THE UNSUSTAINABLE STATE OF THE FLORIDA

PROPERTY INSURANCE INDUSTRY







Who needs Mother Nature to cause a catastrophe?
Florida’s politicians are busy creating an unnatural
disaster in their state insurance market that will
blow away taxpayers when the next big hurricane
hits.
Wall Street Journal, February 4, 2009


I've been around long enough to learn that sometimes
when it looks like a bubble, and feels like a bubble, it
might be a bubble.
Jed Rhoads, Markel Global Re, June 2014




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RH Analytics
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July 2014

TABLE OF CONTENTS

SUMMARY

EVOLUTION OF THE FLORIDA PROPERTY INSURANCE MARKET

I. Historical Perspective

1. The First Wake Up Call – Andrew, 1992

2. The 2004/2005 Season and Its Consequences

II. Florida Property Insurance Market Structure

1. Citizens Property Insurance Corporation

2. Florida Hurricane Catastrophe Fund

3. Florida Insurance Guarantee Association

4. Market Structure Evolution

III. Depopulating Citizens Property Insurance Corp – a Deja-vu

1. Get Them Off the Books – The 1996 Depopulation

2. Let’s Try This Again – The 2006-2009 Depopulation

3. Building on “Success” – The Current Depopulation and the Old/New Kids on the
Block

4. The Verdict on the Depopulation Efforts – Political and Inefficient

IV. Reliance on Reinsurance and the Capital Markets

1. Glut of Alternative Capital Compresses Reinsurance Pricing

2. Why Reinsurance is Critical to the Florida Market

3. How Much Reinsurance to Buy or How to Use Catastrophe Models

CONCLUSION

RECOMMENDATIONS

DISCLAIMER

1
SUMMARY

The politicians of the state of Florida have managed to create a unique mixture of public and private
interests when dealing with the state’s challenging property insurance market. Faced with a gigantic
exposure of coastal development on one of the riskiest stretches of land on the planet, Florida has
attempted to create a system that deals with risks at best very difficult to quantify and at worst
“uninsurable” in order to protect the sacred cow of the state’s economy – coastal real estate
development.

The risks associated with real estate development in hurricane and flood-prone areas will eventually
come to the surface. Unfortunately, under the current system, the taxpayers of Florida and some
pension funds will have to pay that bill while numerous private interests have already accumulated
substantial benefits. It is our belief that when the current state of Florida insurance system unravels, it
will take with it a large number of local Florida insurance companies and will wreak significant
damage on the Florida’s real estate market and economy.

The current status quo is only possible due to two coinciding facts: first, that Florida has experienced
no significant hurricane over the last eight years (the longest such “drought” on record) and second,
the low interest rate environment has attracted a lot of alternative capital to catastrophic risk space
thus lowering the reinsurance price for Florida cat risk beyond a reasonable level. Subprime
insurers have replaced subprime mortgages as the investment fad-de-jour. The combination of
those two factors has made otherwise non-viable insurance models appear profitable. Once one or
both of those factors reverse, the current market structure becomes untenable.

State regulation with often conflicting policies has led to a “dysfunctional property insurance
system that has distorted pricing, undermined competition and placed a heavy burden on state’s
taxpayers.”
1
Importantly, it has exacerbated one of the root problems of the system – the inadequate
spread of risk. The State of Florida has made a number of attempts to shift those risks from state-
owned to private entities offering substantial inducements only to see a number of “fly-by’night”
insurance companies take the benefits and leave the public to face the liabilities.

We will not be the first ones to sound the alarm on the vulnerability of the current state of affairs.
Between 2010 and 2011, the Sarasota Herald Tribune’s journalist Paige St. John wrote a series of
excellent articles outlining some of the problems and providing insights into how weak insurers put
millions of Floridians at risk. She won the Pulitzer Prize for investigative journalism for 2011.
2


Yet, little has changed. In the meantime some of the “domestic Florida insurers” (DFIs) discussed in
this report have enjoyed phenomenal stock market performances, paid handsome dividends and
bonuses, engaged in aggressive share buybacks and questionable related-party and investment
transactions. Those companies should trade at significant discounts to their current market valuation
given not only the systemic and political but also the idiosyncratic risk associated with them.

In this report we review the main factors shaping the Florida’s property insurance industry. We not
only highlight the challenges but also try to offer recommendations for solving some of the problems.

1
Ten Reforms to Fix Florida’s Property Insurance Marketplace, The James Madison Institute, November 2013
2
www.pulitzer.org/archives/9192

2
EVOLUITION OF THE FLORIDA PROPERTY INSURANCE MARKET

Florida has the nation’s highest insured losses and most vulnerable landscape. It boasts nearly
$2.9 trillion of coastal property exposure up from $1.9 trillion in 2004. Florida’s demographics
and land-use policies make certain that catastrophe losses will rise in the future. Despite having
only 5% of America’s population, it accounts for half of all hurricane exposure.
3


It is the kind of wealth concentration in an extremely risky place that defies the logic of
insurance. People are allowed to build increasingly more expensive structures in areas that are
vulnerable to storm damage.
4
If you reran today the hurricane that struck Miami in 1926, for
instance, it would take out not the few hundred million dollars of property it destroyed at the time but
$60 billion to $100 billion.
5
The little known Lake Okeechobee hurricane of 1928 that killed at least
2,500 in the United States will probably cause as much as $65 billion in damages if it were to occur
today.

A catastrophe modeling firm has estimated that a large hurricane in southeast Florida could cause
insured losses of $130B and a total economic loss of $260B.
6
As the table below illustrates, half
of the historical hurricanes likely cause more than $10B in insured losses if they were to strike
again in 2012 made landfall in Florida. Robert Hunter, director of insurance at the Consumer
Federation of America, wryly commented on the Florida hurricane insurance market: “In a locale
whose major university football team is called the Hurricanes, the question is not whether a
hurricane will strike but when and how big.”
7


Top 10 Historical Hurricanes Current Exposures
Year Hurricane Region Insured Loss
(2012 dollars)
1926 The Great Miami Florida South $125 B
1928 The Great Okeechobee Florida South $ 65B
1900 Galveston Texas $ 50B
1947 Ft. Lauderdale Florida South $ 50B
1992 Andrew Florida South $ 50B
1915 Galveston Texas $ 40B
2005 Katrina Gulf $ 40B
1938 The Great New England Northeast $ 35B
1960 Donna Florida Northeast $ 25B
1954 Hazel Southeast $ 20B
Source: Karen Clark & Co.

3
Restoring Florida Insurance Market, Eli Lehrer, The James Madison Institute, Issue 55, February 2008
4
Florida’s Insurance Markets: An Overview, Insurance Information Institute
5
In Nature’s Casino, Michael Lewis, The New York Times, August 26, 2007
6
Florida’s Financial Exposure from its “Self-Insurance” Programs, Special Report, April 2010, Florida Council of
Economic Advisors at Florida Tax Watch
7
Catastrophe Insurance, Dynamic Premium Strategies and the Market for Capital, Russell, Jaffee, Alternative
Approaches to Insurance Regulation, National Association of Insurance Commissioners, 1998

3
According to Karen Clark & Co. estimates, the US is likely to experience on average a $10B or
larger insured loss event one year out of four. In other words, there is a 25 percent chance of a
$10B or larger loss this year. There is almost a five percent chance of a $50B or larger loss.
8


There are three factors which put hurricanes, along with several other natural catastrophes in the
category of risk that is typically referred to as “uninsurable”:

- damages may occur infrequently but can be substantial;
- damages are typically concentrated in one geographic region (and most buildings in that
region are affected to some extent);
- it is hard to objectively estimate the expected damage cost.

The term “uninsurable” was coined by the insurance industry itself. It refers to the fact that
private insurance companies usually try to avoid insuring risks of this kind or do so only at
premiums that are substantially higher than expected damage cost.
9


Strong private insurance markets are characterized by the orderly matching of buyers and sellers,
adequate coverage of consumers, competitive pricing and moderate government intervention.
Florida’s market faces structural challenges on each of those elements and its government plays
a very active role in its insurance market.
10
As Towers Watson, a consulting company puts it:
“There is no question: Florida’s insurance market is in a state of disarray, and property insurers
and homeowners have huge challenges ahead of them.”
11


Insurance is generally regulated at the state level, with each state having its own statutes and
rules. Florida has experienced frequently changing and complex insurance regulations, which are
both challenging and expensive to implement. Regulation is particularly volatile for property
insurance with periods when rates are suppressed due to public pressure on politicians. As a
result, companies have not been able to charge prices that reflect their costs of operating in one of
the world’s most catastrophe-prone markets. The big insurers have responded by cutting back
on the amount of insurance policies they are willing to write or withdrawing from the market
altogether. Florida has replaced them with a crop of generally weak homegrown companies.

The political risk in the Florida property insurance market is very high. Elections are won or lost
based on proposed insurance policies that are crucial for both real estate development and
affordability. Insurers sell a “promise”, one essential to the flow of credit, whose value comes
from insurers’ ability to pay claims. As such one can argue that Florida’s current homeowners’
insurance system is broken since one major hurricane has the potential to bankrupt private
insurers and the State’s self-insurance programs.
12





8
Historical Hurricanes that Would Cause $10B or More of Insured Losses Today, Karen Clark &Co., August 2012
9
Hurricane Insurance in Florida, Ungern-Sternberg, Faculty of Business and Economics, University of Lausanne
10
Florida Property Insurance, The Window of Opportunity, Towers Watson, January 2010
11
Ibid.
12
Florida’s Financial Exposure from its “Self-Insurance” Programs, Special Report, April 2010, Florida Council of
Economic Advisors at Florida Tax Watch

4
I. Historical Perspective

1. The First Wake Up Call – Andrew, 1992

In 1992 after years of relative calm, category five (maximum intensity) hurricane Andrew hit
South Florida. It resulted in 40 deaths, cost more than $25B in nominal dollars of damages and
left a quarter of million Floridians (most of them in Miami-Dade county) with destroyed or
uninhabitable homes.

