Florida's fragile insurance market in many ways is deeply impacted by what happens twice a year inside a glass office building sheltered on a side road in northeast Tallahassee, far away from both the capitol and the state's financial sectors.

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

The sophisticated guesswork that goes into this is more than some academic exercise. This number is a reflection of the stability of the Cat Fund, itself an important backstop for insurers that operate in the state, including Citizens Property Insurance Corp.

And this year the answer is somewhat troubling.

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

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

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

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

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

The fund has certain advantages, including that it is a tax-exempt organization with low-administrative costs. Also, in the event of large losses, it has the power to levy assessments on nearly every insurance policy in the state to recoup the expenses.

But in the last decade—as Florida has been battered by a series of hurricanes and some insurers have fled the state—state policymakers have come to increasingly rely on the Cat Fund as a lever on insurance rate hikes. Four years ago, they created an optional layer of reinsurance that added billions in potential exposure.

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

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

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

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

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

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

The fund's financial advisors, however, acknowledge that this year's estimate is one built on assumptions and that "significant uncertainty still exists."

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

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

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

Despite the new estimates, there are some positive trends.

Insurers continue to pare back the amount of optional reinsurance they are purchasing from the Cat Fund, which in turn lowers its obligations. The latest figures for this storm season show that private carriers were expected to purchase only $1.14 billion worth of optional coverage despite $6 billion being offered. Part of the drop is because of the increasing cost of the optional coverage.

Additionally, Citizens made the decision to purchase private reinsurance and borrow money this year instead of purchasing additional coverage from the Cat Fund.

Nicholson also took comfort in the amount of cash that the Cat Fund is expected to have by the end of the 2011 hurricane season.

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

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

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

They followed that up 3 years later in a special session when they created the second layer of coverage known as the Temporary Increase in Coverage Limit (TICL). Legislators signed off on this second layer in the wake of voter anger at insurance rate hikes following the storm seasons of 2004 and 2005.

The initial amount of TICL was $12 billion, which greatly expanded the total potential exposure of the fund. However, this led to criticism that the Cat Fund was overexposed and that the state of Florida itself would be held financially responsible if the reinsurance fund was unable to pay off its obligations.

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

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

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

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

"The fund needs to be more of a 'guarantee' of coverage, not speculation," Nicholson continued. "The idea of right sizing is more of an art than an exact science, but it has a lot to do with common sense and judgment."

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

A Reality Check on Rates, Expansion
However, it is likely that insurers will be forced to raise rates if they have to purchase private reinsurance instead of relying on the Cat Fund. State lawmakers remain skittish about allowing anything that could sharply increase insurance rates.

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

"A reduction in the mandatory layer—which would more accurately reflect our ability to borrow—would have some upward pressure on rates but that, my friend, is the hard reality and at the very heart of our problem,'' Brown wrote.

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

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

Brown also said, "It's not just folks who build on the beach…It's also folks who live in Orlando who divvy up their monthly mortgage and insurance budgets based on real mortgage costs but imaginary insurance cost. We don't do anyone a service when we mislead them."

Special Reports /

Florida’s Cat Fund: Healthy Enough for Another Year?

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