A report on the Florida homeowner's insurance market, detailing historical and recent developments. It shows how the twin forces of catastrophic hurricane risk and politics have combined to create a dysfunctional insurance market dominated by the state and a group of small, thinly capitalized local companies.
THE UNSUSTAINABLE STATE OF THE FLORIDA PROPERTY INSURANCE INDUSTRY Who needs Mother Nature to cause a catastrophe? Florida’s politicians are busy creating an unnatural disaster in their state insurance market that will blow away taxpayers when the next big hurricane hits. Wall Street Journal, February 4, 2009 I've been around long enough to learn that sometimes when it looks like a bubble, and feels like a bubble, it might be a bubble. Jed Rhoads, Markel Global Re, June 2014
Transcript
THE UNSUSTAINABLE STATE OF THE FLORIDA
PROPERTY INSURANCE INDUSTRY
Who needs Mother Nature to cause a catastrophe? Florida’s politicians are busy creating an unnatural disaster in their state insurance market that will blow away taxpayers when the next big hurricane hits.
Wall Street Journal, February 4, 2009 I've been around long enough to learn that sometimes when it looks like a bubble, and feels like a bubble, it might be a bubble. Jed Rhoads, Markel Global Re, June 2014
DISCLAIMER By reading this report, you agree that the use of The Authors research is at your own risk. In no event will you hold The Authors or any affiliated party liable for any direct or indirect losses caused by information in this report. All content in this report represents the opinions of The Authors. Individuals and institutions must conduct their own research and analysis to form their own opinions and conclusions that may differ substantially from The Authors. Research reports are not and are not intended to be investment advice and do not constitute any form of invitation or inducement by the Authors to engage in investment activities. The Authors are not investment advisors and do not hold themselves out as such. You should assume that The Authors have positions in any publicly traded companies mentioned in this report and may profit from any change in value from said securities. As such, The Authors interests may be different from and conflict with your own. See the disclaimer at the end of this report for more complete discussion of why this report is the opinion of The Authors and presented for information purposes and should not be relied on for decision making purposes of any kind.
SUMMARY EVOLUTION OF THE FLORIDA PROPERTY INSURANCE MARKET
I. Historical Perspective
1. The First Wake Up Call – Andrew, 1992 2. The 2004/2005 Season and Its Consequences
II. Florida Property Insurance Market Structure
1. Citizens Property Insurance Corporation 2. Florida Hurricane Catastrophe Fund
3. Florida Insurance Guarantee Association
4. Market Structure Evolution
III. Depopulating Citizens Property Insurance Corp – a Deja-vu
1. Get Them Off the Books – The 1996 Depopulation 2. Let’s Try This Again – The 2006-2009 Depopulation
3. Building on “Success” – The Current Depopulation and the Old/New Kids on the
Block
4. The Verdict on the Depopulation Efforts – Political and Inefficient
IV. Reliance on Reinsurance and the Capital Markets
1. Glut of Alternative Capital Compresses Reinsurance Pricing
2. Why Reinsurance is Critical to the Florida Market
3. How Much Reinsurance to Buy or How to Use Catastrophe Models CONCLUSION RECOMMENDATIONS DISCLAIMER
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SUMMARY The politicians of the state of Florida have managed to create a unique mixture of public and private interests when dealing with the state’s challenging property insurance market. Faced with a gigantic exposure of coastal development on one of the riskiest stretches of land on the planet, Florida has attempted to create a system that deals with risks at best very difficult to quantify and at worst “uninsurable” in order to protect the sacred cow of the state’s economy – coastal real estate development. The risks associated with real estate development in hurricane and flood-prone areas will eventually come to the surface. Unfortunately, under the current system, the taxpayers of Florida and some pension funds will have to pay that bill while numerous private interests have already accumulated substantial benefits. It is our belief that when the current state of Florida insurance system unravels, it will take with it a large number of local Florida insurance companies and will wreak significant damage on the Florida’s real estate market and economy. The current status quo is only possible due to two coinciding facts: first, that Florida has experienced no significant hurricane over the last eight years (the longest such “drought” on record) and second, the low interest rate environment has attracted a lot of alternative capital to catastrophic risk space thus lowering the reinsurance price for Florida cat risk beyond a reasonable level. Subprime insurers have replaced subprime mortgages as the investment fad-de-jour. The combination of those two factors has made otherwise non-viable insurance models appear profitable. Once one or both of those factors reverse, the current market structure becomes untenable. State regulation with often conflicting policies has led to a “dysfunctional property insurance system that has distorted pricing, undermined competition and placed a heavy burden on state’s taxpayers.”1 Importantly, it has exacerbated one of the root problems of the system – the inadequate spread of risk. The State of Florida has made a number of attempts to shift those risks from state-owned to private entities offering substantial inducements only to see a number of “fly-by’night” insurance companies take the benefits and leave the public to face the liabilities. We will not be the first ones to sound the alarm on the vulnerability of the current state of affairs. Between 2010 and 2011, the Sarasota Herald Tribune’s journalist Paige St. John wrote a series of excellent articles outlining some of the problems and providing insights into how weak insurers put millions of Floridians at risk. She won the Pulitzer Prize for investigative journalism for 2011.2 Yet, little has changed. In the meantime some of the “domestic Florida insurers” (DFIs) discussed in this report have enjoyed phenomenal stock market performances, paid handsome dividends and bonuses, engaged in aggressive share buybacks and questionable related-party and investment transactions. Those companies should trade at significant discounts to their current market valuation given not only the systemic and political but also the idiosyncratic risk associated with them. In this report we review the main factors shaping the Florida’s property insurance industry. We not only highlight the challenges but also try to offer recommendations for solving some of the problems.
1 Ten Reforms to Fix Florida’s Property Insurance Marketplace, The James Madison Institute, November 2013 2 www.pulitzer.org/archives/9192
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EVOLUITION OF THE FLORIDA PROPERTY INSURANCE MARKET Florida has the nation’s highest insured losses and most vulnerable landscape. It boasts nearly $2.9 trillion of coastal property exposure up from $1.9 trillion in 2004. Florida’s demographics and land-use policies make certain that catastrophe losses will rise in the future. Despite having only 5% of America’s population, it accounts for half of all hurricane exposure.3 It is the kind of wealth concentration in an extremely risky place that defies the logic of insurance. People are allowed to build increasingly more expensive structures in areas that are vulnerable to storm damage.4 If you reran today the hurricane that struck Miami in 1926, for instance, it would take out not the few hundred million dollars of property it destroyed at the time but $60 billion to $100 billion.5 The little known Lake Okeechobee hurricane of 1928 that killed at least 2,500 in the United States will probably cause as much as $65 billion in damages if it were to occur today. A catastrophe modeling firm has estimated that a large hurricane in southeast Florida could cause insured losses of $130B and a total economic loss of $260B.6 As the table below illustrates, half of the historical hurricanes likely cause more than $10B in insured losses if they were to strike again in 2012 made landfall in Florida. Robert Hunter, director of insurance at the Consumer Federation of America, wryly commented on the Florida hurricane insurance market: “In a locale whose major university football team is called the Hurricanes, the question is not whether a hurricane will strike but when and how big.”7 Top 10 Historical Hurricanes Current Exposures
Year Hurricane Region Insured Loss (2012 dollars)
1926 The Great Miami Florida South $125 B 1928 The Great Okeechobee Florida South $ 65B 1900 Galveston Texas $ 50B
1947 Ft. Lauderdale Florida South $ 50B
1992 Andrew Florida South $ 50B 1915 Galveston Texas $ 40B
Source: Karen Clark & Co. 3 Restoring Florida Insurance Market, Eli Lehrer, The James Madison Institute, Issue 55, February 2008 4 Florida’s Insurance Markets: An Overview, Insurance Information Institute 5 In Nature’s Casino, Michael Lewis, The New York Times, August 26, 2007 6 Florida’s Financial Exposure from its “Self-Insurance” Programs, Special Report, April 2010, Florida Council of Economic Advisors at Florida Tax Watch 7 Catastrophe Insurance, Dynamic Premium Strategies and the Market for Capital, Russell, Jaffee, Alternative Approaches to Insurance Regulation, National Association of Insurance Commissioners, 1998
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According to Karen Clark & Co. estimates, the US is likely to experience on average a $10B or larger insured loss event one year out of four. In other words, there is a 25 percent chance of a $10B or larger loss this year. There is almost a five percent chance of a $50B or larger loss.8 There are three factors which put hurricanes, along with several other natural catastrophes in the category of risk that is typically referred to as “uninsurable”:
- damages may occur infrequently but can be substantial; - damages are typically concentrated in one geographic region (and most buildings in that
region are affected to some extent); - it is hard to objectively estimate the expected damage cost.
