catastrophe bonds by eliminating U.S. taxation of the SPRV. If special tax treatment were legislated, expanded use of catastrophe bonds might occur.

On the other hand, under certain conditions, the federal government could experience tax revenue losses and other industry sectors might pressure the government for similar tax treatment. Also, some elements of the insurance industry believe such legislation would create an uneven playing field for domestic reinsurance companies.

Finally, unlike other bonds, catastrophe bonds, most of which are non-investment grade, have not been sold to a wide range of investors. While investment fund managers we interviewed appreciated the diversification aspects of catastrophe bonds, the risks are difficult to assess and investors are concerned about the bonds' limited liquidity and track record. Madam Chairwoman, members of the subcommittee, that concludes my oral summary and I would be happy to answer questions.

[The prepared statement of Davi D'Agostino can be found on page 56 in the appendix.]

Chairwoman KELLY. Thank you very much, Ms. D'Agostino.

Mr. Shear, do you have anything you want to add to that?
Mr. SHEAR. No, I do not think so.

Chairwoman KELLY. All right, thank you.

Mr. Moriarty? Before you start, let me just say that we have for the audience facing this direction, you may not have seen the map that the GAO had up on the back screen. I wonder if we could put that map back up. I do not know how many people saw that. You may be interested in taking a look at that. Can we leave it up there for a little bit?

Good. Thank you.

I am sorry, Mr. Moriarty. Please go on.

STATEMENT OF MICHAEL MORIARTY, DIRECTOR, CAPITAL MARKETS BUREAU, NEW YORK DEPARTMENT OF INSURANCE, ON BEHALF OF THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS

Mr. MORIARTY. Thank you, Madam Chairwoman. It is a pleasure to be here today to provide the subcommittee with an update on the state regulatory practices that deal with reinsurance and the related use of securities to transfer insurance risk. You have my written testimony, and I will try to use this allotted time to summarize the major points. State regulators are responsible for supervising activities of insurance companies that sell products here in the United States.

One of our main tasks is monitoring the financial condition of these insurance companies to ensure that they are able to honor the obligations to their policyholders and to claimants. Insurers that write policies here in the United States for the public invariably transfer some of the risk written to other entities in the insurance marketplace, primarily via the use of reinsurance. Like other financial services, companies and insurers try to spread and diversify risk among many of the market participants.

Because a primary insurer is under obligation to honor these direct or original insurance contracts, it is critical to their financial

well being that reinsurers are able to reimburse a ceding company for losses that are incurred. Hence it is incumbent upon regulators to effectively supervise the reinsurer and any other form of risk transfer. License reinsurers are subject to financial regulation similar to direct writing insurers.

Transactions with unlicensed reinsurers, especially those based abroad, are subject to regulation that focuses on securing collateral. A detailed explanation of the manner in which state regulators supervise reinsurance is included in my written testimony. Insurance securitization is another means to transfer insurance risk. Instead of transferring risk to the insurance marketplace, it is transferred directly to capital markets investors.

The NAIC formed a working group on insurance securitization in 1998 to determine our regulatory response to developments in insurance securitization. The NAIC's position is that U.S. regulators should encourage the development of alternative sources of capacity such as insurance securitizations, provided adequate standards governing these transactions are applied. Further deliberations of the working group at the NAIC led to a determination that it will be preferable if insurance securitizations could be done here in the United States instead of off-shore.

To further that position, the NAIC has adopted separate model acts to facilitate on-shore securitization using two different methods-protected cells and special purpose reinsurance vehicles. Under the protected cell method, a segregated unit of the insurance company would issue the debt securities. The funds taken in from the sales of these bonds would be kept separate from the insurer's general fund. If there is a loss to the insurance company or a triggering event, money can be kept by the insurance company. If not, it is paid back with interest to the bondholders.

The second method is the establishment of a special purpose reinsurance vehicle. This vehicle's only purpose is to transfer insurance risk to the capital markets via investment securities.

