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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.
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    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, 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.
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    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.
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    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 a green light obviously means go.
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    With that, we turn to you, Ms. D'Agostino, and we greatly appreciate your presence here today.


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

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    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.
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    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 on-shore.
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    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.
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    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, especially 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.
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    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 high-risk 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.
    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 indemnity-based. I do think, though, that the basis risk can be addressed.
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    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 one-half 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?
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    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 9-11 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.
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    Dr. WELDON. Do either of you from GAO, Mr. Shear and Ms. D'Agostino want to add to that at all? Do you disagree or agree?
    Mr. SHEAR. I do not disagree that recently it appears from the information we analyze that there have been increases in prices in certain types of reinsurance, and reduced availability. Part of the question which again we do not want to forecast, is how large the response would be to catastrophe bonds and potentially other forms of risk-linked securities.
    Dr. WELDON. Mr. Moriarty, would you characterize the crisis as national or regional? Is it based on the nature of the risk?
    Mr. MORIARTY. I would characterize the increasing prices and the increasing lack of coverage to be national. Anecdotally, I have heard that it is becoming more difficult in certain catastrophe-prone areas to secure reinsurance, but that is more anecdotal. But clearly, across the board the prices of reinsurance and the terms that ceding companies have been able to secure are becoming more difficult across the board.
    Dr. WELDON. And you do not see a specific impact of a certain kind of peril on that availability at all? It is across the board, nationwide, and not affected by the peril being insured for?
    Mr. MORIARTY. On a very broad basis, I think commercial reinsurance is more difficult to secure, and clearly terrorism coverage stands by itself on the side as being very unavailable and very unaffordable.
    Dr. WELDON. Thank you, Madam Chairman.
    Chairwoman KELLY. Thank you, Dr. Weldon. I would like to go back to you, Ms. D'Agostino. The GAO's report states that SPRVs are typically located off-shore for tax, regulatory and legal advantages. Wouldn't consumers be better advantaged if we improved our tax and regulatory treatment and bring the SPRVs back into the country, both for capital investment and for regulatory control?
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    Ms. D'AGOSTINO. I think arguments can and have been made on both sides. With every action one could take to improve the conditions for domestic SPRVs and catastrophe bonds on-shore, there could be a co-related trade-off. I mean, everything involves trade-offs. It is really up to the Congress to weigh those trade-offs and decide for itself as a matter of policy and law which direction it wants to take.
    Chairwoman KELLY. That is a very interesting answer.
    Thank you.
    Mr. Moriarty, how soon can we expect the NAIC to revise its accounting treatment for risk transfer to help facilitate securitization of disaster risk?
    And once the NAIC adopts the changes, who has to promulgate the changes in order to have them be effective?
    Mr. MORIARTY. I will separate that into two responses. With respect to the indemnity-based transactions which reimburse the ceding company on a dollar-for-dollar basis, the NAIC has already promulgated accounting standards to allow, or have accounting standards in place with respect to special purpose vehicles, to allow companies to take credit for this transfer of risk. With respect to the model laws that allow the formation of protected cells, I believe that seven states thus far have enacted that model. With respect to special purpose reinsurance vehicles, two states have adopted the model.
    The other part of the answer with respect to the non-indemnity-based triggers, my sense is that the NAIC would be in a position next year to promulgate accounting guidance with respect to index-based securitization transactions. Being an accounting standard, it need not be adopted on a state-by-state basis. Most state statutes adopt the NAIC codification of statutory accounting principles once they are adopted by the NAIC, although states have the option of not adopting NAIC-specific principles. So I think we are looking at next year to finalize the accounting rules with respect to nonindemnity-based transactions.
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    Chairwoman KELLY. Thank you. Mr. Moriarty. What concerns do you have with the use of off-shore SPRVs? Do you share a similar concern with traditional reinsurance provided by off-shore entities?
    Mr. MORIARTY. Well, the securitization deals that have been done off-shore have been done by a select number of either companies or investment banks who have been more than willing to share information with us. Nonetheless, the fact that they are done off-shore could lead to a concern for transparency when looking at a transaction.
    We think that there would be a lot of benefit in terms of sheer transparency if they were done on-shore, if they were subject to review by state regulators. Clearly, that would enhance our ability to get all the details should there be a concern sometime in the future. But that being said, the deals that have been done off-shore, they are not inherently bad. Just from a pure transparency viewpoint, regulators would be better served if they were done on-shore.
    Chairwoman KELLY. Thank you. I would like to ask you both, based on your discussions with private sector people, what segment of the market is most likely to use these risk-linked securities? Can you give me a reason why? I have a follow-up question to that, but I would like to hear your answer to this. Can you give me—either one of you—just please answer that one question. Ms. D'Agostino, do you want to start?
    Ms. D'AGOSTINO. If you are talking about the investment side, it is institutional investors. Part of that is driven by the nature of the catastrophe bonds, and part of it is driven by how they are issued under a specific type of rule, 144b, that the SEC is in charge of. If you are talking about from the issuance side, mostly insurance companies and reinsurance companies issue them. The other interesting fact is that insurance companies and reinsurance companies also buy them. So it is just—it is an interesting area.
    We have learned a lot, and some of the things I cannot explain, like why a part of the industry that both buys them and issues them might feel uncomfortable with risk-linked securities coexisting in the marketplace with regular reinsurance.
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    Chairwoman KELLY. Would transparency help? Would increased transparency help, as Mr. Moriarty pointed out?
