CATASTROPHE BONDS: SPREADING RISK

Tuesday, October 8, 2002

U.S. HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATION,

COMMITTEE ON FINANCIAL SERVICES,

Washington, D.C.

The subcommittee met, pursuant to call, at 2:08 p.m., in Room 2128, Rayburn House Office Building, Hon. Sue Kelly [chairman of the subcommittee] presiding.

Present: Representatives Weldon, Tiberi, and Inslee.

Chairwoman KELLY. [Presiding.] Good afternoon. In the interest of time, I am going to go ahead and start this hearing. I understand there are other members that are on their way down, but I am going to go ahead and start because you have all come-a few from some distance, and I want to be able to get you fully heard before we end this hearing. So this hearing of the Financial Services Committee, Subcommittee on Oversight and Investigations will come to order. I want to thank all members of Congress who will be coming today. Without objection, all members present will participate fully in the hearing and all opening statements and questions will be made part of the official hearing record. The chair recognizes her self for a brief opening statement.

Let me first say welcome to what will likely be the last hearing of the Financial Services Committee for the 107th Congress. It would be an understatement to say that this committee has been busy. I know our staff agrees, and I want to take this opportunity to publicly thank the remarkable and very professional staff of the Financial Services Committee for their work this year.

They have done yeoman's work and we all appreciate it. The topic of discussion today is a new slant on an old problem. We only have to go back one Congress in the old banking committee to recall the numerous hours spent debating the creation of insurance capacity for disaster-prone areas. Individuals can disagree about the nature of the solution.

The fact still remains that increasing capacity in our insurance markets is incredibly important. Whether you are a disaster-prone state like Florida or California, or from a state like mine, New York, with terrorist-targeted properties, it remains to be seen how much in the way of accumulated losses the private insurance and reinsurance market can absorb before the entire market is put at risk. As we see today, large insurers and reinsurers are being downgraded by rating agencies and markets continue to harden. When we last looked at the issue of natural disaster exposures,

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there was mention made of using the capital markets perhaps as a way to spread risk beyond the traditional insurance markets.

Let me quote from 1999 testimony in front of this committee. "The potential capacity from the capital markets should not be ignored or underestimated during consideration of what was then Rick Lazio's federal disaster reinsurance bill. While still in its infancy, a lot of resources are being directed by capital markets intermediaries to encourage the development of the market." And further testimony stated, "The development of this risk-linked securities market would revolutionize catastrophe insurance funding and greatly expand the capacity of the U.S. insurance market."

In other words, the private capital markets made sense then and probably make even more sense now. Last year, Chairman Oxley requested the General Accounting Office to look at the use of catastrophe bonds and their track record to date. Some in the private sector suggested that what was once counted as the next big financing instrument never really took off in the market as anticipated. The committee asked the GAO to find out why exactly that was. Specifically, the committee inquired, if it was a structural problem, meaning these instruments are too complicated or produce prohibitive transaction costs, or if it was because the market did not understand how to evaluate their underlying risk, or if it was because the traditional insurance market was soft and there was not a demonstrated need for new sources of capital.

GAO appears before us today to discuss its findings, with an emphasis on the barriers and hurdles these instruments face. The team that put this report together is to be commended for their work in taking such a complicated topic and really boiling it down into its essential nuts and bolts. The committee greatly appreciates the GAO's work in this area and its cooperation with our committee staff in drawing its conclusions. Before I close, let me quickly make two points. The first is that this committee is looking to facilitate capacity creation in the insurance marketplace. In this case, we are examining catastrophe bonds. This is not to suggest that a booming market for these bonds should replace or be an alternative to traditional insurance financing such as risk-spreading by way of reinsurance.

Second, in no way should anyone leave this room thinking the Financial Services Committee is creating a new class of government bond or government-backed security. This committee is simply looking at ways to possibly remove barriers that will bring about greater acceptance of an instrument that already exists in the marketplace today.

With that, the chair will recognize the gentleman from Florida, my very good friend, Congressman Weldon. Congressman Weldon, have you an opening statement?

[The prepared statement of Hon. Sue W. Kelly can be found on page 30 in the appendix.]

Dr. WELDON. Yes, Madam Chairman. I apologize for being slightly late, Madam Chairman. I want to commend you for calling this hearing on a very important issue, not just for my congressional district in the State of Florida, but as well for the nation, and focusing the attention of the committee on the risks of catastrophic

events. My state of Florida is wrestling with this very issue as it braces itself for the kinds of storms that just hit Louisiana.

As is mentioned in the GAO study released today, the adequacy of the insurance industry's capacity to cover large catastrophes is a difficult question to answer. As you know, I have introduced legislation that addresses this capacity question by establishing the federal government as the insurer of last resort for mega-catastrophic events. The state of Florida experiences significant exposure to catastrophic events, yet people continue to relocate there, making it one of the fastest growing states in the country. Florida is also beset by litigation exposure, the complications of legislative and regulatory efforts and other factors such as sinkholes and mold.

Whether capital markets can enhance the capacity of an industry affected by so many forces remains to be seen. Who must act to stimulate the trading of risk-linked securities. Can they generate the kind of resources necessary that would motivate both primary insurers and reinsurers to confidently write more policies in Florida? Earlier this year, Chairwoman Kelly convened a hearing looking at the risks associated by not passing federal terrorism insurance legislation. During that hearing, Alice Schroeder, senior U.S. non-life equity insurance analyst for Morgan Stanley, stated that, quote, "Insurance companies generally destroy, rather than create, value for their shareholders." I look forward to hearing from today's witnesses how risk-linked securities may overcome this dynamic, and I again thank you for calling this hearing. I yield back.

Chairwoman KELLY. Thank you very much, Dr. Weldon.

