The Florida Market: A Reinsurance Perspective

At the first meeting of the Task Force for Long-Term Solutions for Florida's Hurricane Insurance Market's first meeting, Steve Goldberg offered his views on the Florida market and the challenges ahead.

The financial structures that exist in Florida today were not put in place overnight and there are no overnight solutions to the challenges ahead. But one of the benefits of having a task force is that it allows us to take a long-term view of what must be done to ensure there is adequate capital in the market. To begin, there must be some fundamental principles and agreements consistent with that goal.

Florida has been exposed to devastating hurricanes for centuries. Geographically, the state is located in a position that exposes it to hurricanes developing in both the Atlantic Ocean and the Gulf of Mexico. As such, the state is at enormous risk every year to suffer intense damage and large financial losses from any number of hurricanes.

Much science has been devoted to predicting the annual frequency and severity of hurricanes and recently there is a growing debate over whether global warming is increasing the frequency and severity of these storms. So far, this debate has been controversial and inconclusive. Nevertheless, since 1850, there has been a cyclical pattern of hurricane activity. As pointed out by the Office of Insurance Regulation, “While only four major hurricanes (Category 3 and higher) made landfall in Florida from 1850 to 1900, 18 major hurricanes landed in Florida between 1910 and the mid 1950s. That was followed by a fairly quiet hurricane period until the mid-1990s.” Because of the fast-paced real estate development and population surge, hurricanes that used to impact only alligators and orange groves are now affecting people and property.

Only time will tell whether conclusive results can be achieved in the area of predicting hurricanes. As a matter of financial reality and to develop sound public policy, one must assume that the state will continue to be impacted by devastating events with some frequency.

Capital and Exposure

Robert Hartwig, chief economist of the Insurance Information Institute, has testified to the legislature and to other groups as to the impact of hurricane exposure to the economy in Florida. I offer these observations based on Hartwig's analyses.

The only long-term measure of success of any business, including insurance, is sustained profitability. In reality, Florida's homeowners' insurance market has never been profitable or self-sustaining. Investors cannot and should not tolerate consistent losses in an insurer's operations. Therefore, there is a reasonable expectation that this situation should be addressed. Capital is finite and must be treated as a precious commodity by insurers.

Florida is a fast-growing state. In order to support this growth, it will need to attract large amounts of capital in the years ahead. Any true solution should seek to provide capital with a reasonable rate of return.

Eliminate Price Controls

Unlike auto and other personal lines, there is no method to predict when, or how many, hurricanes will affect a state in a given year. In auto, thousands of claims occur each day and there are actuarial methods that can statistically project exposure and loss data. With hurricanes, however, historical data is of limited use, which necessitates the need for computer catastrophic models. These models are used in setting overall rate levels, evaluating differences in loss propensity by geographic area, and determining the level of capital that an insurer should retain.

Florida has benefited from the establishment of the Florida Commission on Hurricane Loss Projection Methodology, which was created during the 1995 legislative session and serves as an independent panel to evaluate computer models. Lawmakers also specified that reliable projections of hurricane losses are necessary to assure that rates for residential property insurance are neither excessive nor inadequate. Computer models have helped make this possible.

Accepted models should be applied without any artificial curtailment or rigid price controls. Rates should be allowed to strictly follow actuarial rate-making principles, including the full cost of capital. We urge the task force to examine the rationale for continuing the current regulatory method of reviewing and approving rates. Insurance is clearly a competitive market with dozens of providers. It is hardly a utility. The rate approval process can be contrary to the goal of acquiring adequate capital to fund Florida's hurricane exposure because, by definition, it forces rates to a level that is not market-based.

No other publicly necessary competitive business has to submit to the scrutiny of state rate filing requirements as insurance does. Our free market economy allows prices for all kinds of essential goods to float to the level where supply reflects demand. You need only look at today's gasoline prices to see an even more urgent pressure on consumers' pocketbooks. Yet no one seems to be advocating prior approval of gasoline prices.

Funding need not take the form of rate increases alone. While wind deductibles have been increasing over the past few years, there still is considerable savings to be achieved by encouraging higher deductibles. Given the magnitude of the potential losses from a hurricane, deductibles can have a large impact on the amount of capital required. For example, in California, following the 1994 Northridge earthquake, lawmakers created a so-called mini-policy that has a standard earthquake deductible of 15 percent of the home value. State residents have the option to purchase additional coverage that reduces the deductible to 10 percent. In addition, the mini-policy restricts contents coverage and additional living expenses. While this may seem draconian in Florida relative to the deductible and coverage levels today, it needs to be added into the mix of possible solutions.

