Catastrophe Insurance Risks: The Role of Risk-Linked Securities and Factors Affecting Their Use
Published: 2002-09-24T00:00:00

Fast Facts:

Highlights:
section_title: What GAO Found
paragraphs: Because of population growth, resulting real estate development, and using real estate values in hazard-prone areas, the nation is increasingly exposed to much higher property-casualty losses--both insured and uninsured--from natural catastrophes than in the past. In the 1990s, a series of natural disasters, (1) raised questions about the adequacy of the insurance industry's financial capacity to cover large catastrophes without limiting coverage or substantially raising premiums and (2) called attention to ways of raising additional sources of capital to help cover catastrophic risk. Catastrophe risk includes exposure to losses from natural disasters, such as hurricanes, earthquakes and tornadoes, which are infrequent events that can cause substantial financial loss but are difficult to reliably predict. The characteristics of natural disasters prompt most insurers to limit the amount and type of catastrophic risk they hold. Risk-linked securities that can be used to cover risk from natural catastrophes employ many structures and include catastrophic bonds and catastrophic options. GAO identified and analyzed several issues that might affect the use of risk-linked securities. First, the National Association of Insurance Commissioners and insurance industry representatives are considering revisions in the regulatory accounting treatment of risk transfer obtained from nonindemnity-based coverage that would allow credit to the insurer similar to that now afforded additional reinsurance. Such a revision has the potential to facilitate the use of risk-linked securities. Second, the Financial Accounting Standards Board is proposing a new U.S. Generally Accepted Accounting Principles interpretation, which would increase independent capital investment requirements that allow the sponsor to treat special purpose reinsurance vehicles (SPRV) and similar entities as independent entities and report SPRV assets and liabilities separately. Third, "pass-through" tax treatment--which eliminates taxation at the SPRV level--with favorable implementing requirements could facilitate expanded use of catastrophe bonds. Finally, catastrophe bonds, most of which are noninvestment-grade instruments, have not been sold to a wide range of investors beyond institutional investors.

section_title: Letter
paragraphs: Because of population growth, resulting real estate development, and rising  real estate values in hazard-prone areas, our nation is increasingly exposed  to much higher property-casualty losses—both insured and uninsured— from natural catastrophes than in the past.  In the 1990s, a series of natural  disasters, including Hurricane Andrew and the Northridge earthquake, (1)  raised questions about the adequacy of the insurance industry’s financial  capacity to cover large catastrophes without limiting coverage or  substantially raising premiums and (2) called attention to ways of raising  additional sources of capital to help cover catastrophic risk. The nation’s  exposure to higher property-casualty losses increases pressure on federal,  state, and local governments; businesses; and individuals to assume ever- larger liabilities for losses associated with natural catastrophes.  Recognizing this greater exposure and responding to concerns about  insurance market capacity, participants in the insurance industry and  capital markets have developed new capital market instruments (hereafter  called risk-linked securities) as an alternative to traditional property- casualty reinsurance, or insurance for insurers.
Because of these concerns, you asked that we review the role of risk-linked  securities in providing coverage for catastrophic risk and issues related to  their expanded use. As agreed with your office, our objectives were to (1)  describe catastrophe risk and how the insurance and capital markets  provide for coverage against such risks; (2) describe how risk-linked  securities, particularly catastrophe bonds, are structured; and (3) analyze  how key regulatory, accounting, tax, and investor issues might affect the  use of risk-linked securities. Our overall objective was to provide the  Committee with information and perspectives to consider as the  Committee and Congress move forward in this important and complex  area.
Even though we did not have statutory audit or access to records authority  with private-sector entities, we obtained extensive documentary and  testimonial evidence from a large number of entities, including insurance  and reinsurance companies, investment banks, institutional investors,  rating agencies, firms that develop models to analyze catastrophe risks,  regulators, and academic experts. We did not verify the accuracy of data  provided by these entities. Some entities with whom we met voluntarily  provided information they considered to be proprietary; therefore, we did  not report details from such information. In other cases companies decided  not to voluntarily provide proprietary information, and this limited our  inquiry. For example, we did not obtain any reinsurance contracts  representing either traditional reinsurance or reinsurance provided  through the issuance of risk-linked securities.
Although we identified factors that industry and capital markets experts  believe might cause the use of risk-linked securities to expand or contract,  we make no prediction about the future use of these securities—either  under current accounting, regulatory, and tax policies or under changed  policies. Nor are we taking a position that increased use of risk-linked  securities is beneficial or detrimental. Appendix I provides a detailed  discussion of our scope and methodology.
We conducted our work between October 2001 and August 2002 in  Washington, D.C.; Chicago, Ill.; New York, N.Y.; and various locations in  California and Florida in accordance with generally accepted government  auditing standards. Written comments on a draft of this report from the  National Association of Insurance Commissioners (NAIC), the  Reinsurance Association of America (RAA), and the Bond Market Association (BMA) appear in appendixes V, VI, and VII, respectively. We  also obtained technical comments from the Department of the Treasury  (Treasury), the Securities and Exchange Commission (SEC), the  Commodities Futures Trading Commission (CFTC), NAIC, RAA, and BMA  that have been incorporated where appropriate.
subsections: section_title: Background
paragraphs: Natural catastrophes have a low probability of occurrence, but when they  do occur the consequences can be of high severity. Insurance companies  face catastrophe risk associated with their provision of property-casualty  insurance. Major reinsurers are insurance companies with global insurance  and reinsurance operations. Insurers and reinsurers are subject to “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 through to the insurer.”  Therefore,  reinsurers have incentives to limit the possibility that ceding insurers take  actions that would create negative consequences for the reinsurer.  Indemnity reinsurance contracts have the potential to increase a reinsurer’s  risk exposure to the extent that the reinsurer might be unaware of the  underwriting and claims settlement practices of the ceding insurer.
Traditional reinsurance is generally indemnity-based and tailored to the  needs of the ceding company because traditional reinsurance depends, in  part, on well-developed contractual and business relationships between  insurers and reinsurers. When reinsurance coverage is not indemnity- based, the ceding insurer is exposed to basis risk—the risk that there may  be a difference between the payment received from the reinsurance  coverage and the actual accrued claims of the ceding insurance company.  Property-casualty reinsurance agreements are typically single-event,  excess of loss contracts. A single-event contract means that the reinsurer’s  obligations are specific to an event, such as a hurricane in a contractually  specified geographic area. Excess of loss means that the reinsurer makes  payments that are based on a contractually specified share of claims in  excess of a minimum amount, subject to a maximum claim payment.
The financial industry has developed instruments through which primary  financial products, such as lending or insurance, can be funded in the  capital markets. Lenders and insurers continue to provide the primary  products to the customers, but these financial instruments allow the  funding of the products to be “unbundled” from the lending and insurance  business; instead, the funding comes from securities sold to capital market  investors. This process, called securitization, can give insurers access to  the large financial resources of the capital markets. With respect to  funding catastrophe risk in property-casualty insurance, the risk of  investing is tied to the potential occurrence of a specified catastrophic  event and to the quality of underwriting by insurers and reinsurers.
In evaluating risk, capital market investors face the issue of moral hazard  because in the absence of well-developed contractual and business  relationships with primary market insurers, capital market investors might  be unable to monitor the primary insurance company’s underwriting and  claims settlement practices that can act to increase risk. Nonindemnity- based coverage is a means to limit moral hazard for the investor by tying  payment to industry loss indexes, parametric measures, and models of  claims payments rather than actual claims that could be affected by lax  underwriting standards or lax settlement of claims by the ceding insurer.  However, such coverage introduces basis risk for the sponsoring insurance  company.