    Ms. D'AGOSTINO. I am really not sure. I think the transparency might make certain investors more comfortable with them.
    Chairwoman KELLY. Mr. Moriarty, would you like to answer that question? MORIARTY: Sure, Madam Chairwoman. From the insurance industry point of view, most of the deals done to date have been securitization of the very high level catastrophe risk, and we would see that trend continue in view of the apparently increasing price for reinsurance coverage as the return to investors in a securitization deal would better match the risk that they are undertaking. Again, I have heard from the investor's viewpoint, I think establishing those is correct.
    These have been big institutional investors and you will hear from one of them this afternoon—and there apparently is some attractiveness to these types of securities in terms of their non-correlation to the rest of their investment portfolio, as the happening of a catastrophe has nothing to do with the sliding real estate market or concerns in the equity of the bond market. But again, the utility of these bonds and these deals to date have been to provide the upper layers of catastrophe covers, and I would think that they would continue along those lines. Conceptually, I think it could cover any high level type of risk.
    Chairwoman KELLY. Thank you. Dr. Weldon, have you another question?
    Dr. WELDON. I just have one or two more questions, Madam Chairman. For the GAO witnesses, could you expand on the fact that risk-linked securities are considered non-investment-grade, and do they help diversify a portfolio? Could these securities be considered a hedge to help investors reduce market risk? Is that the proper way to describe them? Do they therefore then become not an investment of first choice?
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    Ms. D'AGOSTINO. Where do we begin?
    Mr. SHEAR. Yes, where do we begin?
    Ms. D'AGOSTINO. Maybe the—
    Dr. WELDON. Mr. Moriarty, you are free to comment on that.
    Mr. SHEAR. The noninvestment-grade bonds—as we know, there are fairly large transparent markets for noninvestment-grade bonds generally. These are different types of noninvestment-grade bonds. They have the advantage of not being correlated with other forms of credit risk. In terms of some of the questions with transparency, by definition a bond market is going to have greater transparency than the traditional insurance market, which is governed by private contracts.
    To some degree in terms of talking about where this could go and why we are so uncomfortable projecting where these would go, the extent to which any changes along tax or regulatory fronts, other types of fronts, could facilitate use of risk-linked securities, there are advantages to the greater transparency that could occur. There could be more discovery in the marketplace. But this could be a circular argument in the sense that we say there is limited liquidity which limits their attractiveness, yet that limited liquidity in a sense is searching for a larger market.
    So that becomes the big question. We are not quite sure what the response would be to any legislative or other changes. But by the same token, the hope of the market—I think you will hear more on that from the second panel—would be if liquidity could be increased, you might have greater transparency and perhaps a larger investment base.
    Dr. WELDON. Did you want to add to that at all, Mr. Moriarty, or would you rather steer away from the issue?
    Mr. MORIARTY. Again, they are generally noninvestment-grade securities, but there are many noninvestment-grade securities out in the marketplace. Rating agencies review these securities and they assign a rating based upon the probability of default. These bonds have a probability of default, i.e. of a catastrophe happening, the same as any other noninvestment-grade bond. When we look at insurance company portfolios, we look at their credit quality; we look at diversification.
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    To the extent that a life insurance company would hold a catastrophe bond would not alarm us any more than they would hold any other noninvestment-grade bond. Clearly, if they made up a large part of their portfolio or if they did not have the capital to support it, it would cause a concern. But again, I do not think these stand out there as a class by themselves in comparison to all the other noninvestment-grade-type securities.
    Dr. WELDON. Thank you very much, Madam Chairman.
    Chairwoman KELLY. Thank you, Dr. Weldon. If there are no further questions, the chair notes that some members may have additional questions that they may wish to submit in writing. Without objection, the hearing record will remain open for 30 days for members to submit written questions to these witnesses and to place their responses in the record. The first panel is excused, with this committee's great appreciation for your time.
    If the second panel will take their seats at the witness table, I will begin the introductions. On our second panel, we will begin with Mr. Christopher M. McGhee, who is the managing director of the Marsh and McLennan Securities Corporation, testifying on behalf of the Bond Market Association. Next, we will hear from Mr. John Brynjolfsson, who is the executive vice president of PIMCO, the Pacific Investment Management Company, one of the world's largest fixed-income managers with over $270 billion in fixed income investments.
    Finally, we will hear from Mr. Dan Ozizmir, who is the senior managing director of trading for the Swiss Re Financial Products Corporation, whose American headquarters is located in Armonk, New York. I want to thank you all for taking time out of your busy schedule, and I really appreciate the fact that you are with us today. So without objection, your written statements will be made part of the record.
    You will each be recognized in turn for a five-minute summary of your testimony. If you are ready, Mr. McGhee, we would like to begin with you.

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    Mr. MCGHEE. Good afternoon. On behalf of the Bond Market Association, I would like to thank the committee for holding this hearing on risk-linked securities. My name is Christopher McGhee and I am a Managing Director of Marsh and McLennan Securities Corporation in New York. I also serve as chairman of the Risk-Linked Securities Committee of the Bond Market Association. This committee includes representatives of securities firms that are active in the primary distribution and secondary trading of risk-linked securities.
    I should note that my firm is an affiliate of Marsh and McLennan Companies, a global professional services firm whose operating companies include the world's leading insurance and reinsurance brokers.
    I have submitted a statement for the record that includes a diagram of standard catastrophe bonds transactions. I will summarize my written statement here and will be happy to answer any questions the committee may have at the end of testimony.
