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entitled 'Catastrophe Insurance Risks: Status of Efforts to Securitize
Natural Catastrophe and Terrorism Risk' which was released on October
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Report to Congressional Requesters:
September 2003:
CATASTROPHE INSURANCE RISKS:
Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-1033] GAO-03-
1033:
GAO Highlights:
Highlights of GAO-03-1033, a report to the Chairman, House Committee
on Financial Services, the Chairman, Subcommittee on Capital Markets,
Insurance, and Government Sponsored Enterprises, and House Members
Why GAO Did This Study:
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. Given these financial demands, interest has been raised in
bonds that are sold in the capital markets and thereby diversify
catastrophe funding sources. GAO was asked to update a 2002 report on
“catastrophe bonds” and assess (1) their progress in transferring
natural catastrophe risks to the capital markets, (2) factors that may
affect the issuance of catastrophe bonds by insurance companies, (3)
factors that may affect investment in catastrophe bonds, and (4) the
potential for and challenges associated with securitizing terrorism-
related financial risks.
GAO does not make any recommendations in this report.
What GAO Found:
The market for catastrophe bonds, as discussed in our 2002 report, has
transferred a small portion of natural catastrophe risk to the capital
markets. From 1997 through 2002, a private firm has estimated that a
total of 46 catastrophe bonds were issued or about 8 per year. Another
firm estimated that the nearly $3 billion in catastrophe bonds
outstanding for 2002 (see figure) represented 2.5 to 3.0 percent of
the worldwide catastrophe reinsurance market. Some insurance and
reinsurance companies issue catastrophe bonds because they allow for
risk transfer and may lower the costs of insuring against the most
severe catastrophes. However, other insurers do not issue catastrophe
bonds because their costs are higher than transferring risks to other
insurers. Although some investors see catastrophe bonds as an
attractive investment because they offer high returns and portfolio
diversification, others believe that the bonds’ risks are too high or
too costly to assess. To date, no catastrophe bonds related to
terrorism have been issued covering potential targets in the United
States, and the general consensus of most experts GAO contacted is
that issuing such securities would not be practical at this time due
in part to the challenges of predicting the frequency and severity of
terrorist attacks.
www.gao.gov/cgi-bin/getrpt?GAO-03-1033.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Davi M. D'Agostino at
(202) 512-8678 or dagostinod@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Catastrophe Bond Issuance Has Been Limited:
Catastrophe Bonds Benefit Some Insurers, but Others Believe That the
Bonds' Costs Are Too High:
Institutional Investors Provided Mixed Views on Catastrophe Bonds:
Securitizing Terrorism Risk Poses Significant Challenges:
Observations:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Statutory Accounting Balance Sheet Implications of
Reinsurance Contracts:
Appendix III: FASB Interpretation No. 46, Consolidation of Variable
Interest Entities:
What is a VIE?:
Appendix IV: Texas Windstorm Insurance Association:
Appendix V: Comments from the National Association of Insurance
Commissioners:
GAO Comments:
Appendix VI: Comments from the Bond Market Association:
GAO Comments:
Appendix VII: Comments from the Reinsurance Association of America:
GAO Comments:
Appendix VIII: GAO Acknowledgments and Staff Contacts:
GAO Contacts:
Acknowledgments:
Related GAO Products:
Figures:
Figure 1: Traditional Insurance, Reinsurance, and Retrocessional
Transactions:
Figure 2: Reinsurance Prices in the United States, 1989-2002A:
Figure 3: Special Purpose Reinsurance Vehicle:
Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002:
Figure 5: Catastrophe Bond Issuance and Amount Outstanding 1997-2002:
Figure 6: Type of Catastrophe Bond Issuer 1997-2002:
Figure 7: Residential Reinsurance Issuances:
Figure 8: Effect on Ceding and Reinsurance Companies' Balance Sheets
before and after a Reinsurance Transaction:
Figure 9: Texas Windstorm Insurance Authority Financing:
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:
Letter 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).[Footnote 1]
Given the enormous financial losses associated with such catastrophes
and concerns about the capacity of the insurance industry to cover
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.[Footnote 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.[Footnote 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.[Footnote 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 in catastrophe bonds, and (4)
analyze the potential for and challenges associated with securitizing
terrorism-related financial risks.[Footnote 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.[Footnote 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.
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).[Footnote 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.[Footnote 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.[Footnote 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.[Footnote 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 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.[Footnote 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.[Footnote 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. 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 approved the
proposal.[Footnote 13] 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.[Footnote 14]
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.[Footnote 15]
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.[Footnote 16]
Catastrophe bonds involving terrorism risks have not been issued by
insurers to cover targets in the United States, and insurance industry
and 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.
Overview of Natural and Terrorist Catastrophe Insurance Coverage:
The insurance industry consists of primary and reinsurance companies,
which provide coverage--including coverage for natural catastrophe and
terrorism risk---to their customers through property-casualty,
homeowners, 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:
[See PDF for image]
[End of figure]
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 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.[Footnote 17] Several states--including Florida,
California, and Texas--have established authorities to help ensure that
coverage is available in areas particularly prone to these
events.[Footnote 18] 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 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:
[See PDF for image]
[A] This figure shows a price index set equal to 100 in 1989 normalized
prices.
[End of figure]
Catastrophe Bonds Employ Complex Structures:
As discussed in our previous report, risk-linked securities--including
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.[Footnote 19] 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 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:
[See PDF for image]
[End of figure]
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.[Footnote 20] 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.[Footnote 21] 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.[Footnote 22]
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 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.[Footnote
23] 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.[Footnote
24]
Catastrophe Bond Issuance Has Been Limited:
Private sector data indicate that the catastrophe bond market accounts
for a small share of the worldwide reinsurance market for catastrophe
risk.[Footnote 25] According to Marsh & McLennan Securities, between
1997 and 2002, a total of 46 catastrophe bonds were issued, or about 8
per year as shown in figure 4.[Footnote 26] 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.[Footnote 27] 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.[Footnote 28] 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.[Footnote 29]
Figure 4: Annual Issuance of Catastrophe Bonds, 1997-2002:
[See PDF for image]
[End of figure]
Figure 5: Catastrophe Bond Issuance and Amount Outstanding 1997-2002:
[See PDF for image]
Note: Total shown by figure at top of bar is amount outstanding at year
end.