Following the huge losses, the bankruptcy of 11 small insurance companies, the withdrawal from
the state of some of the large national insurers and the sharp increases in (re)insurance rates,
Florida politicians responded by establishing market-stabilizing mechanisms like a residual
market – Citizens Property Insurance Corporation (Citizens); Florida Hurricane Catastrophe Fund
(FHCF) which provides reinsurance; the Florida Insurance Guaranty Association (FIGA), which
pays losses of failed insurers and the Florida Commission on Hurricane Loss Protection
Methodology which approves catastrophe models that are crucial for rate making by insurers.

A series of 1997 reforms strengthened the ability of the state-sponsored entities to levy taxes
(assessments) to pay for insurance events and expanded their capacity to write insurance. The
system lasted with a few changes until 1999 when a bad season that only grazed Florida caused
the Legislature to bailout Citizens.
13


2. The 2004/2005 Season and Its Consequences

By the end of the 1990s, Florida’s property insurance market had largely recovered from the
effects on Andrew. However, in 2004/2005 the state was battered by a series of storms resulting
in huge losses for insurers. The global insurance and reinsurance industry had reported over $65B
in losses from the hurricanes Katrina, Rita and Wilma (KRW). Further, the season drained the
entire $7B that the FHCF had built up.

As a result several insurers reduced exposure to Florida either by declining to renew policies or
by not accepting new ones. State Farm and Allstate, controlling a third of the market prior to
2004, led the wave of withdrawals, followed by Nationwide, USAA, Hartford and Travelers. As
one blogger put it “The insurance market in Florida is kryptonite to viable insurance
companies.”
14


The higher price and limited availability of property insurance became the dominant issue in the
2006 state election. In January 2007, Governor Charlie Crist and the Florida Legislature
fashioned a political solution in which the state’s taxpayers were left to assume much of the risk
for future catastrophic damage.
15
Citizens was not allowed to raise rates until 2009, causing a
massive influx policies to the state insurer and increasing the chance for to a massive hurricane
tax.

13
Ibid.
14
http://homesteadishome.blogspot.com/2013/05/opt-out-citizens-insurance-under.html
15
Restoring Florida Insurance Market, Eli Lehrer, The James Madison Institute, Backgrounder, Issue 55, February d
2008

5
II. Florida Property Insurance Market Structure
The magnitude and variability of catastrophic windstorm losses makes it virtually impossible to
entirely finance them in any single time period. Florida, like other catastrophe-prone states has
chosen to fund a large portion of its risk exposure through post-loss assessments. These
assessments are levied on most property-casualty insurance policyholders by the state-sponsored
insurance entities.
Certain types of state intervention have proven to be successful in Europe in stabilizing property
insurance markets. The best known examples in this respect are the local monopoly property
insurance providers in large parts of Switzerland, the monopoly state reinsurance company for
catastrophes in Spain, the state guaranteed reinsurer in France etc.
16
The success of such entities
depends on the sustainability of the resulting market structure. In contrast, Florida’s attempt to
create a viable market is marked by serious vulnerabilities.
1. Citizens Property Insurance Corporation (Citizens)

Citizens was created on August 1
st
, 2002 through the merger of two previously existing state
insurers of last resort to provide “affordable” property insurance to Florida. It is a state-owned
entity and has three distinct accounts: the Personal Lines Account, the Commercial Lines
Account and the Coastal (formerly High-Risk Account). When any of these accounts has a
deficit, Citizens may levy assessments not only against its policyholders but also against the
policy holders of private insurers in almost all lines of property casualty insurance.

In its current form Citizens can be broken down into five main categories of policies. The first
one covers the real residual market that is uninsurable in the traditional sense of the word due to
loss ratios. The second category is the coastal account where largely expensive properties are
getting the benefit of the subsidized coverage. The third category of policies covers the tri-county
(Miami-Dade, Broward and Palm Beach) that has very high non-catastrophe loss ratios much of
which is a result of fraud (The severity in Miami-Dade is double that of any other part of the
state). The fourth category encompasses manufactured housing half of which is not insured. The
fifth category are policies in “sinkhole alley”.

Following the 2004/2005 season, the Florida legislature passed a bill that was to provide Citizens
with actuarially adequate rates. It would have increased premiums by 75% statewide by mid-
March 2007. The public outcry fuelled the gubernatorial campaign of Charlie Crist who promised
to reduce premiums at any cost. According to the plan, any shortfall was to be managed by
assessments. As illustrated on the chart below, a Citizens policyholder can be required to pay
85% on his homeowner’s insurance premium and 38% on his auto premium in the form of
assessments in any one year.


16
Hurricane Insurance in Florida, Thomas von Ungern-Sternberg, Faculty of Business and Economics, University of
Lausanne

6

Source: https://www.citizensfla.com/about/CitizensAssessments.cfm

Mr. Crist won and he promptly passed House Bill 1A which rolled back Citizens’ rates to 2006
level, froze rates going forward, allowed policyholders to purchase Citizens policies without first
being rejected by the admitted market. The Citizens glidepath legislation passed in 2009 unfroze
rates but limited increases to 10% per year imposing de facto price controls. It will be many
years, given the current rate restrictions and deficiencies, before Citizens policyholders are
priced at actuarially fair rates. According to Maroney, Nyce and Newman, policyholders in
Miami-Dade County will still be underpriced in 2020, given the present glidepath.
17


Jay Liles, policy consultant for the Florida Wildlife Fund, has summed it up “Artificial rate
suppression has caused financially stable insurers like State Farm and Cotton States Insurance to
simply abandon the market.” Subsidized premiums for vulnerable properties provide little
incentive for businesses and out-of-towners to consider the real cost of building. In fact, a 2013
report by the Tampa Bay Times found that nearly 70% of Citizens policies don’t insure a primary
home.
18


After a number of years without a hurricane, Citizens has accumulated over $7.6B in reserves and
the political pressure to shrink its size has mounted. The current Republican governor Rick Scott
has introduced a new Citizens legislation in 2013 that limits the state insurer’s exposure. A
clearinghouse whereby all new and renewal personal residential property insurance is reviewed
for eligibility and placement in the private market was established in January 2014. Citizens
currently holds under 1 million policyholders for the first time since 2006.

Despite the financial cushion that Citizens has managed to compile, a report prepared by the
actuarial firm Milliman concluded that it will face severe problems in the future. According to it

17
The State of Florida’s Property Insurance Market, The Florida Catastrophic Storm Risk Management Center,
January 2013
18
How Will Depopulating Citizens Insurance Affect Florida by Alice Holbrook, April 14, 2014, Property Insurance
Assessment Tiers
1. Citizens Policyholder Surcharge
• One-time assessment
• Citizens policyholders only
• Up to 45 percent of premium
2. Regular Assessment
• One-time assessment
• Private-market policyholders, including,
but not limited to homeowners, auto, and specialty
and surplus lines policies
• Up to 2 percent of the remaining
shortfall
3. Emergency Assessment
• Single- or multiyear assessment
• Citizens and private-market

7
even under the best of circumstances, Citizens will see its surplus shrink to the point where it will
likely have to borrow significant funds to pay claims. The improved stability of the fund is
achieved by simply transferring the risks to reinsurer FHCF and the system will probably require
a bail out that will be funded through special assessments on all eligible insurance policies.
19


2. Florida Hurricane Catastrophe Fund (FHCF)

FHCF is a State Tax-Exempt Trust Fund created by the Florida Legislature in 1993 to provide
additional insurance capacity and help stabilize the property insurance market in Florida. It
provides reimbursement coverage to insurance companies by writing a covered policy. These
insurance companies are required by Florida law to purchase coverage from the FHCF as a
condition of doing residential property insurance business in the state (over 40% of FHCF
business is with Citizens). As a compulsory State Trust, the FHCF does not face the same
capitalization rules as private reinsurers and relies instead upon its ability to assess its customers
for any deficits.

The FHCF provides coverage for personal residential and commercial residential covered losses
only; commercial non-residential losses are not covered. Similar to private reinsurance, the FHCF
covers losses once an attachment point is reached. Unlike private reinsurance, the FHCF is a
reimbursement mechanism, meaning that insurers must first pay the underlying claims before
reimbursement from the FHCF is received. This is not a realistic scenario for the majority of
thinly capitalized local insurance companies.

The FHCF annual maximum limit of coverage is set by statute. Currently, the FHCF maximum
potential obligation for the mandatory coverage is $17B for first year and $24.8B for two years.
Its funding depends on the issuance of post-event bonds. However, the FHCF statute specifically
provides that the full faith and credit of the state will not be pledged to payment of FHCF
obligations. By statute, the FHCF is not required to pay out money it does not have and cannot
raise.

FHCF’s obligations are limited to “actual claims-paying capacity.” Insurers are specifically
authorized by law to rely on the estimate of FHCF claims-paying capacity as published in the
Florida Administrative Register for “…all regulatory and reinsurance purposes.” Reliance on
these estimates can have serious consequences for an insurer if, after a hurricane, it turns out that
the FHCF cannot raise enough funds to match the estimate. In such a situation, it is possible that
the insurer hasn’t bought enough private reinsurance resulting in impairment or insolvency.