The term “uninsurable” was coined by the insurance industry itself. It refers to the fact that private insurance companies usually try to avoid insuring risks of this kind or do so only at premiums that are substantially higher than expected damage cost.9 Strong private insurance markets are characterized by the orderly matching of buyers and sellers, adequate coverage of consumers, competitive pricing and moderate government intervention. Florida’s market faces structural challenges on each of those elements and its government plays a very active role in its insurance market.10 As Towers Watson, a consulting company puts it: “There is no question: Florida’s insurance market is in a state of disarray, and property insurers and homeowners have huge challenges ahead of them.”11 Insurance is generally regulated at the state level, with each state having its own statutes and rules. Florida has experienced frequently changing and complex insurance regulations, which are both challenging and expensive to implement. Regulation is particularly volatile for property insurance with periods when rates are suppressed due to public pressure on politicians. As a result, companies have not been able to charge prices that reflect their costs of operating in one of the world’s most catastrophe-prone markets. The big insurers have responded by cutting back on the amount of insurance policies they are willing to write or withdrawing from the market altogether. Florida has replaced them with a crop of generally weak homegrown companies. The political risk in the Florida property insurance market is very high. Elections are won or lost based on proposed insurance policies that are crucial for both real estate development and affordability. Insurers sell a “promise”, one essential to the flow of credit, whose value comes from insurers’ ability to pay claims. As such one can argue that Florida’s current homeowners’ insurance system is broken since one major hurricane has the potential to bankrupt private insurers and the State’s self-insurance programs.12 8 Historical Hurricanes that Would Cause $10B or More of Insured Losses Today, Karen Clark &Co., August 2012 9 Hurricane Insurance in Florida, Ungern-Sternberg, Faculty of Business and Economics, University of Lausanne 10 Florida Property Insurance, The Window of Opportunity, Towers Watson, January 2010 11 Ibid. 12 Florida’s Financial Exposure from its “Self-Insurance” Programs, Special Report, April 2010, Florida Council of Economic Advisors at Florida Tax Watch
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I. Historical Perspective 1. The First Wake Up Call – Andrew, 1992
In 1992 after years of relative calm, category five (maximum intensity) hurricane Andrew hit South Florida. It resulted in 40 deaths, cost more than $25B in nominal dollars of damages and left a quarter of million Floridians (most of them in Miami-Dade county) with destroyed or uninhabitable homes. Following the huge losses, the bankruptcy of 11 small insurance companies, the withdrawal from the state of some of the large national insurers and the sharp increases in (re)insurance rates, Florida politicians responded by establishing market-stabilizing mechanisms like a residual market – Citizens Property Insurance Corporation (Citizens); Florida Hurricane Catastrophe Fund (FHCF) which provides reinsurance; the Florida Insurance Guaranty Association (FIGA), which pays losses of failed insurers and the Florida Commission on Hurricane Loss Protection Methodology which approves catastrophe models that are crucial for rate making by insurers. A series of 1997 reforms strengthened the ability of the state-sponsored entities to levy taxes (assessments) to pay for insurance events and expanded their capacity to write insurance. The system lasted with a few changes until 1999 when a bad season that only grazed Florida caused the Legislature to bailout Citizens.13
2. The 2004/2005 Season and Its Consequences
By the end of the 1990s, Florida’s property insurance market had largely recovered from the effects on Andrew. However, in 2004/2005 the state was battered by a series of storms resulting in huge losses for insurers. The global insurance and reinsurance industry had reported over $65B in losses from the hurricanes Katrina, Rita and Wilma (KRW). Further, the season drained the entire $7B that the FHCF had built up. As a result several insurers reduced exposure to Florida either by declining to renew policies or by not accepting new ones. State Farm and Allstate, controlling a third of the market prior to 2004, led the wave of withdrawals, followed by Nationwide, USAA, Hartford and Travelers. As one blogger put it “The insurance market in Florida is kryptonite to viable insurance companies.”14 The higher price and limited availability of property insurance became the dominant issue in the 2006 state election. In January 2007, Governor Charlie Crist and the Florida Legislature fashioned a political solution in which the state’s taxpayers were left to assume much of the risk for future catastrophic damage.15 Citizens was not allowed to raise rates until 2009, causing a massive influx policies to the state insurer and increasing the chance for to a massive hurricane tax.
13Ibid. 14 http://homesteadishome.blogspot.com/2013/05/opt-out-citizens-insurance-under.html 15 Restoring Florida Insurance Market, Eli Lehrer, The James Madison Institute, Backgrounder, Issue 55, February d 2008
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II. Florida Property Insurance Market Structure
The magnitude and variability of catastrophic windstorm losses makes it virtually impossible to entirely finance them in any single time period. Florida, like other catastrophe-prone states has chosen to fund a large portion of its risk exposure through post-loss assessments. These assessments are levied on most property-casualty insurance policyholders by the state-sponsored insurance entities.
Certain types of state intervention have proven to be successful in Europe in stabilizing property insurance markets. The best known examples in this respect are the local monopoly property insurance providers in large parts of Switzerland, the monopoly state reinsurance company for catastrophes in Spain, the state guaranteed reinsurer in France etc.16 The success of such entities depends on the sustainability of the resulting market structure. In contrast, Florida’s attempt to create a viable market is marked by serious vulnerabilities.
Citizens was created on August 1st, 2002 through the merger of two previously existing state insurers of last resort to provide “affordable” property insurance to Florida. It is a state-owned entity and has three distinct accounts: the Personal Lines Account, the Commercial Lines Account and the Coastal (formerly High-Risk Account). When any of these accounts has a deficit, Citizens may levy assessments not only against its policyholders but also against the policy holders of private insurers in almost all lines of property casualty insurance. In its current form Citizens can be broken down into five main categories of policies. The first one covers the real residual market that is uninsurable in the traditional sense of the word due to loss ratios. The second category is the coastal account where largely expensive properties are getting the benefit of the subsidized coverage. The third category of policies covers the tri-county (Miami-Dade, Broward and Palm Beach) that has very high non-catastrophe loss ratios much of which is a result of fraud (The severity in Miami-Dade is double that of any other part of the state). The fourth category encompasses manufactured housing half of which is not insured. The fifth category are policies in “sinkhole alley”. Following the 2004/2005 season, the Florida legislature passed a bill that was to provide Citizens with actuarially adequate rates. It would have increased premiums by 75% statewide by mid-March 2007. The public outcry fuelled the gubernatorial campaign of Charlie Crist who promised to reduce premiums at any cost. According to the plan, any shortfall was to be managed by assessments. As illustrated on the chart below, a Citizens policyholder can be required to pay 85% on his homeowner’s insurance premium and 38% on his auto premium in the form of assessments in any one year.
16 Hurricane Insurance in Florida, Thomas von Ungern-Sternberg, Faculty of Business and Economics, University of Lausanne
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Source: https://www.citizensfla.com/about/CitizensAssessments.cfm Mr. Crist won and he promptly passed House Bill 1A which rolled back Citizens’ rates to 2006 level, froze rates going forward, allowed policyholders to purchase Citizens policies without first being rejected by the admitted market. The Citizens glidepath legislation passed in 2009 unfroze rates but limited increases to 10% per year imposing de facto price controls. It will be many years, given the current rate restrictions and deficiencies, before Citizens policyholders are priced at actuarially fair rates. According to Maroney, Nyce and Newman, policyholders in Miami-Dade County will still be underpriced in 2020, given the present glidepath.17 Jay Liles, policy consultant for the Florida Wildlife Fund, has summed it up “Artificial rate suppression has caused financially stable insurers like State Farm and Cotton States Insurance to simply abandon the market.” Subsidized premiums for vulnerable properties provide little incentive for businesses and out-of-towners to consider the real cost of building. In fact, a 2013 report by the Tampa Bay Times found that nearly 70% of Citizens policies don’t insure a primary home. 18 After a number of years without a hurricane, Citizens has accumulated over $7.6B in reserves and the political pressure to shrink its size has mounted. The current Republican governor Rick Scott has introduced a new Citizens legislation in 2013 that limits the state insurer’s exposure. A clearinghouse whereby all new and renewal personal residential property insurance is reviewed for eligibility and placement in the private market was established in January 2014. Citizens currently holds under 1 million policyholders for the first time since 2006. Despite the financial cushion that Citizens has managed to compile, a report prepared by the actuarial firm Milliman concluded that it will face severe problems in the future. According to it
17 The State of Florida’s Property Insurance Market, The Florida Catastrophic Storm Risk Management Center, January 2013 18 How Will Depopulating Citizens Insurance Affect Florida by Alice Holbrook, April 14, 2014, Property Insurance
but not limited to homeowners, auto, and specialty
and surplus lines policies
• Up to 2 percent of the remaining
shortfall
3. Emergency Assessment
• Single- or multiyear assessment
• Citizens and private-market
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even under the best of circumstances, Citizens will see its surplus shrink to the point where it will likely have to borrow significant funds to pay claims. The improved stability of the fund is achieved by simply transferring the risks to reinsurer FHCF and the system will probably require a bail out that will be funded through special assessments on all eligible insurance policies.19
2. Florida Hurricane Catastrophe Fund (FHCF) FHCF is a State Tax-Exempt Trust Fund created by the Florida Legislature in 1993 to provide additional insurance capacity and help stabilize the property insurance market in Florida. It provides reimbursement coverage to insurance companies by writing a covered policy. These insurance companies are required by Florida law to purchase coverage from the FHCF as a condition of doing residential property insurance business in the state (over 40% of FHCF business is with Citizens). As a compulsory State Trust, the FHCF does not face the same capitalization rules as private reinsurers and relies instead upon its ability to assess its customers for any deficits. The FHCF provides coverage for personal residential and commercial residential covered losses only; commercial non-residential losses are not covered. Similar to private reinsurance, the FHCF covers losses once an attachment point is reached. Unlike private reinsurance, the FHCF is a reimbursement mechanism, meaning that insurers must first pay the underlying claims before reimbursement from the FHCF is received. This is not a realistic scenario for the majority of thinly capitalized local insurance companies. The FHCF annual maximum limit of coverage is set by statute. Currently, the FHCF maximum potential obligation for the mandatory coverage is $17B for first year and $24.8B for two years. Its funding depends on the issuance of post-event bonds. However, the FHCF statute specifically provides that the full faith and credit of the state will not be pledged to payment of FHCF obligations. By statute, the FHCF is not required to pay out money it does not have and cannot raise. FHCF’s obligations are limited to “actual claims-paying capacity.” Insurers are specifically authorized by law to rely on the estimate of FHCF claims-paying capacity as published in the Florida Administrative Register for “…all regulatory and reinsurance purposes.” Reliance on these estimates can have serious consequences for an insurer if, after a hurricane, it turns out that the FHCF cannot raise enough funds to match the estimate. In such a situation, it is possible that the insurer hasn’t bought enough private reinsurance resulting in impairment or insolvency. The FHCF reimburses property insurers for a selected percentage (45, 75 or 90% with most insurers selecting 90%) of hurricane losses to residential property above the insurer’s retention (deductible). Reimbursement contracts run from June 1st – May 30th. The retention amount for each insurer is different because the amount is based on how much premium the insurer pays to the FHCF and the aggregate retention ($7.2B) for mandatory coverage.20
19 Ibid 20 House of Representatives Staff Analysis, Bill# HB 1107 FHCF, 4/19/2013
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The FHCF’s ability to raise debt capital to cover losses is highly dependent on market conditions – it peaked at $26B in the spring of 2007 and bottomed in the fall of next year at $3B. Further, the FHCF uses a 0-12 month timeframe to estimate its borrowing capacity while some insurers may not be able to survive a year waiting for FHCF recoveries.21 Insurers do not typically need to purchase private reinsurance to duplicate reinsurance bought from FHCF as such costs can not be passed through to policyholders in a rate filing and recouped. The FHCF is required by statute to charge “actuarially indicated” rates but the fund offers coverage to property insurance companies significantly cheaper than reinsurance sold by private insurance companies. It is estimated that coverage purchased through the FHCF varies little from year to year and is between 1/4th to 1/3rd what it would cost in the private reinsurance market.22 A 2007 report by the Office of Insurance Regulation estimated that “a reasonable rate on line for private reinsurance being replaced by the additional FHCF layer is 20% versus the actually charged 2.2%.”23 Our analysis shows that FHCF currently charges around 7.8% while private market ROL are about 10% to 20% for a similar reinsurance layer. FHCF debt has traditionally been considered high quality by the markets because of FHCF’s assessment powers. Its bonds are backed primarily by emergency assessments on property and casualty insurance premiums. The assessments are levied on policyholders and collected by insurers. In the 2009-2011 period FHCF would not have been able to bond enough to pay for its full potential liabilities. The fund is in a better position now with a cash balance of $9.8B at the end of 2013 and a pre-event financing of $2B issued in April 2013. While the FHCF’s total claims-paying capacity is currently estimated to be $19.07 billion, enough to cover all of its obligations, a sufficiently large storm season could exhaust all of the fund’s resources, seriously hindering its ability to meet its obligations in subsequent years. In 2012, the Office of Insurance Regulation estimated that a Cat Fund shortfall of 25 percent would be enough to render nearly half of the state’s top 50 insurers insolvent.24 “Florida’s unprecedented eight-year ‘drought’ in hurricanes has allowed, for the first time in several years, the Cat Fund to accumulate enough cash that, coupled with issuing billions in debt, will allow it to fully cover its obligations,” R Street Florida Director Christian Camara said. “But Floridians would still be soaked with billions in taxes and the fund would be left bare to cover subsequent storms.”25
3. Florida Insurance Guarantee Association (FIGA) The state-sponsored agency charged with dealing with the adverse effects of insolvent insurers was created in 1970 and is called the Florida Insurance Guarantee Association (FIGA). FIGA does not accumulate funds in advance of an insurance company’s insolvency. When an insolvency occurs, FIGA must obtain the funds it needs through pro-rata (regular and/or
21 The Florida Hurricane Catastrophe Fund, Alternative Methods for Managing the Size,December 1, 2013 22 Annual Report, Florica Hurricane Catastrophe Fund Fiscal Year 2010-2011, p.19 23 The Florida Hurricane Catastrophe Fund, Alternative Methods for Managing the Size, December 1, 2013 24 R Steet Welcomes Vote to Right-Size Fla Cat Fund, Feb 4, 2014, www.rstreet.org/florida 25 Ibid.
