84-418 D-3 of investor principal and, if triggered, a formula to specify the compensation level from the investor to the SPRV. The SPRV is to hold the funds raised from the catastrophe bond offering in a trust in the form of Treasury securities and other highly rated assets. The SPRV deposits the payment from the investor as well as the premium from the company into the trust account. The premium paid by the SPRV sponsor and the investment income on the trust account provide the funding for the interest payments to investors and the costs of running the SPRV. If a predefined catastrophe occurs, principal that otherwise would be returned to the investors is used to fund the SPRV's payments to the insurer or sponsor. The investor's reward for taking this risk is a relatively high interest rate paid by the bonds. Recently issued catastrophe bonds have been nonindemnity-based—that In addition to looking at the characteristics and coverage of catastrophe risk and the structure of risk-linked securities, we identified and analyzed regulatory, accounting, tax, and investor issues that might affect the use of risk-linked securities: 'Indemnity coverage specifies a simple relationship that is based on the insurer's actual First, accounting treatment for risk transfers occurring through nonindemnity-based, risk-linked securities is a challenge for regulators. In traditional reinsurance—that is, indemnity-based-transactions, where an insurer is compensated for part or all of its losses from insured claims, the insurer gets credit 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 the reinsurance company will be able to pay any claims. In nonindemnity transactions using catastrophe bonds, payments may be triggered by an index or independently measurable value, such as wind speed, and are not directly related to incurred claims. When a catastrophic event triggers a catastrophe bond, payment formulas determine the reduction of the investors' principal that will compensate the insurance company sponsor. As a result, it is difficult to value the true amount of risk transferred to determine credit for reinsurance. The National Association of Insurance Commissioners and interested insurance industry parties are considering revisions in the regulatory accounting treatment of risk transfer obtained through nonindemnity-based coverage. If insurance accounting standards were changed so that the value of the risk transfer could be accurately calculated and recognized as an offset to potential insurance losses, the insurer could get credit for reinsurance for risk transfers occurring through nonindemnity-based catastrophe bonds. Such changes, if adopted, could facilitate the use of risk-linked securities. However, it is important that credit for nonindemnity-based reinsurance accurately reflect the true risk transferred so that insurance company reporting on both risk evaluation and capital treatment properly reflects the risks retained. Second, the Financial Accounting Standards Board is proposing a new interpretation addressing consolidation of certain special purpose entities on a sponsor's balance sheet. Under current guidance, a sponsor could avoid consolidating an SPRV as a liability on its balance sheet if the SPRV has at least 3 percent independent equity capital investment. The proposal may increase the independent capital investment required for a sponsor to treat an SPRV as independent to 10 percent of total assets. The proposal also contemplates other tests for consolidation of certain special purpose entities. While the proposed guidance is intended to improve financial transparency in capital markets and stem potential abuses of special purpose entities, it could also increase the cost of issuing catastrophe bonds. If the proposed interpretation requires consolidation, sponsors might turn to risk-linked securities, such as catastrophe options, that do not require an SPRV. Third, insurance industry representatives are considering a legislative proposal to help expand the use of domestically issued, or onshore, catastrophe bonds. SPRVS are typically located offshore, in part, to avoid U.S. taxes. By allowing special "pass-through" tax treatment, the proposal would eliminate U.S. taxation at the SPRV level. The pass-through treatment would be similar to that already provided to Real Estate Mortgage Investment Conduits and Financial Asset Securitization Investment Trusts. To the extent that domestic SPRVS gained business at the expense of taxable entities, including reinsurance companies, the federal government could experience tax revenue losses. Expanded use of catastrophe bonds might occur with favorable implementing requirements, but such legislative actions might also create pressure from other industry sectors for similar tax treatment. Some elements of the insurance industry believe that any consideration of changes to the tax treatment of domestic SPRVS would have to take into account the taxation of domestic reinsurance companies. Specifically, the Reinsurance Association of America argues that if special tax treatment is provided to domestic SPRVS, they would operate under tax advantages not afforded to existing U.S. licensed and taxed reinsurance companies. Fourth, unlike other bonds, catastrophe bonds, most of which are noninvestment-grade instruments, have not been sold to a wide range of investors beyond institutional investors. Investment fund managers who included catastrophe bonds in their portfolios told us that catastrophe bonds comprised 3 percent or less of those portfolios. On