The FHCF reimburses property insurers for a selected percentage (45, 75 or 90% with most
insurers selecting 90%) of hurricane losses to residential property above the insurer’s retention
(deductible). Reimbursement contracts run from June 1st – May 30
th
. The retention amount for
each insurer is different because the amount is based on how much premium the insurer pays to
the FHCF and the aggregate retention ($7.2B) for mandatory coverage.
20



19
Ibid
20
House of Representatives Staff Analysis, Bill# HB 1107 FHCF, 4/19/2013

8
The FHCF’s ability to raise debt capital to cover losses is highly dependent on market conditions
– it peaked at $26B in the spring of 2007 and bottomed in the fall of next year at $3B. Further, the
FHCF uses a 0-12 month timeframe to estimate its borrowing capacity while some insurers may
not be able to survive a year waiting for FHCF recoveries.
21
Insurers do not typically need to
purchase private reinsurance to duplicate reinsurance bought from FHCF as such costs can not be
passed through to policyholders in a rate filing and recouped.

The FHCF is required by statute to charge “actuarially indicated” rates but the fund offers
coverage to property insurance companies significantly cheaper than reinsurance sold by
private insurance companies. It is estimated that coverage purchased through the FHCF varies
little from year to year and is between 1/4
th
to 1/3
rd
what it would cost in the private reinsurance
market.
22
A 2007 report by the Office of Insurance Regulation estimated that “a reasonable rate
on line for private reinsurance being replaced by the additional FHCF layer is 20% versus the
actually charged 2.2%.”
23
Our analysis shows that FHCF currently charges around 7.8% while
private market ROL are about 10% to 20% for a similar reinsurance layer.

FHCF debt has traditionally been considered high quality by the markets because of FHCF’s
assessment powers. Its bonds are backed primarily by emergency assessments on property and
casualty insurance premiums. The assessments are levied on policyholders and collected by
insurers. In the 2009-2011 period FHCF would not have been able to bond enough to pay for its
full potential liabilities. The fund is in a better position now with a cash balance of $9.8B at the
end of 2013 and a pre-event financing of $2B issued in April 2013.

While the FHCF’s total claims-paying capacity is currently estimated to be $19.07 billion,
enough to cover all of its obligations, a sufficiently large storm season could exhaust all of the
fund’s resources, seriously hindering its ability to meet its obligations in subsequent years. In
2012, the Office of Insurance Regulation estimated that a Cat Fund shortfall of 25 percent would
be enough to render nearly half of the state’s top 50 insurers insolvent.
24


“Florida’s unprecedented eight-year ‘drought’ in hurricanes has allowed, for the first time in
several years, the Cat Fund to accumulate enough cash that, coupled with issuing billions in debt,
will allow it to fully cover its obligations,” R Street Florida Director Christian Camara said. “But
Floridians would still be soaked with billions in taxes and the fund would be left bare to cover
subsequent storms.”
25


3. Florida Insurance Guarantee Association (FIGA)

The state-sponsored agency charged with dealing with the adverse effects of insolvent insurers
was created in 1970 and is called the Florida Insurance Guarantee Association (FIGA). FIGA
does not accumulate funds in advance of an insurance company’s insolvency. When an
insolvency occurs, FIGA must obtain the funds it needs through pro-rata (regular and/or

21
The Florida Hurricane Catastrophe Fund, Alternative Methods for Managing the Size,December 1, 2013
22
Annual Report, Florica Hurricane Catastrophe Fund Fiscal Year 2010-2011, p.19
23
The Florida Hurricane Catastrophe Fund, Alternative Methods for Managing the Size, December 1, 2013
24
R Steet Welcomes Vote to Right-Size Fla Cat Fund, Feb 4, 2014, www.rstreet.org/florida
25
Ibid.

9
emergency) assessments levied by the Office of Insurance Regulation on insurance companies.
These insurers must then recoup the cost through their policyholders.
26


4. Market Structure Evolution

After Hurricane Andrew, many national insurance companies left Florida or reduced exposure
citing the vulnerability of exposing their capital base to large catastrophes. As a result, Florida
has witnessed the growth of Citizens and a domestic industry heavily reliant upon offshore
catastrophe reinsurance in order to access enough capital to support writing property insurance.

As the chart below illustrates, the DFIs and Citizens account for 75% of the marketplace up
from 16% in 1999.
27
The insurance expert Robert Klein, director of the Center for Risk
Management and Insurance Research at Georgia State University calls that market structure
“Florida-zation of cat risk.”
28
It raises questions as to the ability of the market to withstand
significant storm activity since it concentrates risk rather than disperses it.
29


Evolution of Florida’s Homeowners Insurance Market Share
39%
11%
45%
15%
28%
10%
46%
6%
0%
20%
40%
60%
80%
100%
1999 2012
ANTS Other Nationals Citizens DFIs

Source: Dowling & Partners, 2013

Private insurers in Florida are prohibited from raising rates to cover past losses and must operate
their businesses in a way that allows them to have enough money on hand (or through
reinsurance) to pay for claims they expect to have in the future. This is in sharp contrast with the
post-event funding philosophy of both Citizens and FHCF. DFIs have been operating in the red
on a cumulative basis for over 11 years since hurricane Andrew in 1992 before breaking even and

26
The State of Florida’s Property Insurance Market, The Florida Catastrophic Storm Risk Management Center,
January 2013
27
Office of Insurance Consumer Advocate, June 2013
28
Weak Insurers Pul Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28
th
, 2010
29
Source: Statutory Statements, Citizens, Dowling & Partners Analysis, June 13, 2013

10
returning to profitability in 2003 and then sliding back into the red with back-to-back hurricanes
in 2004/2005. They finally turned a profit in 2012.

A number of factors contributed to the losses even without a hurricane. The frequency (up 26.8%)
and cost of claims (up 32.5%) were up sharply between 2007 and 2009. The average loss per
policy has risen by more than 65% over the same two year period largely as a result of sinkhole
claims and public adjuster filings. At the same time, property insurance rates actually dropped
between 2007 and 2009 due to state-mandated discounts for mitigation measures. Those issues
were addressed in a property insurance bill that among other reforms addressed out-of-control
sinkhole claims and implemented limits on public adjuster fees.
30


The current market structure and the unpredictability of both rates and losses encourage the
emergence of “fly-by-night” insurance companies that enter the market with aggressive pricing
strategies that do not allow them to cover their effective exposure. They are then forced to leave
the market when the first major event hits them. The profits are not used to increase reserves
but are distributed to shareholders and management in the form of dividends, share
buybacks and bonuses. These insurers reap the potential upside of such gambles while
subjecting the public to the potential downside (the banking system presents a similar dilemma
on a much larger scale).
31


As the Pulitzer winning journalist Paige St. John summed: In Florida, “insurers are now risk-
brokers, players with relatively little money and a lot of leverage. In place of huge cash reserves,
they have reinsurance that pays off in a major disaster. Those policies are so costly that most
companies have little money left to build reserves.”
32

III. Depopulating Citizens Property Insurance Corp. - a Déjà-vu
The political climate in Florida periodically favors the aggressive shrinking of the state’s
involvement in the marketplace. This goal is usually achieved through the provisions of
incentives to private companies encouraging the takeover of Citizens policies. That has given rise
to a Florida-specific business model where takeout DFIs only assume policies from Citizens and
do not engage in underwriting voluntary business. There are companies that combine the takeout
with the voluntary model as well as DFIs that only pursue voluntary business.

The takeout process has been opaque, controversial and largely unsustainable. The state
does not disclose the process for how it vets the companies that take over the policies. “There is
no one watchdog or independent evaluator of a takeout deal who is both fully informed and fully
independent. That’s the problem,” says former Citizens board member John Rollins, who became
the company’s chief risk officer in September. “It’s the Achilles’ heel of the system.”
33
History
seems to confirm his point. In fact, the political favors associated with the approval and incentive
process have been controversial for years.

30
Commentary: Sans Storms, Florida Property Insurance Market Continues to Stabilize, March 24, 2014
31
Hurricane Insurance in Florida, Thomas von Ungern-Sternberg, Faculty of Business and Economics, University of
Lausanne
32
Weak Insurers Pul Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28
th
, 2010
33
Ibid.

11
1. Get Them off the Books - The 1996 Depop

The size of the Joint Underwriting Association (JUA, one of Citizens predecessors) exploded
after Andrew. In 1996, the State of Florida, Florida Office of Insurance Regulation (OIR) and the
JUA initiated an effort to depopulate the JUA. The depopulation effort included legislation to
permit Florida to offer financial incentives to insurers that took policies out of the JUA. The
legislation included guidelines and procedures to ensure that the OIR could expedite processing
the insurers that would be formed for the purpose of capitalizing on the financial incentives. The
program allowed 32 companies to take 1 million policies out of the JUA in exchange for $81
million in bonus money.

Citizens’ Market Share
0%
5%
10%
15%
20%
25%
30%
35%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Dowling & Partners, 2013

As the chart above shows, Citizens’ market share fluctuates a lot following hurricanes and/or
regulatory interventions. By 2000, it had shrunk to a mere 60,000 policies from over 950,000
back in 1996. However, A.M. Best, the nation’s oldest financial rating company, issued a report
warning that the state of Florida was growing companies “without the financial depth to survive a
single hurricane, let alone the state’s average of 2.5 a year.”
34
It accused regulators of paying
these new companies to assume policies from the state insurance pool and handing the riskiest
properties to “thinly capitalized, opportunistic insurers.” A.M. Best was proven right just a few
years later when the 2004/2005 season exposed the vulnerabilities of the DFIs.

CLARENDON

Back in 1997, a company called Clarendon offered to take out the riskiest policies for $300 per
policy. Some of the Citizens’ board members were skeptical of the proposal with one of them
commenting on the condition of anonymity that there were hidden costs to the plan that could
push its per-policy cost into the $600 to $1,000 range. Clarendon’s takeout proposal was
approved and 90,544 mobile homeowners, dwelling fire and homeowners policies and 40,800
policies out of the state's windstorm insurance pool were taken over. In return, the company
received incentives worth as much as $47.7 million
35
.