Insurance companies are not regulated at the federal level but are to  comply with the laws of the states in which they operate. The insurance  regulators of the 50 states, the District of Columbia, and U.S. territories  have created NAIC to coordinate regulation of multistate insurers. NAIC  serves as a forum for the development of uniform policy, and its  committees develop model laws and regulations governing the U.S.  insurance industry. Although not required to do so, most states either adopt  model laws or modify them to meet their specific needs and conditions.
NAIC also has established statutory accounting standards, which are  intended for use by insurance departments, insurers, and auditors when  state statutes or regulations are silent. If not in conflict with state statutes  and regulation, or in cases when the state statutes are silent, statutory  accounting standards promulgated by NAIC are intended to apply. In  addition to statutory accounting standards, insurers use GAAP, which are  promulgated by FASB and are designed to meet the varying needs of both  insurance and noninsurance companies. Although NAIC’s statutory  accounting standards use the framework established by GAAP, GAAP  stresses the measurement of earnings from period to period, while NAIC’s  standards stress the measurement of ability to pay claims in the future.  NAIC has also developed the Risk-Based Capital for Insurers Model Act,  adopted in some form in all states, which imposes automatic requirements  on insurers to file plans of action when their capital falls below minimum  standards.
section_title: Insurance and Reinsurance Markets Provide Catastrophe Risk Coverage and Capital Markets Add to Industry Capacity
paragraphs: Natural catastrophes are infrequent events that can cause severe financial  losses. Traditional reinsurance helps insurance companies respond to  severe losses by limiting their individual liability on specific risks and  thereby increases individual insurers’ capacity. However, insurance  companies have been faced with higher reinsurance premiums for certain  coverage following significant past natural catastrophes. Higher costs of  reinsurance helped spur the development of risk-linked securities as an  alternative to traditional reinsurance.
subsections: section_title: Natural Catastrophes Are Infrequent Events but Cause Severe Loss
paragraphs: Although natural catastrophes occur relatively infrequently compared with  other insured events, they can affect large numbers of persons as well as  their property. The U.S. property and casualty insurance industry has  paid, on average, $9.7 billion in catastrophe-related claims per year from  1989 through 2001, and the amount of claims paid can be highly variable.  More than 68 million Americans now live in hurricane-vulnerable coastal  areas. Eighty percent of Californians live near active faults. When natural  disasters occur they cause damage and destruction, which may or may not  be covered by insurance. The four most costly types of insured  catastrophic perils in the United States are earthquakes, hurricanes,  tornadoes, and hailstorms, although earthquakes and hurricanes pose the  most significant catastrophe risk in insurance markets. Figure 1 shows the  combined relative risk of these hazards across the United States.
In August 1992, Hurricane Andrew swept ashore in Florida south of Miami  and at the time set a new record for insured losses. As shown in figure 2,  estimated losses from Andrew were about $30 billion, of which $15.5 billion  was insured. Payments of claims stemming from Andrew reduced the  capital of affected insurance companies and sharply reduced their capacity  to issue new policies. Some of Florida’s largest homeowner insurance  companies had to be rescued by their parent companies and others had to  tap their surpluses to pay claims. Eleven property-casualty insurance  companies went into bankruptcy. In January 1994, an earthquake occurred  about 20 miles northwest of downtown Los Angeles in the Northridge area  of the San Fernando Valley. Also shown in figure 2, estimated losses from  the Northridge earthquake were about $30 billion, of which approximately  $12.5 billion was insured. Earthquake insurance coverage availability  declined precipitously after the Northridge earthquake. Losses from the  Kobe, Japan, earthquake and the September 11, 2001, terrorist attack on the  World Trade Center also are included in figure 2 to illustrate the global  nature of the insurance capacity problem and to provide perspective on the  size of losses.
section_title: Catastrophe Risk Is Usually Covered through Insurance, Reinsurance, and Retrocession
paragraphs: For many individuals and organizations, insurance is the most practical and  effective way of handling a major risk such as a natural catastrophe. By  obtaining insurance, individuals and organizations spread risk so that no  single entity receives a financial burden beyond its ability to pay. But  catastrophic loss presents special problems for insurers in that large  numbers of those insured incur losses at the same time. Reinsurance helps  insurance companies underwrite large risks, limit liability on specific risks,  increase capacity, and share liability when claims overwhelm the primary  insurer’s resources. In reinsurance transactions, one or more insurers  agree, for a premium, to indemnify another insurer against all or part of the  loss that an insurer may sustain under its policies. Figure 3 illustrates  traditional insurance, reinsurance, and retrocessional transactions.
Reinsurance is a global business. According to RAA, almost half of all U.S.  reinsurance premiums were paid to foreign reinsurance companies.
section_title: Insurers Are Subject to Reinsurance Price Swings
paragraphs: Catastrophe reinsurance has experienced cycles in prices, both nationally  and in specific geographic areas. Figure 4 presents a national reinsurance  price index since 1989, which shows that, overall, reinsurance prices  increased both before and after Hurricane Andrew and decreased after the  Northridge earthquake.
The price trend presented in figure 4 does not reflect the situations specific  to Florida and California, where insurers refused to continue writing  catastrophe coverage. In 1993, the Florida state legislature responded by  establishing the Florida Hurricane Catastrophe Fund to provide  reinsurance for insurance companies operating in Florida. Also, the  Northridge earthquake raised serious questions about whether insurers  could pay earthquake claims for any major earthquake. In 1994, insurers  representing about 93 percent of the homeowners insurance market in  California severely restricted or refused to write new homeowners policies.  In 1996, the California state legislature responded by establishing the  California Earthquake Authority (CEA) to sell earthquake insurance to  homeowners and renters. Appendix III more fully discusses the  mechanisms established by Florida and California to deal with the risks  posed by such catastrophes.
In one comprehensive study analyzing the pricing of U.S. catastrophe  reinsurance, the authors concluded that a catastrophic event, such as a  hurricane, reduced capital available to cover nonhurricane catastrophe  reinsurance, thereby affecting reinsurance prices. This finding is consistent  with the “bundled” nature of capital investment in traditional reinsurance  (i.e., capital investors face both the risks associated with company  management and the various perils covered by the insurance company).  Therefore, the finding suggests that price and availability swings for  catastrophe reinsurance covering one peril are affected by catastrophes  involving all other perils.
Given the cyclic nature of the reinsurance market, investors have  incentives to look for alternative capital sources. Hurricane Andrew and  the Northridge earthquake provided an impetus for insurance companies  and others to find different ways of raising capital to help cover  catastrophic risk and helped spur the development of risk-linked securities  and other alternatives to traditional reinsurance.
section_title: Catastrophe Risk Can Be Transferred to Capital Markets
paragraphs: Catastrophe risk securitization began in 1992 with the introduction of  index-linked catastrophe loss futures and options contracts by the Chicago  Board of Trade (CBOT). For more information on catastrophe options, see  Appendix II. Other risk-linked securities, especially catastrophe bonds,  were created and used in the mid-1990s in the aftermath of Hurricane  Andrew and the Northridge earthquake. During this time, traditional  reinsurance prices were relatively high compared with other time periods.  While the most direct means for insurance companies to raise capital in the  capital market is issuing company stock, an investor in an insurance  company’s stock is subject to the risks of the entire company. Therefore, an  investor’s decision to purchase stock will depend on an assessment of the  insurance company’s management, quality of operations, and overall risk  exposures from all perils. In contrast, an investor in an indemnity-based,  risk-linked security can face risk associated with the insurance company’s  underwriting standards but does not take on the risk of the overall  insurance (or reinsurance) company’s operations. The cost of issuing risk- linked securities, such as catastrophe bonds, includes the legal, accounting,  and information costs that are necessary to issue securities and market  them to investors who do not have contractual and/or business  relationships with the insurance company receiving coverage. The market  test for a securitized financial instrument, such as a catastrophe bond,  depends, in part, on how well investors can evaluate the probability and  severity of loss that may affect returns from the investment.
