Is the Fox Back in the Chicken Coop?

“Those who do not learn from history are doomed to repeat it”-G.Santayana.

While the influx of some 24 new entrants into the Florida homeowners' insurance market since 2006 is certainly welcome news, as consumers and industry people, we need to ask ourselves some basic questions. First, how can we — and insurance regulators — be certain that all of these recent entrants have the financial security and underwriting discipline to be there if and when they are most needed? Second, does this concentration of new entrants compound the risk to the overall market in any way?

Certainly the current global financial crisis raises further concerns regarding the need for increased regulatory controls and diligence along with the potential cost and availability of capital should the state of Florida ever need to tap into the bond market to cover catastrophe losses. One of the critical issues of the current financial crisis has been the lack of government regulatory oversight of the non-insurance subsidiaries of insurance holding companies.

A very hard lesson the insurance industry learned a few years back was the need to provide significant oversight and control over certain Managing General Agency (MGA) programs. Back then, a number of MGAs launched their own underwriting companies to provide specialty coverages through various fronting arrangements and what turned out to be inadequate reinsurance security arrangements. While these MGAs secured significant management fees for underwriting, claim handling, and other services, the underwriting companies themselves suffered substantial and ultimately unsustainable losses, resulting in the collapse of many of these firms.

The primary reasons for calamities of the past had to do with the basic business strengths of MGAs versus underwriting companies, and the difficulty the regulatory system has in monitoring the economics of the complex organizational structure of some of those businesses.

MGA Strengths

MGAs have demonstrated remarkable abilities in developing strong sales engines through agent and broker networks. They also are adept at securing relationships with capable insurance companies who underwrite the risk or provide tight guidelines regarding acceptable risks, pricing, and reinsurance security.

The “lowest risk/highest return” economics of the MGA come from a growing and continuous stream of commission revenue and service fees. The insurer must control the underwriting risk of writing business at a price that will generate an adequate return and maintain sufficient capital and reinsurance protection against catastrophic losses.

Historically, MGAs have played a major and important role in providing needed markets for unique or difficult underwriting risks. Similar to the Florida homeowners' insurance market, when conventional insurance markets retrench or create availability problems, MGAs may develop effective programs that satisfy customer needs and do so often at more favorable prices than standard coverages.

MGAs can provide valuable service and support to their agent networks and their customers with special products and services not offered by the agents' traditional markets. The problems in the past have arisen when MGAs and major brokers have assumed control of the underwriting risk of some of these programs.

Reasons for Concern

The conflicts within MGAs remind me of the proverbial “fox in the chicken coop.” There are fundamental, basic differences between underwriting skills and management and agency skills and management.

Starting with economics, the largest portion of an MGA's profit is derived from commissions and management fees, with possibly some contingent profit provided by the insurer from superior underwriting results, although these contingencies have been under fire in recent years. Therefore, the MGA has a significant vested interest in generating high levels of premium in support of its agent network.

It is the responsibility of the insurance company to exercise underwriting discipline in risk selection, pricing adequacy and quality reinsurance protection. In the past, shifting of these responsibilities to the exclusive control of the MGA frequently has created poor underwriting results and, in some instances, significant cost to the consumer in the form of insurer insolvency, related delays in claim payments, and increased unavailability or price increases of insurance coverage.

The greater current economic value to the MGA of continuing sales and service revenue can lead to disastrous underwriting results when the decision resides with the same person, a person grounded more in sales skill than the discipline that comes with extensive underwriting training and experience.

The lack of adequate capital and reinsurance protection has also led to many of these historic problems. Since most of these programs began with limited or borrowed capital in the form of surplus notes (loans) and/or fronting arrangements with larger carriers, they relied heavily on reinsurance.

In many instances, the reinsurers were not of the highest quality and could not ultimately pay their share of the losses. In other instances, where the reinsurers were sound financially, they provided further fuel to continued sales in the face of mounting losses or charged so much to the insurer that an underwriting profit was not achievable.

The Financial Monitoring Issue

Compounding the basic issue of where the greatest economic gain was derived, the organizational structure of these programs made it very difficult for regulators to have a transparent view of cash flow and profit. Most of these programs had multiple companies that were being compensated by the MGA-owned insurance company. In addition to the MGA itself receiving sales commissions, there may have been underwriting and administrative service companies receiving management fees. There likely was a claim service company paid to administer claims.

The regulator would have difficulty seeing or assessing the underlying costs and profitability of each of these entities that were being paid by the MGA-owned insurance company. In the end, while the insurance company might ultimately fail, it would have generated considerable profit with limited downside financial exposure to the MGA.

Safeguarding the Florida Consumer

This lesson in history certainly can and should be avoided as we look at the current situation in Florida. While there is no basis to believe that any of the new entrants will follow down this unfortunate path, the adage of one of our late, great Presidents, “trust but verify,” will serve the state well. What are some of these lessons that will help Florida safeguard against these past industry problems?

Confirm that there are significant checks and balances between the underwriting and sales functions through rigorous and frequent underwriting audits. Reinsurers do this regularly to ensure conformity of their clients through underwriting, claims, and financial audits of the entire organization, not just the insurance entity where management companies are involved.

Be as concerned with unreasonably low pricing as with scrutiny of proposed rate increases. Immediate satisfaction can place a heavy price on future costs. While extremely difficult to do when prices are rising dramatically, challenging highly competitive prices is as important as regulatory pressure on unreasonable rate increases. Unbelievably low prices can be just that, unbelievable and unsustainable.

Place strict transparent financial reporting requirements on all controlled entities of the organization, especially any insurers that have obtained favorable loans, reinsurance protection or other state funding. Regulatory focus must extend to all controlled entities and not just the insurance company in the group.

Place restrictions on how much profit can be generated in the non-underwriting companies until sufficient surplus is generated by the underwriting company — i.e., keep the management company's skin in the game. Like other kinds of business loans and investments, controls and restrictions can and should be placed on any organization receiving favorable terms from the state.

Provide an open consumer forum to educate and receive feedback on specific company practices, advertising accuracy and relative stability. Let the consumers know the value of endorsement from the various rating agencies in making their decisions. Pay close attention to any early warning signs of questionable management practices.

These are some of the steps that can be taken to assure Florida homeowners that their insurer will be there when needed most and that the ultimate burden will not fall back on them after paying for their insurance. Let us hope that the skies are clear and that no one need worry about maintaining protection at a reasonable cost. But given the unique nature of insurance availability in Florida and the current global financial crisis, it does not hurt to remain diligent so as not to repeat the past.