the one hand, the managers appreciate the diversification aspects of catastrophe bonds because the risks are generally uncorrelated with the credit risks of other parts of the bond portfolio. On the other hand, the risks are difficult to assess and investors are concerned about the limited liquidity and track record of the bonds. Madame Chairwoman, Members of the Subcommittee, that concludes my prepared statement. I would be happy to answer any questions at this time. On behalf of The Bond Market Association,' I would like to thank the Committee for holding this hearing on risk-linked securities, an important and growing segment of the fixed-income and reinsurance markets. My name is Christopher McGhee. I am a managing director at Marsh & McLennan Securities Corporation. I currently serve as chairman of the Risk-Linked Securities Committee of The Bond Market Association. The Risk-Linked Securities Committee includes representatives of securities firms that are active in the primary distribution and secondary market trading of risk-linked securities. I should note that my firm is an affiliate of Marsh & McLennan Companies, Inc., a global professional services firm whose operating companies include the world's leading insurance and reinsurance broker. Overview Over the past two decades, participants in the financial markets have developed sophisticated products designed to manage and transfer risk. Instruments such as structured debt and over-the-counter derivatives allow securities issuers and investors to price and manage risk efficiently. The capital markets have applied the same financial principles that have allowed market participants to manage credit and interest-rate risk to the catastrophe risk posed by hurricanes, earthquakes, and other natural perils borne by public entities, consumers and commercial enterprises. Risk-linked securities (RLS) are a capital market innovation that developed in the wake 1 The Association represents securities firms and banks that underwrite, distribute and trade debt securities, both domestically and internationally. Among other roles, the Association's members act as issuers, underwriters and dealers of risk-linked securities. More information about the Association, its members and activities may be obtained from the Association's website at www.bondmarkets.com. of major catastrophes in the 1990s. Following the market-altering losses from Hurricane Andrew in 1992 and the Northridge Earthquake in 1994, catastrophe reinsurance capacity severely contracted and premiums rose significantly. Risk securitization, or the repackaging of insurance risks for capital market investors, was an idea that had been discussed in the years preceding the natural disasters of the early 90's. This idea, however, had never been seriously considered until the capacity crunch and price spike caused by Hurricane Andrew, the Northridge Earthquake and other disasters. As a result of these circumstances, the potential buyers of catastrophic risk protection began to seek alternative ways of transferring risk. The exploration of risk securitization by the capital markets began in earnest. Risk securitization has the potential to generate substantial new sources of catastrophe risk-taking capacity on the part of insurers and reinsurers. This would, in turn, enable insurers and reinsurers to assume greater amounts of catastrophe risk from their policyholders. As such, there is a hope that, much as the secondary mortgage market brought the cost of home finance down significantly, insurance securitization could make catastrophe protection more broadly and cheaply available to policyholders than is currently the case. An increase in coverage could, in turn, reduce the potentially substantial burden on the federal government to provide emergency disaster relief to uninsured homeowners following a natural catastrophe. At the end of 2001, for example, only 17 percent of Californians had earthquake insurance. As in all securitizations, repackaging risk requires the use of a special purpose entity, or SPE (also sometimes referred to as a special purpose vehicle, or SPV). Establishing the SPE in the jurisdiction of the U.S. tax code would expose the RLS transaction to two layers of tax, making the transaction more costly for issuers and less attractive to investors. As a result, the bulk of RLS transactions take place offshore in jurisdictions with no entity-level tax. To fix this problem, Congress could permit reinsurance SPEs to be treated as "flow-through" vehicles that would not be taxable at the entity level. The change would streamline the RLS industry in the United States. Onshore risk securitizations would be less costly and less complicated to transact allowing insurers and reinsurers to manage risk more efficiently. As noted above, policyholders would be the ultimate beneficiaries of this new capacity for risk taking. This issue is, of course, a matter involving the tax code. As such, we recognize it is not subject to the jurisdiction of this committee, but rather the Committee on Ways and Means. The RLS market faces another obstacle in the near term in the form of a pending accounting standard the Financial Accounting Standards Board (FASB) is planning to issue by the end of the year. The rule as presently contemplated would require an SPE in which a third party does not own at least a 10 percent equity stake to be consolidated on the balance sheet of the SPE's chief beneficiary. Depending on how the new standard is finalized, it could inhibit future growth of the RLS market. |