oversight

Catastrophe Insurance Risks: Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk

Published by the Government Accountability Office on 2003-09-24.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to Congressional Requesters




September 2003
                 CATASTROPHE
                 INSURANCE RISKS
                 Status of Efforts to
                 Securitize Natural
                 Catastrophe and
                 Terrorism Risk




GAO-03-1033

                 a

                                                September 2003


                                                CATASTROPHE INSURANCE RISKS

                                                Status of Efforts to Securitize Natural
Highlights of GAO-03-1033, a report to the      Catastrophe and Terrorism Risk
Chairman, House Committee on Financial
Services, the Chairman, Subcommittee on
Capital Markets, Insurance, and
Government Sponsored Enterprises, and
House Members




In addition to potentially costing              The market for catastrophe bonds, as discussed in our 2002 report, has
hundreds or thousands of lives, a               transferred a small portion of natural catastrophe risk to the capital markets.
natural or terrorist catastrophe in             From 1997 through 2002, a private firm has estimated that a total of 46
the United States could place                   catastrophe bonds were issued or about 8 per year. Another firm estimated
enormous financial demands on the               that the nearly $3 billion in catastrophe bonds outstanding for 2002 (see
insurance industry, businesses, and
taxpayers. Given these financial                figure) represented 2.5 to 3.0 percent of the worldwide catastrophe
demands, interest has been raised               reinsurance market. Some insurance and reinsurance companies issue
in bonds that are sold in the capital           catastrophe bonds because they allow for risk transfer and may lower the
markets and thereby diversify                   costs of insuring against the most severe catastrophes. However, other
catastrophe funding sources. GAO                insurers do not issue catastrophe bonds because their costs are higher than
was asked to update a 2002 report               transferring risks to other insurers. Although some investors see catastrophe
on “catastrophe bonds” and assess               bonds as an attractive investment because they offer high returns and
(1) their progress in transferring              portfolio diversification, others believe that the bonds’ risks are too high or
natural catastrophe risks to the                too costly to assess. To date, no catastrophe bonds related to terrorism have
capital markets, (2) factors that               been issued covering potential targets in the United States, and the general
may affect the issuance of                      consensus of most experts GAO contacted is that issuing such securities
catastrophe bonds by insurance
companies, (3) factors that may                 would not be practical at this time due in part to the challenges of predicting
affect investment in catastrophe                the frequency and severity of terrorist attacks.
bonds, and (4) the potential for and
challenges associated with                      Catastrophe Bond Issuance and Amount Outstanding (1997-2002)
securitizing terrorism-related
financial risks.                                Dollars in millions
                                                3,000                                                              2,943
GAO does not make any                                                                                              1,953

recommendations in this report.                 2,500                                                     2,421
                                                                                                          1,454

                                                2,000                                         1,926
                                                                                               804

                                                1,500
                                                                                  1,130
                                                                      1,031
                                                1,000      783                     305        1,122
                                                                       306                                 967     990
                                                            69
                                                                                   825
                                                           714         725
                                                  500


                                                    0
                                                          1997        1998        1999        2000        2001     2002
                                                        Year


                                                                  Issued                    Outstanding from prior years

                                                Source: GAO, based on data provided by Swiss Re Capital Markets.



                                                Note: Totals shown in bold above each bar represent the amount outstanding at end of year.
www.gao.gov/cgi-bin/getrpt?GAO-03-1033.

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and methodology, click on the link above.
For more information, contact Davi M.
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dagostinod@gao.gov.
Contents




Letter
                                                                                                  1
                              Results in Brief                                                           4
                              Background                                                                 7
                              Catastrophe Bond Issuance Has Been Limited                                14
                              Catastrophe Bonds Benefit Some Insurers, but Others Believe That
                                the Bonds’ Costs Are Too High                                           18
                              Institutional Investors Provided Mixed Views on Catastrophe
                                Bonds                                                                   27
                              Securitizing Terrorism Risk Poses Significant Challenges                  30
                              Observations                                                              34
                              Agency Comments and Our Evaluation                                        35


Appendixes
               Appendix I:    Objectives, Scope, and Methodology                                        38
               Appendix II:   Statutory Accounting Balance Sheet Implications of
                              Reinsurance Contracts                                                     40
              Appendix III:   FASB Interpretation No. 46, Consolidation of Variable
                              Interest Entities                                                         43
                              What is a VIE?                                                            43
              Appendix IV:    Texas Windstorm Insurance Association                                     45
               Appendix V:    Comments from the National Association of Insurance
                              Commissioners                                                             47
                              GAO Comments                                                              50
              Appendix VI:    Comments from the Bond Market Association                                 51
                              GAO Comments                                                              59
             Appendix VII:    Comments from the Reinsurance Association of America                      61
                              GAO Comments                                                              68
             Appendix VIII:   GAO Acknowledgments and Staff Contacts                                    70
                              GAO Contacts                                                              70
                              Acknowledgments                                                           70


Related GAO Products                                                                                    71



Figures                       Figure 1: Traditional Insurance, Reinsurance, and Retrocessional
                                        Transactions                                                     8
                              Figure 2: Reinsurance Prices in the United States, 1989-2002a             10



                              Page i                                 GAO-03-1033 Catastrophe Bond Follow-up
Contents




Figure 3: Special Purpose Reinsurance Vehicle                                          11
Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002                              15
Figure 5: Catastrophe Bond Issuance and Amount Outstanding
          1997-2002                                                                    16
Figure 6: Type of Catastrophe Bond Issuer 1997-2002                                    17
Figure 7: Residential Reinsurance Issuances                                            18
Figure 8: Effect on Ceding and Reinsurance Companies’ Balance
          Sheets before and after a Reinsurance Transaction                            41
Figure 9: Texas Windstorm Insurance Authority Financing                                46




Abbreviations

BMA          Bond Market Association

CDO          Collateralized Debt Obligation

CEA          California Earthquake Authority

DEP          Direct Earned Premium

FASB         Financial Accounting Standards Board

FHCF         Florida Hurricane Catastrophe Fund

FIFA         Federation Internationale de Football Association 

LIBOR        London Interbank Offered Rate

NAIC         National Association of Insurance Commissioners

RAA          Reinsurance Association of America

S&P          Standard & Poors

SEC          Securities and Exchange Commission

SPE          special purpose entity

SRPV         special purpose reinsurance vehicle

TRIA         Terrorism Risk Insurance Act

TWIA         Texas Windstorm Insurance Association

USAA         United Services Automobile Association

VIE          variable interest entities



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Page ii                                         GAO-03-1033 Catastrophe Bond Follow-up
A

United States General Accounting Office
Washington, D.C. 20548



                                    September 24, 2003


                                    The Honorable Michael G. Oxley 

                                    Chairman, Committee on Financial Services

                                    House of Representatives


                                    The Honorable Richard H. Baker
                                    Chairman, Subcommittee on Capital Markets,
                                     Insurance, and Government Sponsored Enterprises
                                    House of Representatives

                                    The Honorable Steve Israel
                                    The Honorable Brad Sherman
                                    The Honorable Dave Weldon
                                    House of Representatives

                                    In addition to potentially costing hundreds or thousands of lives, a natural
                                    or terrorist catastrophe in the United States could place enormous financial
                                    demands on the insurance industry, businesses, and taxpayers. According
                                    to insurance industry estimates, a major hurricane striking densely
                                    populated regions of the United States could result in losses as high at $110
                                    billion, a major earthquake could cause losses as high as $225 billion, and
                                    both types of events would generate serious financial difficulties for some
                                    insurance companies. Further, the September 11, 2001, terrorist attacks
                                    resulted in an estimated $80 billion in losses—about half of which was
                                    insured----and another large scale attack or series of attacks has the
                                    potential for similar results. With the passage of the Terrorism Risk
                                    Insurance Act of 2002 (TRIA), the federal government assumed potential
                                    liability of $100 billion in terrorism-related losses annually (until the act
                                    expires in 2004, but may be extended through 2005).1

                                    Given the enormous financial losses associated with such catastrophes and
                                    concerns about the capacity of the insurance industry to cover


                                    1
                                     TRIA provides coverage for certified acts of terrorism. The program is triggered when there
                                    has been an act committed on behalf of any foreign person or foreign interest that results in
                                    at least $5 million in insured losses in the United States. In the event of an act of terrorism,
                                    the federal government, insurers, and policyholders share the risk of loss. The federal
                                    government is responsible for paying 90 percent of each insurer's primary property and
                                    casualty losses after an insurer's exposure exceeds 7 percent of its direct earned premium
                                    (DEP) in 2003, 10 percent of its DEP in 2004, or 15 percent of its DEP in 2005. Federal funds
                                    paid out under the program are capped at $100 billion for each program year.




                                    Page 1                                              GAO-03-1033 Catastrophe Bond Follow-up
catastrophes without dramatic increases in premium prices or reductions
in coverage, interest has been generated in transferring some of these risks
to the capital markets, which had a total value of about $29 trillion as of the
end of the first quarter of 2003.2 Since the mid-1990s, some insurance
companies, reinsurance companies, and capital market participants have
developed financial instruments called risk-linked securities that transfer
various insurance-related risks to the capital markets. The largest category
of these instruments are called catastrophe bonds and, due to their size in
the marketplace, are the subject of this report.3 Risk-linked securities---­
such as catastrophe bonds—can offer a relatively high rate of return to
investors who are willing to accept some of the substantial financial risks
associated with such disasters. Last year we reported on the risks of
natural catastrophes; the structure of risk-linked securities—particularly
catastrophe bonds; and regulatory, accounting, tax, and investor factors
potentially affecting the use of such securities.4

Because of your continuing concerns about the potential costs to the
federal government associated with natural and terrorist catastrophes and
interest in diversifying the potential funding sources to cover such risks,
you asked that we update our 2002 report. Specifically, you asked that we
(1) assess the progress of catastrophe bonds in transferring natural
catastrophe risks to the capital markets; (2) assess factors that may affect
the issuance or sponsorship of catastrophe bonds by insurance and
reinsurance companies, including a status report on accounting issues
raised in our previous report; (3) assess factors that may affect investment




2
 This figure represents the value of U.S. Treasury securities, agency securities, municipal
securities, corporate and foreign bonds, and corporate equities as of March 31, 2003. The
source is the Federal Reserve Flow of Funds data.
3
 Catastrophe bonds are an example of a class of securities called risk-linked securities,
which include quota share transactions, life insurance securities, catastrophe options, and
other insurance related financial instruments. This report focuses on catastrophe bonds,
which are privately placed securities sold to qualified institutional investors as defined
under Securities and Exchange Commission Rule 144A. In general, a qualified institutional
investor under Rule 144A owns and invests on a discretionary basis at least $100 million in
securities of issuers that are not affiliated with the investor.
4
 See U.S. General Accounting Office, Catastrophe Insurance Risks: The Role of Risk-
Linked Securities and Factors Affecting Their Use, GAO-02-941 (Washington, D.C.: Sept.
24, 2002) and U.S. General Accounting Office, Catastrophe Insurance Risks: The Role of
Risk-Linked Securities, GAO-03-195T (Washington, D.C.: Oct. 8, 2002). These products
focused primarily on catastrophe bonds but also mentioned other risk-linked securities.




Page 2                                             GAO-03-1033 Catastrophe Bond Follow-up
in catastrophe bonds, and (4) analyze the potential for and challenges
associated with securitizing terrorism-related financial risks.5

During our follow-up work, we contacted representatives from primary
insurance companies and reinsurance companies, investment banks that
underwrite catastrophe bonds, rating agencies, hedge funds that purchase
catastrophe bonds, large mutual fund companies, accounting firms, firms
that model natural catastrophe and terrorism risk, a state insurance
regulator representing the National Association of Insurance
Commissioners (NAIC), and state natural catastrophe authorities in Texas
and California.6 We obtained data on the financial risks associated with
natural catastrophes and terrorism as well as the issuance of catastrophe
bonds from 1997 to 2002. We did not test the reliability of data we obtained
from the private sector. We asked officials whom we contacted to provide
their views on the development and potential of the market for catastrophe
bonds. We conducted our work between March and August 2003 in New
York, Massachusetts, Ohio, Illinois, Pennsylvania, Texas, and Washington,
D.C. A more extensive discussion of our scope and methodology is in
appendix I.




5
 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 resources of
the capital markets.
6
 Primary insurance companies can purchase insurance for some or all of their risks from
reinsurance companies. Additionally, reinsurance companies can purchase insurance for
some or all of their risks from other insurance companies (a process known as
retrocessional coverage). In the securitization process, ratings agencies, such as Standard &
Poors, Moody’s, and Fitch, typically assign ratings to securities that are sold to the public or
in private placements.