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emergency) assessments levied by the Office of Insurance Regulation on insurance companies. These insurers must then recoup the cost through their policyholders.26
4. Market Structure Evolution
After Hurricane Andrew, many national insurance companies left Florida or reduced exposure citing the vulnerability of exposing their capital base to large catastrophes. As a result, Florida has witnessed the growth of Citizens and a domestic industry heavily reliant upon offshore catastrophe reinsurance in order to access enough capital to support writing property insurance. As the chart below illustrates, the DFIs and Citizens account for 75% of the marketplace up from 16% in 1999.27 The insurance expert Robert Klein, director of the Center for Risk Management and Insurance Research at Georgia State University calls that market structure “Florida-zation of cat risk.”28 It raises questions as to the ability of the market to withstand significant storm activity since it concentrates risk rather than disperses it.29 Evolution of Florida’s Homeowners Insurance Market Share
39%
11%
45%
15%
28%
10%
46%
6%
0%
20%
40%
60%
80%
100%
1999 2012
ANTS Other Nationals Citizens DFIs
Source: Dowling & Partners, 2013 Private insurers in Florida are prohibited from raising rates to cover past losses and must operate their businesses in a way that allows them to have enough money on hand (or through reinsurance) to pay for claims they expect to have in the future. This is in sharp contrast with the post-event funding philosophy of both Citizens and FHCF. DFIs have been operating in the red on a cumulative basis for over 11 years since hurricane Andrew in 1992 before breaking even and
26 The State of Florida’s Property Insurance Market, The Florida Catastrophic Storm Risk Management Center, January 2013 27 Office of Insurance Consumer Advocate, June 2013 28 Weak Insurers Pul Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28th, 2010 29 Source: Statutory Statements, Citizens, Dowling & Partners Analysis, June 13, 2013
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returning to profitability in 2003 and then sliding back into the red with back-to-back hurricanes in 2004/2005. They finally turned a profit in 2012. A number of factors contributed to the losses even without a hurricane. The frequency (up 26.8%) and cost of claims (up 32.5%) were up sharply between 2007 and 2009. The average loss per policy has risen by more than 65% over the same two year period largely as a result of sinkhole claims and public adjuster filings. At the same time, property insurance rates actually dropped between 2007 and 2009 due to state-mandated discounts for mitigation measures. Those issues were addressed in a property insurance bill that among other reforms addressed out-of-control sinkhole claims and implemented limits on public adjuster fees.30 The current market structure and the unpredictability of both rates and losses encourage the emergence of “fly-by-night” insurance companies that enter the market with aggressive pricing strategies that do not allow them to cover their effective exposure. They are then forced to leave the market when the first major event hits them. The profits are not used to increase reserves but are distributed to shareholders and management in the form of dividends, share buybacks and bonuses. These insurers reap the potential upside of such gambles while subjecting the public to the potential downside (the banking system presents a similar dilemma on a much larger scale).31 As the Pulitzer winning journalist Paige St. John summed: In Florida, “insurers are now risk-brokers, players with relatively little money and a lot of leverage. In place of huge cash reserves, they have reinsurance that pays off in a major disaster. Those policies are so costly that most companies have little money left to build reserves.”32
III. Depopulating Citizens Property Insurance Corp. - a Déjà-vu
The political climate in Florida periodically favors the aggressive shrinking of the state’s involvement in the marketplace. This goal is usually achieved through the provisions of incentives to private companies encouraging the takeover of Citizens policies. That has given rise to a Florida-specific business model where takeout DFIs only assume policies from Citizens and do not engage in underwriting voluntary business. There are companies that combine the takeout with the voluntary model as well as DFIs that only pursue voluntary business. The takeout process has been opaque, controversial and largely unsustainable. The state does not disclose the process for how it vets the companies that take over the policies. “There is no one watchdog or independent evaluator of a takeout deal who is both fully informed and fully independent. That’s the problem,” says former Citizens board member John Rollins, who became the company’s chief risk officer in September. “It’s the Achilles’ heel of the system.”33 History seems to confirm his point. In fact, the political favors associated with the approval and incentive process have been controversial for years.
30 Commentary: Sans Storms, Florida Property Insurance Market Continues to Stabilize, March 24, 2014 31 Hurricane Insurance in Florida, Thomas von Ungern-Sternberg, Faculty of Business and Economics, University of Lausanne 32 Weak Insurers Pul Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28th, 2010 33 Ibid.
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1. Get Them off the Books - The 1996 Depop
The size of the Joint Underwriting Association (JUA, one of Citizens predecessors) exploded after Andrew. In 1996, the State of Florida, Florida Office of Insurance Regulation (OIR) and the JUA initiated an effort to depopulate the JUA. The depopulation effort included legislation to permit Florida to offer financial incentives to insurers that took policies out of the JUA. The legislation included guidelines and procedures to ensure that the OIR could expedite processing the insurers that would be formed for the purpose of capitalizing on the financial incentives. The program allowed 32 companies to take 1 million policies out of the JUA in exchange for $81 million in bonus money. Citizens’ Market Share
Source: Dowling & Partners, 2013 As the chart above shows, Citizens’ market share fluctuates a lot following hurricanes and/or regulatory interventions. By 2000, it had shrunk to a mere 60,000 policies from over 950,000 back in 1996. However, A.M. Best, the nation’s oldest financial rating company, issued a report warning that the state of Florida was growing companies “without the financial depth to survive a single hurricane, let alone the state’s average of 2.5 a year.”34 It accused regulators of paying these new companies to assume policies from the state insurance pool and handing the riskiest properties to “thinly capitalized, opportunistic insurers.” A.M. Best was proven right just a few years later when the 2004/2005 season exposed the vulnerabilities of the DFIs. CLARENDON Back in 1997, a company called Clarendon offered to take out the riskiest policies for $300 per policy. Some of the Citizens’ board members were skeptical of the proposal with one of them commenting on the condition of anonymity that there were hidden costs to the plan that could push its per-policy cost into the $600 to $1,000 range. Clarendon’s takeout proposal was approved and 90,544 mobile homeowners, dwelling fire and homeowners policies and 40,800 policies out of the state's windstorm insurance pool were taken over. In return, the company received incentives worth as much as $47.7 million35.
34 Weak Insurers Put Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28th, 2010 35 http://articles.orlandosentinel.com/1999-05-29/business/9905280828_1_clarendon-homeowners-policies-property
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Following the initial success, the company was sold to the large German reinsurer Hannover Re at the beginning of 1999 for $500M. However, even the very experienced industry operator couldn’t make the model work. In early 2005, Hannover announced that: “Clarendon is to exit the Florida homeowners’ market, where last year’s hurricane losses contributed to an overall net loss of 91.4M Euros in 2004.”36 Despite being the fourth largest writer of property insurance in Florida and having “one of the largest and most complex reinsurance programs of any insurance company in the United States”37, Clarendon was placed in runoff in July 2005 and ultimately sold to the runoff specialist Enstar Group in 2010. That fate did not preclude the former owners and directors of Clarendon Robert Ferguson and Ralph Milo from suing Hannover Re in 2005 for “earn out” payments for the years 1999, 2000 and 2001. The company marketed in Florida through its managing general agent (MGA) Tower Hill Insurance Group. Tower Hill collected premiums, received and processed all claims, and administered and managed all policies of Clarendon.38 Tower Hill currently takes policies out of Citizens. Clarendon’s underwriting coordinator, Michal Lyons is the founder and CEO of Weston Insurance, a company that is also a current depopulator. Ralph Milo, the former Clarendon’s CEO and Chairman and William Roche, Clarendon’s Chief Underwriting Officer are now at the helm of the Ocean Harbor Insurance Group which includes the Safe Harbor Insurance company, another active current Florida take out company. POE FINANCIAL GROUP The failure of three Poe Financial Group insurance companies after the hurricanes of 2004-05 marked the largest insurance insolvency in Florida’s history. The total bill Florida homeowners had to foot was over $800-million. The Southern Family company of the group was granted a license in August 1996 and began to aggressively take policies out of Citizens. In August 2006, following the 2004/2005 seasons, the Poe Financial Group filed for Chapter 11 bankruptcy reorganization. The state sued former mayor of Tampa, Bill Poe Sr., and 19 others, including his wife and five children, alleging they diverted more than $140-million from the Poe insurance companies as they headed towards bankruptcy.
2. Let’s Try This Again - The 2006-2009 Depopulation
Following the 2004/2005 storm season, Citizens adopted a $250 million loan plan that called for 13 Florida insurance companies to add as many as 1.7 million customers while substantially shrinking Citizens policy count. However, most of those companies had fewer total customers in 2012 than expected. Meanwhile, Citizens grew from 1.2 million to 1.5 million customers.39 As the chart below illustrates a lot of policies were removed from the state insurer in 2007 and 2008 only to come back after a number of takeout DFIs failed.
