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Report to the Chairman, Committee on Financial Services, House of 

Representatives:



September 2002:



CATASTROPHE INSURANCE RISKS:



The Role of Risk-Linked Securities and Factors Affecting Their Use:



GAO-02-941:



Contents:



Letter:



Results in Brief:



Background:



Insurance and Reinsurance Markets Provide Catastrophe Risk Coverage and 

Capital Markets Add to Industry Capacity:



Risk-Linked Securities Have Complex Structures:



Regulatory, Accounting, Tax, and Investor Issues Might Affect Use of 

Risk-Linked Securities:



Agency Comments and Our Evaluation:



Appendixes:



Appendix I: Scope and Methodology:



Appendix II: Catastrophe Options:



Appendix III: California and Florida Approaches to Catastrophe Risk:



California Earthquake Authority Provides Insurance:



Florida Provides Residential Coverage for Windstorms and Supplements 

Insurance Capacity:



Appendix IV: Statutory Accounting Balance Sheet Implications of 
Reinsurance Contracts:



Appendix V: Comments from the National Association of Insurance 
Commissioners:



Appendix VI: Comments from the the Reinsurance Association of America:



GAO Comments:



Appendix VII: Comments from the Bond Market Association:



GAO Comments:



Figures:



Figure 1: Catastrophic Risk in the United States: Earthquake, 
Hurricane, 

Tornado, and Hail:



Figure 2: Estimated Losses from Recent Large Catastrophes:



Figure 3: Traditional Insurance, Reinsurance, and Retrocessional 

Transactions:



Figure 4: U.S. Reinsurance Prices, 1989-2001:



Figure 5: Special Purpose Reinsurance Vehicle:



Figure 6: Current and Proposed California Earthquake Authority 

Financial Structure:



Figure 7: Effect on Ceding and Reinsurance Companies’ Balance Sheets 

before and after a Reinsurance Transaction:



Abbreviations:



BMA: Bond Market Association:



CBOT: Chicago Board of Trade:



CEA: California Earthquake Authority:



CFTC: Commodity Futures Trading Commission:



EITF: Emerging Issues Task Force:



FASB: Financial Accounting Standards Board:



FASIT: Financial Asset Securitization Investment Trust:



FHCF: Florida Hurricane Catastrophe Fund:



FWUA: Florida Windstorm Underwriting Association:



GAAP: Generally Accepted Accounting Principles:



JUA: Florida Residential Joint Underwriting Association:



LIBOR: London Interbank Offered Rate:



NAIC: National Association of Insurance Commissioners:



PCS: Property Claim Services:



RAA: Reinsurance Association of America:



REMIC: Real Estate Mortgage Investment Conduit:



SEC: Securities and Exchange Commission:



SPE: special purpose entity:



SPRV: special purpose reinsurance vehicles:



Letter September 24, 2002:



The Honorable Michael G. Oxley

Chairman, Committee on Financial Services

House of Representatives:



Dear Mr. Chairman:



Because of population growth, resulting real estate development, and 

rising real estate values in hazard-prone areas, our nation is 

increasingly exposed to much higher property-casualty losses--both 

insured and uninsured--from natural catastrophes than in the 

past.[Footnote 1] In the 1990s, a series of natural disasters, 

including Hurricane Andrew and the Northridge earthquake, (1) raised 

questions about the adequacy of the insurance industry’s financial 

capacity to cover large catastrophes without limiting coverage or 

substantially raising premiums and (2) called attention to ways of 

raising additional sources of capital to help cover catastrophic risk. 

The nation’s exposure to higher property-casualty losses increases 

pressure on federal, state, and local governments; businesses; and 

individuals to assume ever-larger liabilities for losses associated 

with natural catastrophes. Recognizing this greater exposure and 

responding to concerns about insurance market capacity, participants in 

the insurance industry and capital markets have developed new capital 

market instruments (hereafter called risk-linked securities)[Footnote 

2] as an alternative to traditional property-casualty reinsurance, or 

insurance for insurers.



Because of these concerns, you asked that we review the role of risk-

linked securities in providing coverage for catastrophic risk and 

issues related to their expanded use. As agreed with your office, our 

objectives were to (1) describe catastrophe risk and how the insurance 

and capital markets provide for coverage against such risks; (2) 

describe how risk-linked securities, particularly catastrophe bonds, 

are structured; and (3) analyze how key regulatory, accounting, tax, 

and investor issues might affect the use of risk-linked securities. Our 

overall objective was to provide the Committee with information and 

perspectives to consider as the Committee and Congress move forward in 

this important and complex area.



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

authority with private-sector entities, we obtained extensive 

documentary and testimonial evidence from a large number of entities, 

including insurance and reinsurance companies, investment banks, 

institutional investors, rating agencies, firms that develop models to 

analyze catastrophe risks, regulators, and academic experts. We did not 

verify the accuracy of data provided by these entities. Some entities 

with whom we met voluntarily provided information they considered to be 

proprietary; therefore, we did not report details from such 

information. In other cases companies decided not to voluntarily 

provide proprietary information, and this limited our inquiry. For 

example, we did not obtain any reinsurance contracts representing 

either traditional reinsurance or reinsurance provided through the 

issuance of risk-linked securities.



Although we identified factors that industry and capital markets 

experts believe might cause the use of risk-linked securities to expand 

or contract, we make no prediction about the future use of these 

securities--either under current accounting, regulatory, and tax 

policies or under changed policies. Nor are we taking a position that 

increased use of risk-linked securities is beneficial or detrimental. 

Appendix I provides a detailed discussion of our scope and methodology.



We conducted our work between October 2001 and August 2002 in 

Washington, D.C.; Chicago, Ill.; New York, N.Y.; and various locations 

in California and Florida in accordance with generally accepted 

government auditing standards. Written comments on a draft of this 

report from the National Association of Insurance Commissioners 

(NAIC),[Footnote 3] the Reinsurance Association of America 

(RAA),[Footnote 4] and the Bond Market Association (BMA)[Footnote 5] 
appear 

in appendixes V, VI, and VII, respectively. We also obtained technical 

comments from the Department of the Treasury (Treasury), the Securities 

and Exchange Commission (SEC), the Commodities Futures Trading 
Commission 

(CFTC), NAIC, RAA, and BMA that have been incorporated where 
appropriate.



Results in Brief:



Catastrophe risk includes exposure to losses from natural disasters, 

such as hurricanes, earthquakes, and tornadoes, which are infrequent 

events that can cause substantial financial loss but are difficult to 

reliably predict. The characteristics of natural disasters prompt most 

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

For example, property-casualty insurers that hold policies on their 

books that are overly concentrated in certain states, such as 

California and Florida, typically diversify and transfer risk through 

reinsurance.[Footnote 6] Traditional reinsurance depends, in part, on 

well-developed contractual and business relationships between insurers 

and reinsurers. These relationships facilitate relatively low 

transaction costs and indemnity-based coverage, which compensates 

insurers for part or all of their losses from insured claims.[Footnote 

7] However, in the case of extremely large or multiple catastrophic 

events, insurers might not have purchased sufficient reinsurance, or 

traditional reinsurance providers might not have sufficient capital to 

meet their existing obligations. In any event, after a catastrophic 

loss, reinsurance capacity may be diminished and reinsurers might raise 

prices or limit availability of future catastrophic reinsurance 

coverage. In the 1990s, the combination of Hurricane Andrew and the 

Northridge earthquake along with reinsurance market conditions helped 

spur the development of capital market instruments and other 

alternatives to traditional reinsurance, such as state-run programs. 

Yet to date, risk-linked securities have represented a small share of 

the overall property-casualty reinsurance market. According to the 

Swiss Reinsurance Company, in 2000, risk-linked securities represented 

less than 0.5 percent of the worldwide catastrophe insurance.



Risk-linked securities that can be used to cover risk from natural 

catastrophes employ many structures and include catastrophe bonds and 

catastrophe options. Currently, most risk-linked securities are 

catastrophe bonds. The cost of issuing catastrophe bonds includes the 

legal, accounting, and information costs necessary to issue securities 

and market them to investors who do not have contractual or business 

relationships with the insurance company receiving coverage. Although 

catastrophe bonds generally involve higher transaction costs than 

traditional reinsurance and most recently issued bonds have not been 

indemnity-based, they provide broader access to national and 

international capital markets. To provide catastrophe coverage via a 

catastrophe bond, an investment bank or insurance broker creates a 

special purpose reinsurance vehicle (SPRV) to issue bonds to the 

capital markets and to provide the sponsor organization--typically an 

insurance or reinsurance company--with reinsurance. The SPRVs are 

typically located offshore for tax, regulatory, and legal advantages. 

The SPRVs that issue catastrophe bonds receive payments in three forms 

(insurance premiums, interest payments, and principal payments); invest 

in Treasury securities and other highly rated securities; and pay 

investors in another form (interest). If the catastrophe occurs, 

principal that otherwise would be returned to the investors is used to 

fund the SPRV’s payments to the insurer. The investor’s reward for 

taking risk is a relatively high interest rate paid by the bonds. On 

the one hand, insurers prefer indemnity coverage, because the amount 

that the reinsurer pays will be directly linked to the insured claims 

actually incurred. However, that means the reinsurer has to pay more if 

the insurer underwrites (i.e., selects risks) poorly. On the other 

hand, investors cannot monitor the insurer’s behavior as well as the 

traditional reinsurer can, thus investors have greater exposure to risk 

from poor underwriting. Therefore, catastrophe bond issuers have 

developed nonindemnity-based bonds. Recently issued catastrophe bonds 

have been structured to make payments to the sponsor upon the 

occurrence of specified catastrophic events that can be objectively 

verified, such as an earthquake reaching 7.2 or higher in moment 

magnitude.[Footnote 8]



We identified and analyzed four regulatory, accounting, tax, and 

investor issues that might affect the use of risk-linked securities. 

First, NAIC and insurance industry representatives are considering 

revisions in the regulatory accounting treatment of risk transfer 

obtained from nonindemnity-based coverage that would allow credit to 

the insurer similar to that now afforded traditional (indemnity-based) 

reinsurance. Such a revision, if adopted, has the potential to 

facilitate the use of risk-linked securities. Nevertheless, it is 

important yet difficult for U.S. insurance regulators to develop an 

effective measure to account for risk reduction for nonindemnity-based 

coverage so that insurance company filings with respect to risk 

evaluation and capital treatment both properly reflect the risk 

retained. Second, the Financial Accounting Standards Board (FASB) is 

proposing a new U.S. Generally Accepted Accounting Principles (GAAP) 

interpretation, which would increase independent capital investment 

requirements that allow the sponsor to treat SPRVs and similar entities 

as independent entities and report SPRV assets and liabilities 

separately. While the proposed guidance is intended to improve 

financial transparency in capital markets, it also could increase the 

cost of issuing catastrophe bonds and make them less attractive to 

sponsors. If the proposed rule were implemented, sponsors might turn to 

risk-linked securities such as catastrophe options that do not require 

an SPRV.[Footnote 9]



Third, “pass-through” tax treatment--which eliminates taxation at the 

SPRV level--with favorable implementing requirements could facilitate 

expanded use of catastrophe bonds, but such legislative actions may 

also create pressure from other industries for similar tax treatment. 

It is not clear if and when regulatory, accounting, and tax issues will 

be resolved. Fourth, catastrophe bonds, most of which are 

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

investors beyond institutional investors. Investment fund managers 

whose portfolios include catastrophe bonds told us that these bonds 

comprise 3 percent or less of their portfolios. On the one hand, the 

managers appreciate the diversification aspects of catastrophe bonds 

because the risks are generally uncorrelated with the credit risks of 

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

difficult to assess and the bonds have a limited track record. If the 

ability of investors to evaluate the risks and rewards of risk-linked 

securities improves, or if catastrophe reinsurance price and 

availability becomes problematic, the risk-linked securities market has 

the potential to expand.



This report does not contain any recommendations. We obtained comments 

on a draft of this report which are discussed on pages 30 to 32.



Background:



Natural catastrophes have a low probability of occurrence, but when 

they do occur the consequences can be of high severity. Insurance 

companies face catastrophe risk associated with their provision of 

property-casualty insurance. Major reinsurers are insurance companies 

with global insurance and reinsurance operations. Insurers and 

reinsurers are subject to “moral hazard,” which is “the incentive 

created by insurance that induces those insured to undertake greater 

risk than if they were uninsured, because the negative consequences are 

passed through to the insurer.” Therefore, reinsurers have incentives 

to limit the possibility that ceding insurers take actions that would 

create negative consequences for the reinsurer. Indemnity reinsurance 

contracts have the potential to increase a reinsurer’s risk exposure to 

the extent that the reinsurer might be unaware of the underwriting and 

claims settlement practices of the ceding insurer.



Traditional reinsurance is generally indemnity-based and tailored to 

the needs of the ceding company because traditional reinsurance 

depends, in part, on well-developed contractual and business 

relationships between insurers and reinsurers. When reinsurance 

coverage is not indemnity-based, the ceding insurer is exposed to basis 

risk--the risk that there may be a difference between the payment 

received from the reinsurance coverage and the actual accrued claims of 

the ceding insurance company. Property-casualty reinsurance agreements 

are typically single-event, excess of loss contracts. A single-event 

contract means that the reinsurer’s obligations are specific to an 

event, such as a hurricane in a contractually specified geographic 

area. Excess of loss means that the reinsurer makes payments that are 

based on a contractually specified share of claims in excess of a 

minimum amount, subject to a maximum claim payment.



