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Natural Catastrophe and Terrorism Risks' which was released on March 
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Report to the Chairman, Committee on Financial Services, House of 
Representatives: 

February 2005: 

Catastrophe Risk: 

U.S. and European Approaches to Insure Natural Catastrophe and 
Terrorism Risks: 

GAO-05-199: 

GAO Highlights: 

Highlights of GAO-05-199, a report to the Chairman, Committee on 
Financial Services, House of Representatives

Why GAO Did This Study: 

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. 

What GAO Found: 

Despite steps that governments and insurers have taken in recent years 
to strengthen insurer capacity for catastrophic risk, the industry has 
not been tested by a major catastrophic event or series of events (at 
least $50 billion or more in insured losses). While insurers suffered 
losses of over $20 billion in Florida from the 2004 hurricanes, steps 
such as implementing stronger building codes and stricter underwriting 
standards may have limited market disruptions as compared with the 
aftermath of Hurricane Andrew in 1992. For example, in 2004, only 1 
Florida insurance company failed in contrast to the 11 that failed 
after Hurricane Andrew in 1992. However, a more severe catastrophic 
event or series of events could severely disrupt insurance markets and 
impose recovery costs on governments, businesses, and individuals. 

Some insurers and reinsurers benefit from catastrophe bonds because the 
bonds diversify their funding base for catastrophic risk. However, 
these bonds currently occupy a small niche in the global catastrophe 
reinsurance market and many insurers view the costs associated with 
issuing them as significantly exceeding traditional reinsurance. In 
addition, industry participants do not consider catastrophe bonds for 
terrorism risk feasible at this time. Authorizing insurers to establish 
tax-deductible reserves for potential catastrophic events has been 
advanced as a means to enhance industry capacity, but according to some 
industry analysts such reserves would lower federal tax receipts and 
not necessarily bring about a meaningful increase in capacity because 
insurers may substitute the reserves for other types of capacity. 

The six European countries GAO studied use a variety of approaches to 
address catastrophe risk. Some governments require insurers to provide 
natural catastrophe insurance and provide financial assistance to 
insurers in the wake of catastrophic events, while others generally 
rely on the private market. However, the majority of these governments 
have established national terrorism insurance programs. Although their 
approaches vary, insurers in all six countries were allowed to 
establish tax-deductible reserves for potential catastrophic events as 
of 2004. 
The 2004 Hurricanes Resulted in Over $20 Billion in Losses in Florida: 

[See PDF for image]

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To view the full product, including the scope and methodology, click on 
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[End of section]

Contents: 

Letter: 

Results in Brief: 

Background: 

Despite Enhancements to Insurer Capacity, Industry May Not Be Able to 
Address a Major Natural Catastrophe: 

Catastrophe Bonds and Tax-Deductible Reserves May Have the Potential to 
Enhance Insurers' Capacity for Catastrophe Risk: 

European Countries Use a Mix of Approaches to Insure Natural 
Catastrophes, and Most Countries Studied Have National Terrorism 
Insurance Programs: 

Observations: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: TRIA Has Limited Insurers' Financial Exposure to Terrorism 
Risk, but a Significant Portion of Catastrophic Risk Goes Uncovered: 

Appendix III: Tax, Regulatory, and Accounting Issues Might Have 
Affected the Development of the Catastrophe Bond Market: 

Appendix IV: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Acknowledgments: 

Glossary of Terms: 

Figures: 

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

Figure 2: The 2004 Hurricane Season Resulted in More Than $20 Billion 
in Insured Losses in Florida: 

Figure 3: 2004 Hurricanes Did Not Trigger FHCF Payments to Citizens 
Property Insurance Corporation: 

Figure 4: Catastrophe Bond Amount Outstanding, Year-end 1997-2004: 

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

Figure 6: Countries with a National Terrorism Insurance Program Provide 
a State Guarantee: 

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

Figure 8: Extremus 2004 Financing Structure Caps German Government 
Payments: 

Figure 9: Reserve Policies in Selected European Countries: 

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

Figure 11: Special Purpose Reinsurance Vehicle Structure and Payment 
Flows: 

Abbreviations: 

ARC: Accounting Regulatory Committee: 

CatNat: Catastrophes Naturelles: 

CCR: Caisse Centrale de Réassurance: 

CEA: California Earthquake Authority: 

DEP: Direct Earned Premiums: 

EFRAG: European Financial Reporting Advisory Group: 

EU: European Union: 

FASB: Financial Accounting Standards Board: 

FEMA: Federal Emergency Management Administration: 

FHCF: Florida Hurricane Catastrophe Fund: 

FSA: Financial Services Authority: 

GAAP: Generally Accepted Accounting Principles: 

GAPP FER: Swiss Financial Reporting Standards of the Swiss Accounting 
and Reporting Recommendations: 

GAREAT: Gestion de l'Assurance et de la Réassurance des Risques 
Attentats et Actes de Terrorisme: 

IASB: International Accounting Standards Board: 

IFRS 4: International Financial Reporting Standard 4: 

ISO: Insurance Services Office: 

JUA: Florida Residential Joint Underwriting Association: 

NAIC: National Association of Insurance Commissioners: 

OECD: Organization for Economic Cooperation and Development: 

PCS: Property Claim Services: 

SAP: Statutory Accounting Principles: 

SEC: Securities and Exchange Commission: 

SPE: special purpose entity: 

SPRV: special purpose reinsurance vehicle: 

TRIA: Terrorism Risk Insurance Act: 

VIE: variable interest entity: 

Letter February 28, 2005: 

The Honorable Michael G. Oxley: 
Chairman, Committee on Financial Services: 
House of Representatives: 

Dear Mr. Chairman: 

Natural catastrophes and terrorist attacks can place enormous financial 
demands on households, businesses, and the insurance industry, in 
addition to causing significant loss of life. For example, the four 
hurricanes that primarily affected Florida in 2004 caused over $20 
billion in insured losses in the state due to property destruction, and 
Congress appropriated approximately $16 billion to assist victims of 
the hurricanes and repair public infrastructure such as roads and 
military bases.[Footnote 1] Moreover, natural catastrophes and 
terrorist attacks pose unique challenges to property-casualty 
insurers.[Footnote 2] Forecasting the timing and severity of such 
events is difficult and the large losses associated with catastrophes 
can threaten insurer solvency. Insurers frequently respond to 
catastrophic events by cutting back coverage significantly or 
substantially increasing premiums for policyholders. After Hurricane 
Andrew crossed southern Florida in 1992, many insurance and reinsurance 
companies (insurers that offer insurance to other insurance companies) 
raised premiums or stopped offering catastrophic coverage in the state. 
Similar reactions took place in the California insurance market after 
the Northridge earthquake of 1994 and worldwide insurance markets after 
the September 11, 2001, terrorist attacks (September 11 
attacks).[Footnote 3] To the extent that insurers are unable or 
unwilling to insure against catastrophic events, a subsequent lack of 
affordable coverage in the marketplace could impede economic recovery 
and development. 

In response to such insurance market disruptions, governments and the 
private sector have taken steps to enhance the "capacity" of the 
insurance industry to address catastrophic risk. Although there are 
several definitions of industry capacity, we define the term to mean 
the ability of property-casualty insurers to pay customer claims in the 
event of a catastrophic event and their willingness to make 
catastrophic coverage available to their customers, particularly 
subsequent to catastrophes.[Footnote 4] Several states--including 
Florida and California--have established authorities to compensate 
insurers for certain natural catastrophe-related losses and help ensure 
that catastrophe coverage is available. Additionally, with the passage 
of the Terrorism Risk Insurance Act (TRIA), the federal government 
required primary insurance companies to make terrorism coverage 
available to their commercial customers and provides substantial 
compensation to the companies in the event of a foreign terrorist 
attack in the United States.[Footnote 5] 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.[Footnote 6] Proposals have also been made that 
Congress and regulatory agencies take additional steps to increase the 
capacity of the insurance industry to address catastrophe risk. For 
example, a proposal has been made to change U.S. tax laws and 
accounting standards to allow insurers to set aside funds on a tax- 
deductible basis to establish reserves for potential future natural 
catastrophes or terrorist attacks.[Footnote 7]

Because of your continuing concerns about the costs and consequences of 
natural catastrophes and interest in minimizing the federal 
government's potential financial exposure, you asked us to provide 
information on a range of issues that would assist the committee in its 
oversight of the insurance industry. Specifically, our report (1) 
provides an overview of the property-casualty insurance industry's 
current capacity to cover natural catastrophic risk and discusses the 
impacts that the four hurricanes in 2004 had on the industry; (2) 
analyzes the potential of catastrophe bonds and permitting insurance 
companies to establish tax-deductible reserves to cover catastrophic 
risk to enhance private-sector capacity; and (3) describes the 
approaches six selected European countries--France, Germany, Italy, 
Spain, Switzerland, and the United Kingdom--have taken to address 
natural and terrorist catastrophe risk, including whether these 
countries permit insurers to use tax-deductible reserves for such 
events. 

To address our three reporting objectives, we contacted primary and 
reinsurance companies in the United States, Europe, and Bermuda. We 
also 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.[Footnote 8] In the 
six European countries we studied, we obtained documents and 
interviewed officials representing insurance supervisory authorities, 
insurance companies, insurance and business associations, accounting 
firms, national catastrophe insurance programs, and international and 
regional organizations. We asked officials whom we contacted to provide 
their views on the insurance industry's ability to cover, and 
strategies to manage, catastrophe risk. We also obtained data on the 
financial risks associated with natural catastrophes and terrorism, and 
European insurance markets. 

We conducted our work between February 2004 and January 2005 in 
Florida, New York, Washington, D.C., Belgium, France, Germany, Spain, 
Switzerland, and the United Kingdom. Our work was done in accordance 
with generally accepted government auditing standards. A more extensive 
discussion of our scope and methodology appears in appendix I. In 
addition, our report provides information on insurers' financial 
exposure to terrorist attacks under TRIA and the extent to which 
natural catastrophe and terrorism risks are uncovered in the United 
States. These issues are discussed in appendix II. The report also 
includes a glossary of 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. 

Results in Brief: 

Although insurers and state governments have taken steps to enhance the 
industry's capacity to address natural catastrophe risk, a major event 
or series of events surpassing the over $20 billion in losses in 
Florida resulting from the 2004 hurricane season could severely disrupt 
insurance markets and impose substantial recovery costs on governments, 
businesses, and individuals. Insurers increased their equity capital-- 
the financial resources available to cover catastrophic and other types 
of claims that exceed premium and investment income--from 1990 through 
2003.[Footnote 9] However, this measure has several limitations. For 
example, insurers may also face significant financial exposure in risk- 
prone areas, which could partially offset the increase in equity 
capital. Additionally, insurers' equity capital may be required for 
other types of claims besides claims involving catastrophic 
risk.[Footnote 10] Therefore, it is not clear from reviewing equity 
capital alone that the industry is in a relatively better position to 
withstand catastrophic events. According to insurers, regulators, and 
analysts we contacted, the following government and industry actions 
also have the potential to mitigate insurer losses and maintain 
insurance availability after natural catastrophes: 

* the establishment of state catastrophe authorities such as the 
Florida Hurricane Catastrophe Fund (FHCF) and the California Earthquake 
Authority (CEA);

* the establishment of stronger building codes in areas at risk for 
natural catastrophes;

* the development and use of computer programs to model insurers' 
estimated losses from particular catastrophic scenarios and control 
exposures accordingly;

* the implementation of higher deductibles that shift a greater share 
of the losses associated with natural catastrophes from insurers to 
policyholders; and: 

* the creation of new reinsurance companies in Bermuda that specialize 
in catastrophic risk. 

Preliminary information suggests that several of these changes 
generally have facilitated the industry's ability to absorb losses 
associated with the 2004 hurricanes as compared with losses from 
Hurricane Andrew in 1992.[Footnote 11] Because of significant losses, 
particularly from property claims in Florida, some companies have 
restricted coverage in certain areas of the state, and some companies 
have requested rate increases. However, only 1 company failed in 2004 
in contrast to 11 companies that failed after Andrew. Nevertheless, the 
estimated $20 billion in combined losses in Florida from the four 
hurricanes is far below potential losses associated with a major event 
or series of events (hurricanes or earthquakes of such magnitude that 
they have a 1 percent to .4 percent chance of occurring annually), 
which could be $50 billion or more.[Footnote 12] Such an event could 
exhaust the available financial resources of impacted state 
authorities, generate higher premiums, and likely result in the 
failures of some companies. 

