Last year Chairman Oxley requested the Government Accounting Office (GAO) look at the use of catastrophe bonds and their track record to date. Some in the private sector suggest that what was once touted as the next big financing instrument never really took off in the market as anticipated. The committee asked the GAO to find out exactly why 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 didn't understand how to evaluate their underlying risk; or, if it was because the traditional insurance market was soft and there wasn't 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 appreciates the GAO's work in this area and its cooperation with committee staff in drawing its conclusions. Before I close, let me quickly make two points. First, 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. Opening Statement Subcommittee on Oversight and Investigations I would like to thank Chairwoman Kelly for holding this important hearing on the use of capital markets to expand insurance capacity. The relevance and timeliness of this topic cannot be overstated. Uncertainty facing the market grows every day as a result of our terrorism losses. Compound that with the sobering thought of successive major catastrophic events hitting our shores, and it is not unthinkable that traditional risk sharing mechanisms could be paralyzed. As Chairwoman Kelly stated, the Committee has asked the GAO to look at the viability of risk-linked securities as a way to increase insurance capacity. Catastrophe bonds, in particular, provide a unique way for tapping the trillions of dollars of investment capacity in the capital markets. And because the risk associated with these instruments is generally uncorrelated to financial market volatility, they can be particularly attractive for fund managers looking for diversification. We recognize that often there are frictions in the market that make one instrument preferable to another. Sometimes, those impediments are the result of well intended regulatory regimes. The GAO has identified for the Committee some of the limitations that cat bonds face, and we look forward to any recommendations they may have to address them. Again, with investment income so severely strained and traditional reinsurance markets hardened after 9-11, now is the time to really examine all options to help supplement the capacity of the industry. The market has shown resilience in the past. In time, it will recapitalize. In the meantime, I think it is incumbent upon us, working together with private market participants, to look for safety valves to help ease that pressure. As with most things in life, timing is everything. We are one mega-catastrophe away from seeing unprecedented market disruption. Terrorism insurance legislation remains my top priority as this session draws to a close. However, we also face disasters that are not manmade. Just ask my friend Chairman Baker who I am sure breathed a sigh of relief after Hurricane Lili inflicted far less damage than had been expected. I commend the Chairwoman for her work on this issue and for putting together this timely hearing. We receive today's testimony with an eye toward potential action next Congress on the issue. It appears we will be a very busy Committee again next year. Statement of John Brynjolfsson Executive Vice President, PIMCO On Catastrophe Bonds Submitted to the Subcommittee on Oversight and Investigations Committee on Financial Services U.S. House of Representatives October 8, 2002 Committee on Financial Services, John Brynjolfsson Mr. Brynjolfsson Mr. Brynjolfsson is employed by PIMCO, an investment advisor that actively manages over $270 billion of primarily fixed income investments on behalf of U.S. and global pension plans, mutual funds, central banks and other entities. He is an Executive Vice President, Portfolio Manager and manager of the PIMCO Real Return Bond Fund. He directly oversees over $9 billion in client assets. In addition, he is PIMCO's risk-linked securities specialist. Mr. Brynjolfsson joined the firm 13 years ago. He holds a bachelor's degree in Physics and Mathematics from Columbia College, 1986, and a master's in Finance and Economics from the MIT Sloan School of Management, 1989. PIMCO and Risk-Linked Securities PIMCO has been investing in Risk-Linked Securities since June 1997. Its substantial presence in this market is a result of its ability and appetite to buy RiskLinked Securities tactically on behalf of clients who have authorized it to invest in such securities. Typically allocations to these client accounts are made in very small percentages, targeted at less than 1% per peril, across a very large base of approximately $100 billion of assets authorized to invest in Risk-Linked Securities. This results in very substantial potential capacity of $1 billion per peril. Currently PIMCO has $375 million invested in risk-linked securities across various perils, including Florida Wind and California Quake. Committee on Financial Services, John Brynjolfsson Madam Chair and members of the subcommittee, I welcome this opportunity to share my experiences, insights, expertise and recommendations with the Subcommittee on Oversight and Investigations. This testimony is offered in my capacity as an individual with extensive experience relating to Risk-Linked Securities, and not in my official capacity as an officer of PIMCO. I believe that the Risk-Linked Securities market holds great promise for your constituents, and our nation more generally. I therefore am strongly supportive of your efforts to foster the unfettered development of this market. Risk-Linked Disclosure Of course, there is no such thing as a healthy market without full disclosure, so I would like to begin my testimony by sharing with the members here the disclosure PIMCO provides to its investors regarding Risk-Linked Securities, or what I refer to as Event-Linked bonds. Please do not be startled. Like investors, I want each of you to be aware of the risks of event-linked bonds. "Each Fund (except the Money market Fund) may invest in ‘event-linked bonds', which are fixed income securities for which the return of principal and payment of interest is contingent on the non-occurrence of a specific ‘trigger' event, such as a hurricane, earthquake, or other physical or weather-related phenomenon. Some event-linked bonds are commonly referred to as 'catastrophe bonds.' If a trigger event occurs, a Fund may lose a portion or all of its principal invested in the bond. Event-linked bonds often provide for an extension of maturity to process and audit loss claims where a trigger event has, or possibly has, occurred. An extension of maturity may increase volatility. Event-linked bonds may also expose the Fund to certain unanticipated risks including credit risk, adverse regulatory or jurisdictional interpretations, and adverse tax consequences. Event-linked bonds may also be subject to liquidity risk." Questions Mr. Tom McCrocklin forwarded me six questions. Committee members might be interested in my answers to these questions. Question 1: What aspect of catastrophe bonds are attractive to investors? Risk-Linked Securities can provide PIMCO with a handsome yield in exchange for absorbing a small amount of risk. There is no need to make this too complicated so |