    Risk-linked securities developed in the wake of the major catastrophes of the 1990s. Following Hurricane Andrew in 1992 and the Northridge quake in 1994, catastrophe reinsurance prices more than doubled and became much more difficult to obtain. Risk securitization had been discussed in years preceding the natural disasters of the 1990s, but it really took the capacity crunch and price spike caused by Andrew and Northridge for securitization to be seen as a realistic risk-transfer mechanism. Risk securitization has the potential to generate significant sources of catastrophe risk-taking capacity on the part of insurers and reinsurers.
    This would, in turn and most importantly, enable insurers to assume greater amounts of catastrophe risk from their policyholders. Much as the secondary mortgage market brought the cost of home finance down significantly, we hope that insurance securitization could make catastrophe protection more broadly and more cheaply available to policyholders.
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    We hope that such an increase in coverage would substantially reduce the burden on the federal government to provide emergency disaster relief to uninsured homeowners following a natural catastrophe. Bear in mind, at the end of 2001 only 17 percent of Californians had earthquake insurance.
    Since 1997, 45 catastrophe bond transactions have been completed, with a total risk limit securitized of almost $6 billion. While this figure is not insubstantial, it could be larger.
    We do believe there are certain actions which could be taken which would facilitate the development of this marketplace. These include, first, permitting reinsurance special purpose entities to be treated as flow-through vehicles from a tax perspective. As in all securitizations, repackaging risk requires the use of a special purpose entity. Establishing the SPE in the jurisdiction of the U.S. tax code would subject the RLS transaction to two layers of U.S. federal tax and perhaps even state taxes, making the transaction more costly for issuers and less attractive to investors. As a result, the bulk of all these transactions today take place off-shore 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. This has already been done with mortgage-backed securities under REMICs and FCTs This would encourage risk securitization to come on-shore and as such would be less costly and less complicated to transact. We believe that this would result in an increase in transactions overall, and as noted, policyholders would be the ultimate beneficiary of this new risk capacity.
    This issue is, of course, a matter involving the tax code and as such we recognize that this is not subject to the jurisdiction of this committee, but rather than of the Committee on Ways and Means. Therefore, we mention this here only so that we can be complete on the issues facing the marketplace.
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    The second action would be to ensure that the economic substance of all these transactions are taken into account under the pending accounting rules concerning the consolidation of SPEs. In short and in general, we do not believe that any entity other than the SPRV should be made to consolidate the risk-linked security onto its balance sheet, specifically neither the sponsor of the transaction or any investor should be required to consolidate the full transaction.
    Accounting consolidation we think would produce misleading financial statements because the consolidation does not reflect the economic exposure of the parties to the transaction.
    Let me conclude with these final points on behalf of the association. First, risk-linked securities are beneficial to policyholders as they can help expand the availability of competitively priced catastrophe insurance. Second, the RLS market can relieve pressure on governments to insure catastrophe risk.
    Third, flow-through tax treatment of RLS would bring transactions on-shore and we believe would encourage the further development of this marketplace. Again, we recognize that any action on this matter is within the purview of the Committee on Ways and Means.
    Fourth and finally, the proposed FASB accounting rule as currently contemplated should not require consolidation of the SPE's balance sheet in the financial statement of any party involved in the transaction.
    A contrary result would be severely detrimental to the development of the RLS marketplace. Thank you for providing the Bond Market Association the opportunity to testify.

    [The prepared statement of Christopher M. McGhee can be found on page 64 in the appendix.]

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    Chairwoman KELLY. Thank you very much, Mr. McGhee.
    Mr. Brynjolfsson?


    Mr. BRYNJOLFSSON. Madam Chair and members of the Committee on Financial Services, I welcome this opportunity to share my expertise and recommendations. 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. The committee has forwarded to me six questions, four of which I will answer now orally. Question one, what attracts investors to risk-linked securities?
    Risk-linked securities can provide investors with a handsome yield in exchange for absorbing a small amount of risk. I will give an example. Five years ago in 1997 and every year since, PIMCO, my employer, has participated in a transaction known as residential reinsurance. This risk-linked security allowed USAA, one of the nation's largest insurers of military personnel, to cede $400 million of super-catastrophic risk to the capital markets. PIMCO purchased 17 percent of that transaction, representing $69 million of catastrophic hurricane risk.
    In particular, the risk-linked security PIMCO bought was only exposed to the most catastrophic of hurricanes—for example, a category five hurricane passing directly over Miami, where a large number of retired and active military personnel reside, would have triggered a loss on this bond. In contrast, a category four hurricane passing 20 miles south of Miami, as Hurricane Andrew did in 1993, would not have triggered a loss. Despite a relatively handsome yield, the risk of loss on these bonds could be quantified as a once in 100-year event.
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    Question two, what factors have limited your investment in risk-linked securities? One factor that has limited our use of risk-linked securities is that our competitors rarely use them. As a result, upon the first serious loss, our use of risk-linked securities may become a lightning rod for journalists and lawyers who would be quick to second-guess our decision.
    Question three, should individuals invest in risk-linked securities? The risk-linked securities market is by no means appropriate for the direct participation of individual investors. Generally, all risk-linked securities issued in the U.S. have been issued under the framework of regulation 144(a) that limits participation to qualified professional asset managers. Individuals can and do, however, appropriately access the risk-linked securities market in a very small dose through broadly diversified mutual funds managed by competent professionals.