While several insurance and reinsurance companies currently use 
catastrophe bonds to enhance their capacity to address the most severe 
types of natural catastrophes, the bonds occupy a small niche in the 
global catastrophe reinsurance market. By raising funds from the 
capital markets through the issuance of catastrophe bonds, these 
insurers diversified their funding base for the transfer of 
catastrophic risk, which traditionally involves purchasing reinsurance 
or retrocessional coverage. The appeal of catastrophe bonds to these 
insurers, as well as certain institutional investors that value the 
bonds for their relatively high rates of return and importance in 
portfolio diversification, was evidenced by the reported 50 percent 
growth of the market from year-end 2002 to year-end 2004 to a total of 
$4.3 billion in bonds outstanding worldwide. However, that amount was 
still small compared with industry catastrophe exposures, and the bonds 
have not yet achieved widespread insurance industry acceptance. Some 
state catastrophe authorities we contacted and many insurers choose not 
to issue catastrophe bonds because of their relatively high costs 
compared with traditional reinsurance. These costs include the 
transaction costs--such as legal fees--necessary to issue catastrophe 
bonds. In addition, catastrophe bonds have not been issued to address 
terrorism risk in the United States, and according to industry 
participants such bonds are not considered feasible at this time given 
the uncertainties associated with forecasting the timing and severity 
of terrorist attacks. 

Another means to increase capacity--authorizing U.S. insurance 
companies to establish tax-deductible reserves to cover the financial 
risks associated with potential natural catastrophes and terrorist 
attacks--is controversial. Some analysts believe that establishing tax- 
deductible reserves (as is currently permitted in European countries as 
described next) would increase private-sector capacity and lower 
premiums. However, according to industry analysts we contacted, 
permitting these reserves would reduce federal tax receipts, and 
Department of the Treasury staff and reinsurance association officials 
we contacted, said that the proposed changes may not bring about a 
meaningful increase in the insurance industry's ability to pay claims. 
For example, reinsurance association officials and an industry analyst 
said that since reinsurance premiums are already tax deductible, 
insurers may reduce the amount of reinsurance coverage that they 
purchase. 

Among the six European countries we studied, we found a mix of 
government and private-sector approaches to providing natural 
catastrophe insurance, while most of the countries have national 
terrorist insurance programs. For example, natural catastrophe coverage 
is mandatory in France and Spain and the national governments are 
explicitly committed to providing financial support to insurers through 
state-backed entities and state guarantees. Other governments, such as 
Germany, neither require natural catastrophe insurance nor provide 
explicit financial commitments. To cover terrorism risk, four of the 
European national governments we studied (France, Spain, Germany, and 
the United Kingdom) provide financial guarantees similar to those 
provided in the United States under TRIA. In some countries, such as 
Spain, a state-owned entity administers the terrorism insurance 
program. In other countries, such as the United Kingdom, the government 
provides a state guarantee to an otherwise private terrorism insurance 
program. 

Finally, unlike the United States, as of 2004, accounting standards and 
tax laws in each of the six countries we studied allowed insurance 
companies to establish tax-deductible reserves for future catastrophic 
events, although there can be significant differences in the reserving 
approaches used in each country. For example, in two of the six 
countries (Germany and the United Kingdom) insurers must follow 
established standards in determining the amount of money that can be 
added to the reserves each year and the conditions under which the 
money may be withdrawn to cover catastrophe losses. In contrast, 
insurers in the other four countries have more discretion to determine 
the level of contributions to the reserves and when the funds may be 
used. However, under a new international accounting standard designed 
to improve the transparency of insurer financial statements that became 
effective in 2005, insurance groups are no longer allowed to include 
catastrophe reserves in their consolidated financial statements. 
Nevertheless, European insurers and regulators we contacted said that 
countries may allow the subsidiaries or affiliates of insurance groups 
to continue using the reserves for tax purposes. 

Background: 

While insurers assume some risk when they write policies, they employ 
various strategies to manage overall risks so that they may earn 
profits, limit potential financial exposures, and build capacity-- 
generally, equity capital that would be used to pay claims. For 
example, they charge premiums for the coverage provided and establish 
underwriting standards such as (1) refusing coverage to customers who 
may represent unacceptable levels of risk or (2) limiting coverage 
offered in particular areas. Establishing underwriting standards also 
allows insurers to minimize the adverse consequences of "moral hazard," 
which is "the incentive created by insurance that induces those insured 
to undertake greater risk than if they were uninsured, because the 
negative consequences are passed to the insurer."

To manage potential financial exposures and also enhance their 
capacity, insurance companies may also purchase reinsurance.[Footnote 
13] Reinsurers generally cover specific portions of the risk the 
primary insurer carries. For example, a reinsurance contract could 
cover 50 percent of all claims associated with a single event up to 
$100 million from a hurricane over a specified time period in a 
specified geographic area. This type of contract, which specifies 
payments based on the insurer's actual incurred claims, is called 
indemnity coverage. In turn, reinsurers act to limit their risks and 
moral hazard on the part of primary insurers by charging premiums, 
establishing underwriting standards, and maintaining close business 
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).[Footnote 14] 
Catastrophe bonds generally (1) are sold to qualified institutional 
investors such as pension or mutual funds; (2) provide coverage for 
relatively severe types of events such as hurricanes with an annual 
expected occurrence of 1 percent; and (3) pay relatively high rates of 
interest and have less than investment-grade ratings (because in some 
cases, investors may risk all of their principal if a specified 
catastrophe occurs). Catastrophe bonds also potentially expose 
investors to moral hazard because, absent the business relationships 
that typically characterize primary insurers and reinsurers, investors 
may lack information on insurer underwriting standards or the claims 
payment process. That is, an insurer that has issued a catastrophe bond 
may have incentives to lower its underwriting standards and offer 
coverage to riskier insureds because investors have less ability to 
monitor the insurers' risk-taking than would a reinsurer with whom the 
insurer has done business for years. To minimize moral hazard, most 
catastrophe bonds are triggered by objective measures (also referred to 
as "nonindemnity" based coverage) such as wind speed during a hurricane 
or ground movement during an earthquake rather than insurer loss 
experience (indemnity-based). However, nonindemnity based coverage 
exposes insurers to "basis risk," which is the risk that the proceeds 
from the catastrophe bond will not be related to the insurer's loss 
experience. For example, if a hurricane with a specified wind speed 
occurs, the insurer would automatically receive the proceeds of the 
catastrophe bond, which may be either higher or lower than its actual 
losses. See appendix III for additional information on the structure of 
catastrophe bonds. 

Because insurance markets have been severely disrupted by catastrophic 
events, state and federal governments also have taken a variety of 
steps to enhance the capacity of insurers to address catastrophic risk. 
For example, Florida established FHCF to address hurricane risk, and 
California established CEA to address earthquake risk. Although these 
programs cover different risks and use different strategies as 
described in this report, they share a similar goal in ensuring that 
insurers can withstand catastrophic events and continue to make 
coverage available. Similarly, Congress enacted TRIA in 2002 to ensure 
the continued availability of terrorism insurance subsequent to the 
September 11 attacks. TRIA was designed as a temporary program that 
would remain in place until the end of 2005, when it was expected that 
insurers and reinsurers would have had time to establish a market for 
terrorism insurance. However, Congress is currently considering 
extending the 2005 deadline due to concerns about whether insurers will 
offer terrorism insurance after the act's expiration. See appendix II 
for more information about TRIA. 

Despite Enhancements to Insurer Capacity, Industry May Not Be Able to 
Address a Major Natural Catastrophe: 

Despite steps taken in recent years to strengthen insurer capacity for 
catastrophic risk, the industry has not yet been tested by a major 
catastrophic event or series of events. Overall, insurers increased 
their equity capital--financial resources available to cover 
catastrophic and other types of claims that exceed premium and 
investment income--from 1990 through 2003, but this measure of capacity 
has limitations, and therefore, the extent to which capacity has 
increased is not clear. For example, insurers' exposures in risk-prone 
coastal and other areas have also increased over time, which could 
partially offset the increase in equity capital. However, state 
governments and insurers have taken other steps to enhance industry 
capacity for catastrophic risk such as establishing state authorities, 
implementing stronger building codes, and reportedly implementing 
stronger underwriting standards. Several of these changes appear to 
have facilitated the industry's ability to withstand the 2004 
hurricanes better than the impacts of Hurricane Andrew in 1992, but a 
more severe catastrophe or catastrophes could have significant 
financial consequences for insurers and their customers. 

Equity Capital Can Measure Insurance Industry Capacity, but the Data 
Are Subject to Several Limitations: 

The insurance industry's equity capital levels commonly are used to 
assess capacity to cover catastrophic risk. As shown in figure 1, the 
Insurance Services Office, Inc. (ISO) found that from 1990 through 2003 
industry equity capital increased from $194.8 billion to $347 billion 
on an inflation-adjusted basis.[Footnote 15] After steadily increasing 
for 18 years, insurers' equity capital actually declined from 1999 to 
2002 before rebounding in 2003. Capital levels declined for a variety 
of reasons including a series of natural catastrophes in the late 
1990s, declining stock prices that particularly affected the 
investments of large European reinsurers, and the losses associated 
with the September 11 attacks. Insurer capital increased in 2003 for 
several reasons that include lower losses associated with natural 
catastrophes. According to information from ISO, the industry's capital 
level did not decline in 2004 even though insurers experienced 
significant losses associated with the 2004 hurricane season. 

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

[See PDF for image] 

[End of figure] 

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.[Footnote 16] This information is 
discussed in a later section. 

State Governments and Insurers Have Taken Steps to Manage the Financial 
Consequences of Natural Catastrophes: 

While independently assessing insurer capacity for catastrophic risk is 
challenging due to limitations associated with the equity capital 
measure and the lack of key data--such as insurers' reinsurance 
purchases--state governments and insurance companies have taken steps 
that have the potential to mitigate insurer losses and enhance industry 
capacity. We discuss several of the measures that were initiated to 
strengthen the insurance industry's capacity to respond to catastrophic 
events, including the creation of state-run programs, changes to 
building codes, shifts in underwriting, and market innovations. 

Florida and California Established Catastrophe Authorities to Stabilize 
Markets and Maintain or Increase Capacity: 

After Hurricane Andrew, the State of Florida established FHCF to act as 
a reinsurance company for insurers that offer property-casualty 
insurance in the state. According to officials from FHCF, Florida 
insurance regulators, and insurance companies that offer coverage in 
the state, FHCF enhances industry capacity by (1) offering reinsurance 
at lower rates than private reinsurers for catastrophic risk, thereby 
increasing the number of primary companies willing to write policies in 
the state; (2) ensuring that primary companies will be compensated up 
to specified levels when a catastrophic hurricane occurs; and (3) 
continuing to offer reinsurance at relatively stable rates in the 
immediate aftermath of hurricanes. Residential property insurers are 
required by state law to participate in the FHCF program. Coverage from 
FHCF is triggered when participating companies' losses meet their share 
of an aggregate industry retention level of $4.5 billion, and coverage 
is capped at $15 billion.[Footnote 17] FHCF is financed from three 
sources: actuarially-based premiums charged to participating insurers, 
investment earnings, and emergency assessments on Florida insurance 
companies if needed.[Footnote 18] FHCF may also issue bonds to meet its 
obligations. In 2002, Florida also established Citizens Property 
Insurance Corporation (Citizens), a state-run, tax-exempt primary 
insurer that offers coverage for a premium to homeowners who cannot 
obtain property insurance from private companies.[Footnote 19] Citizens 
writes full residential coverage in all 67 Florida counties and wind-
only coverage in the coastal areas of 29 counties. Citizens' claims 
paying resources include premiums, assessments on the industry if its 
financial resources fall to specified levels, and reinsurance from 
FHCF. 

After the Northridge earthquake, the State of California established 
CEA to provide residential earthquake insurance. Insurers that sell 
residential property insurance in California must offer their 
policyholders separate earthquake insurance. Companies can offer a 
private earthquake policy or a CEA policy, but most choose the CEA 
policy. Only insurance companies that participate in CEA can sell CEA 
policies. The funds to pay claims come from premiums, contributions 
from and assessments on member insurance companies, borrowed funds, 
reinsurance, and the return on invested funds. As discussed in appendix 
II, about 15 percent of eligible customers in California purchase 
earthquake insurance in part because apparently many potential 
customers believe that premiums and deductibles are too high. 

States and Counties Have Strengthened Building Codes in Areas at Risk 
for Natural Catastrophes: 

In 1994, in the wake of Hurricane Andrew, Miami-Dade and Broward 
counties enacted a revised South Florida Building Code to ensure that 
buildings would be designed to withstand both the strong wind pressures 
and impact of wind-borne debris experienced during a hurricane. In 
March 2002, Florida instituted a statewide building code that 
implemented similar requirements and replaced a complex system of 400 
local codes. The Florida Building Code was based on a national model 
code, which was amended where necessary to address Florida's specific 
needs for added hurricane protection requirements. The code also 
created a High Velocity Hurricane Zone to continue use of the South 
Florida Building Code's design and construction measures for the highly 
vulnerable Miami-Dade and Broward counties. Local jurisdictions may 
amend the code to make it more stringent when justified and are 
responsible for administering and enforcing it. According to a 2002 
study, building codes have the potential to significantly reduce the 
damage caused by hurricanes.[Footnote 20] 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. 