The financial industry has developed instruments through which primary 

financial products, such as lending or insurance, can be funded in the 

capital markets. Lenders and insurers continue to provide the primary 

products to the customers, but these financial instruments allow the 

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

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

capital market investors. This process, called securitization, can give 

insurers access to the large financial resources of the capital 

markets.[Footnote 10] With respect to funding catastrophe risk in 

property-casualty insurance, the risk of investing is tied to the 

potential occurrence of a specified catastrophic event and to the 

quality of underwriting by insurers and reinsurers.



In evaluating risk, capital market investors face the issue of moral 

hazard because in the absence of well-developed contractual and 

business relationships with primary market insurers, capital market 

investors might be unable to monitor the primary insurance company’s 

underwriting and claims settlement practices that can act to increase 

risk. Nonindemnity-based coverage is a means to limit moral hazard for 

the investor by tying payment to industry loss indexes, parametric 

measures, and models of claims payments rather than actual claims that 

could be affected by lax underwriting standards or lax settlement of 

claims by the ceding insurer. However, such coverage introduces basis 

risk for the sponsoring insurance company.[Footnote 11]



Insurance companies are not regulated at the federal level but are to 

comply with the laws of the states in which they operate. The insurance 

regulators of the 50 states, the District of Columbia, and U.S. 

territories have created NAIC to coordinate regulation of multistate 

insurers. NAIC serves as a forum for the development of uniform policy, 

and its committees develop model laws and regulations governing the 

U.S. insurance industry. Although not required to do so, most states 

either adopt model laws or modify them to meet their specific needs and 

conditions. NAIC also has established statutory accounting standards, 

which are intended for use by insurance departments, insurers, and 

auditors when state statutes or regulations are silent. If not in 

conflict with state statutes and regulation, or in cases when the state 

statutes are silent, statutory accounting standards promulgated by NAIC 

are intended to apply. In addition to statutory accounting standards, 

insurers use GAAP, which are promulgated by FASB and are designed to 

meet the varying needs of both insurance and noninsurance companies. 

Although NAIC’s statutory accounting standards use the framework 

established by GAAP, GAAP stresses the measurement of earnings from 

period to period, while NAIC’s standards stress the measurement of 

ability to pay claims in the future. NAIC has also developed the Risk-

Based Capital for Insurers Model Act, adopted in some form in all 

states, which imposes automatic requirements on insurers to file plans 

of action when their capital falls below minimum standards.



Insurance and Reinsurance Markets Provide Catastrophe Risk Coverage and 

Capital Markets Add to Industry Capacity:



Natural catastrophes are infrequent events that can cause severe 

financial losses. Traditional reinsurance helps insurance companies 

respond to severe losses by limiting their individual liability on 

specific risks and thereby increases individual insurers’ capacity. 

However, insurance companies have been faced with higher reinsurance 

premiums for certain coverage following significant past natural 

catastrophes. Higher costs of reinsurance helped spur the development 

of risk-linked securities as an alternative to traditional reinsurance.



Natural Catastrophes Are Infrequent Events but Cause Severe Loss:



Although natural catastrophes occur relatively infrequently compared 

with other insured events, they can affect large numbers of persons as 

well as their property. The U.S. property and casualty 

insurance[Footnote 12] industry has paid, on average, $9.7 billion in 

catastrophe-related claims per year from 1989 through 2001, and the 

amount of claims paid can be highly variable. More than 68 million 

Americans now live in hurricane-vulnerable coastal areas. Eighty 

percent of Californians live near active faults. When natural disasters 

occur they cause damage and destruction, which may or may not be 

covered by insurance. The four most costly types of insured 

catastrophic perils in the United States are earthquakes, hurricanes, 

tornadoes, and hailstorms, although earthquakes and hurricanes pose the 

most significant catastrophe risk in insurance markets. Figure 1 shows 

the combined relative risk of these hazards across the United States.



Figure 1: Catastrophic Risk in the United States: Earthquake, 

Hurricane, Tornado, and Hail:



[See PDF for image]



Note: Risk is depicted as average annual loss at a given location from 

a broad range of catastrophic events. Losses from fires following 

earthquakes are not included. Because flood-related losses are largely 

covered by the National Flood Insurance Program, flooding and coastal 

storm surges are not included.



Source: Risk Management Solutions.



[End of Figure]



In August 1992, Hurricane Andrew swept ashore in Florida south of Miami 

and at the time set a new record for insured losses. As shown in figure 

2, estimated losses from Andrew were about $30 billion, of which $15.5 

billion was insured. Payments of claims stemming from Andrew reduced 

the capital of affected insurance companies and sharply reduced their 

capacity to issue new policies. Some of Florida’s largest homeowner 

insurance companies had to be rescued by their parent companies and 

others had to tap their surpluses to pay claims. Eleven property-

casualty insurance companies went into bankruptcy. In January 1994, an 

earthquake occurred about 20 miles northwest of downtown Los Angeles in 

the Northridge area of the San Fernando Valley. Also shown in figure 2, 

estimated losses from the Northridge earthquake were about $30 billion, 

of which approximately $12.5 billion was insured. Earthquake insurance 

coverage availability declined precipitously after the Northridge 

earthquake. Losses from the Kobe, Japan, earthquake and the September 

11, 2001, terrorist attack on the World Trade Center also are included 

in figure 2 to illustrate the global nature of the insurance capacity 

problem and to provide perspective on the size of losses.



Figure 2: Estimated Losses from Recent Large Catastrophes:



[See PDF for image]



Note: Dollar figures are estimates of insured, uninsured, and total 

loss.



Sources: Insurance Information Institute and other insurance industry 

sources.



[End of Figure}



Catastrophe Risk Is Usually Covered through Insurance, Reinsurance, and 

Retrocession:



For many individuals and organizations, insurance is the most practical 

and effective way of handling a major risk such as a natural 

catastrophe. By obtaining insurance, individuals and organizations 

spread risk so that no single entity receives a financial burden beyond 

its ability to pay. But catastrophic loss presents special problems for 

insurers in that large numbers of those insured incur losses at the 

same time. Reinsurance helps insurance companies underwrite large 

risks, limit liability on specific risks, increase capacity, and share 

liability when claims overwhelm the primary insurer’s resources. In 

reinsurance transactions, one or more insurers agree, for a premium, to 

indemnify another insurer against all or part of the loss that an 

insurer may sustain under its policies. Figure 3 illustrates 

traditional insurance, reinsurance, and retrocessional 

transactions.[Footnote 13]



Figure 3: Traditional Insurance, Reinsurance, and Retrocessional 

Transactions:



[See PDF for image]



Source: GAO.



[End of Figure]



Reinsurance is a global business. According to RAA, almost half of all 

U.S. reinsurance premiums were paid to foreign reinsurance 

companies.[Footnote 14]



Insurers Are Subject to Reinsurance Price Swings:



Catastrophe reinsurance has experienced cycles in prices, both 

nationally and in specific geographic areas. Figure 4 presents a 

national reinsurance price index since 1989, which shows that, overall, 

reinsurance prices increased both before and after Hurricane Andrew and 

decreased after the Northridge earthquake.[Footnote 15]



Figure 4: U.S. Reinsurance Prices, 1989-2001:



[See PDF for image]



Note: This figure creates a price index set equal to 100 in 1989 

normalized prices. We could not obtain information to assess the 

reliability of the price data.



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

Companies.



[End of Figure]



The price trend presented in figure 4 does not reflect the situations 

specific to Florida and California, where insurers refused to continue 

writing catastrophe coverage. In 1993, the Florida state legislature 

responded by establishing the Florida Hurricane Catastrophe Fund to 

provide reinsurance for insurance companies operating in 

Florida.[Footnote 16] Also, the Northridge earthquake raised serious 

questions about whether insurers could pay earthquake claims for any 

major earthquake. In 1994, insurers representing about 93 percent of 

the homeowners insurance market in California severely restricted or 

refused to write new homeowners policies. In 1996, the California state 

legislature responded by establishing the California Earthquake 

Authority (CEA) to sell earthquake insurance to homeowners and renters. 

Appendix III more fully discusses the mechanisms established by Florida 

and California to deal with the risks posed by such catastrophes.



In one comprehensive study analyzing the pricing of U.S. catastrophe 

reinsurance,[Footnote 17] the authors concluded that a catastrophic 

event, such as a hurricane, reduced capital available to cover 

nonhurricane catastrophe reinsurance, thereby affecting reinsurance 

prices. This finding is consistent with the “bundled” nature of capital 

investment in traditional reinsurance (i.e., capital investors face 

both the risks associated with company management and the various 

perils covered by the insurance company). Therefore, the finding 

suggests that price and availability swings for catastrophe reinsurance 

covering one peril are affected by catastrophes involving all other 

perils.[Footnote 18]



Given the cyclic nature of the reinsurance market, investors have 

incentives to look for alternative capital sources. Hurricane Andrew 

and the Northridge earthquake provided an impetus for insurance 

companies and others to find different ways of raising capital to help 

cover catastrophic risk and helped spur the development of risk-linked 

securities and other alternatives to traditional reinsurance.



Catastrophe Risk Can Be Transferred to Capital Markets:



Catastrophe risk securitization began in 1992 with the introduction of 

index-linked catastrophe loss futures and options contracts by the 

Chicago Board of Trade (CBOT). For more information on catastrophe 

options, see Appendix II. Other risk-linked securities, especially 

catastrophe bonds, were created and used in the mid-1990s in the 

aftermath of Hurricane Andrew and the Northridge earthquake. During 

this time, traditional reinsurance prices were relatively high compared 

with other time periods. While the most direct means for insurance 

companies to raise capital in the capital market is issuing company 

stock, an investor in an insurance company’s stock is subject to the 

risks of the entire company. Therefore, an investor’s decision to 

purchase stock will depend on an assessment of the insurance company’s 

management, quality of operations, and overall risk exposures from all 

perils. In contrast, an investor in an indemnity-based, risk-linked 

security can face risk associated with the insurance company’s 

underwriting standards but does not take on the risk of the overall 

insurance (or reinsurance) company’s operations. The cost of issuing 

risk-linked securities, such as catastrophe bonds, includes the legal, 

accounting, and information costs that are necessary to issue 

securities and market them to investors who do not have contractual 

and/or business relationships with the insurance company receiving 

coverage. The market test for a securitized financial instrument, such 

as a catastrophe bond, depends, in part, on how well investors can 

evaluate the probability and severity of loss that may affect returns 

from the investment.



However, the willingness of capital market investors to purchase 

instruments that securitize catastrophe risk, such as catastrophe 

bonds, and therefore the yields they will require, depends on a number 

of factors, including the investors’ capacity to evaluate risk and the 

degree to which the investment can facilitate diversification of 

overall investment portfolios.[Footnote 19] Demand for risk-linked 

securities by insurance and reinsurance company sponsors will depend, 

in part, on the basis risk faced and the ability of sponsors to 

hedge[Footnote 20] this basis risk.



Although issuance of risk-linked securities has been limited, many of 

the catastrophe bonds issued to date have provided reinsurance coverage 

for catastrophe risk with the lowest probability and highest financial 

severity. Insurance industry officials we interviewed told us that 

their use of risk-linked securities has lowered the cost of some 

catastrophe protection. In addition, one official told us that the 

presence of risk-linked securities as a potential funding option has 

helped lower the cost of obtaining catastrophe protection covering low-

probability, high-severity catastrophes from traditional reinsurers.



According to the Swiss Reinsurance Company, in 2000, risk-linked 

securities represented less than 0.5 percent of worldwide catastrophe 

insurance and, according to estimates provided by Swiss Re and Goldman 

Sachs, between 1996 and August 2002, about $11 to $13 billion in risk-

linked securities had been issued worldwide.[Footnote 21] As of August 

2002, over 70 risk-linked securitizations had been done, according to 

Goldman Sachs. Risk-linked securities have covered perils that include 

earthquakes, hurricanes, and windstorms in the United States, France, 

Germany, and Japan.



Risk-Linked Securities Have Complex Structures:



Catastrophe options offered by CBOT beginning in 1995 were among the 

first attempts to market risk-linked securities. The contracts covered 

exposures on the basis of a number of broad regional indexes that 

exposed insurers to basis risk, and trading in CBOT catastrophe options 

ceased in 1999 due to lower-than-expected demand (see app. 

II).[Footnote 22] Insurance companies and investment banks developed 

catastrophe bonds, and the bonds are offered through the SPRVs. Recent 

catastrophe bonds have been nonindemnity-based to limit moral hazard; 

therefore, they expose the sponsor to basis risk. The SPRVs are usually 

established offshore to take advantage of lower minimum required levels 

of capital, favorable tax treatment, and a generally reduced level of 

regulatory scrutiny.



Currently most risk-linked securities are catastrophe bonds. Most 

catastrophe bonds issued to date have been noninvestment-grade 

bonds.[Footnote 23] Catastrophe bonds achieved recognition in the mid-

1990s. They offered several advantages that catastrophe options did 

not, among them customizable offerings and multiyear pricing. 

Catastrophe bonds, to date, have been offered as private placements 

only to qualified institutional buyers.[Footnote 24] A catastrophe bond 

offering is made through an SPRV that is sponsored by an entity that 

may be an insurance or reinsurance company.[Footnote 25] The SPRV 

provides reinsurance to a sponsoring insurance or reinsurance company 

and is backed by securities issued to investors. The SPRVs are similar 

in purpose to the special purpose entities (SPE) that banks and:



other entities have used for years to obtain funding for their 

loans.[Footnote 26] These SPEs pay investors from principal and 

interest payments made by borrowers to the SPE. In contrast, the SPRVs 

that issue catastrophe bonds receive payments in three forms (premiums, 

principal, and interest); invest in securities; and pay investors in 

another form (interest). The SPRV returns the principal to the investor 

if the specified catastrophe does not occur. Figure 5 illustrates cash 

flows among the participants in a catastrophe bond.



