity-based—that

is, structured to make payments to the sponsor upon the verified

occurrence of specified catastrophic events. Indemnity-based reinsurance

coverage compensates insurers for part or all of their losses from insured

claims.2

 Although insurers prefer indemnity-based coverage because

reinsurance payments are directly linked to claims actually incurred,

reinsurers face the risk of paying more if the insurer underwrites or selects

risks poorly, or has poor claims-settlement practices. With an indemnitybased catastrophe bond, investors would have greater exposure to risks

from poor underwriting and claims settlement practices because investors

might not be able to monitor the insurer’s behavior. As a result, investors

prefer nonindemnity-based bonds because they are tied to an objective

index or measure that is unrelated to the insurance company’s

management.

In addition to looking at the characteristics and coverage of catastrophe

risk and the structure of risk-linked securities, we identified and analyzed

regulatory, accounting, tax, and investor issues that might affect the use of

risk-linked securities:

 2

Indemnity 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 time period in a

certain 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 specifies a specific event that triggers payment and payment formulas that are not

directly related to the insurer’s actual incurred claims.
Page 5 GAO-03-195T

• First, accounting treatment for risk transfers occurring through

nonindemnity-based, risk-linked securities is a challenge for regulators. In

traditional reinsurance—that is, indemnity-based—transactions, where an

insurer is compensated for part or all of its losses from insured claims, the

insurer gets credit on its balance sheet in the form of a deduction from

liability for the risk transferred to the reinsurer and can reduce the amount

of regulatory risk-based capital required. Credit for reinsurance is

designed to ensure that a true transfer of risk has occurred and that the

reinsurance company will be able to pay any claims. In nonindemnity

transactions using catastrophe bonds, payments may be triggered by an

index or independently measurable value, such as wind speed, and are not

directly related to incurred claims. When a catastrophic event triggers a

catastrophe bond, payment formulas determine the reduction of the

investors’ principal that will compensate the insurance company sponsor.

As a result, it is difficult to value the true amount of risk transferred to

determine credit for reinsurance. The National Association of Insurance

Commissioners and interested insurance industry parties are considering

revisions in the regulatory accounting treatment of risk transfer obtained

through nonindemnity-based coverage. If insurance accounting standards

were changed so that the value of the risk transfer could be accurately

calculated and recognized as an offset to potential insurance losses, the

insurer could get credit for reinsurance for risk transfers occurring

through nonindemnity-based catastrophe bonds. Such changes, if adopted,

could facilitate the use of risk-linked securities. However, it is important

that credit for nonindemnity-based reinsurance accurately reflect the true

risk transferred so that insurance company reporting on both risk

evaluation and capital treatment properly reflects the risks retained.

• Second, the Financial Accounting Standards Board is proposing a new

interpretation addressing consolidation of certain special purpose entities

on a sponsor’s balance sheet. Under current guidance, a sponsor could

avoid consolidating an SPRV as a liability on its balance sheet if the SPRV

has at least 3 percent independent equity capital investment. The proposal

may increase the independent capital investment required for a sponsor to

treat an SPRV as independent to 10 percent of total assets. The proposal

also contemplates other tests for consolidation of certain special purpose

entities. While the proposed guidance is intended to improve financial

transparency in capital markets and stem potential abuses of special

purpose entities, it could also increase the cost of issuing catastrophe

bonds. If the proposed interpretation requires consolidation, sponsors

might turn to risk-linked securities, such as catastrophe options, that do

not require an SPRV.
Page 6 GAO-03-195T

• Third, insurance industry representatives are considering a legislative

proposal to help expand the use of domestically issued, or onshore,

catastrophe bonds. SPRVs are typically located offshore, in part, to avoid

U.S. taxes. By allowing special “pass-through” tax treatment, the proposal

would eliminate U.S. taxation at the SPRV level. The pass-through

treatment would be similar to that already provided to Real Estate

Mortgage Investment Conduits and Financial Asset Securitization

Investment Trusts. To the extent that domestic SPRVs gained business at

the expense of taxable entities, including reinsurance companies, the

federal government could experience tax revenue losses. Expanded use of

catastrophe bonds might occur with favorable implementing requirements,

but such legislative actions might also create pressure from other industry

sectors for similar tax treatment. Some elements of the insurance industry

believe that any consideration of changes to the tax treatment of domestic

SPRVs would have to take into account the taxation of domestic

reinsurance companies. Specifically, the Reinsurance Association of

America argues that if special tax treatment is provided to domestic

SPRVs, they would operate under tax advantages not afforded to existing

U.S. licensed and taxed reinsurance companies.

• Fourth, unlike other bonds, catastrophe bonds, most of which are

noninvestment-grade instruments, have not been sold to a wide range of

investors beyond institutional investors. Investment fund managers who

included catastrophe bonds in their portfolios told us that catastrophe

bonds comprised 3 percent or less of those portfolios. On the one hand,

the managers appreciate the diversification aspects of catastrophe bonds

because the risks are generally uncorrelated with the credit risks of other

parts of the bond portfolio. On the other hand, the risks are difficult to

assess and investors are concerned about the limited liquidity and track

record of the bonds.

Madame Chairwoman, Members of the Subcommittee, that concludes my

prepared statement. I would be happy to answer any questions at this time.

(250091)