36 Hannover Re Plans to Trim US Operations, 2005 37 Reinsurance Pricing for Florida Property Risk, Michael Lyons, Weston Insurance Holding Corporation 38 http://www.floir.com/siteDocuments/Clarendon_Select_12312004.pdf 39 Insurers Seeking Citizens Loans Fined, by Charles Elmore, The Palm Beach Post, December 9th, 2012
Source: Citizens Property Insurance Corporation NORTHERN CAPITAL INSURANCE GROUP In 2006, Miami businessmen Alexander Anthony and Albert Fernandez sold their security guard business to launch Northern Capital Insurance Group (NCIC) . It rocketed from $467K in revenue in 2006 to more than $95M by 2008 and was celebrated by Inc. Magazine as “America’s Fastest Growing Private Company.” The award provoked a congratulatory letter from Gov. Charlie Crist thanking the carrier for its phenomenal growth. 40 The growth came at the expense of concentrating the company on the riskiest stretch of properties between Palm Beach and Miami. Even without a storm, NCIC ran into liquidity problems, tried to unsuccessfully raise money in the financial markets and was declared insolvent by the Insurance Commissioner Kevin McCarty in April 2010.41 In 2014, The Florida Department of Financial Services (DFS), acting as a receiver for the company sued the company's directors and officers, claiming they ran Northern Capital into the ground by recklessly pursuing take-out policies from the state's backstop insurer. In a complaint filed in Florida's Eleventh Judicial Circuit, DFS said the directors of the Miami-based insurer pursued growth by acquiring high-risk, geographically concentrated “take-out” insurance policies from the state-backed Citizens Property Insurance Corp. “The director defendants pursued this strategy because their singular focus was on maximizing NCIC's short-term profits to increase their own remuneration,” DFS said. “The director defendants acted with reckless disregard for NCIC's safety and financial soundness.” The directors netted hundreds of thousands of dollars in bonuses for themselves while the insurer was losing money, according to the suit. “They used the assets of NCIC to fund millions of
40 Weak Insurers Put Millions of Floridians at Risk by Paige St. John, Sarasota Herald-Tribune, February 28, 2010 41 Another Florida Insurer Going Under: Northern Capital Insurance Is Insolvent, by Julie Patel, The Sun Sentinel, April 7, 2010
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dollars in dividend payments to themselves and other shareholders of NCIC's parent, Northern Capital Inc.,” DFS said. The agency alleges that NCIC's directors misled the state's Office of Insurance Regulation about the company's operations and its financial condition. DFS is claiming gross negligence and breaches of fiduciary duty against the defendants and is seeking to recover the funds from the allegedly fraudulent transfers.42 MAGNOLIA INSURANCE Then in 2008, there was the curious case of Magnolia Insurance, operated out of the Key Biscayne home of its president Henry James Irl with the help of a Texas Post Office box and a $24M loan from Allianz Risk Transfer. The company didn’t even have an active insurance license when Florida regulators agreed in April 2008 to allow it to take as many as 60,000 policies from Citizens. The company ultimately assumed 116,040 policies out of Citizens in 2008. Officials with the Florida Office of Insurance Regulation refused to discuss Magnolia with Paige St. John, the investigative reporter of the Sarasota Herald Tribune.43 The Florida DFS put Magnolia into receivership in April 2010 after the company became insolvent. The DFS then uncovered what it called “a scheme by Allianz to loot Magnolia by exerting control over its affairs at the expense of the company and the people of Florida”, according to a complaint filed in March 2013. Allianz denies the allegations.44 AMERICAN KEYSTONE Another example of the Citizens’ misguided depopulation effort was American Keystone backed by the Sarasota entrepreneur William Griffin, whose 1999 federal conviction for generating illegal campaign contributions had banned him from the insurance industry for life. The company was licensed in 2008 and was approved to take some of the riskiest coastal condominium association policies. The approval came despite numerous warnings about the company’s precarious financial position coming from Citizens’ own staff and analysts. The company was forced into liquidation on October 13, 2009 after it became apparent that it can not meet minimum statutory requirements and has cancelled parts of its reinsurance for the 2009 season.45 Shown below is a partial list of the insurance companies that have taken over policies from Citizens and ended up insolvent, costing Florida’s taxpayers over $400M.
42 Fla Agency Sues Directors of Defunct Miami-Based Insurer, by Carolina Bolado, January 27th, 2014, www.law360.com 43 Weak Insurers Put Millions of Floridians at Risk by Paige St. John, Sarasota Herald-Tribune, February 28, 2010 44 Florida Sues Over ‘Elaborate Scheme’ to Defraud Insolvent Insurer by Ken Bradley, The Knowledge Effect, Reuters, April 3rd, 2013 45 How Regulators Put Florida Homeowners at Risk, by Paige St. John, Sarasota Herald-Tribune, April 18, 2010
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Insolvent Insurers
INSURANCE COMPANY
Policy Takeouts (year)
Insolvency (year)
Cost to taxpayers
American Keystone 601 (2008) 2011 $2.3 million
Atlantic Preferred 113,577 (2003-2005) 2006 $236.9 million
Homewise Insurance 31,654 (2006) 2011 $36.2 million
Homewise Preferred 49,981 (2007, 2008) 2011 $80.4 million
Magnolia 116,040 (2008) 2010 $21.9 million
Northern Capital 22,004 (2008, 2009) 2010 $26.6 million
Source: Citizens Property Insurance Corp., FIGA These failures have occurred without a single major storm making landfall in Florida and add to the list failed insurers such as Coral Insurance (2009), Edison (acquired by Florida Peninsula 2010) and Argus Fire & Cas (2010). All of the companies mentioned used to enjoy an A rating from Demotech rating service. According to our analysis, 11 out of 29 companies that took policies out of Citizens between 2003 and 2009 ended up insolvent, were ordered to stop writing business or were “taken over” by other takeout companies due to financial troubles. These companies represented over 35% of all policies taken out of Citizens for the period. There is also what appears to be a pattern of “engineered” takeovers among the depop companies. For example, the Homewise group assumed some of the Poe group policies from Citizens after the group was declared insolvent. Then when Homewise itself run into problems, it was taken over by Homeowners Choice, a company currently assuming policies from Citizens. There was also a similar transaction with Edison being purchased by Florida Peninsula Insurance. Of the 761,000 policies that were transferred out of Citizens between 2007 and 2011, nearly 40% have returned, as insurers went under or the customers dropped the new coverage.46 Many of the companies that accepted, then returned, Citizens policies received more than $150M in bonuses and loans from the state-run company or taxpayers. In most cases, the bonuses were not returned.47 46 Citizens Property Insurance Corporation, Depopulation Study 2007 through 2011 47 Despite No Hurricanes, Many “takeout” Insurers Fail by Toluse Olorunnipa, Herald/Times Tallahassee Bureau, June 3, 2013
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3. Building on “Success” - The Current Depopulation and the New/Old Kids on the Block
After relatively limited takeout activity from 2010 though 2012, Citizens intensified its efforts in the last few years with a combination of “old” depop DFIs and a class of new names. The graph below shows the top 10 takeout companies for 2013 and the first two months of 2014 with the new program participants denoted in red. Top 10 Takeout Companies January 2013 – February 2014
53,095
34,872
33,903
33,289
30,249
27,016
24,593
24,494
19,284
116,155
- 20,000 40,000 60,000 80,000 100,000 120,000
Heritage P&C
Tower Hill
Homeowners Choice Ins.
Southern Fidelity Ins
United P&C
Safepoint Ins.
Weston Ins.
Southern Oak Ins.
First Community Ins.
Elements
# Policies Taken
Source: Citizens Property Insurance Corporation SOUTHERN OAK INSURANCE Southern Oak Insurance is among the takeout “royalty” - companies that have taken the largest number of policies out of Citizens in the last decade. The company was launched by a prominent Democrat and a former candidate for governor, Stephen Pajcic. Southern Oak's president and majority shareholder, Tony Loughman, and director Ron Natherson previously worked at Citizens Property Insurance. Pajcic and his legal firm have contributed $1.6-million to Florida political candidates between 1996 and 2008. Southern Oak received a bonus of $1.75-million in 2008 for about 38,000 policies assumed from Citizens in 2005-2006.48 In January 2011 The Florida Office of Insurance Regulation (OIR) said it has approved the company to take out 14,000 policies. The approval came despite serious concerns about the company’s agreement with its Managing General Agent (MGA)—although the insurer posted underwriting losses, its MGA was generating profits. The insurer paid the MGA $72M between 2004 and 2010, returning only $12.6M when the practice was questioned by the OIR.49 According to the order, the OIR believed the insurer had a MGA agreement that is "unfair and unreasonable" to policyholders.