Solvency Hinges on Capital

With the increase in market share of Citizens Property Insurance, the logical question to ask is: How can we encourage risks to be moved to private markets? In the present environment, we are seeing several carriers either placing limits on new business or withdrawing from the market. At the same time, new start-up insurers are willing to take business out of the residual market.

The state has embarked on a bonus program as an incentive to encourage private insurers to assume policies that otherwise would be placed into the residual market. The bonus added to the allowed premium seems to have provided, in many cases, just the right amount of sweetener to get these risks into private markets. The key point that needs to be addressed, however, is whether the state has fully explored the financial credit worthiness of each new entity. Is this new capital na?ve and subject to insolvency at the next moderate-to-strong hurricane event? Or perhaps is this new capital precisely determined to be just enough to clear initial regulatory scrutiny, but actually designed to be unable to respond to the next major event?

It does little good to have approved an undercapitalized entity to take business out of Citizens, simply to wind up paying claims out of the guaranty fund when the new entity goes under.

End Unfair Subsidization

Today's catastrophe models are the tools that most accurately assess exposure differences by geographic area. Intuitively, one would imagine that a risk right on the coast is more vulnerable to hurricane damage than one that is two miles inland. But there is no need to rely on intuition when a realistic appraisal can be made. Rates can now be accurately based on relative risk.

Citizens, as the insurer of last resort, has by its nature institutionalized a form of unfair subsidization. This is because many of the high-end property risks it takes on could possibly be written in the private market at the right price for the exposure. Citizens insures most of the high-end property along Florida's coastline.

Accounting for Catastrophic Events

Most people do not think about closing the books annually as an accounting paradigm. It just seems natural that at the end of the year we should be able to determine with some accuracy whether we made or lost money. Unfortunately, this paradigm has negative consequences for public policy when we are trying to encourage capacity for events that are devastating but infrequent. In any given year, the provision in rates for catastrophes will be a broad average, yet the actual experience in that year will rarely equal that average. In fact, in most years, if the catastrophe provision is accurate, catastrophe losses will be less than the average to allow for years like 1992 and 2004, which far exceeded average losses.

It is tempting to look at the annual experience in years when no major events occur and observe what one could argue as to be excess profits realized by insurers. We need to understand that, in essence, these years are saving up retained earnings for those years in which the market suffers a catastrophic loss. However, under the current regulatory structure, insurers are taxed on what many consider profits. This inhibits insurers' ability to save up for the next big event because a considerable amount of capital that could be used for hurricane losses is skimmed off in taxes.

Importance of Tax-Exempt Status

When lawmakers structured the Florida Hurricane Catastrophe Fund, the legislature considered the accounting phenomenon just described and was able to achieve a federal tax exemption, which permits the fund to accumulate capital unencumbered by a drain on the funds from taxes. This exemption is not available to private entities. According to the claim-paying capacity chart on the Cat Fund's web site, this has allowed the fund to grow to a cash balance of $6.1 billion in 2004. However, following payments from claims for the 2004 events, the current Cat Fund's cash balance is approximately $2.9 billion. With a bonding capacity supported by policyholder assessments, the Cat Fund can now cover $15 billion in initial season claim-paying capacity and $15 billion in subsequent season claim-paying capacity.

To maximize capital overall, Florida should continue to exploit this tax advantage. While some within the insurance industry may argue that this “crowds out” private capital, the private capital simply cannot compete with the advantage that the Cat Fund has in its ability to accumulate capital. It would be a mistake not to utilize this to maximize the benefits to Florida consumers.

Cooperation Is Essential

The task force has a unique opportunity to bring together the views of all stakeholders. It would not be an understatement to say that the future viability of the Florida economy will depend on the effectiveness of whatever proposals the task force finally recommends. Solutions will evolve over time and the recommendations will undoubtedly need to be reviewed over the years to make sure they still are relevant.

Toward that end, one enduring contribution the task force could make would be to lower the rhetoric and come together in a conciliatory manner.

We must respect each other's perspective as we all attempt to face up to the certainty of large losses from future hurricanes. It is a time to carefully listen to the range of options, many of which are likely to require some form of sacrifice. The exposure faced in Florida is nobody's fault, it is real and it is not going away.

Steve Goldberg is chief actuary of the Reinsurance Intermediary, Benfield.