Insurers Use Statistical Models to Monitor Catastrophe Exposure and 
Better Manage Their Risk Exposures: 

According to insurance market participants, many, if not all, insurance 
companies and state authorities currently use computer programs offered 
by several modeling firms to estimate the financial consequences of 
various natural catastrophe scenarios and manage their financial 
exposures. To generate the loss estimates, the computer programs use 
large databases that catalog the past incidence and severity of natural 
catastrophes as well as proprietary insurance company data on policies 
written in particular states or areas. Using the estimates provided by 
these computer programs, insurers can attempt to manage their exposures 
in particularly high-risk areas. For example, an insurer could estimate 
the impact to the company of a hurricane with specified wind speeds 
striking Miami, given the number of policies that the insurer has 
written in the city as well as the value of insured property. Based on 
these types of estimates, companies can manage their risk and control 
their exposures (for example, by limiting the number and volume of 
policies written in a particular area or purchasing reinsurance if 
available on favorable terms) so that their losses are not expected to 
exceed a particular threshold, such as a specified percentage of their 
existing equity capital (a commonly used measure is from 10 to 20 
percent of capital). According to industry officials we contacted, 
insurance and reinsurance companies generally use the computer programs 
to have greater confidence that they would have sufficient capital 
remaining to meet their obligations to customers and remain in business 
even in the aftermath of a major event. Whether individual companies 
are successful in managing their losses should such an event occur will 
depend in part on the accuracy of the estimates and the quality of the 
company's risk management practices. 

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.[Footnote 21] Although state authorities can ensure that 
coverage is available in risk-prone areas, such insurers are generally 
not able to diversify their insurance portfolios and may suffer 
disproportionate losses when catastrophes occur. 

Insurers Have Implemented Higher Deductibles to Shift a Greater Share 
of Losses from Insurers to Policyholders: 

Insurers have increased policyholder deductibles for certain natural 
catastrophe risks in risk-prone areas. For example, prior to Hurricane 
Andrew in 1992, insurers in Florida generally required homeowners to 
pay a standard deductible of $500 for wind-related damage and would 
cover remaining losses to specified limits. After Hurricane Andrew, the 
Florida legislature instituted percentage hurricane deductibles. For 
homes valued at $100,000 or more, insurers may now establish 
deductibles from 2 to 5 percent of the policy limits for hurricane 
damage.[Footnote 22] According to an insurance association, 2 percent 
is the most common deductible level, although 5 percent deductibles are 
widespread on higher-priced dwellings. The new deductible is much 
higher than the previous deductible and to some extent limits insurers' 
financial exposures due to increases in property values resulting from 
inflation, since the dollar value of the 2 percent deductible increases 
as property values increase. General deductibles--usually $500--still 
apply to all homeowner policies for nonhurricane losses, including 
tornadoes, severe thunderstorms, and fire. Moreover, according to 
information from insurance market participants, percentage deductibles 
are now standard in risk-prone areas throughout the United States. 

Development of Bermuda Reinsurance Market Reportedly Has Expanded 
Capacity: 

Insurers and analysts we contacted said that the growth of the Bermuda 
reinsurance market over the past 15 years has enhanced the industry's 
capacity to withstand natural catastrophes. According to an industry 
report, many reinsurance companies were incorporated in Bermuda after 
Hurricane Andrew in 1992 and the September 11 attacks to take advantage 
of the high global premium rates for catastrophic coverage, and many 
specialize in catastrophe risk. Additionally, regulatory and industry 
officials we contacted said that Bermuda's favorable tax environment 
(no corporate income or capital gains taxes), a flexible regulatory 
environment that permits companies to be created more quickly than in 
other jurisdictions, and a concentration of individuals with insurance 
expertise have contributed to the growth of the Bermuda insurance 
market. 

According to a Bermuda insurance industry association, Bermuda 
reinsurers currently provide a total of 50 percent of all Florida 
reinsurance. One large primary company we contacted said that Bermuda 
companies are of critical importance to its overall risk management 
strategy. In addition, one state authority official reported buying 
reinsurance from companies in Bermuda. Other industry participants 
noted that Bermuda companies have diversified the worldwide reinsurance 
market. Moreover, some Bermuda companies specialize in providing 
reinsurance to about 30 primary companies that were established to 
"take out" policies from Citizens.[Footnote 23] Citizens pays bonuses 
to primary companies, called take out companies, as an incentive to 
assume the liability on polices that are taken out for 3 years. The 
bonuses are based on a percentage of the premiums for the policies 
taken out of Citizens.[Footnote 24] 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.[Footnote 25]

2004 Hurricane Season Tested Measures Implemented to Better Manage 
Natural Catastrophes: 

The four hurricanes that struck within a 6-week period in 2004 provided 
the first test of the steps the state and the insurance industry have 
taken to enhance industry capacity since Hurricane Andrew (see fig. 2). 
As of the end of 2004, they had generated an estimated 1.5 million 
claims from property owners with over $20 billion in insured losses in 
Florida--equating to losses with an expected annual occurrence from 2 
to 5 percent (that is, a 1-in-20 to a 1-in-45 year loss). Although many 
insurers incurred significant losses, 1 take out company failed, and 
some insurers are restricting coverage and requesting rate increases, 
industry participants and state officials generally agreed that the 
steps taken after Hurricane Andrew in 1992 helped the industry better 
absorb the hurricane losses and provided stability in the insurance 
markets. For example, only 1 company failed in 2004 in contrast to 11 
that failed after Andrew. According to one modeling firm official, 
while the hurricane losses are significant, insurers typically plan to 
absorb more than double the losses experienced in these four events. 
However, some of the steps taken after Andrew were designed to manage 
losses from a single storm similar to Andrew, rather than the unusual 
occurrence of four hurricanes making landfall in the United States and 
causing major damage in the same general area.[Footnote 26] Therefore, 
state officials and insurers are considering further changes to better 
address the potential for a future hurricane season with similar 
events. 

Figure 2: The 2004 Hurricane Season Resulted in More Than $20 Billion 
in Insured Losses in Florida: 

[See PDF for image] 

[End of figure] 

FHCF and Reinsurers Losses Limited Due to Multiple Mid-Sized Hurricanes 
Striking Florida Rather Than One Major Storm: 

FHCF's payments to its members were limited due to the fact that four 
relatively mid-sized hurricanes struck Florida rather than one major 
storm such as Andrew. As previously discussed, FHCF payments to its 
members are generally triggered when members' losses from a particular 
storm reach $4.5 billion (a company may receive FHCF payments if its 
losses exceed its individual retention level--or deductible--even if 
overall industry losses are less than $4.5 billion). According to an 
FHCF official, all four storms are expected to trigger FHCF recoveries 
totaling about $2 billion in payments to 123 of about 230 participating 
insurers. FHCF members that did not receive payments, including 
Citizens, did not have losses that reached their individual retention 
levels (see fig. 3). As a result of the 2004 hurricanes, Florida 
officials are considering changes to FHCF, such as lowering the 
industry retention level from the current $4.5 billion, lowering the 
retention after the second hurricane in a season, or applying a single 
hurricane season retention, rather than the per hurricane retentions 
currently in place. 

Figure 3: 2004 Hurricanes Did Not Trigger FHCF Payments to Citizens 
Property Insurance Corporation: 

[See PDF for image] 

[End of figure] 

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.[Footnote 
27] 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.[Footnote 28]

Revised Building Codes May Have Mitigated Losses: 

Although it is too early for definitive conclusions, insurers, a 
Florida regulatory official, and a consumer representative we contacted 
said that the state's revised building codes may have mitigated insurer 
losses from the 2004 hurricanes. For example, a recent study of damage 
caused by Hurricanes Charley, Frances, and Ivan found that structures 
built according to the new building codes fared better than structures 
built under older building codes.[Footnote 29] However, in some cases, 
insurance market participants said that newer structures sustained 
damage despite the revised building codes. For example, the officials 
said that materials blown off of older structures struck newer 
buildings causing damage such as shattered windows. In addition, 
Florida officials reported that some builders of structures subject to 
revised codes did not use proper materials or techniques, which 
resulted in damage and losses. 

Steps Industry Took Based on Catastrophe Model Estimates Viewed as 
Mitigating Losses: 

Overall, insurance companies and other industry participants reported 
that steps insurers took based on information generated by computer 
models of exposures mitigated their losses during the 2004 hurricane 
season; however, some insurers noted that the models did not accurately 
estimate their actual losses. According to two modeling firm 
representatives, the purpose of catastrophe modeling is not to predict 
exact losses from specific storms but to anticipate the likelihood and 
severity of potential future events so that companies can prepare 
accordingly. 

Insurers and other industry participants also reported some aspects of 
the models that could be improved. Insurance industry officials noted 
that the models did not take into account the increased cost of labor 
and construction materials after the hurricanes, or demand surge. In 
addition, companies noted that the models did not take into account the 
impact of damage caused to the same properties by storms with 
overlapping tracks. Officials from the modeling firms told us that 
since the models are based on historical data, they do factor in the 
possibility of multiple events in 1 year. However, one firm noted that 
the models assume that the damage caused by each event is independent. 
Representatives from three modeling firms told us that the companies 
will incorporate meteorological and claims data from the 2004 hurricane 
season into their models and consider other improvements in future 
upgrades. 

Insurers Increased Deductibles to Mitigate Losses, but Multiple 
Deductibles Have Raised Concerns: 

Insurance company and other industry officials we contacted said that 
using percentage-based deductibles mitigated losses associated with the 
2004 hurricanes. However, Florida insurance regulatory officials told 
us that some consumers complained that they were surprised by the high 
amount of their deductibles. In addition, with multiple storms 
sometimes crossing the same paths, paying multiple deductibles became 
an issue of consumer fairness. According to state regulatory officials, 
some insurance companies have decided to apply a single deductible to 
all their policies. Some insurers we interviewed said that they are 
deciding on a case-by-case basis whether multiple deductibles should 
apply. For example, one insurer told us that if the claims adjuster 
could not determine what damage was caused by what storm, generally 
only one deductible would be applied. According to state regulatory 
officials, there are approximately 29,000 cases of multiple 
deductibles. On December 16, 2004, the state legislature passed 
legislation to reimburse policyholders who had to pay multiple 
deductibles. According to the new law, up to $150 million will be 
borrowed from FHCF to provide grants of up to $10,000 to policyholders 
subject to two deductibles and up to $20,000 for policyholders subject 
to three or more deductibles. Funds borrowed from FHCF will be repaid 
by increasing insurers' FHCF premiums beginning in 2006. For policies 
issued or renewed on or after May 1, 2005, the new law also permits 
insurers to apply a single deductible for each hurricane season. When 
the deductible is exhausted, the deductible for other perils--generally 
$500--will be applied to claims for damage from subsequent storms. 

Bermuda Reinsurers That Specialize in Catastrophe Risk Are Expected to 
Meet Their Obligations from the 2004 Hurricanes: 

Bermuda reinsurers are expected to pay a significant amount of 
reinsurance losses compared with other reinsurance companies because of 
their specialization in catastrophe risk (such as providing reinsurance 
to take out companies). A Bermuda insurance industry association 
representative estimated that Bermuda reinsurers will pay about $2.6 
billion in losses from the four hurricanes, or about 10 percent of the 
total losses. These losses could exhaust from 25 to 40 percent of 
companies' earnings for 2004. The Bermuda insurance industry 
association official noted that no Bermuda companies are expected to 
fail as a result of these losses and that the ratings of Bermuda 
companies have not been affected by the hurricane losses. The 
association official also said that these companies are well 
capitalized and have had several years with low catastrophe losses. 

A Severe Natural Catastrophe or Series of Catastrophes Could Generate 
Major Insurance Market Disruptions: 

While state government and insurer measures initiated since the 1990s 
likely facilitated insurers' ability to respond to the 2004 hurricane 
season, an event with losses representing an expected annual occurrence 
of no more than 1 percent to .4 percent could have major consequences 
for insurers and insurance availability. Neither the 2004 hurricane 
season, as discussed previously, nor Hurricane Andrew or the Northridge 
earthquake qualified as an event with losses representing a 1 percent 
expected annual occurrence, yet many insurers experienced significant 
losses and some restricted coverage as a result of these 
catastrophes.[Footnote 30] It follows that a more severe hurricane (or 
series of hurricanes) or earthquake with estimated losses of $50 
billion or more would have even more severe consequences. For example, 
FHCF's total available financial resources of $15 billion are intended 
to cover losses from a hurricane with an estimated occurrence of about 
2 percent annually (approximately a 1-in-50 year event). If a more 
severe hurricane or series of hurricanes struck Florida, FHCF would 
likely impose assessments on the insurance industry to cover the costs 
of bonds issued to meet its obligations and its financial resources 
would be exhausted. Insurers, in turn, might impose higher premiums on 
policyholders to cover the cost of these assessments. Moreover, a 
severe hurricane would likely impose much higher losses on the 
reinsurance industry than did the 2004 hurricane season, particularly 
because primary insurers' losses may exceed the retention levels 
specified in their reinsurance contracts. 

Our previous work, as well as recent discussions with NAIC officials, 
also indicates that a catastrophe with an expected occurrence of no 
more than 1 percent annually would likely cause a significant number of 
insurer insolvencies among companies with high exposures to such events 
and inadequate risk management practices.[Footnote 31] 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.[Footnote 32] However, it is 
not clear that the state guaranty funds would have sufficient resources 
to withstand the failures of many insurers associated with a major 
catastrophic event or series of events. 