However, the willingness of capital market investors to purchase  instruments that securitize catastrophe risk, such as catastrophe bonds,  and therefore the yields they will require, depends on a number of factors,  including the investors’ capacity to evaluate risk and the degree to which  the investment can facilitate diversification of overall investment  portfolios. Demand for risk-linked securities by insurance and  reinsurance company sponsors will depend, in part, on the basis risk faced  and the ability of sponsors to hedge this basis risk.
Although issuance of risk-linked securities has been limited, many of the  catastrophe bonds issued to date have provided reinsurance coverage for  catastrophe risk with the lowest probability and highest financial severity.  Insurance industry officials we interviewed told us that their use of risk- linked securities has lowered the cost of some catastrophe protection. In  addition, one official told us that the presence of risk-linked securities as a  potential funding option has helped lower the cost of obtaining catastrophe  protection covering low-probability, high-severity catastrophes from  traditional reinsurers.
According to the Swiss Reinsurance Company, in 2000, risk-linked  securities represented less than 0.5 percent of worldwide catastrophe  insurance and, according to estimates provided by Swiss Re and Goldman  Sachs, between 1996 and August 2002, about $11 to $13 billion in risk- linked securities had been issued worldwide. As of August 2002, over 70  risk-linked securitizations had been done, according to Goldman Sachs.  Risk-linked securities have covered perils that include earthquakes,  hurricanes, and windstorms in the United States, France, Germany, and  Japan.
section_title: Risk-Linked Securities Have Complex Structures
paragraphs: Catastrophe options offered by CBOT beginning in 1995 were among the  first attempts to market risk-linked securities. The contracts covered  exposures on the basis of a number of broad regional indexes that exposed  insurers to basis risk, and trading in CBOT catastrophe options ceased in  1999 due to lower-than-expected demand (see app. II). Insurance  companies and investment banks developed catastrophe bonds, and the  bonds are offered through the SPRVs. Recent catastrophe bonds have been  nonindemnity-based to limit moral hazard; therefore, they expose the  sponsor to basis risk. The SPRVs are usually established offshore to take  advantage of lower minimum required levels of capital, favorable tax  treatment, and a generally reduced level of regulatory scrutiny.
Currently most risk-linked securities are catastrophe bonds. Most  catastrophe bonds issued to date have been noninvestment-grade bonds.  Catastrophe bonds achieved recognition in the mid-1990s. They offered  several advantages that catastrophe options did not, among them  customizable offerings and multiyear pricing. Catastrophe bonds, to date,  have been offered as private placements only to qualified institutional  buyers. A catastrophe bond offering is made through an SPRV that is  sponsored by an entity that may be an insurance or reinsurance company.  The SPRV provides reinsurance to a sponsoring insurance or reinsurance  company and is backed by securities issued to investors. The SPRVs are  similar in purpose to the special purpose entities (SPE) that banks and other entities have used for years to obtain funding for their loans.  These  SPEs pay investors from principal and interest payments made by  borrowers to the SPE. In contrast, the SPRVs that issue catastrophe bonds  receive payments in three forms (premiums, principal, and interest); invest  in securities; and pay investors in another form (interest). The SPRV  returns the principal to the investor if the specified catastrophe does not  occur. Figure 5 illustrates cash flows among the participants in a  catastrophe bond.
As shown in figure 5, the sponsoring insurance company enters into a  reinsurance contract and pays reinsurance premiums to the SPRV to cover  specified claims. The SPRV issues bonds or debt securities for purchase by  investors. The catastrophe bond offering defines a catastrophe that would  trigger a loss of investor principal and, if triggered, a formula to specify the  compensation level from the investor to the SPRV. The SPRV is to hold the  funds raised from the catastrophe bond offering in a trust in the form of  Treasury securities and other highly rated assets. To avoid consolidation  on the sponsor’s balance sheet, the trust also is to contain a minimum  independent equity-capital investment of at least 3 percent of the SPRV’s  assets, per GAAP. According to a rating agency official, the 3 percent equity  capital is usually obtained from capital markets in the form of preferred  stock. Typically, investors earn a return of the London Interbank Offered  Rate (LIBOR) plus an agreed spread. The SPRV deposits the payment  from the investor as well as the premium 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.
Under the terms of nonindemnity-based catastrophe bonds, for the  sponsoring insurance company to collect part or all of the investors’  principal when the catastrophe occurs, an independent third party must  confirm that the objective catastrophic conditions were met, such as an  earthquake reaching 7.2 in moment magnitude as reported by the U.S.  Geological Survey. Such nonindemnity bonds also allow the sponsor to  continue to write new business without impacting the risk level of the bond  and provide for faster reimbursement to the sponsor in the event of a  catastrophe. The sponsor is exposed to basis risk because the claims on the  investors’ principal might not fully hedge the sponsor’s actual catastrophe  exposure. However, the sponsor has minimal credit risk—the risk of  nonpayment in the event of the covered catastrophe—because the bond is  fully collateralized. The SPRVs are usually established offshore—typically  in Bermuda or the Cayman Islands—to take advantage of lower minimum required levels of capital, favorable tax treatment, and a generally reduced  level of regulatory scrutiny.
Bond rating agencies, such as Fitch, Moody’s, and Standard & Poors,  provide bond ratings that are based on their assessment of loss  probabilities and financial severity. Some SPRVs have issued catastrophe  bonds in tranches having more than one risk structure. The rating  agencies rate the bonds according to expected loss. Catastrophe bonds  issued to date have generally received noninvestment-grade ratings  because investors face a higher risk of loss of their principal. The rating  agencies rely, in part, on the risk assessments of three major catastrophe- modeling firms—the same firms are used by traditional reinsurers to help  them understand catastrophe risk. These modeling firms rely on large  computing capacity; sophisticated mathematical modeling techniques; and  very large databases containing information on past catastrophes,  population densities, construction techniques, and other relevant  information to assess loss probabilities and financial severities.  Catastrophe bond-offering statements to investors include rating  information and the results from the catastrophe modeling.