34
Weak Insurers Put Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28
th
, 2010
35
http://articles.orlandosentinel.com/1999-05-29/business/9905280828_1_clarendon-homeowners-policies-property

12

Following the initial success, the company was sold to the large German reinsurer Hannover Re
at the beginning of 1999 for $500M. However, even the very experienced industry operator
couldn’t make the model work. In early 2005, Hannover announced that: “Clarendon is to exit the
Florida homeowners’ market, where last year’s hurricane losses contributed to an overall net loss
of 91.4M Euros in 2004.”
36


Despite being the fourth largest writer of property insurance in Florida and having “one of the
largest and most complex reinsurance programs of any insurance company in the United
States”
37
, Clarendon was placed in runoff in July 2005 and ultimately sold to the runoff specialist
Enstar Group in 2010. That fate did not preclude the former owners and directors of Clarendon
Robert Ferguson and Ralph Milo from suing Hannover Re in 2005 for “earn out” payments for
the years 1999, 2000 and 2001.

The company marketed in Florida through its managing general agent (MGA) Tower Hill
Insurance Group. Tower Hill collected premiums, received and processed all claims, and
administered and managed all policies of Clarendon.
38
Tower Hill currently takes policies out of
Citizens. Clarendon’s underwriting coordinator, Michal Lyons is the founder and CEO of Weston
Insurance, a company that is also a current depopulator. Ralph Milo, the former Clarendon’s CEO
and Chairman and William Roche, Clarendon’s Chief Underwriting Officer are now at the helm
of the Ocean Harbor Insurance Group which includes the Safe Harbor Insurance company,
another active current Florida take out company.

POE FINANCIAL GROUP

The failure of three Poe Financial Group insurance companies after the hurricanes of 2004-05
marked the largest insurance insolvency in Florida’s history. The total bill Florida homeowners
had to foot was over $800-million. The Southern Family company of the group was granted a
license in August 1996 and began to aggressively take policies out of Citizens. In August 2006,
following the 2004/2005 seasons, the Poe Financial Group filed for Chapter 11 bankruptcy
reorganization. The state sued former mayor of Tampa, Bill Poe Sr., and 19 others, including his
wife and five children, alleging they diverted more than $140-million from the Poe insurance
companies as they headed towards bankruptcy.

2. Let’s Try This Again - The 2006-2009 Depopulation

Following the 2004/2005 storm season, Citizens adopted a $250 million loan plan that called for
13 Florida insurance companies to add as many as 1.7 million customers while substantially
shrinking Citizens policy count. However, most of those companies had fewer total customers in
2012 than expected. Meanwhile, Citizens grew from 1.2 million to 1.5 million customers.
39
As
the chart below illustrates a lot of policies were removed from the state insurer in 2007 and 2008
only to come back after a number of takeout DFIs failed.

36
Hannover Re Plans to Trim US Operations, 2005
37
Reinsurance Pricing for Florida Property Risk, Michael Lyons, Weston Insurance Holding Corporation
38
http://www.floir.com/siteDocuments/Clarendon_Select_12312004.pdf
39
Insurers Seeking Citizens Loans Fined, by Charles Elmore, The Palm Beach Post, December 9
th
, 2012

13

Policies Removed from Citizens 01/2003 – 02/2014

-
100,000
200,000
300,000
400,000
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Citizens Property Insurance Corporation

NORTHERN CAPITAL INSURANCE GROUP

In 2006, Miami businessmen Alexander Anthony and Albert Fernandez sold their security guard
business to launch Northern Capital Insurance Group (NCIC). It rocketed from $467K in
revenue in 2006 to more than $95M by 2008 and was celebrated by Inc. Magazine as “America’s
Fastest Growing Private Company.” The award provoked a congratulatory letter from Gov.
Charlie Crist thanking the carrier for its phenomenal growth.
40


The growth came at the expense of concentrating the company on the riskiest stretch of properties
between Palm Beach and Miami. Even without a storm, NCIC ran into liquidity problems, tried
to unsuccessfully raise money in the financial markets and was declared insolvent by the
Insurance Commissioner Kevin McCarty in April 2010.
41
In 2014, The Florida Department of
Financial Services (DFS), acting as a receiver for the company sued the company's directors and
officers, claiming they ran Northern Capital into the ground by recklessly pursuing take-out
policies from the state's backstop insurer.

In a complaint filed in Florida's Eleventh Judicial Circuit, DFS said the directors of the Miami-
based insurer pursued growth by acquiring high-risk, geographically concentrated “take-out”
insurance policies from the state-backed Citizens Property Insurance Corp. “The director
defendants pursued this strategy because their singular focus was on maximizing NCIC's
short-term profits to increase their own remuneration,” DFS said. “The director defendants
acted with reckless disregard for NCIC's safety and financial soundness.”

The directors netted hundreds of thousands of dollars in bonuses for themselves while the insurer
was losing money, according to the suit. “They used the assets of NCIC to fund millions of

40
Weak Insurers Put Millions of Floridians at Risk by Paige St. John, Sarasota Herald-Tribune, February 28, 2010
41
Another Florida Insurer Going Under: Northern Capital Insurance Is Insolvent, by Julie Patel, The Sun Sentinel,
April 7, 2010

14
dollars in dividend payments to themselves and other shareholders of NCIC's parent, Northern
Capital Inc.,” DFS said. The agency alleges that NCIC's directors misled the state's Office of
Insurance Regulation about the company's operations and its financial condition. DFS is claiming
gross negligence and breaches of fiduciary duty against the defendants and is seeking to recover
the funds from the allegedly fraudulent transfers.
42


MAGNOLIA INSURANCE

Then in 2008, there was the curious case of Magnolia Insurance, operated out of the Key
Biscayne home of its president Henry James Irl with the help of a Texas Post Office box and a
$24M loan from Allianz Risk Transfer. The company didn’t even have an active insurance
license when Florida regulators agreed in April 2008 to allow it to take as many as 60,000
policies from Citizens. The company ultimately assumed 116,040 policies out of Citizens in
2008.

Officials with the Florida Office of Insurance Regulation refused to discuss Magnolia with Paige
St. John, the investigative reporter of the Sarasota Herald Tribune.
43
The Florida DFS put
Magnolia into receivership in April 2010 after the company became insolvent. The DFS then
uncovered what it called “a scheme by Allianz to loot Magnolia by exerting control over its
affairs at the expense of the company and the people of Florida”, according to a complaint filed in
March 2013. Allianz denies the allegations.
44


AMERICAN KEYSTONE

Another example of the Citizens’ misguided depopulation effort was American Keystone backed
by the Sarasota entrepreneur William Griffin, whose 1999 federal conviction for generating
illegal campaign contributions had banned him from the insurance industry for life. The company
was licensed in 2008 and was approved to take some of the riskiest coastal condominium
association policies. The approval came despite numerous warnings about the company’s
precarious financial position coming from Citizens’ own staff and analysts. The company was
forced into liquidation on October 13, 2009 after it became apparent that it can not meet
minimum statutory requirements and has cancelled parts of its reinsurance for the 2009 season.
45


Shown below is a partial list of the insurance companies that have taken over policies from
Citizens and ended up insolvent, costing Florida’s taxpayers over $400M.







42
Fla Agency Sues Directors of Defunct Miami-Based Insurer, by Carolina Bolado, January 27
th
, 2014,
www.law360.com
43
Weak Insurers Put Millions of Floridians at Risk by Paige St. John, Sarasota Herald-Tribune, February 28, 2010
44

Florida Sues Over ‘Elaborate Scheme’ to Defraud Insolvent Insurer by Ken Bradley, The Knowledge Effect, Reuters, April 3rd, 2013

45
How Regulators Put Florida Homeowners at Risk, by Paige St. John, Sarasota Herald-Tribune, April 18, 2010

15
Insolvent Insurers


INSURANCE
COMPANY
Policy Takeouts
(year)
Insolvency
(year)
Cost to taxpayers
American Keystone 601 (2008) 2011 $2.3 million
Atlantic Preferred 113,577 (2003-2005) 2006 $236.9 million
Homewise Insurance 31,654 (2006) 2011 $36.2 million
Homewise Preferred 49,981 (2007, 2008) 2011 $80.4 million
Magnolia 116,040 (2008) 2010 $21.9 million
Northern Capital 22,004 (2008, 2009) 2010 $26.6 million
Source: Citizens Property Insurance Corp., FIGA


These failures have occurred without a single major storm making landfall in Florida and add
to the list failed insurers such as Coral Insurance (2009), Edison (acquired by Florida Peninsula
2010) and Argus Fire & Cas (2010). All of the companies mentioned used to enjoy an A rating
from Demotech rating service.

According to our analysis, 11 out of 29 companies that took policies out of Citizens between
2003 and 2009 ended up insolvent, were ordered to stop writing business or were “taken over” by
other takeout companies due to financial troubles. These companies represented over 35% of
all policies taken out of Citizens for the period.

There is also what appears to be a pattern of “engineered” takeovers among the depop companies.
For example, the Homewise group assumed some of the Poe group policies from Citizens after
the group was declared insolvent. Then when Homewise itself run into problems, it was taken
over by Homeowners Choice, a company currently assuming policies from Citizens. There was
also a similar transaction with Edison being purchased by Florida Peninsula Insurance.

Of the 761,000 policies that were transferred out of Citizens between 2007 and 2011, nearly 40%
have returned, as insurers went under or the customers dropped the new coverage.
46
Many of the
companies that accepted, then returned, Citizens policies received more than $150M in bonuses
and loans from the state-run company or taxpayers. In most cases, the bonuses were not
returned.
47





46
Citizens Property Insurance Corporation, Depopulation Study 2007 through 2011
47
Despite No Hurricanes, Many “takeout” Insurers Fail by Toluse Olorunnipa, Herald/Times Tallahassee Bureau,
June 3, 2013

16
3. Building on “Success” - The Current Depopulation and the New/Old Kids on the
Block

After relatively limited takeout activity from 2010 though 2012, Citizens intensified its efforts in
the last few years with a combination of “old” depop DFIs and a class of new names. The graph
below shows the top 10 takeout companies for 2013 and the first two months of 2014 with the
new program participants denoted in red.

