Further, as previously noted, in the wake of catastrophic events reinsurers  and insurers may sharply increase premiums and significantly restrict  coverage. Because insurance markets have been severely disrupted by catastrophic  events, state and federal governments also have taken a variety of steps to  enhance the capacity of insurers to address catastrophic risk. Despite Enhancements to Insurer Capacity, Industry May Not Be Able to Address a Major Natural Catastrophe

Despite steps taken in recent years to strengthen insurer capacity for  catastrophic risk, the industry has not yet been tested by a major  catastrophic event or series of events. For example, only 1 company  failed in 2004 in contrast to 11 that failed after Andrew. It follows that a  more severe hurricane (or series of hurricanes) or earthquake with  estimated losses of $50 billion or more would have even more severe  consequences. Catastrophe Bonds and Tax-Deductible Reserves May Have the Potential to Enhance Insurers’ Capacity for Catastrophe Risk

Insurers’ reactions to past catastrophic events—for example, restrictions  on reinsurance coverage and higher reinsurance premiums—and the  potential consequences for insurers from an even more severe catastrophe  have generated financial instruments and proposals designed to enhance  industry capacity for both natural events and terrorist attacks. Some state authorities we contacted and many  insurers view the total costs of catastrophe bonds—including transaction  costs such as legal fees—as significantly exceeding the costs of traditional  reinsurance. In particular,  permitting tax-deductible reserves would result in lower federal tax  receipts according to industry analysts we contacted. The other three countries generally rely on insurance markets to  provide natural catastrophe coverage. Each  of these countries has considered the necessity for a national terrorism  insurance program. Insurance Companies in European Countries We Studied Are Permitted to Establish Tax-Deductible Reserves for Future Catastrophic Events

As of 2004, regulations, tax law, and accounting standards in the six  European countries we reviewed allowed insurance companies to establish  tax-deductible reserves for potential losses associated with catastrophic  events. Further, industry  participants do not consider catastrophe bonds feasible for terrorism risks  at this time. Further, all six countries we studied use their tax codes to  encourage insurers to establish reserves for potential catastrophic events. Agency Comments and Our Evaluation

We provided a draft of this report to the Department of the Treasury and  the National Association of Insurance Commissioners. Treasury provided  technical comments on the report that were incorporated as appropriate. Our  objectives were to (1) provide an overview of the property-casualty  insurance industry’s current capacity to cover natural catastrophic risk and  discuss the impacts that four hurricanes in 2004 had on the industry; (2)  analyze the potential of catastrophe bonds and permitting insurance  companies to establish tax-deductible reserves to cover catastrophic risk  to enhance private-sector capacity; and (3) describe the approaches six  selected European countries—France, Germany, Italy, Spain, Switzerland,  and the United Kingdom—have taken to address natural and terrorist  catastrophe risk, including whether these countries permit insurers to use  tax-deductible reserves for such events. We also obtained estimates of the insured losses and claims  resulting from the 2004 hurricanes from the Florida Office of Insurance  Regulation. Institutional Investor

An organization such as a bank or insurance company that buys and sells  large quantities of securities.
Why GAO Did This Study

Natural catastrophes and terrorist attacks can place enormous financial demands on the insurance industry, result in sharply higher premiums and substantially reduced coverage. As a result, interest has been raised in mechanisms to increase the capacity of the insurance industry to manage these types of events. In this report, GAO (1) provides an overview of the insurance industry's current capacity to cover natural catastrophic risk and discusses the impacts of the 2004 hurricanes; (2) analyzes the potential of catastrophe bonds--a type of security issued by insurers and reinsurers (companies that offer insurance to insurance companies) and sold to institutional investors--and tax-deductible reserves to enhance private-sector capacity; and (3) describes the approaches that six European countries have taken to address natural and terrorist catastrophe risk, including whether these countries permit insurers to use tax-deductible reserves for such events. We provided a draft of this report to the Department of the Treasury and the National Association of Insurance Commissioners. Treasury provided technical comments that were incorporated as appropriate.

What GAO Found

Despite steps that governments and insurers have taken in recent years to strengthen insurer capacity for catastrophic risk, the industry has not been tested by a major catastrophic event or series of events (at least $50 billion or more in insured losses). While insurers suffered losses of over $20 billion in Florida from the 2004 hurricanes, steps such as implementing stronger building codes and stricter underwriting standards may have limited market disruptions as compared with the aftermath of Hurricane Andrew in 1992. For example, in 2004, only 1 Florida insurance company failed in contrast to the 11 that failed after Hurricane Andrew in 1992. However, a more severe catastrophic event or series of events could severely disrupt insurance markets and impose recovery costs on governments, businesses, and individuals. Some insurers and reinsurers benefit from catastrophe bonds because the bonds diversify their funding base for catastrophic risk. However, these bonds currently occupy a small niche in the global catastrophe reinsurance market and many insurers view the costs associated with issuing them as significantly exceeding traditional reinsurance. In addition, industry participants do not consider catastrophe bonds for terrorism risk feasible at this time. Authorizing insurers to establish tax-deductible reserves for potential catastrophic events has been advanced as a means to enhance industry capacity, but according to some industry analysts such reserves would lower federal tax receipts and not necessarily bring about a meaningful increase in capacity because insurers may substitute the reserves for other types of capacity. The six European countries GAO studied use a variety of approaches to address catastrophe risk. Some governments require insurers to provide natural catastrophe insurance and provide financial assistance to insurers in the wake of catastrophic events, while others generally rely on the private market. However, the majority of these governments have established national terrorism insurance programs. Although their approaches vary, insurers in all six countries were allowed to establish tax-deductible reserves for potential catastrophic events as of 2004.