One example of a catastrophe bond is Redwood Capital I, Ltd., which is  linked to California earthquakes. Lehman Re, a reinsurance company, is the  sponsor of the bond. Due to the catastrophe bond structure, investors are  exposed to potential loss of principal of about $160 million. The contract  provides insurance for 12 months beginning January 1, 2002, covering  specified earthquake losses to property in California. The interest rates  promised on the principal-at-risk variable rate notes and preference shares  are LIBOR+5.5 percent and LIBOR+7 percent. Investor losses are tied to  the Property Claim Services (PCS) index, an indicator of insured property  losses for catastrophes. The issuer provides reinsurance coverage for the  earthquake peril in California to Lehman Re, the sponsor, for triggering  events causing industry losses that range from $22.5 billion to $31.5 billion  as estimated by PCS. Proceeds from the issuance of the securities are to be  deposited into a collateral account and invested in securities that are  guaranteed or insured by the U.S. government and in highly rated  commercial paper and other securities. The securities have been offered  only to qualified institutional buyers as defined by SEC Rule 144A. Moody’s  rated the bond a Ba2 (i.e., a noninvestment-grade bond rating) on the basis  of the determination that it is comparable to a Ba2-rated conventional bond  of similar duration. The rating took into account the risk analysis of a  catastrophe-modeling firm.
section_title: Regulatory, Accounting, Tax, and Investor Issues Might Affect Use of Risk- Linked Securities
paragraphs: We identified and analyzed regulatory, accounting, tax, and investor issues  that might affect the use of risk-linked securities. Our analysis included (1)  current accounting treatment of risk-linked securities and proposed  changes to accounting treatment, (2) potential changes in equity  requirements for the SPRVs, (3) a preliminary tax proposal by insurance  industry representatives to encourage domestic issuance of catastrophe  bonds by creating “pass-through” tax treatment,  and (4) reasons for limited  investor participation in risk-linked securities.
subsections: section_title: Regulators Are Reconsidering Accounting Treatment of Risk-Linked Securities
paragraphs: Under certain conditions, NAIC’s Statutory Accounting Principles allow an  insurance company that obtains reinsurance to reflect the transfer of risk  (effected by the purchase of reinsurance) on the financial statement it files  with state regulators. These regulatory requirements are designed to  ensure that a true transfer of risk has occurred and the reinsurance  company will be able to pay any claims. In receiving “credit” for  reinsurance, an insurance company may count the payments owed it from  the reinsurance company on claims it has paid as an asset or as a deduction  from liability. In doing so, a company can increase earnings reported on its  financial statement and lower the amount of capital it needs to meet risk- based capital requirements established by regulators. The ability to record  an asset or to take a deduction from gross liability for reinsurance is  consequent upon the transfer of risk and can strongly affect an insurance  company’s financial condition.
Traditional reinsurance pays off on an indemnity trigger—that is, payment  is based on the actual claims incurred by the insurance company. Some  risk-linked securities have also provided payments from principal on an  indemnity basis, and, under insurance accounting principles, these risk- linked securities have enabled the SPRVs to provide reinsurance that has  received what is called “underwriting accounting treatment,” thereby  allowing the SPRV sponsor to gain credit for reinsurance. In other cases,  recovery under a catastrophe bond may not be indemnity based and may  rely on a financial model of the insured claims of the insurance company  rather than on the actual claims of the company. In these cases, there is a  risk that the modeled claims will not equal the insurance company’s actual  claims. There are also risks that the financial model will produce a  recovery less or greater than the companies’ incurred claims. Current  accounting guidance requires that the contract must indemnify the  company against loss or liability associated with insurance risk in order to  qualify for reinsurance accounting.
However, NAIC is currently reconsidering the appropriate statutory  accounting treatment of nonindemnity-based insurance, which would  include risk-linked securities. Both exchange-traded instruments and  over-the-counter instruments can be used to hedge underwriting results  (i.e., to offset risk). The triggering event on a risk-linked contract must be  closely related to the insurance risks being hedged so that the payoff is  expected to be consistent with the expected claims, even though some  basis risk may still exist. This correlation is known as “hedge  effectiveness.”  NAIC is currently considering how hedge effectiveness  should be measured. Should NAIC determine a  hedge-effectiveness  measure, statutory insurance accounting standards could be changed so  that a fair value of the contract could be calculated and recognized as an  offset to insurance losses, hence allowing a credit to the insurer similar to  that granted for reinsurance. If nonindemnity-based, risk-linked securities  are accepted by insurance regulators as an effective hedge of underwriting  results, they could help make such contracts more appealing to insurance  companies by providing treatment similar to that afforded traditional  reinsurance. Nevertheless, it is important yet difficult for U.S. insurance  regulators to develop an effective measure to account for risk reduction for  nonindemnity-based coverage so that insurance company reporting on  both risk evaluation and capital treatment properly reflects the risk  retained. Appendix IV contains a discussion of credit for reinsurance  accounting treatment and the balance sheet implications of such treatment.
section_title: Proposed Rule on Equity Requirements Could Affect Catastrophe Bonds
paragraphs: An SPE is created solely to carry out an activity or series of transactions  directly related to a specific purpose. The use of an SPE (or more  specifically an SPRV) in a catastrophe bond securitization transaction  involves a number of complex financial accounting issues in the United  States. Current FASB guidance generally provides that the sponsor of an  SPE report all assets and liabilities of the SPE in its financial statements,  unless all of the following criteria are met: 1.
Independent third-party owner’s(s’) investment in the SPE is at least 3  percent of the SPE’s total debt and equity or total assets. 2. The independent third-party owner(s) has a controlling financial  interest in the SPE (generally meaning that the owner holds more than  50 percent of the voting interest of the SPE).
3.
Independent third-party owners must possess the substantive risk and  rewards of its investment in the SPE (generally meaning that the  owner’s investment and potential return are “at risk” and not  guaranteed by another party).
In response to issues arising from Enron’s use of SPEs, FASB is currently  considering a new approach to accounting for SPEs. The new FASB  interpretation would require the primary beneficiary of an SPE to  consolidate (list assets and liabilities of) the SPE in its financial statements,  unless the SPE has “economic substance” sufficient not to be consolidated;  that is, the SPE would have to have the ability to fund or finance its  operations without assistance from or reliance on any other party involved  in the SPE. In turn, the SPE would have that ability if it had independent  third-party owners who have substantive voting equity investment at risk,  exposure to variable returns, and the ability to make decisions and manage  the SPE’s activities. A presumption is set that substantive equity investment  in an SPE should be at least 10 percent of the SPE’s total assets throughout  the life of the SPE. Therefore, according to information provided by FASB,  many existing SPEs would probably be consolidated on the sponsors’  financial statements under the new requirement. The potential revision for  equity requirements is intended to improve transparency in capital  markets. According to rating agency officials, the current 3 percent  independent equity requirements in recent catastrophe bond transactions  have been met by issuing preferred stock. Our work did not determine the  extent to which the 3 percent independent equity requirement is currently  being met by the insurance industry.
Bond market representatives told us that the proposed FASB equity  requirements also have the potential to create a substantial hurdle to  structuring catastrophe bond SPEs because few investors would be willing  to purchase preferred shares because of the difficulties in understanding  the risks. These representatives argue that risk-linked securitizations are  different from other securitizations using SPEs because the insurer does  not control the funds held by the SPE, and therefore, should not be subject  to the new 10 percent equity investment requirement.
The proposed new FASB interpretation also considers who bears the  largest potential risks of the SPE when determining whether to consolidate  with the primary beneficiary. Should the primary beneficiary bear the  largest dollar loss if the SPE should fail, then consolidation would be  required with the primary beneficiary. According to one FASB  representative, one issue that needs to be considered is whether the insurer  or the investors should be responsible for reporting or consolidating the  assets and liabilities of the SPE in financial statements depending on who  bears the largest potential risks of the SPE. If an insurer must consolidate  the assets and liabilities of the SPE onto its own balance sheet, the insurer  will also lose part of the benefit of the reinsurance contract that it enters  into with the SPE.