Page 3                                              GAO-03-1033 Catastrophe Bond Follow-up
Results in Brief	   Private sector data indicate that the market for catastrophe bonds, as
                    discussed in our 2002 report, has to date transferred a small portion of
                    insurers’ natural catastrophe risk to the capital markets. According to
                    Marsh and McLennan Securities, from 1997 through 2002, 46 catastrophe
                    bonds were issued (about 8 per year).7 According to Swiss Reinsurance
                    Company (Swiss Re) Capital Markets, there were nearly $3 billion in
                    catastrophe bonds outstanding at the end of 2002. Swiss Re also estimated
                    that outstanding catastrophe bonds represented about 2.5 to 3.0 percent of
                    worldwide catastrophe reinsurance coverage in 2002.8

                    Although catastrophe bonds played an important role for some insurance
                    companies and reinsurance companies, representatives from other
                    insurers and financial market participants said that the costs associated
                    with the bonds and other factors have limited their use.9 Some insurance
                    and reinsurance companies used catastrophe bonds as a supplement to
                    traditional approaches to managing natural catastrophe risks--such as
                    reinsurance and limiting coverage in high-risk areas. Representatives from
                    one insurance company also told us that the bonds lower the costs
                    associated with providing coverage for the most severe types of
                    catastrophic risks.10 However, representatives from two large insurance
                    companies we contacted, two state authorities that offer natural
                    catastrophe coverage, and financial market participants said that the total


                    7
                     Our previous report stated that there had been some 70 risk-linked securities issued by
                    August 2002. We report a lower number this time because our report focuses on catastrophe
                    bonds.
                    8
                     The reinsurance market represents that portion of their exposure that primary insurance
                    companies have decided to transfer from their books. In our previous report, we reported
                    that Swiss Re estimated that catastrophe bonds accounted for 0.5 percent of the worldwide
                    catastrophe market. The 0.5 percent figure represented Swiss Re’s estimate of the amount of
                    reinsurance premiums that insurers dedicate to fund catastrophe bonds (see Background)
                    as compared to the total amount of reinsurance premiums paid to cover catastrophe risks.
                    Swiss Re officials said that the premium measure is also an appropriate measure of
                    catastrophe bond’s presence in the worldwide catastrophe insurance market and that the
                    0.5 percent figure had not changed as of December 31, 2002.
                    9
                     Although technically the initiator of the catastrophe bond transaction—the insurance
                    company, reinsurance company, or noninsurance company—is different from the special
                    purpose reinsurance vehicle that issues the catastrophe bond (see Background), for the
                    purpose of simplicity, we use the terms “issue” or “issuer” in this report to describe
                    organizations that initiate catastrophe bonds.
                    10
                     Natural catastrophes—such as hurricanes or earthquakes—of such severity that they are
                    only expected to occur every 100 to 250 years.




                    Page 4                                           GAO-03-1033 Catastrophe Bond Follow-up
costs of catastrophe bonds—including relatively high rates of return paid
to investors and administrative costs---significantly exceed the costs
associated with purchasing reinsurance coverage. On the other hand, some
financial market participants question the insurers’ analysis of the costs
associated with catastrophe bonds. For example, investment bank officials
said that the insurers’ analysis failed to account for the fact that many
reinsurance companies have experienced financial difficulties and may not
be able to meet their obligations if a catastrophe occurs.11

We found that NAIC is still considering one statutory accounting issue
discussed in our previous report that potentially affects the use of
catastrophe bonds, while the potential effects of a separate accounting
issue remain unclear. 12 The first issue concerned the differing statutory
accounting standards that apply to traditional reinsurance and to certain
financial instruments, which can include certain types of catastrophe
bonds. 13 Current statutory accounting standards allow insurers that
purchase traditional reinsurance to reflect the transfer of risk in financial
reports that they file with state insurance regulators and thereby improve
their stated financial condition, which may make the insurers more willing
to write additional policies. However, this accounting treatment is not
currently permitted for certain financial instruments—including certain
catastrophe bonds—because these instruments have not been viewed as
comparable to reinsurance. Although one NAIC committee has approved a
proposal that would allow similar accounting treatment for these
instruments under specified conditions, another NAIC committee has not


11
   Due to the costs associated with the September 11, 2001, terrorist attacks and declines in
worldwide stock markets, several reinsurance companies—particularly those
headquartered in Europe--have experienced declining credit quality since 2000. Some
financial analysts believe that potential reinsurer defaults during a catastrophe are costs
that need to be considered in comparing catastrophe bonds to reinsurance.
12
  NAIC establishes statutory accounting standards for insurance companies that may be
adopted by states and their insurance regulators. Statutory accounting standards may differ
from U.S. generally accepted accounting principles.
13
   Current statutory accounting allows an insurance company that has obtained traditional
reinsurance or issues indemnity based catastrophe bonds to reflect this transfer of risk on
the financial statements that it files with state insurance regulators. By obtaining this
accounting treatment, insurance companies may be more willing to write additional
policies. However, current statutory accounting standards do not allow similar accounting
treatment for nonindemnity based instruments that hedge insurance risk, which can include
nonindemnity based catastrophe bonds, because such instruments have not been viewed as
comparable to reinsurance or indemnity based catastrophe bonds. See this report and
appendix II for a detailed discussion.




Page 5                                             GAO-03-1033 Catastrophe Bond Follow-up
approved the proposal.14 The second accounting issue—a 2002 proposal by
the Financial Accounting Standards Board (FASB) that could have limited
the appeal of catastrophe bonds---has been revised.15 Accounting firms and
other financial market participants said that it was not clear (as of the date
of this report) what effects FASB’s revised guidance---would have on
catastrophe bonds. Although the revised guidance could make catastrophe
bonds less attractive to issuers and investors, it remains to be seen how the
guidance will be interpreted and implemented.16

Representatives from institutional investors—such as pension and mutual
funds---we contacted provided mixed views on the purchase of catastrophe
bonds. Some institutions favored catastrophe bonds because of their
relatively high rates of return and usefulness in diversifying investment
portfolios. However, because of the risks associated with catastrophe
bonds, the institutions said that they limited their investments in the bonds
to no more than 3.0 percent of their total portfolios. Representatives from
several other institutional investors—such as some large mutual funds--­
said that they avoided purchasing catastrophe bonds altogether because of
their perceived risks or because it would not be cost-effective for them to
develop the technical capacity to analyze the risks of securities so different
from the securities in which they currently invested. Some large mutual
fund representatives also told us that they were not willing to purchase
catastrophe bonds because of their relative illiquidity when compared with
traditional bonds and equities.17

Catastrophe bonds involving terrorism risks have not been issued by
insurers to cover targets in the United States, and insurance industry and


14
  NAIC is considering a proposal that would allow similar accounting treatment for financial
instruments that effectively hedge insurers’ risks. This issue is discussed in more detail in
this report.
15
 FASB is a private body that establishes accounting and auditing rules under generally
accepted accounting principles. FASB’s Interpretation No. 46, clarifies accounting policy for
special purpose entities to improve financial reporting and disclosure by companies using
these entities. See this report and appendix III for a detailed discussion.
16
   As discussed in this report, consolidation could make insurers less willing to issue
catastrophe bonds. We note that while consolidation may be required under generally
accepted accounting principles it is not required under NAIC’s statutory accounting
standards.
17
 In an illiquid market, securities cannot be converted into cash easily or without incurring a
substantial reduction in the price of the security.




Page 6                                             GAO-03-1033 Catastrophe Bond Follow-up
              financial market participants we contacted noted that issuing such a
              security would be challenging. One challenge involves developing
              statistical models to predict with some certainty the frequency and severity
              of terrorist attacks. Developing such models would be difficult because
              terrorist attacks may be influenced by a wide variety of factors that may be
              difficult to quantify or predict. These factors include terrorist intentions,
              the ability of terrorists to enter the United States, target vulnerability, types
              of weapons that may be used, and the effectiveness of the efforts to prevent
              terrorist acts. Nevertheless, several modeling firms are developing models
              that were being used to assist insurers in providing terrorism insurance.
              However, the view of most financial market participants we contacted was
              that the models are too new and untested to support catastrophe bonds
              related to terrorism. Moreover, investor concerns about the risks
              associated with catastrophe bonds covering terrorism in the United States
              might also make the costs associated with issuing securities related to
              terrorism prohibitive. For example, investors might not believe that they
              have sufficient information about insurers’ underwriting standards and
              efforts to limit the insurer’s financial exposure to terrorism. Consequently,
              investors might demand a “risk-premium” to invest in a security related to
              terrorism that would be above the rate that insurance companies would be
              willing to pay.

              We are not making any recommendations in this report.

              We provided a draft of this report to NAIC, the Bond Market Association
              (BMA), and the Reinsurance Association of America (RAA), which are
              reprinted in appendixes V, VI, and VII respectively. We also received
              technical comments from these organizations, which have been
              incorporated where appropriate. In general, these organizations
              commented that the draft report provided a fair and useful analysis of
              efforts to securitize natural catastrophe and terrorism risks. However, BMA
              and RAA also disagreed with certain aspects of our analysis. Our
              evaluations of the NAIC, BMA, and RAA comments are discussed later in
              this report and in appendixes V, VI, and VII.



Background	   This section provides an overview of (1) insurance coverage for natural and
              terrorist catastrophe risk and (2) the complex structure of natural
              catastrophe bonds.




              Page 7                                      GAO-03-1033 Catastrophe Bond Follow-up
Overview of Natural and                   The insurance industry consists of primary and reinsurance companies,
Terrorist Catastrophe                     which provide coverage—including coverage for natural catastrophe and
                                          terrorism risk---to their customers through property-casualty, homeowners,
Insurance Coverage                        automobile, and commercial policies among others (see fig. 1). Primary
                                          insurers typically write policies for residential and commercial customers
                                          and are responsible for reviewing customer claims and making payments if
                                          consistent with the customers’ policies. Primary insurers, however, often
                                          hold more exposure to risk than management considers appropriate. For
                                          example, a primary property and casualty insurer may hold a large number
                                          of homeowners insurance policies along the Florida coast. If a catastrophic
                                          hurricane were to hit this area, the insurer would have to pay out on those
                                          policies, which could damage the company’s financial condition. In order to
                                          transfer some of this risk, primary insurers purchase coverage from a
                                          reinsurance company. Reinsurers cover specific portions of the risk the
                                          primary insurer carries. For example, a reinsurer may cover events that
                                          cost the primary insurer more than $100 million. Likewise, reinsurers may
                                          also carry more risk exposure than they consider prudent and so they may
                                          contract with other reinsurers for coverage, which is a process referred to
                                          as retrocessional coverage.



Figure 1: Traditional Insurance, Reinsurance, and Retrocessional Transactions


                     Insurance                          Reinsurance                       Retrocessional
                     coverage                           coverage                          coverage

         Firm        Premium             Primary        Premium             Reinsurer        Premium            Reinsurer
                                         insurer                               #1                                  #2
                      Loss payments                      Loss payments                        Loss payments




Source: GAO.



                                          The insurance industry faces potentially significant financial exposure due
                                          to natural and terrorist catastrophes. Heavily populated areas along the
                                          coast in the Northeast, Southeast, Texas, and California have among the
                                          highest value of insured properties in the United States. Moreover, some of
                                          these areas also face the highest likelihood of major hurricanes—in the
                                          cases of the Northeast, Southeast, and Texas---and major earthquakes in
                                          the case of California. According to insurance industry estimates, a large
                                          hurricane in urban Florida or earthquake in urban California could cause



                                          Page 8                                        GAO-03-1033 Catastrophe Bond Follow-up
up to $110 billion in insured losses with total losses as high as $225 billion.
We also note that a major earthquake in the central Mississippi Valley--­
which includes the New Madrid fault—could also result in significant loss
of life and financial losses.18 Several states—including Florida, California,
and Texas—have established authorities to help ensure that coverage is
available in areas particularly prone to these events.19 In addition, the
insurance industry faces potentially large losses associated with terrorist
attacks as demonstrated by the industry’s $40 billion in expected losses
resulting from the September 11, 2001, attacks. With the passage of TRIA,
the federal government also has substantial potential financial exposure to
terrorist attacks.

The costs associated with providing insurance coverage for natural
catastrophes helped generate the market for risk-linked securities---such as
catastrophe bonds—as an alternative means of risk transfer for primary
insurance companies and reinsurance companies. As shown in figure 2,
reinsurance prices increased significantly in 1992, which was the year that
Hurricane Andrew struck Florida. Reinsurance prices may increase after
major catastrophes as reinsurance companies attempt to restore their
financial condition through higher revenues or coverage restrictions.
Because of the increase in reinsurance prices and restricted coverage in the
mid 1990s, some insurance companies developed catastrophe bonds with
the view that the capital markets would be able to provide coverage for
some natural catastrophes at a lower cost than reinsurers. We note that
after declining in the mid-to-late 1990’s, reinsurance prices increased from
1999 to 2002 due to several factors including losses associated with
hurricanes, adverse loss development on business written in 1997 through
2000, adverse loss development relating to asbestos, the declining credit
quality of some European reinsurers due to declining stock prices, the


18
  The New Madrid seismic zone lies within the central Mississippi Valley, extending from
northeast Arkansas, through southeast Missouri, western Tennessee, and western Kentucky
to southern Illinois. Historically, this area has been the site of some of the largest
earthquakes in North America. Between 1811 and 1812, four catastrophic earthquakes, with
magnitudes greater than 7.0 occurred during a 3-month period. Since 1974 when seismic
instruments were installed around this area, more than 4,000 earthquakes have been
located, most of which were too small to be felt. The probability for an earthquake of
magnitude 6.0 or greater is significant in the near future. A quake with a magnitude equal to
that of the 1811-1812 quakes could result in great loss of life and property damage in the
billions of dollars.
19
   Our 2002 report provided information on the Florida Hurricane Catastrophe Fund and the
California Earthquake Authority. This report provides information about the Texas
Windstorm Insurance Association. See appendix IV.




Page 9                                            GAO-03-1033 Catastrophe Bond Follow-up
                                                               declining investment income due to decreased interest rates, and the costs
                                                               associated with the September 11, 2001, terrorist attacks.