As Ms. D'Agostino indicated, it is our understanding that an impediment to the utility of both of these options here in the United States is tax uncertainty. Both of these methods depend on certain tax treatment which may require amendments to the tax code. The special purpose reinsurance vehicle needs a pass-through tax treatment. The protected cell needs to be recognized as part of the insurance company. The majority of the securitizations to date have been done off-shore. Many states do not have the laws to enable securitization vehicles and, as I indicated before, there are tax disadvantages or at least some uncertainty when doing these deals onshore.

From a regulatory perspective, doing these deals on-shore would provide more transparency and better oversight. Even with traditional catastrophe reinsurance, coverage placed with non-U.S. reinsurers entails a certain amount of credit risk to the United States ceding companies. U.S. laws require collateral, but only of incurred losses. The sufficiency of collateral provided by off-shore reinsurers can only be known for certain after a catastrophic loss has occurred. Credit and collateral risk are clearly reduced by the use of securitization since they are required under the model laws to be fully funded.

Due to that security, companies that transfer risk via securitization now get credit on the balance sheet and income statement for the transfer of risk. Insurers' underwriting accounts, which measure the profit and loss for insurance transactions are adjusted accordingly for these indemnity-based transactions. The use of index-based triggers on non-indemnity transactions is more challenging. It is important that the basis risk in these types of transactions be measured or managed by the ceding company, and the NAIC is working with the industry on developing means to both measure and manage this basis risk. In conclusion, the NAIC supports creating an environment that facilitates a more fluid transfer of insurance risk to the capital markets.

Given the amount of capital in the property and casualty industry, a major catastrophe or series of catastrophes could strain the ability of the industry to respond to its customers. Capital markets have the capacity and apparent willingness to take on insurance risk. Capital markets also have precedence in the securitization of other risks such as mortgages, credit card receivables and other types of cash flows. The securitization of insurance risk is not a cure-all for the funding of catastrophe risk. We see it as an addition, rather than a replacement to traditional reinsurance. We cannot gauge the appetite of capital markets investors for these securities.

However, the NAIC believes it is important to enable the marketplace to make that determination. Other initiatives to address capacity needs for catastrophe and for other types of coverage should continue to be explored.

This concludes my oral summary and I would be happy to address any questions the subcommittee may have.

Thank you.

[The prepared statement of Michael Moriarty can be found on page 72 in the appendix.]

Chairwoman KELLY. Thank you, Mr. Moriarty. Ms. D'Agostino, in your report you break down the analysis of cat bonds into four main areas-regulatory accounting treatment, capitalization requirements, taxation and assessing the investment risk. Based on your analysis, can you rank the relative order of importance of these areas and offer recommendations to address them?

Ms. D'AGOSTINO. I think that it would be very difficult to rank them in order of importance. Some of them hinge upon each other and some of them are totally unrelated to each other. The accounting and tax treatment are mainly issues pertaining to whether these SPRVS come on-shore or not, and also in terms of the Financial Accounting Standards Board proposal, there are arguments that say that if the 10 percent outside equity capital requirement applied to these vehicles, then they would probably go away.

We are not sure about that, but we know that they would become a lot more expensive to issue and create. One of the key areas I think that really has an impact, and I think some of the people who will talk later will talk to this even more, is the investor-related issues. These are relatively new securities instruments so they do not have a great track record, and people are looking for a track record. There are some attractive elements to the bonds, es

pecially the fact that they do not correlate with other risks in a portfolio.

At the same time, very few are issued, there is limited liquidity in them, and it is very difficult for people to evaluate the risk or get a comfort level with the risks in the catastrophe bonds. Further, some people who have not bought these because we did try to find out from people who have not bought catastrophe bonds why they have not bought-and there were some concerns raised about their suitability for a certain element of investors in, say, a mutual fund-the more moderate income investors. I think that is a pretty important challenge to overcome.

Even if you took care of some of the other issues, you still would have that hurdle to deal with-trying to educate investors and make them more comfortable with purchasing catastrophe bonds and finding a place in their portfolio for them.

Chairwoman KELLY. Ms. D'Agostino, have you any recommendations for creating or helping people have some sense that these instruments are worthy of investment?