While the proposed guidance is intended to improve financial transparency  in capital markets, it could also increase the cost of issuing catastrophe  bonds and make them less attractive to sponsors. If the proposed rule were  implemented, sponsors might turn to risk-linked securities that do not  require an SPE, such as catastrophe options.
section_title: Insurance Industry Representatives Have Proposed Pass-Through Tax Treatment of Risk-Linked Securities
paragraphs: NAIC is concerned that offshore SPRVs reduce economic efficiency and  limit the oversight ability of insurance regulators. To further encourage the  use of onshore SPRVs, NAIC’s working group on securitization has  interacted with a group of insurance industry representatives that is  considering how to structure a legislative proposal to make onshore SPRVs  tax-exempt entities. The SPRVs have been established in offshore tax  haven jurisdictions, where the SPRV itself is not subject to any income or  other tax; the SPRVs also usually operate in a manner intended to help  ensure that they avoid U.S. taxation by conducting most activities outside  of the United States. Taxation of the U.S. holders of SPRV-issued  securities depends upon whether the securities are characterized as debt or  equity. This characterization in turn depends upon a number of factors,  including the likelihood of loss of principal, the relative degree of  subordination of the instrument in the SPRV’s capital structure, and the  accounting treatment of the instrument.
Although almost all SPRVs have been established offshore, there has been  interest in facilitating the creation of onshore transactions because it is  argued that onshore SPRVs would lessen transactional costs and afford  regulators greater scrutiny of the SPRVs’ activities. NAIC has already  approved a model state insurance law that allows for the creation of an  onshore SPRV. Under the model law, an onshore SPRV would be an entity  domiciled in and organized under state law for a limited purpose. Insurance  regulators’ scope of authority would be limited for the SPRVs, which would  be required to be minimally capitalized, and the domiciliary state’s laws on  insolvency would apply to the SPRV.
However, it is likely that the onshore SPRV would be subject to federal  income taxation, making the transaction more expensive. To further  encourage the use of onshore SPRVs, a group of industry attendees at the  NAIC’s insurance securitization working group is considering a legislative  proposal to make the onshore SPRVs tax-exempt. Currently, the industry  representatives are considering using a structure that would receive tax  treatment similar to the treatment received by an issuer of asset- or  mortgage-backed securities. Issuers of asset-backed securities are  generally not subject to tax on the income from underlying assets as they  pass through the issuer to the investors in the securities. It would not be  economical for an SPE to issue an asset-backed security if the SPE  incurred material tax costs on the payments collected and paid over to the  investors as taxable income. Securitizations address the problem of taxes  in one of two ways:  First, if an asset-backed security is considered debt for  tax purposes, deductions are allowed for the interest expense, and the tax  burden is shifted to the investors. Second, if the securities are not classified  as debt, tax is avoided by treating the SPE as a pass-through entity with  income allocated and taxed to its owners.
The current proposal by the industry representatives would create a  structure similar to a Real Estate Mortgage Investment Conduit (REMIC)  or a Financial Asset Securitization Investment Trust (FASIT). REMICs and  FASITs are pools of real property mortgages or debt instruments that issue  multiple classes, or tranches, of financial payments among investors. The  REMIC and FASIT legislation adopt two approaches to avoiding an issuer  tax:  They treat the issuer as a pass-through entity and classify regular  interest as debt for purposes of allowing an interest deduction to the issuer.  The proposal would mimic REMICs and FASITs by providing pass-through  treatment for the onshore SPRV and ensuring that the regular payments in  the SPRV are classified as debt. To the extent that domestic SPRVs gained  business at the expense of taxable entities, the federal government could  experience tax revenue losses. The statutory and regulatory requirements  used to implement any such legislation would also affect tax revenue.
Expanded use of catastrophe bonds might occur with favorable  implementing requirements, but such legislative actions may also create  pressure from other industry sectors for similar tax treatment.
Also, some elements of the insurance industry believe that any  consideration of changes to the tax treatment of domestic SPRVs would  have to take into account the taxation of domestic reinsurance companies.  Domestic reinsurance companies are taxed under the special rules of  Subchapter L of the Internal Revenue Code. Under these rules, all  insurance companies are taxed as corporations.  Premiums earned by a  domestic reinsurance company, after deducting premiums paid for  retrocessional insurance coverage, are taxable. Investment income earned  by the reinsurer is also taxable. A ceding commission paid by a reinsurer to  an insurer to cover costs, including marketing and sale of the premium, is  taxable to the ceding insurance company. However, many reinsurers are  either incorporated offshore or are affiliated with companies created  offshore to take advantage of reduced levels of taxation. Payments to an  offshore reinsurer may be subject to an excise tax. In addition, because of  the potential for abuses, the Secretary of the Treasury has special statutory  authority to reallocate deductions, assets, and income between unrelated  parties when a reinsurance transaction has a significant tax avoidance  effect.
RAA officials expressed concerns about the impact of NAIC’s model act  creating an onshore SPRV. RAA objects to both the special regulatory  treatment in the model act and the tax advantages proposed for the  onshore SPRV. RAA argues that the NAIC model act creates a new class of  reinsurer that will operate under regulatory and tax advantages not  afforded to existing U.S. licensed and taxed reinsurance companies. RAA  maintains that the SPRV will act as a reinsurer and yet not be subject to  insurance regulation, thus endangering solvency regulation and creating an  uneven playing field for reinsurers.
section_title: Risk-Linked Securities Do Not Have Broad Investor Participation
paragraphs: Catastrophe bonds have not attracted a wide range of investors beyond  institutional investors. Investor participation in risk-linked securities is  limited in part because the risks of these securities are difficult to assess.  Investment bank representatives and investment advisors we interviewed  noted that catastrophe bonds have thus far been issued only to  sophisticated institutional investors and a small number of large  investment fund managers for inclusion in bond portfolios that include  noninvestment-grade bonds. Most catastrophe bonds carry noninvestment- grade bond ratings from the rating agencies, but a low rating by itself has  not been a barrier to active investor interest in other types of bonds, such  as corporate bonds. The investment fund managers told us that catastrophe  bonds comprise 3 percent or less of the portfolios in which they are  included. On the one hand, the managers like the diversification aspects of  catastrophe bonds because the risks are generally uncorrelated with the  credit risks of other parts of the bond portfolio. On the other hand,  managers stated that they have concerns about the limited liquidity and  track record of catastrophe bonds as well as the lack of in-house expertise  to understand the perils, indexes, and other features of the bonds.
As requested, we explored the potential for individual investors to  purchase shares in mutual funds that purchase catastrophe bonds for  inclusion with other securities in a mixed asset fund. We analyzed the SEC  rules governing catastrophe bond issuance and mutual fund composition  and confirmed with SEC that these rules and regulations do not preclude  mutual funds from purchasing catastrophe bonds. One of the investment  advisors we interviewed told us that his firm included a small amount of  catastrophe bonds in mutual funds sold to the public. However, a mutual  fund industry association official told us that the mutual fund companies  that the association surveyed—including three of the largest—have not  included catastrophe bonds in funds available to individual investors  because the companies lack the capacity to evaluate the risks. The mutual  fund industry official also raised the issue of whether the risk associated  with risk-linked securities would be appropriate or suitable for investments  by a broad range of investors, including moderate-income investors.
section_title: Agency Comments and Our Evaluation
paragraphs: We received written comments on a draft of this report from NAIC, RAA,  and BMA. We also obtained technical comments from Treasury, SEC,  CFTC, NAIC, RAA, and BMA that have been incorporated where  appropriate. NAIC commented that it supports developing alternative  sources of reinsurance capacity, the securitizing of catastrophic risk within  the United States, and subjecting SPRVs to U.S. insurance regulation. As  stated in our report, a group of insurance industry representatives  interacting with NAIC’s working group on securitization is considering how  to structure a legislative proposal to make the onshore SPRV a tax-exempt  entity. Our report also indicates that such legislation also could result in tax  revenue losses and other potential costs. NAIC stated that SPRVs, however,  would be subject to onshore supervision by U.S. regulators, but it is not  clear to us how risk-linked securities would actually be regulated once  brought onshore.
