Florida's fragile insurance market in many ways is deeplyimpacted by what happens twice a year inside a glass officebuilding sheltered on a side road in northeast Tallahassee, faraway from both the capitol and the state's financial sectors.

Inside a gray-carpeted conference room in this building anobscure panel signs off on an important number: Just how much moneycould the state-created reinsurance fund known as the FloridaHurricane Catastrophe Fund (Cat Fund) borrow if the state got hitby a big hurricane, or just as bad, a series of smaller storms?

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The sophisticated guesswork that goes into this is more thansome academic exercise. This number is a reflection of thestability of the Cat Fund, itself an important backstop forinsurers that operate in the state, including Citizens PropertyInsurance Corp.

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And this year the answer is somewhat troubling.

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Hurt by the ongoing volatility in the municipal bond market, thelatest round of estimates adopted in late May by the fund'sadvisory council conclude that the Cat Fund could borrow $12billion to help cover its obligations for the 2011 season.

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However, that borrowing power is a significant drop—roughly $4billion less—than what the fund's financial advisors previouslyconcluded in October.

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"Our cushion has eroded,'' said Jack Nicholson, chief operatingofficer for the Cat Fund.

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Good News About Reserves
These new estimates confirm that the Cat Fund remains largelydependent on swings in the global financial markets, and itcontinues to raise questions about the framework now in place tohelp bolster the state's entire property insurance market.

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The Cat Fund was created in the wake of 1992's Hurricane Andrewto help stabilize the Florida property insurance market by offeringlow-cost reinsurance coverage to insurers who do business in thestate. Every carrier that sells policies in the state is requiredto purchase a mandatory level of coverage.

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The fund has certain advantages, including that it is atax-exempt organization with low-administrative costs. Also, in theevent of large losses, it has the power to levy assessments onnearly every insurance policy in the state to recoup theexpenses.

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But in the last decade—as Florida has been battered by a seriesof hurricanes and some insurers have fled the state—statepolicymakers have come to increasingly rely on the Cat Fund as alever on insurance rate hikes. Four years ago, they created anoptional layer of reinsurance that added billions in potentialexposure.

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The good news right now is that the Cat Fund has a large amountof money at its disposal. After 5 years without storms, thereinsurance fund has built up its resources and has access to morethan $7 billion.

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Still, that means the Cat Fund would have to rely on borrowingto cover the rest of its obligations, now estimated for thishurricane season at more than $18.5 billion. 

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Fortunately, the math has worked out, at least for now. Numbers Continue to Move
New estimates drawn up by consulting with Wall Street firmsconclude that the fund could now borrow about $12 billion. That isslightly higher than the $11.3 billion the fund would need.

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Yet, these estimates continue to fluctuate greatly. This is thethird major change in the last 3 years.

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During the height of the 2008 financial meltdown, the Cat Fundwas confronted with the sobering estimate that it could borrow only$3 billion. That gradually changed over the last 2 years as creditloosened up.

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Last year financial advisors concluded the fund could borrow asmuch as $16 billion if the state was struck with devastating stormsand needed to pay off reinsurance claims.

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The fund's financial advisors, however, acknowledge that thisyear's estimate is one built on assumptions and that "significantuncertainty still exists."

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The fund's financial advisor, John Forney of Raymond James &Associates, made a presentation to the advisory council in which henoted there has been a significant drop in the amount of municipalbonds issued this year. There has been a bit of volatility inmunicipal bond markets as some investors earlier this year fled themarkets amid fears of financial instability.

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"The ability of the Cat Fund to handle it from a theoreticalstandpoint is there," Forney said. "It's a question of what themarket will bear."

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Another item that could hurt Cat Fund resources is the fact thatit will lose access to $3.5 billion in bond proceeds next year asthose bonds mature.

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Despite the new estimates, there are some positive trends.

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Insurers continue to pare back the amount of optionalreinsurance they are purchasing from the Cat Fund, which in turnlowers its obligations. The latest figures for this storm seasonshow that private carriers were expected to purchase only $1.14billion worth of optional coverage despite $6 billion beingoffered. Part of the drop is because of the increasing cost of theoptional coverage.

