Underwriting property catastrophe reinsurance in Florida is a uniquely difficult undertaking. In general, property catastrophe deals written on an excess of loss (XOL) basis are considered relatively simple compared to other lines of reinsurance. In Florida, however, when selling XOL coverage for residential risks, incorporating the effect of the state-run reinsurance company, the Florida Hurricane Catastrophe Fund (Cat Fund), adds complexity to otherwise straightforward deals.
Residential insurers in Florida are required to purchase at least some Cat Fund coverage, and many elect to purchase the maximum amount of limit possible from the mandatory layer. Cat Fund coverage is therefore a critical aspect of a Florida residential insurer’s reinsurance program and must be blended with traditional products.
A lack of understanding the critical differences between Cat Fund coverage and traditional reinsurance can lead to unintended consequences. Examples of these differences include calculation of loss adjustment expenses (LAE), potential cash flow issues 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 calculated in traditional reinsurance contracts and the Cat Fund.
The Cat Fund is a creature of statute and, as such, is limited to providing only that coverage set forth under Florida law. It is a “one-trick pony” in that it only covers losses from hurricanes causing insured loss in Florida. Losses are limited to direct incurred losses under a residential policy, including additional living expenses (sub-limited at 40 percent of the insured value of the structure or its contents). LAE is calculated separately at a flat rate of 5 percent of reimbursed losses.
Traditional reinsurance differs from Cat Fund coverage in that it covers 100 percent of LAE incurred by the insurer. Being unaware of this key difference leads to one of the most significant unintended consequences of underwriting Florida residential risk. As LAE is typically closer to 10 percent of losses, this leads to the question, “What happens to the other 5 percent?”
To answer this, first we must take a step back and understand how residential catastrophe XOL programs are structured in Florida. Most insurance companies purchase their catastrophe programs in three tranches, or layers, of reinsurance coverage. The first layer is designed to sit below the Cat Fund, which means the limit and retention are set to cover losses up until Cat Fund coverage responds. This first layer protects a company for loss amounts that fall within the Cat Fund retention.
The second layer sits alongside the Cat Fund. Maximum Cat Fund coverage only reimburses an insurer for 90 percent of its losses, with the remaining 10 percent being the responsibility of the insurer. In most catastrophe programs, this 10 percent co-participation is covered by the second layer of coverage.
A catastrophe program’s third layer typically incepts at the point of Cat Fund exhaustion, and provides coverage up to an amount selected by the insurer to coincide with an estimated probable maximum loss. To summarize: The first layer is below the Cat Fund, the second layer is alongside the Cat Fund, and the third layer is above the Cat Fund.
The answer to the question “What happens to the other 5 percent?” of LAE is, “The reinsurers on the second and third layers pay it.” Traditional reinsurance usually has a clause stating that Cat Fund recoveries inure to the benefit of the reinsurance. That means if the Cat Fund is supposed to reimburse an insurer for a loss, the private reinsurance will not pay it. If it is not reimbursable by the Cat Fund, and is otherwise covered under their treaty, then the private reinsurance will pay it. LAE clearly falls in this category, and to the extent that LAE is greater than 5 percent, it will not be reimbursed by the Cat Fund but rather will “bleed” into the second and third layers of the private program.
LAE Mismatch and Unexpected Losses
The unintended consequence of this LAE mismatch arises primarily with respect to the second layer. As discussed above, most second layers cover the insurer’s 10 percent co-participation. For every $10 of loss, $9 is covered by the Cat Fund and $1 is covered by private reinsurance. Any unreimbursed LAE from losses in the Cat Fund flows directly into the second, and then the third, layers.
In the event of a partial limit loss to the Cat Fund, the unreimbursed LAE greatly amplifies the losses in the second layer of reinsurance, leading to a larger loss than anticipated for a given event size. This amplification is exacerbated by the fact that, while the Cat Fund pays a flat 5 percent of reimbursable losses as LAE (that is, 5 percent of the loss paid by the Cat Fund), actual LAE accumulates on all losses, including those retained by the insurer.
A simplified example may help clarify this LAE mismatch.
Let’s say Florida Insurance Co. elects the 90 percent coverage level on its Cat Fund coverage, which is $15 million of limit excess of a $5 million retention. The reinsurer writes 100 percent of the 10 percent Cat Fund co-participation (second layer), which is $1.67 million excess of a $5 million retention. Not let us assume that Florida Insurance Co. suffers a $15 million loss from a hurricane. If LAE averages 10 percent, total ground-up losses would be $16.5 million. The $5 million would be retained by Florida Insurance 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 expect to pay 10 percent of $10 million, or $1 million, plus LAE calculated at 10 percent of $1 million, for a total of $1.1 million. However, remember that total ground-up loss was $16.5 million. If we subtract the $5 million retention and the $9.45 million paid by the Cat Fund, that leaves the reinsurer with an unreimbursed loss of $2.05 million, or almost twice its expected loss.
The net result of the unintended consequences of the LAE mismatch is that, for certain event sizes, losses in the second layer of private reinsurance are amplified significantly over what would be expected if the Cat Fund covered LAE the same way as private reinsurers.
The Cat Fund distorts private coverage more than might be anticipated. Many reinsurers understand this mismatch and traditional reinsurance most likely takes this increased loss exposure into account. However, an unwary reinsurer who underwrites Florida property catastrophe risk without a keen understanding of the operation of the Cat Fund can incur unexpected losses.