Figure 2: Reinsurance Prices in the United States, 1989-2002a
Dollars

300



250                                                                         Northridge earthquake
                                        Hurricane Andrew


200

                                                                                                                                                   September 11
                                                                                                                                                 terrorist attacks
150



100



 50



  0
      1989         1990          1991         1992          1993          1994       1995      1996      1997       1998       1999       2000        2001           2002
      Year
Source: Guy Carpenter & Company, Inc., a subsidiary of Marsh & McLennan Companies.

                                                               a
                                                                This figure shows a price index set equal to 100 in 1989 normalized prices.




Catastrophe Bonds Employ                                       As discussed in our previous report, risk-linked securities—including
Complex Structures                                             catastrophe bonds—have complex structures. Figure 3 illustrates the cash
                                                               flows among the participants in a catastrophe bond. Typically, a
                                                               catastrophe bond offering is made through an entity called a special
                                                               purpose reinsurance vehicle (SPRV) that may be sponsored by an
                                                               insurance or reinsurance company.20 The insurance company enters into a
                                                               reinsurance contract and pays reinsurance premiums to the SPRV to cover
                                                               specified claims. The SPRV issues bonds or debt or debt securities for
                                                               purchase by investors. The catastrophe bond offering defines a catastrophe


                                                               20
                                                                SPRVs are a type of special purpose entity. Most SPRVs are based offshore for tax,
                                                               regulatory, and legal purposes.




                                                               Page 10                                                GAO-03-1033 Catastrophe Bond Follow-up
                                                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 from the catastrophe bond offering in a trust in the form
                                                of Treasury securities and other highly rated assets. The SPRV deposits the
                                                payment from the investor as well as the premium income from the
                                                company into a trust account. The premium paid by the insurance or
                                                reinsurance company and the investment income on the trust account
                                                provide the funding for the interest payments to investors and the costs of
                                                running the SPRV. If no event occurs that triggers the bond’s provisions and
                                                it matures, the SPRV is responsible for paying investors the principal and
                                                interest that they are owed.



Figure 3: Special Purpose Reinsurance Vehicle



                                      Premium                                                               Principal and interest

               Insurer or reinsurer                        Special purpose                                                                  Investors
                                                           reinsurance vehicle
                                      Reinsurance cover                                                               Principal
                                                             Principal and investment




                                                                                                Principal
                                                             income




                                                                                        Trust



Source: GAO.




                                                Page 11                                                                      GAO-03-1033 Catastrophe Bond Follow-up
Catastrophe bonds also have the following characteristics:

1.	 The bonds are typically only offered to qualified institutional investors
    under Securities and Exchange Commission (SEC) Rule 144A and are
    not available for direct purchase by retail investors.

2.	 The bonds typically offer a return to investors based on the London
    Interbank Offered Rate (LIBOR) plus an agreed spread.21 The return to
    investors on catastrophe bonds is relatively high, either equaling or
    exceeding the returns on some comparable fixed-rate investments,
    such as high-yield corporate debt.22 Under some catastrophe bond
    structures, however, investors may face the risk of losing all or
    substantially all of their principal if a catastrophe triggering the bond’s
    provisions occurs.23

3.	 The bonds typically receive noninvestment grade ratings from bond
    ratings agencies such as Fitch, Moody’s, and Standard & Poors (S&P)
    because bond holders face potentially large losses on the securities.
    The ratings agencies rely in part on three major modeling firms to help
    understand the risks associated with specific catastrophe bonds. The
    modeling firms use sophisticated computer systems and large
    databases of past natural catastrophes to assess loss probabilities and
    financial severities.

4.	 The bonds typically cover risks that are considered the lowest
    probability and highest severity. That is, the bonds typically cover
    hurricanes or earthquakes that are expected to occur no more than
    once every 100 to 250 years. The bonds do not typically provide


21
  LIBOR is the rate most international creditworthy banks charge one another for large
loans.
22
 Cochran, Caronia Securities LLC reports that catastrophe bonds returned on average 9.07
percent in 2002, 9.45 percent in 2001, and 11.42 percent in 2000. The 9.07 percent return in
2002 exceeded selected fixed-income sector returns for high-yield (or noninvestment grade)
corporate debt. According to the Bond Market Association, the yields on catastrophe bonds
have been comparable to the yields on noninvestment grade corporate debt.
23
   However, some catastrophe bonds have been structured to contain different risk tranches
having varying probabilities of loss occurrence. If the probability of loss occurrence for a
bond tranche is very low, such as might occur if the bond's payout provisions could be
triggered only upon the occurrence of a third consecutive specified catastrophic event
within a set time period, the bond tranche could even receive a triple-A investment-grade
rating.




Page 12                                           GAO-03-1033 Catastrophe Bond Follow-up
     coverage for events expected to occur more frequently than once every
     100 years.

5.	 To offset investors’ lack of information about insurer underwriting
    practices, the bonds are typically nonindemnity rather than indemnity-
    based and specify industry loss estimates or parametric triggers (such
    as wind speed during a hurricane or ground movement during an
    earthquake) as the events that trigger the bonds’ provisions.24 By tying
    payment to an estimate of industry losses or an objective measure such
    as wind speed, investors do not have to completely understand an
    individual company’s underwriting practices.25




24
   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 period for a
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
is not related to actual or incurred claims. The provisions of a catastrophe bond, for
example, may provide $100 million in coverage to the issuing insurance company if a
hurricane or earthquake of a specified magnitude occurs or established insurance industry
formulas estimate that a catastrophe causes industry wide losses of a specified amount.
25
  One factor that may limit investors’ understanding of an insurers’ underwriting practices is
moral hazard, which means that two parties to a contract change their behavior because of
that contract. Due to moral hazard, the potential exists that an insurer would increase its
risk-taking, such as by providing coverage for properties more vulnerable to natural
catastrophes or in paying claims without adequate review. Moral hazard may be present in
other insurance arrangements—besides catastrophe bonds—such as in the case of an
insurer providing coverage for natural catastrophe risk through residential or business
policies. Because reinsurers have established business relationships with insurers, they may
be able to better monitor insurer underwriting practices than investors.




Page 13                                            GAO-03-1033 Catastrophe Bond Follow-up
Catastrophe Bond    Private sector data indicate that the catastrophe bond market accounts for
                    a small share of the worldwide reinsurance market for catastrophe risk.26
Issuance Has Been   According to Marsh & McLennan Securities, between 1997 and 2002, a total
Limited             of 46 catastrophe bonds were issued, or about 8 per year as shown in figure
                    4.27 Figure 5 shows that the annual dollar volume of catastrophe bond
                    issuance remained relatively stable between 1997 and 2002, with 2000
                    representing the highest volume with a total of $1.1 billion in total
                    issuance.28 Between 1997 and 2002, the total value of outstanding
                    catastrophe bonds increased more than three-fold from about $800 million
                    to $2.9 billion. However, outstanding catastrophe bonds accounted for only
                    2.5 to 3.0 percent of worldwide catastrophe reinsurance coverage.29 As of
                    September 2003, no natural catastrophe had occurred that would have
                    triggered one of the 46 bonds’ provisions and resulted in payments to
                    issuers to cover their losses.30




                    26
                       Organizations involved in the catastrophe bond market may also report additional figures
                    for other risk-linked securities or methods that transfer catastrophe risk or other insurance
                    risk to securities markets. Such other securities and methods include collateralized debt
                    obligations (CDO), quota share arrangements, swaps, options, and contingent capital. A
                    catastrophe-related CDO is a portfolio of already issued catastrophe bonds and other risk-
                    linked securities. Investors in securitized quota share arrangements share directly in the
                    performance of a reinsurance portfolio, sharing losses as well as gains.
                    27
                     Marsh & McLennan Securities did not report catastrophe bond issuance prior to 1997.
                    However, available data indicate that three bonds were issued in the period 1994-96. We
                    chose to report catastrophe bond issuance starting in 1997 (through 2002) because this is
                    the first year that the market expanded to include a number of issuers. According to
                    securities market participants, a total of four catastrophe bonds were issued in 2003 through
                    July.
                    28
                       In 2002, Swiss Re introduced “shelf issuance” of catastrophe bonds, which allows them to
                    periodically issue bonds over a several year period based on one offering statement to
                    investors. Marsh & McLennan reported Swiss Re’s three quarterly issuances of this bond as
                    one issuance in 2002.
                    29
                         Estimates obtained from Swiss Re and Fermat Capital Management.
                    30
                     According to an investment bank we contacted, the payout provisions of one catastrophe
                    bond issued in 1996 have been triggered.




                    Page 14                                           GAO-03-1033 Catastrophe Bond Follow-up
Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002

Number of issuances


10





 8





 6





 4





 2





 0

        1997          1998          1999          2000           2001   2002

      Year
Source: GAO, based on data provided by Marsh & McLennan Securities.




Page 15                                                                 GAO-03-1033 Catastrophe Bond Follow-up
Figure 5: Catastrophe Bond Issuance and Amount Outstanding 1997-2002
Dollars in millions

3,000                                                               2,943
                                                                    1,953

2,500                                                     2,421
                                                          1,454

2,000                                         1,926
                                               804

1,500

                                  1,130
                      1,031
1,000      783                     305        1,122
                       306                                          990
           69                                              967
                                   825
           714         725
  500



    0
          1997        1998        1999        2000        2001      2002
        Year


                  Issued


                  Outstanding from prior years


Source: GAO, based on data provided by Swiss Re Capital Markets.


Note: Total shown by figure at top of bar is amount outstanding at year end.




Page 16                                                            GAO-03-1033 Catastrophe Bond Follow-up
Figure 6 shows that insurance and reinsurance companies have issued
almost all catastrophe bonds. Insurance companies accounted for 22 of the
46 catastrophe bonds issued in 1997 through 2002, reinsurers accounted for
22, and two commercial companies--Oriental Land and Vivendi, SA—issued
the other two securities. Figure 7 provides a recent example of a
catastrophe bond issuance. The following section provides reasons why
some insurance and reinsurance companies use catastrophe bonds while
others do not.



Figure 6: Type of Catastrophe Bond Issuer 1997-2002
                                                            Number of issuances

                                                            4%
                                                            Noninsurance
                                                            companies............ 2




          48%
                                    48%                     Insurers.............. 22




                                                            Reinsurers.......... 22

                                                            Total:               46
Source: GAO, based on data provided by Marsh & McLennan Securities.




Page 17                                                               GAO-03-1033 Catastrophe Bond Follow-up
                         Figure 7: Residential Reinsurance Issuances


                             One example of a catastrophe bond is a $125 million of variable rate notes issued by
                             Residential Reinsurance 2002 Limited, a special purpose reinsurance company, for the ultimate
                             benefit of United Services Automobile Association (USAA). Offered only to qualified institutional
                             buyers as defined by SEC Rule 144A, these bonds were privately placed by Goldman, Sachs &
                             Co., Lehman Brothers, and Merrill Lynch & Co. These bonds were sold to investors with a
                             coupon of 3-month LIBOR plus 4.9 percent during the loss occurrence period and received
                             ratings of Ba3 from Moody's and BB+ from S&P, both noninvestment grade ratings.a The ratings
                             reflect the expected loss to note holders, calculated by a catastrophe-modeling firm, relative to
                             the promise of receiving the present value of the required interest and principal payments as
                             provided by the governing documents.

                             The issuer provides reinsurance coverage for 3 years to USAA against hurricane losses in the
                             East and Gulf Coast states of the United States and in Hawaii beginning June 1, 2002. Losses
                             to investors are tied to actual losses experienced by USAA due to qualified hurricanes affecting
                             its portfolio of exposures in the covered areas at any time during the risk period. Qualified
                             hurricanes are those classified on the Saffir-Simpson scale as a Category 3, 4, or 5.b If more
                             than one qualifying event were to occur in any given year, only one event, at the discretion of
                             USAA, will be considered in calculating losses to the notes. An independent third party is to
                             review loss payout. The proceeds from issuance of the bonds were deposited into a trust
                             account and invested in high quality-rated commercial paper or money market instruments and
                             investment-grade securities.

                             In 2003, Residential Reinsurance issued another $160 million of variable rate notes, its seventh
                             consecutive placement of catastrophic risk for the benefit of USAA. The bonds provided
                             aggregate coverage for USAA's hurricane and earthquake risk in the United States, including
                             the risk of loss caused by fire following an earthquake. This issue was the first catastrophe
                             bond to include Alaska and Hawaii earthquake risk. The bonds were sold with a coupon of 3-
                             month LIBOR plus 4.95 percent and received noninvestment grade ratings of Ba2 (Moody's) /
                             BB+ (S&P). The bonds were privately placed by Goldman Sachs and BNP Paribas.


                         Source: GAO analysis based on information from Moody's Investors' Service, Residential Reinsurance 2002 

                         Limited Catastrophe Linked Notes, Structured Finance New Isue Report, July 30, 2002 and Marsh & McLennan Securities, 

                         Market Update: The Catastrophe Bond Market at Year-End 2002.


                         a
                         Libor is the rate that creditworthy international banks generally change each other for large loans.
                         b
                          The Saffir-Simpson Hurricane Scale is a 1-5 rating based on the hurricane’s intensity. This is used to
                         give an estimate of the potential property damage and flooding expected along the coast from a
                         hurricane landfall. Wind speed is the determining factor in the scale, as storm surge values (used to
                         estimate flooding) are highly dependent on the slope of the continental shelf in the landfall region.




