“Those who do not learn from history are doomed to repeatit”-G.Santayana.

While the influx of some 24 new entrants into the Floridahomeowners' insurance market since 2006 is certainly welcome news,as consumers and industry people, we need to ask ourselves somebasic questions. First, how can we — and insurance regulators — becertain that all of these recent entrants have the financialsecurity and underwriting discipline to be there if and when theyare most needed? Second, does this concentration of new entrantscompound the risk to the overall market in any way?

Certainly the current global financial crisis raises furtherconcerns regarding the need for increased regulatory controls anddiligence along with the potential cost and availability of capitalshould the state of Florida ever need to tap into the bond marketto cover catastrophe losses. One of the critical issues of thecurrent financial crisis has been the lack of government regulatoryoversight of the non-insurance subsidiaries of insurance holdingcompanies.

A very hard lesson the insurance industry learned a few yearsback was the need to provide significant oversight and control overcertain Managing General Agency (MGA) programs. Back then, a numberof MGAs launched their own underwriting companies to providespecialty coverages through various fronting arrangements and whatturned out to be inadequate reinsurance security arrangements.While these MGAs secured significant management fees forunderwriting, claim handling, and other services, the underwritingcompanies themselves suffered substantial and ultimatelyunsustainable losses, resulting in the collapse of many of thesefirms.

The primary reasons for calamities of the past had to do withthe basic business strengths of MGAs versus underwriting companies,and the difficulty the regulatory system has in monitoring theeconomics of the complex organizational structure of some of thosebusinesses.

MGA Strengths

MGAs have demonstrated remarkable abilities in developing strongsales engines through agent and broker networks. They also areadept at securing relationships with capable insurance companieswho underwrite the risk or provide tight guidelines regardingacceptable risks, pricing, and reinsurance security.

The “lowest risk/highest return” economics of the MGA come froma growing and continuous stream of commission revenue and servicefees. The insurer must control the underwriting risk of writingbusiness at a price that will generate an adequate return andmaintain sufficient capital and reinsurance protection againstcatastrophic losses.

Historically, MGAs have played a major and important role inproviding needed markets for unique or difficult underwritingrisks. Similar to the Florida homeowners' insurance market, whenconventional insurance markets retrench or create availabilityproblems, MGAs may develop effective programs that satisfy customerneeds and do so often at more favorable prices than standardcoverages.

MGAs can provide valuable service and support to their agentnetworks and their customers with special products and services notoffered by the agents' traditional markets. The problems in thepast have arisen when MGAs and major brokers have assumed controlof the underwriting risk of some of these programs.

Reasons for Concern

The conflicts within MGAs remind me of the proverbial “fox inthe chicken coop.” There are fundamental, basic differences betweenunderwriting skills and management and agency skills andmanagement.

Starting with economics, the largest portion of an MGA's profitis derived from commissions and management fees, with possibly somecontingent profit provided by the insurer from superiorunderwriting results, although these contingencies have been underfire in recent years. Therefore, the MGA has a significant vestedinterest in generating high levels of premium in support of itsagent network.

It is the responsibility of the insurance company to exerciseunderwriting discipline in risk selection, pricing adequacy andquality reinsurance protection. In the past, shifting of theseresponsibilities to the exclusive control of the MGA frequently hascreated poor underwriting results and, in some instances,significant cost to the consumer in the form of insurer insolvency,related delays in claim payments, and increased unavailability orprice increases of insurance coverage.

The greater current economic value to the MGA of continuingsales and service revenue can lead to disastrous underwritingresults when the decision resides with the same person, a persongrounded more in sales skill than the discipline that comes withextensive underwriting training and experience.

The lack of adequate capital and reinsurance protection has alsoled to many of these historic problems. Since most of theseprograms began with limited or borrowed capital in the form ofsurplus notes (loans) and/or fronting arrangements with largercarriers, they relied heavily on reinsurance.

In many instances, the reinsurers were not of the highestquality and could not ultimately pay their share of the losses. Inother instances, where the reinsurers were sound financially, theyprovided further fuel to continued sales in the face of mountinglosses or charged so much to the insurer that an underwritingprofit was not achievable.

The Financial Monitoring Issue

Compounding the basic issue of where the greatest economic gainwas derived, the organizational structure of these programs made itvery difficult for regulators to have a transparent view of cashflow and profit. Most of these programs had multiple companies thatwere being compensated by the MGA-owned insurance company. Inaddition to the MGA itself receiving sales commissions, there mayhave been underwriting and administrative service companiesreceiving management fees. There likely was a claim service companypaid to administer claims.

The regulator would have difficulty seeing or assessing theunderlying costs and profitability of each of these entities thatwere being paid by the MGA-owned insurance company. In the end,while the insurance company might ultimately fail, it would havegenerated considerable profit with limited downside financialexposure to the MGA.

Safeguarding the Florida Consumer

This lesson in history certainly can and should be avoided as welook at the current situation in Florida. While there is no basisto believe that any of the new entrants will follow down thisunfortunate path, the adage of one of our late, great Presidents,“trust but verify,” will serve the state well. What are some ofthese lessons that will help Florida safeguard against these pastindustry problems?

Confirm that there are significant checks and balances betweenthe underwriting and sales functions through rigorous and frequentunderwriting audits. Reinsurers do this regularly to ensureconformity of their clients through underwriting, claims, andfinancial audits of the entire organization, not just the insuranceentity where management companies are involved.

Be as concerned with unreasonably low pricing as with scrutinyof proposed rate increases. Immediate satisfaction can place aheavy price on future costs. While extremely difficult to do whenprices are rising dramatically, challenging highly competitiveprices is as important as regulatory pressure on unreasonable rateincreases. Unbelievably low prices can be just that, unbelievableand unsustainable.

Place strict transparent financial reporting requirements on allcontrolled entities of the organization, especially any insurersthat have obtained favorable loans, reinsurance protection or otherstate funding. Regulatory focus must extend to all controlledentities and not just the insurance company in the group.

Place restrictions on how much profit can be generated in thenon-underwriting companies until sufficient surplus is generated bythe underwriting company — i.e., keep the management company's skinin the game. Like other kinds of business loans and investments,controls and restrictions can and should be placed on anyorganization receiving favorable terms from the state.

Provide an open consumer forum to educate and receive feedbackon specific company practices, advertising accuracy and relativestability. Let the consumers know the value of endorsement from thevarious rating agencies in making their decisions. Pay closeattention to any early warning signs of questionable managementpractices.

These are some of the steps that can be taken to assure Floridahomeowners that their insurer will be there when needed most andthat the ultimate burden will not fall back on them after payingfor their insurance. Let us hope that the skies are clear and thatno one need worry about maintaining protection at a reasonablecost. But given the unique nature of insurance availability inFlorida and the current global financial crisis, it does not hurtto remain diligent so as not to repeat the past.