Figure 5: Special Purpose Reinsurance Vehicle:



[See PDF for image]



Source: GAO.



[End of Figure]



As shown in figure 5, the sponsoring insurance company enters into a 

reinsurance contract and pays reinsurance premiums to the SPRV to cover 

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

by investors. The catastrophe bond offering defines a catastrophe that 

would trigger a loss of investor principal and, if triggered, a formula 

to specify the compensation level from the investor to the SPRV. The 

SPRV is to hold the funds raised from the catastrophe bond offering in 

a trust in the form of Treasury securities and other highly rated 

assets.[Footnote 27] To avoid consolidation on the sponsor’s balance 

sheet, the trust also is to contain a minimum independent equity-

capital investment of at least 3 percent of the SPRV’s assets, per 

GAAP. According to a rating agency official, the 3 percent equity 

capital is usually obtained from capital markets in the form of 

preferred stock. Typically, investors earn a return of the London 

Interbank Offered Rate (LIBOR)[Footnote 28] plus an agreed spread. The 

SPRV deposits the payment from the investor as well as the premium from 

the company into a trust account. The premium paid by the insurance or 

reinsurance company and the investment income on the trust account 

provide the funding for the interest payments to investors and the 

costs of running the SPRV.



Under the terms of nonindemnity-based catastrophe bonds, for the 

sponsoring insurance company to collect part or all of the investors’ 

principal when the catastrophe occurs, an independent third party must 

confirm that the objective catastrophic conditions were met, such as an 

earthquake reaching 7.2 in moment magnitude as reported by the U.S. 

Geological Survey. Such nonindemnity bonds also allow the sponsor to 

continue to write new business without impacting the risk level of the 

bond and provide for faster reimbursement to the sponsor in the event 

of a catastrophe. The sponsor is exposed to basis risk because the 

claims on the investors’ principal might not fully hedge the sponsor’s 

actual catastrophe exposure. However, the sponsor has minimal credit 

risk--the risk of nonpayment in the event of the covered catastrophe--

because the bond is fully collateralized. The SPRVs are usually 

established offshore--typically in Bermuda or the Cayman Islands--to 

take advantage of lower minimum required levels of capital, favorable 
tax 

treatment, and a generally reduced level of regulatory 
scrutiny.[Footnote 29]



Bond rating agencies, such as Fitch, Moody’s, and Standard & Poors, 

provide bond ratings that are based on their assessment of loss 

probabilities and financial severity. Some SPRVs have issued 

catastrophe bonds in tranches having more than one risk 

structure.[Footnote 30] The rating agencies rate the bonds according to 

expected loss.[Footnote 31] Catastrophe bonds issued to date have 

generally received noninvestment-grade ratings because investors face a 

higher risk of loss of their principal.[Footnote 32] The rating 

agencies rely, in part, on the risk assessments of three major 

catastrophe-modeling firms--the same firms are used by traditional 

reinsurers to help them understand catastrophe risk. These modeling 

firms rely on large computing capacity; sophisticated mathematical 

modeling techniques; and very large databases containing information on 

past catastrophes, population densities, construction techniques, and 

other relevant information to assess loss probabilities and financial 

severities. Catastrophe bond-offering statements to investors include 

rating information and the results from the catastrophe modeling.



One example of a catastrophe bond is Redwood Capital I, Ltd., which is 

linked to California earthquakes. Lehman Re, a reinsurance company, is 

the sponsor of the bond. Due to the catastrophe bond structure, 

investors are exposed to potential loss of principal of about $160 

million. The contract provides insurance for 12 months beginning 

January 1, 2002, covering specified earthquake losses to property in 

California. The interest rates promised on the principal-at-risk 

variable rate notes and preference shares are LIBOR+5.5 percent and 

LIBOR+7 percent. Investor losses are tied to the Property Claim 

Services (PCS) index, an indicator of insured property losses for 

catastrophes. The issuer provides reinsurance coverage for the 

earthquake peril in California to Lehman Re, the sponsor, for 

triggering events causing industry losses that range from $22.5 billion 

to $31.5 billion as estimated by PCS. Proceeds from the issuance of the 

securities are to be deposited into a collateral account and invested 

in securities that are guaranteed or insured by the U.S. government and 

in highly rated commercial paper and other securities. The securities 

have been offered only to qualified institutional buyers as defined by 

SEC Rule 144A. Moody’s rated the bond a Ba2 (i.e., a noninvestment-

grade bond rating) on the basis of the determination that it is 

comparable to a Ba2-rated conventional bond of similar duration. The 

rating took into account the risk analysis of a catastrophe-modeling 

firm.



Regulatory, Accounting, Tax, and Investor Issues Might Affect Use of 

Risk-Linked Securities:



We identified and analyzed regulatory, accounting, tax, and investor 

issues that might affect the use of risk-linked securities. Our 

analysis included (1) current accounting treatment of risk-linked 

securities and proposed changes to accounting treatment, (2) potential 

changes in equity requirements for the SPRVs, (3) a preliminary tax 

proposal by insurance industry representatives to encourage domestic 

issuance of catastrophe bonds by creating “pass-through” tax treatment, 

and (4) reasons for limited investor participation in risk-linked 

securities.



Regulators Are Reconsidering Accounting Treatment of Risk-Linked 

Securities:



Under certain conditions, NAIC’s Statutory Accounting Principles allow 

an insurance company that obtains reinsurance to reflect the transfer 

of risk (effected by the purchase of reinsurance) on the financial 

statement it files with state regulators. These regulatory requirements 

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

the reinsurance company will be able to pay any claims.[Footnote 33] In 

receiving “credit” for reinsurance, an insurance company may count the 

payments owed it from the reinsurance company on claims it has paid as 

an asset or as a deduction from liability. In doing so, a company can 

increase earnings reported on its financial statement and lower the 

amount of capital it needs to meet risk-based capital requirements 

established by regulators. The ability to record an asset or to take a 

deduction from gross liability for reinsurance is consequent upon the 

transfer of risk and can strongly affect an insurance company’s 

financial condition.



Traditional reinsurance pays off on an indemnity trigger--that is, 

payment is based on the actual claims incurred by the insurance 

company. Some risk-linked securities have also provided payments from 

principal on an indemnity basis, and, under insurance accounting 

principles, these risk-linked securities have enabled the SPRVs to 

provide reinsurance that has received what is called “underwriting 

accounting treatment,” thereby allowing the SPRV sponsor to gain credit 

for reinsurance. In other cases, recovery under a catastrophe bond may 

not be indemnity based and may rely on a financial model of the insured 

claims of the insurance company rather than on the actual claims of the 

company. In these cases, there is a risk that the modeled claims will 

not equal the insurance company’s actual claims. There are also risks 

that the financial model will produce a recovery less or greater than 

the companies’ incurred claims. Current accounting guidance requires 

that the contract must indemnify the company against loss or liability 

associated with insurance risk in order to qualify for reinsurance 

accounting.



However, NAIC is currently reconsidering the appropriate statutory 

accounting treatment of nonindemnity-based insurance, which would 

include risk-linked securities.[Footnote 34] Both exchange-traded 

instruments and over-the-counter instruments can be used to hedge 

underwriting results (i.e., to offset risk). The triggering event on a 

risk-linked contract must be closely related to the insurance risks 

being hedged so that the payoff is expected to be consistent with the 

expected claims, even though some basis risk may still exist. This 

correlation is known as “hedge effectiveness.” NAIC is currently 

considering how hedge effectiveness should be measured. Should NAIC 

determine a hedge-effectiveness measure, statutory insurance 

accounting standards could be changed so that a fair value of the 

contract could be calculated and recognized as an offset to insurance 

losses, hence allowing a credit to the insurer similar to that granted 

for reinsurance. If nonindemnity-based, risk-linked securities are 

accepted by insurance regulators as an effective hedge of underwriting 

results, they could help make such contracts more appealing to 

insurance companies by providing treatment similar to that afforded 

traditional reinsurance. Nevertheless, it is important yet difficult 

for U.S. insurance regulators to develop an effective measure to 

account for risk reduction for nonindemnity-based coverage so that 

insurance company reporting on both risk evaluation and capital 

treatment properly reflects the risk retained. Appendix IV contains a 

discussion of credit for reinsurance accounting treatment and the 

balance sheet implications of such treatment.



Proposed Rule on Equity Requirements Could Affect Catastrophe Bonds:



An SPE is created solely to carry out an activity or series of 

transactions directly related to a specific purpose. The use of an SPE 

(or more specifically an SPRV) in a catastrophe bond securitization 

transaction involves a number of complex financial accounting issues in 

the United States. Current FASB guidance generally provides that the 

sponsor of an SPE report all assets and liabilities of the SPE in its 

financial statements, unless all of the following criteria are met:



1. Independent third-party owner’s(s’) investment in the SPE is at 

least 3 percent of the SPE’s total debt and equity or total assets.



2. The independent third-party owner(s) has a controlling financial 

interest in the SPE (generally meaning that the owner holds more than 

50 percent of the voting interest of the SPE).



3. Independent third-party owners must possess the substantive risk and 

rewards of its investment in the SPE (generally meaning that the 

owner’s investment and potential return are “at risk” and not 

guaranteed by another party).[Footnote 35]



In response to issues arising from Enron’s use of SPEs, FASB is 

currently considering a new approach to accounting for SPEs. The new 

FASB interpretation would require the primary beneficiary of an SPE to 

consolidate (list assets and liabilities of) the SPE in its financial 

statements, unless the SPE has “economic substance” sufficient not to 

be consolidated; that is, the SPE would have to have the ability to 

fund or finance its operations without assistance from or reliance on 

any other party involved in the SPE. In turn, the SPE would have that 

ability if it had independent third-party owners who have substantive 

voting equity investment at risk, exposure to variable returns, and the 

ability to make decisions and manage the SPE’s activities. A 

presumption is set that substantive equity investment in an SPE should 

be at least 10 percent of the SPE’s total assets throughout the life of 

the SPE. Therefore, according to information provided by FASB, many 

existing SPEs would probably be consolidated on the sponsors’ financial 

statements under the new requirement. The potential revision for equity 

requirements is intended to improve transparency in capital markets. 

According to rating agency officials, the current 3 percent independent 

equity requirements in recent catastrophe bond transactions have been 

met by issuing preferred stock. Our work did not determine the extent 

to which the 3 percent independent equity requirement is currently 

being met by the insurance industry.



Bond market representatives told us that the proposed FASB equity 

requirements also have the potential to create a substantial hurdle to 

structuring catastrophe bond SPEs because few investors would be 

willing to purchase preferred shares because of the difficulties in 

understanding the risks. These representatives argue that risk-linked 

securitizations are different from other securitizations using SPEs 

because the insurer does not control the funds held by the SPE, and 

therefore, should not be subject to the new 10 percent equity 

investment requirement.



The proposed new FASB interpretation also considers who bears the 

largest potential risks of the SPE when determining whether to 

consolidate with the primary beneficiary. Should the primary 

beneficiary bear the largest dollar loss if the SPE should fail, then 

consolidation would be required with the primary beneficiary. According 

to one FASB representative, one issue that needs to be considered is 

whether the insurer or the investors should be responsible for 

reporting or consolidating the assets and liabilities of the SPE in 

financial statements depending on who bears the largest potential risks 

of the SPE. If an insurer must consolidate the assets and liabilities 

of the SPE onto its own balance sheet, the insurer will also lose part 

of the benefit of the reinsurance contract that it enters into with the 

SPE.



While the proposed guidance is intended to improve financial 

transparency in capital markets, it could also increase the cost of 

issuing catastrophe bonds and make them less attractive to sponsors. If 

the proposed rule were implemented, sponsors might turn to risk-linked 

securities that do not require an SPE, such as catastrophe options.	:



Insurance Industry Representatives Have Proposed Pass-Through Tax 

Treatment of Risk-Linked Securities:



NAIC is concerned that offshore SPRVs reduce economic efficiency and 

limit the oversight ability of insurance regulators. To further 

encourage the use of onshore SPRVs, NAIC’s working group on 

securitization has interacted with a group of insurance industry 

representatives that is considering how to structure a legislative 

proposal to make onshore SPRVs tax-exempt entities. The SPRVs have been 

established in offshore tax haven jurisdictions, where the SPRV itself 

is not subject to any income or other tax; the SPRVs also usually 

operate in a manner intended to help ensure that they avoid U.S. 

taxation by conducting most activities outside of the United 

States.[Footnote 36] Taxation of the U.S. holders of SPRV-issued 

securities depends upon whether the securities are characterized as 

debt or equity. This characterization in turn depends upon a number of 

factors, including the likelihood of loss of principal, the relative 

degree of subordination of the instrument in the SPRV’s capital 

structure, and the accounting treatment of the instrument.



Although almost all SPRVs have been established offshore, there has 

been interest in facilitating the creation of onshore transactions 

because it is argued that onshore SPRVs would lessen transactional 

costs and afford regulators greater scrutiny of the SPRVs’ activities. 

NAIC has already approved a model state insurance law that allows for 

the creation of an onshore SPRV. Under the model law, an onshore SPRV 

would be a corporation domiciled in and organized under state law for a 

limited purpose. Insurance regulators’ scope of authority would be 

limited for the SPRVs, which would be required to be minimally 

capitalized, and the domiciliary state’s laws on insolvency would apply 

to the SPRV.



However, it is likely that the onshore SPRV would be subject to federal 

income taxation, making the transaction more expensive. To further 

encourage the use of onshore SPRVs, a group of industry attendees at 

the NAIC’s insurance securitization working group is considering a 

legislative proposal to make the onshore SPRVs tax-exempt. Currently, 

the industry representatives are considering using a structure that 

would receive tax treatment similar to the treatment received by an 

issuer of asset-or mortgage-backed securities. Issuers of asset-backed 

securities are generally not subject to tax on the income from 

underlying assets as they pass through the issuer to the investors in 

the securities. It would not be economical for an SPE to issue an 

asset-backed security if the SPE incurred material tax costs on the 

payments collected and paid over to the investors as taxable income. 

