Catastrophe Risk: U.S. and European Approaches to Insure Natural Catastrophe and Terrorism Risks
Published: 2005-02-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Natural catastrophes and terrorist attacks can place enormous financial demands on the insurance industry, result in sharply higher premiums and substantially reduced coverage. As a result, interest has been raised in mechanisms to increase the capacity of the insurance industry to manage these types of events. In this report, GAO (1) provides an overview of the insurance industry's current capacity to cover natural catastrophic risk and discusses the impacts of the 2004 hurricanes; (2) analyzes the potential of catastrophe bonds--a type of security issued by insurers and reinsurers (companies that offer insurance to insurance companies) and sold to institutional investors--and tax-deductible reserves to enhance private-sector capacity; and (3) describes the approaches that six European countries have taken to address natural and terrorist catastrophe risk, including whether these countries permit insurers to use tax-deductible reserves for such events. We provided a draft of this report to the Department of the Treasury and the National Association of Insurance Commissioners. Treasury provided technical comments that were incorporated as appropriate.
section_title: What GAO Found
paragraphs: Despite steps that governments and insurers have taken in recent years to strengthen insurer capacity for catastrophic risk, the industry has not been tested by a major catastrophic event or series of events (at least $50 billion or more in insured losses). While insurers suffered losses of over $20 billion in Florida from the 2004 hurricanes, steps such as implementing stronger building codes and stricter underwriting standards may have limited market disruptions as compared with the aftermath of Hurricane Andrew in 1992. For example, in 2004, only 1 Florida insurance company failed in contrast to the 11 that failed after Hurricane Andrew in 1992. However, a more severe catastrophic event or series of events could severely disrupt insurance markets and impose recovery costs on governments, businesses, and individuals. Some insurers and reinsurers benefit from catastrophe bonds because the bonds diversify their funding base for catastrophic risk. However, these bonds currently occupy a small niche in the global catastrophe reinsurance market and many insurers view the costs associated with issuing them as significantly exceeding traditional reinsurance. In addition, industry participants do not consider catastrophe bonds for terrorism risk feasible at this time. Authorizing insurers to establish tax-deductible reserves for potential catastrophic events has been advanced as a means to enhance industry capacity, but according to some industry analysts such reserves would lower federal tax receipts and not necessarily bring about a meaningful increase in capacity because insurers may substitute the reserves for other types of capacity. The six European countries GAO studied use a variety of approaches to address catastrophe risk. Some governments require insurers to provide natural catastrophe insurance and provide financial assistance to insurers in the wake of catastrophic events, while others generally rely on the private market. However, the majority of these governments have established national terrorism insurance programs. Although their approaches vary, insurers in all six countries were allowed to establish tax-deductible reserves for potential catastrophic events as of 2004.

section_title: Letter
paragraphs: Natural catastrophes and terrorist attacks can place enormous financial  demands on households, businesses, and the insurance industry, in  addition to causing significant loss of life. For example, the four hurricanes  that primarily affected Florida in 2004 caused over $20 billion in insured  losses in the state due to property destruction, and Congress appropriated  approximately $16 billion to assist victims of the hurricanes and repair  public infrastructure such as roads and military bases. Moreover, natural  catastrophes and terrorist attacks pose unique challenges to property- casualty insurers. Forecasting the timing and severity of such events is  difficult and the large losses associated with catastrophes can threaten  insurer solvency. Insurers frequently respond to catastrophic events by  cutting back coverage significantly or substantially increasing premiums  for policyholders. After Hurricane Andrew crossed southern Florida in  1992, many insurance and reinsurance companies (insurers that offer  insurance to other insurance companies) raised premiums or stopped  offering catastrophic coverage in the state. Similar reactions took place in  the California insurance market after the Northridge earthquake of 1994  and worldwide insurance markets after the September 11, 2001, terrorist  attacks (September 11 attacks). To the extent that insurers are unable or  unwilling to insure against catastrophic events, a subsequent lack of  affordable coverage in the marketplace could impede economic recovery  and development.
In response to such insurance market disruptions, governments and the  private sector have taken steps to enhance the “capacity” of the insurance  industry to address catastrophic risk.  Although there are several  definitions of industry capacity, we define the term to mean the ability of  property-casualty insurers to pay customer claims in the event of a  catastrophic event and their willingness to make catastrophic coverage  available to their customers, particularly subsequent to catastrophes.  Several states—including Florida and California—have established  authorities to compensate insurers for certain natural catastrophe-related  losses and help ensure that catastrophe coverage is available. Additionally,  with the passage of the Terrorism Risk Insurance Act (TRIA), the federal  government required primary insurance companies to make terrorism  coverage available to their commercial customers and provides substantial  compensation to the companies in the event of a foreign terrorist attack in  the United States. Insurance companies have made significant changes in  their approaches to providing coverage for natural catastrophes—as  discussed in this report—and some insurance and reinsurance companies  and capital market participants have developed catastrophe bonds, which  are a type of security that may be purchased by institutional investors and  cover certain insurer natural catastrophic risks. Proposals have also been  made that Congress and regulatory agencies take additional steps to  increase the capacity of the insurance industry to address catastrophe risk.  For example, a proposal has been made to change U.S. tax laws and  accounting standards to allow insurers to set aside funds on a tax- deductible basis to establish reserves for potential future natural  catastrophes or terrorist attacks.
Because of your continuing concerns about the costs and consequences of  natural catastrophes and interest in minimizing the federal government’s  potential financial exposure, you asked us to provide information on a  range of issues that would assist the committee in its oversight of the  insurance industry. Specifically, our report (1) provides an overview of the  property-casualty insurance industry’s current capacity to cover natural  catastrophic risk and discusses the impacts that the four hurricanes in 2004  had on the industry; (2) analyzes the potential of catastrophe bonds and  permitting insurance companies to establish tax-deductible reserves to  cover catastrophic risk to enhance private-sector capacity; and (3)  describes the approaches six selected European countries—France,  Germany, Italy, Spain, Switzerland, and the United Kingdom—have taken to  address natural and terrorist catastrophe risk, including whether these  countries permit insurers to use tax-deductible reserves for such events.
To address our three reporting objectives, we contacted primary and  reinsurance companies in the United States, Europe, and Bermuda. We also  interviewed officials from rating agencies, modeling firms, accounting  firms, insurance industry associations, a consumer group, the National  Association of Insurance Commissioners (NAIC), state natural catastrophe  authorities in California, Florida, and Texas, a state insurance regulator’s  office, and we spoke with academics. We also updated our previous work  on catastrophe bonds. In the six European countries we studied, we  obtained documents and interviewed officials representing insurance  supervisory authorities, insurance companies, insurance and business  associations, accounting firms, national catastrophe insurance programs,  and international and regional organizations. We asked officials whom we  contacted to provide their views on the insurance industry’s ability to  cover, and strategies to manage, catastrophe risk. We also obtained data on  the financial risks associated with natural catastrophes and terrorism, and  European insurance markets.
We conducted our work between February 2004 and January 2005 in  Florida, New York, Washington, D.C., Belgium, France, Germany, Spain,  Switzerland, and the United Kingdom. Our work was done in accordance  with generally accepted government auditing standards. A more extensive  discussion of our scope and methodology appears in appendix I. In  addition, our report provides information on insurers’ financial exposure to  terrorist attacks under TRIA and the extent to which natural catastrophe  and terrorism risks are uncovered in the United States. These issues are  discussed in appendix II. The report also includes a glossary of insurance- related terms. We provided a draft of this report to the Department of the  Treasury and the National Association of Insurance Commissioners.  Treasury provided technical comments on the report that were  incorporated as appropriate.
subsections: section_title: Background
paragraphs: While insurers assume some risk when they write policies, they employ  various strategies to manage overall risks so that they may earn profits,  limit potential financial exposures, and build capacity—generally, equity  capital that would be used to pay claims. For example, they charge  premiums for the coverage provided and establish underwriting standards  such as (1) refusing coverage to customers who may represent  unacceptable levels of risk or (2) limiting coverage offered in particular  areas. Establishing underwriting standards also allows insurers to  minimize the adverse consequences of “moral hazard,” which is “the  incentive created by insurance that induces those insured to undertake  greater risk than if they were uninsured, because the negative  consequences are passed to the insurer.”
To manage potential financial exposures and also enhance their capacity,  insurance companies may also purchase reinsurance. Reinsurers  generally cover specific portions of the risk the primary insurer carries. For  example, a reinsurance contract could cover 50 percent of all claims  associated with a single event up to $100 million from a hurricane over a  specified time period in a specified geographic area. This type of contract,  which specifies payments based on the insurer’s actual incurred claims, is  called indemnity coverage. In turn, reinsurers act to limit their risks and  moral hazard on the part of primary insurers by charging premiums,  establishing underwriting standards, and maintaining close business  relationships with insurers that generally have been maintained over a long  period.
In contrast to other types of insurance risks, catastrophic risk poses unique  challenges for primary insurers and reinsurers. To establish their exposures  and price insurance and reinsurance premiums, insurance companies need  to be able to predict with some reliability the frequency and severity of  insured losses. For example, the incidence of most property insurance  claims, such as automobile insurance claims, is fairly predictable, and  losses generally do not occur to large numbers of policyholders at the same  time. However, catastrophes are infrequent events that may affect many  households, businesses, and public infrastructure across large areas and  thereby result in substantial losses that can impair insurer capital levels.  Given the higher levels of capital that reinsurers must hold to address  major catastrophic events (for example, hurricanes or earthquakes with  expected annual occurrences of no more than 1 percent), reinsurers  generally charge higher premiums and restrict coverage for such events.  Further, as previously noted, in the wake of catastrophic events reinsurers  and insurers may sharply increase premiums and significantly restrict  coverage.
The reinsurance market disruptions associated with the Andrew and  Northridge catastrophes provided an impetus for insurance companies and  others to find different ways of raising capital to help cover catastrophic  risk. The mid-1990s saw the development of catastrophe bonds, a capital  market alternative to reinsurance (in the sense that other parties assume  some of the insurer’s risks). Catastrophe bonds generally (1) are sold to  qualified institutional investors such as pension or mutual funds; (2)  provide coverage for relatively severe types of events such as hurricanes  with an annual expected occurrence of 1 percent; and (3) pay relatively  high rates of interest and have less than investment-grade ratings (because  in some cases, investors may risk all of their principal if a specified  catastrophe occurs). Catastrophe bonds also potentially expose investors  to moral hazard because, absent the business relationships that typically  characterize primary insurers and reinsurers, investors may lack  information on insurer underwriting standards or the claims payment  process. That is, an insurer that has issued a catastrophe bond may have  incentives to lower its underwriting standards and offer coverage to riskier  insureds because investors have less ability to monitor the insurers’ risk- taking than would a reinsurer with whom the insurer has done business for  years. To minimize moral hazard, most catastrophe bonds are triggered by  objective measures (also referred to as “nonindemnity” based coverage)  such as wind speed during a hurricane or ground movement during an  earthquake rather than insurer loss experience (indemnity-based).  However, nonindemnity based coverage exposes insurers to “basis risk,”  which is the risk that the proceeds from the catastrophe bond will not be  related to the insurer’s loss experience. For example, if a hurricane with a  specified wind speed occurs, the insurer would automatically receive the  proceeds of the catastrophe bond, which may be either higher or lower  than its actual losses. See appendix III for additional information on the  structure of catastrophe bonds.