Top 10 Takeout Companies January 2013 – February 2014
53,095
34,872
33,903
33,289
30,249
27,016
24,593
24,494
19,284
116,155
- 20,000 40,000 60,000 80,000 100,000 120,000
Heritage P&C
Tower Hill
Homeowners Choice Ins.
Southern Fidelity Ins
United P&C
Safepoint Ins.
Weston Ins.
Southern Oak Ins.
First Community Ins.
Elements
# Policies Taken

Source: Citizens Property Insurance Corporation

SOUTHERN OAK INSURANCE

Southern Oak Insurance is among the takeout “royalty” - companies that have taken the largest
number of policies out of Citizens in the last decade. The company was launched by a prominent
Democrat and a former candidate for governor, Stephen Pajcic. Southern Oak's president and
majority shareholder, Tony Loughman, and director Ron Natherson previously worked at
Citizens Property Insurance. Pajcic and his legal firm have contributed $1.6-million to Florida
political candidates between 1996 and 2008. Southern Oak received a bonus of $1.75-million in
2008 for about 38,000 policies assumed from Citizens in 2005-2006.
48


In January 2011 The Florida Office of Insurance Regulation (OIR) said it has approved the
company to take out 14,000 policies. The approval came despite serious concerns about the
company’s agreement with its Managing General Agent (MGA)—although the insurer posted
underwriting losses, its MGA was generating profits. The insurer paid the MGA $72M between
2004 and 2010, returning only $12.6M when the practice was questioned by the OIR.
49

According to the order, the OIR believed the insurer had a MGA agreement that is "unfair and
unreasonable" to policyholders.

48
A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington
and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012
49
How Insurers Make Millions on the Side by Paige St. John, Sarasota Herald-Tribune, March 14, 2010

17
The OIR also had worries about Southern Oak’s wind exposure and reinsurance retention
levels.
50
In 2012, Weiss ratings analyst Gavin Magor was quoted as saying that “Southern Oak
has insufficient reserves and poor overall stability.”
51


OLYMPUS INSURANCE

Olympus Insurance, like Magnolia, was started by taking policies out of Citizens in 2007 as a
recipient of a 20-year $16.5M surplus note from the state insurer.
52
The company was threatened
with suspension by the OIR in April of 2010 on charges of inadequate reinsurance and exorbitant
pay to its MGA. The regulator claimed that the company could not withstand an event without
becoming insolvent.
53
Olympus was cleared by Florida regulators in June 2010.
54
It was approved
to take out 15,000 policies from Citizens in October 2013.
55


SAFE HARBOR INSURANCE

Safe Harbor is part of the Ocean Harbor Group of companies controlled by Ralph Milo whom we
discussed previously in relation to Clarendon. Safe Harbor was downgraded by A.M. Best to C
(Marginal) from B (Fair) in June 2012 following the acquisition by the group of a Midwest and
Hawaiian insurers. Concurrently, A.M. Best has withdrawn the ratings in response to Safe Harbor
management’s request to no longer participate in its interactive rating process.
56
The company is
still rated A by Demotech; however it has almost twice the number of complaints per policy than
the average Florida insurer (and an F rating) based on data from 2009 through 2012.
57


ELEMENTS INSURANCE

Elements Insurance was started in September 2013 sponsored by Dowling Capital Partners and a
number of (re)insurance carriers including AXIS Capital, Arch Capital, Renaissance Re and
Ironshore. Florida insurance industry veteran Robert Ricker who was Citizens president from
2003 through 2006 serves as CEO. On Sept. 27, the Tallahassee-based company received a state
license to do business in Florida. On the same day, it received state insurance regulators' approval
to take on 45,000 Citizens policies.

The swift consent came even before Elements received approval to sell the catastrophic coverage
required by Fannie Mae and Freddie Mac, the nation's federally-backed mortgage lenders. The
company has been assigned a Financial Stability Rating of A from Demotech. As the Sun
Sentinel noted: “It's hard to know exactly what carried the day for Elements — or any other

50
Southern Oak to Assume 14,000 Fla Last Resort Insurance Policies, by Chad Hemenway,, January 18, 2011
51
A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington
and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012
52
Small companies dominate Florida insurance market by Beatrice Garcia, The Miami Herald, August 4
th
, 2008
53
Florida Regulator: Olympus Insurance Must Take Corrective Action or Face Suspension
54
http://www.insurancejournal.com/news/southeast/2010/06/10/110622.htm
55
More Citizens Policies to Be Moved but Previous Takeout Numbers Down, The Florida Current, October 3
rd
, 2013
56
A.M. Best Downgrades and Withdraws Ratings of Safe Harbor Insurance Company, Press release June 29, 2012
57
http://smartshopyourcarinsurance.com/Blog/?p=2943

18
takeout company, for that matter — because the process for vetting the companies is done
confidentially.”
58


HERITAGE INSURANCE

The biggest of the new upstarts is Heritage Insurance (HRTG). Incorporated in August 2012 it
managed to assume policies on seven different occasions in 2013 and 2014.
59
In May 2013 in a
deal that did not go through the usual approval process and was voted 3-2 by the Citizens’ board,
Heritage received $33M in premiums dating back to Jan 1 to remove 40,000 policies. It also
could earn another $43.8 million in unearned premiums on those policies for a total of $76.9
million.

Carol Everhart, a Citizens governor stated: “I am concerned that Citizens’ staff is so focused on
reducing exposure that it may not being using Citizens’ earned surplus to best serve its
policyholders. We’re giving up a lot of surplus that could be used in the event of a storm. We
need to get the public trust on Citizens’ side again, and I believe this is not going to help us. I am
not in favor of that assumption.”
60


Heritage donated more than $140,000 to Gov.Scott and the Republican Party of Florida in recent
months, and spent tens of thousands more lobbying the Legislature. The firm employs the ex-
Insurance Commissioner Tom Gallagher as a lobbyist.
61
The efforts seem to have paid off
through the special treatment from Florida's state-run insurance firm in the form of the unusual
and lucrative "reinsurance quota share" agreement.

The company’s president Richard Widdicombe has run a handful of insurance companies in
Florida and at least two of them were cited for dozens of violations, ranging from “failure to pay
claim timely” to “failure to comply with unfair trade practice requirements to making
“misleading” advertisements.
62


The central tenet of the Heritage business plan is taking advantage of the extremely low cat bond
pricing to lower the cost of reinsurance. It has issued $200M through its Citrus Re vehicle (we
hope it is not a lemon). The company did an initial public offering in 2014 raising $66M ($30M
less than it had hoped for). Nephila Capital, the largest alternative reinsurance capital manager
and a participant in the HRTG’s reinsurance program, was eager to put even more money to work
by investing $10M for a minority equity stake in a private placement.

Despite its short existence, Heritage has already taken over 116,155 policies out of Citizens or
6.2% of all depopulation policies between 2003 and 2014. In return the company has committed
to not only keeping the policies for three years but not raising prices by more than 10%.

58
Many Homeowners Will Soon Be Unable to Stay with State-backed Insurer Citizens by By Kathleen Haughney
and Maria Mallory White, Sun Sentinel, November 2
nd
, 2013
59
https://www.citizensfla.com/about/depopinfo.cfm
60
Citizens Property Insurance Corp, Minutes of the Board of Governors Meeting, May 22
nd
, 2013
61
After Big Donations to Governor Scott, Insurance Company May Reap $52M, By Toluse Olorunnipa,
Times/Herald Tallahassee Bureau, May 21
st
, 2013

62
Despite hundreds of insurance violations, president of upstart company could get $52 million deal from Citizens,
Toluse Olorunnipa, Miami Herald, May 22
nd
, 2013

19
It was also granted permission to take over the policies of Sunshine State Insurance, another
failed DFI. Sunshine announced significant accounting restatements related to its reinsurance
contracts in March 2014. In May, after a few weeks of due diligence, United Insurance Holdings
Corp. (UIHC) terminated its bid to acquire the financially-troubled company. On June 13
th
, 2014,
HRTG announced received a court order to takeover approximately 35,000 policies of Sunshine.

WESTON INSURANCE

This was not the only subsidy Citizens bequeathed upon an upstart private insurer in 2013 using
its surplus. In February 2013, Citizens' board approved a deal with Weston Insurance, agreeing
to pay the young company $63 million to take out 30,000 policies. The company has spent more
than $250,000 on lobbying in 2013, and two of Citizens' seven board members abstained from
voting on the deal because of conflicts of interest.

The company was licensed for wind-only coverage in December 2012, a market previously
handled only by Citizens. Perhaps the most disconcerting thing to its clients – and Florida
Insurance Consumer Advocate Robin Westcott – is the high interest Weston is supposed to pay
on a $15 million, 10-year surplus note (basically a loan) that it used to boost reserves. The terms
call for escalating interest in the 15-20 percent range, which Westcott called "pricey" and
"dangerous."
63 ,64


In both deals, the payments are structured as backdated "reinsurance" agreements, where
Citizens essentially pays the company to cover Citizens' losses on certain policies over a specified
period of time. Since the period of time is in the past, the company can actively select policies
that had no losses, in effect making the deal virtually risk-free.
65
Under terms of the takeout,
when policies renew, Weston will also have to adhere to the same 10-percent rate-hike cap as
Citizens for three years.