Catastrophe Bonds        Representatives from some insurance and reinsurance companies told us
                         that catastrophe bonds served a useful role in their overall approach to
Benefit Some Insurers,   managing their natural catastrophe risk exposures and that such bonds
but Others Believe       lowered the costs associated with the most severe types of catastrophe
                         risk. However, representatives from two large insurers and two state
That the Bonds’ Costs    authorities said that the total costs associated with the bonds were high
Are Too High             compared with traditional reinsurance and affected their willingness to




                         Page 18                                                               GAO-03-1033 Catastrophe Bond Follow-up
                         issue the bonds.31 Other financial market participants believed that
                         insurers’ comparisons of the prices of catastrophe bonds and traditional
                         reinsurance do not fully account for important factors, such as the credit
                         quality of reinsurers. This section also provides information on the status
                         of two accounting issues that potentially affect the use of catastrophe
                         bonds and which we discussed in our previous report.



Some Insurance and       Representatives from some large insurers and reinsurers we contacted said
Reinsurance Companies    that catastrophe bonds were a complement to several other basic risk
                         management tools: raising more equity capital by selling more company
Identified Benefits of
                         stock, transferring risks to the reinsurance markets, and limiting risks
Catastrophe Bonds        through the underwriting and asset management process. Representatives
                         from one insurance company said that of the natural catastrophe exposure
                         that was transferred by their company, 76 percent was sold to traditional
                         reinsurance companies and 24 percent was transferred through
                         catastrophe bonds. Company representatives said that while reinsurance
                         accounted for most risk transfer needs, catastrophe bonds were also
                         beneficial in this regard. Representatives from a reinsurance company said
                         that catastrophe bonds allowed the company to transfer a portion of its
                         natural catastrophe exposures to the capital markets rather than retaining
                         the exposure on its books or retroceding the risks to other reinsurers.

                         As discussed in our 2002 report, catastrophe bonds can play a role in
                         lowering the costs of reinsuring catastrophe risks. According to various
                         financial market representatives, because of the larger amount of capital
                         that traditional reinsurers need to hold for lower probability and higher
                         financial severity areas of catastrophe risk---such as the risk of hurricanes
                         in Florida or earthquakes in California expected to occur only once every
                         100 to 250 years---these reinsurers limit their coverage and charge
                         increasingly higher premiums for these risks. Many of the catastrophe
                         bonds issued to date have provided coverage for such severe catastrophe
                         risks. Representatives from one insurance company said that the company
                         cannot obtain the amount of reinsurance it needs in this risk category from
                         traditional reinsurers at reasonable prices. As a result, the company has


                         31
                            As discussed in our previous report, one of these authorities—the California Earthquake
                         Authority (CEA)—also does not issue catastrophe bonds because they are based offshore.
                         While CEA has not issued catastrophe bonds through SPRVs, some of its catastrophe risks
                         have been included in catastrophe bonds issued by a reinsurer with whom CEA has a
                         business relationship.




                         Page 19                                          GAO-03-1033 Catastrophe Bond Follow-up
                             obtained some of its reinsurance coverage in this risk category from
                             catastrophe bonds. The officials said that they believed that the
                             catastrophe bond market has had a moderating effect on reinsurance
                             prices, which, as shown in figure 2, increased from 1999 through 2002.
                             Other market participants also said that the presence of catastrophe bonds
                             as an alternative means of transferring natural catastrophe risk may have
                             prevented reinsurance prices from increasing any faster than they did.

                             We note that two noninsurance corporations—Oriental Land and Vivendi—
                             have issued catastrophe bonds to address some of the risks facing their
                             properties from hurricanes and earthquakes. Oriental Land—the operator
                             of Tokyo Disneyland---sponsored the Concentric, Ltd. security that
                             provides $100 million in coverage for an earthquake or earthquakes in a
                             particular region of Japan over a 5-year period ending in 2004. The
                             transaction allows Oriental Land to directly insure against certain
                             earthquake risks. Vivendi sponsored a $175 million catastrophe bond to
                             provide coverage for certain earthquakes affecting Southern California.32



Several Insurers Said That   Although some insurance and reinsurance companies have found
Catastrophe Bonds Were       catastrophe bonds to be cost-effective for some of their catastrophe
                             coverage, representatives from two large insurance companies and two
More Expensive Than
                             state authorities, as well as other market participants, said that the costs
Traditional Natural          associated with catastrophe bonds could be significantly higher than the
Catastrophe Reinsurance      costs of buying traditional reinsurance coverage. The insurance company
                             and state authority representatives said that they monitored the costs
                             associated with catastrophe bonds by reviewing price information
                             provided by investment banks and comparing these prices to quotes
                             offered on reinsurance contracts. Some insurance company officials and
                             state authority representatives estimated that the total costs associated
                             with catastrophe bonds could be as much as twice as high as traditional
                             reinsurance. In addition, representatives from two investment banks that
                             have participated in many catastrophe bond transactions, insurance
                             brokers that monitor the market, and other market participants said that
                             catastrophe bond costs typically exceeded the cost of reinsurance for many
                             insurers.


                             32
                              Vivendi Universal, S.A. did this transaction through its affiliated company, Gulfstream
                             Insurance Ltd., located in Ireland. Gulfstream Insurance entered into a reinsurance contract
                             with Swiss Re, which, in turn, entered into a retrocessional contract with Studio Re Ltd., the
                             special purpose reinsurer that issued the catastrophe bonds and preference shares.




                             Page 20                                            GAO-03-1033 Catastrophe Bond Follow-up
One of the costs associated with catastrophe bonds are the interest costs
that insurers must pay to compensate investors for purchasing securities
that involve a substantial risk of loss of principal. As discussed previously,
the yields on catastrophe bonds have generally equaled or exceeded the
yields on some risky fixed-income investments, such as high-yield
corporate debt. Representatives from two large insurers and a state
authority told us that quotes that they received from investment banks on
the interest costs associated with catastrophe bonds exceeded the costs of
comparable reinsurance. Additionally, representatives from two large
insurance companies said that the insurance rates they develop to cover
their expected losses on natural catastrophes and operating expenses and
then file with state regulators are frequently denied as being too high. As a
result, a representative of one of the insurers said that the company did not
earn sufficient premium income to cover the costs associated with
catastrophe bonds and tended to restrict coverage in states that do not
allow for adequate premium increases. NAIC commented that the process
of determining appropriate insurance rates is complex and that insurers
and state regulators can reasonably disagree on the proper rate to charge
for a specific insurance product.

Insurance industry representatives as well as other market participants
cited administrative and transaction costs as another reason for the
relatively high costs associated with catastrophe bonds as compared to
reinsurance. Representatives from a state authority estimated that
transaction costs represented 2 percent of the total coverage provided by a
catastrophe bond (for example, $2 million for a security providing $100
million in coverage). These costs include:

• underwriting fees charged by investment banks;

•	 fees charged by modeling firms to develop models to predict the
   frequency and severity of the event—such as the hurricane or
   earthquake—that is covered by the security;

•	 fees charged by the rating agencies to assign a rating to the securities;
   and

•	 legal fees associated with preparing the provisions of the security and
   preparing disclosures for investors.

The price of a reinsurance contract would not typically include such
additional fees.



Page 21                                   GAO-03-1033 Catastrophe Bond Follow-up
                            Insurers’ preference for traditional reinsurance as compared to catastrophe
                            bonds may also be explained by their long-standing business relationships
                            with reinsurance companies and the general nature of reinsurance
                            contracts. Reinsurance contracts often cover a range of a primary insurer’s
                            risks including natural catastrophe and other risks, and the insurer’s
                            premium payments to the reinsurer cover all potential losses to the
                            insurance company after some initial retention of risk by the insurer.
                            Moreover, reinsurance contracts typically cover an insurer’s losses, such as
                            those resulting from hurricanes in a specified area up to a specified dollar
                            limit, such as $100 million. In contrast, catastrophe bonds focus on one
                            type of risk (for example, natural catastrophe) and can be highly
                            customized (for example, the development of parametric triggers) which
                            may add to their administrative costs and require a greater commitment of
                            management time to develop, particularly the first time that they are used.



Some Financial Market       Some financial market participants that supported the use of catastrophe
Participants Questioned     bonds—such as investment banks—and some insurers questioned other
                            insurers’ analysis of cost differences between catastrophe bonds and
Insurers’ Analysis of the
                            traditional reinsurance. These representatives said that catastrophe bonds
Costs Associated with       may be cost-competitive with traditional reinsurance for high severity and
Catastrophe Bonds           low probability risks, for retrocessional coverage, and for larger-sized
                            transactions. The representatives also said that insurers tended to
                            undervalue the risk that—due to credit deterioration—reinsurers might not
                            be able to honor their reinsurance contracts if a natural catastrophe were
                            to occur. They said catastrophe bonds, on the other hand, pose no or
                            minimal credit risk to insurers because the funds are immediately
                            deposited into a trust account upon the bonds’ issuance to investors.
                            Representatives from insurers we contacted said that while they
                            recognized that some reinsurers’ credit quality had declined, they have
                            established credit standards for the companies with whom they do
                            business and continually monitored their financial condition.33




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




                            Page 22                                           GAO-03-1033 Catastrophe Bond Follow-up
Some financial market participants also said that various provisions in
reinsurance contracts—such as deductibles, termination clauses, and
reinstatement premiums—may also raise their costs and should be
factored into the cost comparison between catastrophe bonds and
reinsurance costs. Furthermore, they said that because catastrophe bond
funds were held in trust accounts, insurers would likely be able to quickly
claim the funds to cover natural catastrophe losses. In contrast, the
representatives said that reinsurance contracts frequently involved
litigation over whether insurer claims should be paid. RAA disagreed with
this statement and said that reinsurance contracts rarely involve litigation
and that the contracts typically include arbitration clauses. RAA said that
arbitration typically settles disputes more quickly than does litigation. RAA
also commented that because the provisions of catastrophe bonds have
never been triggered, it is not clear that such bond payments would not be
subject to litigation.34

One reinsurance company has developed a method of issuing catastrophe
bonds that may lower issuance costs. The reinsurer—Swiss Re—issued a
security known as Pioneer in June 2002. Pioneer’s structure contains six
separate “tranches,” or individual bonds, that cover five types of perils—
hurricanes in the North Atlantic, windstorms in Europe, earthquakes in
California, earthquakes in the central United States, earthquakes in
Japan—and one that covers all of the five perils. Pioneer is also an “off-the-
shelf” security, which means that Swiss Re can issue the security to
investors over a period of time as necessary to meet its business needs and
the demand of investors. By covering multiple perils and allowing risks to
be transferred over time, market participants said that the security could
pay a lower yield because the market would not have to absorb a relatively
larger issuance in a shorter time span. In addition, it would lower
administrative costs because most of the paperwork and disclosures to
issue the security would already be in place, which means they do not have
to be recreated, as is the case with other catastrophe bonds.




34
   Although none of the 46 catastrophe bonds issued from 1997 through 2002 have generated
investor losses, one investment bank told us that the payout provisions of a catastrophe
bond issued in 1996 had been triggered and generated investor losses.




Page 23                                         GAO-03-1033 Catastrophe Bond Follow-up
Some Insurers Noted That    Besides cost, some insurance company and state authority representatives
Catastrophe Bonds Were      we contacted cited other reasons why they did not choose to issue
                            catastrophe bonds. They said that they were not attracted to catastrophe
Not Cost-Effective for      bonds’ traditional focus on covering events with the lowest frequency and
Natural Catastrophes That   the highest severity (for example, hurricanes or earthquakes expected to
Were More Likely to Occur   occur every 100 to 250 years). Rather, the representatives said that their
or for Lower Coverage       coverage needs were for less severe events expected to take place more
Amounts                     frequently than every 100 years. In addition, they and other market
                            representatives said that it is not cost-effective to issue catastrophe bonds
                            below a certain level. They estimated that this this level ranged from $100
                            million to $800 million. Some insurers said that they typically bought
                            reinsurance for smaller amounts and might be more willing to issue
                            catastrophe bonds if they were offered coverage in amounts less than $100
                            million. BMA commented that catastrophe bonds have been issued in
                            smaller denominations than $100 million.

                            RAA commented that nonindemnity based catastrophe bonds may not be
                            appealing to insurers because of basis risk, which is the risk to the insurer
                            that the payment from the catastrophe bond will not cover all of its losses.
                            Traditional reinsurance and indemnity based catastrophe bonds mitigate
                            basis risk. In addition, RAA said that catastrophe bonds may not appeal to
                            insurers because they do not adequately cover “tail risk,” which is the risk
                            to the insurer that it will take a protracted period (perhaps years) to settle
                            all of the claims associated with a natural catastrophe. RAA stated that
                            traditional reinsurance remains an “open account” to settle such claims
                            when they come due while catastrophe bond contracts typically require
                            that all claims be quickly settled (perhaps within 2 years). RAA commented
                            that the insurer could ultimately become responsible for any claims filed
                            after the catastrophe bond cut-off period.