    Question four, what does the future hold? I would suggest that the risk-linked securities market is currently struggling to get any notice whatsoever. This is temporary and simply caused by the substantial turmoil that the equity and corporate bond market are currently experiencing. Ultimately, the risk-linked securities market will likely develop into an instrumental part of the global reinsurance infrastructure.
    Before I conclude, allow me to more concretely and specifically highlight for you how I think the development of the risk-linked securities market will impact your constituents.
    First, the risk-linked securities market has the potential to substantially and dramatically increase the capacity and lower the cost of capacity in the reinsurance market. This is particularly true in the case of capacity relating to super-catastrophic risks—those once in a hundred-year events that inevitably occur and fill the pages of Life magazine.
    Increasing this capacity frees up the limited capacity reinsurance companies have to address more complex risks such as terrorism. Ultimately of course, expanding capacity benefits both individual and small business consumers of insurance services. Your constituents may benefit a second time when the premiums the insurance industry charges are passed through in the form of interest on bonds to your constituents' pension plans, mutual funds and other investment vehicles.
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    One last constituent is the IRS, whose revenues have the potential to benefit from the development of a robust risk-linked securities market. As the risk-linked securities market develops, premiums traditionally earned by distantly domiciled insurance companies will begin to be earned instead by taxpayers. I commend this committee for its proven success in making the U.S. financial markets more competitive globally.
    Specifically with respect to risk-linked securities, I am supportive of your efforts to firstly lower barriers to development of the risk-linked securities market; two, to encourage the understanding and foster prudent use; three, to enhance market efficiency by promoting increased transparency and risk disclosure; four, solidify the contractual nature of risk-linked securities; five, streamline regulation and enable on-shore domiciling of special purpose reinsurance vehicles; six, standardize the fragmented nature of state insurance regulations. Most distinguished members of this committee, thank you for your interest. I am of course available to answer your questions.

    [The prepared statement of John Brynjolfsson can be found on page 33 in the appendix.]

    Chairwoman KELLY. Thank you very much, Mr. Brynjolfsson.
    Mr. Ozizmir?


    Mr. OZIZMIR. I would like to thank Chairwoman Kelly and Chairman Oxley for holding this hearing on risk-linked securities, an important and growing segment of the fixed-income and reinsurance markets. My name is Dan Ozizmir. I am the senior managing director and head of trading with Swiss Re Financial Products, a subsidiary of Swiss Re, the largest reinsurer in North America and second largest in the world. Swiss Re is also a member of the Reinsurance Association of America and the Bond Market Association. Swiss Re has an interest in this market from two primary perspectives.
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    We structure and underwrite new risk-linked securities and we access the risk-linked securities market as an alternative source of capital. Insurer motivation—to make sure it can pay claims after a catastrophe, an insurer can do the following: raise more equity capital by selling company stock; transfer risks to the reinsurance markets; limit risks by underwriting and asset management process. While not a perfect substitute for any of these approaches, transferring risks to the risk-linked securities market is a useful, fixed-cost, multi-accompaniment to these other tools for certain peak catastrophic risks to the insurance industry, such as east coast hurricanes and California earthquakes.
    As an aside, an insurer needs to hold significantly more equity to underwrite peak exposures, like a Florida hurricane and California earthquake, than it does to underwrite non-peak exposures such as a single house fire or an auto accident. In fact, equity is an extremely efficient source of capital for non-peak exposures, as we can use the same dollar of capital to underwrite many dollars of coverage.
    The lower the cost of capital to insurers, the greater the availability of affordable insurance to policyholders. Making affordable insurance more available has important public policy implications. For example, as of the end of 2001, only 17 percent of California homeowners had earthquake insurance.
    Presumably if earthquake coverage were less expensive, more consumers would obtain coverage. This in turn would reduce the potential burden on the government to provide emergency disaster relief following a major catastrophe. Investor motivation—generally, bond investors buy risk-linked securities, often known to them as cat bonds, to diversify their investment portfolios.
    Adding risk-linked securities to a fixed-income portfolio reduces the expected standard deviation for the portfolio. In other words, the returns stay similar, but the portfolio risk goes down. This occurs because defaults on corporate bonds and natural disasters are not correlated. Given these diversification benefits, an obvious question is, why have many significant fund investors stayed on the sidelines. I have a more complete response in my written testimony, but the short answer is that some professional investors take the time to learn about the sector and get comfortable, while others have not yet done so. Mr. Brynjolfsson from PIMCO today is an exception.
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    The risk-linked securities market current status and future directions—at present for our company, risk-linked securities represent a relatively small, but strategically important source of capital. At present, we believe that while some low-rate insurers and reinsurers might face capital strain from the equivalent of two natural catastrophes on the order of Hurricane Andrew, yet industry as a whole remains capable of meeting its obligations. Note that notwithstanding the estimated insured losses from September 11, which were greater than Hurricane Andrew and the Northridge earthquake combined, reinsurance remains readily available.
    A major exception, of course, to this rule is terrorism coverage, which is either not available or extremely expensive. On the whole, we expect the risk-linked securities market to continue to grow in several ways. First, we would anticipate the absolute amount of securities outstanding to continue to grow as new investors begin to participate and existing investors devote more capital to the sector. Second, we anticipate that over time, innovation will gradually broaden the types of risk securitized. On the second point, I would note in particular that the risk-linked securities market is not a near-term solution for providing capacity for terrorism risk. Terrorism risk cannot be quantified.