Because insurance markets have been severely disrupted by catastrophic  events, state and federal governments also have taken a variety of steps to  enhance the capacity of insurers to address catastrophic risk. For example,  Florida established FHCF to address hurricane risk, and California  established CEA to address earthquake risk. Although these programs  cover different risks and use different strategies as described in this report,  they share a similar goal in ensuring that insurers can withstand  catastrophic events and continue to make coverage available. Similarly,  Congress enacted TRIA in 2002 to ensure the continued availability of  terrorism insurance subsequent to the September 11 attacks. TRIA was  designed as a temporary program that would remain in place until the end  of 2005, when it was expected that insurers and reinsurers would have had  time to establish a market for terrorism insurance. However, Congress is  currently considering extending the 2005 deadline due to concerns about  whether insurers will offer terrorism insurance after the act’s expiration.  See appendix II for more information about TRIA.
section_title: Despite Enhancements to Insurer Capacity, Industry May Not Be Able to Address a Major Natural Catastrophe
paragraphs: Despite steps taken in recent years to strengthen insurer capacity for  catastrophic risk, the industry has not yet been tested by a major  catastrophic event or series of events. Overall, insurers increased their  equity capital—financial resources available to cover catastrophic and  other types of claims that exceed premium and investment income—from  1990 through 2003, but this measure of capacity has limitations, and  therefore, the extent to which capacity has increased is not clear. For  example, insurers’ exposures in risk-prone coastal and other areas have  also increased over time, which could partially offset the increase in equity  capital. However, state governments and insurers have taken other steps to  enhance industry capacity for catastrophic risk such as establishing state  authorities, implementing stronger building codes, and reportedly  implementing stronger underwriting standards. Several of these changes  appear to have facilitated the industry’s ability to withstand the 2004  hurricanes better than the impacts of Hurricane Andrew in 1992, but a  more severe catastrophe or catastrophes could have significant financial  consequences for insurers and their customers.
subsections: section_title: Equity Capital Can Measure Insurance Industry Capacity, but the Data Are Subject to Several Limitations
paragraphs: The insurance industry’s equity capital levels commonly are used to assess  capacity to cover catastrophic risk. As shown in figure 1, the Insurance  Services Office, Inc. (ISO) found that from 1990 through 2003 industry  equity capital increased from $194.8 billion to $347 billion on an inflation- adjusted basis. After steadily increasing for 18 years, insurers’ equity  capital actually declined from 1999 to 2002 before rebounding in 2003.  Capital levels declined for a variety of reasons including a series of natural  catastrophes in the late 1990s, declining stock prices that particularly  affected the investments of large European reinsurers, and the losses  associated with the September 11 attacks. Insurer capital increased in 2003  for several reasons that include lower losses associated with natural  catastrophes. According to information from ISO, the industry’s capital  level did not decline in 2004 even though insurers experienced significant  losses associated with the 2004 hurricane season.
Although insurers’ equity capital has generally increased over time, it is  difficult to determine whether the growth in insurer equity capital has  resulted in a material increase in the industry’s relative capacity to pay  claims. Insurers may also face significant financial exposure in areas prone  to natural catastrophes such as the southeastern United States, which  could partially offset the increase in insurer capital over the years.  However, individual insurers do not make publicly available specific  information about the extent to which they write policies in risk-prone  areas, the terms offered on these policies, or the level of reinsurance that  they purchase to help cover these risks, which complicates assessments of  insurer capacity.
We have also identified other limitations to using equity capital as a  measure of insurance industry capacity. First, in any given catastrophe,  only a portion of the industry’s capital (and its other resources, such as  catastrophe reinsurance) is available to pay disaster claims because the  insurance industry as a whole does not pay catastrophe claims. Instead,  individual insurance companies pay claims on the basis of the damage that  particular catastrophes inflict on the properties they insure. An insurer  writing policies only in one state would not have to pay any claims if a  catastrophe occurred in another state. Second, only a portion of equity  capital would be available to cover catastrophe claims because the capital  may also be needed to pay claims from all of the other types of risk that  insurers have assumed should the experience of those risks prove  unfavorable.
To better understand insurers’ capacity to address natural catastrophe  risks, we contacted two rating agencies that monitor the insurance  industry. According to one rating agency official, most insurance  companies the agency rated in 2003 were financially secure. The rating  agency determines the financial strength of insurance companies and their  ability to meet ongoing obligations to policyholders by analyzing  companies’ balance sheets, operating performance, and business profiles.  According to officials from one rating agency, when establishing an  insurance company’s rating, the agency considers an insurer secure if the  company would have enough capital after a catastrophic event to maintain  the same rating. In other words, to maintain a secure rating, insurers must  demonstrate that they are able to absorb losses from a hurricane with a 1  percent chance of occurring annually or an earthquake with a .4 percent  chance of occurring annually. Officials from one rating agency told us that  of the 1,058 ratings it issued in 2003, 904 companies obtained secure  ratings, meaning that they would be able to meet ongoing obligations to  policyholders and withstand adverse economic conditions, such as major  catastrophes, over a long period of time. Conversely, 164 insurance  companies obtained vulnerable ratings, meaning that they might have only  a current ability to pay claims or not be able to meet the current obligations  of policyholders at all. Although this rating agency’s analysis concludes that  nearly 90 percent of insurers would remain financially secure under major  catastrophe scenarios, other information suggests that such events could  result in significant insurance market disruptions and the inability of  insurers to meet their financial obligations to policyholders. This  information is discussed in a later section.
section_title: State Governments and Insurers Have Taken Steps to Manage the Financial Consequences of Natural Catastrophes
paragraphs: While independently assessing insurer capacity for catastrophic risk is  challenging due to limitations associated with the equity capital measure  and the lack of key data—such as insurers’ reinsurance purchases—state  governments and insurance companies have taken steps that have the  potential to mitigate insurer losses and enhance industry capacity. We  discuss several of the measures that were initiated to strengthen the  insurance industry’s capacity to respond to catastrophic events, including  the creation of state-run programs, changes to building codes, shifts in  underwriting, and market innovations.
subsections: section_title: Florida and California Established Catastrophe Authorities to Stabilize Markets and Maintain or Increase Capacity
paragraphs: After Hurricane Andrew, the State of Florida established FHCF to act as a  reinsurance company for insurers that offer property-casualty insurance in  the state. According to officials from FHCF, Florida insurance regulators,  and insurance companies that offer coverage in the state, FHCF enhances  industry capacity by (1) offering reinsurance at lower rates than private  reinsurers for catastrophic risk, thereby increasing the number of primary  companies willing to write policies in the state; (2) ensuring that primary  companies will be compensated up to specified levels when a catastrophic  hurricane occurs; and (3) continuing to offer reinsurance at relatively  stable rates in the immediate aftermath of hurricanes. Residential property  insurers are required by state law to participate in the FHCF program.  Coverage from FHCF is triggered when participating companies’ losses  meet their share of an aggregate industry retention level of $4.5 billion, and  coverage is capped at $15 billion. FHCF is financed from three sources:  actuarially-based premiums charged to participating insurers, investment  earnings, and emergency assessments on Florida insurance companies if  needed. FHCF may also issue bonds to meet its obligations. In 2002,  Florida also established Citizens Property Insurance Corporation  (Citizens), a state-run, tax-exempt primary insurer that offers coverage for  a premium to homeowners who cannot obtain property insurance from  private companies. Citizens writes full residential coverage in all 67  Florida counties and wind-only coverage in the coastal areas of 29  counties. Citizens’ claims paying resources include premiums, assessments  on the industry if its financial resources fall to specified levels, and  reinsurance from FHCF.
After the Northridge earthquake, the State of California established CEA to  provide residential earthquake insurance. Insurers that sell residential  property insurance in California must offer their policyholders separate  earthquake insurance. Companies can offer a private earthquake policy or  a CEA policy, but most choose the CEA policy. Only insurance companies  that participate in CEA can sell CEA policies. The funds to pay claims come  from premiums, contributions from and assessments on member insurance  companies, borrowed funds, reinsurance, and the return on invested funds.  As discussed in appendix II, about 15 percent of eligible customers in  California purchase earthquake insurance in part because apparently many  potential customers believe that premiums and deductibles are too high.
section_title: States and Counties Have Strengthened Building Codes in Areas at Risk for Natural Catastrophes
paragraphs: In 1994, in the wake of Hurricane Andrew, Miami-Dade and Broward  counties enacted a revised South Florida Building Code to ensure that  buildings would be designed to withstand both the strong wind pressures  and impact of wind-borne debris experienced during a hurricane. In March  2002, Florida instituted a statewide building code that implemented similar  requirements and replaced a complex system of 400 local codes. The  Florida Building Code was based on a national model code, which was  amended where necessary to address Florida’s specific needs for added  hurricane protection requirements. The code also created a High Velocity  Hurricane Zone to continue use of the South Florida Building Code’s design  and construction measures for the highly vulnerable Miami-Dade and  Broward counties. Local jurisdictions may amend the code to make it more  stringent when justified and are responsible for administering and  enforcing it. According to a 2002 study, building codes have the potential to  significantly reduce the damage caused by hurricanes. The study found  that residential losses from Hurricane Andrew would have been about $8.1  billion lower if all South Florida homes had met the current Miami-Dade  and Broward code.
In California, there is no statewide building code, but certain counties did  implement stronger building codes after the Northridge earthquake in 1994.  For example, Los Angeles County made its building code stronger after  Northridge and has implemented several updates since then. According to  a CEA official, the California legislature has tried to enact a statewide  building code since 1996, but has been unable to reach a consensus. Florida  and California officials we contacted said that while stronger building  codes have been implemented, many older structures that have not been  retrofitted remain vulnerable to hurricane or earthquake damage.
section_title: Insurers Use Statistical Models to Monitor Catastrophe Exposure and Better Manage Their Risk Exposures
paragraphs: According to insurance market participants, many, if not all, insurance  companies and state authorities currently use computer programs offered  by several modeling firms to estimate the financial consequences of various  natural catastrophe scenarios and manage their financial exposures. To  generate the loss estimates, the computer programs use large databases  that catalog the past incidence and severity of natural catastrophes as well  as proprietary insurance company data on policies written in particular  states or areas. Using the estimates provided by these computer programs,  insurers can attempt to manage their exposures in particularly high-risk  areas. For example, an insurer could estimate the impact to the company of  a hurricane with specified wind speeds striking Miami, given the number of  policies that the insurer has written in the city as well as the value of  insured property. Based on these types of estimates, companies can  manage their risk and control their exposures (for example, by limiting the  number and volume of policies written in a particular area or purchasing  reinsurance if available on favorable terms) so that their losses are not  expected to exceed a particular threshold, such as a specified percentage  of their existing equity capital (a commonly used measure is from 10 to 20  percent of capital). According to industry officials we contacted, insurance  and reinsurance companies generally use the computer programs to have  greater confidence that they would have sufficient capital remaining to  meet their obligations to customers and remain in business even in the  aftermath of a major event. Whether individual companies are successful in  managing their losses should such an event occur will depend in part on the  accuracy of the estimates and the quality of the company’s risk  management practices.
Although the use of models and other revised underwriting standards may  enhance insurers’ ability to control the financial consequences they  experience from natural catastrophes, an effect may be reduced insurance  availability. To the extent that private insurers reduce their exposures in  risk-prone areas, consumers only may be able to obtain property insurance  offered by state authorities. For example, according to Citizens officials,  the organization provides 70 percent or more of the wind coverage in  sections of Palm Beach, Broward, and Dade counties. Although state  authorities can ensure that coverage is available in risk-prone areas, such  insurers are generally not able to diversify their insurance portfolios and  may suffer disproportionate losses when catastrophes occur.
section_title: Insurers Have Implemented Higher Deductibles to Shift a Greater Share of Losses from Insurers to Policyholders
paragraphs: Insurers have increased policyholder deductibles for certain natural  catastrophe risks in risk-prone areas. For example, prior to Hurricane  Andrew in 1992, insurers in Florida generally required homeowners to pay  a standard deductible of $500 for wind-related damage and would cover  remaining losses to specified limits. After Hurricane Andrew, the Florida  legislature instituted percentage hurricane deductibles. For homes valued  at $100,000 or more, insurers may now establish deductibles from 2 to 5  percent of the policy limits for hurricane damage. According to an  insurance association, 2 percent is the most common deductible level,  although 5 percent deductibles are widespread on higher-priced  dwellings. The new deductible is much higher than the previous deductible  and to some extent limits insurers’ financial exposures due to increases in  property values resulting from inflation, since the dollar value of the 2  percent deductible increases as property values increase. General  deductibles—usually $500—still apply to all homeowner policies for  nonhurricane losses, including tornadoes, severe thunderstorms, and fire.  Moreover, according to information from insurance market participants,  percentage deductibles are now standard in risk-prone areas throughout  the United States.
section_title: Development of Bermuda Reinsurance Market Reportedly Has Expanded Capacity
paragraphs: Insurers and analysts we contacted said that the growth of the Bermuda  reinsurance market over the past 15 years has enhanced the industry’s  capacity to withstand natural catastrophes. According to an industry  report, many reinsurance companies were incorporated in Bermuda after  Hurricane Andrew in 1992 and the September 11 attacks to take advantage  of the high global premium rates for catastrophic coverage, and many  specialize in catastrophe risk. Additionally, regulatory and industry officials  we contacted said that Bermuda’s favorable tax environment (no corporate  income or capital gains taxes), a flexible regulatory environment that  permits companies to be created more quickly than in other jurisdictions,  and a concentration of individuals with insurance expertise have  contributed to the growth of the Bermuda insurance market.