Catastrophe Bonds and Tax-Deductible Reserves May Have the Potential to 
Enhance Insurers' Capacity for Catastrophe Risk: 

Insurers' reactions to past catastrophic events--for example, 
restrictions on reinsurance coverage and higher reinsurance premiums-- 
and the potential consequences for insurers from an even more severe 
catastrophe have generated financial instruments and proposals designed 
to enhance industry capacity for both natural events and terrorist 
attacks. Catastrophe bonds serve as a potential means for insurers to 
tap the large financial resources of the capital markets to cover the 
large exposures associated with potential catastrophes. In fact, 
several insurance and reinsurance companies currently use catastrophe 
bonds to enhance their capacity to cover low probability, high severity 
natural events, although catastrophe bonds have not been issued yet to 
cover terrorism risk in the United States. However, catastrophe bonds 
are not widely used in the insurance industry due to their relatively 
high cost compared with reinsurance, among other factors. Some 
insurance market analysts have also advocated changing U.S. tax laws 
and accounting standards to permit insurers to set aside reserves on a 
tax-deductible basis to increase their capacity for both natural 
catastrophes and terrorist attacks. However, tax-deductible reserves 
involve tradeoffs such as lower federal revenues and some analysts 
believe that the reserves would not materially enhance capacity because 
insurers might substitute reserves for existing reinsurance coverage, 
the cost of which is tax deductible. 

Catastrophe Bond Market Has Grown Significantly but Is Still Small 
Compared with Overall Catastrophe Exposure: 

According to private-sector data, the value of outstanding catastrophe 
bonds increased substantially from 1997 through 2004 (see fig. 4). The 
value of outstanding catastrophe bonds worldwide increased about 50 
percent from year-end 2002 to year-end 2004 to $4.3 billion. However, 
at $4.3 billion, the value of outstanding catastrophe bonds was small 
compared with industry catastrophe exposures. For example, a major 
hurricane striking densely populated regions of Florida alone could 
cause more than an estimated $50 billion in insured losses. 

Figure 4: Catastrophe Bond Amount Outstanding, Year-end 1997-2004: 

[See PDF for image] 

Note: The data include catastrophe bonds issued and amounts outstanding 
from prior years. These data represent the most current estimates 
available as of the end of 2004 and are based on voluntary submissions. 
According to two private-sector sources, industry participants agree 
that the data are generally consistent. 

[End of figure] 

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.[Footnote 33]

Some institutional investors we contacted also expressed positive views 
about catastrophe bonds. Some investors said that the bonds offered an 
attractive yield compared with traditional investments. These 
institutional investors also said that they purchased catastrophe bonds 
because they were uncorrelated with other risks in bond portfolios and 
helped diversify their portfolios. 

Various Factors May Have Limited the Expansion of the Catastrophe Bond 
Market: 

Although catastrophe bonds benefit some insurers and institutional 
investors, others we contacted said they do not issue or purchase 
catastrophe bonds for a number of reasons, which may have limited the 
expansion of the market. Some state authorities we contacted and many 
insurers view the total costs of catastrophe bonds--including 
transaction costs such as legal fees--as significantly exceeding the 
costs of traditional reinsurance. Insurer and state authority officials 
also said that they were not attracted to catastrophe bonds because 
they generally covered events with the lowest frequency and the highest 
severity. Rather, the officials said that they would prefer to obtain 
coverage for less severe events expected to take place more frequently. 
In addition, a recent study concluded that the fact that most 
catastrophe bonds are issued on a nonindemnity basis has limited the 
growth of the market because such bonds expose insurers to basis risk 
(the risk that the provisions that trigger the catastrophe bond will 
not be highly correlated with the insurer's loss experience).[Footnote 
34]

Representatives from some institutional investors said that the risks 
associated with catastrophe bonds were too high or not worth the costs 
associated with assessing the risks. Some institutional investors also 
said that they decided not to purchase catastrophe bonds because they 
were considered illiquid. However, capital market participants we 
contacted said that the liquidity of the catastrophe bond market has 
improved. 

Moreover, the catastrophe bond market has generally been limited to 
coverage of natural disasters because the general consensus of 
insurance and financial market participants we contacted was that 
developing catastrophe bonds to cover potential targets against 
terrorism attacks in the United States was not feasible at this time. 
In contrast to natural catastrophes, where a substantial amount of 
historical data on the frequency and severity of events exists, 
terrorism risk poses challenges because it is extremely difficult to 
reliably model the frequency and severity of terrorist acts.[Footnote 
35] Although several modeling firms are developing terrorism models 
that are being used by insurance companies to assist in their pricing 
of terrorism exposure, most experts we contacted said these models were 
too new and untested to be used in conjunction with a bond covering 
risks in the United States. Furthermore, potential investor concerns-- 
such as a lack of information about issuer underwriting practices or 
the fear that terrorists would attack targets covered by catastrophe 
bonds--could make the costs associated with issuing terrorism-related 
securities prohibitive. 

Our previous work also identified certain tax, regulatory, and 
accounting issues that might have affected the use of catastrophe 
bonds. We have updated this work and discuss it in detail in appendix 
III. 

Permitting Tax-Deductible Catastrophe Reserves Is Controversial: 

Tax-deductible reserves could confer several potential benefits, 
according to advocates of the proposal, but others argue that reserves 
would not bring about a meaningful increase in industry capacity. 
First, supporters of tax-deductible reserves argue they would provide 
insurers with financial incentives to increase their capital and 
thereby expand their capacity to cover catastrophic risks and avoid 
insolvency. Supporters also argue that they would lower the costs 
associated with providing catastrophic coverage and encourage insurers 
to charge lower premiums, which would increase catastrophic coverage 
among policyholders. Moreover, as mentioned in our discussion of 
catastrophe bonds, the risk exists that reinsurers might not be able to 
honor their reinsurance contracts if a natural catastrophe were to 
occur. Allowing insurers to establish 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.[Footnote 36] The NAIC committee's proposal would make such 
reserves mandatory to promote the safety and soundness of the insurance 
industry. The committee's proposal would also stipulate that specified 
events--such as an earthquake, wind, hail, or volcanic eruption--could 
trigger a drawdown from the reserves--and that the President of the 
United States or Property Claim Services would have to declare that a 
catastrophe had occurred.[Footnote 37] The proposal would specify that 
either insurers' losses reach a certain level or that industry 
catastrophe losses exceed $10 billion for insurers to make a drawdown 
on the reserve. 

However, there are potential tradeoffs associated with allowing 
insurers to establish tax-deductible reserves for potential 
catastrophes. In particular, permitting tax-deductible reserves would 
result in lower federal tax receipts according to industry analysts we 
contacted. Although supporters counter that permitting reserves would 
enhance industry capacity and thereby reduce the federal government's 
catastrophe-related costs over the long term, the size of any such 
benefit is unknown. In addition, Treasury staff said that there would 
be no guarantee that insurance companies would actually increase the 
capital available to cover catastrophic risks. Rather, the officials 
said that insurers might use the reserves to shield a portion of their 
existing capital (or retained earnings) from the corporate income tax. 
Furthermore, reinsurance association officials said that insurance 
companies could inappropriately use tax-deductible reserves to manage 
their financial statements. That is, insurers could increase the 
reserves during good economic times and decrease them in bad economic 
times. In addition, Treasury staff expressed skepticism about the 
reliability of models used to predict the frequency and severity of 
catastrophes. Without reliable models, Treasury staff said that it 
would be difficult to determine the appropriate size of the catastrophe 
reserves. We note that insurers have developed sophisticated models to 
predict the frequency and severity of natural catastrophes such as 
hurricanes and that these models are currently considered more reliable 
than terrorism models. 

Finally, reinsurance association officials and an insurance industry 
analyst who supports tax-deductible reserves said that some insurers 
might reduce the amount of reinsurance coverage that they purchased if 
they were allowed to establish reserves. Because reserving would also 
convey tax advantages, some insurers might feel that they could limit 
the expense of purchasing reinsurance. To the extent that insurers 
reduced their reinsurance coverage in favor of tax-deductible reserves, 
the industry's overall capacity would not necessarily increase. We also 
note that reinsurance is a global business and that reinsurers in other 
countries, particularly European countries and Bermuda, provide a 
significant amount of reinsurance for U.S. insurers. Since many 
European insurers in the countries we studied are already permitted to 
establish tax-deductible reserves (as described in the next section) 
and Bermuda reinsurers are not subject to an income tax, any potential 
enhancement of insurer capacity associated with granting U.S. insurers 
the authority to establish such reserves may be limited. 

European Countries Use a Mix of Approaches to Insure Natural 
Catastrophes, and Most Countries Studied Have National Terrorism 
Insurance Programs: 

European countries also face significant risks associated with natural 
catastrophes and terrorist attacks, and have developed a range of 
approaches to enhance insurers' capacity to address catastrophic risks. 
For example, the six European countries we studied--France, Germany, 
Italy, Spain, Switzerland, and the United Kingdom--have developed a mix 
of government and private-sector approaches to covering natural 
catastrophe risk. In three of the countries, standard homeowner 
policies include mandatory coverage for natural catastrophes, and the 
government provides an explicit financial guarantee to pay claims in 
two of these three countries. The other three countries generally rely 
on insurance markets to provide natural catastrophe coverage. 
Concerning terrorism coverage, four of the six countries have 
established national terrorism programs, two of which are mandatory, 
wherein the national governments provide explicit financial guarantees 
to address the financial risks associated with terrorist attacks while 
the two remaining countries generally rely on insurance markets. As of 
the time of our review, all six countries allowed insurers to establish 
tax-deductible reserves to cover the costs associated with potential 
catastrophes, but there are significant variations in each country's 
approach. Further, a new international accounting standard designed to 
prohibit the use of such catastrophe reserves may have a limited effect 
due to the way it is being implemented in Europe. 

Europeans Use a Mix of Government and Private-sector Approaches to 
Insure Natural Catastrophes: 

Insurance for natural catastrophes in the six European countries we 
studied encompass a range of structures--from mandatory coverage with 
state-backed guarantees to wholly private-sector coverage. Figure 5 
provides an overview of how natural catastrophes are insured in the six 
selected European countries. In summary, France and Spain have 
developed national programs with mandatory coverage and unlimited state 
guarantees. Switzerland mandates natural catastrophe coverage, but the 
government does not provide an explicit financial commitment. Germany, 
Italy, and the United Kingdom do not offer national insurance programs 
for natural catastrophes. 

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

[See PDF for image] 

[End of figure] 

Natural Catastrophe Programs in France and Spain Involve Mandatory 
Coverage, State-backed Entities, and Unlimited State Guarantees: 

In France, the Catastrophes Naturelles (CatNat) program was started in 
1982 in response to serious flooding in southern France. French law 
requires standard property insurance policies to include coverage for 
natural catastrophes. According to information from the French 
government, between 95 and 98 percent of the population has taken out 
this comprehensive insurance and thus benefits from CatNat coverage. To 
cover natural catastrophe risk, insurers collect a government- 
determined 12 percent premium surcharge from policyholders. Insurers 
may then choose to forgo reinsurance for natural catastrophes or 
purchase reinsurance from the private market or the Caisse Centrale de 
Réassurance (CCR), a state-backed company authorized by law to reinsure 
natural catastrophe risk. CCR offers unlimited reinsurance coverage 
that is guaranteed by the French government in the event that CCR 
exhausts its 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.[Footnote 38] According to information 
from the French government and a CCR official, the program is set up so 
that insurers manage policyholders' claims because they have the best 
claims-paying experience and expertise. Coverage from CCR takes effect 
after insureds pay a certain deductible.[Footnote 39] Since the program 
was started in 1982, France has declared 110,000 natural disasters and 
paid €6.4 billion (about $8.6 billion) in compensation, over half of 
which was for floods.[Footnote 40] In 2001, the government introduced a 
program to encourage cities to implement loss prevention measures by 
increasing deductibles in the event of repeated natural disasters, such 
as floods, for cities without a prevention plan. 

In Spain, a state-owned entity called the Consorcio de Compensación de 
Seguros (Consorcio) provides coverage for natural catastrophe 
risks.[Footnote 41] Originally established to provide indemnity to 
victims from the Spanish Civil War, the Consorcio now provides coverage 
for catastrophic risks not specifically covered under private-sector 
insurance policies or when an insurance company cannot fulfill its 
obligations.[Footnote 42] According to a Consorcio official, natural 
catastrophe coverage is mandatory and automatically included in 
standard policies, and although Spanish law does not require the 
purchase of standard property insurance policies, most people do have 
insurance because banks require it as a condition of mortgages. As a 
result, most property is covered for natural catastrophes. The 
Consorcio uses data from private insurers and its own claims data to 
calculate the standard surcharge rate for different types of properties 
(such as housing, offices, industrial sites, and public works). As in 
France, insurers collect this surcharge from all policyholders' 
property insurance premiums. Unlike in France, where insurers may use 
the surcharge collected to purchase reinsurance coverage from CCR or 
private reinsurers (or to cover the costs associated with retaining 
natural catastrophe risk), Spanish insurers must transfer the surcharge 
to the Consorcio on a monthly basis and in return receive a 5 percent 
collection commission that is tax deductible. The Consorcio's 
catastrophe coverage protects the same property or persons to at least 
the same level as risks covered under the primary insurance policy from 
the private insurer. The Spanish government provides an unlimited 
guarantee in the event that the Consorcio's resources are exhausted; 
however, the government guarantee has never been triggered. 