Securitizations address the problem of taxes in one of two ways: First, 

if an asset-backed security is considered debt for tax purposes, 

deductions are allowed for the interest expense, and the tax burden is 

shifted to the investors. Second, if the securities are not classified 

as debt, tax is avoided by treating the SPE as a pass-through entity 

with income allocated and taxed to its owners.[Footnote 37]



The current proposal by the industry representatives would create a 

structure similar to a Real Estate Mortgage Investment Conduit 

(REMIC)[Footnote 38] or a Financial Asset Securitization Investment 

Trust (FASIT). REMICs and FASITs are pools of real property mortgages 

or debt instruments that issue multiple classes, or tranches, of 

financial payments among investors. The REMIC and FASIT legislation 

adopt two approaches to avoiding an issuer tax: They treat the issuer 

as a pass-through entity and classify regular interest as debt for 

purposes of allowing an interest deduction to the issuer. The proposal 

would mimic REMICs and FASITs by providing pass-through treatment for 

the onshore SPRV and ensuring that the regular payments in the SPRV are 

classified as debt. To the extent that domestic SPRVs gained business 

at the expense of taxable entities, the federal government could 

experience tax revenue losses. The statutory and regulatory 

requirements used to implement any such legislation would also affect 

tax revenue. Expanded use of catastrophe bonds might occur with 

favorable implementing requirements, but such legislative actions may 

also create pressure from other industry sectors for similar tax 

treatment.



Also, some elements of the insurance industry believe that any 

consideration of changes to the tax treatment of domestic SPRVs would 

have to take into account the taxation of domestic reinsurance 

companies. Domestic reinsurance companies are taxed under the special 

rules of Subchapter L of the Internal Revenue Code. Under these rules, 

all insurance companies are taxed as corporations. Premiums earned by a 

domestic reinsurance company, after deducting premiums paid for 

retrocessional insurance coverage, are taxable. Investment income 

earned by the reinsurer is also taxable. A ceding commission paid by a 

reinsurer to an insurer to cover costs, including marketing and sale of 

the premium, is taxable to the ceding insurance company. However, many 

reinsurers are either incorporated offshore or are affiliated with 

companies created offshore to take advantage of reduced levels of 

taxation. Payments to an offshore reinsurer may be subject to an excise 

tax.[Footnote 39] In addition, because of the potential for abuses, the 

Secretary of the Treasury has special statutory authority to reallocate 

deductions, assets, and income between unrelated parties when a 

reinsurance transaction has a significant tax avoidance 

effect.[Footnote 40]



RAA officials expressed concerns about the impact of NAIC’s model act 

creating an onshore SPRV. RAA objects to both the special regulatory 

treatment in the model act and the tax advantages proposed for the 

onshore SPRV. RAA argues that the NAIC model act creates a new class of 

reinsurer that will operate under regulatory and tax advantages not 

afforded to existing U.S. licensed and taxed reinsurance companies. RAA 

maintains that the SPRV will act as a reinsurer and yet not be subject 

to insurance regulation, thus endangering solvency regulation and 

creating an uneven playing field for reinsurers.



Risk-Linked Securities Do Not Have Broad Investor Participation:



Catastrophe bonds have not attracted a wide range of investors beyond 

institutional investors. Investor participation in risk-linked 

securities is limited in part because the risks of these securities are 

difficult to assess. Investment bank representatives and investment 

advisors we interviewed noted that catastrophe bonds have thus far been 

issued only to sophisticated institutional investors and a small number 

of large investment fund managers for inclusion in bond portfolios that 

include noninvestment-grade bonds. Most catastrophe bonds carry 

noninvestment-grade bond ratings from the rating agencies, but a low 

rating by itself has not been a barrier to active investor interest in 

other types of bonds, such as corporate bonds. The investment fund 

managers told us that catastrophe bonds comprise 3 percent or less of 

the portfolios in which they are included. On the one hand, the 

managers like the diversification aspects of catastrophe bonds because 

the risks are generally uncorrelated with the credit risks of other 

parts of the bond portfolio. On the other hand, managers stated that 

they have concerns about the limited liquidity and track record of 

catastrophe bonds as well as the lack of in-house expertise to 

understand the perils, indexes, and other features of the 

bonds.[Footnote 41]



As requested, we explored the potential for individual investors to 

purchase shares in mutual funds that purchase catastrophe bonds for 

inclusion with other securities in a mixed asset fund. We analyzed the 

SEC rules governing catastrophe bond issuance and mutual fund 

composition and confirmed with SEC that these rules and regulations do 

not preclude mutual funds from purchasing catastrophe bonds. One of the 

investment advisors we interviewed told us that his firm included a 

small amount of catastrophe bonds in mutual funds sold to the public. 

However, a mutual fund industry association official told us that the 

mutual fund companies that the association surveyed--including three of 

the largest--have not included catastrophe bonds in funds available to 

individual investors because the companies lack the capacity to 

evaluate the risks. The mutual fund industry official also raised the 

issue of whether the risk associated with risk-linked securities would 

be appropriate or suitable for investments by a broad range of 

investors, including moderate-income investors.



Agency Comments and Our Evaluation:



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

and BMA. We also obtained technical comments from Treasury, SEC, CFTC, 

NAIC, RAA, and BMA that have been incorporated where appropriate. NAIC 

commented that it supports developing alternative sources of 

reinsurance capacity, the securitizing of catastrophic risk within the 

United States, and subjecting SPRVs to U.S. insurance regulation. As 

stated in our report, a group of insurance industry representatives 

interacting with NAIC’s working group on securitization is considering 

how to structure a legislative proposal to make the onshore SPRV a tax-

exempt entity. Our report also indicates that such legislation also 

could result in tax revenue losses and other potential costs. NAIC 

stated that SPRVs, however, would be subject to onshore supervision by 

U.S. regulators, but it is not clear to us how risk-linked securities 

would actually be regulated once brought onshore.[Footnote 42]



RAA commented that our report provides an excellent summary on the use 

of risk-linked securities in providing coverage for catastrophes. 

However, RAA took exception to (1) our characterization of reinsurance 

industry capacity and (2) our description of risk-linked securities as 

an alternative to reinsurance. RAA noted that in recent occurrences of 

major catastrophic events in the United States, insurers and reinsurers 

had sufficient capital to meet their obligations and added that most of 

the California and Florida market was underwritten by insurers that 

relied very little, if at all, on reinsurance capacity. First, we note 

that while the reinsurance industry has been able to meet its 

obligations from recent events with existing capacity, the industry’s 

capacity must be considered along with issues related to (1) the price 

and availability of catastrophic reinsurance in high-risk areas and (2) 

its ability to handle multiple, sequential catastrophes. Some insurers 

who self-reinsure might do so partially because they believe that the 

price of reinsurance to cover their exposure to catastrophic events is 

not attractive. Second, RAA asked that we characterize risk-linked 

securities as a supplement to reinsurance rather than as an alternative 

because of the relatively small amount of reinsurance coverage 

currently provided through risk-linked securities. We agree, and our 

report states that risk-linked securities add to or supplement 

reinsurance capacity, but we also note that sponsors of catastrophe 

bonds view these securities as alternatives to traditional reinsurance 

when they are more cost-effective.



BMA stated that our report was accurate and well-researched and 

commented on several policy issues raised in the report. Their letter 

raised several concerns with our discussion of tax treatment, 

accounting treatment, and investor interest in risk-linked securities. 

First, BMA disagreed with concerns cited in our report that pass-

through tax treatment for risk-linked securities could result in (1) 

tax revenue losses and unfair tax and (2) regulatory and tax advantages 

that are not afforded to existing U.S.-licensed and taxed reinsurance 

companies. BMA commented that because a large percentage of entities 

that provide reinsurance coverage is based outside of the United 

States, including all reinsurance companies established since September 

11, 2001, the tax impact would not be dramatic. In addition, BMA noted 

that any potential loss of U.S. tax revenue must be weighed against the 

policy benefits associated with creating additional private-sector 

capacity to absorb and distribute insurance risk. We agree that many 

reinsurance entities are not U.S.-based, but the potential tax revenue 

losses would depend on a number of factors, including business lost by 

taxable entities and the regulatory requirements used to implement such 

legislation. We also agree that many considerations must be weighed in 

the policy decision to grant special tax treatment for onshore SPRVs, 

including potential tax revenue losses and the extent to which an 

uneven playing field is created for domestic reinsurance companies.



Second, BMA commented that our description of FASB’s SPE consolidation 

proposal was not based on the final exposure draft and that they 

interpret the proposal to allow SPRVs to apply only a variable 

interests approach and not satisfy a particular outside equity 

threshold. Our draft report discussion of the FASB proposal was based 

on the final exposure draft. While we did not evaluate BMA’s 

interpretation of the FASB proposal, we included their position in our 

report. Finally, BMA commented that our discussion of reasons for the 

lack of broader investor participation in risk-linked securities was 

incomplete and somewhat inaccurate. They noted that several mutual 

funds have purchased risk-linked securities as part of their overall 

portfolios, that mutual fund managers are well-equipped to evaluate the 

risk associated with these securities, and that lack of broader 

investor participation may be due to limited issuance. We agree that 

some mutual funds have purchased risk-linked securities and that lack 

of broader participation may be attributed to some degree to limited 

issuance of risk-linked securities. However, information we obtained 

indicates that some of the largest mutual fund companies did not 

include risk-linked securities in their mutual fund portfolios mainly 

because of their unusual and unfamiliar risk characteristics.



Unless you publicly announce its contents earlier, we plan no further 

distribution of this report until 30 days from the date of this letter. 

At that time, we will send copies of this report to the Ranking 

Minority Member of the House Committee on Financial Services and the 

Chairmen and Ranking Minority Members of the Senate Committee on 

Banking, Housing and Urban Affairs; and the House Committee on Ways and 

Means. We also will make copies available to others upon request. In 

addition, this report will be available for no charge on GAO’s Internet 

home page at http://www.gao.gov.



Please contact Bill Shear, Assistant Director, or me at (202) 512-8678 

if you or your staff have any questions concerning this report. Key 

contributors to this work were Rachel DeMarcus, Lynda Downing, Patrick 

Dynes, Christine Kuduk, and Barbara Roesmann.



Sincerely yours,



Davi M. D’Agostino

Director, Financial Markets and Community Investment:

Signed by Davi M. D’Agostino:



[End of section]



Appendixes:



Appendix I: Scope and Methodology:



You asked us to report on the potential for risk-linked securities to 

cover catastrophic risks arising from natural events. As agreed with 

your office, our objectives were to (1) describe catastrophe risk and 

how insurance and capital markets provide for insurance against such 

risks; (2) describe how risk-linked securities, particularly 

catastrophe bonds, are structured; and (3) analyze how key regulatory, 

accounting, tax, and investor issues might affect the use of risk-

linked securities.



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

the private-sector entities, we obtained extensive documentary and 

testimonial evidence from a large number of entities, including 

insurance and reinsurance companies, investment banks, institutional 

investors, rating agencies, firms that develop models to analyze 

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

not verify the accuracy of data provided by these entities. Some 

entities we met with voluntarily provided information they considered 

to be proprietary, and therefore we did not report details from such 

information. In other cases, companies decided not to provide 

proprietary information, and this limited our inquiry. For example, we 

did not obtain any reinsurance contracts representing either 

traditional reinsurance or reinsurance provided through issuance of 

risk-linked securities.



To describe catastrophe risk and how insurance and capital markets 

provide for insurance against such risks, we examined a variety of 

documents, including books on insurance and reinsurance; academic 

articles and essays; and analyses done by the Insurance Information 

Institute, the Insurance Services Office, modeling firms, and the 

Congressional Budget Office. We also interviewed officials from 

insurance companies, reinsurance companies, the California Earthquake 

Authority (CEA), the Florida Hurricane Catastrophe Fund (FHCF), 

modeling firms, and university finance departments and schools.



To describe how risk-linked securities, particularly catastrophe bonds, 

are structured, we examined catastrophe bond-offering circulars, 

investment bank documents, reinsurance company analyses, rating agency 

reports, academic studies, futures exchange documents, and analyses 

prepared by the American Academy of Actuaries. We also met with 

officials of investment banks, insurance companies, reinsurance 

companies, rating agencies, modeling firms, a futures exchange, 

investment advisors, and the American Academy of Actuaries.



To analyze how key regulatory, accounting, tax, and investor issues 

might affect the use of risk-linked securities, we examined a variety 

of documents, including books on insurance accounting and taxation, the 

Financial Accounting Standards Board’s (FASB) proposed consolidation 

principles for special-purpose entities, accounting firm publications, 

the National Association of Insurance Commissioners’ (NAIC) Statutory 

Accounting Principles, and the proceedings of NAIC’s Working Group on 

Securitization. We met with officials from many organizations, 

including NAIC’s Working Group on Securitization, the Bond Market 

Association (BMA), the Reinsurance Association of America, the 

Investment Company Institute--a mutual fund company association, and 

FASB. We also met with officials from the Securities and Exchange 

Commission (SEC), the Commodity Futures Trading Commission (CFTC), and 

the Department of the Treasury (Treasury).