                            Page 24                                   GAO-03-1033 Catastrophe Bond Follow-up
Impact of Accounting Issues   Our previous report stated that NAIC’s current statutory accounting
Potentially Affecting the     requirements might affect insurers’ use of nonindemnity-based catastrophe
                              bonds. 35 Under statutory accounting, an insurance company that buys
Use of Catastrophe Bonds      traditional indemnity-based reinsurance or issues an indemnity based
Still Unclear                 catastrophe bond can reflect the transfer of risk (effected by the purchase
                              of reinsurance) on the financial statements that it files with state
                              regulators. As a result of the risk transfer, the insurance company can
                              improve its stated financial condition and it may be willing to write
                              additional insurance policies. However, statutory accounting rules
                              currently do not allow insurance companies to obtain a similar credit for
                              using nonindemnity based financial instruments that hedge insurance
                              risk—which can include nonindemnity-based catastrophe bond
                              structures—and may therefore limit the appeal of these types of
                              catastrophe bonds to potential issuers. Statutory accounting standards
                              have differed because unlike traditional reinsurance, instruments that are
                              nonindemnity-based have not been viewed as providing a true transfer of
                              insurers’ risks. However, during 2003, NAIC’s Securitization Working Group
                              approved a proposal that would establish criteria for allowing reinsurance
                              like accounting treatment for such instruments---including nonindemnity­
                              based catastrophe bonds—that provide a highly effective hedge against
                              insurer losses. The proposal must still be considered by NAIC’s Statutory
                              Accounting Committee, which must give final approval before the
                              accounting treatment is put into effect. According to an NAIC official, if
                              NAIC were to ultimately approve a reinsurance credit for financial
                              instruments that effectively hedge insurer losses, it could take about 1 year
                              for the new standards to be implemented. See appendix II for a detailed
                              discussion of this accounting issue.

                              35
                                 NAIC is currently considering the appropriate accounting treatment for nonindemnity
                              based financial instruments that hedge insurance risk, which could include nonindemnity­
                              based catastrophe bonds. Both exchange-traded instruments and over-the-counter
                              instruments can be used to hedge underwriting results (i.e., to offset risk). The triggering
                              event on a catastrophe bond contract must be closely correlated to the insurance risks being
                              hedged so that the pay-off is expected to be consistent with the expected claims, even
                              though there is some risk that it will not (referred to as “basis risk”). This correlation is
                              known as “hedge effectiveness” and NAIC is currently considering how it should be
                              measured. Should NAIC determine a hedge-effectiveness measure, statutory accounting
                              standards could be changed so that a fair value measure of the catastrophe bond contract
                              could be calculated and recognized as an offset to insurance losses, hence allowing credit to
                              the insurer similar to that granted for reinsurance. If nonindemnity-based catastrophe bonds
                              are accepted as an effective hedge of underwriting results, they could become more
                              attractive to potential issuers. We note that the process for developing an effective measure
                              to account for risk reduction through the issuance of nonindemnity-based coverage is
                              difficult and complex.




                              Page 25                                           GAO-03-1033 Catastrophe Bond Follow-up
In September 2002, we also reported that FASB was considering a new
approach for accounting for special purpose entities (SPE)—special
purpose reinsurance vehicles (SPRV) used to issue catastrophe bonds are a
type of SPE---that had the potential to raise the costs associated with
issuing catastrophe bonds and make them less attractive to issuers.36 The
proposal was considered in response to the problems at Enron
Corporation, which raised questions about the accounting for SPEs. FASB’s
proposed interpretation could have, among other things, (1) required the
primary beneficiary of an SPE to consolidate the assets and liabilities of the
SPE in its financial statements and (2) set a presumptive equity investment
requirement for SPEs at 10 percent as compared to the previous standard
of 3 percent.

In January 2003, FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities (FIN 46), which revised the guidance under
consideration in 2002. FIN 46 is quite complex and does not expressly
discuss reinsurance, but provides criteria to determine if consolidation is
required.37 FIN 46 introduces “variable interest entities” (VIE), a new term
that encompasses most SPEs. A VIE is broadly defined as an entity which
meets either of two conditions: (1) equity investors have not invested
enough for the entity to stand on its own (insufficiency is presumed if the
equity investment is less than 10 percent of the equity’s total assets) or (2)
equity investors lack any of the characteristics of a controlling financial
interest (the risks or rewards of ownership). If an entity is deemed a VIE,
then it is evaluated for possible consolidation according to the new risk and
reward approach in FIN 46. Accounting firm officials that we contacted
said that most catastrophe bond structures likely qualify as VIEs because
most SPRVs do not meet the ten percent equity threshold. Moreover, an
accounting firm official said that insurance companies may be less likely to
issue catastrophe bonds if they were required to consolidate SPRV assets
and liabilities on their balance sheets. The official said that insurance
companies do not typically believe that they “own” SPRV assets or “owe”
SPRV liabilities. The official said that insurance companies may decide that
the costs associated with issuing confusing and potentially misleading
financial statements would outweigh the benefits of issuing catastrophe
bonds through SPRVs.

36
     Companies have used SPEs for many years to carry out specific financial transactions.
37
   FIN 46 is applicable under U.S. generally accepted accounting principles and has no direct
application to insurance company financial statements prepared according to statutory
accounting principles or accounting principles outside the United States.




Page 26                                             GAO-03-1033 Catastrophe Bond Follow-up
                             However, accounting firm and insurance officials also told us that FIN 46 is
                             very complex and that it is not yet certain whether it would require issuers
                             of catastrophe bonds to consolidate the SPRVs on their financial
                             statements.38 The officials said the potential exists that FIN 46 could require
                             investors in catastrophe bonds to consolidate the bonds on their balance
                             sheets or it may not require consolidation by either issuers or investors.
                             FIN 46 is currently in effect for VIEs created after January 31, 2003, and is
                             effective for existing VIEs beginning in the first fiscal year or quarter
                             beginning after June 15, 2003. Because FIN 46 became effective during 2003
                             and each transaction could be structured differently, it remains to be seen
                             how FIN 46 will affect future catastrophe bond transactions. Additional
                             information should be available after December 2003, when insurers that
                             issue catastrophe bonds evaluate the substance of their catastrophe bonds
                             for purposes of reporting their year-end financial statements. See appendix
                             III for additional information about FIN 46.



Institutional Investors      Representatives from some institutional investors told us that catastrophe
                             bonds served a useful but limited role in their overall approach to managing
Provided Mixed Views         their investment portfolios by often providing higher yields than traditional
on Catastrophe Bonds         investments and diversification. Other institutional investors said that the
                             risks of catastrophe bonds were too high or not worth the costs associated
                             with assessing the risks. Some institutional investors also said that they
                             had decided not to purchase catastrophe bonds because they were illiquid.



Some Institutions Invested   The relatively high rates of return offered by catastrophe bonds make them
in Catastrophe Bonds for     attractive to some institutional investors, such as pension funds, hedge
                             funds, and mutual funds—including mutual funds that specialize in
High Yields and Portfolio
                             catastrophe bond investments. As discussed previously, catastrophe bonds
Diversification              carry noninvestment-grade ratings and, during certain time periods, high
                             spreads relative to alternative fixed-income investments, such as high-yield


                             38
                              Determining whether consolidation is required under FIN 46 requires an analysis of what
                             entity—either the issuer or investor in catastrophe bonds—bears the majority of the
                             expected risks and expected rewards. An accounting firm official we contacted said that in
                             his view it is unlikely that insurers would be required to consolidate under FIN 46 because
                             they do not bear the risks associated with catastrophe bonds. Rather, the accounting firm
                             official said that an investor in the bonds may be required to consolidate if it holds more
                             than half of the outstanding bonds in a particular issuance. Determining whether
                             consolidation by an investor is necessary under FIN 46 could require an analysis of the
                             percentage of outstanding bonds held by particular investors.




                             Page 27                                          GAO-03-1033 Catastrophe Bond Follow-up
                               corporate bonds. Officials from one large pension fund said that
                               catastrophe bonds were attractive because they often paid higher rates
                               than similarly rated instruments. Representatives from a hedge fund said
                               that since September 11, 2001, the rate of return on catastrophe bonds has
                               been high and the demand for the bonds has exceeded the supply.

                               Another reason that some large institutional investors---such as pension
                               funds---purchased catastrophe bonds is that they were uncorrelated with
                               other credit risks in their bond portfolios and help diversify their
                               investment risks. In general, institutional investors attempt to invest in
                               equities and debt from a wide range of companies, industries, and
                               geographic locations to minimize their exposure to any particular risk in
                               the event of an economic downturn. Representatives from some
                               institutional investors told us that catastrophe bonds complemented their
                               general diversification strategy. The securities were tied to the occurrence
                               of hurricanes and earthquakes rather than the performance of the
                               economy. That is, investors might realize a relatively high rate of return on
                               catastrophe bonds during an economic downturn, while other assets were
                               performing poorly (assuming that no natural catastrophe occurred to
                               trigger the securities’ provisions). However, due to the potential risks
                               associated with catastrophe bonds, the institutional investor
                               representatives said that they confined their investments to no more than 3
                               percent of their total portfolios. We note that some specialized institutional
                               investors---such as hedge funds and mutual funds that focus on catastrophe
                               bond investments---may assign a greater percentage of their investment
                               portfolios to catastrophe bonds than large institutions.



Some Institutional Investors   As discussed in our previous report, the investor market for catastrophe
Cited High Risks, Lack of      bonds is not broad and some institutional investors—such as mutual
                               funds—did not purchase them.39 Representatives from three large mutual
Analytical Capacity, and
                               funds we contacted for our follow-up work said they did not purchase
Illiquidity as Primary         catastrophe bonds because of their perceived risks. The mutual fund
Reasons for Not Purchasing     officials said that their traditional approach to investing in high-yield debt
Catastrophe Bonds              involved assessing a company’s business strategy, management talent,

                               39
                                  In testimony before the House Financial Services Committee on October 8, 2002,
                               representatives from Swiss Re—one of the largest issuers of risk-linked securities—said
                               that lack of interest by many money managers was the primary reason that the market has
                               not expanded. See The Risk-Linked Securities Market: Testimony before the House
                               Financial Services Committee, Subcommittee on Oversight and Investigations, U.S.
                               House of Representatives. (Oct. 8, 2002).




                               Page 28                                         GAO-03-1033 Catastrophe Bond Follow-up
assets, and cash flow to justify risking customer assets in purchasing the
company’s debt. Even if a company failed, one mutual fund official said that
as creditors they might be able to take over the business, insert new
management, sell assets, and turn the company around. In contrast, a
mutual fund official said that catastrophe bonds differed substantially from
their traditional company-oriented approach and posed unacceptably high
risks of loss to customer funds. The official also expressed doubt about the
accuracy of models that have been developed to predict hurricanes and
earthquakes or said that they lacked the technical expertise to analyze the
models. The official said that insurance companies were in the best
position to assess the risks associated with their natural catastrophe
exposures and that they were not interested in purchasing risks that the
companies did not want to keep on their books. Further, a mutual fund
official said that if a natural catastrophe occurred and the provisions of
catastrophe bonds were activated, creditors would have no opportunities
to minimize their losses as occurs when companies go into bankruptcy.
BMA commented that it is not inevitable that investors will lose all of their
principal if a catastrophe bond is triggered (as discussed previously, some
bond structures minimize the chances that investors will lose all of their
principal).

Mutual fund representatives also said that it was not cost-effective for them
to develop the technical expertise necessary to analyze catastrophe bonds
and determine if they represent a sound investment. First, a mutual fund
official said that it was much safer to simply buy the stocks and bonds of
insurance companies if the fund believed the management of such
companies had the skills necessary to profitably manage their natural
catastrophe and other exposures. Second, a mutual fund official said that
there were alternative investments—such as high-yield corporate debt—
that offered comparable returns and risks that firm officials understood.
Third, a mutual fund official said that given the small size of the
catastrophe bond market, it did not make sense to hire experts in
hurricanes or earthquakes to monitor the market. A mutual fund
representative did say, however, if the market for catastrophe bonds
expanded, the company would reconsider employing experts to better
understand these securities.

Another reason mutual fund representatives said that they did not purchase
catastrophe bonds was that they were illiquid. One mutual fund
representative said that the company preferred investments—such as
mortgage-backed securities, credit card receivables, and government
debt—that had large numbers of buyers and sellers, stable prices, and



Page 29                                   GAO-03-1033 Catastrophe Bond Follow-up
                         narrow bid-ask spreads.40 A liquid market allows investors to sell securities
                         for cash without accepting a substantial discount in price. One mutual fund
                         representative said that catastrophe bonds “trade by appointment,” and
                         that the fund’s policies did not allow for the purchase of such illiquid
                         securities. Another mutual fund representative also commented that their
                         company policies did not allow for the purchase of illiquid securities. BMA
                         disagreed with these statements and commented that the liquidity of the
                         catastrophe bond market is comparable to similar securities.



Securitizing Terrorism   The general consensus of insurance and financial market participants we
                         contacted was that insuring against terrorism risk would be difficult and
Risk Poses Significant   that developing bonds covering potential targets against terrorism attacks
Challenges               in the United States was not feasible at this time. Although, several
                         modeling firms were developing terrorism models that were being used by
                         insurance companies to assist in their pricing of terrorism exposure, most
                         experts we contacted said these models were too new and untested to be
                         used in conjunction with a bond covering risks in the United States.
                         Furthermore, potential investor concerns—such as a lack of information
                         about issuer underwriting practices or the fear that terrorists would attack
                         targets covered by catastrophe bonds---could make the costs associated
                         with issuing terrorism-related securities prohibitive.