Ms. D'AGOSTINO. No, I do not. These instruments are very highrisk and high-return-type instruments, and they are noninvestment-grade bonds, not that that is a deterrent in and of itself, but GAO is not in the business of recommending bonds and the like. We do not have any recommendations for this, otherwise our report would have included them. I think our whole point of doing the work for you was to present the information to you and allow the policymakers to decide on where to go with this. We feel that we have gone as far as we can go in this area.

Chairwoman KELLY. Thank you. I thought it was worth a try. [Laughter.]

Mr. Moriarty, I believe that the NAIC and possibly you have seen a draft of this report, and I wanted to know if you would care to comment, either for yourself or for the NAIC?

Mr. MORIARTY. We have not reviewed it at the NAIC level, so I will just give you my preliminary comments, Madam Chairwoman. I think the GAO did a very good job in setting out the issues, certainly from a regulatory perspective. With respect to the appetite of the marketplace, the investor concerns and even the tax issues there are outside of the purview of insurance regulators. I do not mean to operate in a vacuum here, but just looking at the financial solvency of the ceding companies, we think the biggest issue is with the non-indemnity-based transactions, which I think the capital marketplace would buy more of, so to speak, than the indemnitybased. I do think, though, that the basis risk can be addressed.

There are not best practices in terms of the insurance industry in measuring basis risk, partly because there have not been these transactions out there before and they have not had to measure it. But nonetheless, there is a great deal of talent in the industry in measuring and managing this risk, and we do think that disclosure of how companies measure basis risk when using these instruments can provide the regulators with a good basis to determine whether there has been in fact transfer of risk.

But again, going back to the report, we think it does state all of the issues that have been out there over the past four or five years in an accurate manner.

Chairwoman KELLY. Thank you very much. I am out of time.
Dr. Weldon, any questions?

Dr. WELDON. Yes, thank you very much, Madam Chairman.

Ms. D'Agostino, maybe you cannot answer this, but I will ask it anyway, how much capacity for coverage of natural disasters is likely to be added through risk-linked securities in the near future? Ms. D'AGOSTINO. We did not undertake to try to project the future market for risk-linked securities. They have been covering a growing segment of reinsurance and catastrophe reinsurance, but I do not think that we are in a position to—

Dr. WELDON. I think your report, correct me if I am wrong, indicates it is one-half of one percent?

Ms. D'AGOSTINO. That is according to a Swiss Re report.

Dr. WELDON. So you say it is growing-it went from zero to onehalf of one percent?

Ms. D'AGOSTINO. Well, it is growing in real dollar terms as well, into the billions of dollars.

Dr. WELDON. Is that right?

Ms. D'AGOSTINO. Yes. And actually catastrophe bonds have been written to cover Florida hurricanes as well as California earthquake perils.

Dr. WELDON. Okay. Would you agree it is kind of hard to speculate at this time the potential performance in the future, even though the real dollar amounts may be growing? As a percentage of risk, it is still quite negligible?

Ms. D'AGOSTINO. It is very difficult to project, for us anyway.

Dr. WELDON. You did not look at all at the rate of growth? Is it linear? And is it affected by economic variables at all?

Ms. D'AGOSTINO. Bill, do you want to take that?

Dr. WELDON. I know we did not ask you to study all these things, so I am not I am just trying to get answers to some of these questions.

Mr. SHEAR. The growth has been relatively unlevel, and you would expect that because one of the major determinants is the price and availability of reinsurance through traditional reinsurers. So it has largely been dependent on certain events that affect the pricing of traditional reinsurance.

Dr. WELDON. Mr. Moriarty, in your estimation are we currently facing a capacity crisis? You say yes, is that right?

Mr. MORIARTY. Well, I think in terms of looking at the availability and the affordability of reinsurance, it has clearly spiked in the last year or year and a half. Throughout the 1990s, resinsurance was by all measurements very available and very affordable.

Certain events-certainly when you talk about the events of 911 with respect to terrorism coverage, and the availability of capital in the insurance industry, it is a hard market. So it has become more difficult to get insurance, and one would think that this would be the marketplace where alternatives such as insurance securitization would see a spike in activity. Whether it is an availability and affordability crisis, at this point I do not think so, but again clearly it is becoming more difficult to get reinsurance on terms that are favorable to ceding companies.