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Before the Subcommittee on Oversight and Investigations, Committee on 

Financial Services, House of Representatives:

United States General Accounting Office:


For Release on Delivery Expected at 2:00 p.m., EDT, 

on Tuesday, October 8, 2002:

Catastrophe Insurance Risks:

The Role of Risk-Linked Securities:

Statement of Davi M. D’Agostino, 

Director, Financial Markets and Community Investment:


October 2002:

United States General Accounting Office:


The Role of Risk-Linked Securities:

Highlights of GAO-03-195T, a testimony for the Subcommittee on 

Oversight and Investigations, House Committee on Financial Services:

Why GAO Did This Study:

Because of population growth, resulting real estate development, and 

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

increasingly exposed to higher property casualty losses--both insured 

and uninsured--from natural catastrophes than in the past. In the 

1990s, a series of natural disasters, including Hurricane Andrew and 

the Northridge earthquake, raised questions about the adequacy of the 

insurance industry’s financial capacity to cover large catastrophes 

without limiting coverage or raising premiums. Recognizing this greater 

exposure and responding to concerns about insurance market capacity, 

participants in the insurance industry and capital markets have 

developed new capital market instruments as an alternative to 

traditional property-casualty reinsurance, or insurance for insurers. 

GAO’s objectives were to (1) describe catastrophe risk and how the 

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

describe how risk-linked securities, particularly catastrophe bonds, 

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

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

Figure: Estimated Losses from Recent Large Catastrophes:

[See PDF for image]

[End of figure]

Sources: Insurance Information Institute and other insurance industry 


What GAO Found:

Natural catastrophes are infrequent events that cause severe losses. 

More than 68 million Americans live in hurricane-vulnerable coastal 

areas, and 80 percent of Californians live near active earthquake 

faults. Insurance companies who write property-casualty policies in 

these high-risk areas try to spread the risks, traditionally through 

reinsurance. When reinsurance prices or availability became problematic 

in the 1990s, insurers turned to risk-linked securities as an 

alternative means to spread catastrophe risk. Most risk-linked 

securities are catastrophe bonds, which (1) have complicated 

structures, (2) are created offshore through special purpose entities, 

and (3) generally receive noninvestment-grade ratings. Key regulatory, 

accounting, tax, and investor issues pose challenges to expanding the 

use of risk-linked securities, and GAO discusses the advantages and 

disadvantages of potential changes.

The full testimony is available at

195T. For additional information about the testimony, contact Davi 

D’Agostino (202-512-8678;

Madame Chairwoman and Members of the Subcommittee:

I am pleased to be here today to discuss the results of our work on the 

potential for risk-linked securities to address catastrophic risks 

arising from natural events such as hurricanes and earthquakes. 

Population growth, real estate development, and rising real estate 

values in hazard-prone areas increasingly expose our nation to higher 

losses--both insured and uninsured--from natural catastrophes than in 

the past. This exposure increases pressure on businesses; individuals; 

and federal, state, and local governments to assume ever-larger 

liabilities for losses associated with natural catastrophes. A series 

of natural disasters in the 1990s, including Hurricane Andrew and the 

Northridge earthquake, raised questions about the financial capacity of 

the insurance industry to cover large catastrophes without limiting 

coverage or substantially raising premiums, and called attention to 

ways of raising additional sources of capital to help cover catastrophe 

risk. Participants in the insurance industry and capital markets 

developed new capital market instruments, risk-linked securities, which 

both expand insurance and reinsurance capacity and provide an 

alternative to traditional property-casualty reinsurance. We were asked 

to analyze the role of risk-linked securities in the coverage of 

catastrophe risk and factors affecting their use.

Today I will talk about (1) what catastrophe risk is and how the 

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

risk-linked securities, particularly catastrophe bonds, are 

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

issues might affect the use of these securities. Our overall objective 

is to provide the Committee with information and perspectives to 

consider as it moves forward in this important and complex area. For a 

fuller discussion of these points, I refer you to our report entitled 

Catastrophe Insurance Risks: The Role of Risk-Linked Securities and 

Factors Affecting Their Use (GAO-02-941), which was released today at 

this hearing.

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

authority with respect to the involved private-sector entities, we 

obtained extensive documentary and testimonial evidence from various 

groups, including insurance and reinsurance companies, investment 

banks, investors, rating agencies, firms that develop models to analyze 

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

not able to verify the accuracy of data provided by these groups.

Our statement covers a number of issues affecting risk-linked 

securities, but we make no recommendations. While we have identified 

factors that industry and capital markets experts believe might cause 

the use of risk-linked securities to expand or contract, it is 

difficult to predict the future use of these securities--either under 

current accounting, regulatory, and tax policies or under changed 

policies. We do not take a position on whether the increased use of 

risk-linked securities is beneficial or detrimental.