According to Consorcio and Spanish insurance industry officials, the 
Consorcio provides nearly all the natural catastrophe coverage in 
Spain. Even though private insurers have been allowed to provide 
natural catastrophe coverage since 1990 few, if any, do so. Because 
their risks would not be as geographically diversified as the 
Consorcio's (since it provides coverage to policyholders across the 
country), private insurers would not be able to charge rates 
competitive with the Consorcio. In addition, a Consorcio official said 
that even if insurers provided policyholders with natural catastrophe 
coverage, the insurers would still have to pay the Consorcio surcharge. 
Unlike France, no official government declaration of a disaster is 
required for this coverage to take effect. Coverage from the Consorcio 
is automatic whenever any of the specified catastrophes occurs. The 
Spanish system also differs from the French system in that, according 
to a Consorcio official, the Consorcio compensates policyholders 
directly for their losses. In 2003, the Consorcio paid about €143 
million (about $192 million) in catastrophe losses. As in France, 
floods represent the highest percentage of the total natural 
catastrophe claims. 

While the Swiss Government Mandates Natural Catastrophe Coverage, It 
Provides No Government Guarantee and the Industry Administers Its Own 
Pool: 

Swiss law requires insurers to include coverage for natural 
catastrophes as an extension to all fire insurance contracts on 
buildings and contents. Insurers first integrated natural catastrophe 
coverage into fire insurance policies on a voluntary basis in 1953 
after severe damage caused by avalanches. Since it was too expensive to 
insure those who lived in areas at high risk for avalanches, the 
insurance industry packaged all natural catastrophe risks together and 
attached this package to fire insurance policies. The natural 
catastrophe coverage became a requirement in law in 1992. In addition, 
Switzerland now has regulations controlling building in areas such as 
avalanche zones and flood plains. As in France and Spain, all 
policyholders pay a uniform premium rate for natural catastrophe 
coverage, which is part of the fire insurance premium. The standard 
premium amount, calculated by an actuarially based methodology, is also 
written into law but has not been revised or adjusted since 1993. Most 
property owners in Switzerland are required to have building insurance 
for fire and natural catastrophes.[Footnote 43] As a result of this 
mandatory coverage, most buildings in Switzerland are covered for these 
events. Coverage for building contents is generally optional in 
Switzerland, but according to Swiss insurance industry and government 
officials, most people also have this coverage.[Footnote 44] An 
insurance association official told us that earthquake risk was not 
originally included in the natural catastrophe package because at that 
time, earthquakes were considered uninsurable. According to a Swiss 
Insurance Association official, coverage for earthquakes is available 
from insurers in Switzerland as an additional optional policy, but not 
many people buy it. 

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.[Footnote 45] These state-run insurers have 
established a specialized reinsurance company to manage their natural 
catastrophe risk. According to Swiss government officials, the state- 
run insurers may purchase reinsurance coverage from the private market 
or this specialized reinsurance company. Providing coverage to only the 
state-run insurers, an insurance industry official said that this 
company retains some of the risk and also purchases retrocessional 
coverage from the private market. Similarly, private insurers created 
the Elementarschadenpool, or Swiss Elemental Pool, to spread their 
natural catastrophe risk.[Footnote 46] A Swiss insurance association 
official said that the pool has also obtained reinsurance coverage for 
losses that exceed specified levels. As in France and Spain, the pool's 
flood losses have exceeded the losses for other natural perils, 
according to an industry report. 

National Governments in Italy, Germany, and the United Kingdom Are Not 
Involved in Natural Catastrophe Insurance: 

The governments in Italy, Germany, and the United Kingdom do not 
mandate, provide, or financially guarantee natural catastrophe 
insurance. In Italy and Germany, coverage for natural catastrophes, 
such as floods, is optional and only available from private insurers 
for additional premiums. According to an Italian insurance supervisory 
official, the property of private citizens is generally not covered by 
any kind of natural catastrophe insurance. The official also said that 
some medium and large-sized businesses and, to a lesser extent, small 
businesses are covered against this risk in Italy. In Germany, 
regulatory and insurance officials said that coverage for a wide 
variety of natural catastrophes is generally available from private 
insurers in additional policies. However, the officials also said that 
few policyholders choose to purchase it and it may be difficult to 
obtain flood insurance, particularly in areas prone to repeated 
flooding. In the United Kingdom, coverage for a range of natural 
perils, including flood 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.[Footnote 47] 
Although Italy, Germany, and the United Kingdom do not have national 
catastrophe programs, according to industry and government officials, 
each country has discussed developing such programs in recent years 
largely in the context of providing enhanced flood coverage. However, 
no final decisions had been reached at the time of our review. 

Most European Countries Have National Terrorism Insurance Programs: 

Four of the six European countries we studied provide terrorism 
insurance that is backed by government guarantees (see fig. 6). 
Specifically, France, Spain, Germany, and the United Kingdom have 
established national programs in conjunction with the insurance 
industry to provide terrorism coverage. In contrast, Italy and 
Switzerland do not have national terrorism insurance programs and 
private companies provide the limited coverage that is available. 

Figure 6: Countries with a National Terrorism Insurance Program Provide 
a State Guarantee: 

[See PDF for image] 

[End of figure] 

France, Spain, Germany, and the United Kingdom Offer State Guarantees 
for Terrorism Coverage: 

In France, primary insurers that offer property insurance are required 
by law to provide terrorism insurance and coverage is generally 
included in standard insurance policies, which means that all 
commercial properties are covered. However, after the September 11 
attacks, reinsurers cancelled terrorism coverage and many primary 
insurers that could not obtain reinsurance chose to stop offering 
commercial property insurance to avoid the mandatory terrorism 
coverage. According to French insurance industry officials, the French 
government responded to this situation by temporarily requiring the 
extension of all contracts, but immediately began negotiations with the 
insurance industry to develop a more permanent solution. The Gestion de 
l'Assurance et de la Réassurance des Risques Attentats et Actes de 
Terrorisme (GAREAT) pool, a nonprofit organization, was created based 
on the existing administrative structures of the insurance associations 
and the natural catastrophe program already in place in France. 
[Footnote 48] Completed on December 28, 2001, GAREAT was the first 
national terrorism pool organized with state support after the 
September 11 attacks. In 2002, GAREAT paid two regional terrorism 
claims resulting from attacks on buildings to influence state policy 
totaling €7 million (about $9.4 million). Claims in 2003 amounted to 
€0.25 million (about $336,000). 

GAREAT reinsures terrorism and business interruption risks for 
commercial properties that exceed €6 million (about $8 million) in 
insured value.[Footnote 49] The two insurance associations in France 
require their members to participate in GAREAT. Over 100 companies 
participate in the pool.[Footnote 50] Members of GAREAT must transfer a 
certain percentage of their terrorism risk into the pool. Insurers may 
charge policyholders whatever premium they consider appropriate, then 
the insurers pay 6, 12, or 18 percent of this premium depending on the 
size of the risks insured to obtain reinsurance coverage from the 
pool.[Footnote 51] In 2003, GAREAT earned €210 million (about $282 
million) in premiums on 80,000 policies.[Footnote 52] In the event of a 
terrorist act that meets the definition in the French Criminal Code, 
the French state has agreed to provide an unlimited state guarantee 
after a certain industry retention level through the end of 2006 (see 
fig. 7). The unlimited state guarantee is provided through the same 
government-backed reinsurer that guarantees natural catastrophe claims, 
CCR. 

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

[See PDF for image] 

[End of figure] 

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.[Footnote 53] 
Spain's state-owned company, the Consorcio, provides policyholders 
direct compensation for terrorism losses as well as natural catastrophe 
losses. The state offers an unlimited guarantee, which has never gone 
into effect, if claims exceed the Consorcio's resources. Between 1987 
and 2003, terrorism claims represented 9.9 percent of all losses paid 
by the Consorcio. The Consorcio is in the process of paying claims 
resulting from the terrorist attack on a Madrid commuter train on March 
11, 2004. According to information from the Consorcio, as of January 
2005, €35 million (about $47 million) in claims 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. 

Figure 8: Extremus 2004 Financing Structure Caps German Government 
Payments: 

[See PDF for image] 

[End of figure] 

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. [Footnote 54]

An official from Extremus told us that the company is considering 
making changes to its underwriting based on these concerns--such as 
covering business interruption risks for subsidiaries of German 
companies located in other European Union countries if an attack 
occurred in one of these countries. 

In the United Kingdom, the Pool Reinsurance Company, Limited (Pool Re) 
provides terrorism coverage, which is similar to the French and Spanish 
programs in that the state provides an unlimited guarantee but also 
similar to the German system in that participation by insureds is 
voluntary. Pool Re was established in 1993 by the insurance market with 
support from the British government in response to restrictions on the 
availability of reinsurance following several terrorism incidents in 
London related to the situation in Northern Ireland at that time. Pool 
Re is a mutual insurance company that operates to provide reinsurance 
coverage for only commercial property damage and business interruption 
as a result of a terrorist act. While terrorism coverage is optional in 
the United Kingdom and membership in Pool Re is voluntary, Pool Re 
members are required to provide terrorism coverage to policyholders if 
requested, and members must reinsure all of their terrorism coverage 
with Pool Re. Similarly, insureds cannot select which properties in the 
United Kingdom are insured for terrorism. If they choose to purchase 
terrorism insurance, they must insure either all of their properties or 
none of them. According to one Pool Re official, this policy prevents 
adverse selection from occurring (that is, the risk that Pool Re's 
portfolio would include only the riskiest properties and not be 
diversified). Pool Re's rates are determined by geographic zone in the 
United Kingdom. For example, rates are higher for properties located in 
London than for properties in other parts of the country. Business 
interruption coverage is offered at a standard rate throughout the 
country. Members are free to set their own terrorism premiums for their 
underlying policies. Prior to the September 11 attacks, Pool Re 
coverage was limited to acts of terrorism resulting in fire and 
explosion, according to a Pool Re official. However, after the 
September 11 attacks, reinsurers began 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).[Footnote 55] If 
the resources of Pool Re are exhausted, the British government provides 
an unlimited guarantee. Pool Re pays the government a premium for this 
guarantee and would have to repay the Treasury any amount received from 
the guarantee. This guarantee has never been triggered. Since 1993, 
Pool Re has paid a total of £612 million (about $1.2 billion) and 
currently has about £1.5 billion in reserves (about $2.9 billion). The 
largest event for which Pool Re paid claims occurred in 1993, and 
resulted in payments totaling £262 million (about $509 million). 

Italy and Switzerland Have Not Implemented National Terrorism Insurance 
Programs: 

Italy and Switzerland do not have national terrorism programs, and the 
availability of terrorism insurance is limited. According to a study 
commissioned by the Organization for Economic Cooperation and 
Development (OECD), the majority of insurance policies covering damage 
to high-value properties in Italy exclude terrorism risk.[Footnote 56] 
The OECD report also noted that additional terrorism insurance is 
fairly restricted and very expensive. According to a Swiss insurance 
association official, terrorism risk is excluded from standard fire 
insurance policies above a certain value in Switzerland (set at 10 
million Swiss francs or about $8.8 million).[Footnote 57] Each of these 
countries has considered the necessity for a national terrorism 
insurance program. For example, the Italian National Insurance 
Companies Association submitted a proposal to the government in 2003 to 
create an insurance/reinsurance pool, but it was later withdrawn. 

Insurance Companies in European Countries We Studied Are Permitted to 
Establish Tax-Deductible Reserves for Future Catastrophic Events: 

As of 2004, regulations, tax law, and accounting standards in the six 
European countries we reviewed allowed insurance companies to establish 
tax-deductible reserves for potential losses associated with 
catastrophic events. These tax-deductible reserves are often called 
catastrophe or equalization reserves.[Footnote 58] However, each 
country differs in the way it allows reserves to be set-up and used 
(see fig. 9). 

Figure 9: Reserve Policies in Selected European Countries: 

[See PDF for image] 

[End of figure] 

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.[Footnote 59] 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.[Footnote 60]

* In the United Kingdom, the Financial Services Authority (FSA), the 
regulatory body for the financial services industry, requires insurance 
companies to establish equalization reserves for property and other 
types of insurance, according to a British accounting firm official. 
This official said that under U.K. accounting standards and tax law, 
these reserves are tax deductible and are accrued in the liability 
accounts of the balance sheet. The Interim Prudential Sourcebook for 
Insurers, published by FSA, contains detailed accounting rules for the 
calculation of the reserve, including the contributions, withdrawals, 
and maximum balances of the equalization reserves. However, the 
accounting firm official said that U.K. accounting standards do not 
permit a separate catastrophe reserve. 