We faced a number of limitations in our work. We did not verify the 

accuracy of data provided by the various entities we contacted. While 

we obtained publicly available data on U.S. reinsurance prices, we 

could not obtain information to assess the reliability of the price 

data nor the methodology used to construct the reported price index. We 

obtained offering statements for some catastrophe bond offers. However, 

we could not determine whether the offering statements were 

representative of the universe of catastrophe bond offers, and we 

relied on summary information on the various offers provided to us by 

bond rating agencies. We also faced limitations in identifying the 

specific financing arrangements made to provide independent capital 

investments to special purpose reinsurance vehicles (SPRV) used to 

avoid consolidation with the sponsor’s balance sheet. In addition, 

without access to reinsurance contracts, we could not determine the 

extent to which insurance and reinsurance companies received credit for 

reinsurance, including those companies that relied, in part, on risk-

linked securities to transfer catastrophe risk.



Although we identified factors that industry and capital markets 

experts believe might cause the use of risk-linked securities to expand 

or contract, it was not within the scope of our work to forecast 

increased or reduced future use of these securities--either under 

current accounting, regulatory, and tax policies or under changed 

policies. It also was not within the scope of our work to take a 

position on whether the increased use of risk-linked securities is 

beneficial or detrimental.



We conducted our work between October 2001 and August 2002 in 

Washington, D.C.; Chicago, Ill.; New York, N.Y.; and various locations 

in California and Florida, in accordance with generally accepted 

government auditing standards.



[End of section]



Appendix II: Catastrophe Options:



Catastrophe options were offered by the Chicago Board of Trade (CBOT) 

in 1995. These options contracts were among the first attempts to 

market natural disaster-related securities. Catastrophe options 

offered the advantage of standardized contracts with low transaction 

costs traded over an exchange. Specifically, the purchaser of a 

catastrophe option paid the seller a premium, and the seller provided 

the purchaser with a cash payment if an index measuring insurance 

industry catastrophe losses exceeded a certain level. If the 

catastrophe loss index remained below a specified level for the 

prescribed time period, the option expired worthless, and the seller 

kept the premium. The option might have been purchased by an insurance 

company that wanted to hedge its catastrophe risk and might have been 

sold by firms that would do well in the event of a catastrophe--for 

example, homebuilders--or by investors looking for a chance to 

diversify outside of traditional securities markets.



Catastrophe option contracts were revised several times and covered 

exposures on national, regional, and state bases. On the one hand, 

because the payouts on the contracts were based on an index of 

insurance industry catastrophe losses,[Footnote 43] the transactions 

did not expose the investor to moral hazard or adverse 

selection[Footnote 44] risk. The indexes used were the Property Claim 

Services[Footnote 45] (PCS) catastrophe loss indexes.[Footnote 46] On 

the other hand, the contracts created basis risk for purchasers--the 

differences in the claim patterns between an individual insurer’s 

portfolio and the industry index. The options were to have offered 

minimal credit risk because the CBOT clearinghouse guaranteed the 

transactions. However, low trading volumes on options also raised 

questions about liquidity risk. Trading in CBOT catastrophe options 

ceased in 1999 due to lower-than-expected demand; CBOT delisted 

catastrophe options in 2000.



[End of section]



Appendix III: California and Florida Approaches to Catastrophe Risk:



The insurance markets in California and Florida illustrate the 

difficulties that the catastrophe insurance industry has faced 

nationally. Because California and Florida are markets with high 

catastrophe risk, these states have developed programs to increase 

insurer capacity in these markets. The Northridge earthquake raised 

serious questions about whether insurers could pay earthquake claims 

for any major earthquake. In 1994, insurers representing about 93 

percent of the homeowners insurance market in California severely 

restricted or refused to write new homeowner policies because the 

insurers grew concerned that another earthquake would exhaust their 

resources. Florida experienced a similar insurance crisis after 

Hurricane Andrew in 1992. In response, the state created two 

organizations to provide primary insurance coverage and additional 

reinsurance capacity.



California Earthquake Authority Provides Insurance:



In 1996, the California legislature established CEA as a privately 

funded and publicly managed entity to help residents protect themselves 

against earthquake loss. CEA sells earthquake insurance to homeowners, 

including condominium owners and renters. Insurers doing business in 

California must offer earthquake insurance in their homeowners 

insurance policies, whether a CEA policy or their own. The basic CEA 

policy carries a deductible of 15 percent on the home’s insured value, 

provides up to $5,000 to replace contents and personal possessions, and 

up to $1,500 for emergency living expenses. In 2001, the average policy 

for a house cost $560, but costs were several times higher in areas 

with high seismic risk. While companies must offer earthquake 

insurance, there is no state requirement that consumers purchase 

earthquake insurance or that mortgage lenders require it. About 16 

percent of California residences had earthquake insurance at the end of 

2001, and CEA insured 65 percent of those with earthquake insurance.



As of January 2002, CEA had more than 814,000 policies and a claims 

paying capacity of more than $7 billion against an exposure from all 

policies of about $175 billion. Their claims paying capacity consisted 

of layers of capital, insurance company assessments, and reinsurance 

and a line of credit. Recent external and internal reviews--conducted 

by the California State Auditor, CEA staff, and others--of CEA’s 

finances have focused on its claims paying capacity. The common concern 

of these reviews has been the heavy dependence on the reinsurance 

market--some 40 percent of CEA’s $7.2 billion claims paying capacity. 

Reviewers recommend that some of CEA’s claims paying capacity be 

converted to catastrophe bonds. Such a conversion would make CEA the 

largest catastrophe bond issuer in the world. As shown in figure 6, CEA 

is currently exploring catastrophe bond placements on two layers for 

$400 million and $338 million. Recently the CEA’s Governing Board 

decided not to support CEA issuance of catastrophe bonds because 

catastrophe bonds are done in offshore tax havens. A CEA official told 

us that the Governing Board would revisit the issue when catastrophe 

bonds can be done onshore.



Figure 6: Current and Proposed California Earthquake Authority 

Financial Structure:



[See PDF for Image]



Source: California Earthquake Authority.



[End of figure]



Florida Provides Residential Coverage for Windstorms and Supplements 

Insurance Capacity:



Following Hurricane Andrew in 1992, there was a property insurance 

crisis, and the Florida state legislature created two organizations to 

provide coverage and additional capacity--the Florida Residential Joint 

Underwriting Association (JUA) and the FHCF. JUA provides residential 

coverage in specifically designated areas that are most vulnerable to 

windstorm damage. Qualified recipients are property owners who could 

not obtain coverage from private insurers after Hurricane Andrew. The 

JUA had 68,000 policyholders and an $11 billion exposure as of January 

2001. Rates charged by the JUA in each county must be at least as high 

as the highest rate charged by the 20 largest private insurance 

companies in Florida. The JUA’s capacity to pay claims was $1.9 billion 

as of January 2001; claims would be paid by drawing down its surplus, 

private reinsurance, assessments of members, pre-event notes, a line of 

credit, and reimbursements from the state’s catastrophe fund. In March 

2002, the Florida legislature approved a plan to merge JUA with the 

Florida Windstorm Underwriting Association (FWUA), thereby forming an 

organization called the Citizen’s Property Insurance 

Corporation.[Footnote 47]



The FHCF was created as a source of reinsurance capacity to supplement 

what was available from private sources. The FHCF is run by Florida and 

was set up to encourage insurers to stay in the Florida marketplace in 

the aftermath of Hurricane Andrew, when reinsurance became more 

difficult to obtain. The FHCF reimburses insurers for a portion of 

their claims from future severe hurricanes. Unlike California, where 

catastrophe coverage is voluntary, Florida homeowners’ policies must 

include hurricane coverage. The FHCF is the world’s largest hurricane 

reinsurer, and Florida’s two residential pools (JUA and FWUA) and 

private insurers depend on it. Participation by the state’s insurers is 

mandatory, but insurers may choose different levels of coverage (45 

percent, 75 percent, or 90 percent) above a high-retention or 

deductible level for the participating insurers. The fund is financed 

by (1) about 260 property insurers doing business in the state on the 

basis of their exposure to hurricane loss and (2) bonding secured by 

emergency assessments on other insurers. If the FHCF cash balance is 

not sufficient to reimburse covered losses, it can issue tax-exempt 

revenue bonds, which are financed by an emergency assessment of all 

property-casualty insurers excluding workers’ compensation writers. 

Premiums paid relative to coverage purchased are significantly below 

those in the private-sector. The FHCF’s capacity is currently $11 

billion against an exposure of over $1 trillion. The $11 billion 

capacity comprises approximately $4.9 billion in cash and $6.1 billion 

in borrowing capacity. FHCF is also exempt from federal income tax. 

Although no major claims have occurred since Hurricane Andrew, the FHCF 

is designed to handle a $16.3 billion ground up residential property 
loss, 

which would include its $11 billion:



current capacity limit along with an aggregate insurance industry 

retention of $3.8 billion and an aggregate copayment by insurers of 

about $1.5 billion.



Florida has not announced plans to use risk-linked securities to 

address capacity issues.



[End of section]



Appendix IV: Statutory Accounting Balance Sheet Implications of 

Reinsurance Contracts:



Over the term of insurance policies, premiums that an insurance company 

collects are expected to pay for any insured claims and operational 

expenses of the insurer while providing the insurance company with a 

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

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

insurance company can obtain indemnification against claims associated 

with the insurance policies it has issued by entering into a 

reinsurance contract with another insurance company, referred to as the 

reinsurer. The original insurer, referred to as the ceding company, 

pays an amount to the reinsurer, and the reinsurer agrees to reimburse 

the ceding company for a specified portion of the claims paid under the 

reinsured policy.



Reinsurance contracts can be structured in many different ways. 

Reinsurance transactions over the years have increased in complexity 

and sophistication. Reinsurance accounting practices are influenced not 

only by state insurance departments through NAIC, but also by SEC and 

FASB. If an insurer or reinsurer engages in international insurance, 

both government regulatory requirements and accounting techniques will 

vary widely among countries.



Statutory Accounting Principles promulgated by NAIC allow an insurance 

company that obtains reinsurance to reflect the transfer of risk for 

reinsurance on the financial statements that it files with state 

regulators under certain conditions. The regulatory requirements for 

allowing credit for reinsurance are designed to ensure that a true 

transfer of risk has occurred and any recoveries from reinsurance are 

collectible. By obtaining reinsurance, ceding companies are able to 

write more policies and obtain premium income while transferring a 

portion of the liability risk to the reinsurer. Under many reinsurance 

contracts, a commission is paid by the reinsurer to the ceding company 

to offset the ceding company’s initial acquisition cost, premium taxes 

and fees, assessments, and general overhead. For example, if an insurer 

would like to receive reinsurance for $10 million and negotiates a 20 

percent ceding commission, then the insurer will be required to pay the 

reinsurer $8 million ($10 million premiums ceded, less $2 million 

ceding commission income). The effect of this transaction is to reduce 

the ceding company’s assets by the $8 million paid for reinsurance, 

while reducing the company’s liability for unearned premiums by the $10 

million in liabilities transferred to the reinsurer. The $2 million is 

recorded by the ceding company as commission income. This type of 

transaction results in an economic benefit for the ceding company 

because the ceding commission increases equity. The reinsurer has 

assumed a $10 million liability and would basically report a mirror 

entry that would have the opposite effects on its financial statements. 

Figure 7 shows the effects of the reinsurance transaction on both the 

ceding insurance company and reinsurance company’s balance sheets and 

is intended to show how one transaction increases and decreases assets 

and liabilities.[Footnote 48]



Figure 7: Effect on Ceding and Reinsurance Companies’ Balance Sheets 

before and after a Reinsurance Transaction:



[See PDF for image]



Source: Insurance Accounting Systems Association.



[End of Figure]



Reinsurance contracts do not relieve the ceding insurer from its 

obligation to policyholders. Failure of reinsurers to honor their 

obligations could result in losses to the ceding insurer.



An insurer may also obtain risk reduction from an SPRV that issues an 

indemnity-based, risk-linked security; the recovery by the insurer 

would be similar to a traditional reinsurance transaction. However, if 

an insurer chooses to obtain risk reduction from sponsoring a 

nonindemnity-based, risk-linked security issued through an SPRV, the 

recovery could differ from the recovery provided by traditional 

reinsurance. Even though the insurer is reducing its risk, the 

accounting treatment would not allow a reduction of liability for the 

premiums.



[End of section]



Appendix V: Comments from the National Association of Insurance 

Commissioners:



NAIL:



NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS:



EXECUTIVE HEADQUARTERS:



Ms. Davi M. D’Agostino:



Director, Financial Institutions and Community Investment United States 

General Accounting Office:



Washington, DC 20548:



Dear Ms. D’Agosfino:



September 9, 2002:



Thank you for giving the NAIC the opportunity to comment on the report 

“Catastrophe Insurance Risks: the Role of Risk-Linked Securities and 

Factors Affecting Their Use”.



The National Association of Insurance Commissioners (NAIC is a 

voluntary organization of the chief insurance regulatory officials of 

the 50 states, the District of Columbia and four U.S. territories. The 

association’s overriding objective is to assist state insurance 

regulators in protecting consumers and helping maintain the financial 

stability of the insurance industry by offering financial, actuarial, 

legal, computer, research, market conduct and economic expertise.



The NAIC formed a working group on Insurance Securitization in 1998 to 

‘’investigate whether there needs to be a regulatory response to 

continuing developments in insurance securifizafion, including the use 
of 

non-U.S. special purpose vehicles and to prepare educational material 
for 

regulators.” As a result of its deliberations, the NAIC has taken the 

position that U.S. insurance regulators should encourage the 

development of alternative sources of capacity such as insurance 

securitizations and risk linked securities as long as such developments 

are commensurate with the overriding goal of the NAIC membership of 

consumer protection. As such, the NAIC believes that one goal should be 

to encourage and facilitate securitizations within the United States. 

