Underwriting property catastrophe reinsurance in Florida is auniquely difficult undertaking. In general, property catastrophedeals written on an excess of loss (XOL) basis are consideredrelatively simple compared to other lines of reinsurance. InFlorida, however, when selling XOL coverage for residential risks,incorporating the effect of the state-run reinsurance company, theFlorida Hurricane Catastrophe Fund (Cat Fund), adds complexity tootherwise straightforward deals.

Residential insurers in Florida are required to purchase atleast some Cat Fund coverage, and many elect to purchase themaximum amount of limit possible from the mandatory layer. Cat Fundcoverage is therefore a critical aspect of a Florida residentialinsurer's reinsurance program and must be blended with traditionalproducts.

A lack of understanding the critical differencesbetween Cat Fund coverage and traditional reinsurance can lead tounintended consequences. Examples of these differences includecalculation of loss adjustment expenses (LAE), potential cash flowissues associated with the ex post funding model of the Cat Fund,and availability of sufficient limits to cover multiple events.

This article and accompanying charts address LAE as calculatedin traditional reinsurance contracts and the Cat Fund.

Three-Layer Structure

The Cat Fund is a creature of statute and, as such, is limitedto providing only that coverage set forth under Florida law. It isa “one-trick pony” in that it only covers losses from hurricanescausing insured loss in Florida. Losses are limited to directincurred losses under a residential policy, including additionalliving expenses (sub-limited at 40 percent of the insured value ofthe structure or its contents). LAE is calculated separately at aflat rate of 5 percent of reimbursed losses.

Traditional reinsurance differs from Cat Fund coverage in thatit covers 100 percent of LAE incurred by the insurer. Being unawareof this key difference leads to one of the most significantunintended consequences of underwriting Florida residential risk.As LAE is typically closer to 10 percent of losses, this leads tothe question, “What happens to the other 5 percent?”

To answer this, first we must take a step back and understandhow residential catastrophe XOL programs are structured in Florida.Most insurance companies purchase their catastrophe programs inthree tranches, or layers, of reinsurance coverage. The first layeris designed to sit below the Cat Fund, which means the limit andretention are set to cover losses up until Cat Fund coverageresponds. This first layer protects a company for loss amounts thatfall within the Cat Fund retention.

The second layer sits alongside the Cat Fund. Maximum Cat Fundcoverage only reimburses an insurer for 90 percent of its losses,with the remaining 10 percent being the responsibility of theinsurer. In most catastrophe programs, this 10 percentco-participation is covered by the second layer of coverage.

A catastrophe program's third layer typically incepts at thepoint of Cat Fund exhaustion, and provides coverage up to an amountselected by the insurer to coincide with an estimated probablemaximum loss. To summarize: The first layer is below the Cat Fund,the second layer is alongside the Cat Fund, and the third layer isabove the Cat Fund.

The answer to the question “What happens tothe other 5 percent?” of LAE is, “The reinsurers on the second andthird layers pay it.” Traditional reinsurance usually has a clausestating that Cat Fund recoveries inure to the benefit of thereinsurance. That means if the Cat Fund is supposed to reimburse aninsurer for a loss, the private reinsurance will not pay it. If itis not reimbursable by the Cat Fund, and is otherwise covered undertheir treaty, then the private reinsurance will pay it. LAE clearlyfalls in this category, and to the extent that LAE is greater than5 percent, it will not be reimbursed by the Cat Fund but ratherwill “bleed” into the second and third layers of the privateprogram.

LAE Mismatch and Unexpected Losses

The unintended consequence of this LAE mismatch arises primarilywith respect to the second layer. As discussed above, most secondlayers cover the insurer's 10 percent co-participation. For every$10 of loss, $9 is covered by the Cat Fund and $1 is covered byprivate reinsurance. Any unreimbursed LAE from losses in the CatFund flows directly into the second, and then the third,layers.

In the event of a partial limit loss to the Cat Fund, theunreimbursed LAE greatly amplifies the losses in the second layerof reinsurance, leading to a larger loss than anticipated for agiven event size. This amplification is exacerbated by the factthat, while the Cat Fund pays a flat 5 percent of reimbursablelosses as LAE (that is, 5 percent of the loss paid by the CatFund), actual LAE accumulates on all losses, including thoseretained by the insurer.

A simplified example may help clarify this LAE mismatch.

Let's say Florida Insurance Co. elects the 90 percent coveragelevel on its Cat Fund coverage, which is $15 million of limitexcess of a $5 million retention. The reinsurer writes 100 percentof the 10 percent Cat Fund co-participation (second layer), whichis $1.67 million excess of a $5 million retention. Not let usassume that Florida Insurance Co. suffers a $15 million loss from ahurricane. If LAE averages 10 percent, total ground-up losses wouldbe $16.5 million. The $5 million would be retained by FloridaInsurance Co. and the Cat Fund would pay 90 percent of $10 million,or $9 million, plus LAE calculated at 5 percent of $9 million, or$450,000, for a total of $9.45 million. The reinsurer would expectto pay 10 percent of $10 million, or $1 million, plus LAEcalculated at 10 percent of $1 million, for a total of $1.1million. However, remember that total ground-up loss was $16.5million. If we subtract the $5 million retention and the $9.45million paid by the Cat Fund, that leaves the reinsurer with anunreimbursed loss of $2.05 million, or almost twice its expectedloss.

The net result of the unintended consequences of the LAEmismatch is that, for certain event sizes, losses in the secondlayer of private reinsurance are amplified significantly over whatwould be expected if the Cat Fund covered LAE the same way asprivate reinsurers.

The Cat Fund distorts private coverage more than might beanticipated. Many reinsurers understand this mismatch andtraditional reinsurance most likely takes this increased lossexposure into account. However, an unwary reinsurer who underwritesFlorida property catastrophe risk without a keen understanding ofthe operation of the Cat Fund can incur unexpected losses.