The Complexity of        According to insurance industry representatives, insuring against natural
Forecasting Terrorist    catastrophe risk, despite its challenges, is considered more practical than
                         insuring against or securitizing terrorism risk. To establish their exposures
Attacks Makes Insuring   and to price insurance premiums, companies need to be able to predict
against Terrorism Risk   with some reliability the frequency and severity of insured event risks.
Difficult                Although difficult, risk-modeling firms and insurance companies have
                         developed models to predict the frequency and severity of natural
                         catastrophes such as hurricanes and earthquakes. Representatives from
                         these firms said that there was a substantial amount of historical data on,
                         for example, hurricane frequency and paths as well as earthquake faults
                         and severity. Using data on natural catastrophe frequency and severity,
                         insurers can gauge their exposures in particular areas and more accurately
                         price their coverage. For example, an insurer could estimate the impact to


                         40
                            A bid-ask spread is the difference between the price asked for a security and the price
                         paid.




                         Page 30                                            GAO-03-1033 Catastrophe Bond Follow-up
the insurance company of a Category 5 hurricane in Miami, given the
number of policies that the insurer has written in the city as well as the
value of insured property.41 Within pricing constraints established by
insurance regulators, the company would set premiums at a level designed
to compensate it for predicted losses while allowing for a reasonable rate
of return. The development of models to predict the frequency and severity
of natural catastrophe risks are considered crucial to any market growth
that has thus far taken place for catastrophe bonds.

In contrast, insuring against terrorism risk poses challenges because it
requires the insurer to measure with some reliability the frequency and
severity of terrorist acts. Experts we contacted said such analyses were
extremely difficult because they involved attempts to forecast terrorist
behavior, which were very difficult to quantify. The frequency of attacks
would be subject to a range of factors including terrorist intentions, the
ability of terrorists to enter the United States, target vulnerability, and the
effectiveness of the war on terrorism. One market participant told us that
even if the severity of losses at different targets given specified weapons
were able to be modeled, it would be difficult to forecast losses for
particular attacks given the variety of weapons that could be used by
terrorists.

Recent experience illustrates the difficulties associated with insuring
against terrorism risks. After the September 11, 2001, terrorist attacks,
many primary insurance companies refused to renew terrorism coverage in
their general property and casualty policies for commercial customers and
reinsurance companies stopped providing coverage for terrorism to
primary insurers.42 Although TRIA subsequently required primary
insurance companies to offer terrorism insurance to clients, insurers set
the premiums. While insurance companies did not publish data on how
many of their clients accepted offers of terrorism coverage, one insurer we
contacted said that the overall acceptance rate was about 25 percent.


41
   A Category 5 hurricane is defined by winds greater than 155 mph, storm surge generally
greater than 18 feet above normal, complete roof failure on many residences and industrial
buildings, and some complete building failures with small utility buildings blown over or
away.
42
 In GAO testimony before the House Subcommittee on Oversight and Investigations,
Committee on Financial Services we stated that many insurers consider terrorism an
uninsurable risk because it is not possible to estimate the frequency and severity of terrorist
attacks. See Terrorism Insurance: Rising Uninsured Exposure Heightens Potential
Economic Vulnerabilities. GAO-02-472T. Washington, D.C.: February 27, 2002.




Page 31                                            GAO-03-1033 Catastrophe Bond Follow-up
Terrorism Models under      Representatives from the three major risk-modeling firms said that they
Development Considered by   have developed terrorism risk models. The models differ in the method
                            they employ to model risk but are similar in that they rely on the ability of
Some as Too New and         terrorism experts to forecast the frequency and severity of terrorist
Untested to Support         attacks. One firm uses the Delphi method, another uses game theory, and
Catastrophe Bonds           the third uses a combination of the two. The models account for subjective
                            information such as the particular terrorist organization that is carrying out
                            the attack and the resources available to them; the political situation; and
                            when, where, and how the attack might occur. The Delphi method, for
                            example, analyzes various threats posed by domestic extremists, formal
                            international and state-sponsored terrorist organizations, and loosely
                            affiliated extremist networks. The game theory model analyzes the
                            potential actions of terrorists based on the actions of security forces and
                            counter-terrorism measures.

                            Modeling firm officials and insurance industry representatives said that
                            insurers, reinsurers, group life insurers, and corporations were currently
                            using terrorism models. Some insurance companies were using the models
                            to help them determine their exposure to terrorism and price this risk. For
                            example, some life insurance companies were using the models to ensure
                            that they did not have a high concentration of life insurance policies in
                            properties that might be particularly vulnerable to terrorist attacks.

                            Representatives from reinsurance companies we contacted, however, said
                            that the models were not reliable in predicting the frequency of terrorist
                            attacks, although they provided useful information on the potential severity
                            of attacks. Moreover, officials from ratings agencies we contacted said that
                            they were not convinced about the reliability of the terrorism models at this
                            point and that they would not be willing to rate a catastrophe bond
                            covering targets in the United States based on the models. According to
                            one of the major rating firms, for example, the estimates derived from the
                            three models for predicting the frequency and severity of terrorist attacks
                            could vary by 200 percent or more. Another rating firm official said that
                            investors currently would not believe that the terrorism models adequately
                            reflected the risk. Without acceptance of the models by major ratings
                            agencies and investors, the officials said that the issuance of catastrophe
                            bonds related to terrorism coverage in the United States would be highly
                            unlikely. We note that NAIC officials commented that while developing
                            catastrophe bonds to cover terrorism is very difficult and may not occur in
                            the medium-term, the potential exists that such bonds will be issued.




                            Page 32                                   GAO-03-1033 Catastrophe Bond Follow-up
Investor Concerns Could     Investor concerns about catastrophe bonds related to terrorism could also
Impede the Development of   make the costs to insurers of issuing such bonds prohibitive. In the absence
                            of well-developed and contractual business relationships with the primary
a Market for Terrorism-     insurer, investors might not believe they had sufficient information about
Related Securities          the extent to which an insurance company offered terrorism coverage to
                            properties that were potentially highly vulnerable to a terrorist attack or
                            the quality of an issuer’s underwriting practices and claims payment
                            processes. Because of investors’ potential lack of information about
                            insurer practices, they might demand a significantly higher rate of return
                            before they would purchase a security that covered terrorism risks. Some
                            insurance companies already have decided not to issue catastrophe bonds
                            for natural catastrophes due to their relatively high costs. Given the
                            uncertainties associated with forecasting the frequency and severity of
                            terrorist attacks, it is likely that the costs associated with issuing terrorism-
                            related bonds would be even higher.

                            Investors might also demand high returns on terrorist-related securities
                            because of concerns about strategic behavior by terrorists. Investors might
                            be concerned that terrorists would learn about the conditions that would
                            activate the provisions of a catastrophe bond, and plan attacks on the basis
                            of that knowledge. Although it is not clear that terrorists would make
                            attacks based on such reasoning, investors fear that they would increase
                            the risk premium demanded of such securities.

                            While developing a catastrophe bond to cover terrorism risks in the United
                            States may be difficult, we note that in August 2003 a bond was developed
                            to cover such risks---and other risks---in Europe. The Federation
                            Internationale de Football Association (FIFA), the world governing body of
                            association football—called soccer in the United States—and organizer of
                            the FIFA World Cup developed a catastrophe bond to protect its investment
                            in the 2006 World Cup in Germany. The bond is rated investment grade and
                            covers natural and terrorist catastrophic events that result in the
                            cancellation of the final World Cup game. Representatives from the rating
                            agency that rated the bond said they were able to provide an investment
                            grade rating because the bond’s provisions make it highly unlikely that




                            Page 33                                    GAO-03-1033 Catastrophe Bond Follow-up
                investors will lose their principal.43 For example, the officials said that it
                would require extraordinary circumstances for the final game to be
                cancelled. Under the bond’s provisions, FIFA also has the flexibility to
                reschedule the final game and, if necessary, hold the event in another
                country. While the rating agency official said that the firm relied on natural
                catastrophe models to help assign a rating to the bond, the firm did not rely
                on terrorism models because terrorism is impossible to predict. Instead,
                the rating firm used an analytical approach developed by one of the
                modeling firms to analyze potential terrorist threats to the 2006 World
                Cup.44 It remains to be seen how well the bond is accepted by investors
                and whether it will result in similar issuances.



Observations	   Although catastrophe bonds to date have not transferred a significant
                portion of insurers’ natural catastrophe risk exposures to the capital
                markets, the bonds do play a useful role for some companies and
                institutional investors. For some companies, catastrophe bonds
                supplement traditional reinsurance and may lower the costs associated
                with covering low-probability, high severity events. For some institutional
                investors, catastrophe bonds are attractive in limited quantities because of
                their relatively high rate of return and usefulness in portfolio risk
                diversification. However, the lack of interest by other large insurance
                companies and institutional investors may have been factors in limiting the
                broader expansion of the market for catastrophe bonds. Some large
                insurers and state natural catastrophe authorities viewed the bonds as too
                expensive compared to traditional reinsurance and large institutional
                investors view the bonds as too risky, not worth the costs of understanding
                the risks, and illiquid. Whether the catastrophe bond market expands in the
                future beyond the useful but limited role that it currently serves would
                likely depend upon changing the views of additional large insurance
                companies and institutional investors about the bonds’ utility.



                43
                   The structure of the bond rated investment grade guarantees that investors will recover at
                least 25 percent of their principal. Other provisions in the bond do not provide such
                protection to investors and were not rated. The rating agency also said that investor losses
                were not likely because Germany is not prone to natural disasters, the World Cup
                tournament is spread over many venues, and German security measures are stringent.
                44
                   The rating agency’s analysis concluded that terrorism is unlikely to affect the 2006 World
                Cup because, among other reasons, “…there is less involvement by the U.S. and greater
                sympathy for football in general.”




                Page 34                                            GAO-03-1033 Catastrophe Bond Follow-up
                      The general view of insurance industry officials and financial market
                      participants is that the development of a bond market covering terrorism
                      risks in the United States would be challenging at this time. Although
                      statistical models have been developed to assist insurance companies in
                      providing terrorism insurance, the models appear to be too new and
                      untested to use in conjunction with a bond related to terrorism. Developing
                      such models is considered extremely challenging due to the complexity of
                      attempting to predict the frequency and severity of terrorist attacks.
                      Investors’ lack of complete information about issuer underwriting
                      practices and concerns about strategic behavior by terrorists, may make
                      insurers’ costs of issuing bonds covering terrorism prohibitive.



Agency Comments and   We received written comments on a draft of this report from NAIC, BMA,
                      and RAA. We also received technical comments from these organizations,
Our Evaluation        which we have incorporated into the report text where appropriate.

                      NAIC commented that U.S. insurance regulators should encourage the
                      development of alternative sources of capacity, such as insurance
                      securitizations and risk-linked securities, so long as such developments are
                      consistent with NAIC’s overriding goal of consumer protection. NAIC also
                      made several other points in its comment letter. First, NAIC stated that
                      SPRVs should be brought on-shore and be subject to U.S. regulation, which
                      could lower the costs associated with catastrophe bonds. Second, NAIC
                      stated that the removal of any uncertainty regarding the tax treatment of
                      catastrophe bonds could encourage the use of such bonds. We note that the
                      tax treatment of catastrophe bonds was outside the scope of our review for
                      this report but we discussed the issue in detail in our previous report on
                      risk-linked securities. Third, NAIC concurred with our report finding on the
                      difficulty in securitizing terrorism risk, however, NAIC also commented
                      that some insurers are writing terrorism risk, and if it can be priced, then it
                      can be securitized. In addition, NAIC objected to a reference in the draft
                      report to insurance company representatives implying that state insurance
                      regulators set premium levels below levels that the insurer believed were
                      necessary to cover their expected losses on natural catastrophes and
                      operating expenses. We have revised the report text to more accurately
                      describe the procedures for setting insurance premiums and reflected
                      NAIC’s views in the report.

                      BMA commented that the draft report provided a timely and helpful
                      assessment of the progress of catastrophe bonds in transferring natural and
                      terrorism catastrophe risk to the capital markets. However, BMA



                      Page 35                                    GAO-03-1033 Catastrophe Bond Follow-up
commented that while some insurers believe that catastrophe bonds are
more expensive than reinsurance, other factors—such as reinsurer credit
risk—must also be considered. In particular, BMA stated that that the
relative attractiveness of catastrophe bonds depends upon whether the
particular risk is truly a “peak peril” of the type that has typically been
addressed by catastrophe bonds, which can include Japanese earthquakes,
California earthquakes, and Florida hurricanes. BMA stated that
reinsurance companies charge higher premiums to cover these types of
perils.

As stated in the report, reinsurance companies may limit coverage or
charge increasingly higher premiums for low probability and high severity
events, such as hurricanes or earthquakes expected to occur no more than
once ever 100 to 250 years. Some insurance companies have concluded that
catastrophe bonds serve as a useful risk transfer mechanism for such risks
and as an effective supplement to traditional reinsurance. Some insurance
company officials also stated that catastrophe bonds can serve a role in
lowering the costs of insuring against such risks. Other insurance
companies and state authorities we contacted do provide coverage for such
events as Florida hurricanes and California earthquakes. However, officials
from these organizations said that catastrophe bonds are not cost-effective
as compared to reinsurance for the severity of events that they are willing
to insure against. For example, some insurance companies believe that
reinsurance offers more cost-effective coverage for events expected to
occur more frequently that once every 100 years.

