Insurance and Reinsurance Markets Provide Catastrophe Risk Coverage and Capital Markets Add to Industry Capacity

Natural catastrophes are infrequent events that can cause severe financial  losses. Hurricane Andrew and  the Northridge earthquake provided an impetus for insurance companies  and others to find different ways of raising capital to help cover  catastrophic risk and helped spur the development of risk-linked securities  and other alternatives to traditional reinsurance. Recent catastrophe bonds have been  nonindemnity-based to limit moral hazard; therefore, they expose the  sponsor to basis risk. Most  catastrophe bonds issued to date have been noninvestment-grade bonds. 2. Currently, the industry  representatives are considering using a structure that would receive tax  treatment similar to the treatment received by an issuer of asset- or  mortgage-backed securities. Expanded use of catastrophe bonds might occur with favorable  implementing requirements, but such legislative actions may also create  pressure from other industry sectors for similar tax treatment. Risk-Linked Securities Do Not Have Broad Investor Participation

Catastrophe bonds have not attracted a wide range of investors beyond  institutional investors. Investor participation in risk-linked securities is  limited in part because the risks of these securities are difficult to assess. Scope and Methodology

You asked us to report on the potential for risk-linked securities to cover  catastrophic risks arising from natural events. To analyze how key regulatory, accounting, tax, and investor issues might  affect the use of risk-linked securities, we examined a variety of  documents, including books on insurance accounting and taxation, the  Financial Accounting Standards Board’s (FASB) proposed consolidation  principles for special-purpose entities, accounting firm publications, the  National Association of Insurance Commissioners’ (NAIC) Statutory  Accounting Principles, and the proceedings of NAIC’s Working Group on  Securitization. However, low trading volumes  on options also raised questions about liquidity risk. 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. GAO Comments

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What GAO Found

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.