According to a Bermuda insurance industry association, Bermuda  reinsurers currently provide a total of 50 percent of all Florida reinsurance.  One large primary company we contacted said that Bermuda companies  are of critical importance to its overall risk management strategy. In  addition, one state authority official reported buying reinsurance from  companies in Bermuda. Other industry participants noted that Bermuda  companies have diversified the worldwide reinsurance market. Moreover,  some Bermuda companies specialize in providing reinsurance to about 30  primary companies that were established to “take out” policies from  Citizens. Citizens pays bonuses to primary companies, called take out  companies, as an incentive to assume the liability on polices that are taken  out for 3 years. The bonuses are based on a percentage of the premiums for  the policies taken out of Citizens. According to Florida insurance  regulators, many of the take out companies, therefore, have substantial  exposure to hurricane risk.
We note that some analysts have questioned the extent to which the  Bermuda market has enhanced insurer capacity since some of the capital  raised by Bermuda insurers may represent funds invested by existing  insurance companies.
section_title: 2004 Hurricane Season Tested Measures Implemented to Better Manage Natural Catastrophes
paragraphs: The four hurricanes that struck within a 6-week period in 2004 provided the  first test of the steps the state and the insurance industry have taken to  enhance industry capacity since Hurricane Andrew (see fig. 2). As of the  end of 2004, they had generated an estimated 1.5 million claims from  property owners with over $20 billion in insured losses in Florida— equating to losses with an expected annual occurrence from 2 to 5 percent  (that is, a 1-in-20 to a 1-in-45 year loss). Although many insurers incurred  significant losses, 1 take out company failed, and some insurers are  restricting coverage and requesting rate increases, industry participants  and state officials generally agreed that the steps taken after Hurricane  Andrew in 1992 helped the industry better absorb the hurricane losses and  provided stability in the insurance markets. For example, only 1 company  failed in 2004 in contrast to 11 that failed after Andrew. According to one  modeling firm official, while the hurricane losses are significant, insurers  typically plan to absorb more than double the losses experienced in these  four events. However, some of the steps taken after Andrew were designed  to manage losses from a single storm similar to Andrew, rather than the  unusual occurrence of four hurricanes making landfall in the United States  and causing major damage in the same general area. Therefore, state  officials and insurers are considering further changes to better address the  potential for a future hurricane season with similar events.
FHCF’s payments to its members were limited due to the fact that four  relatively mid-sized hurricanes struck Florida rather than one major storm  such as Andrew. As previously discussed, FHCF payments to its members  are generally triggered when members’ losses from a particular storm  reach $4.5 billion (a company may receive FHCF payments if its losses  exceed its individual retention level—or deductible—even if overall  industry losses are less than $4.5 billion). According to an FHCF official, all  four storms are expected to trigger FHCF recoveries totaling about $2  billion in payments to 123 of about 230 participating insurers. FHCF  members that did not receive payments, including Citizens, did not have  losses that reached their individual retention levels (see fig. 3). As a result  of the 2004 hurricanes, Florida officials are considering changes to FHCF,  such as lowering the industry retention level from the current $4.5 billion,  lowering the retention after the second hurricane in a season, or applying a  single hurricane season retention, rather than the per hurricane retentions  currently in place.
Reinsurance company officials, except for Bermuda companies described  in a subsequent section, said that their losses from the 2004 hurricanes  were also limited for the same general reasons as FHCF. That is,  reinsurance contracts typically require primary companies to retain a  specified percentage of the losses associated with hurricanes and are  written on a per occurrence basis. The reinsurance company officials said  that each of the four hurricanes generally did not result in losses that  exceeded the primary companies’ retention levels. Additionally,  reinsurers’ exposures may have been limited because primary companies  only purchased reinsurance for one or two storms and may not have  purchased reinsurance coverage for a third or fourth storm. Because, in  general, many reinsurance companies were not significantly affected by the  2004 hurricane season, insurance market analysts generally do not expect  significant increases in reinsurance premiums similar to those that took  place after Hurricane Andrew in 1992.
subsections: section_title: Revised Building Codes May Have Mitigated Losses
paragraphs: Although it is too early for definitive conclusions, insurers, a Florida  regulatory official, and a consumer representative we contacted said that  the state’s revised building codes may have mitigated insurer losses from  the 2004 hurricanes. For example, a recent study of damage caused by  Hurricanes Charley, Frances, and Ivan found that structures built according  to the new building codes fared better than structures built under older  building codes. However, in some cases, insurance market participants  said that newer structures sustained damage despite the revised building  codes. For example, the officials said that materials blown off of older  structures struck newer buildings causing damage such as shattered  windows. In addition, Florida officials reported that some builders of  structures subject to revised codes did not use proper materials or  techniques, which resulted in damage and losses.
section_title: Steps Industry Took Based on Catastrophe Model Estimates Viewed as Mitigating Losses
paragraphs: Overall, insurance companies and other industry participants reported that  steps insurers took based on information generated by computer models of  exposures mitigated their losses during the 2004 hurricane season;  however, some insurers noted that the models did not accurately estimate  their actual losses. According to two modeling firm representatives, the  purpose of catastrophe modeling is not to predict exact losses from  specific storms but to anticipate the likelihood and severity of potential  future events so that companies can prepare accordingly.
Insurers and other industry participants also reported some aspects of the  models that could be improved. Insurance industry officials noted that the  models did not take into account the increased cost of labor and  construction materials after the hurricanes, or demand surge. In addition,  companies noted that the models did not take into account the impact of  damage caused to the same properties by storms with overlapping tracks.  Officials from the modeling firms told us that since the models are based on  historical data, they do factor in the possibility of multiple events in 1 year.  However, one firm noted that the models assume that the damage caused  by each event is independent. Representatives from three modeling firms  told us that the companies will incorporate meteorological and claims data  from the 2004 hurricane season into their models and consider other  improvements in future upgrades.
section_title: Insurers Increased Deductibles to Mitigate Losses, but Multiple Deductibles Have Raised Concerns
paragraphs: Insurance company and other industry officials we contacted said that  using percentage-based deductibles mitigated losses associated with the  2004 hurricanes. However, Florida insurance regulatory officials told us  that some consumers complained that they were surprised by the high  amount of their deductibles. In addition, with multiple storms sometimes  crossing the same paths, paying multiple deductibles became an issue of  consumer fairness. According to state regulatory officials, some insurance  companies have decided to apply a single deductible to all their policies.  Some insurers we interviewed said that they are deciding on a case-by-case  basis whether multiple deductibles should apply. For example, one insurer  told us that if the claims adjuster could not determine what damage was  caused by what storm, generally only one deductible would be applied.  According to state regulatory officials, there are approximately 29,000  cases of multiple deductibles. On December 16, 2004, the state legislature  passed legislation to reimburse policyholders who had to pay multiple  deductibles. According to the new law, up to $150 million will be borrowed  from FHCF to provide grants of up to $10,000 to policyholders subject to  two deductibles and up to $20,000 for policyholders subject to three or  more deductibles. Funds borrowed from FHCF will be repaid by increasing  insurers’ FHCF premiums beginning in 2006. For policies issued or  renewed on or after May 1, 2005, the new law also permits insurers to apply  a single deductible for each hurricane season. When the deductible is  exhausted, the deductible for other perils—generally $500—will be applied  to claims for damage from subsequent storms.
section_title: Bermuda Reinsurers That Specialize in Catastrophe Risk Are Expected to Meet Their Obligations from the 2004 Hurricanes
paragraphs: Bermuda reinsurers are expected to pay a significant amount of  reinsurance losses compared with other reinsurance companies because of  their specialization in catastrophe risk (such as providing reinsurance to  take out companies). A Bermuda insurance industry association  representative estimated that Bermuda reinsurers will pay about $2.6  billion in losses from the four hurricanes, or about 10 percent of the total  losses. These losses could exhaust from 25 to 40 percent of companies’  earnings for 2004. The Bermuda insurance industry association official  noted that no Bermuda companies are expected to fail as a result of these  losses and that the ratings of Bermuda companies have not been affected  by the hurricane losses. The association official also said that these  companies are well capitalized and have had several years with low  catastrophe losses.
section_title: A Severe Natural Catastrophe or Series of Catastrophes Could Generate Major Insurance Market Disruptions
paragraphs: While state government and insurer measures initiated since the 1990s  likely facilitated insurers’ ability to respond to the 2004 hurricane season,  an event with losses representing an expected annual occurrence of no  more than 1 percent to .4 percent could have major consequences for  insurers and insurance availability. Neither the 2004 hurricane season, as  discussed previously, nor Hurricane Andrew or the Northridge earthquake  qualified as an event with losses representing a 1 percent expected annual  occurrence, yet many insurers experienced significant losses and some  restricted coverage as a result of these catastrophes. It follows that a  more severe hurricane (or series of hurricanes) or earthquake with  estimated losses of $50 billion or more would have even more severe  consequences. For example, FHCF’s total available financial resources of  $15 billion are intended to cover losses from a hurricane with an estimated  occurrence of about 2 percent annually (approximately a 1-in-50 year  event). If a more severe hurricane or series of hurricanes struck Florida,  FHCF would likely impose assessments on the insurance industry to cover  the costs of bonds issued to meet its obligations and its financial resources  would be exhausted. Insurers, in turn, might impose higher premiums on  policyholders to cover the cost of these assessments. Moreover, a severe  hurricane would likely impose much higher losses on the reinsurance  industry than did the 2004 hurricane season, particularly because primary  insurers’ losses may exceed the retention levels specified in their  reinsurance contracts.
Our previous work, as well as recent discussions with NAIC officials, also  indicates that a catastrophe with an expected occurrence of no more than 1  percent annually would likely cause a significant number of insurer  insolvencies among companies with high exposures to such events and  inadequate risk management practices. Several assessments by state  catastrophe authorities, such as FHCF and Citizens, and state guaranty  funds (described next) could reduce insurers’ equity capital, which would  already be strained by significant losses. Insurers that experience  substantial losses and declines in equity capital would likely face rating  downgrades from the rating agencies. Consequently, such companies might  no longer be able to meet their obligations to their customers and state  authorities could intervene to ensure that some claims were paid. All states  have established so-called guaranty funds, which are financed by  assessments on the insurance industry for this purpose. However, it is not  clear that the state guaranty funds would have sufficient resources to  withstand the failures of many insurers associated with a major  catastrophic event or series of events.
section_title: Catastrophe Bonds and Tax-Deductible Reserves May Have the Potential to Enhance Insurers’ Capacity for Catastrophe Risk
paragraphs: Insurers’ reactions to past catastrophic events—for example, restrictions  on reinsurance coverage and higher reinsurance premiums—and the  potential consequences for insurers from an even more severe catastrophe  have generated financial instruments and proposals designed to enhance  industry capacity for both natural events and terrorist attacks. Catastrophe  bonds serve as a potential means for insurers to tap the large financial  resources of the capital markets to cover the large exposures associated  with potential catastrophes. In fact, several insurance and reinsurance  companies currently use catastrophe bonds to enhance their capacity to  cover low probability, high severity natural events, although catastrophe  bonds have not been issued yet to cover terrorism risk in the United States.  However, catastrophe bonds are not widely used in the insurance industry  due to their relatively high cost compared with reinsurance, among other  factors. Some insurance market analysts have also advocated changing  U.S. tax laws and accounting standards to permit insurers to set aside  reserves on a tax-deductible basis to increase their capacity for both  natural catastrophes and terrorist attacks. However, tax-deductible  reserves involve tradeoffs such as lower federal revenues and some  analysts believe that the reserves would not materially enhance capacity  because insurers might substitute reserves for existing reinsurance  coverage, the cost of which is tax deductible.
subsections: section_title: Catastrophe Bond Market Has Grown Significantly but Is Still Small Compared with Overall Catastrophe Exposure
paragraphs: According to private-sector data, the value of outstanding catastrophe  bonds increased substantially from 1997 through 2004 (see fig. 4). The  value of outstanding catastrophe bonds worldwide increased about 50  percent from year-end 2002 to year-end 2004 to $4.3 billion. However, at  $4.3 billion, the value of outstanding catastrophe bonds was small  compared with industry catastrophe exposures. For example, a major  hurricane striking densely populated regions of Florida alone could cause  more than an estimated $50 billion in insured losses.