48 A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012 49 How Insurers Make Millions on the Side by Paige St. John, Sarasota Herald-Tribune, March 14, 2010
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The OIR also had worries about Southern Oak’s wind exposure and reinsurance retention levels.50 In 2012, Weiss ratings analyst Gavin Magor was quoted as saying that “Southern Oak has insufficient reserves and poor overall stability.”51 OLYMPUS INSURANCE Olympus Insurance, like Magnolia, was started by taking policies out of Citizens in 2007 as a recipient of a 20-year $16.5M surplus note from the state insurer.52 The company was threatened with suspension by the OIR in April of 2010 on charges of inadequate reinsurance and exorbitant pay to its MGA. The regulator claimed that the company could not withstand an event without becoming insolvent.53 Olympus was cleared by Florida regulators in June 2010.54 It was approved to take out 15,000 policies from Citizens in October 2013.55 SAFE HARBOR INSURANCE Safe Harbor is part of the Ocean Harbor Group of companies controlled by Ralph Milo whom we discussed previously in relation to Clarendon. Safe Harbor was downgraded by A.M. Best to C (Marginal) from B (Fair) in June 2012 following the acquisition by the group of a Midwest and Hawaiian insurers. Concurrently, A.M. Best has withdrawn the ratings in response to Safe Harbor management’s request to no longer participate in its interactive rating process.56 The company is still rated A by Demotech; however it has almost twice the number of complaints per policy than the average Florida insurer (and an F rating) based on data from 2009 through 2012.57 ELEMENTS INSURANCE Elements Insurance was started in September 2013 sponsored by Dowling Capital Partners and a number of (re)insurance carriers including AXIS Capital, Arch Capital, Renaissance Re and Ironshore. Florida insurance industry veteran Robert Ricker who was Citizens president from 2003 through 2006 serves as CEO. On Sept. 27, the Tallahassee-based company received a state license to do business in Florida. On the same day, it received state insurance regulators' approval to take on 45,000 Citizens policies. The swift consent came even before Elements received approval to sell the catastrophic coverage required by Fannie Mae and Freddie Mac, the nation's federally-backed mortgage lenders. The company has been assigned a Financial Stability Rating of A from Demotech. As the Sun Sentinel noted: “It's hard to know exactly what carried the day for Elements — or any other
50 Southern Oak to Assume 14,000 Fla Last Resort Insurance Policies, by Chad Hemenway,, January 18, 2011 51 A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012 52 Small companies dominate Florida insurance market by Beatrice Garcia, The Miami Herald, August 4th, 2008 53 Florida Regulator: Olympus Insurance Must Take Corrective Action or Face Suspension 54 http://www.insurancejournal.com/news/southeast/2010/06/10/110622.htm 55 More Citizens Policies to Be Moved but Previous Takeout Numbers Down, The Florida Current, October 3rd, 2013 56 A.M. Best Downgrades and Withdraws Ratings of Safe Harbor Insurance Company, Press release June 29, 2012 57 http://smartshopyourcarinsurance.com/Blog/?p=2943
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takeout company, for that matter — because the process for vetting the companies is done confidentially.”58 HERITAGE INSURANCE The biggest of the new upstarts is Heritage Insurance (HRTG). Incorporated in August 2012 it managed to assume policies on seven different occasions in 2013 and 2014.59 In May 2013 in a deal that did not go through the usual approval process and was voted 3-2 by the Citizens’ board, Heritage received $33M in premiums dating back to Jan 1 to remove 40,000 policies. It also could earn another $43.8 million in unearned premiums on those policies for a total of $76.9 million. Carol Everhart, a Citizens governor stated: “I am concerned that Citizens’ staff is so focused on reducing exposure that it may not being using Citizens’ earned surplus to best serve its policyholders. We’re giving up a lot of surplus that could be used in the event of a storm. We need to get the public trust on Citizens’ side again, and I believe this is not going to help us. I am not in favor of that assumption.”60 Heritage donated more than $140,000 to Gov.Scott and the Republican Party of Florida in recent months, and spent tens of thousands more lobbying the Legislature. The firm employs the ex-Insurance Commissioner Tom Gallagher as a lobbyist.61 The efforts seem to have paid off through the special treatment from Florida's state-run insurance firm in the form of the unusual and lucrative "reinsurance quota share" agreement. The company’s president Richard Widdicombe has run a handful of insurance companies in Florida and at least two of them were cited for dozens of violations, ranging from “failure to pay claim timely” to “failure to comply with unfair trade practice requirements to making “misleading” advertisements.62 The central tenet of the Heritage business plan is taking advantage of the extremely low cat bond pricing to lower the cost of reinsurance. It has issued $200M through its Citrus Re vehicle (we hope it is not a lemon). The company did an initial public offering in 2014 raising $66M ($30M less than it had hoped for). Nephila Capital, the largest alternative reinsurance capital manager and a participant in the HRTG’s reinsurance program, was eager to put even more money to work by investing $10M for a minority equity stake in a private placement. Despite its short existence, Heritage has already taken over 116,155 policies out of Citizens or 6.2% of all depopulation policies between 2003 and 2014. In return the company has committed to not only keeping the policies for three years but not raising prices by more than 10%.
58 Many Homeowners Will Soon Be Unable to Stay with State-backed Insurer Citizens by By Kathleen Haughney and Maria Mallory White, Sun Sentinel, November 2nd, 2013 59 https://www.citizensfla.com/about/depopinfo.cfm 60 Citizens Property Insurance Corp, Minutes of the Board of Governors Meeting, May 22nd, 2013 61 After Big Donations to Governor Scott, Insurance Company May Reap $52M, By Toluse Olorunnipa, Times/Herald Tallahassee Bureau, May 21st, 2013 62 Despite hundreds of insurance violations, president of upstart company could get $52 million deal from Citizens, Toluse Olorunnipa, Miami Herald, May 22nd, 2013
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It was also granted permission to take over the policies of Sunshine State Insurance, another failed DFI. Sunshine announced significant accounting restatements related to its reinsurance contracts in March 2014. In May, after a few weeks of due diligence, United Insurance Holdings Corp. (UIHC) terminated its bid to acquire the financially-troubled company. On June 13th, 2014, HRTG announced received a court order to takeover approximately 35,000 policies of Sunshine. WESTON INSURANCE This was not the only subsidy Citizens bequeathed upon an upstart private insurer in 2013 using its surplus. In February 2013, Citizens' board approved a deal with Weston Insurance, agreeing to pay the young company $63 million to take out 30,000 policies. The company has spent more than $250,000 on lobbying in 2013, and two of Citizens' seven board members abstained from voting on the deal because of conflicts of interest. The company was licensed for wind-only coverage in December 2012, a market previously handled only by Citizens. Perhaps the most disconcerting thing to its clients – and Florida Insurance Consumer Advocate Robin Westcott – is the high interest Weston is supposed to pay on a $15 million, 10-year surplus note (basically a loan) that it used to boost reserves. The terms call for escalating interest in the 15-20 percent range, which Westcott called "pricey" and "dangerous."63 ,64 In both deals, the payments are structured as backdated "reinsurance" agreements, where Citizens essentially pays the company to cover Citizens' losses on certain policies over a specified period of time. Since the period of time is in the past, the company can actively select policies that had no losses, in effect making the deal virtually risk-free.65 Under terms of the takeout, when policies renew, Weston will also have to adhere to the same 10-percent rate-hike cap as Citizens for three years. HOMEOWNERS CHOICE Another member of the takeout “royalty” is Homeowners Choice Property & Casualty Insurance Co. Inc (HCI). It was founded by Pareshbai Surykant Patel in 2007 it counts the past president of Citizens (2007-2011) Scott Wallace as a president of its property/casualty division. Despite the inadequacy of the Citizens’ rates, the company did not have any rate increases at its first six takeouts. Clearly, they have discovered something nobody else is aware of.66 67 Gavin Magor, senior financial analyst with Weiss ratings was quoted as saying that Homeowners Choice has grown too fast and, despite rising capital, may have trouble dealing with a major event.68
63 Despite hundreds of insurance violations, president of upstart company could get $52 million deal from Citizens, Tolu Olorunnipa, Miami Herald, May 22nd, 2013 64 Can Insurance Upstarts Be Trusted to Replace Citizens? By Michael Mayo, Sun Sentinel, June 8, 2013 65 Ibid. 66 A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012 67 Citizens Depopulation Summit, June 1, 2012 68 A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012
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DFIs Assuming over 5% of the Citizens Takeout Policies 2003-2014
Southern Oak, 11%
American Integrity, 9%
Heritage, 6%Magnolia, 6%
Poe Group, 6%
United, 6%
Others, 31%Homeowners Choice, 12%
Florida Peninsula, 13%
Note: Homeowners Choice share includes policies assumed by the Homewise group; Florida Peninsula share includes policies assumed by Edison Ins. Source: Citizens Property Insurance Corp.
As the chart illustrates, eight companies have assumed more than 2/3 of the policies taken out of Citizens over the last decade. Two are insolvent – Magnolia and the Poe group and two other - the Homewise group and Edison were taken over when they ran into trouble. Mr. Patel, the CEO of HCI, has likened the process of creating DFIs to one more familiar to those working in a slaughterhouse or a butcher’s shop: “It's like making sausage. It's not a pretty process. What the insolvencies tell you is there is risk. You can go out of business without a hurricane. “69 Just don’t ask what’s inside.
4. The Verdict on the Depopulation Efforts – Political and Inefficient
The insolvencies, the political contributions, the revolving management door between Citizens and the takeout DFIs coupled with the lack of clear rules has tarnished the reputation of the process’ participants. There is evidence of a widespread consumer lack of confidence in the takeout DFIs with cases of 9,200 out of 30,000 policies opting out on a single takeout. There has been an effort to try and portray the DFIs as stable insurers in order to reduce the churn of the process which according to Bob Ritchie, the CEO of American Integrity reached 50% on one of their assumption deals. There have also been suggestions to limit the ability of people of opt-out of a takeout.70 The recent introduction of the clearinghouse is a step towards making the process involuntary for the insured.
69 http://www.tampabay.com/news/business/banking/going-where-others-fear-to-tread-pays-off-for-ceo-of-homeowners-choice/2152685 70 Citizens Depopulation Summit, June 1, 2012
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The reasons for the churn are multifaceted with price adequacy, captive Citizens agents and high non-cat losses all major issues. Citizens usually provides incentives to the takeout companies. However, due to the political sensitivity to direct subsidies (a proposed $350M surplus notes program was recently tabled), the inducements are in the more opaque form of lowered reinsurance costs and zero assumption commissions. The companies are allowed to assume policies in November/December without purchasing reinsurance till June. Alternately, companies that assume policies closer to the June 1 can be paid through backdated reinsurance contracts. The current system creates the potential for private carriers to realize several months of unearned premium without assuming full risk. Policies can then return to Citizens if the price is increased significantly upon renewal. As a result Citizens is left with half of its annual premium to cover most of the wind risk on these policies. A 2012 survey of DFIs showed that only 9% of the participants had an interest in removing policies from Citizens. The inadequate rates were cited as the biggest reason for the lack of interest, with cost of reinsurance, quality and availability of data from Citizens and the average annual loss-to-premium ratio of the properties making up the top four insurers’ concerns.71 As Bob Ritchie from American Integrity sums it up: “There are three things that are needed to depopulate Citizens – rate, rate and rate..”72 According to a May 2013 study by Goldman Sach’s Investment Banking Division presented to Citizens to evaluate the viability of its proposed surplus note program, the takeout policies of the sample portfolio submitted by the Tower Hill company are barely profitable to the DFIs. The only desirable economics are in the initial period before the first policy renewal where high profitability is driven by the lack of administrati ve expenses, acquisition and reinsurance costs. DFIs vs. Citizens’ Expenses as % of Premium
Source: Goldman Sachs, May 2013
71 https://www.citizensfla.com/bnc_meet/docs/471/03B_Depopulation_Report_final_7_26_12.pdf 72 Citizens Depopulation Summit, June 1, 2012
Rates adequacy is required for sustainability of the takeout process. However, rates are a politically-driven issue in the state of Florida. With close elections in the fall of 2014, the future direction of insurance rates is highly uncertain. Ex-governor Democrat Charlie Crist moved aggressively to contain insurance premiums when he was in office through Citizens rate freezes (2007-2009) followed by a glidepath increases of no more than 10% a year and wind mitigation credits widely criticized by the industry which reduced premiums by 20% to 50%. Most DFIs were pushed in the red from 2009 to 2011. The Republican Rick Scott assumed the Florida governor’s office in January 2011 having spent $75M of his own money in the campaign. A few months later he signed a sweeping property insurance reform that allowed insurance companies to pass on reinsurance costs to policyholders, shortened and limited the window for filing sinkhole and storm-related damage claims. Private companies were allowed to file for and were approved for significant price increases with the OIR and a new Citizens bill limiting its exposure was passed in 2013. However, with looming 2014 gubernatorial elections, Florida Chief Financial Officer Jeff Atwater sent a letter to the OIR in August 2013 in which he questioned why the rates are not falling given the falling reinsurance prices. It took the Florida Insurance Commissioner Kevin McCarty (serving under both Crist and Scott) six months to reply but in January 2014 filings for rate reductions (from 2.4% to 9.2%) from the largest insurers are reported by the OIR73. This fall will see Mr. Crist and Mr. Scott battling it out in a contested election the results of which can be as powerful as a category 5 hurricane on the DFIs. As Tower Watson summed: “The legislative process is one of the greatest risks that companies face in Florida.”74 Although conceived as a way to decrease the state’s involvement in the insurance market and increase the private bearing of risks (largely through the Bermuda reinsurance market), the depopulation program’s administration, the line between public incentives for private gain and its ultimate result remain controversial. The simple solution of pushing policies to private companies actually shifts the riskiest policies to Florida’s smaller insurance companies. Ultimately, rate regulation will become more tenuous as small insurers, having the least amount of rate flexibility, seek larger and larger rate increases to compensate for the increased risk of their portfolios. Absent those increases and the backstop of cheap FHCF reinsurance their business model is unsustainable despite the incentives. Some consumer groups have also questioned the ability of certain insurance companies to pay claims in the event of a large-scale disaster – potentially leaving the state with the balance. Bill Newton, executive director of the Florida Consumer Action Network, asks, “How is that any different from Citizens assessments, should they occur? It isn’t any different at all.” 75
73 Reinsurance Costs Helping Lower FloridaHomeowners Rates: OIR report, by Michael Adams, Insurance Journal, January 21, 2014 74 The Changing Winds in Florida, Property Insurance Implications by Bob Betz, Judith Durdan, Lloyd Stofko and Brian O’Neill, Towers Watson 75 How Will Depopulating Citizens Insurance Affect Florida by Alice Holbrook, April 14, 2014, Property Insurance
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Below is a realistic picture of the Florida insurance market. In 2013, Weiss Ratings, one of the most respected rating agencies - not paid by the insurers - gave the DFIs barely passing grades.