In March 2004, as part of an effort to achieve global convergence of 
accounting standards, the International Accounting Standards Board 
(IASB) issued International Financial Reporting Standard 4 Insurance 
Contracts (IFRS 4), which includes guidance that effectively prohibits 
the use of catastrophe and equalization reserves.[Footnote 61] Under 
the new international accounting standards, loss reserves can only be 
accrued if the event has occurred and the related losses are estimable. 
IFRS 4 presents several arguments in favor of prohibiting the use of 
reserves for future catastrophic events. For example, provisions for 
such reserves do not necessarily qualify as liabilities because the 
losses have not occurred yet and treating 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.[Footnote 62] However, the EU gives member 
states the option of permitting or requiring these individual 
affiliates or subsidiaries to follow IFRS 4 requirements in preparing 
their individual financial statements. EU countries also have the 
option of allowing unlisted companies to follow these standards. For 
example, according to government and Consorcio officials, Spanish 
insurance regulators have decided to exercise this option and prohibit 
the Consorcio--an unlisted company--from following IFRS 4. According to 
the EU regulation, the designated insurance companies are required to 
follow IFRS 4, starting with financial statements prepared on or after 
January 1, 2005. 

European officials we contacted in some cases expressed differing views 
on the elimination of catastrophe and equalization reserves under IFRS 
4. A European Commission official indicated that European insurance 
companies should be able to cope with the elimination of catastrophe 
and equalization reserves because individual companies could still 
establish and maintain the reserves for tax purposes, but the reserves 
would be eliminated in the financial statements on a consolidated 
level.[Footnote 63] 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.[Footnote 64] 
However, insurance industry participants in some of the European 
countries that we reviewed expressed the following concerns about the 
provision eliminating reserves: 

* Insurance industry officials in France stated that reserving is 
essential as a precaution for coverage of natural catastrophe risks. In 
addition, representatives from a large German accounting firm said that 
reserves provide transparency in financial reporting and help users of 
financial statements to better understand insurers' risk management 
practices. 

* One insurance industry representative expressed concern that having 
two sets of financial statements would result in complexities and 
ambiguities in financial reporting and national tax regulations and 
policies. 

* Other officials said they are concerned that the local taxation 
authorities might follow IFRS 4 and change their policies to 
discontinue the use of tax-deductible reserves. Insurers might have to 
respond by purchasing reinsurance in order to obtain coverage for 
catastrophic risks, which the reserves would have provided. 

As of the time of this review we were not aware of any changes in these 
countries' regulations or tax laws regarding the use of catastrophe 
reserves for tax purposes. 

Observations: 

The insurance industry may not be able to withstand major catastrophic 
events without federal government intervention. Although the industry 
has improved its ability to respond to the losses associated with 
natural catastrophes--at least those on the scale of the 2004 hurricane 
season--without widespread market disruptions, industry capacity has 
not yet been tested by a major catastrophe (such as an event with an 
expected annual 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). 

Agency Comments and Our Evaluation: 

We provided a draft of this report to the Department of the Treasury 
and the National Association of Insurance Commissioners. Treasury 
provided technical comments on the report that were incorporated as 
appropriate. NAIC 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 
[Hyperlink, http://www.gao.gov]. 

If you or your staff have any questions about this report, please 
contact me at (202) 512-8678 or shearw@gao.gov or Wesley M. Phillips, 
Assistant Director, at phillipsw@gao.gov. GAO staff who made major 
contributions to this report are listed in appendix IV. 

Sincerely yours,

Signed by: 

William B. Shear: 
Director, Financial Markets and Community Investment: 

[End of section]

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

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. 

[End of section]

Appendix II: TRIA Has Limited Insurers' Financial Exposure to Terrorism 
Risk, but a Significant Portion of Catastrophic Risk Goes Uncovered: 

This appendix provides information from our previous reports and other 
sources on (1) insurers' financial exposures to terrorist attacks under 
the Terrorism Risk Insurance Act (TRIA) and (2) the extent to which 
natural catastrophe and terrorism risks may be uncovered in the United 
States. 

TRIA Has Limited Insurers' Financial Exposure from Terrorist Attacks: 

Congress enacted TRIA in 2002 to ensure the continued availability of 
terrorism insurance in the United States after the September 11 
attacks. Under TRIA, the Department of the Treasury (Treasury) would 
reimburse insurers for a large share of the losses associated with 
certain acts of foreign terrorism that occur during the term of the 
act. TRIA caps the federal government's and the industry's exposure to 
terrorist attacks at $100 billion annually. TRIA also requires that all 
insurers selling commercial lines of property-casualty insurance make 
available coverage for certain terrorist events and defines make 
available to mean that the coverage must be offered for insured losses 
arising from certified terrorist events and not differ materially from 
the terms, amounts, and limitations applicable to coverage for other 
insured losses. The act's provisions are set to expire on December 31, 
2005, but Congress is currently considering proposals to extend that 
date. 

Under TRIA, primary insurers have assumed responsibility for the 
financial consequences of terrorist attacks up to the levels specified 
in the act while the federal government is responsible for 90 percent 
of losses above those levels up to $100 billion annually. In 2005, 
primary insurers' financial exposure is limited to 15 percent of their 
direct earned premiums (DEP), and they are responsible for 10 percent 
of losses above that amount while the federal government is responsible 
for the remaining 90 percent. Determining individual insurer's 
financial exposures depends upon varying scenarios of the potential 
costs associated with terrorist attacks (for example, to what extent 
the cost of the attack would exceed 15 percent of an insurer's DEP and 
the insurer's 10 percent share of any losses beyond that amount). 

Since TRIA's make available provisions do not apply to reinsurers, 
these companies have discretion in deciding how much terrorism coverage 
to offer to primary companies. As we have previously reported, 
available evidence indicates that reinsurers have cautiously reentered 
the market for terrorism insurance and are offering coverage up to the 
deductible (percentage of DEP) limits and 10 percent share specified in 
TRIA.[Footnote 65] However, we have previously reported that available 
evidence also suggests that few primary companies are buying this 
reinsurance to cover deductibles and co-pays because--as discussed 
next--many of their customers choose not to buy terrorism insurance or 
the primary companies consider reinsurance premiums to be too high. 

In the absence of TRIA, we have reported that reinsurers may not return 
to the terrorism insurance market, thereby further limiting their 
liability. Insurers we contacted stated that they cannot estimate 
potential losses from terrorism without a pricing model that can 
estimate both the frequency and severity of terrorist attacks. 
Reinsurance officials said that current models of risks for terrorist 
events do not have enough historical data to dependably forecast timing 
and severity, and therefore, are not reliable. 

Significant Percentage of Individuals and Businesses Lack Coverage for 
Some Catastrophic Events Even When Protection Is Available: 

A significant percentage of individuals and businesses lack coverage 
for some catastrophic events, even though protection is available from 
a variety of sources. For example, the California Earthquake Authority 
(CEA) estimates that about 15 percent of California residents purchase 
earthquake insurance. As shown in figure 10, an Insurance Services 
Office (ISO) study found that consumers have expressed a number of 
reasons for deciding not to purchase earthquake insurance in 
California, including the beliefs that they are not at risk, premiums 
and deductibles are too high, and the federal government would provide 
financial assistance in the event of a disaster. Insurers with whom we 
spoke expressed similar views on why their customers do not purchase 
certain types of catastrophic coverage. We note that earthquake 
insurance is voluntary in California, whereas participation in the 
Florida Hurricane Catastrophe Fund (FHCF) is mandatory for Florida 
insurers and mortgage lenders require that homeowners and businesses 
purchase wind protection. Consequently, most homeowners and businesses 
in Florida have wind coverage. 

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

[See PDF for image]

[End of figure]

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.[Footnote 66] 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.[Footnote 67] However, as we have previously reported, there 
are indications that some level of noncompliance exists.[Footnote 68] 
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. 

[End of section]

Appendix III: Tax, Regulatory, and Accounting Issues Might Have 
Affected the Development of the Catastrophe Bond Market: 

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.[Footnote 69] 
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).[Footnote 70] 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. 

Figure 11: Special Purpose Reinsurance Vehicle Structure and Payment 
Flows: 

[See PDF for image] 

[End of figure] 

Catastrophe bonds also: 

* typically are offered only to qualified institutional investors under 
Securities and Exchange Commission (SEC) Rule 144A;

* produce relatively high returns, either equaling or exceeding the 
returns on some comparable fixed-rate investments such as high-yield 
corporate debt;

* typically do not receive investment-grade ratings because bondholders 
face potentially large losses on the securities; and typically cover 
event risks that are considered the lowest probability and highest 
severity.[Footnote 71]

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.[Footnote 
72] 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.[Footnote 73] 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.[Footnote 74] 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.[Footnote 75] 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.[Footnote 76] 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. 

[End of section]

Appendix IV: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

William B. Shear (202) 512-8678; 
Wesley M. Phillips (202) 512-5660: 

Acknowledgments: 

In addition to those named above, Patrick S. Dynes, Jill M. Johnson, 
Matthew Keeler, Wing Lam, Marc Molino, and Barbara Roesmann made key 
contributions to this report. 

[End of section]

Glossary of Terms: 

1 in 100 year event: 

A catastrophic event with a 1 percent chance of occurring annually. 

Adverse Selection: 

The tendency of those exposed to a higher risk to seek more insurance 
coverage than those at a lower risk. 

Balance Sheet: 

Provides a snapshot of a company's financial condition at one point in 
time. It shows assets, including investments and reinsurance, and 
liabilities, such as loss reserves to pay claims in the future, as of a 
certain date. It also states a company's equity, which for insurance 
companies is known as policyholder surplus. Changes in that surplus are 
one indicator of an insurer's financial standing. 

Basis Risk: 

The risk that the proceeds from a financial instrument--such as a 
nonindemnity based catastrophe bond--will not be related to the 
insurer's loss experience. 

Capacity: 

The ability of property-casualty insurers to pay customer claims in the 
event of a catastrophic event and their willingness to make 
catastrophic coverage available to their customers, particularly 
subsequent to catastrophes. 

Catastrophe: 

Term used for statistical recording purposes to refer to a single 
incident or a series of closely related incidents causing severe 
insured property losses totaling more than a given amount. 

Catastrophe Bonds: 

Risk-based securities that pay relatively high interest rates and 
provide insurance companies with a form of reinsurance to pay losses 
from a catastrophe such as those caused by a major hurricane. They 
allow insurance risk to be sold to institutional investors in the form 
of bonds, thus spreading the risk. 

Catastrophe Model: 

Using computers, a method to mesh long-term disaster information with 
current demographic, building, and other data to determine the 
potential cost of natural disasters and other catastrophic losses for a 
given geographic area. 

Deductible: 

The amount of loss paid by the policyholder. Either a specified dollar 
amount, a percentage of the claim amount, or a specified amount of time 
that must elapse before benefits are paid. The bigger the deductible, 
the lower the premium charged for the same coverage. 

Equity Capital: 

Equity capital, or insurers' surplus, is defined as net worth under the 
Statutory Accounting Principles (SAP) promulgated by the National 
Association of Insurance Commissioners. As such, surplus is the 
difference between assets valued according to SAP and liabilities 
valued according to SAP. 

Generally Accepted Accounting Principles: 

Generally accepted accounting principles (GAAP) refers to the 
conventions, rules, and procedures that define acceptable accounting 
practices at a particular time. These practices form the framework for 
financial statement preparation. 

Guaranty Fund: 

The mechanism by which solvent insurers ensure that some of the 
policyholder and third-party claims against insurance companies that 
fail are paid. Such funds are required in all 50 states, the District 
of Columbia, and Puerto Rico, but the type and amount of claims covered 
by the fund varies from state to state. Some states pay policyholders' 
unearned premiums--the portion of the premium for which no coverage was 
provided because the company was insolvent. Some have deductibles. Most 
states have no limits on workers compensation payments. Guaranty funds 
are supported by assessments on insurers doing business in the state. 

Homeowners Insurance Policy: 

The typical homeowners insurance policy covers the house, the garage, 
and other structures on the property, as well as personal possessions 
inside the house such as furniture, appliances, and clothing, against a 
wide variety of perils including windstorms, fire, and theft. The 
extent of the perils covered depends on the type of policy. An all-risk 
policy offers the broadest coverage. This covers all perils except 
those specifically excluded in the policy. Homeowners insurance also 
covers additional living expenses. Known as "loss of use," this 
provision in the policy reimburses the policyholder for the extra cost 
of living elsewhere while the house is being restored after a disaster. 
Coverage for flood and earthquake damage is excluded and must be 
purchased separately. 

Indemnity Coverage: 

Coverage with a simple relationship that is based on the insurer's 
actual incurred claims. For example, an insurer could contract with a 
reinsurer to cover half of all claims--up to $100 million in claims-- 
from a hurricane over a specified time period in a specified geographic 
area. If a hurricane occurs where the insurer incurs $100 million or 
more in claims, the reinsurer would pay the insurer $50 million. 

Insolvency: 

Insurer's inability to pay debts. Insurance insolvency standards and 
the regulatory actions taken vary from state to state. When regulators 
deem an insurance company is in danger of becoming insolvent, they can 
take one of three actions: place a company in conservatorship or 
rehabilitation if the company can be saved or liquidation if salvage is 
deemed impossible. The difference between the first two options is one 
of degree--regulators guide companies in conservatorship but direct 
those in rehabilitation. Typically the first sign of problems is an 
inability to pass the financial tests regulators administer as a 
routine procedure. 