As discussed in our previous reports, some insurance and reinsurance  companies view catastrophe bonds as an important means of diversifying  their overall strategy for transferring catastrophe risks, which traditionally  involves purchasing reinsurance or retrocessional coverage. By raising  funds from investors through the issuance of catastrophe bonds, insurers  can expand the pool of capital available to cover the transfer of  catastrophic risk. In addition, most of the catastrophe bonds issued provide  coverage for catastrophic risk with high financial severity and low  probability (such as events with an expected occurrence of no more than 1  percent annually). Consequently, none of the bonds issued to date that  include coverage of U.S. wind risk were triggered by the 2004 hurricane  season. According to various financial market representatives, because of  the larger amount of capital that traditional reinsurers need to hold for high  severity and lower-probability events, reinsurers limit their coverage and  charge increasingly higher premiums for these risks. Representatives from  one insurance company said that the company cannot obtain the amount of  reinsurance it needs for the highest risks at reasonable prices and has  obtained some of its reinsurance coverage in this risk category from  catastrophe bonds as a result. This firm and other market participants said  that the presence of catastrophe bonds as an alternative means of  transferring risk may have moderated reinsurance premium increases over  the years.
Some insurers also find catastrophe bonds beneficial because they pose  little or no credit risk. That is, financial market participants told us that  insurers can be exposed to the credit risk of reinsurers not being able to  honor their reinsurance contracts if a natural catastrophe were to occur.  Catastrophe bonds, on the other hand, create little or no credit risk for  insurers because the funds are immediately deposited into a trust account  upon bond issuance to investors. Representatives from some insurers we  contacted said that while they recognize that some reinsurers’ credit  quality had declined in recent years, they guarded against credit risks by  establishing credit standards for the companies with whom they do  business and continually monitoring their financial condition.
Some institutional investors we contacted also expressed positive views  about catastrophe bonds. Some investors said that the bonds offered an  attractive yield compared with traditional investments. These institutional  investors also said that they purchased catastrophe bonds because they  were uncorrelated with other risks in bond portfolios and helped diversify  their portfolios.
section_title: Various Factors May Have Limited the Expansion of the Catastrophe Bond Market
paragraphs: Although catastrophe bonds benefit some insurers and institutional  investors, others we contacted said they do not issue or purchase  catastrophe bonds for a number of reasons, which may have limited the  expansion of the market. Some state authorities we contacted and many  insurers view the total costs of catastrophe bonds—including transaction  costs such as legal fees—as significantly exceeding the costs of traditional  reinsurance. Insurer and state authority officials also said that they were  not attracted to catastrophe bonds because they generally covered events  with the lowest frequency and the highest severity. Rather, the officials said  that they would prefer to obtain coverage for less severe events expected  to take place more frequently. In addition, a recent study concluded that  the fact that most catastrophe bonds are issued on a nonindemnity basis  has limited the growth of the market because such bonds expose insurers  to basis risk (the risk that the provisions that trigger the catastrophe bond  will not be highly correlated with the insurer’s loss experience).
Representatives from some institutional investors said that the risks  associated with catastrophe bonds were too high or not worth the costs  associated with assessing the risks. Some institutional investors also said  that they decided not to purchase catastrophe bonds because they were  considered illiquid. However, capital market participants we contacted said  that the liquidity of the catastrophe bond market has improved.
Moreover, the catastrophe bond market has generally been limited to  coverage of natural disasters because the general consensus of insurance  and financial market participants we contacted was that developing  catastrophe bonds to cover potential targets against terrorism attacks in  the United States was not feasible at this time. In contrast to natural  catastrophes, where a substantial amount of historical data on the  frequency and severity of events exists, terrorism risk poses challenges  because it is extremely difficult to reliably model the frequency and  severity of terrorist acts. Although several modeling firms are developing  terrorism models that are being used by insurance companies to assist in  their pricing of terrorism exposure, most experts we contacted said these  models were too new and untested to be used in conjunction with a bond  covering risks in the United States. Furthermore, potential investor  concerns—such as a lack of information about issuer underwriting  practices or the fear that terrorists would attack targets covered by  catastrophe bonds—could make the costs associated with issuing  terrorism-related securities prohibitive.
Our previous work also identified certain tax, regulatory, and accounting  issues that might have affected the use of catastrophe bonds. We have  updated this work and discuss it in detail in appendix III.
section_title: Permitting Tax-Deductible Catastrophe Reserves Is Controversial
paragraphs: Tax-deductible reserves could confer several potential benefits, according  to advocates of the proposal, but others argue that reserves would not  bring about a meaningful increase in industry capacity. First, supporters of  tax-deductible reserves argue they would provide insurers with financial  incentives to increase their capital and thereby expand their capacity to  cover catastrophic risks and avoid insolvency. Supporters also argue that  they would lower the costs associated with providing catastrophic  coverage and encourage insurers to charge lower premiums, which would  increase catastrophic coverage among policyholders. Moreover, as  mentioned in our discussion of catastrophe bonds, the risk exists that  reinsurers might not be able to honor their reinsurance contracts if a  natural catastrophe were to occur. Allowing insurers to establish tax- deductible reserves could help ensure that funds are available to pay claims  if a catastrophe were to take place. Finally, information from NAIC states  that under current accounting rules, insurers are not required to fully  disclose the financial risks that they face from natural catastrophes and  that these risks are not accounted for on insurers’ balance sheets. By  requiring insurers to establish a mandatory reserve on their balance sheets  and disclose it in the footnotes of the financial statements, the NAIC  officials argue that the insurers’ financial statements would be more  transparent and provide better information about the potential  catastrophic risks that they face.
An NAIC committee has made a catastrophe reserve proposal—which the  NAIC has not officially endorsed—that would require insurers to gradually  build up industrywide catastrophe reserves of a total of $40 billion over a  20-year period, or not more than $2 billion per year. The NAIC  committee’s proposal would make such reserves mandatory to promote the  safety and soundness of the insurance industry. The committee’s proposal  would also stipulate that specified events—such as an earthquake, wind,  hail, or volcanic eruption—could trigger a drawdown from the reserves— and that the President of the United States or Property Claim Services  would have to declare that a catastrophe had occurred. The proposal  would specify that either insurers’ losses reach a certain level or that  industry catastrophe losses exceed $10 billion for insurers to make a  drawdown on the reserve.
However, there are potential tradeoffs associated with allowing insurers to  establish tax-deductible reserves for potential catastrophes. In particular,  permitting tax-deductible reserves would result in lower federal tax  receipts according to industry analysts we contacted. Although supporters  counter that permitting reserves would enhance industry capacity and  thereby reduce the federal government’s catastrophe-related costs over the  long term, the size of any such benefit is unknown. In addition, Treasury  staff said that there would be no guarantee that insurance companies  would actually increase the capital available to cover catastrophic risks.  Rather, the officials said that insurers might use the reserves to shield a  portion of their existing capital (or retained earnings) from the corporate  income tax. Furthermore, reinsurance association officials said that  insurance companies could inappropriately use tax-deductible reserves to  manage their financial statements. That is, insurers could increase the  reserves during good economic times and decrease them in bad economic  times. In addition, Treasury staff expressed skepticism about the reliability  of models used to predict the frequency and severity of catastrophes.  Without reliable models, Treasury staff said that it would be difficult to  determine the appropriate size of the catastrophe reserves. We note that  insurers have developed sophisticated models to predict the frequency and  severity of natural catastrophes such as hurricanes and that these models  are currently considered more reliable than terrorism models.
Finally, reinsurance association officials and an insurance industry analyst  who supports tax-deductible reserves said that some insurers might reduce  the amount of reinsurance coverage that they purchased if they were  allowed to establish reserves. Because reserving would also convey tax  advantages, some insurers might feel that they could limit the expense of  purchasing reinsurance. To the extent that insurers reduced their  reinsurance coverage in favor of tax-deductible reserves, the industry’s  overall capacity would not necessarily increase. We also note that  reinsurance is a global business and that reinsurers in other countries,  particularly European countries and Bermuda, provide a significant  amount of reinsurance for U.S. insurers. Since many European insurers in  the countries we studied are already permitted to establish tax-deductible  reserves (as described in the next section) and Bermuda reinsurers are not  subject to an income tax, any potential enhancement of insurer capacity  associated with granting U.S. insurers the authority to establish such  reserves may be limited.
section_title: European Countries Use a Mix of Approaches to Insure Natural Catastrophes, and Most Countries Studied Have National Terrorism Insurance Programs
paragraphs: European countries also face significant risks associated with natural  catastrophes and terrorist attacks, and have developed a range of  approaches to enhance insurers’ capacity to address catastrophic risks. For  example, the six European countries we studied—France, Germany, Italy,  Spain, Switzerland, and the United Kingdom—have developed a mix of  government and private-sector approaches to covering natural catastrophe  risk. In three of the countries, standard homeowner policies include  mandatory coverage for natural catastrophes, and the government provides  an explicit financial guarantee to pay claims in two of these three  countries. The other three countries generally rely on insurance markets to  provide natural catastrophe coverage. Concerning terrorism coverage, four  of the six countries have established national terrorism programs, two of  which are mandatory, wherein the national governments provide explicit  financial guarantees to address the financial risks associated with terrorist  attacks while the two remaining countries generally rely on insurance  markets. As of the time of our review, all six countries allowed insurers to  establish tax-deductible reserves to cover the costs associated with  potential catastrophes, but there are significant variations in each country’s  approach. Further, a new international accounting standard designed to  prohibit the use of such catastrophe reserves may have a limited effect due  to the way it is being implemented in Europe.
subsections: section_title: Europeans Use a Mix of Government and Private- sector Approaches to Insure Natural Catastrophes
paragraphs: Insurance for natural catastrophes in the six European countries we  studied encompass a range of structures—from mandatory coverage with  state-backed guarantees to wholly private-sector coverage. Figure 5  provides an overview of how natural catastrophes are insured in the six  selected European countries. In summary, France and Spain have  developed national programs with mandatory coverage and unlimited state  guarantees. Switzerland mandates natural catastrophe coverage, but the  government does not provide an explicit financial commitment. Germany,  Italy, and the United Kingdom do not offer national insurance programs for  natural catastrophes.
In France, the Catastrophes Naturelles (CatNat) program was started in  1982 in response to serious flooding in southern France. French law  requires standard property insurance policies to include coverage for  natural catastrophes. According to information from the French  government, between 95 and 98 percent of the population has taken out  this comprehensive insurance and thus benefits from CatNat coverage. To  cover natural catastrophe risk, insurers collect a government-determined  12 percent premium surcharge from policyholders. Insurers may then  choose to forgo reinsurance for natural catastrophes or purchase  reinsurance from the private market or the Caisse Centrale de Réassurance  (CCR), a state-backed company authorized by law to reinsure natural  catastrophe risk. CCR offers unlimited reinsurance coverage that is  guaranteed by the French government in the event that CCR exhausts its  resources. However, a CCR official noted that insurance companies must  transfer half of their natural catastrophe risk to CCR in order to be covered  under the state guarantee. According to one insurance broker and a French  Treasury official, most insurers in France reinsure their natural catastrophe  risk through CCR to obtain the state guarantee coverage.
Under the French program, the government must declare that an event  qualifies as a natural disaster. According to information from the French  government and a CCR official, the program is set up so that insurers  manage policyholders’ claims because they have the best claims-paying  experience and expertise. Coverage from CCR takes effect after insureds  pay a certain deductible. Since the program was started in 1982, France  has declared 110,000 natural disasters and paid €6.4 billion (about $8.6  billion) in compensation, over half of which was for floods. In 2001, the  government introduced a program to encourage cities to implement loss  prevention measures by increasing deductibles in the event of repeated  natural disasters, such as floods, for cities without a prevention plan.
In Spain, a state-owned entity called the Consorcio de Compensación de  Seguros (Consorcio) provides coverage for natural catastrophe risks.  Originally established to provide indemnity to victims from the Spanish  Civil War, the Consorcio now provides coverage for catastrophic risks not  specifically covered under private-sector insurance policies or when an  insurance company cannot fulfill its obligations. According to a  Consorcio official, natural catastrophe coverage is mandatory and  automatically included in standard policies, and although Spanish law does  not require the purchase of standard property insurance policies, most  people do have insurance because banks require it as a condition of  mortgages. As a result, most property is covered for natural catastrophes.  The Consorcio uses data from private insurers and its own claims data to  calculate the standard surcharge rate for different types of properties (such  as housing, offices, industrial sites, and public works). As in France,  insurers collect this surcharge from all policyholders’ property insurance  premiums. Unlike in France, where insurers may use the surcharge  collected to purchase reinsurance coverage from CCR or private reinsurers  (or to cover the costs associated with retaining natural catastrophe risk),  Spanish insurers must transfer the surcharge to the Consorcio on a  monthly basis and in return receive a 5 percent collection commission that  is tax deductible. The Consorcio’s catastrophe coverage protects the same  property or persons to at least the same level as risks covered under the  primary insurance policy from the private insurer. The Spanish government  provides an unlimited guarantee in the event that the Consorcio’s resources  are exhausted; however, the government guarantee has never been  triggered.