RAA commented that our report provides an excellent summary on the use  of risk-linked securities in providing coverage for catastrophes. However,  RAA took exception to (1) our characterization of reinsurance industry  capacity and (2) our description of risk-linked securities as an alternative  to reinsurance. RAA noted that in recent occurrences of major catastrophic  events in the United States, insurers and reinsurers had sufficient capital to  meet their obligations and added that most of the California and Florida  market was underwritten by insurers that relied very little, if at all, on  reinsurance capacity. First, we note that while the reinsurance industry has  been able to meet its obligations from recent events with existing capacity,  the industry’s capacity must be considered along with issues related to (1)  the price and availability of catastrophic reinsurance in high-risk areas and  (2) its ability to handle multiple, sequential catastrophes. Some insurers  who self-reinsure might do so partially because they believe that the price  of reinsurance to cover their exposure to catastrophic events is not  attractive. Second, RAA asked that we characterize risk-linked securities as  a supplement to reinsurance rather than as an alternative because of the  relatively small amount of reinsurance coverage currently provided  through risk-linked securities. We agree, and our report states that risk- linked securities add to or supplement reinsurance capacity, but we also  note that sponsors of catastrophe bonds view these securities as  alternatives to traditional reinsurance when they are more cost-effective.
BMA stated that our report was accurate and well-researched and  commented on several policy issues raised in the report. Their letter raised  several concerns with our discussion of tax treatment, accounting  treatment, and investor interest in risk-linked securities. First, BMA  disagreed with concerns cited in our report that pass-through tax treatment  for risk-linked securities could result in (1) tax revenue losses and (2) regulatory and tax advantages that are not afforded to existing U.S.- licensed and taxed reinsurance companies. BMA commented that because  a large percentage of entities that provide reinsurance coverage is based  outside of the United States, including all reinsurance companies  established since September 11, 2001, the tax impact would not be  dramatic. In addition, BMA noted that any potential loss of U.S. tax revenue  must be weighed against the policy benefits associated with creating  additional private-sector capacity to absorb and distribute insurance risk.  We agree that many reinsurance entities are not U.S.-based, but the  potential tax revenue losses would depend on a number of factors,  including business lost by taxable entities and the regulatory requirements  used to implement such legislation. We also agree that many considerations  must be weighed in the policy decision to grant special tax treatment for  onshore SPRVs, including potential tax revenue losses and the extent to  which an uneven playing field is created for domestic reinsurance  companies.
Second, BMA commented that our description of FASB’s SPE consolidation  proposal was not based on the final exposure draft and that they interpret  the proposal to allow SPRVs to apply only a variable interests approach and  not satisfy a particular outside equity threshold. Our draft report discussion  of the FASB proposal was based on the final exposure draft. While we did  not evaluate BMA’s interpretation of the FASB proposal, we included their  position in our report. Finally, BMA commented that our discussion of  reasons for the lack of broader investor participation in risk-linked  securities was incomplete and somewhat inaccurate. They noted that  several mutual funds have purchased risk-linked securities as part of their  overall portfolios, that mutual fund managers are well-equipped to evaluate  the risk associated with these securities, and that lack of broader investor  participation may be due to limited issuance. We agree that some mutual  funds have purchased risk-linked securities and that lack of broader  participation may be attributed to some degree to limited issuance of risk- linked securities. However, information we obtained indicates that some of  the largest mutual fund companies did not include risk-linked securities in  their mutual fund portfolios mainly because of their unusual and unfamiliar  risk characteristics.
Unless you publicly announce its contents earlier, we plan no further  distribution of this report until 30 days from the date of this letter. At that  time, we will send copies of this report to the Ranking Minority Member of  the House Committee on Financial Services and the Chairmen and Ranking  Minority Members of the Senate Committee on Banking, Housing and  Urban Affairs; and the House Committee on Ways and Means. We also will  make copies available to others upon request. In addition, this report will  be available for no charge on GAO’s Internet home page at  http://www.gao.gov.
Please contact Bill Shear, Assistant Director, or me at (202) 512-8678 if you  or your staff have any questions concerning this report. Key contributors to  this work were Rachel DeMarcus, Lynda Downing, Patrick Dynes, Christine  Kuduk, and Barbara Roesmann.
section_title: Scope and Methodology
paragraphs: You asked us to report on the potential for risk-linked securities to cover  catastrophic risks arising from natural events. As agreed with your office,  our objectives were to (1) describe catastrophe risk and how insurance and  capital markets provide for insurance against such risks; (2) describe how  risk-linked securities, particularly catastrophe bonds, are structured; and  (3) analyze how key regulatory, accounting, tax, and investor issues might  affect the use of risk-linked securities.
Even though we did not have audit or access-to-records authority with the  private-sector entities, we obtained extensive documentary and testimonial  evidence from a large number of entities, including insurance and  reinsurance companies, investment banks, institutional investors, rating  agencies, firms that develop models to analyze catastrophic risks,  regulators, and academic experts. However, we did not verify the accuracy  of data provided by these entities. Some entities we met with voluntarily  provided information they considered to be proprietary, and therefore we  did not report details from such information. In other cases, companies  decided not to provide proprietary information, and this limited our inquiry.  For example, we did not obtain any reinsurance contracts representing  either traditional reinsurance or reinsurance provided through issuance of  risk-linked securities.
To describe catastrophe risk and how insurance and capital markets  provide for insurance against such risks, we examined a variety of  documents, including books on insurance and reinsurance; academic  articles and essays; and analyses done by the Insurance Information  Institute, the Insurance Services Office, modeling firms, and the  Congressional Budget Office. We also interviewed officials from insurance  companies, reinsurance companies, the California Earthquake Authority  (CEA), the Florida Hurricane Catastrophe Fund (FHCF), modeling firms,  and university finance departments and schools.
To describe how risk-linked securities, particularly catastrophe bonds, are  structured, we examined catastrophe bond-offering circulars, investment  bank documents, reinsurance company analyses, rating agency reports,  academic studies, futures exchange documents, and analyses prepared by  the American Academy of Actuaries. We also met with officials of  investment banks, insurance companies, reinsurance companies, rating  agencies, modeling firms, a futures exchange, investment advisors, and the  American Academy of Actuaries.
To analyze how key regulatory, accounting, tax, and investor issues might  affect the use of risk-linked securities, we examined a variety of  documents, including books on insurance accounting and taxation, the  Financial Accounting Standards Board’s (FASB) proposed consolidation  principles for special-purpose entities, accounting firm publications, the  National Association of Insurance Commissioners’ (NAIC) Statutory  Accounting Principles, and the proceedings of NAIC’s Working Group on  Securitization. We met with officials from many organizations, including  NAIC’s Working Group on Securitization, the Bond Market Association  (BMA), the Reinsurance Association of America, the Investment Company  Institute—a mutual fund company association, and FASB. We also met with  officials from the Securities and Exchange Commission (SEC), the  Commodity Futures Trading Commission (CFTC), and the Department of  the Treasury (Treasury).