Institutional Investor: 

An organization such as a bank or insurance company that buys and sells 
large quantities of securities. 

Joint Underwriting Association: 

Insurers that join together to provide coverage for a particular type 
of risk or size of exposure, when there are difficulties in obtaining 
coverage in the regular market, and share in the profits and losses 
associated with the program. 

Moral Hazard: 

The incentive created by insurance that induces those insured to 
undertake greater risk than if they were uninsured, because the 
negative consequences are passed to the insurer. 

Nonindemnity Coverage: 

Coverage that specifies a specific event that triggers payment and 
payment formulas that are not directly related to the insurer's actual 
incurred losses. Payment could be tied to industry loss indexes, 
parametric measures such as wind speed during a hurricane or ground 
movement during an earthquake, or models of claims payments rather than 
actual claims. 

Peril: 

A specific risk or cause of loss covered by an insurance policy, such 
as a fire, windstorm, flood, or theft. A named-peril policy covers the 
policyholder only for the risks named in the policy in contrast to an 
all-risk policy, which covers all causes of loss except those 
specifically excluded. 

Premium: 

The price of an insurance policy typically charged annually or 
semiannually. 

Property-Casualty Insurance: 

Covers damage to or loss of policyholders' property and legal liability 
for damages caused to other people or their property. Property-casualty 
insurance, which includes auto, homeowners, and commercial insurance, 
is one segment of the insurance industry. The other sector is 
life/health. Outside the United States, property-casualty insurance is 
referred to as nonlife or general insurance. 

Rating Agency: 

Six major credit agencies determine insurers' financial strength and 
viability to meet claims obligations. They are A.M. Best Co.; Duff & 
Phelps Inc.; Fitch, Inc.; Moody's Investors Services; Standard & Poor's 
Corp.; and Weiss Ratings, Inc. Ratings agencies consider factors such 
as company earnings, capital adequacy, operating leverage, liquidity, 
investment performance, reinsurance programs, and management ability, 
integrity, and experience. 

Reinsurance: 

Reinsurance is insurance for insurers. A reinsurer assumes part of the 
risk and part of the premium originally taken by the primary insurer. 
Reinsurers reimburse insurers for claims paid. The business is global 
and some of the largest reinsurers are based abroad. 

Reserves: 

A company's best estimate of what it will pay for claims. 

Retention: 

The amount of risk retained by an insurance company that is not 
reinsured. 

Retrocession: 

The reinsurance bought by reinsurers to protect their financial 
stability. 

Risk: 

The chance of loss of the person or entity that is insured. 

Risk Management: 

Management of the varied risks to which a business firm or association 
might be subject. It includes analyzing all exposures to gauge the 
likelihood of loss and choosing options to better manage or minimize 
loss. These options typically include reducing and eliminating the risk 
with safety measures, buying insurance, and self-insurance. 

Securitization of Insurance Risk: 

Using the capital markets to expand and diversify the assumption of 
insurance risk. The issuance of bonds or notes to third-party investors 
directly or indirectly by an insurance or reinsurance company as a 
means of raising money to cover risks. 

Solvency: 

Insurance companies' ability to pay the claims of policyholders. 
Regulations to promote solvency include minimum capital and surplus 
requirements, statutory accounting conventions, limits to insurance 
company investment and corporate activities, financial ratio tests, and 
financial data disclosure. 

Statutory Accounting Principles (SAP): 

Accounting principles that are required by law. In the insurance 
industry, these standards are more conservative than GAAP and are 
intended to emphasize the present solvency of insurance companies. SAP 
is directed toward measuring whether the company will have sufficient 
funds readily available to meet anticipated insurance obligations by 
recognizing liabilities earlier or at a higher value than GAAP and 
assets later or at a lower value. For example, SAP requires that 
selling expenses be recorded immediately rather than amortized over the 
life of the policy. 

(250190): 

FOOTNOTES

[1] Total estimated insured losses in the United States (including 
Alabama and other affected states) and the Caribbean range as high as 
$27 billion. 

[2] Property insurance includes the loss or damage to real estate and 
personal property because of perils such as fire. Casualty insurance is 
a broad field of insurance and covers whatever is not covered by fire, 
marine, and life insurers. For example, automobile, liability, and 
workers compensation insurance are included in casualty insurance. In 
this report, the term insurer refers to property-casualty insurers. In 
addition, while the term catastrophe is most often associated with 
natural events (such as hurricanes or earthquakes), it can also be used 
when there is widespread damage from man-made disasters (such as fires, 
pollution, or nuclear fallout). The term catastrophe in this report 
refers to natural events or terrorist attacks. Insurers may face the 
risk of catastrophic losses from other types of man-made events. For 
example, asbestos-related losses could reach as much as $65 billion for 
the U.S. insurance industry. However, these risks are outside the scope 
of this report. 

[3] Primary insurance companies may be able to purchase insurance for 
some or all of their risks from reinsurance companies. Additionally, 
reinsurance companies may be able to purchase insurance for some or all 
of their risks from other insurance companies (a process known as 
retrocessional coverage). 

[4] Defining insurance capacity is difficult and the concept itself is 
subject to differing interpretations. The definition used in this 
report is based on our previous work and subsequent analysis of 
insurance markets. See GAO, Insurers' Ability to Pay Catastrophe 
Claims, GAO/GGD-00-57R (Washington, D.C.: Feb. 8, 2000). On the other 
hand, some insurers we contacted defined capacity as the total amount 
of dollar coverage that a company will write for particular risks, such 
as natural catastrophes or terrorism, or in terms of insurers obtaining 
the amount of reinsurance that they wished to purchase at consistent 
prices. 

[5] See GAO, Terrorism Insurance: Implementation of the Terrorism Risk 
Insurance Act of 2002, GAO-04-307 (Washington, D.C.: Apr. 23, 2004). 
TRIA provides coverage for certified acts of terrorism. The program is 
triggered when there has been an act committed on behalf of any foreign 
person or foreign interest that results in at least $5 million in 
insured losses in the United States. In the event of an act of 
terrorism, the federal government, primary insurers, and policyholders 
share the risk of loss. The federal government is responsible for 
paying 90 percent of each insurer's primary property-casualty losses 
after an insurer's exposure exceeds 7 percent of its direct earned 
premium (DEP) in 2003, 10 percent of its DEP in 2004, or 15 percent of 
its DEP in 2005. Federal funds paid out under the program are capped at 
$100 billion for each program year. TRIA will expire on December 31, 
2005. 

[6] Catastrophe bonds are an example of a class of securities called 
risk-linked securities, which include quota share transactions, life 
insurance securities, catastrophe options, and other insurance-related 
financial instruments. This report focuses on catastrophe bonds, which 
are privately placed securities sold to qualified institutional 
investors as defined under Securities and Exchange Commission Rule 
144A. In general, a qualified institutional investor under Rule 144A 
owns and invests on a discretionary basis at least $100 million in 
securities of issuers that are not affiliated with the investor. 

[7] Under U.S. accounting standards, reserves for future losses can be 
accrued in liability accounts on the balance sheet if the losses are 
probable and reasonably estimable. In general, this means that an event 
such as a hurricane has already occurred and an insurance company is in 
the process of estimating its potential losses. Insurers are not 
permitted to set aside reserves on a tax-deductible basis for events 
that have not occurred and the losses from which are not probable and 
reasonably estimable, such as potential natural catastrophes or 
terrorist attacks. 

[8] See GAO, Catastrophe Insurance Risks: Status of Efforts to 
Securitize Natural Catastrophe and Terrorism Risk, GAO-03-1033 
(Washington, D.C.: Sept. 24, 2003) and GAO, Catastrophe Insurance 
Risks: The Role of Risk-Linked Securities and Factors Affecting Their 
Use, GAO-02-941 (Washington, D.C.: Sept. 24, 2002). 

[9] Equity capital, also referred to as insurers' surplus, is defined 
as net worth under the Statutory Accounting Principles (SAP) 
promulgated by NAIC. As such, equity capital or surplus is the 
difference between assets and liabilities valued according to SAP. 

[10] This report also identifies other limitations in the insurer 
equity capital measure that complicate assessments of insurer capacity. 
For example, not all of the reported industry capital would necessarily 
be available in the event of a catastrophe. In particular, only those 
companies whose policies are affected, not the industry as a whole, 
would pay claims resulting from a particular event. 

[11] Industry losses were comparable on an inflation-adjusted basis. 
Losses from Hurricane Andrew were $20 billion, adjusted to 2004 
dollars. 

[12] An event with a 1 percent chance of occurring annually is referred 
to as a 1-in-100 year event. An event with a .4 percent chance of 
occurring annually is referred to as a 1-in-250 year event. In this 
report, we refer to the probability of these occurrences in annual 
percentage terms because these events could occur in any given year. 

[13] Some large national insurance companies generally do not purchase 
private reinsurance. These companies are able to retain their risk 
because they have large capital bases and are well-diversified. In 
addition, an official from one state authority said that the 
organization purchases reinsurance to manage the risk of an event with 
a 1 percent chance of occurring annually, but not for the risk of an 
event with a .4 percent chance of occurring annually because of the 
high cost for reinsurance at the higher level and the low risk of such 
an event occurring in the state. 

[14] GAO-02-941. 

[15] ISO provides information about the property-casualty insurance 
business, including statistical and actuarial information. Equity 
capital figures are in 2003 dollars adjusted for inflation and include 
all private U.S. property-casualty insurers and reinsurers that file 
statutory financial statements with state insurance regulators as well 
as the U.S. subsidiaries and affiliates of foreign insurers, as long as 
those subsidiaries and affiliates are required to file statutory 
financial statements with state regulators. 

[16] The rating agency's analysis focuses on hurricanes with an 
expected annual occurrence of no more than 1 percent. The potential 
exists that a hurricane with an expected annual occurrence of .4 
percent would generate higher losses and financial difficulties for 
affected insurers. 

[17] Each company has an individual retention, or deductible, which is 
its proportionate share of the industry aggregate of $4.5 billion. An 
insurer taking unusually heavy losses from a smaller storm from which 
aggregate industry losses do not meet $4.5 billion could qualify for 
FHCF reimbursement, while the industry overall might not. For example, 
the fund paid about $13 million to a few insurers after Hurricanes Erin 
and Opal in 1995 even though the combined losses from these two storms 
only reached about $1.7 billion. 

[18] FHCF premiums are based in part on hurricane catastrophe models, 
which are discussed later in this report. 

[19] After Hurricane Andrew, Florida created FHCF as well as another 
organization, the Florida Residential Joint Underwriting Association 
(JUA). JUA provided residential coverage in specifically designated 
areas most vulnerable to windstorm damage. In 2002, JUA merged with the 
Florida Windstorm Underwriting Association to form Citizens. 

[20] Applied Insurance Research, Inc., in collaboration with the 
Institute for Business & Home Safety, "Impact of Building Code 
Developments on Potential Hurricane Losses in Florida," (May 2002). 

[21] Private-sector insurers provide coverage to some of the remaining 
30 percent of properties in these counties. 

[22] For homes valued under $100,000, the insurer must offer a 
hurricane deductible no lower than $500 and no higher than 2 percent of 
policy limits. For homes valued above $100,000, the insurer may offer a 
policy that contains up to a 2 percent deductible if the insurer 
guarantees that it will renew the policy for another year. The maximum 
allowable deductible is 2 percent for homes valued under $100,000, 5 
percent for homes valued between $100,000 and $500,000, and there is no 
maximum limit for homes valued in excess of $500,000. There are also 
separate provisions for mobile homes. 

[23] Some U.S. reinsurers also provide coverage to take out companies. 

[24] According to a Citizens official, take out companies are required 
to take a minimum number of policies and also write a minimum number of 
those policies including wind coverage in Dade, Broward, and Palm Beach 
counties in order to receive the bonus amounts. 

[25] In 2001, 10 new Bermuda companies were formed. In some cases, the 
sources of the capital came from established industry players. For 
example, the principal sponsors of one of these new companies were 
three existing insurance and reinsurance companies. 

[26] According to two insurance broker reports, there have been 4 years 
with four hurricanes making landfall in the United States since 1900 
(1906, 1909, 1964, and 2004), 1 year with five hurricanes (1933), and 2 
years with six hurricanes (1916 and 1985). A hurricane rating 3, 4, or 
5 on the Saffir Simpson scale is considered a major hurricane. There 
has not been a year where four major hurricanes made landfall in the 
United States in over 105 years. Moreover, the year 1886 was the last 
time more than three landfalls occurred in one state. 

[27] Primary insurance companies in Florida are required to purchase 
reinsurance from FHCF, which provides a layer of reinsurance coverage 
below what is typically offered by reinsurers. That is, FHCF provides 
coverage for storms with an expected annual occurrence of about 2 
percent annually (approximately the 1-in-50 year storm). Primary 
companies may purchase reinsurance for catastrophes that exceed the 
FHCF levels (such as storms with an expected annual occurrence of less 
than 2 percent--for example, a 1-in-100 year storm). Since each of the 
four hurricanes had an expected annual occurrence of greater than 2 
percent and FHCF payments were minimized as a result, reinsurance 
contracts were frequently not triggered. 