According to Consorcio and Spanish insurance industry officials, the  Consorcio provides nearly all the natural catastrophe coverage in Spain.  Even though private insurers have been allowed to provide natural  catastrophe coverage since 1990 few, if any, do so. Because their risks  would not be as geographically diversified as the Consorcio’s (since it  provides coverage to policyholders across the country), private insurers  would not be able to charge rates competitive with the Consorcio. In  addition, a Consorcio official said that even if insurers provided  policyholders with natural catastrophe coverage, the insurers would still  have to pay the Consorcio surcharge. Unlike France, no official  government declaration of a disaster is required for this coverage to take  effect. Coverage from the Consorcio is automatic whenever any of the  specified catastrophes occurs. The Spanish system also differs from the  French system in that, according to a Consorcio official, the Consorcio  compensates policyholders directly for their losses. In 2003, the Consorcio  paid about €143 million (about $192 million) in catastrophe losses. As in  France, floods represent the highest percentage of the total natural  catastrophe claims.
subsections: section_title: While the Swiss Government Mandates Natural Catastrophe Coverage, It Provides No Government Guarantee and the Industry Administers Its Own Pool
paragraphs: Swiss law requires insurers to include coverage for natural catastrophes as  an extension to all fire insurance contracts on buildings and contents.  Insurers first integrated natural catastrophe coverage into fire insurance  policies on a voluntary basis in 1953 after severe damage caused by  avalanches. Since it was too expensive to insure those who lived in areas at  high risk for avalanches, the insurance industry packaged all natural  catastrophe risks together and attached this package to fire insurance  policies. The natural catastrophe coverage became a requirement in law in  1992. In addition, Switzerland now has regulations controlling building in  areas such as avalanche zones and flood plains. As in France and Spain, all  policyholders pay a uniform premium rate for natural catastrophe  coverage, which is part of the fire insurance premium. The standard  premium amount, calculated by an actuarially based methodology, is also  written into law but has not been revised or adjusted since 1993. Most  property owners in Switzerland are required to have building insurance for  fire and natural catastrophes. As a result of this mandatory coverage,  most buildings in Switzerland are covered for these events. Coverage for  building contents is generally optional in Switzerland, but according to  Swiss insurance industry and government officials, most people also have  this coverage. An insurance association official told us that earthquake  risk was not originally included in the natural catastrophe package because  at that time, earthquakes were considered uninsurable. According to a  Swiss Insurance Association official, coverage for earthquakes is available  from insurers in Switzerland as an additional optional policy, but not many  people buy it.
Although the Swiss government does not provide a state guarantee to cover  losses from a major catastrophe, as is the case in France and Spain, Swiss  insurers have developed programs to share catastrophe losses. In some  areas of Switzerland, state-run insurers provide building insurance. These  state-run insurers have established a specialized reinsurance company to  manage their natural catastrophe risk. According to Swiss government  officials, the state-run insurers may purchase reinsurance coverage from  the private market or this specialized reinsurance company. Providing  coverage to only the state-run insurers, an insurance industry official said  that this company retains some of the risk and also purchases  retrocessional coverage from the private market. Similarly, private insurers  created the Elementarschadenpool, or Swiss Elemental Pool, to spread  their natural catastrophe risk. A Swiss insurance association official said  that the pool has also obtained reinsurance coverage for losses that exceed  specified levels. As in France and Spain, the pool’s flood losses have  exceeded the losses for other natural perils, according to an industry  report.
section_title: National Governments in Italy, Germany, and the United Kingdom Are Not Involved in Natural Catastrophe Insurance
paragraphs: The governments in Italy, Germany, and the United Kingdom do not  mandate, provide, or financially guarantee natural catastrophe insurance.  In Italy and Germany, coverage for natural catastrophes, such as floods, is  optional and only available from private insurers for additional premiums.  According to an Italian insurance supervisory official, the property of  private citizens is generally not covered by any kind of natural catastrophe  insurance. The official also said that some medium and large-sized  businesses and, to a lesser extent, small businesses are covered against this  risk in Italy. In Germany, regulatory and insurance officials said that  coverage for a wide variety of natural catastrophes is generally available  from private insurers in additional policies. However, the officials also said  that few policyholders choose to purchase it and it may be difficult to  obtain flood insurance, particularly in areas prone to repeated flooding. In  the United Kingdom, coverage for a range of natural perils, including flood  insurance, is generally included in standard property insurance policies;  however, the premiums and terms of the policy reflect the property’s flood  risk. According to British insurance association officials, insurance for  natural perils is generally available from the private market and 99 percent  of homeowners have coverage, including coverage for flood. Although  Italy, Germany, and the United Kingdom do not have national catastrophe  programs, according to industry and government officials, each country  has discussed developing such programs in recent years largely in the  context of providing enhanced flood coverage. However, no final decisions  had been reached at the time of our review.
section_title: Most European Countries Have National Terrorism Insurance Programs
paragraphs: Four of the six European countries we studied provide terrorism insurance  that is backed by government guarantees (see fig. 6). Specifically, France,  Spain, Germany, and the United Kingdom have established national  programs in conjunction with the insurance industry to provide terrorism  coverage. In contrast, Italy and Switzerland do not have national terrorism  insurance programs and private companies provide the limited coverage  that is available.
In France, primary insurers that offer property insurance are required by  law to provide terrorism insurance and coverage is generally included in  standard insurance policies, which means that all commercial properties  are covered. However, after the September 11 attacks, reinsurers cancelled  terrorism coverage and many primary insurers that could not obtain  reinsurance chose to stop offering commercial property insurance to avoid  the mandatory terrorism coverage. According to French insurance industry  officials, the French government responded to this situation by temporarily  requiring the extension of all contracts, but immediately began  negotiations with the insurance industry to develop a more permanent  solution. The Gestion de l’Assurance et de la Réassurance des Risques  Attentats et Actes de Terrorisme (GAREAT) pool, a nonprofit organization,  was created based on the existing administrative structures of the  insurance associations and the natural catastrophe program already in  place in France. Completed on December 28, 2001, GAREAT was the first  national terrorism pool organized with state support after the September 11  attacks. In 2002, GAREAT paid two regional terrorism claims resulting from  attacks on buildings to influence state policy totaling €7 million (about $9.4  million). Claims in 2003 amounted to €0.25 million (about $336,000).
GAREAT reinsures terrorism and business interruption risks for  commercial properties that exceed €6 million (about $8 million) in insured  value. The two insurance associations in France require their members to  participate in GAREAT. Over 100 companies participate in the pool.  Members of GAREAT must transfer a certain percentage of their terrorism  risk into the pool. Insurers may charge policyholders whatever premium  they consider appropriate, then the insurers pay 6, 12, or 18 percent of this  premium depending on the size of the risks insured to obtain reinsurance  coverage from the pool. In 2003, GAREAT earned €210 million (about  $282 million) in premiums on 80,000 policies. In the event of a terrorist act  that meets the definition in the French Criminal Code, the French state has  agreed to provide an unlimited state guarantee after a certain industry  retention level through the end of 2006 (see fig. 7). The unlimited state  guarantee is provided through the same government-backed reinsurer that  guarantees natural catastrophe claims, CCR.
In Spain, coverage for terrorism risk is handled in the same way as natural  catastrophe risk—it is included in standard property insurance policies and  all policyholders pay a premium surcharge on their primary insurance  contracts to fund coverage for both risks. Spain’s state-owned company,  the Consorcio, provides policyholders direct compensation for terrorism  losses as well as natural catastrophe losses. The state offers an unlimited  guarantee, which has never gone into effect, if claims exceed the  Consorcio’s resources. Between 1987 and 2003, terrorism claims  represented 9.9 percent of all losses paid by the Consorcio. The Consorcio  is in the process of paying claims resulting from the terrorist attack on a  Madrid commuter train on March 11, 2004. According to information from  the Consorcio, as of January 2005, €35 million (about $47 million) in claims  had been paid, including benefits for deaths, permanent disability, and  property damage.
Germany also has a national terrorism insurance program with a state  guarantee, although it differs from the Spanish and French programs in that  insureds have the option of purchasing the coverage and the state  guarantee is limited. After the September 11 attacks, most insurance  companies excluded terrorism coverage from their commercial policies  and the German government came under pressure from businesses as well  as insurance companies to find a solution to the lack of terrorism  insurance, according to insurance officials we contacted. One official said  that industry representatives feared that German businesses were at a  competitive disadvantage because terrorism insurance was available in  other European countries. As a result, the German government, insurance  industry, and business groups collaborated to form Extremus  Versicherungs-AG (Extremus), a specialized insurance company that  covers only terrorism risk. Extremus provides voluntary coverage for  commercial and industrial properties and business interruption losses in  Germany with an insured value above €25 million (about $34 million). The  premium rate for coverage from Extremus is a standard rate based on the  value of the property insured, with no differentiation according to risk or  location of the property. Unlike the French and Spanish programs, the  guarantee from the German government is capped at €8 billion (about $10.7  billion) and would take effect after insurers and reinsurers had absorbed  €2.0 billion (about $2.7 billion) in losses (see fig. 8). The total capacity of  the program therefore is €10 billion (about $13 billion). According to an  Extremus official, the state guarantee was limited to 3 years, and the  government will have to decide whether to continue the guarantee after  2005.
Demand for terrorism coverage from Extremus has been much lower than  expected, according to Extremus officials. In the first year of business,  Extremus had a goal of collecting €300 million (about $403 million) in  premiums, which was increased to €500 million (about $671 million) in the  following years, but collected only €105 million in premiums (about $141  million). In addition, many of the contracts were from smaller businesses.  As a result, Extremus renegotiated its reinsurance contracts and the level  of the state guarantee was reduced in March 2004. Extremus originally  planned to phase out the state guarantee by building up sufficient reserves  to handle potential claims. However, premium income has been too low to  build a substantial reserve. Extremus continues to struggle to meet its  goals, as five large clients did not renew their policies in 2004.  Representatives from an organization representing German businesses told  us that several factors may have contributed to low demand, including  the perception of many insureds that they were at a low risk of a  terrorism attack and that Extremus coverage would not be cost- effective;   gaps in Extremus coverage (for example, Extremus only covers  properties within Germany and excludes liability coverage); and   competition from other international insurers and reinsurers that could  offer coverage similar to Extremus.
An official from Extremus told us that the company is considering making  changes to its underwriting based on these concerns—such as covering  business interruption risks for subsidiaries of German companies located  in other European Union countries if an attack occurred in one of these  countries.
In the United Kingdom, the Pool Reinsurance Company, Limited (Pool Re)  provides terrorism coverage, which is similar to the French and Spanish  programs in that the state provides an unlimited guarantee but also similar  to the German system in that participation by insureds is voluntary. Pool Re  was established in 1993 by the insurance market with support from the  British government in response to restrictions on the availability of  reinsurance following several terrorism incidents in London related to the  situation in Northern Ireland at that time. Pool Re is a mutual insurance  company that operates to provide reinsurance coverage for only  commercial property damage and business interruption as a result of a  terrorist act. While terrorism coverage is optional in the United Kingdom  and membership in Pool Re is voluntary, Pool Re members are required to  provide terrorism coverage to policyholders if requested, and members  must reinsure all of their terrorism coverage with Pool Re. Similarly,  insureds cannot select which properties in the United Kingdom are insured  for terrorism. If they choose to purchase terrorism insurance, they must  insure either all of their properties or none of them. According to one Pool  Re official, this policy prevents adverse selection from occurring (that is,  the risk that Pool Re’s portfolio would include only the riskiest properties  and not be diversified). Pool Re’s rates are determined by geographic zone  in the United Kingdom. For example, rates are higher for properties located  in London than for properties in other parts of the country. Business  interruption coverage is offered at a standard rate throughout the country.  Members are free to set their own terrorism premiums for their underlying  policies. Prior to the September 11 attacks, Pool Re coverage was limited to  acts of terrorism resulting in fire and explosion, according to a Pool Re  official. However, after the September 11 attacks, reinsurers began  excluding damage caused by perils other than fire and explosion. As a  result, Pool Re agreed, in consultation with the U.K. Treasury, members,  and insurance industry participants, to expand its coverage to include  other conventional perils beyond fire and explosion and also the risk of  nuclear, biological, and chemical attacks.