HOMEOWNERS CHOICE

Another member of the takeout “royalty” is Homeowners Choice Property & Casualty
Insurance Co. Inc (HCI). It was founded by Pareshbai Surykant Patel in 2007 it counts the past
president of Citizens (2007-2011) Scott Wallace as a president of its property/casualty division.
Despite the inadequacy of the Citizens’ rates, the company did not have any rate increases at its
first six takeouts. Clearly, they have discovered something nobody else is aware of.
66

67
Gavin
Magor, senior financial analyst with Weiss ratings was quoted as saying that Homeowners
Choice has grown too fast and, despite rising capital, may have trouble dealing with a major
event.
68


63
Despite hundreds of insurance violations, president of upstart company could get $52 million deal from Citizens,
Tolu Olorunnipa, Miami Herald, May 22
nd
, 2013
64
Can Insurance Upstarts Be Trusted to Replace Citizens? By Michael Mayo, Sun Sentinel, June 8, 2013
65
Ibid.
66
A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington
and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012
67
Citizens Depopulation Summit, June 1, 2012
68
A Closer Look at Five Insurers Taking a Big Chunk of Citizens Property Insurance Policies, by Jeff Harrington
and Toluse Olorunnipa, Tampa Bay Times, October 3, 2012

20
DFIs Assuming over 5% of the Citizens Takeout Policies 2003-2014
Southern Oak,
11%
American
Integrity, 9%
Heritage, 6%
Magnolia, 6%
Poe Group, 6%
United, 6%
Others, 31%
Homeowners
Choice, 12%
Florida
Peninsula, 13%

Note: Homeowners Choice share includes policies assumed by the Homewise group; Florida Peninsula share
includes policies assumed by Edison Ins.
Source: Citizens Property Insurance Corp.

As the chart illustrates, eight companies have assumed more than 2/3 of the policies taken out of
Citizens over the last decade. Two are insolvent – Magnolia and the Poe group and two other -
the Homewise group and Edison were taken over when they ran into trouble. Mr. Patel, the CEO
of HCI, has likened the process of creating DFIs to one more familiar to those working in a
slaughterhouse or a butcher’s shop: “It's like making sausage. It's not a pretty process. What the
insolvencies tell you is there is risk. You can go out of business without a hurricane. “
69
Just don’t
ask what’s inside.
4. The Verdict on the Depopulation Efforts – Political and Inefficient

The insolvencies, the political contributions, the revolving management door between Citizens
and the takeout DFIs coupled with the lack of clear rules has tarnished the reputation of the
process’ participants. There is evidence of a widespread consumer lack of confidence in the
takeout DFIs with cases of 9,200 out of 30,000 policies opting out on a single takeout. There has
been an effort to try and portray the DFIs as stable insurers in order to reduce the churn of the
process which according to Bob Ritchie, the CEO of American Integrity reached 50% on one of
their assumption deals. There have also been suggestions to limit the ability of people of opt-out
of a takeout.
70
The recent introduction of the clearinghouse is a step towards making the process
involuntary for the insured.


69
http://www.tampabay.com/news/business/banking/going-where-others-fear-to-tread-pays-off-for-ceo-of-
homeowners-choice/2152685
70
Citizens Depopulation Summit, June 1, 2012

21
The reasons for the churn are multifaceted with price adequacy, captive Citizens agents and high
non-cat losses all major issues. Citizens usually provides incentives to the takeout companies.
However, due to the political sensitivity to direct subsidies (a proposed $350M surplus notes
program was recently tabled), the inducements are in the more opaque form of lowered
reinsurance costs and zero assumption commissions. The companies are allowed to assume
policies in November/December without purchasing reinsurance till June. Alternately, companies
that assume policies closer to the June 1 can be paid through backdated reinsurance contracts.

The current system creates the potential for private carriers to realize several months of unearned
premium without assuming full risk. Policies can then return to Citizens if the price is increased
significantly upon renewal. As a result Citizens is left with half of its annual premium to cover
most of the wind risk on these policies.

A 2012 survey of DFIs showed that only 9% of the participants had an interest in removing
policies from Citizens. The inadequate rates were cited as the biggest reason for the lack of
interest, with cost of reinsurance, quality and availability of data from Citizens and the average
annual loss-to-premium ratio of the properties making up the top four insurers’ concerns.
71
As
Bob Ritchie from American Integrity sums it up: “There are three things that are needed to
depopulate Citizens – rate, rate and rate..”
72


According to a May 2013 study by Goldman Sach’s Investment Banking Division presented to
Citizens to evaluate the viability of its proposed surplus note program, the takeout policies of the
sample portfolio submitted by the Tower Hill company are barely profitable to the DFIs. The
only desirable economics are in the initial period before the first policy renewal where high
profitability is driven by the lack of administrative expenses, acquisition and reinsurance
costs.
DFIs vs. Citizens’ Expenses as % of Premium

Source: Goldman Sachs, May 2013


71
https://www.citizensfla.com/bnc_meet/docs/471/03B_Depopulation_Report_final_7_26_12.pdf
72
Citizens Depopulation Summit, June 1, 2012
35.3%
9.5%
40.0%
40.0%
25.0%
12.3%
0%
25%
50%
75%
100%
DFI Citizens
Reinsurance Costs Non-Cat Losses Administrative Costs
100.3%
61.8%

22
Rates adequacy is required for sustainability of the takeout process. However, rates are a
politically-driven issue in the state of Florida. With close elections in the fall of 2014, the
future direction of insurance rates is highly uncertain. Ex-governor Democrat Charlie Crist
moved aggressively to contain insurance premiums when he was in office through Citizens rate
freezes (2007-2009) followed by a glidepath increases of no more than 10% a year and wind
mitigation credits widely criticized by the industry which reduced premiums by 20% to 50%.
Most DFIs were pushed in the red from 2009 to 2011.

The Republican Rick Scott assumed the Florida governor’s office in January 2011 having spent
$75M of his own money in the campaign. A few months later he signed a sweeping property
insurance reform that allowed insurance companies to pass on reinsurance costs to policyholders,
shortened and limited the window for filing sinkhole and storm-related damage claims. Private
companies were allowed to file for and were approved for significant price increases with the
OIR and a new Citizens bill limiting its exposure was passed in 2013.

However, with looming 2014 gubernatorial elections, Florida Chief Financial Officer Jeff
Atwater sent a letter to the OIR in August 2013 in which he questioned why the rates are not
falling given the falling reinsurance prices. It took the Florida Insurance Commissioner Kevin
McCarty (serving under both Crist and Scott) six months to reply but in January 2014 filings for
rate reductions (from 2.4% to 9.2%) from the largest insurers are reported by the OIR
73
.

This fall will see Mr. Crist and Mr. Scott battling it out in a contested election the results of
which can be as powerful as a category 5 hurricane on the DFIs. As Tower Watson summed:
“The legislative process is one of the greatest risks that companies face in Florida.”
74


Although conceived as a way to decrease the state’s involvement in the insurance market and
increase the private bearing of risks (largely through the Bermuda reinsurance market), the
depopulation program’s administration, the line between public incentives for private gain and its
ultimate result remain controversial. The simple solution of pushing policies to private companies
actually shifts the riskiest policies to Florida’s smaller insurance companies. Ultimately, rate
regulation will become more tenuous as small insurers, having the least amount of rate flexibility,
seek larger and larger rate increases to compensate for the increased risk of their portfolios.
Absent those increases and the backstop of cheap FHCF reinsurance their business model is
unsustainable despite the incentives.

Some consumer groups have also questioned the ability of certain insurance companies to pay
claims in the event of a large-scale disaster – potentially leaving the state with the balance. Bill
Newton, executive director of the Florida Consumer Action Network, asks, “How is that any
different from Citizens assessments, should they occur? It isn’t any different at all.”
75




73
Reinsurance Costs Helping Lower FloridaHomeowners Rates: OIR report, by Michael Adams, Insurance Journal,
January 21, 2014
74
The Changing Winds in Florida, Property Insurance Implications by Bob Betz, Judith Durdan, Lloyd Stofko and
Brian O’Neill, Towers Watson
75
How Will Depopulating Citizens Insurance Affect Florida by Alice Holbrook, April 14, 2014, Property Insurance

23
Below is a realistic picture of the Florida insurance market. In 2013, Weiss Ratings, one of the
most respected rating agencies - not paid by the insurers - gave the DFIs barely passing grades.

76
barel

The current efforts to limit the size of Citizens try to mask both the risk subsidy problem and the
risk pooling problem of the system. The shifting of policies to companies that are Florida-only
concentrates rather than spreads risk. Insurance is predicated on pooling; it works effectively
when losses from any individual event are embedded in a pool so large that the loss from any
single event is immaterial.
77
According to a top insurance executive “No other state could get
away with doing all the goofy things that Florida is trying. There is just so much premium in
Florida that companies are bending over backwards to stay in.”
78


As history has shown the current Citizens depopulation model largely leads to the privatization of
gains (via policy assumption incentives and prepaid reinsurance) and socialization of losses after
insolvency puts the weak DFIs out of business. Barry Gilway who became president of Citizens
in 2012 admitted that “There is enormous pressure to reduce the policy count in Citizens. The
questions is: how do you do it?”
79


76
http://www.palmbeachpost.com/news/business/real-estate/weiss-rates-usaa-citizens-strong-other-florida-
ins/nWHhd/
77
Florida’s Financial Exposure from its “Self-Insurance” Programs, Special Report, April 2010, Florida Council of
Economic Advisors at Florida Tax Watch
78
Restoring Florida Insurance Market, Eli Lehrer, The James Madison Institute, Issue 55, February 2008
79
Property Insurance Report, Vol.19, November 5
th
, 2012

24
IV. Reliance on Reinsurance and the Capital Markets

It is the extremely low reinsurance prices of the last few years that have allowed the current
depopulation effort to appear a “success”. Florida has tried to mitigate some the current DFIs
risks through reliance on reinsurance (see chart below). In its traditional form, reinsurance is
insurance for insurance companies, policies bought in relatively small amounts to protect carriers
from the remote chance of a very large disaster. However, due to the structure and players in the
Florida property market, reinsurance has replaced traditional insurance altogether in all but name.
According to Aon Benfield 2012 report, reinsurers’ exposure to a Florida 1 in 100 year and 1 in
250 year events is 26.4% and 24.4% respectively expressed as a ceded percent of gross loss.
80
We
think that exposure has grown further over the last two years.