[End of figure]
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:
[See PDF for image]
[End of figure]
Figure 7: Residential Reinsurance Issuances:
[See PDF for image]
[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.
[End of figure]
Catastrophe Bonds Benefit Some Insurers, but Others Believe That the
Bonds' Costs Are Too High:
Representatives from some insurance and reinsurance companies told us
that catastrophe bonds served a useful role in their overall approach
to managing their natural catastrophe risk exposures and that such
bonds lowered the costs associated with the most severe types of
catastrophe risk. However, representatives from two large insurers and
two state authorities said that the total costs associated with the
bonds were high compared with traditional reinsurance and affected
their willingness to issue the bonds.[Footnote 30] 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 Reinsurance Companies Identified Benefits of
Catastrophe Bonds:
Representatives from some large insurers and reinsurers we contacted
said that catastrophe bonds were a complement to several other basic
risk management tools: raising more equity capital by selling more
company stock, transferring risks to the reinsurance markets, and
limiting risks 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 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.[Footnote 31]
Several Insurers Said That Catastrophe Bonds Were More Expensive Than
Traditional Natural Catastrophe Reinsurance:
Although some insurance and reinsurance companies have found
catastrophe bonds to be cost-effective for some of their catastrophe
coverage, representatives from two large insurance companies and two
state authorities, as well as other market participants, said that the
costs associated with catastrophe bonds could be significantly higher
than the 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.
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.
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 Participants Questioned Insurers' Analysis of the
Costs Associated with Catastrophe Bonds:
Some financial market participants that supported the use of
catastrophe bonds--such as investment banks--and some insurers
questioned other insurers' analysis of cost differences between
catastrophe bonds and traditional reinsurance. These representatives
said that catastrophe bonds may be cost-competitive with traditional
reinsurance for high severity and 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.[Footnote
32]
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.[Footnote 33]
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.
Some Insurers Noted That Catastrophe Bonds Were Not Cost-Effective for
Natural Catastrophes That Were More Likely to Occur or for Lower
Coverage Amounts:
Besides cost, some insurance company and state authority
representatives we contacted cited other reasons why they did not
choose to issue catastrophe bonds. They said that they were not
attracted to catastrophe bonds' traditional focus on covering events
with the lowest frequency and the highest severity (for example,
hurricanes or earthquakes expected to occur every 100 to 250 years).
Rather, the representatives said that their coverage needs were for
less severe events expected to take place more 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.
Impact of Accounting Issues Potentially Affecting the Use of
Catastrophe Bonds Still Unclear:
Our previous report stated that NAIC's current statutory accounting
requirements might affect insurers' use of nonindemnity-based
catastrophe bonds.[Footnote 34] Under statutory accounting, an
insurance company that buys traditional indemnity-based reinsurance or
issues an indemnity based catastrophe bond can reflect the transfer of
risk (effected by the purchase of reinsurance) on the financial
statements that it files with state regulators. As a result of the risk
transfer, the insurance company can improve its stated financial
condition and 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.
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.[Footnote 35] 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.[Footnote 36] 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.
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.[Footnote 37] 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 Provided Mixed Views on Catastrophe Bonds:
Representatives from some institutional investors told us that
catastrophe bonds served a useful but limited role in their overall
approach to managing their investment portfolios by often providing
higher yields than traditional 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 in Catastrophe Bonds for High Yields and
Portfolio Diversification:
The relatively high rates of return offered by catastrophe bonds make
them attractive to some institutional investors, such as pension funds,
hedge funds, and mutual funds--including mutual funds that specialize
in catastrophe bond investments. As discussed previously, catastrophe
bonds carry noninvestment-grade ratings and, during certain time
periods, high spreads relative to alternative fixed-income investments,
such as high-yield 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 Cited High Risks, Lack of Analytical
Capacity, and Illiquidity as Primary Reasons for Not Purchasing
Catastrophe Bonds:
As discussed in our previous report, the investor market for
catastrophe bonds is not broad and some institutional investors--such
as mutual funds--did not purchase them.[Footnote 38] Representatives
from three large mutual funds we contacted for our follow-up work said
they did not purchase catastrophe bonds because of their perceived
risks. The mutual fund officials said that their traditional approach
to investing in high-yield debt involved assessing a company's business
strategy, management talent, 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
narrow bid-ask spreads.[Footnote 39] 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 Risk Poses Significant Challenges:
The general consensus of insurance and financial market participants we
contacted was that insuring against terrorism risk would be difficult
and that developing bonds covering potential targets against terrorism
attacks 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 Forecasting Terrorist Attacks Makes Insuring against
Terrorism Risk Difficult:
According to insurance industry representatives, insuring against
natural catastrophe risk, despite its challenges, is considered more
practical than insuring against or securitizing terrorism risk. To
establish their exposures and to price insurance premiums, companies
need to be able to predict with some reliability the frequency and
severity of insured event risks. 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 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.[Footnote 40] 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.[Footnote 41] 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.
Terrorism Models under Development Considered by Some as Too New and
Untested to Support Catastrophe Bonds:
Representatives from the three major risk-modeling firms said that they
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 terrorism experts to forecast the frequency and severity of
terrorist attacks. One firm uses the Delphi method, another uses game
theory, and 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.
Investor Concerns Could Impede the Development of a Market for
Terrorism-Related Securities:
Investor concerns about catastrophe bonds related to terrorism could
also make the costs to insurers of issuing such bonds prohibitive. In
the absence of well-developed and contractual business relationships
with the primary insurer, investors might not believe they had
sufficient information about 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 investors will lose
their principal.[Footnote 42] 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.[Footnote 43] 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.
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 Our Evaluation:
We received written comments on a draft of this report from NAIC, BMA,
and RAA. We also received technical comments from these organizations,
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
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.
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 [Hyperlink, http://www.gao.gov] 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.
Signed by:
Davi M. D'Agostino
Director, Financial Markets and Community Investment:
[End of section]
Appendixes:
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.[Footnote 44]
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 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.
[End of section]
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 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:
[See PDF for image]
[End of figure]
Reinsurance contracts do not relieve the ceding insurer from its
obligation to policyholders. Failure of reinsurers to honor their
obligations could result in losses to the ceding insurer.
An insurer may also obtain risk reduction from 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.
[End of section]
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.[Footnote
45] 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:
* 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 Consolidate:
The interpretation requires existing unconsolidated VIEs to be
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.