    We believe that the only solution to this important and difficult problem is passage of a government backstop. In conclusion, we believe that the risk-linked security market plays a useful role in providing additional capital to the reinsurance and insurance industry. To the extent that it succeeds, it can also help increase the availability of affordable insurance to policyholders exposed to peak perils and therefore reduce the amount of uninsured losses from natural catastrophes. This concludes my testimony. Thank you very much.

    [The prepared statement of Dan Ozizmir can be found on page 215 in the appendix.]
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    Chairwoman KELLY. Thank you very much, Mr. Ozizmir.
    I have a question for you, Mr. McGhee.
    If the FASB adopts new rules governing SPRVs to increase their equity requirements, how would that affect your securitization efforts to help protect consumers against natural disasters?
    Mr. MCGHEE. We think it would clearly inhibit the growth of that sector. It would add expense, certainly. The equity component of a transaction would need to be paid more than they currently are under the fixed-income approach, so there would be an expense component there.
    But in addition, there is a challenge in finding equity investors for these kinds of transactions. This is traditionally been a fixed-income market for fixed-income investors. Finding equity investors for this transaction we think is complicated and difficult. So we actually believe it would be a significant impediment to the growth of this marketplace.
    Chairwoman KELLY. Thank you. Mr. Brynjolfsson, how can we facilitate the acceptance of natural disaster bonds by the investment marketplace? Do you think we need to help standardize information parameters or to improve the disclosure requirements? I asked this question of the prior panel. I would be interested in what you have to say.
    Mr. BRYNJOLFSSON. Sure. At our firm, we have done everything that we can do to, let's say, maximize disclosure; and to actually limit these securities strictly to portfolios where the clients have previously acknowledged that we have the authority to invest in these bonds. Even there, we are still somewhat concerned about liability associated with our investing in these types of bonds.
    It may just be a matter of education. What the committee is doing today in the form of publicizing, in effect, the GAO report and having hearings on this topic may help move the market in the direction of acceptance. Investors quite appropriately are concerned about the risk in their portfolios, now more so than ever. We have invested time and effort in developing the expertise to invest in these bonds.
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    To some extent, I have tried to facilitate our competitors' developing expertise by speaking at the Bond Market Association conferences on these topics and so on. But ultimately, my job is to take care of my investors and I hope others do the same for their investors.
    Chairwoman KELLY. How would you assess the current market for these risk instruments?
    Mr. BRYNJOLFSSON. Well, we have been an aggressive purchaser of these bonds, sometimes buying 25 percent or even 30 or 40 percent of individual transactions that have come to market over the past five years. In the past 12 months or so, we have been a little bit less aggressive. Part of the reason for that is the appetite for risk among the capital markets has been waning.
    We have to some extent anticipated that, to some extent just been a victim of it. But the whole purpose of integrating the reinsurance market with the capital markets is to bring the reinsurance markets away from the reinsurance cycle that you may be aware of where reinsurance rates harden and soften and harden and soften. Unfortunately, capital markets also have a cycle where capital market investors get driven by fear and greed and then fear and then greed. Right now, fear is the dominant sentiment in capital markets.
    Chairwoman KELLY. I have another question for you, and that is, do you really need a Ph.D. in physical sciences in order to understand this risk?
    Mr. BRYNJOLFSSON. You know, I have spent the past 12 years intensely focusing on the financial markets. Obviously, these securities are by and large a financial security. The firms that model the risk of this will have a dozen or more than that—50 or 60—Ph.D. scientists all evaluating the latest theories in earthquake, hurricane and so forth. Having some credentials in the physical sciences at least gives me some confidence that I can, let's say, read the reports that these scientists publish. I do not know if I would want to write them.
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    Chairwoman KELLY. Our hat is off to the GAO, I guess. I have run out of time here, so I am going to turn to
    Dr. Weldon. Dr. Weldon, have you questions?
    Dr. WELDON. Yes, thank you, Madam Chairman. I have got a question for Mr. McGhee and maybe Mr. Brynjolfsson, you can comment on it, too. There was some discussion—Mr. Brynjolfsson, you purchased a bond for a category five hurricane going over Miami.
    Mr. BRYNJOLFSSON. Correct.
    Dr. WELDON. Let me start with you, Mr. McGhee. What do you think would be the impact on the market if that were to happen?
    Mr. MCGHEE. If there were an event like that?
    Dr. WELDON. Next week.
    Mr. MCGHEE. We have talked a lot about that question. The concern has always been that a big loss occurs and as a result investors exit the market. Our sense is that the investor universe in this particular category is extremely well informed. They understand the risks they are running, and we believe that it is unlikely that they would immediately exit the marketplace.
    We think in fact that this might draw more investors in because the opportunities to buy more bonds at increased prices or increased yields we think would be available. So our sense is that investors would not cut and run; that they would actually stay there. We think this marketplace does have staying power.
    Dr. WELDON. Do you agree with that, Mr. Brynjolfsson?
    Mr. BRYNJOLFSSON. Well, there are two parts to that question. One is will the capacity we provide be there when an event occurs. As a major hurricane occurs, market participants start to get white knuckles and start to brace. Trading activity, pricing of the risk may occur. Bond prices may fall.
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    However, our firm is not really well positioned to monitor the minute-to-minute development of hurricanes. As a result, we are essentially buying these bonds ahead of time with the belief and plans to hold them throughout any disaster. Then we will see how the sword falls, and I hope avoid dying by the sword, if you will.
    So what that means is that the capacity that is provided is there and will be there for the event that occurs. The second part of the question implicitly is, on subsequent events, would we necessarily step up and provide additional capacity.