We faced a number of limitations in our work. We did not verify the  accuracy of data provided by the various entities we contacted. While we  obtained publicly available data on U.S. reinsurance prices, we could not  obtain information to assess the reliability of the price data nor the  methodology used to construct the reported price index. We obtained  offering statements for some catastrophe bond offers. However, we could  not determine whether the offering statements were representative of the  universe of catastrophe bond offers, and we relied on summary  information on the various offers provided to us by bond rating agencies.  We also faced limitations in identifying the specific financing arrangements  made to provide independent capital investments to special purpose  reinsurance vehicles (SPRV) used to avoid consolidation with the sponsor’s  balance sheet. In addition, without access to reinsurance contracts, we  could not determine the extent to which insurance and reinsurance  companies received credit for reinsurance, including those companies that  relied, in part, on risk-linked securities to transfer catastrophe risk.
Although we identified factors that industry and capital markets experts  believe might cause the use of risk-linked securities to expand or contract,  it was not within the scope of our work to forecast increased or reduced  future use of these securities—either under current accounting, regulatory,  and tax policies or under changed policies. It also was not within the scope  of our work to take a position on whether the increased use of risk-linked  securities is beneficial or detrimental.
We conducted our work between October 2001 and August 2002 in  Washington, D.C.; Chicago, Ill.; New York, N.Y.; and various locations in  California and Florida, in accordance with generally accepted government  auditing standards.
section_title: Catastrophe Options
paragraphs: Catastrophe options were offered by the Chicago Board of Trade (CBOT) in  1995. These options contracts were among the first attempts to market  natural disaster-related securities. Catastrophe options offered the  advantage of standardized contracts with low transaction costs traded over  an exchange. Specifically, the purchaser of a catastrophe option paid the  seller a premium, and the seller provided the purchaser with a cash  payment if an index measuring insurance industry catastrophe losses  exceeded a certain level. If the catastrophe loss index remained below a  specified level for the prescribed time period, the option expired worthless,  and the seller kept the premium. The option might have been purchased by  an insurance company that wanted to hedge its catastrophe risk and might  have been sold by firms that would do well in the event of a catastrophe— for example, homebuilders—or by investors looking for a chance to  diversify outside of traditional securities markets.
Catastrophe option contracts were revised several times and covered  exposures on national, regional, and state bases. On the one hand, because  the payouts on the contracts were based on an index of insurance industry  catastrophe losses, the transactions did not expose the investor to moral  hazard or adverse selection risk. The indexes used were the Property  Claim Services (PCS) catastrophe loss indexes. On the other hand, the  contracts created basis risk for purchasers—the differences in the claim  patterns between an individual insurer’s portfolio and the industry index.  The options were to have offered minimal credit risk because the CBOT  clearinghouse guaranteed the transactions. However, low trading volumes  on options also raised questions about liquidity risk. Trading in CBOT  catastrophe options ceased in 1999 due to lower-than-expected demand;  CBOT delisted catastrophe options in 2000.
section_title: California and Florida Approaches to Catastrophe Risk
paragraphs: The insurance markets in California and Florida illustrate the difficulties  that the catastrophe insurance industry has faced nationally. Because  California and Florida are markets with high catastrophe risk, these states  have developed programs to increase insurer capacity in these markets.  The Northridge earthquake raised serious questions about whether  insurers could pay earthquake claims for any major earthquake. In 1994,  insurers representing about 93 percent of the homeowners insurance  market in California severely restricted or refused to write new  homeowner policies because the insurers grew concerned that another  earthquake would exhaust their resources. Florida experienced a similar  insurance crisis after Hurricane Andrew in 1992. In response, the state  created two organizations to provide primary insurance coverage and  additional reinsurance capacity.
subsections: section_title: California Earthquake Authority Provides Insurance
paragraphs: In 1996, the California legislature established CEA as a privately funded  and publicly managed entity to help residents protect themselves against  earthquake loss. CEA sells earthquake insurance to homeowners, including  condominium owners and renters. Insurers doing business in California  must offer earthquake insurance in their homeowners insurance policies,  whether a CEA policy or their own. The basic CEA policy carries a  deductible of 15 percent on the home’s insured value, provides up to $5,000  to replace contents and personal possessions, and up to $1,500 for  emergency living expenses. In 2001, the average policy for a house cost  $560, but costs were several times higher in areas with high seismic risk.  While companies must offer earthquake insurance, there is no state  requirement that consumers purchase earthquake insurance or that  mortgage lenders require it. About 16 percent of California residences had  earthquake insurance at the end of 2001, and CEA insured 65 percent of  those with earthquake insurance.
As of January 2002, CEA had more than 814,000 policies and a claims  paying capacity of more than $7 billion against an exposure from all  policies of about $175 billion. Their claims paying capacity consisted of  layers of capital, insurance company assessments, and reinsurance and a  line of credit. Recent external and internal reviews—conducted by the  California State Auditor, CEA staff, and others—of CEA’s finances have  focused on its claims paying capacity. The common concern of these  reviews has been the heavy dependence on the reinsurance market—some  40 percent of CEA’s $7.2 billion claims paying capacity. Reviewers  recommend that some of CEA’s claims paying capacity be converted to  catastrophe bonds. Such a conversion would make CEA the largest  catastrophe bond issuer in the world. As shown in figure 6, CEA is  currently exploring catastrophe bond placements on two layers for $400  million and $338 million. Recently the CEA’s Governing Board decided not  to support CEA issuance of catastrophe bonds because catastrophe bonds  are done in offshore tax havens. A CEA official told us that the Governing  Board would revisit the issue when catastrophe bonds can be done  onshore.
section_title: Florida Provides Residential Coverage for Windstorms and Supplements Insurance Capacity
paragraphs: Following Hurricane Andrew in 1992, there was a property insurance crisis,  and the Florida state legislature created two organizations to provide  coverage and additional capacity—the Florida Residential Joint  Underwriting Association (JUA) and the FHCF. JUA provides residential  coverage in specifically designated areas that are most vulnerable to  windstorm damage. Qualified recipients are property owners who could  not obtain coverage from private insurers after Hurricane Andrew. The JUA  had 68,000 policyholders and an $11 billion exposure as of January 2001.  Rates charged by the JUA in each county must be at least as high as the  highest rate charged by the 20 largest private insurance companies in  Florida. The JUA’s capacity to pay claims was $1.9 billion as of January  2001; claims would be paid by drawing down its surplus, private  reinsurance, assessments of members, pre-event notes, a line of credit, and  reimbursements from the state’s catastrophe fund. In March 2002, the  Florida legislature approved a plan to merge JUA with the Florida  Windstorm Underwriting Association (FWUA), thereby forming an  organization called the Citizen’s Property Insurance Corporation.
The FHCF was created as a source of reinsurance capacity to supplement  what was available from private sources. The FHCF is run by Florida and  was set up to encourage insurers to stay in the Florida marketplace in the  aftermath of Hurricane Andrew, when reinsurance became more difficult to  obtain. The FHCF reimburses insurers for a portion of their claims from  future severe hurricanes. Unlike California, where catastrophe coverage is  voluntary, Florida homeowners’ policies must include hurricane coverage.  The FHCF is the world’s largest hurricane reinsurer, and Florida’s two  residential pools (JUA and FWUA) and private insurers depend on it.  Participation by the state’s insurers is mandatory, but insurers may choose  different levels of coverage (45 percent, 75 percent, or 90 percent) above a  high-retention or deductible level for the participating insurers. The fund is  financed by (1) about 260 property insurers doing business in the state on  the basis of their exposure to hurricane loss and (2) bonding secured by  emergency assessments on other insurers. If the FHCF cash balance is not  sufficient to reimburse covered losses, it can issue tax-exempt revenue  bonds, which are financed by an emergency assessment of all property-  casualty insurers excluding workers’ compensation writers. Premiums paid  relative to coverage purchased are significantly below those in the private- sector. The FHCF’s capacity is currently $11 billion against an exposure of  over $1 trillion. The $11 billion capacity comprises approximately $4.9 billion in cash and $6.1 billion in borrowing capacity. FHCF is also  exempt from federal income tax. Although no major claims have occurred  since Hurricane Andrew, the FHCF is designed to handle a $16.3 billion  ground up residential property loss, which would include its $11 billion current capacity limit along with an aggregate insurance industry retention  of $3.8 billion and an aggregate copayment by insurers of about $1.5 billion.