Bermuda-based reinsurance is “the lifeblood for scores of under-capitalized, highly leveraged
start-up insurers”
81
, according to Christian Camara, director of the Florida Insurance Project at
the Heartland Institute think-tank in Tallahassee:“ Reinsurance comprises between 37% to 64%
of expenses of the DFIs as compared to a nationwide average figure of 19%. That makes the
business model extremely sensitive to changes in reinsurance pricing. Luckily for the DFIs,
the influence from direct capital markets’ participation in reinsurance programs, coupled with
catastrophic insured losses well below historical averages in 2013, put enormous pressure on
global catastrophic reinsurance pricing.

Structure of the Florida’s Property Insurance and Reinsurance Market


Source: Dowling & Partners, June 13
th
, 2013

80
Credit Risk of Property Catastrophe Reinsurers, Aon Benfiled, Summer 2012
81
Bermuda Controls Floridians’ Hurricane Insurance Rates, by Paige Saint John, The Sarasota Herald Tribune,
October 24, 2010
Citizens
(28%, $2.7B)
Other Nationals
(15%, $1.5B)
FL Stand Alones
(57%, $5.5B)
FHCF
($995M)
Private
Reinsurance
3rd Party
($3,290M)
Bermuda
(50%,$1,665M)
Other
(50%, $1,625M)
Primary Florida Market
$9.8B (2012)
Florida Reinsurance Market
$4.3B (2012)

25
1. Glut of Alternative Capital Compresses Reinsurance Pricing

The reinsurance industry has changed drastically in recent years. The low interest rate
environment has prompted large investors (mainly pension funds) to look for yield and
diversification in non-traditional asset classes and has precipitated an influx of capital to ILS
(Insurance-linked Securities) space (see chart below).

Being Lured by High-Yield Uncorrelated Cat Risk



Guy Carpenter, a broker, puts the non-traditional capacity at 14% of total worldwide cat limits
and predicts that it will ultimately comprise 20% to 30% of total reinsurance spend. Aon Benfield
estimates that as much as $100B of alternative capital can flow into reinsurance in the next five
years on top of the current record level of $525B of global reinsurer capital.
82,83
John Nelson,
chairman of Lloyd’s, the world’s oldest insurance market, called on regulators in London last
month to be “extremely watchful” of alternative capital, saying the new entrants could pose a
threat by pricing risk too cheaply.
84


Some traditional players like Berkshire Hathaway have pulled back on the U.S. catastrophe
re/insurance business as they felt that the rates no longer commensurate with the risks. While
pricing and premiums on U.S. catastrophe reinsurance business have declined, Buffett does not

82
S&P: Bermuda May Become a Victim of Its Own Success, Bermuda Insurance Magazine, April 24, 2014
83
Reinsurance Market Outlook, Aon Benfield, January 2014
84
http://www.businessweek.com/news/2013-10-27/pensions-muscle-into-reinsurance-for-yield-in-catastrophe-
wagers#p2

26
feel that the risk of suffering losses have declined, suggesting he no longer finds the market
appealing at current rates.
85


The chart below outlining the rate-on-line (ROL) which is the price paid for reinsurance vs. the
expected loss confirms Mr. Buffet’s observation. The ILS market is now offering the lowest cost
of reinsurance for peak perils witnessed since [1992’s] Hurricane Andrew.
86


Willis ROL vs. Expected Loss Index


Source: Willis

Lane Financial analyst Morton Lane calculated that deals with expected losses of around 100
basis points (a 1-in-100-year event) have historically attracted multiples of 4.25x in softer
markets and 6.25x in harder markets. These boundaries are being pushed lower than ever, with
multiples of around 3x the expected loss common for 2014 deals.
87

The collapsing reinsurance prices for Florida cat risk are reflected in Citizen’s rate on line nose-
diving from 21% to below 10% in four short years.









85
Warren Buffett: U.S. Catastrophe Rates Too Low for Berkshire Hathaway, www.artemis.bm, March 15, 2014
86
Reinsurance Market, Aon Benfield, Reinsurance Capacity Growth Continues to Outpace Demand, Jan 1, 2013
87
The Road to Lower Returns, Insider Quarterly

27
Citizens Risk Transfer and ROL 2011-2014


Source: Artemis

In April 2012, Citizens issued its first catastrophe bond through Everglades Re Ltd., a special
purpose vehicle formed for the issue. The $750M bond has an expected loss of 2.53% and a
coupon of 17.75%. However, the $250M Citizens’ bond issued in 2013 yields only 10% (below
its suggested range of 11%-12%) despite sitting lower in the loss structure. In 2014 Citizens
increased the size of its bond offering from $400M to $1.25B with yield pushing lower to 7.5%
for the much broader cover of an aggregate protection and the much larger amount of coverage
secured. As Artemis commented:” The reinsurance and capital markets have supported Citizens
risk transfer needs at a low-level of pricing that it may never witness again.”
88


The 2014/2015 Florida cat reinsurance market has been described as a “bloodbath” by some
analysts with rates dropping between 15% and 30%.
89
Universal Insurance Holdings, a DFI,
has recently reported that it has achieved “extraordinary cost reductions” at its 2014/2015
reinsurance contracts with pricing some of the “most competitive the firm has seen in its history.”
Further, it noted that the traditional reinsurers matched the quotes offered by the ILS space. “In
fact, in some cases the ILS specialists have been the ones matching prices proposed by the
traditional market as the competitive desire to sign premiums has resulted in reinsurers outpacing
ILS price declines on some programs.”
90


Please contact us if you have an interest in discussing the specific reinsurers’ and others
exposures to Florida risks and particular programs.

Kevin O’Donnell, the President & CEO of Renaissance Re, the largest Florida reinsurer has
commented on the company’s last conference call (April 30
th
, 2104) that: “ At a macro level, we
are starting to see undisciplined behavior with some risk being priced below an acceptable level
of return for any form of capital. This behavior cannot persist permanently in financial

88
http://www.artemis.bm/blog/2014/04/28/florida-citizens-buys-68-more-reinsurance-for-2014-at-less-cost/
89
http://www.insiderquarterly.com/florida-bloodbath
90
Nephila Capital Helps Universal to Extraordinary Reinsurance Cost Reductions by Artemis, June 3
rd
, 2014

28
markets. On the other hand, it can exist for a long time, and pricing decisions by suppliers
are often only revisited after an event.”
91
Markel Global Re president Jed Rhoads said “There
is some fundamental core pricing to our business or it makes a mockery of what I've done for a
living for a very long time,"
92


Reinsurance companies have traditionally provided reliable coverage to Florida losses and have
maintained high credit ratings. The rating agencies (A.M.Best and S&P) have increased the
industry’s capital requirements following the WTC attacks and the U.S. hurricane activity of
2004/2005. The four reinsurance companies that were placed in run-off following catastrophic
losses in 2004/2005 – Olympus Reinsurance, PXRE Reinsurance, Quanta Reinsurance and
Rosemont Re – settled most of their claims (over 99% of the catastrophe loss balances have been
paid).
93


However, the reinsurance industry is facing some significant changes. As Willis Re Chairman
noted, “To date, the traditional model of fresh capital coming into the market has been through the
formation of new companies but it is being overtaken by a new model of fast capital flowing in
through less permanent structures. For an industry where primary insurance companies value
sustainability, this emerging model brings many challenges. While some reinsurers are
considering how to respond, others are developing third party capital management propositions to
offer their own skills and platforms as fund managers. The advent of new capital is likely to have
a significant impact on any post-event response which may occur after a major loss.”
94

In a recently issued report on the state of Bermuda reinsurance, the S&P analyst Gharib argues,
“We think that companies without a defendable competitive position, or those that are more
aggressive in maintaining market share by competing on price or relaxing their underwriting
discipline, are most at risk. We could revise our assessment of those (re)insurers' business risk
profiles to reflect the relatively higher risk. In addition, we believe Bermudian (re)insurers with
diminished capital buffers, or those whose earnings capacity is persistently constrained, could
face rating pressure.”
95

Adding to the weakening reinsurance fundamentals, in 2007 Florida became the first state to
enact a statute authorizing waiver or reduction of collateral requirements for non- U.S.
reinsurers. The move was a direct response to the 2004/2005 hurricane season and the state’s
desire to attract more reinsurance capital to its property insurance industry. Prior to the 2008 rule
based on the law, foreign reinsurance companies generally were required to post 100 percent
collateral while regulated United States insurers posted no collateral.