    As Mr. McGhee suggested, probably not unless the price were even more attractive than initially. There is actually a market for what we call second event bonds, and we do participate in the second event bond market. That is a market where we are actually paid a premium in order to absorb the possibility of two major catastrophic events occurring.
    The second event market is really a good example of how the capital markets can step in to provide not just backup capacity, but backup capacity to the backup capacity.
    Dr. WELDON. I was not aware of this. This is a developing market, you are saying?
    Mr. BRYNJOLFSSON. Well, it is part of the risk-linked securities market, and just as you have wind-risk bonds, earthquake-risk bonds, hailstorm bonds and so forth, you have something called a second event bond, which would not trigger on the first category five hurricane that hit Miami, but the second one would trigger it.
    And they are usually structure so that you would need two smaller events like two category four hurricanes to hit in the same season, which again we can probabilistically model.
    Dr. WELDON. Mr. McGhee, based on the diagram on page four of your testimony, the issuance of catastrophe bonds has decreased or flattened—is that true? Do you feel that it is a tax issue that is causing it to happen? Why do you think it is flattening out?
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    Mr. MCGHEE. It is hard to speculate, because I think there are a series of things that are feeding into why this marketplace has stayed relatively flat. The central issue is that catastrophe bonds are perceived by the potential sponsors of the transactions—insurance companies and reinsurance companies—as still relatively expensive as risk transfer mechanisms.
    So essentially it is a cost issue. There is a certain large fixed cost component to issuing cat bonds. That relatively large fixed transaction cost means that there are a relatively small number of potential issuers because they must be issuing large transactions to spread that cost over the large transaction size. So it is essentially a cost issue, and if those costs could be brought down, we think that the capacity being sought in the capital markets would increase. So it is really a cost issue.
    Mr. BRYNJOLFSSON. I would also add that it is my sense, and I do not have the data to back this up but perhaps one of the other panelists could verify what I am going to presume and that is, that recent transactions have tended to be multi-year transactions. This means that for any given amount of capacity, or for any given amount of issuance, rather than covering one year of risk, it is covering, say, three years of risk. From a capacity point of view you could multiply these reported numbers by a factor of three, because new bonds do not have to be reissued as frequently just to cover the same risk.
    Mr. OZIZMIR. In fact, I believe the number right now of the outstanding capacity in the market is on the order of about $2.5 billion. So even as a dimension, if you issue $1 billion a year and they are multi-year transactions, over time the actual capacity that exists in the market that the reinsurance and insurance companies can take advantage of is in excess of that.
    Dr. WELDON. I believe my time has expired. Madam Chairman, I did have a follow-up question.
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    Chairwoman KELLY. Go ahead and ask your follow-up question.
    Dr. WELDON. In the GAO report, they have got on page 12, figure 2, Hurricane Andrew was $30 billion, with about $15 billion being insured and a little less than half uninsured. Northridge was $30 billion.
    Then they show the World Trade Center, $80 billion—again about half is insured, half is not insured. It is very interesting—they have Kobe, Japan, the 1995 earthquake there, $147 billion of which $142.9 billion was uninsured. The impression I get is that relative to the amount of risk we have out there, this may be a growing segment and in dollar amounts it may be growing.
    This is really a drop in the bucket relative to the amount of risk that is out there. Is that an accurate statement? It sounds like a good way to try to address the risk, and I am not in any way trying to knock the industry, but it is not covering a lot of risk.
    Mr. BRYNJOLFSSON. Looking at just these four events and the decade or more they cover, if we were just to average the annual loss per year, we would be looking at something that appears in the neighborhood of $30 billion. As pointed out, this market is $2 billion or more. The capital markets in total are typically seen measured in terms of $30 trillion. So the capital markets clearly have the ability to absorb $2 billion, as they currently are, or $4 billion or $8 billion or $12 billion of catastrophic risk. Any of those numbers is not just a noticeable fraction, but a substantial fraction of catastrophic risk.
    Dr. WELDON. So you think the market could absorb the risk—more of the risk, substantially more?
    Dr. WELDON. But as I understand your testimony, and all of your testimony, the two principal stumbling blocks are the tax treatment and the nature of the market. It is very complicated to get into and there are a lot of people in the industry who do not have the expertise or the willingness to get acquainted with the complexity of this type of investment instrument.
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    Mr. OZIZMIR. Let me add a couple of things to what you said there. I would add that marginal cost is important. I mean, we discussed the fact that the risk-linked securities market is relatively small percentage. But in any market, I think the marginal cost is often what defines the overall price. So I think that we need to look at the growth of this market in the context of that.
    The second thing that I would like to talk about is, we are talking about a lot of knowledge here from the point of view of investors. We at Swiss Re and many other participants in this market are really not focusing just on knowledge to the investors, but also to the potential sedants or the insurers who are using this product.
    I think that that is something that also needs to grow as well. For example, there were some conversations here about the NAIC looking very carefully at how to define basis risk, when it is acceptable and when it is not. That is the same process that we and other insurers go through when they look at these parametric structures, because since we are not able to sell indemnity risk into the capital markets as well for the obvious reasons of transparency and disclosure and objectivity, it is important that the knowledge is not just on the investor side, but also on the user side.
    Dr. WELDON. I thank you, Madam Chairman.
    Chairwoman KELLY. Thank you. Mr. Ozizmir, how do you relate the current situation with terrorism to the potential use of the risk-based securities? You mentioned terrorism before.