If transactions that are currently performed offshore were brought back 

to the United States, they would be subject to on-shore supervision by 

U.S. regulators. Both the NAIC’s Special Purpose Reinsurance Vehicle 
Model 

Act and the protected Cell Company Model Act would require that at 
least 

one U.S. insurance commissioner would review each transaction in depth 
and 

set the appropriate standards. In addition, an NAIC member chairs the 

International Association of Insurance Supervisors’ Subgroup on 

Insurance Seeuritizafion and fully agrees with these views.



At present, off shore insurance seeuritizafions are not subject to U.S. 

regulation, and the NAIC members are concerned about the appropriate 

use of Special Purpose Vehicles. The recent events at Enron have 
demonstrated 

how inappropriate use of special purpose vehicles can endanger 
solvency. 

The NAIL membership believes that, properly used and structured, 

Special Purpose Reinsurance Vehicles may provide extra capacity, more 

competition, and may reduce the overall costs of insurance for the 

public. The NAIL membership therefore believes that on-shore SPRVs, 

regulated by U.S. insurance regulators, would be preferable to the 

current situation where most securitizations are conducted off shore.



Again, we thank you for the opportunity to review and comment on the 

report.



Sincerely,



Therese M. Vaughan, President, NAIL:



Iowa Insurance Commissioner:



Signed by Therese M. Vaughan:



[End of section]



Appendix VI: Comments from the Reinsurance Association of America:



REINSURANCE ASSOCIATION OF AMERICA:



1301 Pennsylvania Avenue, N.W., Suite 900, Washington, D.C. 20004-1701	

Telephone: (202) 638-3690 Facsimile: (202) 638-0936 http://

www.reinsurance.org:



September 9, 2002:



Ms. Davi M. D’Agostino Director of Financial Markets and Community 

Investment:



United States General Accounting Office 441 G Street, NW:



Washington, DC 20508:



Dear Ms. D’Agostino:



Thank you for providing the RAA an opportunity to comment on the GAO’s 

preliminary report entitled “CATASTROPHE INSURANCE RISKS: The Role of 

Risk Linked Securities and Factors Affecting Their Use.” We greatly 

appreciate this opportunity.



The Reinsurance Association of America (RAA) is a national trade 

association representing property and casualty organizations that 

specialize in reinsurance. The RAA membership is diverse, including 

large and small, broker and direct, U.S. companies and subsidiaries of 

foreign companies. Together, RAA members write more than 75% of the 

reinsurance written by U.S. property casualty reinsurers.



In general, we believe that the report provides an excellent summary of 

this complex and technical topic and should be a valuable primer for 

Congress relative to the roles of reinsurance and risk-linked 

securities in managing catastrophic risks. We would like to thank you 

for addressing our comments raised previously regarding the abundant 

capacity of the insurance and reinsurance industry to underwrite 

catastrophe risk exposure. We continue to have concerns in this area 

and have addressed them below. We also have differences regarding the 

GAO’s characterization of risk-linked securities as “an alternative to 

reinsurance,” which we have addressed below as well. Finally we have 

listed some more technical suggestions we believe should be 

incorporated in the report.



Capacity:



On page 5 the Report states, “in the case of extremely large or 

multiple catastrophic events, traditional reinsurance providers might 

not have sufficient capital to meet their existing obligations.” In 

recent occurrences of major catastrophic events in the U.S., insurers 

and reinsurers have had sufficient capital to meet their obligations. 

For instance, after Hurricane Andrew (1992) $19.6 billion and the 

Northridge (1994) earthquake $14.9 billion in 2001 additional dollars, 

the two largest natural disasters on record in the U.S., not one 

reinsurer went insolvent and not one reinsurer failed to pay a claim as 

a result of insolvency or financial distress. Most recently, the 

reinsurance industry faced the largest insured loss event ever as a 

result of the September 11, 2001 terrorist attacks. The insured losses 

are expected to total approximately $60 billion, with the reinsurance 

industry paying for about 65% of that total. To date, reinsurers’ track 

record is excellent. We know of only one insolvency of a Japanese 
insurer 

regarding aviation liability.



Clearly there may be an event so large that it may threaten the ability 

of insurers and reinsurers to pay. However, since that has not been the 

case thus far we ask the GAO to add either a sentence or footnote 

explaining that traditional reinsurers have had the capital to meet 

their obligations in recent major catastrophic events. To not do so may 

draw an inference that the reinsurance industry does not meet is 

capital obligations.



Similarly, page 16 of the report states that in “Florida and California 

insurers refused to continue writing catastrophe coverage because of 

the lack of availability of reinsurance.” We believe that the lack of 

reinsurance was not a key reason insurance companies refused to write. 

We ask that that sentence be modified to include the following 

additional factors that played a major role in the decision of insurers 

to write coverage.



Most of the California and Florida market was underwritten by insurers 

(State Farm, Allstate, and Farmers) that relied very little, if at all, 

on reinsurance capacity. In fact we note reinsurance capacity rebounded 

very quickly and the heightened market demand following Hurricane 

Andrew and Northridge Earthquake led to the creation of a new class of 

specialized property catastrophe reinsurers. The problem of insurance 

capacity in Florida and California was over concentration in the market 

among 3-4 primary companies, not the lack of reinsurance. The insured 

losses resulting from Andrew led many of these companies to reevaluate 

their market share.



Pricing problems also led to insurers refusing to write policies. 

Regulators did not permit the insurance market to charge adequate rates 

corresponding with the risks of those insurance policies. Inadequate 

insurance rates can make a risk that is insurable, uninsurable. 

Inadequate rates used by insurers threaten the viability of the 

underwriting entity. Those that wanted to write were restricted from 

doing so because the freeze on pricing restricted their ability to 

fully recoup their costs. Lastly, inadequate coverage flexibility 

affected insurers willingness to write new business, as did competition 

from subsidized residual market pools. All of these factors had a major 

impact on insurers’ decision not to write after Andrew and Northridge, 

and we ask that this be noted in the report.



Use of Risk-Linked Securities:



There are numerous references in the report that “risk-linked 

securities are an alternative to reinsurance.” We disagree with the 

characterization that securitized products are an alternative to 

reinsurance. Because of the significant differences between indemnity 

based reinsurance and risk-linked securities as well as the relative 

depth of the reinsurance market and the minimal actual use of 

securitization as an alternative market, it is an overstatement to 

characterize these instruments as a viable alternative to reinsurance. 

We ask that when such a reference is made that the reports state that 

they are a supplement to reinsurance. They supplement reinsurance 

capacity mainly for: (1) high layer coverage, for very rare events 

where they provide some experimental capacity on the fringe of the 

traditional market capacity and (2) where direct indemnity for losses 

is less important to the ceding companies. The relatively few 

securitizations actually put in effect in the last 5 years makes clear 

that insurers view securitization as supplemental to reinsurance and 

not a replacement.



Other comments:



Several technical suggestions follow:



* Modify sentence on page 16 as follows: “In 1992 the Florida state 

legislature responded by establishing the Florida Hurricane Catastrophe 

fund to provide a layer of reinsurance for insurance companies 

operating in Florida.” The CAT fund is not the sole provider of 

reinsurance in Florida, for the private reinsurance market provides 

reinsurance to many primary companies. Private reinsurance remains an 

integral part of insurers catastrophe risk management. We ask that this 

fact be recognized in the report.



We believe it is important to note that not one catastrophe bond 

contract has ever been triggered by an actual event. Therefore, not one 

securitization has yet to go through the process of paying out claims. 

Due to the very untested nature of these products we believe it is 

important to disclose this in the reports discussion of the regulatory, 

accounting, tax and investor issues that affect the use of risk-linked 

securities.



Throughout the report there are statements that risk-linked securities 

developed after significant catastrophe events. While this is true, we 

believe that in order to be more thorough there must be a footnote or 

discussion that property catastrophe events have also led to the 

creation of the Bermuda property reinsurance market. The Bermuda market 

has played a major role in introducing new capacity into the 

marketplace after a major event. This is not only evidenced in the 

market development after Hurricane Andrew, but most recently after the 

terrorist attacks of September 11.



On page 7 in the discussion on the regulatory, accounting, tax and 

investor issues for risk-linked securities we believe it should be 

noted that the Financial Accounting Standards Board is developing new 

more stringent standards requiring consolidation of special purpose 

entities.



* On page 19 in the discussion as to why risk-linked securities are 

conducted offshore it should be noted that another reason is due to 

bankruptcy remoteness.



Thank your for the opportunity to provide comments on the preliminary 

report on risk-linked securities. If you have any questions please 

contact me at 202-638-3690.



Sincerely,



Franklin W. Nutter:

President:

Signed by Franklin W. Nutter:



The following are GAO’s comments on the Reinsurance Association of 

America’s letter dated September 9, 2002.



GAO Comments:



1. In appendix III of the draft report we had already noted that the 

Florida Hurricane Catastrophe Fund provides reinsurance to supplement 

that available from private sources. We added a footnote on page 15 to 

note that reinsurance is also available from private sources for 

property and casualty insurance companies doing business in Florida.



2. We agree and have added a footnote on page 29 to state that no 

catastrophe bond contracts have been triggered by an actual event.



3. We agree and have added a footnote on page 14 on the creation of the 

Bermuda reinsurance market and its role in introducing new capacity 

into the marketplace after a major event.



4. This issue is covered on pages 24 through 26.



5. Bankruptcy remoteness is among the reasons that the special purpose 

entities are established, whether domestically or offshore.



[End of section]



Appendix VII: Comments from the Bond Market Association:



40 Broad Street:



New York, NY 10004-2373 Telephone 212.440.9400 Fax 212.440.5260 

www.bondmarkets.com:



1399 New York Avenue, NW Washington, DC 20005-4711 Telephone 

202.434.8400 Fax 202.434.8456:



St. Michael’s House 1 George Yard London EC3V 9DH Telephone 44.20.77 43 

93 00 Fax 44.20.77 43 93 01:



September 10, 2002:



Ms. Davi M. D’Agostino:



Director, Financial Markets and Community Investment United States 

General Accounting Office:



Washington, D.C. 20548:



Re:



Comments on Draft GAO Report, “Catastrophe Insurance Risks: The Role of 

Risk-Linked Securities and Factors Affecting Their Use” (GAO-02-941):



Dear Ms. D’Agostino:



The Bond Market Association (the “Association”)’ is pleased to respond 

to GAO’s request for comments on the above-referenced draft report (the 

“Report”).



Overall, we believe that the Report is an accurate, well-researched and 

well-written document. As such, we think it will be helpful in 

facilitating a broader understanding of the purposes and benefits of 

risk-linked securities (“RLS”), and certain key business, economic, 

regulatory and other factors that may affect the viability of this 

innovative tool for the management and transfer of catastrophic 

insurance risk.



We have divided our comments on the Report into two principal sections. 

The first section of this letter offers broader, general comments and 

observations that relate to several important policy issues raised in 

the Report. The second section provides input on a number of specific, 

technical issues throughout the document. Our general and specific 

comments follow.



I. Broader/General Comments:



A. The Role of RLS as a Private Capital Market Alternative to Potential 

Governmental Assumption of Insurance Risk:



The Report correctly notes that the nation’s exposure to higher 

property and casualty losses increases pressure within the private and 

public sector alike to assume ever-larger liabilities for losses 

associated with natural catastrophes. This observation is particularly 

relevant for state and federal governments, who are sometimes viewed as 

“insurers of last resort.”3 RLS constitute an important, supplemental 

tool for risk management and risk transfer. The emergence of RLS has 

created additional capacity, and new mechanisms, 

for the private sector assumption and distribution of catastrophic risk 

beyond that which has historically been available via the traditional 

insurance and reinsurance markets. The fully collateralized structure 
of 

RLS provides a mechanism to significantly mitigate the risk of 
uncollectible 

reinsurance following a major catastrophic event. As such, the expanded 
usage

and application of RLS can relieve pressures that governments may 
otherwise 

face to bear these risks directly. We believe that this potential 
“replacement” 

effect is significant in its own right. It is especially relevant, 
however 

when considering various policy issues and potential trade-offs 
associated 

with efforts to facilitate growth of the RLS market:



B. Motivations for Off-Shore RLS Issuance and the Facilitation of On-

Shore Issuance Vehicles:



The Report states in several places that RLS issuance vehicles are 

usually established offshore to take advantage of lower minimum 

required levels of capital, favorable tax treatment, and a generally 

reduced level of regulatory scrutiny. We believe that the Report should 

clarify this statement in several respects, as well as the related 

motivation to establish on-shore RLS issuance vehicles.



The principal reason that RLS vehicles are organized offshore is to 

avoid entity-level taxation of those vehicles-not, as the Report 

appears to suggest, to avoid regulatory scrutiny by U.S. authorities. 

The Report correctly notes that in certain respects the status of RLS 

issuance vehicles for U.S. federal income tax purposes is uncertain, 

and that this uncertainty risks the vehicle being subjected to entity-

level taxation. This outcome would substantially impair the economic 

rationale for most, if not all RLS issuance, and is the principal 

reason that such vehicles are organized and conduct most of their 

activities outside of the U.S. It is true that in other respects, the 

laws and regulations of the principal offshore jurisdictions may offer 

a more favorable regulatory environment for RLS issuance than is the 

case in the U.S. Again, however, neither regulatory “arbitrage” nor the 

avoidance of scrutiny by U.S. regulatory authorities is a primary 

factor underlying the prevalence of offshore RLS issuance vehicles.



The Report notes that pass-through treatment of RLS has been proposed. 