RAA commented that our draft report provided a generally fair summary of
the effort to securitize natural catastrophe risks and provides a very good
overview of differing views on the utility of such bonds. However, RAA
took exception to our draft report’s characterization of NAIC statutory
accounting requirements for reinsurance as favorable compared to NAIC
accounting requirements for certain catastrophe bonds. We have changed
the language in the report to more clearly distinguish between the current
grant of credit for traditional reinsurance and indemnity-based catastrophe
bonds and NAIC’s review of potential changes to statutory accounting
standards that would grant similar accounting treatment for nonindemnity
based financial instruments that hedge insurance risk (including
nonindemnity based catastrophe bonds). Such changes would allow credit
to instruments that effectively hedge insurance risk because they are highly
correlated with the issuer’s actual losses. We note that traditional
reinsurance does not need hedge accounting treatment because it already
receives credit for risk transfer.



Page 36                                  GAO-03-1033 Catastrophe Bond Follow-up
As agreed with your offices, unless you publicly announce the contents of

this report earlier, we plan no further distribution of this report until 30 

days from the report date. At that time, we will provide copies of this report 

to the Chairman and Ranking Minority Member, Senate Committee on 

Banking, Housing, and Urban Affairs and the Ranking Minority Members,

House Committee on Financial Services and its Subcommittee on Capital 

Markets, Insurance, and Government Sponsored Enterprises. Copies will 

also be provided to NAIC, BMA, RAA, and other interested parties. In 

addition, the report will be available at no charge on GAO’s home page at 

http://www.gao.gov.


If you or your staff have any questions regarding this report, please contact 

Mr. Wesley M. Phillips or me at (202) 512-8678. GAO staff that made major 

contributions to this report are listed in appendix VIII.





Davi M. D’Agostino

Director, Financial Markets and

 Community Investment





Page 37                                    GAO-03-1033 Catastrophe Bond Follow-up
Appendix I

Objectives, Scope, and Methodology



              You asked us to update our September 2002 report on the role of
              catastrophe bonds and factors affecting their use and to report on the
              potential for terrorism risk to be securitized. As agreed with your offices,
              our objectives were to (1) assess the progress of catastrophe bonds in
              transferring natural catastrophe risks to the capital markets; (2) assess
              factors that affect the issuance or sponsorship of catastrophe bonds by
              insurance and reinsurance companies, including a status report on
              accounting issues raised in our previous report; (3) assess factors that
              affect investment in catastrophe bonds, and (4) analyze the potential for
              and challenges associated with securitizing terrorism-related financial
              risks.

              Our general methodology involved meeting with a range of private-sector
              and regulatory officials to obtain diverse viewpoints on the status of efforts
              to securitize natural catastrophe and terrorism risks. We met with (1) three
              large insurers or reinsurers that currently issue catastrophe bonds and two
              insurers who currently do not, (2) two state authorities that currently do
              not issue catastrophe bonds through SPRVs, (3) three institutional
              investors—including a large pension fund and two hedge funds—that
              purchase catastrophe bonds and three large mutual funds that do not
              purchase catastrophe bonds, (4) investment banks that underwrite
              catastrophe bonds and monitor the market, (5) three large ratings agencies,
              (6) three modeling firms, (7) two large accounting firms, (8) two firms that
              engage in insurance and reinsurance brokerage, (9) the National
              Association of Insurance Commissioners (NAIC), (10) the Bond Market
              Association, and (11) the Reinsurance Association of America. Because of
              our reporting deadlines, we selected a judgmental sample of organizations
              to contact. We also reviewed our previous work on catastrophe bonds and
              insurance (see Related GAO Products) and data and reports provided by
              private-sector sources.1

              Even though we did not have audit or access-to-records authority for the
              private-sector entities, we obtained extensive testimonial and documentary
              evidence from them. However, we did not verify the accuracy of the data
              from these entities. We note that there is no central source of information
              on key issues, such as the number of catastrophe bonds issued or the


              1
               One of the insurance companies with whom we met does not currently issue catastrophe
              bonds, but did issue one such bond several years ago. One of the state authorities does not
              issue catastrophe bonds through SPRVs, but some risks that it had transferred to a reinsurer
              were included in a catastrophe bond issued by that reinsurer.




              Page 38                                           GAO-03-1033 Catastrophe Bond Follow-up
Appendix I

Objectives, Scope, and Methodology





amount of catastrophe bonds outstanding. In such cases, we used
professional judgment to determine how to present the data and what
period of time to report.

To respond to the first objective, we reviewed data on catastrophe bond
issuance from 1997 through 2002 provided by a firm that specializes in
these securities. We also obtained data from a large reinsurer that collects
data on the size of the catastrophe bond market relative to the worldwide
reinsurance market and a firm that collects data on reinsurance prices. We
also obtained data from the firm on the issuance of catastrophe bonds by
large insurers and reinsurers.

To respond to the second objective, we asked insurance and reinsurance
companies that issue or have issued catastrophe bonds why they had done
so and what role the bonds played for their companies. We also asked other
large insurance companies and two state catastrophe authorities that do
not currently issue catastrophe bonds the basis for that decision. In
addition, we asked financial market participants that support the use of
catastrophe bonds—such as an investment bank and hedge fund—for their
views on the costs associated with catastrophe bonds as opposed to
reinsurance contracts. To update accounting issues raised in our 2002
report, we reviewed FIN 46 and interviewed officials from accounting
firms, insurers, and NAIC.

To respond to the third objective, we spoke with three institutional
investors that purchased catastrophe bonds and discussed their reasons for
doing so. We also contacted representatives from three large mutual funds
that had not purchased catastrophe bonds to obtain their views. We also
obtained data comparing the returns on catastrophe bonds to other fixed-
income investments, such as high-yield bonds.

To respond to objective four, we contacted insurance and reinsurance
companies, modeling firms, rating agencies, investment banks, and NAIC.
We reviewed a variety of documents including academic studies, insurance
company and reinsurance company articles on terrorism and terrorism
insurance, modeling firm and rating firm publications, and offering
circulars.

We conducted our work between March and August 2003 in New York,
Massachusetts, Ohio, Illinois, Pennsylvania, Texas, and Washington, D.C.




Page 39                                  GAO-03-1033 Catastrophe Bond Follow-up
Appendix II

Statutory Accounting Balance Sheet
Implications of Reinsurance Contracts

               Over the duration 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 the National Association of
               InsuranceCommissioners (NAIC), but also by the Securities and Exchange
               Commission and the Financial Accounting Standards Board. 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.

               To illustrate, 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




               Page 40                                   GAO-03-1033 Catastrophe Bond Follow-up
Appendix II

Statutory Accounting Balance Sheet 

Implications of Reinsurance Contracts





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 8 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.



Figure 8: Effect on Ceding and Reinsurance Companies’ Balance Sheets before and
after a Reinsurance Transaction

 Ceding company
                                               Before                                  After
                                                        Liabilities/                            Liabilities/
                                      Assets                                  Assets
                                                          Equity                                  Equity
 Cash                            $25,000,000                               $17,000,000
 Unearned premium
 reserve                                            $20,000,000                                $10,000,000
 Policyholders'
 surplus                                                 5,000,000                               7,000,000

 Total                           $25,000,000        $25,000,000            $17,000,000         $17,000,000



 Reinsurance company
                                               Before                                  After
                                                        Liabilities/                            Liabilities/
                                      Assets                                  Assets
                                                          Equity                                  Equity
 Cash                            $30,000,000                               $38,000,000

 Unearned premium
 reserve                                            $25,000,000                                $35,000,000
 Policyholders'
 surplus                                                 5,000,000                               3,000,000

 Total                           $30,000,000        $30,000,000            $38,000,000         $38,000,000
Source: Insurance Accounting Systems Association.




Page 41                                                          GAO-03-1033 Catastrophe Bond Follow-up
Appendix II

Statutory Accounting Balance Sheet 

Implications of Reinsurance Contracts





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 a special purpose
reinsurance vehicle (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.




Page 42                                  GAO-03-1033 Catastrophe Bond Follow-up
Appendix III

FASB Interpretation No. 46, Consolidation of
Variable Interest Entities

                  In January 2003, the Financial Accounting Standard Board (FASB) released
                  Interpretation No. 46 with the objective of improving financial reporting by
                  entities involved in variable interest entities (VIE)—an entity subject to
                  consolidation according to the provisions of the Interpretation---and not to
                  restrict the use of VIEs.1 The goal is to help financial statement users
                  understand the financial statements of VIE primary beneficiaries that
                  consolidate as well as those with a significant variable interest that do not
                  consolidate. Interpretation No. 46 states that to faithfully represent the
                  total assets that an enterprise controls and liabilities for which an
                  enterprise is responsible, assets and liabilities of the VIE for which the
                  enterprise is the primary beneficiary must be included in an enterprise’s
                  consolidated financial statements.



What is a VIE?	   The interpretation explains how to identify VIEs, which are entities that, by
                  design, have one or both of the following characteristics:

                  1.	 The total equity investment at risk is not sufficient (insufficiency is
                      presumed if the equity investment is less than 10 percent of the equity’s
                      total assets, but this presumption may be rebutted) to permit the entity
                      to finance its activities without additional subordinated financial
                      support from other parties. In other words, the equity investment at
                      risk is not greater than the expected losses of the entity. Such
                      subordinated financial support may be provided through other interests
                      (including ownership, contractual, or other pecuniary interests) that
                      will absorb some or all of the expected losses of the entity.

                  2.	 The equity investors lack one or more of the following essential
                      characteristics of a controlling financial interest:

                      •	 The direct or indirect ability to make decisions about the entity’s
                         activities through voting rights or similar rights;

                      •	 The obligation to absorb the expected losses of the entity if they
                         occur, which makes it possible for the entity to finance its activities;
                         or



                  1
                   This analysis of FIN 46 is based on existing interpretations by private-sector analysts and
                  publications. See, for example, Michael J. Pinsel. “Impact of FIN 46 on Insurance Industry
                  Transactions.” Insurance and Financial Services Report (Second Quarter Issue, 2003).




                  Page 43                                            GAO-03-1033 Catastrophe Bond Follow-up
                             Appendix III

                             FASB Interpretation No. 46, Consolidation of 

                             Variable Interest Entities





                                •	 The right to receive the expected residual returns of the entity if they
                                   occur, which is the compensation for the risk of absorbing the
                                   expected losses.



Consolidate or Not?	         The interpretation also gives guidance on how an enterprise assesses its
                             interests in a VIE to consolidate that entity. FASB says that if a business
                             enterprise has a controlling financial interest in a VIE, the assets, liabilities,
                             and results of the activities of the VIE should be included in consolidated
                             financial statements of the business enterprise. A direct or indirect ability
                             to make decisions that significantly affect the results of the activities of a
                             VIE is a strong indication that an enterprise has one or both of the
                             characteristics that would require consolidation of the variable interest
                             entity.



Primary Beneficiaries Must   The interpretation requires existing unconsolidated VIEs to be
Consolidate	                 consolidated by their primary beneficiaries if the entities do not effectively
                             disperse risks among parties involved. A primary beneficiary is the party
                             that absorbs a majority of the VIE’s expected losses if they occur, receives a
                             majority of its expected residual returns if they occur, or both. The primary
                             beneficiary of the VIE is required to disclose (1) the nature, purpose, and
                             size of the VIE; (2) the carrying amount and classification of consolidated
                             assets that are collateral; and (3) any lack of recourse by creditors.




                             Page 44                                          GAO-03-1033 Catastrophe Bond Follow-up
Appendix IV

Texas Windstorm Insurance Association



              In 1971, the Texas Legislature established the Texas Windstorm Insurance
              Association (TWIA) as a mechanism to provide wind and hail coverage to
              residents of 14 counties along the coast and portions of 1 additional county
              who are unable to obtain insurance in the voluntary market. The
              legislature’s action was in response to insurance market constrictions
              along the Texas Gulf Coast after several hurricanes in the late 1960s and
              Hurricane Celia, which struck Corpus Christi in August 1970. TWIA is a
              pool of property and casualty insurance companies authorized to write
              coverage in Texas. Since its inception, the legislature has made it clear that
              TWIA was to write limited coverage for wind and hail in order to provide
              for the “orderly economic growth of the Coastal counties.”

              Residential and commercial rates for the TWIA are controlled by statute.
              The average residential policy costs more than $500. There is an annual
              rate increase or decrease cap on both residential and commercial rates of
              10 percent, except under unusual circumstances following a catastrophe or
              series of catastrophes, when the Commissioner of Insurance—after a
              public hearing—has the authority to lift the cap. Currently, it is estimated
              that TWIA provides 20 percent of the residential coverage for wind and hail
              and 50 percent of the seaward coverage in Texas.

              As of June 30, 2003, TWIA had more than 89,000 residential and commercial
              policies and a claims paying capacity of more than $1.1 billion. TWIA’s total
              liability on these residential and commercial policies was more than $17
              billion. The organization’s claims paying capacity consists of layers of
              assessment of their pool of insurers, the Catastrophe Trust Fund, and
              reinsurance. As shown in figure 9, for the bottom level of financing ($0 to
              $100 million) and the highest probability of occurrence (one in every 9
              years), TWIA has coverage through its pool of insurers. For the next level
              of financing ($100 to $200 million) and probability of occurrence of once
              every 9 to 15 years, coverage comes from the Catastrophe Trust Fund.