In summary:

Catastrophe risk is a global phenomenon and insurance and reinsurance 

companies with global operations often provide coverage. We focused on 

catastrophe risk in the United States. The map before you shows the 

geographic distribution of catastrophe risk in the United States and 

highlights areas that are the most likely to experience certain types 

of natural catastrophes. The characteristics of natural disasters 

prompt most insurers to limit the amount and type of catastrophe risk 

they hold. For example, property-casualty insurers with too many 

policies concentrated in California and Florida--states that are more 

subject to natural catastrophes--need ways to diversify and transfer 

that risk. One key way to transfer risk is through reinsurance. 

Traditional reinsurance provides indemnity-based coverage, which 

compensates part or all of an insurer’s losses as they are incurred, 

and depends on well-developed business relationships between insurers 

and reinsurers, which facilitate relatively low transaction costs. 

However, in a situation involving extremely large or multiple 

catastrophic events, insurers might not have purchased sufficient 

reinsurance or reinsurers might not have sufficient capital to meet 

their existing obligations. Further, reinsurance capital is diminished 

after a catastrophic loss, and reinsurers might raise prices or limit 

the availability of future coverage. In the 1990s, the combination of 

two extremely costly disasters--Andrew and Northridge--and conditions 

in the reinsurance market helped spur the development of risk-linked 

securities and other alternatives to traditional reinsurance. The 

securities provided new access to national and international capital 

markets. Yet to date, risk-linked securities represent a small share--

less than 0.5 percent--of worldwide catastrophe insurance, according to 

the Swiss Reinsurance Company.

We focused on catastrophe bonds because they currently comprise the 

largest share of risk-linked securities, which also include other 

instruments such as options.[Footnote 1] To develop a catastrophe bond, 

a sponsor, usually an insurance or reinsurance company, creates a 

special purpose reinsurance vehicle (SPRV) to provide reinsurance to 

the sponsor and to issue bonds to the securities market. SPRVs are 

similar in purpose to the special purpose entities that banks and 

others have used to securitize their loans. These special purpose 

entities “pass through” principal and interest from borrowers to 

investors. In contrast, SPRVs, which are typically located offshore for 

tax, regulatory, and legal advantages, receive payments in three forms 

(insurance premiums, interest, and principal), invest in Treasury 

securities and other highly rated securities, and pay investors in 

another form (interest). Figure 1 illustrates cash flows among the 

participants in a catastrophe bond.

Figure 1: Cash Flows for a Special Purpose Reinsurance Vehicle:

[See PDF for image]

Source: GAO.

[End of figure]

The sponsoring insurance company enters into a reinsurance contract and 

pays reinsurance premiums to the SPRV to cover specified claims. The 

SPRV issues bonds or debt securities for purchase by investors. The 

catastrophe bond offering defines a catastrophe that would trigger a 

loss of investor principal and, if triggered, a formula to specify the 

compensation level from the investor to the SPRV. The SPRV is to hold 

the funds raised from the catastrophe bond offering in a trust in the 

form of Treasury securities and other highly rated assets. The SPRV 

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

company into the trust account. The premium paid by the SPRV sponsor 

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 a predefined catastrophe occurs, principal that otherwise would be 

returned to the investors is used to fund the SPRV’s payments to the 

insurer or sponsor. The investor’s reward for taking this risk is a 

relatively high interest rate paid by the bonds.

Recently issued catastrophe bonds have been nonindemnity-based--that 

is, structured to make payments to the sponsor upon the verified 

occurrence of specified catastrophic events. Indemnity-based 

reinsurance coverage compensates insurers for part or all of their 

losses from insured claims.[Footnote 2] Although insurers prefer 

indemnity-based coverage because reinsurance payments are directly 

linked to claims actually incurred, reinsurers face the risk of paying 

more if the insurer underwrites or selects risks poorly, or has poor 

claims-settlement practices. With an indemnity-based catastrophe bond, 

investors would have greater exposure to risks from poor underwriting 

and claims settlement practices because investors might not be able to 

monitor the insurer’s behavior. As a result, investors prefer 

nonindemnity-based bonds because they are tied to an objective index or 

measure that is unrelated to the insurance company’s management.