[28] Reinsurance premiums were reportedly declining prior to the 2004 
hurricane season. As a result of losses incurred by reinsurers, 
insurance market analysts we contacted said they do not expect 
reinsurance premiums to decline as rapidly as prior to the advent of 
the four hurricanes. 

[29] Institute for Business & Home Safety, "Preliminary Damage 
Observations, Hurricanes Charley, Frances & Ivan 2004," (2004). 

[30] The $19 to $20 billion in losses from Hurricane Andrew and the 
Northridge earthquake generally qualify as losses with a 2 percent 
annual occurence (1-in-50 year loss) or more. 

[31] See GAO/GGD-00-57R. 

[32] The lines of insurance covered by guaranty funds and the maximum 
amount paid on any claims vary from state to state. 

[33] In addition, when dealing with a reinsurer with poorer credit 
quality, a representative of one insurer that purchases a large amount 
of reinsurance also said that his company and other firms put the 
reinsurance premiums into a "funds held" account, paying the reinsurers 
only interest on the premium funds held for the duration of the 
reinsurance contract. However, this method collateralizes only the 
premiums paid, not the full amount of the insurance coverage. Another 
method used is to obtain a letter of credit up to the full amount of 
the exposure that is ceded. 

[34] Sylvie Bouriaux, Ph.D., and William L. Scott, Ph.D., "Capital 
Market Solutions to Terrorism Risk Coverage: A Feasibility Study," 
Journal of Risk and Finance Vol. 5, No. 4 (2004): 33-44. 

[35] See GAO-03-1033. 

[36] The proposal was made by NAIC's Catastrophe Insurance Working 
Group to NAIC's Property and Casualty Committee in 2000. See NAIC 
Catastrophe Working Group, "Summary of the NAIC Catastrophe Reserve 
Proposal," NAIC Research Quarterly 6, no. 2 (Summer 2000). According to 
an NAIC official, the NAIC will not adopt the proposal beyond the 
working group level unless the tax laws are changed to allow insurance 
companies to establish reserves for future catastrophic events on a tax-
deductible basis. 

[37] The ISO's Property Claim Services (PCS) provides widely used data 
on insured property losses from catastrophes in the United States, 
Puerto Rico, and the U.S. Virgin Islands. PCS investigates reported 
disasters and determines the extent and type of damage, dates of 
occurrence, and geographic areas affected. PCS is the only insurance 
industry resource for compiling and reporting estimates of insured 
property losses resulting from catastrophes. For each catastrophe, the 
PCS loss estimate represents anticipated industrywide insurance 
payments for property lines of insurance covering fixed property, 
building contents, business interruption losses, vehicles, and inland 
marine (diverse goods and properties). 

[38] There is no real definition of a natural disaster (either of 
covered or noncovered risks) in the law establishing the French 
program. The only triggering point is that an event be uninsurable and 
of abnormal intensity. A nonexhaustive list of qualifying events 
includes floods and mudslides, earthquakes, tidal waves, avalanches, 
and landslides. 

[39] CCR's coverage for natural disasters is unlimited because of the 
state guarantee. The deductible under the CCR reinsurance contract, 
therefore, represents the maximum amount that an insurer will have to 
bear in the course of a year, regardless of how many losses occur. 

[40] For the exchange rate from euros to dollars, we used the daily 12 
noon buying rate as certified by the New York Federal Reserve Bank on 
December 6, 2004, which was 1.3431. This rate is quoted in U.S. dollars 
per foreign currency unit. 

[41] While state owned, the Consorcio operates as a private company and 
must follow the same regulations and standards as private companies. 
The Consorcio's resources for coverage of catastrophic risk come from 
surcharges paid by policyholders, and not from the state's budget. As 
discussed in the next section, the Consorcio also covers risks such as 
terrorism, civil commotion, and riot. 

[42] The Consorcio also operates as a guarantee fund and would 
indemnify policyholders if an insurance company covered a natural 
catastrophe risk, but subsequently filed for bankruptcy, suspended 
payments, or become insolvent. 

[43] Building insurance is not compulsory in 4 of Switzerland's 26 
cantons--or states. 

[44] Coverage for building contents is compulsory in 2 cantons. 

[45] State-run insurers established by cantonal building insurance 
offices have a monopoly on providing property insurance in 19 cantons. 
These insurers are not allowed to offer any other type of insurance 
(except state-run insurers in two cantons that are allowed to also 
offer contents insurance). According to an industry official, the state-
run insurers offer the same natural catastrophe coverage as private 
insurers and charge the same risk premium as the private insurers. Some 
of the state-run insurers also cover earthquake risk. 

[46] According to a Swiss insurance industry official, private insurers 
provide building insurance in areas of the country not served by public 
insurers and provide contents insurance in the whole country. 

[47] The insurance industry agreed to provide flood insurance in three- 
quarters of the United Kingdom's floodplains after the government 
agreed to implement certain flood prevention measures. In locations 
where the insurance industry association considers the risk of flooding 
to be unacceptably high, there may be some limitations on the 
availability of coverage, especially if no flood prevention measures 
are planned. 

[48] According to a GAREAT official, GAREAT employees are on loan from 
their insurance companies. The cost of running GAREAT is 0.25 percent 
of the premium. The board is made up of representatives from insurance 
and reinsurance companies and CCR (representing the state). 

[49] Properties under €6 million may be ceded to the pool on a 
voluntary basis. 

[50] Around 70 nonlife insurance companies that are members of the two 
insurance associations are involved in the pool. Membership is optional 
for any company authorized to carry out direct insurance operations in 
France or certain other insurers that cover French industrial risks. 
Around 35 of these companies are involved in the pool. 

[51] A scale of reinsurance rates applies to property premiums for 
three risk categories: 6 percent for insured values under €20 million; 
12 percent for insured values between €20-50 million; and 18 percent 
for insured values above €50 million. 

[52] This number includes coinsurance, where two or more insurance 
companies provide partial coverage for one property. Without counting 
coinsurance policies, the estimated number of properties insured by the 
pool is almost 34,000, about 74 percent of which are for policies 
insured for sums between €6-20 million. 

[53] Indemnification from the Consorcio is automatically linked to 
insurance policies from any primary insurance company in the market for 
the following classes: property, motor damage, theft, machinery 
breakdown, information technology, construction and assembly, business 
interruption, and personal accident. The coverage for extraordinary 
risks is mandatory for all of these classes. 

[54] None of the pools currently in operation provide international 
coverage. 

[55] The reinsurance cover provided to members of Pool Re is subject to 
an individual retention per event combined with an annual industrywide 
limit. The annual industrywide retention level will increase to £150 
million in 2005 and to £200 million in 2006. For the exchange rate from 
pounds to dollars, we used the daily 12 noon buying rate in New York as 
certified by the New York Federal Reserve Bank on December 6, 2004, 
which was 1.9423. This rate is quoted U.S. dollars per foreign currency 
unit. 

[56] John Cooke, "The Coverage of Terrorism Risks at the National 
Level," Organization for Economic Cooperation and Development, 
Conference on Catastrophic Risks and Insurance, (Paris: November 2004). 

[57] For the exchange rate from Swiss francs to dollars, we used the 
daily 12 noon buying rate as certified by the New York Federal Reserve 
Bank on December 6, 2004, which was 1.1381. This rate is quoted in 
foreign currency units per U.S. dollar. 

[58] Catastrophe reserves are generally built up over the years from 
premium income, sometimes following a prescribed formula, until a 
specific limit is reached. Catastrophe reserves are intended to be used 
for future catastrophic losses covered by current or future contracts 
for events such as nuclear accidents and terrorism. Equalization 
reserves are intended to cover random fluctuations of claim expenses 
for some types of insurance contracts such as hail insurance, using a 
formula based on multiyear claims experience. 

[59] French accounting standards are a subset of the French basic 
business law, and consequently every business entity is required to 
comply with them. French business law incorporates different sources of 
law, such as European Union directives and French regulatory texts 
including decrees and regulations. 

[60] Swiss GAAP FER stands for Swiss Financial Reporting Standards of 
the Swiss Accounting and Reporting Recommendations. Internationally 
accepted accounting frameworks that prohibit such reserves include 
International Financial Reporting Standard 4 (IFRS 4) or U.S. GAAP. 

[61] IFRS 4 has two phases. Phase I was completed on March 31, 2004, 
with the goal of introducing improved disclosures and recognition and 
measurement practices for insurance companies, as well as providing 
better information for financial statements users. The second phase of 
IFRS 4 will address broader conceptual and practical issues related to 
insurance accounting and is currently under development. The Phase II 
standards will be in effect by 2007. IASB is an independent, privately 
funded accounting standard setter committed to developing, in the 
public interest, a single set of high quality, global accounting 
standards that require transparent and comparable information in 
general purpose financial statements. In pursuit of this objective, 
IASB cooperates with national accounting standard-setters to achieve 
convergence in accounting standards around the world. 

[62] According to EU regulation 1606/2002, all listed EU companies, as 
well as companies with listed debt, should present financial reports 
following the endorsed international accounting standards as of January 
1, 2005. The international accounting standards were endorsed at the EU 
level by the Accounting Regulatory Committee (ARC) after recommendation 
from the European Financial Reporting Advisory Group (EFRAG). 

[63] The European Commission is an operating arm of the EU. It proposes 
legislation, administers policies, enforces EU law, and negotiates 
international agreements. One of the activities of the European 
Commission is to promote a single insurance market to achieve economic 
efficiency and market integration, allowing insurers to operate 
throughout the EU and establish and provide services freely. 

[64] U.S. corporations prepare financial statements for tax purposes, 
which may differ from public financial statements prepared under U.S. 
GAAP. 

[65] See GAO-04-307. 

[66] In 1968, in recognition of the increasing amount of flood damage, 
the lack of readily available insurance for property owners, and the 
cost to the taxpayer for flood-related disaster relief, Congress 
enacted the National Flood Insurance Act (P.L. 90-448) that created the 
National Flood Insurance Program. 

[67] Flood insurance is mandatory for properties in participating 
communities for the life of mortgage loans made or held by federally 
regulated lending institutions, guaranteed by federal agencies, or 
purchased by government-sponsored enterprises. 

[68] See GAO, Flood Insurance: Challenges Facing the National Flood 
Insurance Program, GAO-03-606T (Washington, D.C.: Apr. 1, 2003). 

[69] See GAO-02-941 and GAO-03-1033. 

[70] SPRVs are a type of special purpose entity (SPE). Companies have 
used SPEs for many years to carry out specific financial transactions. 

[71] According to the Bond Market Association, the yields on 
catastrophe bonds have been comparable to the yields on noninvestment- 
grade corporate debt. 

[72] See GAO-02-941 and GAO-03-1033. NAIC is currently considering the 
appropriate accounting treatment for nonindemnity-based financial 
instruments that hedge insurance risk, which could include nonindemnity-
based catastrophe bonds. Both exchange-traded instruments and over-the-
counter instruments can be used to hedge underwriting results (that is, 
to offset risk). The triggering event on a catastrophe bond contract 
must be closely correlated to the insurance risks being hedged so that 
the pay-off is expected to be consistent with the expected claims, even 
though there is some risk that it will not be (referred to as "basis 
risk"). This correlation is known as "hedge effectiveness" and NAIC is 
currently considering how it should be measured. Should NAIC create a 
hedge-effectiveness measure, statutory accounting standards could be 
changed so that a fair value measure (the current quoted market price) 
of the catastrophe bond contract could be calculated and recognized as 
an offset to insurance losses, allowing credit to the insurer similar 
to that granted for reinsurance. If nonindemnity-based catastrophe 
bonds are accepted as an effective hedge of underwriting results, they 
could become more attractive to potential issuers. We note that the 
process for developing an effective measure to account for risk 
reduction through the issuance of nonindemnity-based coverage is 
difficult and complex. 

[73] NAIC establishes statutory accounting standards that may be 
adopted by states and their insurance regulators. Statutory accounting 
standards may differ from U.S. generally accepted accounting principles 
(GAAP). 

[74] See GAO-03-1033. 

[75] FIN 46 introduced the variable interest entity (VIE), a new term 
that encompasses most special purpose entities (SPE). A VIE is broadly 
defined as an entity that meets either of two conditions: (1) equity 
investors have not invested enough for the entity to stand on its own 
(insufficiency is presumed if the equity investment is less than 10 
percent of the equity's total assets) or (2) equity investors lack any 
of the characteristics of a controlling financial interest (the risks 
or rewards of ownership). If an entity is deemed a VIE, then it is 
evaluated for possible consolidation according to the new risk and 
reward approach in FIN 46. Most catastrophe bond structures likely 
qualify as VIEs because most SPRVs do not meet the 10 percent equity 
threshold. 

[76] The revised interpretation, FIN 46R, requires the consolidation of 
a VIE by an enterprise if that enterprise either absorbs a majority of 
the VIE's expected losses or receives a majority of the VIE's expected 
residual returns as a result of ownership, contractual, or other 
financial interests in the VIE. This enterprise is defined as a primary 
beneficiary in the guidance. 

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