Although the details require further development and refinement, the 

Association believes that such an initiative represents a desirable 

policy action and should be pursued. As suggested above, establishing 

pass-through tax treatment (ideally, by establishing special tax rules 

governing the structure and permitted activities of RLS issuance 

vehicles, along the lines of the REMIC and FASIT legislative 

initiatives described in the Report) would facilitate the creation of 

onshore RLS vehicles. This would, also as noted in the Report, lessen 
transaction 

costs associated exclusively with current requirements to conduct most 
activities 

relating to the creation and operation of the issuing vehicle in a non-
U.S. 

jurisdiction. Reducing these transaction costs would render the 
execution of 

RLS transactions even more efficient.



The primary concerns cited in the report in connection with the 

allowance of pass-through tax treatment-potential tax revenue losses to 

the U.S. Treasury, and unfair regulatory and tax advantages that are 

not afforded to existing U.S.-licensed and taxed reinsurance companies-

are not relevant to RLS structures, in the Association’s view.



With respect to possible tax revenue losses, the Report notes that such 

losses could result to the extent that domestic issuance vehicles 

gained business at the expense of taxable entities, such as reinsurers. 

The fact that a large percentage of entities that currently provide 

reinsurance coverage are based outside of the U.S.-including all new 

reinsurance companies established in the wake of September 11, 2001-

suggests that any such tax impact would not be dramatic. In addition, 

the issuance vehicles for RLS are themselves tax neutral in the sense 

that they generate no economic gain or loss. All premium received and 

investment income generated by these vehicles are paid out to 

investors, after expenses of administration of the vehicles, in the 

form of coupon on the RLS issued by the vehicles. Moreover, any 

potential loss of U.S. tax revenue must be weighed against the policy 

benefits associated with creating additional private sector capacity to 

absorb and distribute insurance risk. As noted in the Report and in our 

comments, this outcome would be facilitated by establishing pass-

through tax treatment for RLS, and with it, the use of on-shore RLS 

issuance vehicles.



With respect to possible unfair regulatory advantages, the Report notes 

opposition from the Reinsurance Association of America to the creation 

of onshore RLS vehicles. This opposition includes the concern that such 

vehicles act as reinsurers without being subject to insurance 

regulation, thus endangering solvency regulation. We believe that any 

such solvency-related concerns are misplaced, given that RLS are fully 

collateralized and entail no credit risk for their insurance company 

sponsors.



C. Proposed Accounting Treatment Affecting RLS:



In the section of the Report beginning on page 28 entitled, “A Proposed 

Rule on Equity Requirements Could Affect Catastrophe Bonds,” 

prospective changes to U.S. generally accepted accounting principles 

(“GAAP”) are discussed. Specifically, this section of the Report 

describes proposals under consideration by the Financial Accounting 

Standards Board (“FASB”) relating to consolidation of special-purpose 

entities, or SPEs (which would generally encompass RLS issuance 
vehicles), 

and related third-party equity requirements to avoid consolidation of 
the 

RLS vehicle by its primary beneficiary.



Throughout the spring and early summer of 2002, FASB engaged in 

extensive deliberations on the nature of proposed revisions to its 

existing SPE consolidation criteria. During these deliberations, a 

number of different conceptual models and specific consolidation 

criteria were discussed, amended and refined. This led to FASB’s 

issuance on June 28, 2002, of a definitive exposure draft setting forth 

proposed changes to existing GAAP standards governing SPE 

consolidation.



The description of FASB’s SPE consolidation proposals contained in the 

Report appears to relate to criteria that had been under discussion by 

FASB at various times during the above deliberations, but which were 

amended in several important respects in the final exposure draft. In 

particular, the final exposure draft provides several alternative means 

of evaluating SPEs for consolidation. One such alternative does not 

require satisfaction of any specific outside equity threshold for 

transaction structures where the risks and rewards of SPE assets have 

been transferred to independent third parties (the “variable interests” 

approach, as further described in the exposure draft).



In general, the Association believes that it may be possible to apply 

FASB’s proposed variable interests approach to SPEs used in RLS 

transactions in a manner that eliminates any requirement to satisfy a 

particular outside equity threshold.	Under the variable interests 

analysis, the return to investors would appear to constitute the true 

variability in the economics of the transaction structure for RLS.



To the extent that any single investor holds a majority of these 

variable interests (i.e., the securities issued by the SPE), then 

consolidation by that investor would be appropriate, as it could be 

viewed as possessing a controlling financial interest in the SPE. 

Absent such a majority holding by any single entity or other 

demonstrable evidence of a de facto controlling financial interest in 

an SPE, the Association believes that it would be inappropriate for any 

entity to reflect the entirety of the SPE’s assets and liabilities on 

its balance sheet, as it neither has access to those assets nor 

exposure to those liabilities. In these circumstances, consolidation 

would be inconsistent with the underlying economics of the transaction, 

and would produce misleading financial statements. Moreover, the risk 

of such consolidation would likely operate as a substantial 

disincentive to future RLS issuance, as transaction sponsors, investors 

and other entities would be unwilling to assume the risk of an 

inappropriate “ballooning” of their balance sheets.



Unfortunately, under FASB’s proposal as drafted, no special 

circumstances or demonstrable de facto controlling financial interest 

is necessary to require consolidation without a majority of variable 

interests. The absolute rule (not even a rebuttable presumption) is 

that if no party holds a majority of an SPE’s variable interests, then 

any party that has a significant variable interest that is 

significantly larger than any other party’s is required to consolidate. 

We believe that this new paradigm will result in numerous false 
positives, 

requiring consolidation by enterprises that in fact do not exercise a 

controlling financial interest. We strongly oppose this result and, 

consequently, also oppose the new paradigm.



The comment period for FASB’s exposure draft expired on August 30, 

2002, with final guidance expected to be issued by year-end. The 

Association and its adjunct American Securitization Forum provided 

extensive comments to FASB in connection with these proposals. These 

comments focused primarily on the impact that these proposals would 

have on various categories of “risk-dispersing” SPEs, such as those 

employed in RLS transactions, for which consolidation should generally 

not be required. A complete copy of those comments may be obtained from 

the Association’s Internet website, at the address contained in 

footnote 1 of this letter.



D. Investor Participation in the RLS Market:



The Report notes that RLS do not have broad investor participation, and 

that these instruments have not attracted a wide range of investors 

beyond larger institutions. Several reasons are provided to explain 

this phenomenon, including that “the risks of these securities are 

difficult to assess” as well as “concerns about the limited liquidity 

and track record of catastrophe bonds.”:



The above comments suggest that limited investor involvement to date in 

the RLS sector is due principally to the complexity and lack of a 

sufficient performance history of RLS, which has impaired their broader 

liquidity and marketability. We believe that this represents an 

incomplete and somewhat inaccurate portrayal of the dynamics of 

investor participation in the RLS sector.



Because of suitability concerns, RLS are not sold directly to 

individual investors. However, we believe that they are entirely 

appropriate for mutual funds in which individual investors hold shares. 

In fact, several major fixed income funds have purchased RLS as part of 

their overall portfolios. As institutional investors, mutual fund 

managers are well-equipped to perform the necessary analysis of 

relative value and risk associated with RLS. From the perspective of a 

mutual fund investor, the complexity and risk associated with RLS are 

no more pronounced than for other investment products that are widely 

held by mutual funds, and that require a comparable level of 

sophistication to comprehend basic investment risk (e.g., mortgage-

backed securities, where valuation analysis depends largely upon 

assessing the optionality associated with principal prepayments by 

underlying borrowers). In addition, the low correlation of RLS with 

other asset classes can enhance a fund’s overall risk-adjusted return.



Moreover, it is not clear whether the lack of broader investor interest 

in RLS results from the absence of understanding of or demand for these 

instruments per se, or whether it is more simply a function of 
relatively 

limited issuance (which in turn is driven principally by reinsurance 
pricing 

levels, as discussed below). The supply of RLS brought to market to 
date has 

been readily absorbed by investors. There is no compelling basis to 
conclude 

that additional supply would not be similarly absorbed, possibly by a 
wider 

range of investors as liquidity concerns diminish. In fact, the 
universe of 

RLS investors expanded after September 11, 2001. This universe now 
includes 

several additional funds created specifically to invest in RLS. The 

additional commitment of funds to this asset class has contributed to a 

decline in the level of spreads in both the new issuance and secondary 

markets. This level is now below the level of spreads prior to 

September 11.



E. Importance and Global Interdependence of Reinsurance Pricing for RLS 

Market:



In several sections of the Report-principally, under the headings 

“Insurers are Subject to Reinsurance Price and Availability Swings” on 

page 16, and “Catastrophic Risk Can be Transferred to Capital Markets” 

on page 18, several references are made to the way in which reinsurance 

pricing affects the relative attractiveness of RLS to potential 

transaction sponsors. The Association agrees that reinsurance pricing 

is one of several important factors that drive RLS issuance. 

Traditional catastrophic reinsurance, RLS issuance and equity capital 

issuance are complements to each other, because they all address an 

insurer’s need to maintain sufficient capital to meet claims made 

following a catastrophic event. If the cost of either traditional 

reinsurance or equity capital increases, RLS becomes more attractive. 

Perhaps more importantly for the growth of the RLS market, as the cost 

of RLS declines, issuance rises because RLS becomes a cheaper source of 

capital.



Figure 4 on page 17 of the Report, which sets forth an index for U.S 

reinsurance pricing between 1989 and 2001,9 shows an uptick in the 

price index in 1999, after a long downward trend following the 

Northridge earthquake. The reason for this reversal is the near record 

worldwide-insured losses in 1999 of approximately $28 billion, slightly 

under 1992 losses of approximately $29 billion. The primary causes of 

1999 insurance losses were two back-to-back winter storms in Europe, 

Lothar and Martin, that caused total insured losses of approximately $7 

billion. While not as dramatic as the insured losses caused by 

Hurricane Andrew and the Northridge earthquake, these winter storm 

events, together with a number of smaller losses occasioned by other 

catastrophic events that year (including Hurricane Floyd), caused near-

record insurance losses and were sufficient to reverse the downward 

price trend in the reinsurance market. The central conclusion to be 

drawn from these data, we believe, is the interdependence of 

reinsurance market pricing (and thus the relative attractiveness of 

RLS) and, more specifically, the effect that non-U.S. catastrophic 

events can have on U.S. reinsurance pricing.



On page 19, the Report states that “Demand by insurance company 

sponsors [to issue RLS] will depend, in part, on basis risk faced and 

the ability of sponsors to hedge this basis risk.” This statement is 

correct, but could imply that a sponsor’s ability to hedge basis risk 

constitutes the principal motivation for RLS issuance. As suggested 

above, while the ability to hedge basis risk is a factor that insurance 

company sponsors need to consider when evaluating risk coverage 

options, reinsurance pricing is a critical driver of RLS issuance. to:



II. Specific/Technical Comments:



For ease of reference, the following technical comments are keyed to 

specific page numbers of the Report:



Page 6: The first full sentence of this page states that 

“...catastrophe bonds involve higher transaction costs than traditional 

reinsurance...” This is not always the case, as the efficiencies 

associated with larger volume, multi-year RLS transactions can render 

these costs comparable.



Page	Page 21: These sections of the Report include statements to the 

effect that all catastrophe bonds (RLS) carry a non-investment grade 

credit rating. In fact, a small but growing percentage of newly-issued 

RLS has been investment grade. TTThe emergence of dedicated RLS mutual 

funds seeking investment grade products has contributed to this trend.



Page 19: Data is cited at the bottom of the page stating that between 

1996 and August 2001, approximately $11-13 billion of RLS were issued 

worldwide. These data include life and synthetic credit 

securitizations; since the focus of the Report is on catastrophe bonds, 

it may be appropriate to state that approximately $6-7 billion in 

catastrophe-related RLS were issued during this time period.



Page I9: At the top of this page, a number of investor preferences for 

nonindemnity-based insurance coverage are noted. We believe that it 

would be useful to point out that there are often compelling reasons 

for RLS transaction sponsors to utilize nonindemnity-based structures. 

Among other reasons, such structures may more effectively shield the 

confidentiality of the sponsor’s underwriting criteria; may provide for 

more streamlined deal structuring and execution; and facilitate a more 

rapid payout in response to triggering events.



Page 21: This section of the Report briefly discusses and contrasts 

catastrophe bonds with catastrophe options. Several relative advantages 

of catastrophe bonds are noted, including customizable offerings and 

multi-year pricing. We believe that the more important advantage that 

catastrophe bonds confer in comparison with catastrophe options is that 

the former, unlike the latter, are fully collateralized and carry no 
credit 

risk on the part of the sponsor. We believe that this distinction is 

the principal reason underlying the relatively limited historical 

appeal of catastrophe options in distributing insurance risk via the 

capital markets.



Page 24: The carry-over paragraph on this page should clarify that both 

traditional reinsurers and state insurance departments rely on 

catastrophe modeling firms. The third sentence in this paragraph should 

state that rating agencies rate the bonds according to frequency of 

loss as well as expected loss.



Page 43: The discussion of the California Earthquake Authority 

Financial Structure should be updated. We understand that this 

structure was not executed, based principally on concerns about the 

appearance created by the use of an offshore issuance vehicle.



III. Conclusion:



Again, the Association greatly appreciates the opportunity to comment 

on the Report. We commend the GAO for producing a useful and 

illuminating document, which should inform future legislative, 

regulatory and broader policy discussions concerning the innovative 

risk-linked securities market.



We would be pleased to assist you in any further research you may 

conduct in connection with this topic. Should you have questions or 

desire additional information concerning any of the matters addressed 

in the foregoing comments, please do not hesitate to contact either of 

the undersigned at (212) 440-9400.



Sincerely,



George Miller:

Senior Vice President and Deputy General Counsel The Bond Market 

Association:



Signed by George Miller:



Michel de Konkoly Thege Vice President and Associate General Counsel 

The Bond Market Association:



Signed by Michel de Konkoly:



The following are GAO’s comments on the Bond Market Association’s 

letter dated September 10, 2002.