[End of section]
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.
Figure 9: Texas Windstorm Insurance Authority Financing:
[See PDF for image]
[End of figure]
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.
[End of section]
Appendix V: Comments from the National Association of Insurance
Commissioners:
NAIC:
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS:
EXECUTIVE HEADQUARTERS:
2301 MCGEE STREET
SUITE 800
KANSAS CITY MO 64108-2662
VOICE 816-842-3600
FAX 816-783-8175:
Ms. Davi M. D'Agostino:
Director, Financial Institutions and Community Investment United States
General Accounting Office:
Washington, DC 20548:
September 5, 2003:
Dear Ms. D'Agostino:
FEDERAL AND INTERNATIONAL RELATIONS:
HALL OF THE STATES 444 NORTH CAPITOL ST NW SUITE 701 WASHINGTON DC
20001-1509 VOICE 202-624-7790 FAX 202-624-8579:
Thank you for giving the NAIC the opportunity to comment on the report
"Catastrophe Insurance Risks: Status of Efforts to Securitize Natural
Catastrophe and Terrorism Risk".
The National Association of Insurance Commissioners (NAIC) is a
voluntary organization of the chief insurance regulatory officials of
the 50 states, the District of Columbia and four U.S. territories. The
association's overriding objective is to assist state insurance
regulators in protecting consumers and helping maintain the financial
stability of the insurance industry by offering financial, actuarial,
legal, computer, research, market conduct and economic expertise.
As we mentioned in our comment letter to the previous GAO report,
"Catastrophe Insurance Risks: The Role of Risk-Linked Securities and
Factors Affecting Their Use", the NAIC formed a working group on
Insurance Securitization in 1998 to "investigate whether there needs to
be a regulatory response to continuing developments in insurance
securitization, including the use of non-U.S. special purpose vehicles
and to prepare educational material for regulators." As a result of its
deliberations, the NAIC has taken the position that U.S. insurance
regulators should encourage the development of alternative sources of
capacity such as insurance securitizations and risk linked securities
as long as such developments are commensurate with the overriding goal
of the NAIC membership of consumer protection.
The NAIC continues to believe that one goal should be to encourage and
facilitate securitizations within the United States. If transactions
that are currently performed offshore were brought back to the United
States, they would be subject to on-shore supervision by U.S.
regulators. At present, off-shore insurance securitizations are not
subject to U.S. regulation, and the NAIC members are concerned about
the appropriate use of Special Purpose Vehicles. The NAIC membership
believes that, properly used and structured, Special Purpose
Reinsurance Vehicles may provide extra capacity, more competition,
and may reduce the overall costs of insurance for the public. The NAIC
membership therefore believes that on-shore SPRVs, regulated by U.S.
insurance regulators, would be preferable to the current situation
where most securitizations are conducted offshore. In particular, the
report mentions that certain commentators regard the costs of
catastrophe bonds as too high and the market too illiquid: NAIC members
hope that the creation of a domestic on-shore market for
securitizations would expand the market and reduce overall costs, while
increasing its liquidity.
It would appear that at least one major stumbling block to the wider
use of risk linked securities remains the uncertainty regarding their
tax treatment. While the NAIC membership takes no position on Federal
Taxation issues, we would encourage the removal of the uncertainty one-
way or the other.
The report at times reflects the flavor of an either/or argument
regarding reinsurance and catastrophe bonds. The NAIC membership takes
no position on whether catastrophe bonds are better or worse than
reinsurance. The membership feels that consumers are best protected in
the long term when there are alternative markets to provide protection.
We suspect that, were investors to be required to consolidate SPRVs,
this would be detrimental to the development of the market. However, it
would appear that such a requirement would probably only exist when one
investor owns more than 50% of a bond issuance, and this would likely
be a rare occurrence.
We concur with the conclusion that terrorism risk would likely be very
difficult to securitize, but believe that efforts are being made to
model the risk. Additionally, some insurers are writing terrorism risk,
and if it can be priced, then it can be securitized. However, the
current practical difficulties pointed out in the report would likely
prevent this occurring in the medium term.
We object to the reference to the insurance company representative
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." It is not
within the purview of state insurance regulators to establish rate
levels for insurers. The statutory framework requires that the insurer
develop rates and, in some jurisdictions, file these resulting rate
levels with insurance regulators. In some cases the regulator has
approval authority over the rates charged, however, often the statutory
language places limitations on that authority.
Further, ratemaking is an art rather than a science. Reasonable people
can disagree on the proper rate to charge for a specific insurance
product. Rates are made on a prospective basis and any two actuaries
can make different assessments regarding factors that influence the
price of a product in the future. They might disagree on the rate of
inflation or trend factors that are used to
estimate the future losses. Thus, it is incorrect to assume that any
time a regulatory actuary and an industry actuary disagree on "the
price" that the regulatory actuary is always wrong and engaging in rate
suppression. This person is not complaining about the price of
reinsurance or of catastrophe bonds - he is simply saying that his
actuary and a regulatory actuary disagree on "the price" and clearly he
believes that his actuary was correct and the regulatory actuary was
wrong. It should also be noted that it is rare for insurance companies
to complain that approved insurance rates are too high.
Again, we thank you for the opportunity to review and comment on the
report.
Sincerely,
Ernst N. Csiszar
Vice President, NAIC Director of Insurance,
State of South Carolina:
Signed by Ernst N. Csiszar:
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.
[End of section]
Appendix VI: Comments from the Bond Market Association:
The Bond Market Association:
360 Madison Avenue
New York, NY 10017-7111
Telephone 646.637.9200
Fax 646.637.9126
www.bondmarkets.com:
1399 New York Avenue, NW
Washington, DC
20005-4711
Telephone 202.434.8400
Fax 202.434.8456:
St. Michael's House
1 George Yard
London EC3V 9DH
Telephone 44.20.77 43 93 00
Fax 44.20.77 43 93 01:
September 5, 2003:
Ms. Davi M. D'Agostino:
Director, Financial Markets and Community Investment United States
General Accounting Office:
Washington, D.C. 20548:
Re:
Comments on Draft GAO Report, "Status of Efforts to Securitize Natural
Catastrophe and Terrorism Risk" (GAO-03-1033):
Dear Ms. D'Agostino:
The Bond Market Association (the "Association")[NOTE 1] is pleased to
respond to GAO's request for comments on the above-referenced draft
report (the "Report").