76barel The current efforts to limit the size of Citizens try to mask both the risk subsidy problem and the risk pooling problem of the system. The shifting of policies to companies that are Florida-only concentrates rather than spreads risk. Insurance is predicated on pooling; it works effectively when losses from any individual event are embedded in a pool so large that the loss from any single event is immaterial.77 According to a top insurance executive “No other state could get away with doing all the goofy things that Florida is trying. There is just so much premium in Florida that companies are bending over backwards to stay in.”78 As history has shown the current Citizens depopulation model largely leads to the privatization of gains (via policy assumption incentives and prepaid reinsurance) and socialization of losses after insolvency puts the weak DFIs out of business. Barry Gilway who became president of Citizens in 2012 admitted that “There is enormous pressure to reduce the policy count in Citizens. The questions is: how do you do it?”79
76 http://www.palmbeachpost.com/news/business/real-estate/weiss-rates-usaa-citizens-strong-other-florida-ins/nWHhd/ 77 Florida’s Financial Exposure from its “Self-Insurance” Programs, Special Report, April 2010, Florida Council of Economic Advisors at Florida Tax Watch 78 Restoring Florida Insurance Market, Eli Lehrer, The James Madison Institute, Issue 55, February 2008 79 Property Insurance Report, Vol.19, November 5th, 2012
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IV. Reliance on Reinsurance and the Capital Markets It is the extremely low reinsurance prices of the last few years that have allowed the current depopulation effort to appear a “success”. Florida has tried to mitigate some the current DFIs risks through reliance on reinsurance (see chart below). In its traditional form, reinsurance is insurance for insurance companies, policies bought in relatively small amounts to protect carriers from the remote chance of a very large disaster. However, due to the structure and players in the Florida property market, reinsurance has replaced traditional insurance altogether in all but name. According to Aon Benfield 2012 report, reinsurers’ exposure to a Florida 1 in 100 year and 1 in 250 year events is 26.4% and 24.4% respectively expressed as a ceded percent of gross loss.80 We think that exposure has grown further over the last two years. Bermuda-based reinsurance is “the lifeblood for scores of under-capitalized, highly leveraged start-up insurers” 81, according to Christian Camara, director of the Florida Insurance Project at the Heartland Institute think-tank in Tallahassee:“ Reinsurance comprises between 37% to 64% of expenses of the DFIs as compared to a nationwide average figure of 19%. That makes the business model extremely sensitive to changes in reinsurance pricing. Luckily for the DFIs, the influence from direct capital markets’ participation in reinsurance programs, coupled with catastrophic insured losses well below historical averages in 2013, put enormous pressure on global catastrophic reinsurance pricing. Structure of the Florida’s Property Insurance and Reinsurance Market
Source: Dowling & Partners, June 13th, 2013
80 Credit Risk of Property Catastrophe Reinsurers, Aon Benfiled, Summer 2012 81 Bermuda Controls Floridians’ Hurricane Insurance Rates, by Paige Saint John, The Sarasota Herald Tribune, October 24, 2010
Citizens (28%, $2.7B)
Other Nationals (15%, $1.5B)
FL Stand Alones (57%, $5.5B)
FHCF ($995M)
Private Reinsurance
3rd Party ($3,290M)
Bermuda (50%,$1,665M)
Other (50%, $1,625M)
Primary Florida Market $9.8B (2012)
Florida Reinsurance Market $4.3B (2012)
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1. Glut of Alternative Capital Compresses Reinsurance Pricing
The reinsurance industry has changed drastically in recent years. The low interest rate environment has prompted large investors (mainly pension funds) to look for yield and diversification in non-traditional asset classes and has precipitated an influx of capital to ILS (Insurance-linked Securities) space (see chart below). Being Lured by High-Yield Uncorrelated Cat Risk
Guy Carpenter, a broker, puts the non-traditional capacity at 14% of total worldwide cat limits and predicts that it will ultimately comprise 20% to 30% of total reinsurance spend. Aon Benfield estimates that as much as $100B of alternative capital can flow into reinsurance in the next five years on top of the current record level of $525B of global reinsurer capital.82,83 John Nelson, chairman of Lloyd’s, the world’s oldest insurance market, called on regulators in London last month to be “extremely watchful” of alternative capital, saying the new entrants could pose a threat by pricing risk too cheaply.84 Some traditional players like Berkshire Hathaway have pulled back on the U.S. catastrophe re/insurance business as they felt that the rates no longer commensurate with the risks. While pricing and premiums on U.S. catastrophe reinsurance business have declined, Buffett does not
82 S&P: Bermuda May Become a Victim of Its Own Success, Bermuda Insurance Magazine, April 24, 2014 83 Reinsurance Market Outlook, Aon Benfield, January 2014 84 http://www.businessweek.com/news/2013-10-27/pensions-muscle-into-reinsurance-for-yield-in-catastrophe-wagers#p2
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feel that the risk of suffering losses have declined, suggesting he no longer finds the market appealing at current rates.85 The chart below outlining the rate-on-line (ROL) which is the price paid for reinsurance vs. the expected loss confirms Mr. Buffet’s observation. The ILS market is now offering the lowest cost of reinsurance for peak perils witnessed since [1992’s] Hurricane Andrew.86 Willis ROL vs. Expected Loss Index
Source: Willis Lane Financial analyst Morton Lane calculated that deals with expected losses of around 100 basis points (a 1-in-100-year event) have historically attracted multiples of 4.25x in softer markets and 6.25x in harder markets. These boundaries are being pushed lower than ever, with multiples of around 3x the expected loss common for 2014 deals.87
The collapsing reinsurance prices for Florida cat risk are reflected in Citizen’s rate on line nose-diving from 21% to below 10% in four short years.
