SECTION: CAPITOL HILL HEARING TESTIMONY

LENGTH: 2453 words

COMMITTEE: HOUSE FINANCIAL SERVICES

SUBCOMMITTEE: OVERSIGHT AND INVESTIGATIONS

HEADLINE: INCREASING INSURANCE CAPACITY TO HANDLE CATASTROPHIC LOSS

TESTIMONY-BY: JOHN BRYNJOLFSSON, EXECUTIVE VICE PRESIDENT

AFFILIATION: PIMCO

BODY:
Statement of John Brynjolfsson Executive Vice President, PIMCO

Subcommittee on Oversight and Investigations Committee on House Financial Services,

October 8, 2002

I welcome this opportunity to share my experiences, insights, expertise and recommendations with the U.S. House of Representatives Committee on Financial Services. This testimony is offered in my capacity as an individual with extensive experience relating to Risk-Linked Securities, and not in my official capacity as an officer of PIMCO.

I believe that the Risk-Linked Securities market holds great promise for your constituents, and our nation more generally. I therefore am strongly supportive of your efforts to foster the unfettered development of this market.

Risk-Linked Disclosure

Of course, there is no such thing as a healthy market without full disclosure, so I would like to begin my testimony by sharing with the members here the disclosure PIMCO provides to its investors regarding Risk-Linked Securities, or what I refer to as Event-Linked bonds. Please do not be startled. Like investors, I want each of you to be aware of the risks of event-linked bonds.

"Each Fund (except the Money market Fund) may invest in 'event- linked bonds', which are fixed income securities for which the return of principal and payment of interest is contingent on the non-occurrence of a specific 'trigger' event, such as a hurricane, earthquake, or other physical or weather- related phenomenon. Some event-linked bonds are commonly referred to as 'catastrophe bonds.' If a trigger event occurs, a Fund may lose a portion or all of its principal invested in the bond. Event-linked bonds often provide for an extension of maturity to process and audit loss claims where a trigger event has, or possibly has, occurred. An extension of maturity may increase volatility. Event-linked bonds may also expose the Fund to certain unanticipated risks including credit risk, adverse regulatory or jurisdictional interpretations, and adverse tax consequences. Event-linked bonds may also be subject to liquidity risk."

Questions

Mr. Tom McCrocklin forwarded me six questions. Committee members might be interested in my answers to these questions.

Question 1: What aspect of catastrophe bonds are attractive to investors?

Risk-Linked Securities can provide PIMCO with a handsome yield in exchange for absorbing a small amount of risk. There is no need to make this too complicated so I'll just give you an example.

Five years ago, in 1997, and every year since, PIMCO 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 hurricane risk stretching from Texas to Maine to the capital markets, for a period of 1 year covering the 1997 hurricane season. PIMCO purchased 17% of that transaction, representing $69 million of catastrophic risk.

For each $100 I invested I received almost $5.76 plus interest. Now of course, part of the reason I am sitting here is because there were not any major catastrophic wind events in 1996. However, more seriously, PIMCO was careful to quantify what risks of this transaction.

In particular, the Risk-Linked Security I bought was only exposed to the most catastrophic of hurricanes. The legal definition of this risk was of course detailed, but an example would be a Category 5 Hurricane making landfall and passing directly over Miami, where a large number of retired and active military personnel reside. In contrast, a category 4 Hurricane passing 20 miles south of Miami, as Hurricane Andrew did in 1993, would not have triggered a loss, despite $23 billion of industry losses.

In the case of Residential Reinsurance, sophisticated third party risk modeling entities confirmed our analysis of the risk, and in fact quantified the risk of loss on the USAA bonds as less than once in one hundred years on average.

Question 2: What factors have limited your investment in catastrophe bonds?