We believe that the Report offers a timely and helpful assessment of
the progress of catastrophe bonds in transferring natural catastrophe
risk to the capital markets, several key business, economic, and
regulatory factors that may affect the issuance of and investment in
catastrophe bonds, and the potential for securitizing terrorism-related
financial risks.
We have divided our comments on the Report into two principal sections.
The first section of this letter offers several general comments and
observations that relate to certain broader themes and policy issues
raised in the Report. The second section provides input on a number of
specific, technical issues throughout the document. Our general and
specific comments follow.
I. Broader/General Comments:
A. The Comparable Costs of Catastrophe Bonds and Traditional
Reinsurance:
The Report correctly notes that some insurers believe that the total
costs of catastrophe bonds-including relatively higher rates of return
to investors and administrative costs-significantly exceed the costs
associated with purchasing reinsurance coverage. However, as further
noted in the Report, some financial market participants believe that
insurers' comparisons of the costs of catastrophe
bonds and traditional reinsurance fail adequately to account for
several important factors that can materially influence this analysis,
such as the credit quality and stability of reinsurers. In addition to
the elimination of counterparty credit risk, we believe there are
several other important factors to consider when analyzing cost
difference between catastrophe bonds and traditional reinsurance.
First, we believe that the relative attractiveness of catastrophe bonds
depends on whether the particular risk is truly a "peak" peril of a
type that has customarily been addressed via catastrophe bonds-perils
where the potential industry aggregate insured losses are the greatest.
Insurers incur greater costs and credit risk in connection with
traditional reinsurance for these types of perils, which may make the
relative costs and credit quality of catastrophe bonds more attractive.
Examples of peak perils would include Japanese earthquake, California
earthquake, and Florida hurricane exposures. Reinsurers need to hold
more capital in reserve for peak peril catastrophes than for non-peak
perils and, therefore, need to charge greater premiums to cover the
cost of this additional capital. In addition, from an insurer's
perspective, peak industry risks magnify counterparty concerns already
present in traditional reinsurance. In other words, a single reinsurer
is more likely to become insolvent following a San Francisco earthquake
than following a Galveston hurricane.
Page 24 of the Report states that insurers that are considering issuing
catastrophe bonds likely must pay substantial interest costs in order
to attract investors, and that at least one large insurer and state
catastrophe fund reported that quotes they received from investment
banks on the interest costs associated with catastrophe bonds exceeded
the costs of comparable reinsurance. We believe that this specific
example likely involved a non-peak peril, resulting in reinsurance
rates that are considerably lower than a peak-peril risk, thus making
catastrophe bonds a less relevant choice in that circumstance.
We believe a second important factor to consider when comparing costs
of catastrophe bonds and traditional reinsurance is that catastrophe
bonds offer multi-year fixed pricing, thereby protecting the insurer
against reinsurance price volatility and allowing the purchaser to
hedge against future increases in reinsurance rates. This is
particularly important for a primary insurer subject to rate regulation
where such regulation limits the insurer's ability to fully pass
through reinsurance rate increases to their policyholders in a single
year. In comparing costs, in addition to considering the peak peril/
non-peak peril distinction discussed above, additional adjustments are
appropriate for the value of multi-year fixed pricing.
Finally, the Report also notes that some insurance company officials
and state catastrophe fund representatives cited administrative and
transaction costs as one of the reasons for the relatively high costs
associated with catastrophe bonds, and that the transaction costs alone
could represent 2 percent of the coverage provided. We believe it is
important to note that catastrophe bond transaction costs decline as a
percentage of limit provided when the deal size and bond maturity
increase. It should also be noted that most catastrophe bond
transactions are 3-5 years in term and the cost is amortized over the
life of the bond. Therefore, on an annualized basis, transaction costs
related to catastrophe bond issuance are more comparable to traditional
reinsurance. These costs also represent a one-time administrative cost
rather than the ongoing costs generated by continuous price and credit
monitoring and negotiations with the reinsurance market. We also note
that in order to address superfluous transaction costs associated with
the need to structure catastrophe bonds through off-shore special
purpose reinsurance vehicles (SPRVs), the Association has urged changes
to the Internal Revenue Code which would allow on-shore catastrophe
bond transactions. This change would reduce transaction costs and
expand the potential investor base for catastrophe bonds at little or
no cost to the federal treasury.
We believe that substantial support can be found for the above views
among senior credit rating agency personnel who are responsible for
evaluating insurers' financial strength. To the extent time and
resources permit, speaking with these individuals may be a valuable
opportunity for additional GAO follow up.
B. Accounting Issues Affecting Insurers:
In its discussion of the accounting issues raised by FASB's
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN
46), the Report states that if an insurer were required to consolidate
the assets and liabilities of an SPRV under FIN 46, the insurer would
lose part of the benefit of the reinsurance contract that it enters
into with the SPRV. In other words, the risks that the insurer had
transferred from its books through the issuance of catastrophe bonds
would be "returned" to the insurer. We believe that this is not an
entirely accurate description of the result. If a catastrophe bond SPRV
is required to be consolidated by the transaction sponsor, and the bond
is triggered to exhaustion (a complete loss), the consolidating
transaction sponsor would receive a payment from the SPRV and the
insurer's assets would remain the same (assets in the SPRV which the
insurer did not control are converted to cash which it owns); however,
the liability for debts it did not owe is reduced to zero.
We further note that such consolidation under FIN 46 would also limit
the appeal of catastrophe bonds because the proceeds of the bond
offering would appear as additional leverage on the insurer's balance
sheet although these proceeds are dedicated for a specific purpose.
Finally, the Report states that the National Association of Insurance
Commissioners (NAIC) is still considering a statutory accounting issue,
discussed in the GAO's 2002 Report, concerning insurers' current
inability to obtain statutory accounting treatment for certain
catastrophe bonds that is similar to the regulatory accounting
treatment they receive for purchasing reinsurance. We believe it is
important to note that NAIC
accounting treatment is only important for certain primary insurance
companies. For most potential transaction sponsors, NAIC accounting
treatment is not an applicable or relevant consideration.
