Fearful that a giant storm or a series of hurricanes could cripple the Florida Hurricane Catastrophe Fund (Cat Fund) this year and lead to huge assessments, the trustees of the fund in July made an extraordinary decision to pay $224 million now to secure a guarantee from Berkshire Hathaway that the Nebraska-based conglomerate would buy $4 billion in bonds in the event that the amount of storm losses reach $25 billion.

Governor Charlie Crist, Attorney General Bill McCollum, and Chief Financial Officer Alex Sink all voted in favor of the transaction, but it only came after a round of criticism from both McCollum and Sink that the state was in a bind due to the potential exposure of the Cat Fund, which was expanded in 2007 right after Crist came into office. The two elected officials implored Crist to set aside time in the coming months to consider alternatives that could reduce the potential claims paid by the Cat Fund, which would likely trigger large assessments.

“I don't like being in a panic,” said Sink, who faulted the Florida legislature for failing to approve her proposal that called for reducing the amount of risk that the Cat Fund now faces by at least $3 billion. During the 2008 hurricane season, the Cat Fund has maximum obligations that exceed $29 billion.

Crist said he was not “panicked” but “concerned,” and that is why he and his office asked the State Board of Administration (SBA) back in March to start researching what could be done to ensure that the Cat Fund has enough money to fulfill its responsibilities to insurers that purchase coverage from the state-created reinsurance program. (The SBA oversees the Cat Fund.)

Credit Crunch Raises Fears

John Forney of Raymond James & Associates led a team of financial advisors who concluded that while the Cat Fund entered the 2008 hurricane season with its largest set of cash resources than ever before, it still wasn't enough. The Cat Fund has roughly $8.1 billion available through a combination of cash reserves and previously purchased bonds.

While a senior underwriting team continues to believe that the Cat Fund could raise $10 billion in the bond markets in the event of large losses, Forney said the financial team became concerned that the ongoing crisis with financial markets could make it difficult to quickly go out in the private market and raise needed cash in the event of a storm that brought huge losses. He said “access to private markets could be a perilous process.”

In analyzing what could be done, Forney said the financial team concentrated primarily on finding some type of backup to cover Cat Fund losses between $25 billion and $29 billion, or storms as powerful as Hurricane Andrew or Hurricane Katrina. After looking at various options, including purchasing private reinsurance, or buying bond insurance, Forney said the approach that was the most practical was to purchase a tax-exempt bond “put option,” which is where the Cat Fund pays an upfront fee in exchange for a guarantee that any bonds it issues will be purchased.

Under the terms negotiated with Berkshire Hathaway, the state would sell the bonds to the conglomerate if losses reached the $25 billion threshold. The bonds would last 30 years and pay an interest rate of 6.5 percent, leading to an annual debt service of $382 million, which would require an additional one percent assessment to support. Initially Berkshire Hathaway was only willing to buy the bonds in the event of one storm that triggered a huge storm, but after negotiations agreed to also buy the bonds if the aggregate losses from multiple storms also reached the $25 billion threshold.

McCollum called the put option a “very bad deal” and said there was only a three or four percent chance that the state would actually need to borrow the additional $4 billion. But he also said it was the only responsible action that the state could take at the current time given the needs of the Cat Fund. Sink, likewise, criticized the deal, saying that Berkshire Hathaway was the only financial entity that was willing to negotiate with the state right now.

“We are being held hostage by one product,” said Sink, who noted that Berkshire Hathaway CEO Warren Buffet “did not become a multi-billionaire by not doing good deals for himself.

“We've got both hands tied behind our back,” she added.

Focusing on 2009

While the 2008 hurricane season has just started, Sink and McCollum said state officials need to start in the next few months to figure out how to change the exposure of the Cat Fund in time for the 2009 season. They also asked the SBA to continue to look at issuing additional pre-event bonds that could lower the amount of additional financing the Cat Fund would need after a storm hits Florida.

“I am concerned where we are with this entire insurance situation,” said McCollum, who said if a storm hits he was concerned that interior residents of Florida would wind up paying more to subsidize people who live on the coast. “The situation we are in today for the people of Florida is not good.”

One possible solution in the year to come: having the state go out to the private market and purchase reinsurance. Craig Bissell of Aon Re told state officials that reinsurers could offer a series of financial options that could add as much as $3 billion in additional capacity for a total cost of between $225 million to $300 million.

No Rate Hikes Needed for Now

Initially, SBA staff had recommended that the board trustees approve a change in the 2008 Cat Fund premium formula in order to pay for the $224 million that would go to Berkshire Hathaway. This would have triggered a 17 percent hike in the premium charged to insurers, who would then be able to ask for increases from the Office of Insurance Regulation in order to recoup the cost. One state analysis calculated that this would have resulted in a 2.5 percent increase to policyholders.

But Crist, who supported the purchase of the additional support from Berkshire Hathaway, voted against a change in the premium formula, saying that he would not support anything that would result in a rate hike for insurance customers. Both Sink and McCollum did vote in favor of the premium change, but Crist's staff contended that state law required a unanimous vote.

McCollum's office was initially asked to come up with a legal review of whether a unanimous vote was needed. But then SBA Interim Director Bob Milligan did a turnaround, issuing a statement that said the money needed to purchase the put option would come out of the Cat Fund reserves. That means that the Cat Fund, which was projected to have $3.62 billion in cash by the end of the year, will only have $3.59 billion on hand to pay claims.

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