PIMCO's involvement in the Risk-Linked Securities market has been very substantial, perhaps more substantial than any other single capital markets investor. As an investment manager, I do face some inevitable, and in some cases appropriate limits. Prudence and my fiduciary duty is first and foremost in my mind at all times, and appropriately restricts me from haphazardly investing large percentages of clients' "generic" bond mandates in Risk-Linked Securities. Other limits include restrictions on issue, issuer and industry concentrations. Also, I strive to comply with an internally imposed goal of no more than 1% exposure to any single peril. However market development among my competitors would have ancillary benefits for us, and I support such development.

PIMCO and its competitors will mold what could legally be defined as standards of practice in the industry. PIMCO is known as a successful innovator. However, despite extensive and explicit disclosure, we are also at risk of becoming a lightning rod for criticism upon the first loss-making event in the Risk-Linked Securities market. Therefore, we have employed a cadre of attorneys and risk assessment specialists and have worked closely with clients, regulators, investment bankers and reinsurance companies to develop this market.

Of course, bringing competitors into the market is primarily the role of investment banks that distribute Risk-Linked Securities to the capital markets. However, in order to facilitate their efforts, I have personally traveled around the world. I have even gone as far as presenting to groups of my competitors at conferences hosted by, for example, my co-panelist the Bond Market Association.

Question 3: Discuss the appropriateness or suitability of catastrophe bonds for individual investors or mutual funds that would be purchased by individual investors?

The Risk-Linked Securities Market is by no means appropriate for the direct participation of anyone except the most sophisticated investor. Generally all Risk-Linked Securities issued in the U.S. have been issued under the framework of Regulation 144A that limits participation to "Qualified Professional Asset Managers."

Individuals can, and do, however, appropriately access the Risk- Linked Securities markets, in very small doses, through broadly diversified mutual funds managed by competent professionals. I would put investors in the mutual funds that I manage in this category. For example the PIMCO Real Return Fund holds over $6 billion in assets, and includes perhaps $100 million of catastrophe bonds.

I have a number of credentials that enable me to contribute to the process of evaluating Risk-Linked Bonds for PIMCO. I have undergraduate degrees in both Physics and Mathematics from Columbia College. In addition, I studied under the direct attention of two Nobel prize-winning, and a number of other gifted finance theorists at MIT's historic department. Complementing my theoretical training, I have now worked under the direct attention of the legendary fixed income investor Bill Gross for 13 years. In this capacity I have directly witnessed, from what I might call the eye of the storm, many of the largest capital market events of the last decade.

Still, however, I would not contemplate participating in the Catastrophe Bond market as an isolated individual. Without my colleagues, many of whom have PhD's in the physical sciences or capital market experience comparable to my own, without the staff of in-house and outside attorneys and other professionals supporting my efforts, without connections in the investment banking and reinsurance industry, I would be unqualified to invest in RLS.

Of course, one of the most important factors that any mutual fund manager would have to take into account in deciding whether or not to invest in risk-linked securities is whether they possess sufficient expertise to analyze the risks of those securities, in order to be able to weigh the risks versus the returns. As I indicated, my colleagues and I at PIMCO do have the necessary expertise. However, some fund managers may well conclude that the costs of hiring or training personnel with the requisite expertise would not be justified, given the specialized nature of these securities.

Question 4: What is your prognosis for the future of risk-linked securities including catastrophe bonds and options?

I would suggest the Risk-Linked Securities market is currently struggling to get any notice whatsoever. This is temporary.

In particular, at this very moment the capital markets are in turmoil. Major airlines, automobile companies, energy companies, finance companies and others are struggling to get new financing, or even roll-over their existing debt that is coming due. As some of you may know, even FNMA's debt has recently been experiencing a widening of its spread to benchmarks. Meanwhile investors fear that capital already lent may not be repaid and are hesitant to lend more regardless of the tempting high levels of current corporate bond yields.

Given the compelling advantages of securitizing catastrophic event risk, and efficiently distributing these securities through capital market channels, I am highly confident that the Risk-Linked Securities market will continue, and perhaps accelerate the substantial growth it has experienced over the past 5 years, despite the current turmoil in the corporate bond market.