GAO Comments:



1. Our report does not assign relative weights to the factors that lead 

to risk-linked securities being established offshore. We have added a 

footnote on page 21 to indicate that BMA believes that the principal 

reason risk-linked securities are organized offshore is to avoid 

taxation.



2. In contrast to BMA’s view, we state that a primary reason for 

limited investor participation in risk-linked securities is that the 

risks of these securities are difficult to assess. Also, the risks of 

risk-linked securities and mortgage-backed securities are assessed 

differently. For example, the risk of loss from a natural catastrophic 

event, such as an earthquake in a specified geographic area over a 

specified time period, is often based on events that will only happen 

once over a long-time horizon and in some cases as long as an 100-year 

period. Therefore, investors must rely heavily on complex scientific 

analysis of the likelihood of the event, rather than statistical 

modeling. In contrast, the risk of loss from events such as defaults on 

home mortgage payments by borrowers occurs frequently, and extensive 

statistics are available to assess such risks.



3. We agree and our draft report discussed the relationship between 

reinsurance prices and interest in risk-linked securities as 

alternatives to traditional reinsurance. We also agree and have added a 

footnote on page 15 to indicate that U.S. reinsurance prices are 

influenced by catastrophic events outside of the United States.



4. We did not order by relative importance the reasons insurance 

companies stated for their interest in risk-linked securities.



5. We have changed the text on page 4 by inserting the word 

“generally.”:



6. In our analysis, we relied on information provided by rating 

agencies for our discussion of credit ratings. Our draft report 

indicated that some catastrophe bonds contain tranches that have 

received investment-grade ratings. We added language to a footnote on 

page 18 to note BMA’s statement that some newly issued, risk-linked 

securities have been investment grade.



7. We have added language to a footnote on page 17 to note BMA’s 

statement that about $6 to $7 billion in catastrophe related, risk-

linked securities were issued during this time period.



8. We have added a footnote on page 17 that states BMA’s view that 

there are often compelling reasons for sponsors of risk-linked 

securities to use nonindemnity-based structures.



9. On the basis of information we obtained from the CBOT and market 

participants, our draft report stated that the options were to have 

offered minimal credit risk because the Board of Trade Clearing 

Corporation guaranteed the transactions. There were several reasons why 

catastrophe options had limited appeal, including daily marking to 

market, difficulties in accounting for options trading in insurance 

company accounting, basis risk, the unfamiliarity of locals with the 

product, lack of insurance company membership at CBOT, lack of 

investment by CBOT, the structure of the contract, lack of liquidity, 

and other factors.



10. We have added language to a footnote on page 21 saying that bonds 

are rated according to frequency of loss as well as expected loss. As 

stated in our draft report, rating agencies provide bond ratings on the 

basis of their assessment of loss probabilities and financial severity. 

We use the term expected loss to mean the outcome from analyzing 

frequency of loss and expected loss when it occurs.



11. We added language in appendix III that the Governing Board of the 

California Earthquake Authority has not authorized use of catastrophe 

bonds because of concerns about the appearance of being involved in 

offshore transactions in tax havens.



FOOTNOTES



[1] In this report, we use the term “catastrophe risk” to mean risk 

from natural catastrophes. For a discussion of insurance issues 

surrounding terrorism, see U.S. General Accounting Office, Terrorism 

Insurance: Alternative Programs for Protecting Insurance Consumers, 

GAO-02-175T (Washington, D.C.: Oct. 24, 2001).



[2] In this report, we refer to capital market instruments that cover 

insured catastrophe risks as “risk-linked securities,” even though some 

of these instruments are not securities in the formal sense.



[3] NAIC is a voluntary organization of the chief insurance regulatory 

officials of the 50 states, the District of Columbia, and four U.S. 

territories.



[4] RAA is a national trade association representing property and 

casualty organizations that specialize in reinsurance.



[5] BMA represents securities firms and banks that underwrite, 

distribute, and trade fixed income securities, both domestically and 

internationally.



[6] Reinsurance is insurance for insurers that enables the insurer to 

transfer some of its risk to another insurer, called a reinsurer.



[7] Indemnity coverage specifies a simple relationship that is based on 

the insurer’s actual incurred claims. For example, an insurer could 

contract with a reinsurer to cover half of all claims--up to $100 

million in claims--from a hurricane over a specified time period in a 

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. In contrast, nonindemnity coverage specifies a 

specific event that triggers payment and payment formulas that are not 

directly related to the insurer’s actual incurred claims.



[8] Moment magnitude, a measure of earthquake intensity similar to the 

more commonly known Richter scale, has been used in catastrophe bonds 

securitizing earthquake risk.



[9] See appendix II for a discussion of catastrophe options.



[10] To illustrate the size of U.S. capital markets, we used Federal 

Reserve Board Flow of Funds data for the quarter ended March 31, 2002. 

Our calculation indicated that the size of the U.S. capital markets was 

about $31 trillion. We included outstanding levels of U.S. Treasury 

securities (excluding savings bonds), agency securities, municipal 

securities, corporate and foreign bonds, and corporate equities.



[11] Basis risk is the possibility that the value of a hedge will not 

move precisely with the value of the item being hedged. For catastrophe 

risk, basis risk is the risk that, for example, the value of a 

catastrophe option will not move precisely with the insurer’s 

catastrophe loss experience.



[12] Property-casualty insurance protects individuals and commercial 

businesses against the risks associated with the loss of property from 

fire and other hazards, or loss deriving from liability for personal 

injury and damage to the property of others. Property-casualty 

insurance includes damage to real estate, automobiles, glass, and other 

items.



[13] Retrocessional coverage is reinsurance obtained by a reinsurance 

company when it transfers risk to another reinsurer.



[14] According to RAA, in 2000 U.S. insurance companies paid 53.4 

percent of their premiums to U.S. reinsurance companies and alien 

reinsurers received 46.6 percent of reinsurance premiums. Premiums paid 

by U.S. insurance companies to offshore companies were most likely to 

go to reinsurance companies domiciled in Bermuda, the Cayman Islands, 

the United Kingdom, Germany, and Switzerland.



[15] RAA commented that property catastrophe events have led to the 

creation of the Bermuda property reinsurance market that has played a 

major role in introducing new capacity into the marketplace after a 

major event.



[16] RAA commented that the private reinsurance market provides 

reinsurance to many primary companies in Florida.



[17] Froot, Kenneth A. and Paul G.J. O’Connell, “The Pricing of U.S. 

Catastrophe Reinsurance,” in Kenneth A. Froot, ed., The Financing of 

Catastrophe Risk, National Bureau of Economic Research Project Report, 

(Chicago: Univ. of Chicago Press, 1999). We did not verify the 

reliability of the data used nor the authors’ methodology. The authors 

relied on Guy Carpenter & Company pricing data for the years 1970 

through 1994.



[18] BMA commented that reinsurance prices in the United States are 

influenced by events in other parts of the world.



[19] BMA commented that there are often compelling reasons for sponsors 

of risk-linked securities to use nonindemnity-based structures, 

including that they (1) more effectively shield the confidentiality of 

the sponsor’s underwriting criteria, (2) may provide for more 

streamlined deal structuring and deal execution, and (3) may facilitate 

a more rapid payout in response to triggering events.



[20] A hedge is a strategy used to offset risk. For example, investors 

can hedge against inflation by purchasing assets that they believe will 

rise in value faster than inflation.



[21] Estimates of the number and dollar amount of risk-linked 

securities vary. These estimates are published by various industry 

sources, such as investment banks, insurance brokers, and rating 

agencies. The estimates differ because some of these data, such as 

those for privately placed catastrophe bonds, are not generally 

available and because the sources differ in how they define the 

instruments and transactions included as risk-linked securities. For 

example, an instrument called contingent equity may be included by some 

sources and not by other sources. BMA commented that about $6 to $7 

billion in catastrophe-related, risk-linked securities were issued 

during this time period.



[22] For a description of other capital market instruments used to 

manage catastrophe risk, see U.S. General Accounting Office, Insurers’ 

Ability to Pay Catastrophe Claims, GAO/GGD-00-57R (Washington, D.C.: 

Feb. 8, 2000).



[23] Some catastrophe bonds contain tranches that have received 

investment grade ratings. BMA commented that a small but growing 

percentage of newly issued, risk-linked securities have been investment 

grade.



[24] A private placement is a sale of a security to an institutional 

investor that does not have to be registered with SEC. Here, an 

institutional investor is defined by Rule 144A. This SEC rule provides 

an exemption for limited secondary market trading of privately placed 

securities.



[25] A noninsurance business that has catastrophe exposure can also 

sponsor catastrophe bonds through a similar entity, a special purpose 

vehicle.



[26] According to Federal Reserve Board Flow of Funds data, at the end 

of 2001, over $1.8 trillion of loans outstanding were financed by 

asset-backed securities issued by such SPEs. The underlying loans were 

made to consumers, students, businesses, and homeowners exclusive of 

mortgage-backed securities guaranteed by government agencies, 

government corporations, and government-sponsored enterprises.



[27] The fixed-rate interest payments are swapped for floating-rate 

interest payments from a highly rated swap counterparty.



[28] LIBOR is the rate that the most creditworthy international banks 

charge each other for large loans. The SPRVs enter into interest rate 

swaps to exchange fixed-rate interest payments earned by funds invested 

in conservative instruments, such as U.S. government Treasury 

securities, for floating-rate interest payments, such as LIBOR.



[29] BMA commented that the principal reason risk-linked securities are 

organized offshore is to avoid entity-level taxation of those vehicles.



[30] Tranches are classes of a security that have different 

characteristics of risks and returns. The issuer of a security can 

split the security’s scheduled cash flows into separate classes known 

as tranches. Often, one tranche of an issue has greater exposure to 

risk than another tranche, and the different rates that investors can 

earn on these different tranches reflect their different risks.



[31] There are some differences among rating agencies in their 

methodology for assigning ratings for some of the catastrophe risk 

structures. BMA commented that bonds are rated according to frequency 

of loss as well as expected loss.



[32] Some catastrophe bonds contain tranches that have received 

investment-grade ratings and tranches with a noninvestment-grade 

rating.



[33] While such requirements have been promulgated, many insurance 

regulators hold the view that it is not within their oversight 

responsibility to police individual reinsurance business transactions 

between insurance companies, as such transactions are between 

sophisticated parties. See U.S. General Accounting Office, Summary of 

Reinsurance Activities and Rating Actions Tied to Selected Insurers 

Involved in the Failed “Unicover” Venture, GAO-01-977R (Washington, 

D.C.: Aug. 24, 2002).



[34] A white paper on the subject written by members of NAIC’s 

securitization subcommittee specifically addressed treatment of 

nonindemnity-based insurance derivatives, such as catastrophe options. 

However, NAIC is addressing this issue as it relates more broadly to 

risk-linked securities.



[35] See Emerging Issues Task Force (EITF), Topic Number D-14, 

Transactions Involving Special Purpose Entities and other related EITF 

issues.



[36] The status of the SPRV for U.S. federal income tax purposes is 

dependent upon a number of factual issues. If the SPRV were determined 

to be engaged in a U.S. trade or business, it could be subject to U.S. 

income tax at a rate of up to 35 percent, and to a 30 percent branch 

profits tax on its income, resulting in an effective U.S. federal tax 

rate of up to 54.5 percent. This tax rate would substantially reduce 

the return to investors. The SPRVs are generally characterized as 

passive foreign investment companies and treat the bonds that they 

issue as equity for federal income tax purposes. See Bertil Lundqvist, 

Securitization of Risk of Loss from Future Events, 829 PLI/Comm 875, 

2001.



[37] The principal types of mortgage or other asset-backed securities 

currently available are pass-through certificates, pay-through bonds, 

equity interests in domestic issuers of pay-through bonds, pass-through 

debt certificates, and Real Estate Mortgage Investment Conduits and 

Financial Asset Securitization Investment Trusts interests. Offshore 

corporations also are used to issue some asset-backed securities. See 

David Nirenberg, Tax Developments in Securitization, 829 PLI/Comm 411, 

2001.



[38] Several concerns with the use of pass-through certificates and 

pay-through bonds arose, including the inability of a grantor trust to 

issue pass-through certificates that are divided into multiple classes 

with staggered maturities. To address some of these concerns, the Tax 

Reform Act of 1986 enacted the REMIC rules.



[39] 26 U.S.C. §4371.



[40] 26 U.S.C. §845.



[41] The September 9, 2002, comment letter from RAA notes that no 

catastrophe bond contracts have been triggered by catastrophic events.



[42] In one case, companies experienced an estimated $1 to $2 billion 

in losses in reinsuring the occupational accident portion of workers’ 

compensation insurance policies. See GAO-01-977T.



[43] The payouts varied with industry catastrophe losses, limited to 

certain maximums.



[44] Adverse selection is the tendency of persons with a higher-than-

average chance of loss to seek reinsurance at average rates, which, if 

not controlled by underwriting, results in higher-than-expected loss 

levels.



[45] PCS, a unit of the Insurance Services Office, provides estimates 

of insured losses related to catastrophes incurred by the insurance 

industry.



[46] The indexes track PCS’s estimates of the insurance industry’s 

aggregate direct property losses as a result of catastrophes.



[47] The FWUA was created in the 1970s to provide wind coverage to 

property owners who cannot obtain hurricane and windstorm coverage from 

private insurance companies. It has 430,000 policies with an exposure 

exceeding $90 billion.



[48] Whereas it appears that the ceding company increases its 

policyholders’ surplus, this transaction does not include the effects 

of other normal business transactions that will cause the surplus to 

decrease.



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