Demand and Supply in Cat Fund Financing

For the past 13 years, Florida property insurers have been comforted knowing that no matter how many severe hurricanes hit the state, they always had a backstop of reinsurance through the Florida Hurricane Catastrophe Fund. Often known as the “crown jewel” of the post Hurricane Andrew reforms, according to most experts the Cat Fund has been responsible for sustaining a private market that otherwise may have fled the state, especially after the hurricane seasons of 2004 and 2005 that cost the industry over $33 billion dollars. But never before has the market and the state leaned so heavily on the fund's ability to prop up the market in the event of a major hurricane. All of which, leaves open the question of how much financial pressure can the Cat Fund take.

When Governor Charlie Crist was elected on the platform of lowering homeowners' rates, the Cat Fund became a major player in accomplishing that goal. Showing confidence in the Cat fund, lawmakers changed state law to have the fund pick up more risk, lessening the exposure of private insurance companies in an effort to lower the premiums homeowners pay for their wind damage coverage. The trade-off is that the catastrophe fund will be on the hook to pay more in claims from a large storm.

To get the Cat Fund in a better financial position to react to a major storm, Crist and state officials in charge of the Cat Fund sought to borrow about $7 billion from the capital markets so the state would have a total of about $12 billion available almost immediately after a storm. “The idea is to make sure that we have the money there,” Crist said after a cabinet meeting approved the idea in late July. “If we have a big storm, we've got the money to pay to make sure our people are covered.”

Turbulence in the Capital Markets

But a not-so-funny thing happened as the Cat Fund prepared to seek additional financing by selling bonds: It found the credit markets had grown much tighter than expected–largely because of the fallout from the sub-prime mortgage lending fiasco.

As a result, the state Board of Administration fund managers that oversee the Cat Fund decided to delay indefinitely issuing any bonds. The unexpected delay, which occurred at the peak of the Atlantic hurricane season, has sent shivers throughout the Florida insurance industry. The concern is not so much can the Cat Fund raise the money now, but whether it will be able to raise billions more after a catastrophic storm.

“There is a concern about how quickly the Cat Fund can raise the money it needs,” said Sam Miller, spokesman for the Florida Insurance Council. “Would the Cat Fund run into the same problem after a major hurricane? There always was a concern among some insurers about whether the Cat Fund would have enough money, now there is a lot more concern.”

Before the legislative changes enacted in January, the Cat Fund was only on the hook for $16 billion in claims. Now, that figure is a whopping $28 billion. Currently, the fund has $3.8 billion cash on hand now and, barring a hurricane, will have $5.2 billion by the end of the year. Private insurance firms purchase backup insurance from the state's catastrophe fund. The fund begins to pay damage claims when total property losses exceed $6 billion.

A Question of Liquidity

William Stander, assistant vice president and regional manager for the Property Casualty Insurers Association of America, also has concerns about the Cat Fund's future viability. “Would the capital markets be able to absorb a huge offering of $20 billion or more following a storm,” he said. “There is definitely a question of liquidity and it is unclear if the Cat Fund would be in a precarious position.”

The main issue, Stander said, is that after a big storm it won't just be the Cat Fund going to the capital markets for money. Citizens Property Insurance Co., the state's largest insurer and insurer of last resort, would also likely be looking to borrow billions as well. This raises the question of whether the bond market would be able to handle both. The single largest bond offering ever made by a tax exempt organization was $10 billion by an Illinois public works project, Stander noted.

Under laws passed by the state legislature, insurers have to pay claims within 90 days. So the insurers won't have months to delay seeking funding in the case of a natural disaster. If the Cat Fund can't meet its obligations, the State of Florida or Florida consumers will have to step in. That would mean either a special assessment on homeowners or a big bump in sales taxes.

Boosting Reserves: an Option?

The state catastrophe fund has always had the ability to issue bonds and assess policyholders after a major hurricane. But, the Florida Cabinet decided that the catastrophe fund needed more in the bank before a hurricane so it would be ready to respond quicker. Financial advisors to the Cat Fund last January said they didn't expect the fund to have any problem boosting its reserves, which many expected to be done through a series of bond offerings. But that was before the $1.2 trillion sub-prime home loan market fell into a deep freeze this summer as delinquencies by borrowers continue to rise and credit rating agencies downgrade the securities.

A lending slowdown in a housing market that is already seeing lower average home prices across the U.S. is threatening to spill over into broader credit markets and slow economic growth even further. Officials from the Florida Cat Fund had little to say after postponing its bond offering, and they refused to talk about its prospects of having enough money or liquidity should a major storm hit. “We normally don't provide any type of commentary or attempt to speculate on future events,” said Cat Fund spokesman Mike McCauley. As far as when it will go to the bond market again: “The State will continue to evaluate market conditions and access the market as conditions normalize,” he said.

Citizens Changes the Equation

In the short term at least, Florida homeowners will likely benefit by the state's decision to delay selling bonds in the tight credit market. That's because, by waiting, Florida could find a better rate on the bonds later, state fund managers and analysts agree. To average Floridians, the decision means that potential assessments, fees collected by the catastrophe fund that show up on insurance policies, would be pricier if bonds were issued now than if the state were to wait.

Meanwhile, insurers, citing the catastrophe fund's low cash reserves, are purchasing a special kind of reinsurance that would give them access to quick cash to pay claims if hurricanes strike, in case the catastrophe fund is slow to pay. Some are also seeking to charge policyholders for that cost, which has irked some state insurance officials.

The PCIA, whose 1,000-plus members write more than $194 billion in premiums, supported expansion of the Florida catastrophe fund. That was before the “dramatic expansion” of Citizens, which is using “artificially suppressed” rates. If a 1-in-25-year storm hits Florida, Citizens would suffer a $3.7 billion deficit and the Cat Fund would suffer a $22.3 billion deficit, according to a report by Milliman Inc., which was commissioned by the PCI.

To pay for claims, those entities would likely have to seek out the bond market to raise up to $26 billion for a 1-in-25-year storm and up to $69 billion for a 1-in-250-year event, Milliman said. That would take time to arrange, and might negatively impact the state's credit rating, it said.

Florida Insurance Commissioner Kevin McCarty is very aware of the potential problems. “Certainly you can conjure a scenario where a number of storms can bankrupt the Cat Fund and Citizens insurance company,” McCarty said. Yet, given the state's critical situation, “I think Florida has done the prudent and responsible thing,” he said.

McCarty has criticized Florida insurers for spending the savings from the legislative reforms buying reinsurance instead of passing on the savings to policyholders. But insurers say they are only being prudent.

“Consumers have not seen savings anywhere near those promised by the governor because the 'reforms' enacted during the Special Session ignored the economic reality that hurricanes present to all Floridians,” Stander said. “The fact is, Florida has more coastal property–nearly $2 trillion worth–exposed to more frequent and severe storms than anywhere in the world.”

To follow the history of the Florida Cat Fund's annual bonding capacity and end of year balance go to www.sbafla.com/fhcf/pdf/bonding-estimates/be.pdf.