In the event of an attack, the British government issues a certificate  determining the event to be an act of terrorism. Coverage from Pool Re  takes effect after members pay individual retention levels, which are  calculated as proportions of an industrywide figure based on the degree of  members’ participation in Pool Re. For 2004, the industrywide retention  level is £100 million (about $194 million). If the resources of Pool Re are  exhausted, the British government provides an unlimited guarantee. Pool  Re pays the government a premium for this guarantee and would have to  repay the Treasury any amount received from the guarantee. This  guarantee has never been triggered. Since 1993, Pool Re has paid a total of  £612 million (about $1.2 billion) and currently has about £1.5 billion in  reserves (about $2.9 billion). The largest event for which Pool Re paid  claims occurred in 1993, and resulted in payments totaling £262 million  (about $509 million).
subsections: section_title: Italy and Switzerland Have Not Implemented National Terrorism Insurance Programs
paragraphs: Italy and Switzerland do not have national terrorism programs, and the  availability of terrorism insurance is limited. According to a study  commissioned by the Organization for Economic Cooperation and  Development (OECD), the majority of insurance policies covering damage  to high-value properties in Italy exclude terrorism risk. The OECD report  also noted that additional terrorism insurance is fairly restricted and very  expensive. According to a Swiss insurance association official, terrorism  risk is excluded from standard fire insurance policies above a certain value  in Switzerland (set at 10 million Swiss francs or about $8.8 million). Each  of these countries has considered the necessity for a national terrorism  insurance program. For example, the Italian National Insurance Companies  Association submitted a proposal to the government in 2003 to create an  insurance/reinsurance pool, but it was later withdrawn.
section_title: Insurance Companies in European Countries We Studied Are Permitted to Establish Tax-Deductible Reserves for Future Catastrophic Events
paragraphs: As of 2004, regulations, tax law, and accounting standards in the six  European countries we reviewed allowed insurance companies to establish  tax-deductible reserves for potential losses associated with catastrophic  events. These tax-deductible reserves are often called catastrophe or  equalization reserves. However, each country differs in the way it allows  reserves to be set-up and used (see fig. 9).
Following are brief descriptions of each European country’s approach for  establishing and maintaining catastrophe and equalization reserves:   According to an insurance industry official, French accounting  standards and tax law allow insurance companies to establish both  catastrophe and equalization reserves. A French insurance industry  participant told us that these reserves can be used for natural events  such as storms and hail, but also for nuclear, pollution, aviation, and  terrorism risks. The industry officials also said that under French  accounting standards and tax law, the maximum limit on the tax- deductible amount that can be put into these reserves is 75 percent of  the income for each year, provided that the total amount of the reserve  does not exceed 300 percent of annual income. The funds reserved each  year are released after 10 years if not used. However, neither the  regulator nor the French accounting standards provides guidance on  when money can be withdrawn from the reserves.
German commercial law requires insurance companies to establish  catastrophe and equalization reserves for catastrophic risk, according to  German accounting firm officials. These officials said that catastrophe  reserves cover losses from nuclear, pharmaceutical liability, and  terrorism risks but cannot be used for natural catastrophes. Instead,  insurance companies can use equalization reserves to manage losses  from natural catastrophes. To prevent abuse of the reserves, the  accounting firm officials said that German accounting standards contain  specific guidance for calculating the additions, withdrawals, and limits  on both catastrophe and equalization reserves for different lines of  businesses. The officials also said that under German tax law, these  reserves are tax deductible.
According to an Italian government official, the insurance supervisory  authority in Italy requires insurance companies to establish catastrophe  reserves for nuclear risk and natural catastrophes such as earthquakes  and volcanic eruptions, but reserves are not permitted for terrorism  risk. The official also said that equalization reserves are required for hail  and other climate risks. Under Italian accounting standards and tax law,  the government official said that catastrophe and equalization reserves  are built through tax-deductible contributions. In addition, the official  noted that although there are specific limits on the total amount  companies can hold in reserve for each type of risk, currently there are  no regulations for determining the amounts of additions and  withdrawals for these reserves.
According to Spanish government and insurance industry officials,  Spanish insurance regulators allow the state-owned insurer, the  Consorcio, and private insurance companies to establish catastrophe  reserves for catastrophic events and equalization reserves for other  liability risks such as automobile. However, as previously discussed, the  Consorcio effectively handles all natural catastrophe and terrorism  risks, and therefore, insurance industry officials told us that private  insurers do not need catastrophe reserves. According to Spanish tax law  and accounting standards, catastrophe reserves are tax deductible and  are accrued in the liability accounts on the balance sheet. Spanish  accounting firm officials said that the funds in the Consorcio’s  catastrophe reserve are tax deductible to a certain limit. Once the  reserved funds exceed this limit, they are taxed. The accounting firm  officials also said that there is no regulation controlling the amount of  funds the Consorcio has to maintain in its reserve and no formula for  contributions to and withdrawals from the reserve. However, a  Consorcio official told us that the Consorcio’s general practice is to  maintain an amount in reserve equal to three times the highest amount  of claims it had ever paid in a year.
According to a Swiss accounting firm official, under Swiss tax and  accounting standards, insurance companies are allowed to establish tax- deductible catastrophe reserves provided the Federal Office of Private  Insurance (the Swiss insurance supervisory body) approves a  justification of the reserve. The official said that currently, there are no  explicit regulations on how the contributions, withdrawals, or total  amount of reserves should be calculated. Instead, the Swiss supervisory  body provides guidance on a case-by-case basis on how to increase and  withdraw reserves. According to government officials, the insurance  supervisory authority is currently developing new solvency standards,  which include more explicit rules to ensure consistency and  standardization in calculating contributions and balances of the  reserves. Although Swiss tax and accounting standards generally allow  catastrophe reserves and Swiss insurance companies could establish  these reserves on the individual company level, insurance industry  officials said that not many companies that are organized into insurance  groups have them on a consolidated level (for example, the reserves are  not included in the combined financial statements of an insurance  group, which may have individual affiliates or subsidiaries in many  different countries). According to the accounting firm official, these  reserves would be eliminated on the consolidated level if Swiss GAAP  FER or another internationally accepted accounting framework that  prohibits such reserves is used.
In the United Kingdom, the Financial Services Authority (FSA), the  regulatory body for the financial services industry, requires insurance  companies to establish equalization reserves for property and other  types of insurance, according to a British accounting firm official. This  official said that under U.K. accounting standards and tax law, these  reserves are tax deductible and are accrued in the liability accounts of  the balance sheet. The Interim Prudential Sourcebook for Insurers,  published by FSA, contains detailed accounting rules for the calculation  of the reserve, including the contributions, withdrawals, and maximum  balances of the equalization reserves. However, the accounting firm  official said that U.K. accounting standards do not permit a separate  catastrophe reserve.
In March 2004, as part of an effort to achieve global convergence of  accounting standards, the International Accounting Standards Board  (IASB) issued International Financial Reporting Standard 4 Insurance  Contracts (IFRS 4), which includes guidance that effectively prohibits the  use of catastrophe and equalization reserves. Under the new international  accounting standards, loss reserves can only be accrued if the event has  occurred and the related losses are estimable. IFRS 4 presents several  arguments in favor of prohibiting the use of reserves for future catastrophic  events. For example, provisions for such reserves do not necessarily  qualify as liabilities because the losses have not occurred yet and treating  them as if they had could diminish the relevance and reliability of an  insurer’s financial statements. As previously mentioned, some analysts  argue that reserves would ensure funds were available to pay claims in the  event of a catastrophe. However, IASB argues that the general purpose of  financial reporting is not to enhance solvency, but to provide information  that is useful to a wide range of users for economic decisions.
In November 2004, the European Union (EU) endorsed IFRS 4, and  specified that only companies listed on their respective national stock  exchanges, as well as companies with listed debt, be required to prepare  their consolidated financial statements (for example, the combined  financial statements of an insurance group, which may have individual  affiliates or subsidiaries in many different countries) in accordance with  IFRS 4. However, the EU gives member states the option of permitting or  requiring these individual affiliates or subsidiaries to follow IFRS 4  requirements in preparing their individual financial statements. EU  countries also have the option of allowing unlisted companies to follow  these standards. For example, according to government and Consorcio  officials, Spanish insurance regulators have decided to exercise this option  and prohibit the Consorcio—an unlisted company—from following IFRS 4.  According to the EU regulation, the designated insurance companies are  required to follow IFRS 4, starting with financial statements prepared on or  after January 1, 2005.
European officials we contacted in some cases expressed differing views  on the elimination of catastrophe and equalization reserves under IFRS 4. A  European Commission official indicated that European insurance  companies should be able to cope with the elimination of catastrophe and  equalization reserves because individual companies could still establish  and maintain the reserves for tax purposes, but the reserves would be  eliminated in the financial statements on a consolidated level. In the  consolidation for financial reporting, the reserves would be moved from  liabilities to equity. Representatives from a large German accounting firm  said that German insurance companies would most likely prepare two sets  of financial statements. One would exclude reserves and comply with the  international accounting standards, and the other would include the  reserves and be submitted to the taxation authorities, similar to U.S.  practices. However, insurance industry participants in some of the  European countries that we reviewed expressed the following concerns  about the provision eliminating reserves:   Insurance industry officials in France stated that reserving is essential  as a precaution for coverage of natural catastrophe risks. In addition,  representatives from a large German accounting firm said that reserves  provide transparency in financial reporting and help users of financial  statements to better understand insurers’ risk management practices.
One insurance industry representative expressed concern that having  two sets of financial statements would result in complexities and  ambiguities in financial reporting and national tax regulations and  policies.
Other officials said they are concerned that the local taxation  authorities might follow IFRS 4 and change their policies to discontinue  the use of tax-deductible reserves. Insurers might have to respond by  purchasing reinsurance in order to obtain coverage for catastrophic  risks, which the reserves would have provided.
As of the time of this review we were not aware of any changes in these  countries’ regulations or tax laws regarding the use of catastrophe reserves  for tax purposes.
section_title: Observations
paragraphs: The insurance industry may not be able to withstand major catastrophic  events without federal government intervention. Although the industry has  improved its ability to respond to the losses associated with natural  catastrophes—at least those on the scale of the 2004 hurricane season— without widespread market disruptions, industry capacity has not yet been  tested by a major catastrophe (such as an event with an expected annual  occurrence of no more than 1 percent to .4 percent). Such a catastrophe or  series of catastrophes could result in significant disruptions to insurance  markets. In addition, it is not clear how state governments and insurers  would react to such a scenario, restore stability to insurance markets, and  ensure the continued availability of critical insurance coverage, or whether  they would have the capacity to do so. Moreover, because of the federal  government’s size and financial resources, it could be called upon to  provide financial assistance to insurers and policyholders in addition to  traditional obligations, such as repairing public facilities and providing  temporary assistance to affected individuals.
It is also not yet clear the extent to which the catastrophe bond market or  authorizing insurers to establish tax-deductible reserves has the potential  to materially enhance industry capacity and thereby mitigate financial risks  to the federal government and others. Although several insurers use  catastrophe bonds to address the most severe types of catastrophic risk,  the bonds are not yet widely accepted in the insurance industry due to cost  and other factors. In addition, some industry participants question the  viability of the catastrophe bond market because no catastrophe bond has  ever been triggered, even by the 2004 hurricane season. Further, industry  participants do not consider catastrophe bonds feasible for terrorism risks  at this time. Although supporters believe that authorizing tax-deductible  reserves could enhance industry capacity, such a policy change would also  reduce federal tax revenue and may not materially enhance capacity since  the reserves may substitute for reinsurance.
In response to the financial and market risks associated with natural  catastrophes and terrorism attacks, major European countries have, with  important exceptions, generally adopted policies that rely on national  government intervention to enhance industry capacity to a greater extent  than is the case in the United States. France, Spain, and to some extent  Switzerland (but not Germany, the United Kingdom, and Italy) have  adopted national programs to address a range of natural catastrophe risk,  whereas the United States government does not have a comparable  program (although it does have a flood insurance program as discussed in  app. II). Further, all six countries we studied use their tax codes to  encourage insurers to establish reserves for potential catastrophic events.  A key similarity between Europe and the United States is that four of the  six countries we reviewed have adopted national programs to address  terrorism risk similar in many respects to TRIA. One important difference  is that TRIA was designed as a temporary program that was expected to be  discontinued when a private market for terrorism insurance could be  established, whereas the European programs are generally not expected to  be discontinued.