Question 5 What factor would accelerate the growth of risklinked securities?

Ultimately it is incumbent upon capital market professionals to educate themselves and appreciate the fruits that Risk-Linked Securities have to offer their constituents. However, in the meantime, I would suggest this committee can best serve its constituents firstly by not standing in the way of market evolution, and secondly by promoting market development through a streamlining of regulation, taxation and legal liability associated with participating in the Risk-Linked Securities market. Educational efforts such as today's hearing will go a long way towards promoting market efficiency.

Question 6: What factor would discourage the use of risk-linked securities?

Obviously the number one concern about investing in Risk-Linked Bonds is, and should be, evaluating the risk of disasters occurring. Unfortunately I believe it is beyond the authority of this committee to legislate away Hurricanes, Earthquakes and other disasters. However, more seriously, another risk relates to potential losses due to ambiguous or adverse regulatory, tax or fiduciary treatment. Certainly it is healthy for us to be careful and fully and explicitly disclose to investors the risk of investing in Event- Linked bonds. However, that fear should not be overwhelming, and for example, should not be so overwhelming as to exclude my competitors from self- assuredly entering the market.

Beneficiaries

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 directly or indirectly impact your constituents

Firstly, 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 and the like. Increasing this capacity frees up the limited capacity of reinsurance companies to address more complex risks, for example, risks associated with terrorism. Ultimately of course this benefits consumers, both individuals and small businesses.

Your constituents may benefit a second time when they have an opportunity to indirectly participate in the premiums the insurance industry garners through their pension-plans, mutual funds and other investment vehicles managed by Qualified Professional Investors, under Regulation 144A.

Such pooling of individual catastrophic risk and premiums across society very broadly is of course the essence of the concept of a mutual insurance company. In principal it extends much more broadly to the whole insurance industry through the RLS market.

You may wonder whether anyone is hurt by development of this market. Perhaps, however, I don't know whom. I believe the RLS market is one of those elusive, but much talked about, win-win situations that can make the world a better place. For example, the Risk-Linked Securities market operates strictly at the wholesale level, so local insurance agents and primary insurance markets are helped, and will likely appreciate the lower wholesale premiums they will consequently have access to. Reinsurers likewise, seem to welcome the off-loading of capacity, particularly in those types of risk that are most difficult to diversify and most catastrophic.

One last, yet often maligned constituent is the IRS, whose revenues have the potential to benefit from the development of a robust, RLS market. Whether Special Purpose Reinsurance Vehicles are domiciled on-shore, or offshore, premiums traditionally earned by distantly domiciled insurance companies will begin to be earned instead by tax paying, mutual fund shareholders and pensioners who are receiving or accruing the income.

Conclusion

I am strongly supportive of any efforts this committee may undertake to lower barriers to development of the Risk-Linked Securities Market. In addition, I am strongly supportive of any efforts to encourage understanding and foster prudent use of Risk- Linked Securities. I support efforts to enhance market efficiency by promoting increased transparency and risk disclosure. I am supportive of efforts to streamline regulation, reduce taxation, and enable on-shore domiciling of Special Purpose Reinsurance Vehicles. I am supportive of efforts to standardize, unify, rationalize, and codify the fragmented nature of State Insurance Regulatory involvement of Risk-Linked Securities markets. I am supportive of restrictions that limit use of Risk- Linked Securities to "Qualified Purchasers" who have the ability to analyze the complexity of Risk-Linked Securities and the wherewithal to suffer losses. I am supportive of efforts that solidify the contractual nature of Risk-Linked Securities and eliminate legal technicalities, or legal exceptions, as a source of risk for those who are ceding or receiving premiums.

Thank you for your interest. I am, of course available this afternoon, to answer any questions you may have.

LOAD-DATE: October 9, 2002