85 Warren Buffett: U.S. Catastrophe Rates Too Low for Berkshire Hathaway, www.artemis.bm, March 15, 2014 86 Reinsurance Market, Aon Benfield, Reinsurance Capacity Growth Continues to Outpace Demand, Jan 1, 2013 87 The Road to Lower Returns, Insider Quarterly
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Citizens Risk Transfer and ROL 2011-2014
Source: Artemis In April 2012, Citizens issued its first catastrophe bond through Everglades Re Ltd., a special purpose vehicle formed for the issue. The $750M bond has an expected loss of 2.53% and a coupon of 17.75%. However, the $250M Citizens’ bond issued in 2013 yields only 10% (below its suggested range of 11%-12%) despite sitting lower in the loss structure. In 2014 Citizens increased the size of its bond offering from $400M to $1.25B with yield pushing lower to 7.5% for the much broader cover of an aggregate protection and the much larger amount of coverage secured. As Artemis commented:” The reinsurance and capital markets have supported Citizens risk transfer needs at a low-level of pricing that it may never witness again.”88 The 2014/2015 Florida cat reinsurance market has been described as a “bloodbath” by some analysts with rates dropping between 15% and 30%.89 Universal Insurance Holdings, a DFI, has recently reported that it has achieved “extraordinary cost reductions” at its 2014/2015 reinsurance contracts with pricing some of the “most competitive the firm has seen in its history.” Further, it noted that the traditional reinsurers matched the quotes offered by the ILS space. “In fact, in some cases the ILS specialists have been the ones matching prices proposed by the traditional market as the competitive desire to sign premiums has resulted in reinsurers outpacing ILS price declines on some programs.”90 Please contact us if you have an interest in discussing the specific reinsurers’ and others exposures to Florida risks and particular programs. Kevin O’Donnell, the President & CEO of Renaissance Re, the largest Florida reinsurer has commented on the company’s last conference call (April 30th, 2104) that: “ At a macro level, we are starting to see undisciplined behavior with some risk being priced below an acceptable level of return for any form of capital. This behavior cannot persist permanently in financial
88 http://www.artemis.bm/blog/2014/04/28/florida-citizens-buys-68-more-reinsurance-for-2014-at-less-cost/ 89 http://www.insiderquarterly.com/florida-bloodbath 90 Nephila Capital Helps Universal to Extraordinary Reinsurance Cost Reductions by Artemis, June 3rd, 2014
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markets. On the other hand, it can exist for a long time, and pricing decisions by suppliers are often only revisited after an event.”91 Markel Global Re president Jed Rhoads said “There is some fundamental core pricing to our business or it makes a mockery of what I've done for a living for a very long time," 92 Reinsurance companies have traditionally provided reliable coverage to Florida losses and have maintained high credit ratings. The rating agencies (A.M.Best and S&P) have increased the industry’s capital requirements following the WTC attacks and the U.S. hurricane activity of 2004/2005. The four reinsurance companies that were placed in run-off following catastrophic losses in 2004/2005 – Olympus Reinsurance, PXRE Reinsurance, Quanta Reinsurance and Rosemont Re – settled most of their claims (over 99% of the catastrophe loss balances have been paid).93 However, the reinsurance industry is facing some significant changes. As Willis Re Chairman noted, “To date, the traditional model of fresh capital coming into the market has been through the formation of new companies but it is being overtaken by a new model of fast capital flowing in through less permanent structures. For an industry where primary insurance companies value sustainability, this emerging model brings many challenges. While some reinsurers are considering how to respond, others are developing third party capital management propositions to offer their own skills and platforms as fund managers. The advent of new capital is likely to have a significant impact on any post-event response which may occur after a major loss.”94
In a recently issued report on the state of Bermuda reinsurance, the S&P analyst Gharib argues, “We think that companies without a defendable competitive position, or those that are more aggressive in maintaining market share by competing on price or relaxing their underwriting discipline, are most at risk. We could revise our assessment of those (re)insurers' business risk profiles to reflect the relatively higher risk. In addition, we believe Bermudian (re)insurers with diminished capital buffers, or those whose earnings capacity is persistently constrained, could face rating pressure.”95
Adding to the weakening reinsurance fundamentals, in 2007 Florida became the first state to enact a statute authorizing waiver or reduction of collateral requirements for non- U.S. reinsurers. The move was a direct response to the 2004/2005 hurricane season and the state’s desire to attract more reinsurance capital to its property insurance industry. Prior to the 2008 rule based on the law, foreign reinsurance companies generally were required to post 100 percent collateral while regulated United States insurers posted no collateral. To qualify for waiver or reduction of collateral, a non-U.S. reinsurer must meet certain minimum financial requirements. The reinsurer must have surplus in excess of $100 million and have a secure financial strength rating from at least two nationally recognized statistical rating organizations deemed acceptable to Florida. Generally speaking a credit rating of AAA from the 91 http://seekingalpha.com/article/2178113-renaissancere-holdings-ltd-s-ceo-discusses-q1-2014-results-earnings-call-transcript 92 http://www.insiderquarterly.com/florida-bloodbath 93 Credit Risk of Property Catastrophe Reinsurers, Aon Benfield, Summer 2012 94 Willis Re Says Cat Bonds a Threat to Reinsurers, the Royal Gazette, April 4th, 2013 95 Barbarians At the Gates: Are Bermudian (Re)insurers Victims of Their Own Success,
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S&P allows a foreign reinsurer to post no collateral, AA allows for 10%, A allows for 20%, and BBB for 75%.96 The first agreement was signed with Hannover Re in 2010. There are now over 20 “Eligible Reinsurers” in Florida.97 Back in 2007, the National Association of Mutual Insurance Companies (NAMIC) with members representing 31% of the Florida market wrote in its comments opposing the waiver rule, "The proposed rule could lead to a weakened solvency position for U.S. primary insurers.” “It is critical to note that any weaknesses in a relaxed collateral regime will be revealed only in the wake of catastrophes or events leading to large numbers of claims. Even the reinsurer with superb financial strength before a major catastrophe may be sorely tested by such an event and experience financial weakness as a result of having assumed catastrophe and related risk.”98 Rating downgrades of some of the Bermuda reinsurers can potentially trigger a daisy-chain of collateral requirements. The search for uncorrelated yield has once again resulted in pricing that does not compensate for the risks. Reinsurance pricing can be a fickle matter especially if market conditions tighten and/or catastrophic events test the new alternative structures.
2. Why Reinsurance is Crucial to the Florida Market? Florida as a state comprises nearly 10% of the nation’s total direct premium written (DPW) in homeowners insurance. Selling nearly 29% of the State’s DPW in homeowners insurance, DFIs are responsible for a substantial portion of homeowners risk in the State. Clearly, Florida independent insurers collect a lot of premium. The surplus levels shown in table below reflect the most disconcerting difference between Florida and other states. Despite its relatively large market size, Florida’s year-end 2011 policyholder surplus (PHS), at just under $93 billion, was lower than any of the other hurricane-exposed states. Despite their 29% market share of premiums, DFIs contributed only slightly more than 1% of the State’s total PHS, at slightly over $1 billion. 99 The current Florida homeowners’ insurance market is heavily dependent on small companies with limited capitalization and risk diversification capabilities. Despite collecting a lot of premium, they operate on a tiny level of capital surplus. 96 http://www.floir.com/siteDocuments/ReinsuranceCollateralRule.pdf 97 http://www.floir.com/sections/pandc/eligiblereinsurers.aspx 98 http://www.namic.org/pdf/071210FlaReinsComments.pdf 99 The State of Florida’s Property Insurance Market, The Florida Catastrophic Storm Risk Management Center, January 2013
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Group and Independent Insurers’ Share of DPW and PHS
Source: The Florida Catastrophic Storm Risk Management Center The DFIs have very limited levels of capital surplus. Instead of trying to build reserves over time, the current model encourages the siphoning of cash out of the statutory insurance companies through different mechanisms. Reinsurance enables the fast growth. Instead of building up a company slowly by amassing enough surplus to write new policies, new insurers can pledge a portion of future premiums and instantly take on thousands more customers and billions more dollars in hurricane risk.100 In the absence of reserves, the only thing standing between disaster and billions of dollars of coastal exposure is reinsurance. The question is whether the DFIs are buying enough or the right coverage for their exposures.
3. How Much Reinsurance to Buy or How to Use Catastrophe Models? That is a difficult question to answer. Current (re)insurance pricing and probable maximum loss (PML) estimates are based on computer models that came into existence post hurricane Andrew. Back in 1992, a woman by the name of Karen Clark contended that the industry vastly underestimates losses following a few quiet decades. She was proven right as her estimate of Andrews’ damages of $13B came much closer to the $15.5B of actual losses compared to that of Lloyd’s at $6B.101 This event gave rise to the computer hurricane loss estimation modeling industry that uses long-term storm historical data, building codes and structure information to calculate PMLs for the (re)insurance industry. There are three major players: AIR (Ms. Clark’s firm which she sold in 2002), RMS and Eqecat. Conceptually the models consist of three modules: the hazard module simulates possible storm paths and wind speeds, the engineering (vulnerability) module applies engineering statistics to calculate exposures affected by the storms and the financial module
100 Weak Insurers Pul Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28th, 2010 101 In Nature’s Casino by Michael Lewis, The New York Times, August 26, 2007
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providing loss estimates. Some of the models are even incorporating the probable effects of the warming of the Altantic Ocean on hurricane landfalls along the US coast.102 However, the models have overestimated the insured losses from 2006 to 2010 by as much as $45B. Ms. Clark has cautioned against the use of long-term models to provide short term estimates. “Using the information in models to pinpoint a metric (such as a 1-in-100-year PML) is not helpful,” she said. “Models can get you a range—they can get you in the ballpark—but you can’t narrow the range.” “That is the whole point,” she said. “[Hurricanes] are random. You can’t predict when there will be an increase in losses and there is no connectivity to the frequency of storms.”103 The problem is how to measure the level of reinsurance necessary for thinly capitalized DFIs. In 2010 Florida removed its long standing mandate that required insurers to purchase reinsurance up to 1 in 100 PML based on an approved model. The Insurance Commissioner Kevin McCarty argued that the move will lower consumer premiums.104 Instead, the OIR has focused more on multiple events (side) coverage and reinstatements as opposed to one-storm coverage (top).105 The Demotech rating agency still requires the DFI to purchase reinsurance covering both 1 in 100 PML for a first event and 1:50 PML for a second event in order to keep their A rating.106 Although according to Florida’s Insurance Commissioner, nearly all private insurers in Florida purchase insurance up to at least 1 in 100 year storm, the financial impact on any given storm is expected to vary widely between insurers depending upon their individual reinsurance programs and spread of risk. As Robert Westcott, the state’s insurance consumer advocate sums it: “It is conceivable that some private domestic insurers will fail in events less than the 1 in 100 year storm.”107 The exposure estimates vary significantly depending on the model/s used and the different model versions. AIR and RMS estimate losses from 1 in 100 US hurricane event at $124B and $180B respectively (over 30% difference) and losses from 1 in 250 US hurricane at $199B and $263B respectively (24% difference).108 Guy Carpenter analysis shows that the uncertainty around the mean estimated values is so significant that a two standard deviations interval for a national writer’s 100-year or higher PML goes from 50% to 230% of the PML estimate.109 Given the very limited historical data on event generation, the models are unlikely to ever be accurate despite the scientific advancements. As a result, the insurers (and the regulators) need to operate with the understanding that catastrophe risk is characterized by deep uncertainty and work to diagnose the sensitivity of their own portfolios to key uncertainties in the model. The hurricane risk should be thought about as a fairly wide band of uncertainty around the output of
102 http://www.ft.com/intl/cms/s/0/76438596-0432-11e3-8aab-00144feab7de.html#axzz30pjoCeGq 103 http://www.propertycasualty360.com/2011/01/18/near-term-models-misjudge-hurricane-losses-by-bill 104 In Major Hurricne, Insurers Face Huge Risk, by Paige St. John, The Herald Tribune, July 24th, 2011 105 Why Florida is Rethinking its 1 in 100 Reinsurance Requirement, http://www.insurancejournal.tv/videos/3814/ 106 http://www.demotech.com/pdfs/papers/20140207_fl_whitepaper_addendum.pdf 107 Office of the Insurance Consumer Advocate, Robin Smith Westcott, Esq, June 24th, 2013 108 A Primer on Property Catastrophe Risk, ILS Capital Management 109 Opening the Black Box, Special Report: CAT Modeling, Global Reinsurance, March 2013
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any cat model, typically illustrated as a loss exceedance curve (see graph below). Such a view lacks the comfort of a single point estimate but paints a more realistic picture of cat risk. Loss Exceedance Curve
How protected are the DFIs from a big hurricane or a series of storms? It depends. Some companies have purchased much more coverage than others. A review of the DFIs 2011/2012 storm season coverage by the Herald Tribune revealed that about half the companies barely had 1 in 100 year coverage while the other half had programs as robust as 1 in 250 year suggesting that there are two business models at work: companies interested in staying in business for the long run where
premium is enough to properly reinsure the book and “risk brokers” that are unable to finance a proper program and are willing to take big risks while in the meantime reaping the benefits of the event-free years.110 The importance of the intersection between models and insurance is highlighted by reviewing the reinsurance practices of the biggest private Florida insurer - Universal Property and Casualty Insurance (UVE), a public company. It carries 500,000 policies for a total insured value of $107B.111 The company is an example of an odd Florida growth story that started life as a distributor of sports memorabilia and then dabbled in pest control and pool cleaning. In 2006 Universal’s small insurance operations took off with the help of a $25M surplus note from the state of Florida. The company underwrites risky policies in the Miami-Dade, Broward and Palm Beach counties most of which otherwise will be taken only by Citizens. We have reviewed the company’s OIR filings since 2008 and discovered that the catastrophe models that the company uses to evaluate the level of reinsurance required are all marked as trade secret. The company’s PMLs for each of those years for different frequencies of events are also not available. Some disclosures are made in the SEC filings for certain years but, by and large, the information is not available. Some of these confidential documents were leaked to the Herald Tribune in 2011 and revealed that for that particular year UVE had coverage to about 1 in 80 event, putting the company in direct violation of its surplus note covenants. The insurance commissioner refused to comment saying “to do so could imperil the company.”112 As the table below highlights, not only was UVE in violation of its covenants but the company would have been insolvent had one storm occurred with a first event representing 145% of the company’s surplus at the time. Based on our analysis, the book was largely uninsurable in an economic way at the time which UVE tried to circumvent by employing segregated cell T25 to
110 In Major Hurricane, Insurers Face Huge Risk, by Paige St. John, The Herald Tribune, July 24th, 2011 111 FLOIR database as of Q4/2013 112 Ibid.
