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

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