Since there are no more opening statements, we will begin with the witnesses on our first panel. Presenting the GAO report is Ms. Davi D'Agostino, the director of financial markets and community investment division from the General Accounting Office. Accompanying her is Mr. Bill Shear, also from the same division. Next we will turn to the first of our two witnesses from the great state of New York, and I would like to welcome Mr. Michael Moriarty who is the director of the capital market bureau for the New York Department of Insurance. Mr. Moriarty appears on behalf of the National Association of Insurance Commissioners and serves as the vice chair of the NAIC securitization committee.

We thank you for joining us today to share your expertise on these issues. Without objection, your written statements will be made part of the record. Ms. D'Agostino has agreed that GAO will be given an extended period for its oral testimony, given the presentment of the report. All of our other witnesses will be recognized for a five minute summary of their testimony, and if you have not testified here before, at the end of the table there is a box that has different colored lights in it. Red lights mean stop; yellow light means you have one minute to sum up; and green light obviously

means go.

With that, we turn to you, Ms. D'Agostino, and we greatly appreciate your presence here today.

STATEMENT OF DAVI D'AGOSTINO, DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, GENERAL ACCOUNTING OFFICE

Ms. D'AGOSTINO. Thank you very much, Madam Chairwoman. Madam Chairwoman and members of the subcommittee, I am pleased to be here today before you to discuss our work on how risk-linked securities are used to address catastrophic risks.

These risks arise from natural events such as hurricanes and earthquakes. Population growth, real estate development and rising real estate values in hazard-prone areas increasingly expose the nation to higher losses from natural disasters than in the past. More than 68 million Americans live in hurricane-vulnerable coastal areas and 80 percent of Californians live near active earthquake faults. 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 disasters-these are important words without limiting coverage or substantially raising premiums.

They also called attention to ways of raising additional sources of capital to help cover catastrophic risk. The insurance industry and capital markets developed risk-linked securities which both supplement the insurance industry's capacity and do provide an alternative to traditional property casualty reinsurance, which is insurance for insurers. Today, I will talk about one, how the insurance and capital markets provide coverage for catastrophic risk; two, how risk-linked securities, specifically catastrophe bonds, are structured and how they work; and three, how regulatory, accounting, tax and investor issues might affect the use of these securities and the advantages and disadvantages of potential changes.

First, catastrophe risk is a global phenomenon, and insurance and reinsurance companies with global operations often provide coverage. The color map before you on the screen, as well as in our report, highlights the areas of the United States that are most likely to experience certain types of natural catastrophes. Most insurance companies try to limit the amount and type of catastrophe risk they hold on their books.

For example, if property casualty insurers have written too many policies concentrated in California or Florida, they need ways to diversify and transfer that risk. One way is through reinsurance, where for all or part of the premiums collected, the reinsurer agrees to compensate all or part of an insurer's claims as they are incurred. When reinsurance prices or availability became problematic in the mid-1990s, insurers turned to risk-linked securities as an alternative way to spread catastrophe risk. Now, I will turn to the second area of my statement, which is how risk-linked securities are structured and how they actually work.

If you turn to page three of the written statement, you will see a graphic that will help you walk through how they are set up, at least in basic terms. Most risk-linked securities are catastrophe bonds these days, and they have complicated structures, as you can see, that are created off-shore. And they are created through special purpose entities which generally receive non-investment grade ratings. To develop a catastrophe bond, a sponsor, which is usually an insurance or reinsurance company, creates a special purpose re

insurance vehicle or an SPRV, which you will see in the graphic before you, to provide reinsurance to the sponsor and to issue bonds to the securities market. SPRVs, which are typically located off-shore for tax and other advantages, receive payments in the form of insurance premiums, interest, and investor principal; invest in Treasury and other highly rated securities; and pay out to the investors in the form of interest.

The reinsurance provided to the sponsor through catastrophe bonds is different from that provided through traditional reinsurance contracts. Most of the recently issued catastrophe bonds are non-indemnity based. This means that they are structured to make payments to the sponsor upon the verified occurrence of specified catastrophic events. The payments are also based on pre-agreed financial formulas. The payments from the investor's principal to the insurer/sponsor are not directly related to the insurer's actual claims, and they are triggered by an event that meets an objective index or measure such as wind speed in the case of a hurricane. In this way, the investors avoid exposure to the risk that the sponsor or primary insurer has poor underwriting or claims settlement practices.

This very point is important to understanding some of the issues that were identified by industry observers to us and the third area of my testimony, the regulatory, accounting, tax and other investor issues that challenge catastrophe bonds. Accounting treatment for risk transfers occurring through non-indemnity-based catastrophe bonds is a challenge for regulators. With traditional indemnitybased reinsurance, an insurer gets credit for reinsurance 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 any recoveries from reinsurance are collectible.

Calculating the credit with indemnity-based coverage is fairly straightforward. In contrast, it is very complicated to value the true amount of risk transferred to determine credit for reinsurance with nonindemnity-based coverage. The National Association of Insurance Commissioners is considering revising accounting treatment to accurately calculate and recognize nonindemnity-based reinsurance.

While these changes could facilitate the use of catastrophe bonds, it is very important that the credit accurately reflect the true risk transferred. Another development that could affect the use of catastrophe is a proposed change being considered by the Financial Accounting Standards Board to address consolidation of certain special purpose entities on a sponsor's balance sheet. The proposed guidance may increase the outside equity capital investment required and add other tests for a sponsor to treat an SPRV as "off balance sheet".

While the proposed guidance is intended to improve financial transparency in capital markets and to stem potential abuses of special purpose entities, it could also increase the cost of issuing catastrophe bonds. We also explored some of the tax issues raised by industry representatives. These representatives are considering a legislative proposal that would encourage domestic issuance of