    Mr. OZIZMIR. Yes. Our view at Swiss Re is that the critical element of this market is developing knowledge, objectivity and transparency in how transactions are structured. We feel that terrorism risk, even away from the securitization process, is not quantifiable.
    So if it is not quantifiable in the traditional insurance and reinsurance market, we do not see anything in the near term that would permit the risk-linked securities market to transfer risk in the terrorism market.
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    Mr. MCGHEE. May I just add to that?
    Chairwoman KELLY. By all means.
    Mr. MCGHEE. I would say that there are a lot of very smart people with lots of initials after their names, like Ph.D., that are working very hard on exactly this problem of terrorism. There are modeling firms that have all recently come out with early, early issues of models that try to assess the probability of loss of terror attacks.
    If those models were to become generally accepted, and we believe this will take some time, then it is possible, we think, that with time securitization of terror risk is a possibility. But, I should stress, this is very early days in this marketplace, though there are many people who are working very hard on this issue.
    Chairwoman KELLY. Thank you, Mr. McGhee. I really appreciate that. We have worked very hard on terrorism and trying to address the situation, and both of you have shed some light that may help us along our way, so thank you very much.
    I would like to go back to you, Mr. Ozizmir. According to the Institutional Investor last month, several European insurers are now seriously considering securitization as an alternative source of capital to fund their underwriting capacity. How can reinsurers take advantage of their unique ability to analyze high-level risk and work with the securities market and investors to bring confidence into these deals? What do you think Congress can do to facilitate this?
    Mr. OZIZMIR. I will start with the whole issue, and go back to the initial issue of knowledge. It is critical that there is transparency in the transactions. I think it has been mentioned that bringing the transactions on-shore has various benefits, and we do agree with that. That said, we do believe that the transactions, the parametric structures that are currently being done are adequate from a transparency point of view in terms of how the risks are modeled and how the risks are disclosed.
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    The critical thing that a reinsurance company needs to do if they decide to access the capital markets is recognize a few things. One is that since this is a new market, the cost of getting coverage in the capital markets is high. In some cases, it is higher than traditional reinsurance; in some cases, it is about the same; and in some cases slightly lower. But the fact is, it is not a lower cost of coverage. So a reinsurance company needs to make sure that they control and manage the basis risk.
    This is a very, very critical issue. The investors, again, are going to accept transparent modeled objective structures. The reinsurer or the insurer is going to have their own book of business which may change in a multi-year period of time. For example, if you do a four-year structure, much of the reinsurance or insurance you have written is a one-year contract. So a reinsurer will have to anticipate how their book of business may change over time.
    They are also going to have to look very carefully at where their risk is. We talk about category four hurricanes, category five hurricanes. In the case of Europe, it would be what would be called a European windstorm would be the predominant risk, such as Lothar that hit France a few years ago. So the reinsurer needs to, with the help of the modeling agencies and their own internal analytics, determine at a certain wind speed what their losses would be. This is a very, very complicated process, but something that needs to be done.
    Chairwoman KELLY. I would like to thank you.
    I would like to, Mr. Ozizmir, ask you another question. In your testimony, you state, reinsurance remains readily available. It seems to me that any discussion that we have here on reinsurance capacity ought to cover catastrophic events, ought to include a discussion of the price of covering catastrophic events because price may mean that reinsurance is not readily available. So I would like to have you discuss that a bit.
    Mr. OZIZMIR. Okay. One of the reasons we do support the development of this market is we agree that prices have increased over the last few years and in spite of the fact that they increased from a relatively low level in the late 1990s, clearly capacity coming into the market will reduce the cost.
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    We think that that is good for primarily all constituents here in terms of having greater coverage. That said, the capital markets, as I said, are not providing distinctly different prices than what is available in the reinsurance markets right now.
    Chairwoman KELLY. We may give you a written question to follow-up on that. I am out of time. Dr. Weldon, have you any other questions?
    Dr. WELDON. Yes, I just have one more follow-up question. Mr. Brynjolfsson, let's go back to Miami, category five comes over the city. Does the catastrophic bonds that we have been talking about that cover that type of event do anything to help the people who are living, say, 20 miles south or 20 miles north of the city?
    Mr. BRYNJOLFSSON. Sure. The example I gave is actually not specifically part of the contractual nature of the bond. The way the contract that is written for the specific bond that I was describing is that if USAA lost more than $1 billion, then the cat bond would in effect indemnify that insurance company for losses of greater than $1 billion.
    The firms that I alluded to that do the modeling of catastrophic risks were able to quantify for us relatively objectively that $1 billion was high enough a threshold that the insurance company itself could cover those losses out of the first $1 billion of coverage through its general operating reserves and the like, and that in order to have more than $1 billion of losses, either one large hurricane hitting a metropolitan area would have to occur, or alternately a smaller hurricane that hit successively three or four or five communities would have to occur.
    For example, if a hurricane went up the coast, it could trigger $1 billion or more in losses. So there is no exclusion of any particular homeowner or anything like that. It is more just a function of how the industry works. Now, more generally, obviously the way an insurance company works is they try to write as many premiums as they can without exceeding certain capital constraints. Any cat bond that helps relieve their capital usage frees up capital to underwrite in other areas.
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    The capital markets are, I believe, best equipped to protect against super-catastrophic risks, meaning those one in one-hundred year events that I alluded to, and also relatively generic risks which I as a bond manager can contemplate, understand and have modeling firms advise me on. Very specific risks relating to the intricacies of workman's compensation or intricacies of business liability or for that matter even intricacies of terrorism coverage, at this stage I am not ready to contemplate. I am not saying that I would never contemplate anything along those lines. However, I do know on the other hand that I am comfortable contemplating straightforward simple risks like massive hurricanes and massive earthquakes.