              Page 45                                   GAO-03-1033 Catastrophe Bond Follow-up
Appendix IV

Texas Windstorm Insurance Association





Figure 9: Texas Windstorm Insurance Authority Financing




 Lowest probability                      Unlimited assessment of pool of insurers
   of occurrence
                       125 years                                                      $1.1B
                                   Reinsurance of $100% of $100M in excess of $1B
                       102 years                                                      $1B

                                          $200M Assessment of pool of insurers

                        67 years                                                      $800M
                                              $100M Catastrophe Trust Fund
                        54 years                                                      $700M


                                              Reinsurance of 100% of $300M
                                                   in excess of $400M


                        27 years                                                      $400M
                                                                   Reinsurance of
                                    $100M Catastrophe
                                                                    50% of $200M
                                        Trust Fund
                                                                 in excess of $200M
                        15 years                                                      $200M
                                              $100M Catastrophe Trust Fund
                         9 years                                                      $100M
 Highest probability                      $100M Assessment of pool of insurers
   of occurrence
                                                                                      0

Source: TWIA.



The Catastrophe Trust Fund consists of funds originally provided by
cancellation of a multiyear reinsurance contract. Coverage comes from the
Catastrophe Trust Fund and reinsurance for the next layer of financing at
($200 to $400 million) and with a probability of occurrence of once every 15
to 27 years. The Catastrophe Trust Fund covers $100 million of this layer
while reinsurance covers an additional $100 million. The next layer of
financing is $300 million of reinsurance and covers events occurring once
every 27 to 54 years. The next layer of financing is $100 million in coverage
from the Catastrophe Trust Fund and covers events that occur once every
54 to 67 years. The next layer up of financing is a $200 million assessment
of its pool of insurers and covers events occurring once every 67 to 102
years. The next level of financing comes from $100 million in reinsurance
coverage. For any losses above this point, there is an unlimited assessment
of TWIA’s pool of insurers.




Page 46                                           GAO-03-1033 Catastrophe Bond Follow-up
Appendix V

Comments from the National Association of
Insurance Commissioners

Note: GAO comments
supplementing those in
the report text appear
at the end of this
appendix.




                         Page 47   GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix V

                 Comments from the National Association of 

                 Insurance Commissioners





See comment 1.




See comment 2.




                 Page 48                                       GAO-03-1033 Catastrophe Bond Follow-up
Appendix V

Comments from the National Association of 

Insurance Commissioners





Page 49                                       GAO-03-1033 Catastrophe Bond Follow-up
               Appendix V

               Comments from the National Association of 

               Insurance Commissioners





               The following are GAO's comments on the National Association of
               Insurance Commissioner's letter dated September 5, 2003.



GAO Comments   1. We have reflected NAIC's views in the report.

               2. We have revised the text and reflected NAIC's views in the report.




               Page 50                                       GAO-03-1033 Catastrophe Bond Follow-up
Appendix VI

Comments from the Bond Market Association



Note: GAO comments
supplementing those in
the report text appear
at the end of this
appendix.




                         Page 51   GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix VI

                 Comments from the Bond Market Association





See comment 1.




See comment 2.




See comment 3.




                 Page 52                                      GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix VI

                 Comments from the Bond Market Association





See comment 4.




                 Page 53                                      GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix VI

                 Comments from the Bond Market Association





See comment 5.




See comment 6.




See comment 7.




See comment 8.




                 Page 54                                      GAO-03-1033 Catastrophe Bond Follow-up
                  Appendix VI

                  Comments from the Bond Market Association





See comment 9.



See comment 10.




See comment 11.




See comment 12.




See comment 13.




See comment 14.




                  Page 55                                      GAO-03-1033 Catastrophe Bond Follow-up
                  Appendix VI

                  Comments from the Bond Market Association





See comment 15.




See comment 16.




See comment 17.




                  Page 56                                      GAO-03-1033 Catastrophe Bond Follow-up
Appendix VI

Comments from the Bond Market Association





Page 57                                      GAO-03-1033 Catastrophe Bond Follow-up
Appendix VI

Comments from the Bond Market Association





Page 58                                      GAO-03-1033 Catastrophe Bond Follow-up
               Appendix VI

               Comments from the Bond Market Association





               The following are GAO's comments on the Bond Marketing Association's
               (BMA) letter dated September 5, 2003.



GAO Comments   1. The two insurance companies that we discussed in this section of the
                  report as well as one state authority cover Florida hurricanes or
                  California earthquakes ("peak perils" as defined by BMA). Officials
                  from each of these organizations said that they have compared the
                  costs associated with catastrophe bonds to traditional reinsurance and
                  did not consider catastrophe bonds cost-effective for their catastrophe
                  reinsurance needs for the level of risks that they insure against
                  (although they may have other reasons for not using catastrophe bonds
                  including the fact that most SPRVs are based offshore). The other state
                  authority does not cover either Florida hurricanes or California
                  earthquakes but considers catastrophe bonds as not cost-effective
                  compared with traditional reinsurance for its business.

               2. While multi-year fixed pricing may be a factor in catastrophe bonds'
                  favor, none of the insurers or state authorities we contacted who
                  currently do not issue catastrophe bonds cited it in our discussions.

               3. The BMA is correct in its statement that catastrophe bond transaction
                  costs decline as a percentage of the (coverage) limit provided as deal
                  size and bond maturity increase. However, some insurance company
                  and state authority representatives said that it was not cost-effective
                  for them to issue catastrophe bonds in amounts large enough to offset
                  the transaction costs.

               4. We have clarified the language in the report with respect to the
                  potential effects that consolidation would have for potential
                  catastrophe bond issuers.

               5. We have reflected BMA's position in the report. We note that BMA's
                  position differs from that of several large mutual fund companies we
                  contacted who said that catastrophe bonds are illiquid.

               6. The mutual fund companies that we contacted offer high-yield bond
                  funds to their investors.

               7. We have clarified language in the report stating that investors do not
                  always face total losses if catastrophe bond provisions are triggered.




               Page 59                                      GAO-03-1033 Catastrophe Bond Follow-up
Appendix VI

Comments from the Bond Market Association





8. We have clarified the language in the report.

9.	 We have added language to the report that provides additional reasons
    that most SPRVs are based offshore.

10. We have made revisions to the figure.

11. We agree that there are different approaches to comparing the returns
    on different types of financial instruments and have clarified language
    in the report. The data we obtained suggest that catastrophe bonds
    have had a higher return than high-yield corporate debt in 2002. The
    scope of our work did not involve identifying or assessing other
    measures, although we note that BMA believes that catastrophe bonds
    yields are comparable to high-yield corporate debt.

12. As discussed in this report, many catastrophe bonds have covered
    events expected to take place no more than once every 100 to 250
    years. It remains to be seen whether a greater number of catastrophe
    bonds covering events expected to take place more frequently than
    once every 100 years will occur.

13. As noted in the report, some insurers issue or have issued indemnity-
    based catastrophe bonds.

14. We have revised the figure in the report.

15. We agree that some insurers find that catastrophe bonds serve as an
    important supplement to traditional means of managing risk, such as
    reinsurance or limiting coverage in high-risk areas.

16. We have reflected BMA's position in the report.

17. A Fitch representative we contacted said that the report cited in the
    draft report had not been updated since 2001. We revised the text and
    stated BMA's position.




Page 60                                      GAO-03-1033 Catastrophe Bond Follow-up
Appendix VII

Comments from the Reinsurance Association
of America

Note: GAO comments
supplementing those in
the report text appear
at the end of this
appendix.




See comment 1.




                         Page 61   GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix VII

                 Comments from the Reinsurance Association 

                 of America





See comment 2.




                 Page 62                                       GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix VII

                 Comments from the Reinsurance Association 

                 of America





See comment 3.




                 Page 63                                       GAO-03-1033 Catastrophe Bond Follow-up
                 Appendix VII

                 Comments from the Reinsurance Association 

                 of America





See comment 4.




See comment 5.




See comment 6.


See comment 7.




See comment 8.




                 Page 64                                       GAO-03-1033 Catastrophe Bond Follow-up
                  Appendix VII

                  Comments from the Reinsurance Association 

                  of America





See comment 9.




See comment 10.




See comment 11.




See comment 12.



See comment 13.




See comment 14.




                  Page 65                                       GAO-03-1033 Catastrophe Bond Follow-up
                   Appendix VII

                   Comments from the Reinsurance Association 

                   of America





 See comment 15.




See comment 16.




See comment 17.




See comment 18.




                   Page 66                                       GAO-03-1033 Catastrophe Bond Follow-up
                  Appendix VII

                  Comments from the Reinsurance Association 

                  of America





See comment 19.




See comment 20.




See comment 21.




                  Page 67                                       GAO-03-1033 Catastrophe Bond Follow-up
               Appendix VII

               Comments from the Reinsurance Association 

               of America





               The following are GAO's comments on the Reinsurance Association of
               America's (RAA) letter dated September 3, 2003.



GAO Comments   1. In this report, we have revised the text to clarify that current statutory
                  accounting standards differ for traditional indemnity reinsurance
                  contracts—including indemnity based catastrophe bonds—and
                  nonindemnity based instruments that hedge insurance risk, such as
                  nonindemnity catastrophe bonds. Where appropriate, we have also
                  revised the text to make clear why the accounting standards differ. That
                  is, traditional reinsurance results in risk transfer while nonindemnity
                  based instruments have not been viewed as providing a comparable
                  risk transfer. We note that NAIC is considering a proposal that would
                  allow similar accounting treatment for nonindemnity based
                  instruments that effectively hedge insurance company risks.

               2. See comment 1. We note that traditional reinsurance does not need
                  hedge accounting treatment afforded an effective hedge because it
                  already receives credit for risk transfer.

               3. See comment 1.

               4. We have altered the report text to indicate that reinsurance contracts
                  may involve litigation over whether insurer claims should be paid. We
                  also state RAA's position in the report.

               5. We have added language to the report stating RAA's positions.

               6. We agree that reinsurance and indemnity based catastrophe bonds
                  receive identical accounting treatment and have revised the text to
                  make this point clear. However, we note that this statutory accounting
                  treatment differs from the accounting treatment that applies to
                  nonindemnity based instruments, such as nonindemnity catastrophe
                  bonds, and this point has also been clarified in the text.

               7. See comment 1.

               8. See comment 1.

               9. See comment 1.




               Page 68                                       GAO-03-1033 Catastrophe Bond Follow-up
Appendix VII

Comments from the Reinsurance Association 

of America





10. See comment 1. We think that insurance statutory accounting rules are
    primarily the concern of issuers and not investors—who would not be
    subject to such rules.

11. We have revised the report text.

12. We have revised the report text.

13. We have revised the text to avoid confusion with other discussions in
    this report.

14. We have revised the report text.

15. We have changed the text so that "frequently" is replaced by "may." We
    have also added RAA's views on the prevalence of insurance litigation.

16. We have added language to the report as suggested by RAA concerning
    additional reasons reinsurance prices increased during the 1999-2002
    period.

17. We have added language to the report on the issue of basis risk
    presented by nonindemnity based catastrophe bonds.

18. We have added the text on tail risk suggested by RAA stating that
    reinsurance contracts may continue to address tail risk while
    catastrophe bonds may not allow claims after several years.

19. See comment 10.

20. We have made some revisions to the report text.

21. We have revised the report language so that the Florida Hurricane
    Catastrophe Fund is properly identified.




Page 69                                       GAO-03-1033 Catastrophe Bond Follow-up
Appendix VIII

GAO Acknowledgments and Staff Contacts




GAO Contacts	      Davi M. D'Agostino (202) 512-8678
                   Wesley M. Phillips (202) 512-5660



Acknowledgments	   In addition to those named above, Lynda Downing, Patrick S. Dynes,
                   Christine Kuduk, Marc Molino, Rachel DeMarcus, and Rachel Seid made
                   key contributions to this report.




                   Page 70                              GAO-03-1033 Catastrophe Bond Follow-up
Related GAO Products



              Insurance Regulation: Preliminary Views on States' Oversight of
              Insurers' Market Behavior. GAO-03-738T. Washington, D.C.: May 6, 2003.

              Catastrophe Insurance Risks: The Role of Risk-Linked Securities. GAO-
              03-195T. Washington, D.C.: October 8, 2002.

              Catastrophe Insurance Risks: The Role of Risk-Linked Securities and
              Factors Affecting Their Use. GAO-02-941. Washington, D.C.: September 24,
              2002.

              Terrorism Insurance: Rising Uninsured Exposure to Attacks Heightens
              Potential Economic Vulnerabilities. GAO-02-472T. Washington, D.C.:
              February 27, 2002.

              Terrorism Insurance: Alternative Programs for Protecting Insurance
              Consumers. GAO-02-199T. Washington, D.C.: October 24, 2001.

              Insurance Regulation: The NAIC Accreditation Program Can Be
              Improved. GAO-01-948. August 31, 2001.

              Regulatory Initiatives of the National Association of Insurance
              Commissioners. GAO-01-885R. Washington, D.C.: July 6, 2001.

              Disaster Assistance: Issues Related to the Development of FEMA's
              Insurance Requirements. GGD/OGC-00-62. Washington, D.C.: February 25,
              2000.

              Insurers' Ability to Pay Catastrophe Claims. GGD-00-57R. Washington,
              D.C.: February 8, 2000.

              FCIC: Catastrophic Risk Protection Endorsement and Federal Crop
              Insurance Reform, Insurance Implementation. OGC-98-69. Washington,
              D.C.: August 17, 1998.




(250134)      Page 71                                GAO-03-1033 Catastrophe Bond Follow-up
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