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Additionally, Citizens made the decision to purchase privatereinsurance and borrow money this year instead of purchasingadditional coverage from the Cat Fund.

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Nicholson also took comfort in the amount of cash that the CatFund is expected to have by the end of the 2011 hurricaneseason.

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"The projected cash balance of $7.245 billion is a big plus,"Nicholson said, adding that it would "buy us some time" if a majorstorm hits.

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Time to "Right Size'' Cat Fund?
However,the ongoing volatility associated with the bond market is one ofthe reasons that Nicholson says the time has come to rethink justhow much exposure the Cat Fund has right now.

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"What really causes concern is the level of our capacity and howwe plan financially to address that," he said. Nicholson pointed out that state leaders haveincreased the capacity of the Cat Fund twice in the last decade.Back in 2004, state lawmakers increased the size of the mandatorylayer from $11 billion to $15 billion.

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They followed that up 3 years later in a special session whenthey created the second layer of coverage known as the TemporaryIncrease in Coverage Limit (TICL). Legislators signed off on thissecond layer in the wake of voter anger at insurance rate hikesfollowing the storm seasons of 2004 and 2005.

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The initial amount of TICL was $12 billion, which greatlyexpanded the total potential exposure of the fund. However, thisled to criticism that the Cat Fund was overexposed and that thestate of Florida itself would be held financially responsible ifthe reinsurance fund was unable to pay off its obligations.

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Lawmakers have since taken some steps to whittle down TICL andagreed to phase it out completely over the next several years.

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Nicholson, however, said the "major over-expansion" of the CatFund's exposure does not serve to stabilize the state's economy. Hesaid the time has come to consider forcing insurers—and ultimatelyconsumers—to have "more skin in the game" by reducing the capacityand size of the Cat Fund over the next few years.

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Nicholson has suggested lowering the current mandatory layer ofcoverage from $17 billion to $12 billion while increasing theamount of co-pay insurers must pay to access thecoverage. 

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"It is hard to say what the 'right size' is for the fund, butI've defined it in terms of how comfortable and certain we can beissuing a level of debt,'' Nicholson said. "Like I havesaid, $5 to $7 billion is doable and reasonable, but over $10billion gets risky. Theoretically, the 'right size' forthe fund is big enough to accomplish its mission (stabilize theinsurance market as well as stabilize and help avoid disruptions toFlorida's economy), but not so large that the issuance of debt isquestionable and highly volatile over time. 

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"The fund needs to be more of a 'guarantee' of coverage, notspeculation," Nicholson continued. "The idea of rightsizing is more of an art than an exact science, but it has a lot todo with common sense and judgment."

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The trade off would be that the threat of assessments would bereduced because a smaller Cat Fund could more easily manage itsobligations without having to borrow massive amounts of money.

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A Reality Check on Rates,Expansion
However, it is likely that insurers will beforced to raise rates if they have to purchase private reinsuranceinstead of relying on the Cat Fund. State lawmakers remain skittishabout allowing anything that could sharply increase insurancerates.

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Don Brown, a former state lawmaker who was one of the few tovote against the expansion of the Cat Fund back in 2007, is alreadytaking up Nicholson's cause. He wrote an op-ed for newspapers wherehe said the time for Nicholson's reforms has come.

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"A reduction in the mandatory layer—which would more accuratelyreflect our ability to borrow—would have some upward pressure onrates but that, my friend, is the hard reality and at the veryheart of our problem,'' Brown wrote.

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He cited the "dynamic changes in the financial markets" as a keyreason for the change but also pointed out that there are fearsthat huge losses during one hurricane season would render the CatFund unable to provide significant coverage the following year.

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"Any expectation of coverage for second season events, and maybesubsequent events in the season, is 'pie in the sky,'" Brown wrote."…For too long we have been fooling ourselves and Floridahomeowners into thinking that if we ignore this problem it will goaway. In the meantime, consumers, deprived of the correct pricingsignals, continue to build beyond their means and, in some cases,in very dangerous places."

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Brown also said, "It's not just folks who build on thebeach…It's also folks who live in Orlando who divvy up theirmonthly mortgage and insurance budgets based on real mortgage costsbut imaginary insurance cost.  We don't do anyone aservice when we mislead them."