C. Factors Affecting Investment:
Several sections of the Report include statements to the effect that
some institutional investors reported they were not willing to purchase
catastrophe bonds because of their relative illiquidity when compared
with traditional bonds and equities. The Association disagrees with
this assertion of relative illiquidity. Most catastrophe bonds are
issued at a BBB or BB rated level. Catastrophe bonds in fact enjoy
similar or better liquidity relative to similarly rated bonds. Bid/ask
spreads are in fact tighter than for comparably rated bonds.
Admittedly, AAA credit card ABS paper trades on a more liquid basis,
but this is not a relevant comparison.
The top of page 36 of the Report quotes a mutual fund representative as
saying that catastrophe bonds "trade by appointment," and that his
fund's policies did not allow for the purchase of such illiquid
securities. We believe that these types of mutual funds do not invest
in high-yield bonds, BB-rated ABS paper, or other similarly rated
bonds.
The top of page 35 of the Report states that one mutual fund official
reported 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.
We believe this is not entirely accurate. While an initial loss might
wipe out a catastrophe bond, it is not an inevitable result that if the
bond is triggered, the bond defaults entirely. Further, with respect to
hurricanes, the storms develop over several days offering trading
opportunities. Also, a number of second and subsequent event
catastrophe bonds exist, offering still further opportunities to trade
away the bonds as they become riskier.
11. Specific/Technical Comments:
For ease of reference, the following technical comments are keyed to
specific page numbers of the Report:
Page 4: At the bottom of this page and the top of page 5, please note
that Swiss Re Capital Markets provided the data on the amount of
catastrophe bonds outstanding at the end of 2002, and Swiss Reinsurance
Company provided the data on outstanding catastrophe bonds as a
percentage of the worldwide catastrophe reinsurance coverage in 2002.
Page 13: The footnote on this page states that "[m]ost SPRVs are based
off-shore for tax purposes." We believe an important reason for setting
up SPRVs in the Cayman Islands and Bermuda is the excellent support
infrastructure for efficiently operating the entities.
Page 14: We believe that several minor changes to Figure 3 would more
precisely depict the components of actual cash flows in a typical
catastrophe bond. Specifically, the arrow depicting the flow of
"principal plus interest" from the SPRV to investors should indicate
that the SPRV pays to investors interest from the assets invested in
the trust, plus the amount of premium that is conveyed by the insurer/
reinsurer to the SPRV (which premium constitutes the principal assets
of the trust). The arrow depicting the flow of "principal and premium"
from the SPRV to the trust should indicate that the SPRV conveys
principal, only (i.e., the amount of premium referred to above) to the
trust.
Page 15: This section of the Report states that one of the
characteristics of catastrophe bonds is a relatively high return to
investors, exceeding the returns on comparable fixed-rate investments,
such as high-yield corporate debt. We believe that historical return is
not the only way to look at pricing as it takes into account
appreciation and depreciation in the positions. Another approach is to
look at yields. From this perspective, BB catastrophe bond yields are
comparable to yields on BB corporate bonds (and BB CMBS) rather than
wider.
Page 16, Page 28: These sections of the Report include statements to
the effect that catastrophe bonds typically cover risks that are
considered the lowest probability and highest severity (those expected
to occur no more than once every 100 to 250 years), and that they do
not typically provide coverage for events expected to occur more
frequently than once every 100 years. While historically this has been
true, in recent times a significantly greater percentage of bonds have
covered events occurring more frequently than 100 years. We expect this
trend to continue.
Page 16: Paragraph (5) on this page states that catastrophe bonds are
typically nonindemnity rather than indemnity-based. While it is true
that there is a market trend toward nonindemnity-based bonds,
indemnity-based transactions do continue to be executed.
Page 21: Residential Re 2003 has been completed since the GAO conducted
its field research for the report. Attached as Exhibit I to this letter
is a one page case study of the Residential Re 2003 transaction. We
submit that GAO may want to replace its description of the 2002
Residential Re transaction with the newer one, which would reflect that
the investors are willing to take much more complex, multi-year, multi-
peril indemnity risk.
Page 26: A statement appears on this page indicating that insurers'
preference for traditional reinsurance may be explained in part by
"their long-standing business relationships with reinsurance
companies." While the quality and duration of such relationships are
important factors in the insurance and reinsurance business, our
members' experience strongly suggests that the existence of such
relationships has not inhibited insurers from pursuing better and more
efficient ways of achieving their business goals.
Page 28: At the bottom of this page, insurance company officials
indicate that catastrophe bonds are typically only available in
coverage denominations of $100 million or more. Although there are
significant economies of scale in catastrophe bond issuances, such
bonds can and have been issued in coverage denominations of less than
this amount.
Page 35: At the bottom of this page, the Report cites a publication
from Fitch which indicated that the secondary market for catastrophe
bonds is limited and investors should be willing to hold them until
they mature. This Fitch report is out of date and no longer accurate.
111. Conclusion:
Again, the Association greatly appreciates the opportunity to comment
on the Report. We commend the GAO for producing a useful and
illuminating document, which should inform future legislative,
regulatory, and broader policy discussions concerning the status of
efforts to securitize natural catastrophe and terrorism risk.
We would be pleased to assist you in any further research you may
conduct in connection with this topic. Should you have questions or
desire additional information concerning any of the matters addressed
in the foregoing comments, please do not hesitate to contact either of
the undersigned at (646) 637-9200.
Sincerely,
George P. Miller:
Senior Vice President and Deputy General Counsel
The Bond Market Association:
Michele C. David:
Vice President and Assistant General Counsel The Bond Market
Association:
Signed by George P. Miller and Michele C. David:
[See PDF for image]
[End of figure]
NOTES:
[1] The Association represents securities firms and banks that
underwrite, distribute, and trade fixed income securities, both
domestically and internationally. Our members are actively involved in
the primary issuance and secondary trading markets for risk-linked
securities. This letter was prepared based upon input provided by
members of the Association's Risk-Linked Securities Committee, which
includes senior business and legal professionals from Association
member firms. Additional information about the Association, its
members, and activities may be obtained via the Internet at
www.bondmarkets.com.
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.
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.
[End of section]
Appendix VII: Comments from the Reinsurance Association of America:
REINSURANCE ASSOCIATION OF AMERICA:
1301 Pennsylvania Avenue, N.W., Suite 900, Washington, D.C. 20004-1701
Telephone: (202) 783-8311 Facsimile: (202) 638-0936 http://
www.reinsurance.org:
September 3, 2003:
Ms. Davi M. D'Agostino
Director of Financial Markets and Community Investment:
United States General Accounting Office 441 G Street, N.W.
