Congress Hears About Cat Bond Benefits

"Whether you are a disaster-prone state like Florida or California, or from a state like mine 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," she said.

Davi M. D'Agostino, director of financial markets and community investment for the U.S. General Accounting Office, cited four factors that affect the use of risk-linked securities like catastrophe bonds.

? First, she said, accounting treatment for risk transfers occurring through non-indemnity-based risk-linked securities is a challenge for regulators. It is difficult, Ms. D'Agostino said, to value the true amount of risk transferred to determine credit for reinsurance.

She noted that the Kansas City, Mo.-based National Association of Insurance Commissioners is considering revisions in the applicable regulatory accounting treatment that could facilitate the use of catastrophe bonds.

? Second, Ms. D'Agostino said, the Financial Accounting Standards Board is proposing a new interpretation addressing consolidation of Special Purpose Reinsurance Vehicles on a sponsor's balance sheet.

Currently, she noted, a sponsor could avoid consolidating an SPRV as a liability if the SPRV has at least 3 percent independent equity capital investment. But FASB, Ms. D'Agostino said, may increase that figure to 10 percent.

The goal of the proposed change is to improve transparency and stem potential abuses of SPRVs, she said, but it could also increase the cost of issuing bonds.

? Third, Ms. D'Agostino said, some in the insurance industry are considering legislation that would establish favorable tax treatment so that SPRVs, which are typically located offshore, could be moved onshore.

This, she said, could have some tax revenue implications for the federal government. Moreover, Ms. D'Agostino said, it might also create pressure from other industry sectors for similar tax treatment.

She noted that the Washington-based Reinsurance Association of America argues that if special tax treatment were provided to onshore SPRVs, they would operate under tax advantages not available to U.S. licensed and taxed reinsurance companies.

? Finally, Ms. D'Agostino noted, catastrophe bonds, most of which are non-investment grade instruments, have not been sold to a wide range of investors.

While investment fund managers that include catastrophe bonds in their portfolios appreciate them from a diversification standpoint, since the risks are generally uncorrelated with credit risks of other instruments, she said the risks are difficult to assess.

Investors, she said, are concerned about the limited liquidity and track record of catastrophe bonds.

Christopher M. McGhee, managing director of Marsh & McLennan Securities Corp., who testified on behalf of The Bond Market Association, said that most risk-linked security transactions occur offshore, where there is no entity-level tax. (An entity-level tax is levied on the premiums collected by the securitization vehicle from the primary insurers, and on the interest earned on the investments held in trust.)

He explained that under current tax laws, securitization vehicles established in the United States would be subject to two layers of tax: one on the entity and another on the investors' return. This "double taxation" makes the transaction costlier for issuers and less attractive to investors, he said. Therefore, Mr. McGhee suggested that Congress allow reinsurance vehicles to be treated as "flow-through" vehicles that would not be taxable at the entity level.

He also testified that by providing a new source of capital to insurers and reinsurers, risk-linked securities would help dampen some of the price and capacity volatility of the marketplace. He added that risk-linked securities would benefit insurance consumers by expanding the availability of competitively priced catastrophe insurance.

Michael Moriarty, director of the capital markets bureau of the New York Department of Insurance, said that the NAIC supports creating an environment that facilitates a more fluid transfer of insurance risk to the capital markets.

Speaking on behalf of the NAIC, Mr. Moriarty said that a major catastrophe or series of catastrophes could strain the ability of the industry to respond to its customers. The capital markets, he said, because of their sheer size can better absorb such events.

However, he said securitization of insurance risk is not a cure-all for the funding of catastrophe risk. The NAIC, Mr. Moriarty said, sees it as an addition, rather than a replacement, to traditional reinsurance. However, he added, the NAIC believes it is important to enable the marketplace to make that determination.

Asked by Rep. Kelly whether the NAIC has concerns with offshore SPRVs, Mr. Moriarty responded that securitization deals have been done by a select number of companies that have shared information with regulators. But he acknowledged that offshore SPRVs could lead to transparency concerns.

There could be transparency benefits if SPRVs are done onshore, he said. He emphasized that he is not saying that offshore SPRVs are inherently bad, but rather that from a transparency standpoint, it may be better if they were done onshore.

In a written statement, Committee Chairman Mike Oxley, R-Ohio, said that problems with the nation's insurance, securities and tax laws have greatly hindered the growth of disaster insurance securitization. He said he would work with interested parties to see how the potential of the nation's capital markets can be maximized to ensure Americans are protected against the damage caused by natural disasters.

Jennifer Gibson, director of federal affairs for the Indianapolis-based National Association of Mutual Insurance Companies, reported that Rep. Kelly said this week's hearing was likely the last meeting of the entire House Financial Services Committee.

However, Ms. Gibson said that due to the apparent interest of subcommittee members in the subject of alternative sources of insurance capital, there could be additional activity when Congress reconvenes in January.