European approaches to addressing natural catastrophe and terrorism  risks illustrate benefits and drawbacks that may be useful for consideration  by policymakers. The mandatory national programs for natural catastrophe  risk in Spain and France, for example, help ensure that coverage is widely  available for such risks, particularly in the wake of catastrophic events.  However, such programs also involve significant government intervention  in insurance markets, such as setting premium rates, which may not be  actuarially based. Consequently, the capability of governments and insurers  to control risk-taking by policyholders and minimize potential government  liabilities may be limited, although some governments have tried to  minimize this liability by implementing loss prevention programs.  Concerning terrorism insurance, the mandatory national programs in  France and Spain ensure that most policyholders have such coverage,  although these programs also involve government intervention in setting  premium rates and in monitoring risk-taking as is the case for natural  catastrophe risk. In contrast, the purely voluntary national terrorism  program in Germany and the private sector approaches in Switzerland and  Italy have not yet been successful in ensuring that policyholders have  terrorism coverage. Many policyholders choose not to purchase terrorism  coverage because they view their risks as acceptably low or the premiums  for terrorism coverage as too high (see app. II for a similar discussion  regarding TRIA).
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Department of the Treasury and  the National Association of Insurance Commissioners. Treasury provided  technical comments on the report that were incorporated as appropriate.  NAIC’s Chief Financial Officer commented that the report was informative  and accurate. In addition, we provided the relevant sections of a draft of  this report to government and industry contacts in each of the European  countries we studied and incorporated their comments where appropriate.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution of this report until 30  days after the report date. At that time, we will provide copies of this report  to the Department of the Treasury, the National Association of Insurance  Commissioners, and other interested parties. We will also make copies  available to others on request. In addition, the report will be available at no  charge on GAO’s Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-8678 or shearw@gao.gov or Wesley M. Phillips, Assistant  Director, at phillipsw@gao.gov. GAO staff who made major contributions to  this report are listed in appendix IV.
section_title: Objectives, Scope, and Methodology
paragraphs: This report provides information on a range of issues to assist the  committee in its oversight of the insurance industry, particularly in light of  the Terrorism Risk Insurance Act’s (TRIA) pending expiration. Our  objectives were to (1) provide an overview of the property-casualty  insurance industry’s current capacity to cover natural catastrophic risk and  discuss the impacts that four hurricanes in 2004 had on the industry; (2)  analyze the potential of catastrophe bonds and permitting insurance  companies to establish tax-deductible reserves to cover catastrophic risk  to enhance private-sector capacity; and (3) describe the approaches six  selected European countries—France, Germany, Italy, Spain, Switzerland,  and the United Kingdom—have taken to address natural and terrorist  catastrophe risk, including whether these countries permit insurers to use  tax-deductible reserves for such events. We also provide information on  insurers’ financial exposure to terrorist attacks under TRIA and the extent  to which catastrophe risks are not covered in the United States. These  issues are discussed in appendix II.
Our general methodology involved meeting with a range of private-sector  and regulatory officials to obtain diverse viewpoints on the capacity of the  insurance industry, status of efforts to securitize catastrophe risks, and the  approaches taken in European countries to address catastrophe risk. We  met with or received written responses from representatives of (1) the U.S.  Department of Treasury; (2) the National Association of Insurance  Commissioners (NAIC); (3) a state insurance regulator; (4) state  catastrophe insurance and fund authorities including the California  Earthquake Authority, Florida Hurricane Catastrophe Fund, and the Texas  Windstorm Insurance Association; (5) national finance or economic  ministries in Europe; (6) national insurance regulators in Europe; (7) the  European Commission; (8) the Bermuda Monetary Authority; (9) the  International Accounting Standards Board; (10) large insurers and  reinsurers based in the United States, Europe, and Bermuda; (11) Citizens  Property Insurance Corporation, (12) ratings agencies; (13) modeling firms;  (14) law firms; (15) academics; (16) the American Academy of Actuaries;  (17) the Insurance Services Office; (18) U.S. insurance and reinsurance  trade associations; (19) global accounting firms; (20) European insurance  associations and a Bermuda insurance association; (21) European business  or property associations; (22) European catastrophe insurance programs;  (23) the Organization for Economic Cooperation and Development; (24)  the International Chamber of Commerce; (25) Lloyd’s; and (26) a consumer  group. We also reviewed our previous work on insurance and catastrophe  bonds and data and reports provided by private-sector and European  government sources. Even though we did not have audit or access-to- records authority for the private-sector entities or foreign organizations  and governments, we obtained extensive testimonial and documentary  evidence. We also obtained estimates of the insured losses and claims  resulting from the 2004 hurricanes from the Florida Office of Insurance  Regulation. We obtained data on the issuance and outstanding value of the  catastrophe bond market from Swiss Re Capital Markets. We did not verify  the accuracy of data obtained from these organizations, but corroborated  the information where possible with other sources. The information on  foreign law in this report does not reflect our independent legal analysis,  but is based on interviews and secondary sources.
To respond to the first objective, we obtained data on insurance industry  capacity from the Insurance Services Office and A.M. Best, the leading  sources for data on the insurance industry. We asked these organizations  and U.S. insurance companies, reinsurance companies, domestic and  foreign insurance trade associations, rating agencies, state catastrophe  authorities, and academic experts their views on insurance industry  capacity, the difficulties of measuring insurance industry capacity, the  implications and limitations of industry surplus data, the role of the  Bermuda insurance market and state insurance funds and authorities in  providing catastrophic insurance coverage, and the impact the 2004  hurricanes had on the insurance industry in Florida, and other issues. We  also reviewed our previous report on insurance industry capacity.
To respond to the second objective, we asked a reinsurance company and  an insurance broker for the latest numbers on the kinds and amounts of  catastrophe bonds issued and outstanding. We also talked to various  organizations about the extent to which they use or do not use catastrophe  bonds and why, the portion of the market for catastrophe risk that is  covered by catastrophe bonds, and other methods of transferring  catastrophe risk. Further, we obtained information about developing  catastrophe bonds to cover terrorism risk; regulatory, tax, and accounting  influences on catastrophe bonds; and views on the advantages and  disadvantages of tax-deductible catastrophe reserves. We also reviewed  our previous reports on catastrophe bonds.
To respond to the third objective, we interviewed representatives of  various national, regional, international, private, and public-sector  organizations in the six countries we studied. We gathered documentary  and testimonial evidence on laws, regulations, and practices related to  catastrophe insurance and catastrophe reserving in each country and  compared and contrasted information obtained from each country. We also  interviewed international and regional organizations and asked  representatives to assess the impact of International Accounting Standards  on European countries’ reserving policies. We did not determine the effect  of tax-deductibility on the overall tax burden imposed on insurance  companies in these countries, or whether the deductibility provided  incentives to create reserves.
We conducted our work between February 2004 and January 2005 in  Florida, New York, Washington, D.C., Belgium, France, Germany, Spain,  Switzerland, and the United Kingdom. Our work was done in accordance  with generally accepted government auditing standards.
section_title: TRIA Has Limited Insurers’ Financial Exposure to Terrorism Risk, but a Significant Portion of Catastrophic Risk Goes Uncovered
paragraphs: This appendix provides information from our previous reports and other  sources on (1) insurers’ financial exposures to terrorist attacks under the  Terrorism Risk Insurance Act (TRIA) and (2) the extent to which natural  catastrophe and terrorism risks may be uncovered in the United States.
subsections: section_title: TRIA Has Limited Insurers’ Financial Exposure from Terrorist Attacks
paragraphs: Congress enacted TRIA in 2002 to ensure the continued availability of  terrorism insurance in the United States after the September 11 attacks.  Under TRIA, the Department of the Treasury (Treasury) would reimburse  insurers for a large share of the losses associated with certain acts of  foreign terrorism that occur during the term of the act. TRIA caps the  federal government’s and the industry’s exposure to terrorist attacks at  $100 billion annually. TRIA also requires that all insurers selling  commercial lines of property-casualty insurance make available coverage  for certain terrorist events and defines make available to mean that the  coverage must be offered for insured losses arising from certified terrorist  events and not differ materially from the terms, amounts, and limitations  applicable to coverage for other insured losses. The act’s provisions are set  to expire on December 31, 2005, but Congress is currently considering  proposals to extend that date.
Under TRIA, primary insurers have assumed responsibility for the financial  consequences of terrorist attacks up to the levels specified in the act while  the federal government is responsible for 90 percent of losses above those  levels up to $100 billion annually. In 2005, primary insurers’ financial  exposure is limited to 15 percent of their direct earned premiums (DEP),  and they are responsible for 10 percent of losses above that amount while  the federal government is responsible for the remaining 90 percent.  Determining individual insurer’s financial exposures depends upon varying  scenarios of the potential costs associated with terrorist attacks (for  example, to what extent the cost of the attack would exceed 15 percent of  an insurer’s DEP and the insurer’s 10 percent share of any losses beyond  that amount).
Since TRIA’s make available provisions do not apply to reinsurers, these  companies have discretion in deciding how much terrorism coverage to  offer to primary companies. As we have previously reported, available  evidence indicates that reinsurers have cautiously reentered the market for  terrorism insurance and are offering coverage up to the deductible  (percentage of DEP) limits and 10 percent share specified in TRIA.  However, we have previously reported that available evidence also  suggests that few primary companies are buying this reinsurance to cover  deductibles and co-pays because—as discussed next—many of their  customers choose not to buy terrorism insurance or the primary companies  consider reinsurance premiums to be too high.
In the absence of TRIA, we have reported that reinsurers may not return to  the terrorism insurance market, thereby further limiting their liability.  Insurers we contacted stated that they cannot estimate potential losses  from terrorism without a pricing model that can estimate both the  frequency and severity of terrorist attacks. Reinsurance officials said that  current models of risks for terrorist events do not have enough historical  data to dependably forecast timing and severity, and therefore, are not  reliable.
section_title: Significant Percentage of Individuals and Businesses Lack Coverage for Some Catastrophic Events Even When Protection Is Available
paragraphs: A significant percentage of individuals and businesses lack coverage for  some catastrophic events, even though protection is available from a  variety of sources. For example, the California Earthquake Authority  (CEA) estimates that about 15 percent of California residents purchase  earthquake insurance. As shown in figure 10, an Insurance Services Office  (ISO) study found that consumers have expressed a number of reasons for  deciding not to purchase earthquake insurance in California, including the  beliefs that they are not at risk, premiums and deductibles are too high, and  the federal government would provide financial assistance in the event of a  disaster. Insurers with whom we spoke expressed similar views on why  their customers do not purchase certain types of catastrophic coverage. We  note that earthquake insurance is voluntary in California, whereas  participation in the Florida Hurricane Catastrophe Fund (FHCF) is  mandatory for Florida insurers and mortgage lenders require that  homeowners and businesses purchase wind protection. Consequently,  most homeowners and businesses in Florida have wind coverage.
Further, a significant percentage of flood risk in the United States remains  uncovered, although, the National Flood Insurance Program was enacted  to increase the availability of insurance for homeowners in areas at high  risk for floods. The Federal Emergency Management Administration  (FEMA), which administers the program, estimates that one-half to two- thirds of structures in special flood hazard areas do not have flood  insurance coverage because the uninsured owners either are unaware that  homeowners insurance does not cover flood damage or do not perceive the  flood risk to which they are exposed as serious. Flood insurance is required  for some of these properties, but the level of noncompliance with this  requirement is unknown. However, as we have previously reported, there  are indications that some level of noncompliance exists. For example, an  August 2000 study by FEMA’s Office of Inspector General examined  noncompliance for 4,195 residences in coastal areas of 10 states and found  that 416—10 percent—were required to have flood insurance but did not.
Finally, despite availability of terrorism coverage due to TRIA, limited  industry data suggest that a significant percentage of commercial  policyholders are not buying terrorism insurance, perhaps because they  perceive their risk of losses from a terrorist act as being relatively low.  Limited, but consistent results from industry surveys suggest from 10 to 30  percent of commercial policyholders are purchasing terrorism insurance.  However, a more recent study estimates that nearly 50 percent of  commercial property owners purchased terrorism insurance mid-2004.  According to industry experts, many policyholders with businesses or  properties not located near major urban centers or in possible high-risk  locations are not buying terrorism insurance because they perceive  themselves at low risk for terrorism and thus view any price for terrorism  insurance as high relative to their risk exposure. Some industry experts are  concerned that adverse selection—where those most at risk from terrorism  are generally the only ones buying terrorism insurance—may be occurring.  The potential negative effects of low purchase rates would become evident  only in the aftermath of a terrorist attack and could include more difficult  economic recovery for affected businesses without terrorism coverage.
section_title: Tax, Regulatory, and Accounting Issues Might Have Affected the Development of the Catastrophe Bond Market
paragraphs: This appendix describes the structure of catastrophe bonds and certain  tax, regulatory, and accounting issues that might have affected the use of  catastrophe bonds as described in our previous reports. We have also  updated some of the information from those reports.