Washington, DC 20508:
Dear Ms. D'Agostino:
The Reinsurance Association of America (RAA) appreciates this
opportunity to comment on the GAO's draft report entitled "Catastrophe
Insurance Risks: Status of Efforts to Securitize Natural Catastrophe
and Terrorism Risk.":
The RAA is a national trade association representing property and
casualty organizations that specialize in reinsurance. The RAA
membership is diverse, including large and small, broker and direct,
U.S. companies and subsidiaries of foreign companies. Together RAA
members write more than two-thirds of the reinsurance written by U.S.
property casualty reinsurers.
We believe that this report provides a generally fair summary of this
issue and is a valuable follow-up to your first report on this topic
entitled "Catastrophe Insurance Risks: The Role of Risk Linked
Securities and Factors Affecting Their Use." However, we also believe
that the report contains errors with respect to the characterization
that current NAIL accounting guidance favors indemnity reinsurance as
compared to certain types of catastrophe bonds. The discussion of the
accounting environment fails to adequately differentiate between
indemnity reinsurance contracts and financial instruments such as
index-linked catastrophe bonds that are intended to hedge insurance
risks.
The report provides a very good overview of the insurance industry's
and capital markets' perspectives on the relative advantages of
reinsurance and catastrophe bonds. While we take issue with some of the
comments attributed to financial markets participants in the report, we
found this information enlightening. We agree with the conclusion in
the report that securitization of terrorism risk poses significant
challenges. We agree that transactions intended to transfer or hedge
terrorism risk via risk-linked bonds are unlikely to occur in the near
future.
Current NAIL Accounting Requirements for Reinsurance and Catastrophe
Bonds are Consistent:
There are numerous references in the report, which indicate that
current NAIC accounting rules favor traditional reinsurance contracts
over certain types of catastrophe bonds. We believe these statements
are in error and may cause a fundamental misunderstanding of the
current NAIC and GAAP guidance for indemnity (re)insurance and hedging
transactions. Traditional reinsurance transactions and indemnity-based
catastrophe bonds both provide reinsurance credit to the cedant.
Similarly, reinsurance accounting credit is not granted for either non-
indemnity-based reinsurance or for non-indemnity catastrophe bonds. The
reinsurance cover provided by the SPRV to the cedant and illustrated in
Figure 3 of the report is treated the same way as a reinsurance cover
provided by a reinsurer directly. Moreover, the NAIC Special Purpose
Reinsurance Vehicle Model Act requires that SPRV's follow the same
requirements of the Credit For Reinsurance Model Law and Regulation
applicable to reinsurance transactions.
The pending accounting change under consideration by the NAIC relates
to the accounting requirements for index-based insurance-linked
derivatives. If and when this guidance is adopted, it could be applied
to non-indemnity (index-based) triggers in a catastrophe bond
transaction. If that occurs, index-based catastrophe bonds may be
granted financial statement credit similar to reinsurance if the
transaction effectively hedges the insurance risk. Traditional
reinsurance transactions are not eligible for this favorable hedge
accounting because they are subject to SSAP No. 62 and SFAS No. 113.
Thus if the NAIC adopts this guidance, SPRV's would receive hedge
accounting treatment that is not granted to traditional reinsurance.
There is a fundamental difference between the indemnification provided
by a traditional reinsurance contract (or an indemnity-based SPRV
reinsurance contract) and a financial instrument that hedges insurance
risk. That difference is the existence of true risk transfer. NAIC SSAP
No 62 Property Casualty Reinsurance states that:
"The essential ingredient of a reinsurance contract is the transfer of
risk. The essential element of every true reinsurance agreement is the
undertaking by the reinsurer to indemnify the ceding entity, i.e.,
reinsured entity, not only in form but in fact, against loss or
liability by reason of the original insurance. Unless the agreement
contains this essential element of risk transfer no (accounting) credit
shall be recorded.":
An index-based catastrophe bond (or a non-indemnity-based reinsurance
contract) does not indemnify the cedant and transfer insurance risk
under this definition. The intent of the proposed NAIC guidance for
index-based insurance-linked derivatives is to create a favorable
exception for financial instruments that effectively hedge insurance
risk and therefore are expected to be highly correlated with the
cedant's actual losses. The key to this exception is the determination
that the derivative is a highly effective hedge of the cedant's
insurance risk. This measure of effectiveness is intended to be
comparable to the
risk transfer thresholds necessary for traditional reinsurance
contracts under SSAP No. 62 and FASB No. 113.
In summary, NAIL accounting guidance currently treats traditional
reinsurance and indemnity catastrophe bonds identically because both
transfer risk in accordance with SSAP No. 62. If adopted, the proposed
NAIC guidance for index-based insurance-linked derivatives will
establish reinsurance-like accounting for highly effective hedges of
insurance risk, including non-indemnity catastrophe bonds. This
proposed reinsurance-like treatment will not be available to
reinsurance transactions, which are subject to SSAP No. 62 and FASB No.
113.
Insurance Indemnification and Financial Instrument Hedges are
Different:
A related problem in the draft report is the use of hedging and
indemnity reinsurance terminology as if they were interchangeable. As
noted above, there are fundamental differences between indemnity-based
(re)insurance and hedging risks using financial instruments. These
differences are recognized in the U.S. tax code, which provides unique
rules for deduction of indemnity-based insurance reserves and in GAAP
guidance in the U.S. and around the world. In fact, one of the major
problems with the International Accounting Standards Board's project on
insurance contracts is rooted in their efforts to treat insurance
contracts as if they were equivalent to other financial instruments.
Because of these differences, the NAIC proposal on insurance-linked
derivatives does not grant reinsurance accounting to these
transactions. Instead, the NAIC proposal creates "reinsurance-like"
accounting that is reported separately from reinsurance on the
financial statements. The proposed guidance also includes separate and
comprehensive disclosure of insurance hedging transactions to recognize
these differences. Indemnification is unique to (re)insurance contracts
and it should not be confused with financial instrument hedging
transactions.
Characterization of Reinsurance Costs by Investment Banks:
The draft report states that some investment banks question insurers'
analysis of cost differences between catastrophe bonds and traditional
reinsurance. These comments focused on credit deterioration of some
reinsurers and the assertion that reinsurance contracts frequently
involve litigation. We believe that insurers are better positioned to
evaluate these costs and agree with the insurers' comments that they
have adequate policies to continually monitor reinsurance credit risk.