Florida has not announced plans to use risk-linked securities to address  capacity issues.
section_title: Statutory Accounting Balance Sheet Implications of Reinsurance Contracts
paragraphs: Over the term of insurance policies, premiums that an insurance company  collects are expected to pay for any insured claims and operational  expenses of the insurer while providing the insurance company with a  profit. The amount of projected claims that a single insurance policy may  incur is estimated on the basis of the law of averages. An insurance  company can obtain indemnification against claims associated with the  insurance policies it has issued by entering into a reinsurance contract with  another insurance company, referred to as the reinsurer. The original  insurer, referred to as the ceding company, pays an amount to the reinsurer,  and the reinsurer agrees to reimburse the ceding company for a specified  portion of the claims paid under the reinsured policy.
Reinsurance contracts can be structured in many different ways.  Reinsurance transactions over the years have increased in complexity and  sophistication. Reinsurance accounting practices are influenced not only  by state insurance departments through NAIC, but also by SEC and FASB.  If an insurer or reinsurer engages in international insurance, both  government regulatory requirements and accounting techniques will vary  widely among countries.
Statutory Accounting Principles promulgated by NAIC allow an insurance  company that obtains reinsurance to reflect the transfer of risk for  reinsurance on the financial statements that it files with state regulators  under certain conditions. The regulatory requirements for allowing credit  for reinsurance are designed to ensure that a true transfer of risk has  occurred and any recoveries from reinsurance are collectible. By obtaining  reinsurance, ceding companies are able to write more policies and obtain  premium income while transferring a portion of the liability risk to the  reinsurer. Under many reinsurance contracts, a commission is paid by the  reinsurer to the ceding company to offset the ceding company’s initial  acquisition cost, premium taxes and fees, assessments, and general  overhead. For example, if an insurer would like to receive reinsurance for  $10 million and negotiates a 20 percent ceding commission, then the  insurer will be required to pay the reinsurer $8 million ($10 million  premiums ceded, less $2 million ceding commission income). The effect of  this transaction is to reduce the ceding company’s assets by the $8 million  paid for reinsurance, while reducing the company’s liability for unearned  premiums by the $10 million in liabilities transferred to the reinsurer. The  $2 million is recorded by the ceding company as commission income. This  type of transaction results in an economic benefit for the ceding company  because the ceding commission increases equity. The reinsurer has  assumed a $10 million liability and would basically report a mirror entry  that would have the opposite effects on its financial statements. Figure 7  shows the effects of the reinsurance transaction on both the ceding  insurance company and reinsurance company’s balance sheets and is  intended to show how one transaction increases and decreases assets and  liabilities.
Reinsurance contracts do not relieve the ceding insurer from its obligation  to policyholders. Failure of reinsurers to honor their obligations could  result in losses to the ceding insurer.
An insurer may also obtain risk reduction from an SPRV that issues an  indemnity-based, risk-linked security; the recovery by the insurer would be  similar to a traditional reinsurance transaction. However, if an insurer  chooses to obtain risk reduction from sponsoring a nonindemnity-based,  risk-linked security issued through an SPRV, the recovery could differ from  the recovery provided by traditional reinsurance. Even though the insurer  is reducing its risk, the accounting treatment would not allow a reduction  of liability for the premiums.
section_title: Comments from the National Association of Insurance Commissioners
paragraphs: Ms. Davi M. D’Agostino  Director, Financial Institutions and Community Investment  United States General Accounting Office  Dear Ms. D’Agostino:  Thank you for giving the NAIC the opportunity to comment on the report  “Catastrophe Insurance Risks: the Role of Risk-Linked Securities and Factors  Affecting Their Use”.
The National Association of Insurance Commissioners (NAIC) is a voluntary  organization of the chief insurance regulatory officials of the 50 states, the  District of Columbia and four U.S. territories. The association’s overriding  objective is to assist state insurance regulators in protecting consumers and  helping maintain the financial stability of the insurance industry by offering  financial, actuarial, legal, computer, research, market conduct and economic  expertise.
The NAIC formed a working group on Insurance Securitization in 1998 to  “investigate whether there needs to be a regulatory response to continuing  developments in insurance securitization, including the use of non-U.S. special  purpose vehicles and to prepare educational material for regulators.” As a result  of its deliberations, the NAIC has taken the position that U.S. insurance  regulators should encourage the development of alternative sources of capacity  such as insurance securitizations and risk linked securities as long as such  developments are commensurate with the overriding goal of the NAIC  membership of consumer protection. As such, the NAIC believes that one goal  should be to encourage and facilitate securitizations within the United States. If  transactions that are currently performed offshore were brought back to the  United States, they would be subject to on-shore supervision by U.S. regulators.
Both the NAIC’s Special Purpose Reinsurance Vehicle Model Act and the  Protected Cell Company Model Act would require that at least one U.S.  insurance commissioner would review each transaction in depth and set the  appropriate standards. In addition, an NAIC member chairs the International  Association of Insurance Supervisors’ Subgroup on Insurance Securitization  and fully agrees with these views.
At present, off-shore insurance securitizations are not subject to U.S. regulation,  and the NAIC members are concerned about the appropriate use of Special  Purpose Vehicles. The recent events at Enron have demonstrated how  inappropriate use of special purpose vehicles can endanger solvency. The NAIC  membership believes that, properly used and structured, Special Purpose  Reinsurance Vehicles may provide extra capacity, more competition, and may  reduce the overall costs of insurance for the public. The NAIC membership  therefore believes that on-shore SPRVs, regulated by U.S. insurance regulators,  would be preferable to the current situation where most securitizations are  conducted off-shore.
Again, we thank you for the opportunity to review and comment on the report.
section_title: Comments from the Reinsurance Association of America
paragraphs: The following are GAO’s comments on the Reinsurance Association of  America’s letter dated September 9, 2002.
subsections: section_title: GAO Comments
paragraphs: 1.
In appendix III of the draft report we had already noted that the Florida  Hurricane Catastrophe Fund provides reinsurance to supplement that  available from private sources. We added a footnote on page 15 to note  that reinsurance is also available from private sources for property and  casualty insurance companies doing business in Florida.  2. We agree and have added a footnote on page 29 to state that no  catastrophe bond contracts have been triggered by an actual event.  3. We agree and have added a footnote on page 14 on the creation of the  Bermuda reinsurance market and its role in introducing new capacity  into the marketplace after a major event.  4. This issue is covered on pages 24 through 26.  5. Bankruptcy remoteness is among the reasons that the special purpose  entities are established, whether domestically or offshore.
section_title: Comments from the Bond Market Association
section_title: Appendix VII
paragraphs: The following are GAO’s comments on the Bond Market Association’s letter  dated September 10, 2002.