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reinsure itself. The OIR questioned the practice and more specifically the provision of a guaranteed profit of 25% to the captive reinsurer in a filing but ultimately chose not to act. Universal Insurance Surplus and 1st Event Exposure 2008-2014
PML freq. TradeSecret TradeSecret TradeSecret 1 in 80 1 in 127 1 in 114 1 in 145
Model TradeSecret TradeSecret TradeSecret AIRv.12.04 AIR v.11.0 TradeSecret TradeSecret
Note: The 2014 statutory surplus data as of March 2014 Source: OIR, SEC filings and estimates We understand the OIR’s hesitation in creating a tenuous situation at the state’s largest private insurer in the middle of a hurricane season. However, we believe UVE’s level of risk should not have been acceptable to any insurance regulator. Finally, the OIR addressed some of these and a laundry list of other issues (such as post claim underwriting, excessive junior mining stock trading, losses and commissions, etc.) in a May 2013 order and imposed a $1.26M administrative fine on the company. Four months before the order was issued, Bradley Meier – the UVE’s largest shareholder, as well as chairman, CEO and President – resigned. UVE’s current reinsurance program (outside of a broad outline filed as an 8K with the SEC) as well as the model the company uses to calculate hurricane risk remains trade secrets. We are at a loss why the company should be permitted to hide this information from its customers and the general public. We also think that the SEC should require such critical information for the assessment the company’s exposure be disclosed. However, it appears that UVE was able to take full advantage of the newly available alternative reinsurance capital and place a reinsurance program that just a few short years ago was uninsurable. We argue that this is “as good as it gets” for the DFIs with a couple of years of rate increases combined with subsidies and extremely low reinsurance costs create the illusion of a functioning private market. The current very low reinsurance prices have made the DFI model seem plausible. However, it should be clear that the problems of Florida’ market aren’t the result of rapacious offshore reinsurance companies but, rather, a system that has persistently overregulated the rates while abdicating the state’s responsibility to ensure that those same insurers remain solvent and able to pay claims. Florida’s insurance system is badly broken113, but offshore reinsurers aren’t the problem but rather an enabler of an unsustainable business model.
113 Report: Bermuda Insurers Not to Blame, Bernews, November 10, 2010
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CONCLUSION The current condition of the Florida property insurance market has developed from a confluence of natural and man-made events that have taken place in the last three decades. Hurricane Andrew in 1992 and the combined effects of the 2004/2005 storm seasons, population growth and changing demographics, the evolution of the catastrophe modeling industry, management of catastrophe exposure by insurers/reinsurers, and legislative/regulatory actions in Florida have all contributed to the current market conditions. The dependence on coastal development as an economic driver and the potential impact of climate change on storm activity and damages are all challenges facing the marketplace.114 In the 22 years since Hurricane Andrew, many have sought solutions to the challenges of the Florida marketplace and the right formula has not yet been found. The market is now much more reliant on governmental entities and capital market conditions than ever before. However, in the final analysis, the issue at heart is quite simple – an inadequate level of premiums.115 The efforts to “hide” or “avoid” this issue have led to significant market distortions as well as unsustainable business models that will ultimately need to be corrected. Real estate development plans will have to adapt to the underlying realities of Florida risk instead of “socializing” the cat losses. “We don’t believe that the U.S. has the balance between industry and government intervention right, “said Sean McGovern, Lloyds director of North America. “The cost to the U.S. taxpayer is huge and is not sustainable.”116 A.M. Best study covering 1969-2010 examined the main drivers behind U.S. insurer insolvencies. Notably, the largest single reason of insurer insolvency over this time horizon is deficient loss reserves and inadequate pricing, representing 40 percent of all insolvencies.117 These two factors remain the highest risk for Florida insurers today. What makes that insurance model seem possible and even profitable right now is the influx of capital from pension and hedge funds into the ISL space. However, there is the issue of information asymmetry as most investors neither have the expertise nor avenues available to critically assess the pricing methodologies behind cat bonds and other structures, with most being wowed by ‘road shows’ displaying the high degree of sophistication and rigor behind the analyses, or simply relying on an alphabetical rating. When it comes to Florida property insurance, political realities in Tallahassee are clashing head on with traditional industry standards of fiscal responsibility. The homeowner is caught in the middle. Florida’s property insurance system remains broken and in need of significant changes. It poses a large risk to the state’s economy both through a direct threat to the government’s fiscal situation and through the risk of multiple assessments after a major storm or a series of smaller events.118
114 The State of Florida’s Property Insurance Market, The Florida Cat Storm Risk Management Center, January 2013 115 According to Dowling&Partners, rates in Florida need to increase over 50% to reach adequate double digit ROE over time; Perspectives on the Florida (Re)insurance Market 13th Annual Participating Insurers Workshop, 2013 116 Climate, Insurance and the Next Financial Meltdown, January 6, 2012 117 Credit Risk of Property Catastrophe Reinsurers, Aon Benfield, Summer 2012 118 Ten Reforms to Fix Florida’s Property Insurance Marketplace, The James Madison Institute, Backgrounder, Issue 74, November 2013
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RECOMMENDATIONS The incentive structures associated with the limited liability corporate form are not conducive to the sound provision of catastrophe insurance. The companies can (and do) simply distribute their earned catastrophe premiums as dividends (or other payments) if there is no loss, then declare insolvency if a catastrophe hits.119 History shows that private marine insurance, a market with many catastrophe-like features, was viable because it solved what is the catastrophe markets fundamental problem, a mismatch between the size of annual premiums and the size of maximum annual losses. The industry accomplished that by advancing all of the capital at risk to the insured at the beginning of the policy, forgiving the loan if a loss occurred or by arranging access to a large pool of capital (the unlimited wealth of the Lloyds Names) with which to pay losses after the event. Some of the newfound bonanza of low priced CAT reinsurance is a welcome step towards prefunding parts of the catastrophic risks. On the other hand, FHCF and Citizens, when managed properly, provide the access to a large pool of capital. The value-add of the DFIs is limited or non-existent as they “siphon” away a great portion of the premiums through related companies. Florida’s politicians should stop pouring incentives into private pockets while at the same time subsidizing losses when dealing with the state’s property insurance system. We believe the dual goals of sustainability and risk diversification can be best achieved though a program that involves Citizens’ and FHCF’s active participation in the private reinsurance markets. It is in Citizens’ best interest to transfer a meaningful amount risk to the private market. The best evidence is the 2014 private Citizens reinsurance program that transfers $3.1 billion of risk for premium of $300M, compared to risk transfer of $1.85B for a cost of $304M in 2013, so securing 68% more protection at a lower cost.120 There is a much bigger player willing to take a lot of risk on the reinsurance block. The OIR should develop pricing estimates that reflect the true risks of different locations/structures in the state of Florida and a clear “glidepath” should be put in place for premiums to reach those levels over time. As politically painful as that might be, it will put an end to the subsidies to coastal properties and will over time discourage coastal development while creating more opportunities inland. Further, the taxpayers of Florida will no longer be responsible for supporting ultimately uneconomical projects. We believe those steps will also limit the politicians’ ability to interfere and use the property insurance market for political favors and voter pleasing experiments. What is necessary is not short-term populist rhetoric but sustainable long-term solutions for the citizens of Florida. We hope the people of Florida will assert their rights and demand a fair solution to the property insurance problem from their elected representatives.
119 Catastrophe Insurance, Dynamic Premium Strategies and the Market for Capital, Russell, Jaffee, Alternative Approaches to Insurance Regulation, National Association of Insurance Commissioners, 1998 120 http://www.artemis.bm/blog/2014/04/28/florida-citizens-buys-68-more-reinsurance-for-2014-at-less-cost/
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DISCLAIMER All content in this report represent the opinions of The Authors. Individuals and institutions must conduct their own research and analysis to form their own opinions and conclusions that may differ substantially from the Authors. The Authors have obtained all information herein from public sources they believe to be accurate and reliable. However, such information is presented “as is”, without warranty of any kind – whether express or implied. The Authors make no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. All expressions of opinion are subject to change without notice, and the Authors do not undertake to update or supplement this report or any information contained herein. This document is for informational purposes only and it is not intended as an official confirmation of any transaction. All data and other information are not warranted as to completeness or accuracy and are subject to change without notice. The information included in this document is based upon selected public market data and reflects prevailing conditions and the Authors’ views as of this date, all of which are accordingly subject to change. The Authors’ opinions and estimates constitute a best efforts judgment and should be regarded as indicative, preliminary and for illustrative purposes only. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein. Also, this document does not in any way constitute an offer or solicitation of an offer to buy or sell any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction. To the best of the Authors’ abilities and beliefs, all information contained herein is accurate and reliable. The Authors reserve the rights for their affiliates, officers, and employees to hold cash or derivative positions in any company discussed in this document at any time. Research reports are not and are not intended to be investment advice and do not constitute any form of invitation or inducement by the Authors to engage in investment activities. The Authors are not investment advisors and do not hold themselves out as such. The information contained in this document may include, or incorporate by reference, forward looking statements, which would include any statements that are not statements of historical fact. Any or all of the Authors’ forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond the Authors’ control.