While many reinsurers have experienced credit deterioration recently,
this has been due to unusually large losses relating to September 11,
adverse loss development relating to certain mass tort risks such as
asbestos and to declines in investment income. With regard to
investment income, investment losses have been much more severe for
reinsurers domiciled in non-U.S. jurisdictions where equity security
losses have not been mitigated by the more stringent investment
limitations required of U.S. reinsurers.
Though not perfect by any means, the U.S. regulatory system addresses
reinsurance exposure for major catastrophe and tort losses as well.
U.S. insurers and reinsurers are subject to limits with respect to the
amount of exposure to a single risk or reinsurance contract. U.S.
(re)insurers are subject to comprehensive regulation and to
comprehensive reporting in the NAIC Annual and Quarterly Statement
filings. U.S. reinsurers are subject to annual independent audits and
to very stringent annual actuarial opinions. To receive reinsurance
credit, a cedant's reinsurance must be with an authorized (U.S.
regulated) reinsurer or be subject to collateral requirements. All of
these factors, plus the cedant's ongoing credit analysis of its
reinsurance exposure substantially mitigate reinsurance credit risk.
We strongly disagree with the comment that reinsurance contracts
frequently involve litigation over whether insurer claims should be
paid. First, virtually every reinsurance contract contains an
arbitration clause. Disputes that arise are rarely litigated. Instead
disputes are subject to arbitration by industry experts that generally
result in a more swift and fair resolution than would litigation.
Second, if reinsurance contracts frequently resulted in litigation,
surely there would be much less use of these contracts. A certain
percentage of contracts in any type of business or industry give rise
to disputes between the parties. Reinsurance contracts are no
exception. However, one must bear in mind that the number of these
contracts entered into each year are in the hundreds of thousands. The
fact is that the vast majority of reinsurance claims are paid in the
normal course of business.
Finally, and as noted in our comments on the first GAO report on
securitization, it is important to recognize that not one catastrophe
bond contract has ever been triggered by an actual event. Therefore not
one securitization has yet to go through the process of paying out
claims. Despite the fact that the catastrophe bond proceeds are
maintained in a trust, this does not immunize these transactions from
litigation risk if the capital market investors believe that they were
not apprised of all of the facts and risks of the transaction.
Technical Comments:
Reinsurance Does Not Receive More Favorable Accounting Treatment:
* First full paragraph on page 6 is incorrect. Reinsurance and
catastrophe bonds receive identical accounting treatment as described
in the body of our comments above.
* Footnote 13 on page 6 is incorrect. Current NAIL guidance does
provide risk transfer treatment for catastrophe bond reinsurance
transactions that are indemnity based. Currently, neither index-based
catastrophe bonds nor index-based reinsurance transactions receive risk
transfer treatment. If the NAIL proposal is adopted index-based
catastrophe bonds will receive reinsurance-like accounting that is not
available to reinsurance transactions.
* Last sentence of first full paragraph on page 26 is incorrect. "Also
as described below, current accounting rules favor traditional
reinsurance contracts as compared
to certain types of catastrophe bond issuances." This statement is
incorrect as described above.
* Page 29 discussion of NAIC accounting requirements. Except for the
comments below, this is an accurate description of the accounting
issues pending at the NAIC. However, the conclusion drawn is incorrect.
Because the NAIC has not granted special, reinsurance-like accounting
treatment for non-indemnity catastrophe bonds, it does not follow that
traditional reinsurance currently enjoys more favorable treatment. This
issue is discussed in detail elsewhere in this letter.
* The sentence in the middle of page 29 should be amended as follows:
"However, statutory accounting rules currently do not allow insurance
companies to obtain a similar credit for non-indemnity-based ire
hedging transactions - which can include certain catastrophe bond
structures - and may therefore limit the appeal of catastrophe bonds to
potential investors. As described elsewhere in this document non-
indemnity-based insurance is a misnomer and the appeal is primarily for
investors not issuers.
* Page 30 penultimate sentence should be amended as follows: "if NAIC
were to ultimately approve a reinsurance-like credit for non-indemnity-
based hedging transactions, it could take about one year for the new
standards to be implemented. See comments above and below.
Indemnity Versus Hedging:
* Modify first sentence on page 10 as follows: "In order to transfer
some of this risk, primary insurers purchase coverage from an insurance
company." By definition, reinsurance indemnifies the cedant and
provides risk transfer, while financial instruments are used for
hedging transactions.
* Last two sentences on page 22. This language muddles the risk transfer
vs. hedging issue. The report states "[insurance] Company officials
said that while reinsurance accounted for most risk transfer needs,
catastrophe bonds help hedge some of the company's natural catastrophe
risks. Representatives from a reinsurance company said that catastrophe
bonds allowed them to transfer a portion of their natural catastrophe
exposures to the capital markets rather than retaining the exposure on
their books or retroceding the risks to other reinsurers" (emphasis
added).
In one case the insurer is hedging risk with catastrophe bonds and in
the other the reinsurer is transferring risk with catastrophe bonds.
This is correct only if the insurer is using non-indemnity (index
based) cat bonds and the reinsurer used indemnity-based bonds.
* Footnote 29 page 29. The second sentence should be amended as
follows: "However, NAIC is currently considering the appropriate
accounting treatment for non-indemnity-based hedging -transactions
which could include certain catastrophe bonds." Non-indemnity-based
insurance does not exist for reinsurance contracts as discussed above.
The remainder of this footnote includes an accurate discussion of basis
risk, correlation in hedging transactions and the potential granting of
credit that is similar to reinsurance. See also comments in accounting
section regarding pages 29 and 30.
Statement that Reinsurance Contracts Frequently Involve Litigation is
Incorrect and Not Supported:
* Last Sentence of first paragraph on page 27. In a comment attributed
to financial markets participants, the report states that "reinsurance
contracts frequently involved litigation over whether insurer claims
should be paid." As described above, we do not believe the facts
support this statement. The report should either provide the insurance
and reinsurance industry's view of this issue or better still, provide
statistics on reinsurance paid claims volume versus disputed claims
volume.