As discussed in our previous reports, a catastrophe bond offering is  typically made through a special purpose reinsurance vehicle (SPRV) that  may be sponsored by an insurance or reinsurance company (see fig. 11).  The SPRV issues bonds or debt securities for purchase by investors. The  catastrophe bond offering defines a catastrophe that would trigger a loss of  investor principal and, if triggered, a formula to specify the compensation  level from the investor to the SPRV. The SPRV holds the funds from the  catastrophe bond offering in a trust in the form of Treasury securities and  other highly rated assets. The SPRV then deposits the payments from the  investors as well as the premium income from the company into a trust  account. The premium paid by the insurance or reinsurance company and  the investment income on the trust account provide the funding for the  interest payments to investors and the costs of running the SPRV. If no  event occurs that triggers the bond’s provisions and it matures, the SPRV  pays investors the principal and interest that they are owed.  typically are offered only to qualified institutional investors under  Securities and Exchange Commission (SEC) Rule 144A;  produce relatively high returns, either equaling or exceeding the returns  on some comparable fixed-rate investments such as high-yield  corporate debt;  typically do not receive investment-grade ratings because bondholders  face potentially large losses on the securities; and typically cover event  risks that are considered the lowest probability and highest severity.
Most catastrophe bonds are issued through SPRVs located offshore—in  jurisdictions such as Bermuda—rather than in the United States. Unlike the  United States, several of these jurisdictions exempt SPRVs from income or  other taxes, which provides financial incentives for insurers to issue  catastrophe bonds offshore. The National Association of Insurance  Commissioners (NAIC) and some insurance industry groups have argued  that insurers should be encouraged to issue catastrophe bonds onshore to  lessen transaction costs and afford regulators greater scrutiny of SPRV  activities. Some insurance industry groups have advocated that Congress  change U.S. tax laws so that SPRVs would not be subject to income tax but  instead receive “pass-through” treatment similar to that afforded mortgage- backed securities. In other words, the SPRV would not be taxed on the  investment income from the trust account, and the tax would be passed on  to the investor. Eliminating taxation at the SPRV level with pass-through  treatment might facilitate expanded use of catastrophe bonds, but such  legislative actions might also create pressure from other industries for  similar tax treatment. In addition, to the extent that domestic SPRVs gained  business at the expense of taxable entities, the federal government could  lose tax revenue.
Our previous reports also stated that NAIC’s current statutory accounting  requirements might affect insurers’ use of nonindemnity-based financial  instruments such as many catastrophe bonds. 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 may be  willing to write additional insurance policies. However, statutory  accounting rules currently do not allow insurance companies to obtain a  similar credit for using nonindemnity-based financial instruments that  hedge insurance risk—which can include nonindemnity-based catastrophe  bonds—and may therefore limit the appeal of these types of catastrophe  bonds to potential issuers. Statutory accounting standards treat indemnity-  and nonindemnity-based products differently because instruments that are  nonindemnity-based have not been viewed as providing a true risk transfer.  Although NAIC’s Securitization Working Group has approved a proposal  that would allow reinsurance-like accounting treatment for such  instruments, NAIC’s Statutory Accounting Committee must give final  approval. The committee met in June 2004, but has not yet made a decision  on this issue.
Finally, we reported in 2003 that the Financial Accounting Standards Board  (FASB) had issued guidance under GAAP that had the potential to limit the  appeal of catastrophe bonds. Specifically, under the provisions of FASB  Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46),  variable interest entities, which include most catastrophe bond structures,  were subject to consolidation on issuers’ financial statements. This  provision had the potential to raise the costs associated with issuing  catastrophe bonds and make them less attractive to issuers. Our September  2003 report stated that the impact of FIN 46 on the use of catastrophe  bonds was unclear because insurers and financial market participants were  not certain whether it would require insurers or investors to consolidate  catastrophe bond assets and liabilities on their financial statements. In  December 2003, FASB issued FIN 46R, revised guidance that eliminated  some of the requirements for consolidation. One large issuer of  catastrophe bonds we contacted consolidated some of its SPRVs in its  financial statements under the criteria set in FIN 46R. However, another  large issuer decided not to consolidate any of its SPRVs after evaluation of  the criteria set in FIN 46R.
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to those named above, Patrick S. Dynes, Jill M. Johnson,  Matthew Keeler, Wing Lam, Marc Molino, and Barbara Roesmann made key  contributions to this report.
section_title: Glossary of Terms
paragraphs: A catastrophic event with a 1 percent chance of occurring annually.
subsections: section_title: Adverse Selection
paragraphs: The tendency of those exposed to a higher risk to seek more insurance  coverage than those at a lower risk.
section_title: Balance Sheet
paragraphs: Provides a snapshot of a company’s financial condition at one point in time.  It shows assets, including investments and reinsurance, and liabilities, such  as loss reserves to pay claims in the future, as of a certain date. It also  states a company’s equity, which for insurance companies is known as  policyholder surplus. Changes in that surplus are one indicator of an  insurer’s financial standing.
section_title: Basis Risk
paragraphs: The risk that the proceeds from a financial instrument—such as a  nonindemnity based catastrophe bond—will not be related to the insurer’s  loss experience.
section_title: Capacity
paragraphs: The ability of property-casualty insurers to pay customer claims in the  event of a catastrophic event and their willingness to make catastrophic  coverage available to their customers, particularly subsequent to  catastrophes.
section_title: Catastrophe
paragraphs: Term used for statistical recording purposes to refer to a single incident or  a series of closely related incidents causing severe insured property losses  totaling more than a given amount.
section_title: Catastrophe Bonds
paragraphs: Risk-based securities that pay relatively high interest rates and provide  insurance companies with a form of reinsurance to pay losses from a  catastrophe such as those caused by a major hurricane. They allow  insurance risk to be sold to institutional investors in the form of bonds,  thus spreading the risk.
section_title: Catastrophe Model
paragraphs: Using computers, a method to mesh long-term disaster information with  current demographic, building, and other data to determine the potential  cost of natural disasters and other catastrophic losses for a given  geographic area.
section_title: Deductible
paragraphs: The amount of loss paid by the policyholder. Either a specified dollar  amount, a percentage of the claim amount, or a specified amount of time  that must elapse before benefits are paid. The bigger the deductible, the  lower the premium charged for the same coverage.
section_title: Equity Capital
paragraphs: Equity capital, or insurers' surplus, is defined as net worth under the  Statutory Accounting Principles (SAP) promulgated by the National  Association of Insurance Commissioners. As such, surplus is the difference  between assets valued according to SAP and liabilities valued according to  SAP.
section_title: Generally Accepted Accounting Principles
paragraphs: Generally accepted accounting principles (GAAP) refers to the  conventions, rules, and procedures that define acceptable accounting  practices at a particular time. These practices form the framework for  financial statement preparation.
section_title: Guaranty Fund
paragraphs: The mechanism by which solvent insurers ensure that some of the  policyholder and third-party claims against insurance companies that fail  are paid. Such funds are required in all 50 states, the District of Columbia,  and Puerto Rico, but the type and amount of claims covered by the fund  varies from state to state. Some states pay policyholders’ unearned  premiums—the portion of the premium for which no coverage was  provided because the company was insolvent. Some have deductibles.  Most states have no limits on workers compensation payments. Guaranty  funds are supported by assessments on insurers doing business in the state.
section_title: Homeowners Insurance Policy
paragraphs: The typical homeowners insurance policy covers the house, the garage, and  other structures on the property, as well as personal possessions inside the  house such as furniture, appliances, and clothing, against a wide variety of  perils including windstorms, fire, and theft. The extent of the perils covered  depends on the type of policy. An all-risk policy offers the broadest  coverage. This covers all perils except those specifically excluded in the  policy. Homeowners insurance also covers additional living expenses.  Known as “loss of use,” this provision in the policy reimburses the  policyholder for the extra cost of living elsewhere while the house is being  restored after a disaster. Coverage for flood and earthquake damage is  excluded and must be purchased separately.
section_title: Indemnity Coverage
paragraphs: Coverage with a simple relationship that is based on the insurer’s actual  incurred claims. For example, an insurer could contract with a reinsurer to  cover half of all claims—up to $100 million in claims—from a hurricane  over a specified time period in a specified geographic area. If a hurricane  occurs where the insurer incurs $100 million or more in claims, the  reinsurer would pay the insurer $50 million.
section_title: Insolvency
paragraphs: Insurer’s inability to pay debts. Insurance insolvency standards and the  regulatory actions taken vary from state to state. When regulators deem an  insurance company is in danger of becoming insolvent, they can take one  of three actions: place a company in conservatorship or rehabilitation if the  company can be saved or liquidation if salvage is deemed impossible. The  difference between the first two options is one of degree—regulators guide  companies in conservatorship but direct those in rehabilitation. Typically  the first sign of problems is an inability to pass the financial tests regulators  administer as a routine procedure.
section_title: Institutional Investor
paragraphs: An organization such as a bank or insurance company that buys and sells  large quantities of securities.
section_title: Joint Underwriting Association
paragraphs: Insurers that join together to provide coverage for a particular type of risk  or size of exposure, when there are difficulties in obtaining coverage in the  regular market, and share in the profits and losses associated with the  program.
section_title: Moral Hazard
paragraphs: The incentive created by insurance that induces those insured to undertake  greater risk than if they were uninsured, because the negative  consequences are passed to the insurer.
section_title: Nonindemnity Coverage
paragraphs: Coverage that specifies a specific event that triggers payment and payment  formulas that are not directly related to the insurer’s actual incurred losses.  Payment could be tied to industry loss indexes, parametric measures such  as wind speed during a hurricane or ground movement during an  earthquake, or models of claims payments rather than actual claims.
section_title: Peril
paragraphs: A specific risk or cause of loss covered by an insurance policy, such as a  fire, windstorm, flood, or theft. A named-peril policy covers the  policyholder only for the risks named in the policy in contrast to an all-risk  policy, which covers all causes of loss except those specifically excluded.
section_title: Premium
paragraphs: The price of an insurance policy typically charged annually or  semiannually.
section_title: Property-Casualty Insurance
paragraphs: Covers damage to or loss of policyholders’ property and legal liability for  damages caused to other people or their property. Property-casualty  insurance, which includes auto, homeowners, and commercial insurance,  is one segment of the insurance industry. The other sector is life/health.  Outside the United States, property-casualty insurance is referred to as  nonlife or general insurance.
section_title: Rating Agency
paragraphs: Six major credit agencies determine insurers’ financial strength and  viability to meet claims obligations. They are A.M. Best Co.; Duff & Phelps  Inc.; Fitch, Inc.; Moody’s Investors Services; Standard & Poor’s Corp.; and  Weiss Ratings, Inc. Ratings agencies consider factors such as company  earnings, capital adequacy, operating leverage, liquidity, investment  performance, reinsurance programs, and management ability, integrity, and  experience.
section_title: Reinsurance
paragraphs: Reinsurance is insurance for insurers. A reinsurer assumes part of the risk  and part of the premium originally taken by the primary insurer. Reinsurers  reimburse insurers for claims paid. The business is global and some of the  largest reinsurers are based abroad.
section_title: Reserves
paragraphs: A company’s best estimate of what it will pay for claims.
section_title: Retention
paragraphs: The amount of risk retained by an insurance company that is not reinsured.
section_title: Retrocession
paragraphs: The reinsurance bought by reinsurers to protect their financial stability.
section_title: Risk
paragraphs: The chance of loss of the person or entity that is insured.
section_title: Risk Management
paragraphs: Management of the varied risks to which a business firm or association  might be subject. It includes analyzing all exposures to gauge the likelihood  of loss and choosing options to better manage or minimize loss. These  options typically include reducing and eliminating the risk with safety  measures, buying insurance, and self-insurance.
section_title: Securitization of Insurance Risk
paragraphs: Using the capital markets to expand and diversify the assumption of  insurance risk. The issuance of bonds or notes to third-party investors  directly or indirectly by an insurance or reinsurance company as a means  of raising money to cover risks.
section_title: Solvency
paragraphs: Insurance companies’ ability to pay the claims of policyholders.  Regulations to promote solvency include minimum capital and surplus  requirements, statutory accounting conventions, limits to insurance  company investment and corporate activities, financial ratio tests, and  financial data disclosure.
section_title: Statutory Accounting Principles (SAP)
paragraphs: Accounting principles that are required by law. In the insurance industry,  these standards are more conservative than GAAP and are intended to  emphasize the present solvency of insurance companies. SAP is directed  toward measuring whether the company will have sufficient funds readily  available to meet anticipated insurance obligations by recognizing  liabilities earlier or at a higher value than GAAP and assets later or at a  lower value. For example, SAP requires that selling expenses be recorded  immediately rather than amortized over the life of the policy.