In addition to looking at the characteristics and coverage of 

catastrophe risk and the structure of risk-linked securities, we 

identified and analyzed regulatory, accounting, tax, and investor 

issues that might affect the use of risk-linked securities:

* First, accounting treatment for risk transfers occurring through 

nonindemnity-based, risk-linked securities is a challenge for 

regulators. In traditional reinsurance--that is, indemnity-based--

transactions, where an insurer is compensated for part or all of its 

losses from insured claims, the insurer gets credit on its balance 

sheet in the form of a deduction from liability for the risk 

transferred to the reinsurer and can reduce the amount of regulatory 

risk-based capital required. Credit for reinsurance is designed to 

ensure that a true transfer of risk has occurred and that the 

reinsurance company will be able to pay any claims. In nonindemnity 

transactions using catastrophe bonds, payments may be triggered by an 

index or independently measurable value, such as wind speed, and are 

not directly related to incurred claims. When a catastrophic event 

triggers a catastrophe bond, payment formulas determine the reduction 

of the investors’ principal that will compensate the insurance company 

sponsor. As a result, it is difficult to value the true amount of risk 

transferred to determine credit for reinsurance. The National 

Association of Insurance Commissioners and interested insurance 

industry parties are considering revisions in the regulatory accounting 

treatment of risk transfer obtained through nonindemnity-based 

coverage. If insurance accounting standards were changed so that the 

value of the risk transfer could be accurately calculated and 

recognized as an offset to potential insurance losses, the insurer 

could get credit for reinsurance for risk transfers occurring through 

nonindemnity-based catastrophe bonds. Such changes, if adopted, could 

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

that credit for nonindemnity-based reinsurance accurately reflect the 

true risk transferred so that insurance company reporting on both risk 

evaluation and capital treatment properly reflects the risks retained.

* Second, the Financial Accounting Standards Board is proposing a new 

interpretation addressing consolidation of certain special purpose 

entities on a sponsor’s balance sheet. Under current guidance, a 

sponsor could avoid consolidating an SPRV as a liability on its balance 

sheet if the SPRV has at least 3 percent independent equity capital 

investment. The proposal may increase the independent capital 

investment required for a sponsor to treat an SPRV as independent to 10 

percent of total assets. The proposal also contemplates other tests for 

consolidation of certain special purpose entities. While the proposed 

guidance is intended to improve financial transparency in capital 

markets and stem potential abuses of special purpose entities, it could 

also increase the cost of issuing catastrophe bonds. If the proposed 

interpretation requires consolidation, sponsors might turn to risk-

linked securities, such as catastrophe options, that do not require an 


* Third, insurance industry representatives are considering a 

legislative proposal to help expand the use of domestically issued, or 

onshore, catastrophe bonds. SPRVs are typically located offshore, in 

part, to avoid U.S. taxes. By allowing special “pass-through” tax 

treatment, the proposal would eliminate U.S. taxation at the SPRV 

level. The pass-through treatment would be similar to that already 

provided to Real Estate Mortgage Investment Conduits and Financial 

Asset Securitization Investment Trusts. To the extent that domestic 

SPRVs gained business at the expense of taxable entities, including 

reinsurance companies, the federal government could experience tax 

revenue losses. Expanded use of catastrophe bonds might occur with 

favorable implementing requirements, but such legislative actions might 

also create pressure from other industry sectors for similar tax 

treatment. Some elements of the insurance industry believe that any 

consideration of changes to the tax treatment of domestic SPRVs would 

have to take into account the taxation of domestic reinsurance 

companies. Specifically, the Reinsurance Association of America argues 

that if special tax treatment is provided to domestic SPRVs, they would 

operate under tax advantages not afforded to existing U.S. licensed and 

taxed reinsurance companies.

* Fourth, unlike other bonds, catastrophe bonds, most of which are 

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

investors beyond institutional investors. Investment fund managers who 

included catastrophe bonds in their portfolios told us that catastrophe 

bonds comprised 3 percent or less of those portfolios. On the one hand, 

the managers appreciate the diversification aspects of catastrophe 

bonds because the risks are generally uncorrelated with the credit 

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

risks are difficult to assess and investors are concerned about the 

limited liquidity and track record of the bonds.

Madame Chairwoman, Members of the Subcommittee, that concludes my 

prepared statement. I would be happy to answer any questions at this 



[1] Catastrophe options were offered by the Chicago Board of Trade in 

1995 and were delisted in 2000 due to lower-than-expected demand. The 

purchaser of a catastrophe option paid the seller a premium, and the 

seller provided the purchaser with a cash payment if an index measuring 

insurance industry catastrophe losses exceeded a certain level. If the 

catastrophe loss index remained below a specified level for the 

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

kept the premium.

[2] Indemnity coverage specifies a simple relationship that is based on 

the insurer’s actual incurred claims. For example, an insurer could 

contract with a reinsurer to cover half of all claims--up to $100 

million in claims--from a hurricane over a specified time period in a 

certain geographic area. If a hurricane occurs where the insurer incurs 

$100 million or more in claims, the reinsurer would pay the insurer $50 

million. In contrast, nonindemnity coverage specifies a specific event 

that triggers payment and payment formulas that are not directly 

related to the insurer’s actual incurred claims.