Factors Contributing to Reinsurance Price Increases:
* Modify last sentence on page 12 as follows: "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, declining
credit quality of some European reinsurers due to declining stock
prices, declining investment income due to decreased interest rates,
and costs associated with the September 11, 2001, terrorist attacks.":
Insurers' Preference for Traditional Reinsurance:
* Page 26 and other sections of the report discuss the reasons for
insurers' preference for traditional reinsurance. A key element missing
from these discussions is the basis risk associated with non-indemnity
(index-based) catastrophe bonds. Basis risk is defined as the "Risk
that there may be a difference, (either positive or negative) between
the performance of the insurance derivative instrument and the losses
sustained from the indemnified direct or assumed exposure being hedged"
(Index-Based Insurance Derivatives - Interested Parties of the
Insurance Securitization Working Group).
Since indemnity-based reinsurance and catastrophe bond transactions do
not have basis risk, insurance company risk managers can be sure that
actual losses will be offset through actual risk transfer to the
reinsurer. There is no need to worry that the basis risk in an index-
based transaction will result in failure to collect on a hedging
transaction intended to offset actual insurance losses of the cedant.
Index-based transactions primarily benefit the capital markets
investors since they desire a payoff based solely on the performance of
the index, which eliminates moral hazard and the risk that the cedant's
actual losses will exceed the index.
* Page 26. A related issue to basis risk is the issue of tail risk. We
suggest that text addressing tail risk be added to the section on
catastrophe bonds being less attractive to insurers than traditional
reinsurance. We suggest the following language: "Investors in bonds
expect and securitization contracts usually require that after the
natural disaster event occurs, that the losses are fairly quickly
tallied and the claims paid. As a result, the open period for settling
claims and paying out the bond proceeds will take place fairly quickly.
Reinsurance, by contrast, would remain an "open account" with claims
being settled and paid as they come due and thus provides more relative
protection for tail risk.
For example, the tail on settling claims for the Northridge earthquake
is now approaching 10 years. Reinsurance remains open to pay those
claims as long as coverage limits are still available. If a cat bond
had been used instead of reinsurance, this long tail likely would have
been cutoff, probably at two years with the resulting adverse claims
development thus remaining with the original insurer. * Page 29 and
Footnote 29. The text and footnote state that if non-indemnity-based
catastrophe bonds are accepted by the NAIC that they could become more
attractive to potential issuers. We believe that this will make the
transactions more attractive to investors not issuers. If they become
more attractive to issuers it would only be because the cost to the
cedant/issuer might be lower since they would be retaining the basis
risk in the hedging transaction.
Characterization of the Texas Windstorm Insurance Association (TWIA):
* Page 11. We believe it is incorrect to categorize the TWIA with the
California and Florida catastrophe funding programs. The TWIA is a
fairly common residual market mechanism that nearly every coastal state
has in place. We believe the following language would be more accurate:
"Several states - including Florida and California--have established
authorities that transfer certain catastrophic natural disaster risk in
a unique manner. California relies on a combination of funding
resources: capital contributions from insurers, policyholder
assessments, bond debt and reinsurance; Florida relies on reinsurance
premiums and bond debt with policyholder assessments. Nearly all
coastal states from Massachusetts to Texas have established residual
market pools that ensure that coastal property owners can obtain
property insurance. These facilities typically require insurers to make
coverage available, require that the losses from such coverage be paid
by insurance companies which are then later recouped through
assessments against policyholders.":
* Footnote 18 page 11. The name of the Florida Reinsurance Agency should
be corrected to the Florida Hurricane Catastrophe Fund.
Thank you for the opportunity to provide comments on your second report
on risk-linked securities. We trust that as in the past, our letter
will be included as an appendix to the GAO's final report. Should you
have questions please contact me at 202-638-3690.
Sincerely,
Franklin W. Nutter
President:
Signed by Franklin W. Nutter:
The following are GAO's comments on the Reinsurance Association of
America's (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.
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.
[End of section]
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.
[End of section]
Related GAO Products:
[End of section]
Insurance Regulation: Preliminary Views on States' Oversight of
Insurers' Market Behavior. [Hyperlink, http://www.gao.gov/cgi-bin/
getrpt?GAO-03-738T] GAO-03-738T. Washington, D.C.: May 6, 2003.
Catastrophe Insurance Risks: The Role of Risk-Linked Securities.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-195T] GAO-03-
195T. Washington, D.C.: October 8, 2002.
Catastrophe Insurance Risks: The Role of Risk-Linked Securities and
Factors Affecting Their Use. [Hyperlink, http://www.gao.gov/cgi-bin/
getrpt?GAO-02-941] GAO-02-941. Washington, D.C.: September 24, 2002.
Terrorism Insurance: Rising Uninsured Exposure to Attacks Heightens
Potential Economic Vulnerabilities. [Hyperlink, http://www.gao.gov/
cgi-bin/getrpt?GAO-02-472T] GAO-02-472T. Washington, D.C.: February
27, 2002.
Terrorism Insurance: Alternative Programs for Protecting Insurance
Consumers. [Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-199T]
GAO-02-199T. Washington, D.C.: October 24, 2001.
Insurance Regulation: The NAIC Accreditation Program Can Be Improved.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-01-948] GAO-01-948.
August 31, 2001.
Regulatory Initiatives of the National Association of Insurance
Commissioners. [Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-01-
885R] 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):
FOOTNOTES
[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.
[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.
[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.
[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.
[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] 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.
[14] 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.
[15] 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.
[16] In an illiquid market, securities cannot be converted into cash
easily or without incurring a substantial reduction in the price of the
security.
[17] 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.
[18] 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.
[19] SPRVs are a type of special purpose entity. Most SPRVs are based
offshore for tax, regulatory, and legal purposes.
[20] LIBOR is the rate most international creditworthy banks charge one
another for large loans.
[21] 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.
[22] 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.
[23] 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.
[24] 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.
[25] 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.
[26] 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.
[27] 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.
[28] Estimates obtained from Swiss Re and Fermat Capital Management.
[29] According to an investment bank we contacted, the payout
provisions of one catastrophe bond issued in 1996 have been triggered.
[30] 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.
[31] 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.
[32] 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.
[33] 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.
[34] 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.
[35] Companies have used SPEs for many years to carry out specific
financial transactions.
[36] 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.
[37] 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.
[38] 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).
[39] A bid-ask spread is the difference between the price asked for a
security and the price paid.
[40] 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.
[41] 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.
[42] 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.
[43] 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."
[44] 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.
[45] 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).
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