    Dr. WELDON. Go ahead.
    Mr. MCGHEE. I was just going to add to that if I could. It touches back on your question about the size of the cat bond market relative to reinsurance, and it plays in here as well. As Mr. Brynjolfsson said, the cat bond market really plays in that sort of super-cat layer, that area in excess of the one in one hundred year return period.
    One of the things that my firm has done is that we have been looking at the size of risk transfer capacity bought from the cat bond market and from the reinsurance market in this very remote area. We believe that there is a relatively small amount purchased from reinsurance for those super-cat events. It may be as little as $3 billion in total capacity. If that is the case, then catastrophe bonds may represent about 40 percent of the overall risk transfer market in that segment right now. It is a little-understood fact that cat bonds are a very important part of this super-cat marketplace, We think cat bonds could actually add significantly to the synthetic capital that is being created for insurance companies and reinsurance companies that can be then used to provide more coverage to their policyholders.
    Dr. WELDON. I just want to make sure I come away from this hearing properly understanding this issue. It is a very complex issue. We have taken testimony that there is a capacity crisis and then we have taken testimony that there is plenty of capacity out there. Could you, Mr. Brynjolfsson or Mr. McGhee, answer that question for me?
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    Mr. BRYNJOLFSSON. Sure. I would be happy to address that. In the area of super-catastrophic risk in the area of hurricane risk and the area of earthquake risk, there clearly is not a capacity crisis. We have been looking to buy catastrophe bonds at spreads that were previously available that are no longer being offered to us because to some extent there is capacity for those types of risk.
    On the other hand, and I do not want to get excessively anecdotal, but when it comes to very specific types of risk that I am not involved in at PIMCO, then there clearly are problems, even in the area of, well, workman's comp, other things that were directly brought to the industry's attention by the disasters at the World Trade Center.
    For example, the idea that 6,000 people could simultaneously have their lives put at risk was not something that typical workman's comp policies had contemplated or life insurance policies prior to 9-11. My understanding is that air frame and aircraft insurance similarly has become almost unavailable.
    Mr. MCGHEE. May I add to that?
    Dr. WELDON. Yes.
    Mr. MCGHEE. I think you might not characterize it as a crisis, but it may be a crisis that people do not yet recognize as a crisis, if I can put it that way. In California, only 17 percent of homeowners have earthquake insurance. In Florida, as you know, there is a state-sponsored government entity, the Florida Hurricane Cat Fund, that exists because of the need to intercede and provide some quasi-governmental support to make homeowners insurance for hurricanes more readily and cost-effectively available.
    So our sense is that there could be much more insurance being sold to consumers were it available at a competitive cost. We think that this marketplace could help encourage that—perhaps not solve all the problems, but could encourage the availability of more and cheaper capacity.
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    Chairwoman KELLY. Mr. Ozizmir, I would like you to answer that question as well, if you do not mind.
    Mr. OZIZMIR. Okay. In terms of relating capacity to the impact of the risk-linked securities market, I would like to basically agree with what my panel members said. One thing I would highlight here is that again we are talking about quantifiable, objective and transparent risks.
    Now, for that reason, if you look at the actual secondary market trading or the spread of new issues on California earthquake, Florida windstorm, European windstorm and even Tokyo earthquake risks in the market, and if you observe that the trading levels over the last few years, what you will see is that rates have been pretty much stable, except for the fourth quarter of last year, after September 11.
    What that tells me is that in the types of risks that can be specifically addressed by the risk-linked securities market, there are capacity issues possibly, but it is not showing up in the trading of those instruments. Where we are seeing in general the greatest price increases are the non-quantifiable risks like terrorism, if it is even available; hull insurance and other things like that for planes—those have increased dramatically. So again, in the risks that this market can address, we are not seeing as significant an increase in price or as great a dearth of capacity.
    Chairwoman KELLY. Thank you. Mr. Inslee, do you have any questions for this panel?
    Mr. INSLEE. I do. This may be on the periphery of this hearing, but I wanted to ask about the sort of general assessment of risk for weather-related losses, and whether the global warming phenomena is causing any concern, any thoughts in the industry in general.
    We see these relatively rapid loss patterns from weather-related events, and I just wonder, is the industry concerned about global warming and how it affects catastrophic losses in that regard? Or is that something you all can comment on? That is a question to anyone who cares to—if anyone wants to tackle it.
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    Mr. MCGHEE. Well, I can jump in there. It is absolutely clear that the reinsurance industry is thinking about just these issues, and certain large reinsurance companies in Europe have in fact done some studies with respect to the impact of global warming on the incidence of natural catastrophe and the severity of natural catastrophe.
    I do not think anybody has drawn a firm conclusion as to what the result will be, but certainly because the reinsurance and insurance industries, they take the hits when they happen, are concerned about this and trying to assess the potential risks associated with global warming.
    Mr. INSLEE. Thank you. Thank you, Madam Chair.
    Chairwoman KELLY. Thank you, Mr. Inslee. If there are no further questions, the chair notes that some members may have additional questions they may wish to submit in writing. Without objection, the hearing record will remain open for 30 days for members to submit written questions to these witnesses and place their responses in the record.
    This panel is excused with the committee's great thanks and great appreciation for your time. This hearing is adjourned.
    [Whereupon, at 3:48 p.m., the subcommittee was adjourned.]