To qualify for waiver or reduction of collateral, a non-U.S. reinsurer must meet certain minimum
financial requirements. The reinsurer must have surplus in excess of $100 million and have a
secure financial strength rating from at least two nationally recognized statistical rating
organizations deemed acceptable to Florida. Generally speaking a credit rating of AAA from the

91
http://seekingalpha.com/article/2178113-renaissancere-holdings-ltd-s-ceo-discusses-q1-2014-results-earnings-call-
transcript
92
http://www.insiderquarterly.com/florida-bloodbath
93
Credit Risk of Property Catastrophe Reinsurers, Aon Benfield, Summer 2012
94
Willis Re Says Cat Bonds a Threat to Reinsurers, the Royal Gazette, April 4
th
, 2013
95
Barbarians At the Gates: Are Bermudian (Re)insurers Victims of Their Own Success,

29
S&P allows a foreign reinsurer to post no collateral, AA allows for 10%, A allows for 20%, and
BBB for 75%.
96
The first agreement was signed with Hannover Re in 2010. There are now over
20 “Eligible Reinsurers” in Florida.
97


Back in 2007, the National Association of Mutual Insurance Companies (NAMIC) with members
representing 31% of the Florida market wrote in its comments opposing the waiver rule, "The
proposed rule could lead to a weakened solvency position for U.S. primary insurers.” “It is
critical to note that any weaknesses in a relaxed collateral regime will be revealed only in the
wake of catastrophes or events leading to large numbers of claims. Even the reinsurer with superb
financial strength before a major catastrophe may be sorely tested by such an event and
experience financial weakness as a result of having assumed catastrophe and related risk.”
98


Rating downgrades of some of the Bermuda reinsurers can potentially trigger a daisy-chain of
collateral requirements. The search for uncorrelated yield has once again resulted in pricing that
does not compensate for the risks. Reinsurance pricing can be a fickle matter especially if
market conditions tighten and/or catastrophic events test the new alternative structures.

2. Why Reinsurance is Crucial to the Florida Market?

Florida as a state comprises nearly 10% of the nation’s total direct premium written (DPW) in
homeowners insurance. Selling nearly 29% of the State’s DPW in homeowners insurance, DFIs
are responsible for a substantial portion of homeowners risk in the State. Clearly, Florida
independent insurers collect a lot of premium.

The surplus levels shown in table below reflect the most disconcerting difference between Florida
and other states. Despite its relatively large market size, Florida’s year-end 2011 policyholder
surplus (PHS), at just under $93 billion, was lower than any of the other hurricane-exposed states.
Despite their 29% market share of premiums, DFIs contributed only slightly more than 1% of the
State’s total PHS, at slightly over $1 billion.
99


The current Florida homeowners’ insurance market is heavily dependent on small companies
with limited capitalization and risk diversification capabilities. Despite collecting a lot of
premium, they operate on a tiny level of capital surplus.










96
http://www.floir.com/siteDocuments/ReinsuranceCollateralRule.pdf
97
http://www.floir.com/sections/pandc/eligiblereinsurers.aspx
98
http://www.namic.org/pdf/071210FlaReinsComments.pdf
99
The State of Florida’s Property Insurance Market, The Florida Catastrophic Storm Risk Management Center,
January 2013

30
Group and Independent Insurers’ Share of DPW and PHS

2011 Direct Premium Written DPW (in $ M)
Insurer Type Nat'l FL TX GA
Group $ 59,761 94% $ 4,303 71% $ 3,992 96% $ 1,817 99%
Independent $ 3,848 6% $ 1,745 29% $ 171 4% $ 19 1%
Total $ 63,609 $ 6,048 $ 4,163 $ 1,836
2011 Policyholders Surplus PHS (in $B)
Insurer Type Nat'l FL TX GA
Group $ 290 97% $ 92 99% $ 119 99% $ 164 99%
Independent $ 8 3% $ 1 1% $ 1 1% $ 1 1%
Total $ 298 $ 93 $ 120 $ 165
Source: The Florida Catastrophic Storm Risk Management Center

The DFIs have very limited levels of capital surplus. Instead of trying to build reserves over
time, the current model encourages the siphoning of cash out of the statutory insurance
companies through different mechanisms. Reinsurance enables the fast growth. Instead of
building up a company slowly by amassing enough surplus to write new policies, new insurers
can pledge a portion of future premiums and instantly take on thousands more customers and
billions more dollars in hurricane risk.
100
In the absence of reserves, the only thing standing
between disaster and billions of dollars of coastal exposure is reinsurance.

The question is whether the DFIs are buying enough or the right coverage for their exposures.

3. How Much Reinsurance to Buy or How to Use Catastrophe Models?

That is a difficult question to answer. Current (re)insurance pricing and probable maximum loss
(PML) estimates are based on computer models that came into existence post hurricane Andrew.
Back in 1992, a woman by the name of Karen Clark contended that the industry vastly
underestimates losses following a few quiet decades. She was proven right as her estimate of
Andrews’ damages of $13B came much closer to the $15.5B of actual losses compared to that of
Lloyd’s at $6B.
101


This event gave rise to the computer hurricane loss estimation modeling industry that uses long-
term storm historical data, building codes and structure information to calculate PMLs for the
(re)insurance industry. There are three major players: AIR (Ms. Clark’s firm which she sold in
2002), RMS and Eqecat. Conceptually the models consist of three modules: the hazard module
simulates possible storm paths and wind speeds, the engineering (vulnerability) module applies
engineering statistics to calculate exposures affected by the storms and the financial module

100
Weak Insurers Pul Millions of Floridians at Risk by Page St. John, The Herald Tribune, February 28
th
, 2010
101
In Nature’s Casino by Michael Lewis, The New York Times, August 26, 2007

31
providing loss estimates. Some of the models are even incorporating the probable effects of the
warming of the Altantic Ocean on hurricane landfalls along the US coast.
102


However, the models have overestimated the insured losses from 2006 to 2010 by as much as
$45B. Ms. Clark has cautioned against the use of long-term models to provide short term
estimates. “Using the information in models to pinpoint a metric (such as a 1-in-100-year PML)
is not helpful,” she said. “Models can get you a range—they can get you in the ballpark—but
you can’t narrow the range.” “That is the whole point,” she said. “[Hurricanes] are random. You
can’t predict when there will be an increase in losses and there is no connectivity to the frequency
of storms.”
103


The problem is how to measure the level of reinsurance necessary for thinly capitalized DFIs. In
2010 Florida removed its long standing mandate that required insurers to purchase reinsurance up
to 1 in 100 PML based on an approved model. The Insurance Commissioner Kevin McCarty
argued that the move will lower consumer premiums.
104
Instead, the OIR has focused more on
multiple events (side) coverage and reinstatements as opposed to one-storm coverage (top).
105

The Demotech rating agency still requires the DFI to purchase reinsurance covering both 1 in 100
PML for a first event and 1:50 PML for a second event in order to keep their A rating.
106


Although according to Florida’s Insurance Commissioner, nearly all private insurers in Florida
purchase insurance up to at least 1 in 100 year storm, the financial impact on any given storm is
expected to vary widely between insurers depending upon their individual reinsurance programs
and spread of risk. As Robert Westcott, the state’s insurance consumer advocate sums it: “It is
conceivable that some private domestic insurers will fail in events less than the 1 in 100 year
storm.”
107


The exposure estimates vary significantly depending on the model/s used and the different model
versions. AIR and RMS estimate losses from 1 in 100 US hurricane event at $124B and $180B
respectively (over 30% difference) and losses from 1 in 250 US hurricane at $199B and $263B
respectively (24% difference).
108
Guy Carpenter analysis shows that the uncertainty around the
mean estimated values is so significant that a two standard deviations interval for a national
writer’s 100-year or higher PML goes from 50% to 230% of the PML estimate.
109


Given the very limited historical data on event generation, the models are unlikely to ever be
accurate despite the scientific advancements. As a result, the insurers (and the regulators) need to
operate with the understanding that catastrophe risk is characterized by deep uncertainty and
work to diagnose the sensitivity of their own portfolios to key uncertainties in the model. The
hurricane risk should be thought about as a fairly wide band of uncertainty around the output of

102
http://www.ft.com/intl/cms/s/0/76438596-0432-11e3-8aab-00144feab7de.html#axzz30pjoCeGq
103
http://www.propertycasualty360.com/2011/01/18/near-term-models-misjudge-hurricane-losses-by-bill
104
In Major Hurricne, Insurers Face Huge Risk, by Paige St. John, The Herald Tribune, July 24
th
, 2011
105
Why Florida is Rethinking its 1 in 100 Reinsurance Requirement, http://www.insurancejournal.tv/videos/3814/
106
http://www.demotech.com/pdfs/papers/20140207_fl_whitepaper_addendum.pdf
107
Office of the Insurance Consumer Advocate, Robin Smith Westcott, Esq, June 24
th
, 2013
108
A Primer on Property Catastrophe Risk, ILS Capital Management
109
Opening the Black Box, Special Report: CAT Modeling, Global Reinsurance, March 2013

32
any cat model, typically illustrated as a loss exceedance curve (see graph below). Such a view
lacks the comfort of a single point estimate but paints a more realistic picture of cat risk.

Loss Exceedance Curve

How protected are the DFIs from a big hurricane or
a series of storms? It depends. Some companies
have purchased much more coverage than others. A
review of the DFIs 2011/2012 storm season
coverage by the Herald Tribune revealed that about
half the companies barely had 1 in 100 year
coverage while the other half had programs as
robust as 1 in 250 year suggesting that there are
two business models at work: companies interested
in staying in business for the long run where
premium is enough to properly reinsure the book and “risk brokers” that are unable to finance a
proper program and are willing to take big risks while in the meantime reaping the benefits of the
event-free years.
110


The importance of the intersection between models and insurance is highlighted by reviewing the
reinsurance practices of the biggest private Florida insurer - Universal Property and Casualty
Insurance (UVE), a public company. It carries 500,000 policies for a total insured value of
$107B.
111
The company is an example of an odd Florida growth story that started life as a
distributor of sports memorabilia and then dabbled in pest control and pool cleaning. In 2006
Universal’s small insurance operations took off with the help of a $25M surplus note from the
state of Florida. The company underwrites risky policies in the Miami-Dade, Broward and Palm
Beach counties most of which otherwise will be taken only by Citizens.

We have reviewed the company’s OIR filings since 2008 and discovered that the catastrophe
models that the company uses to evaluate the level of reinsurance required are all marked as
trade secret. The company’s PMLs for each of those years for different frequencies of events are
also not available. Some disclosures are made in the SEC filings for certain years but, by and
large, the information is not available. Some of these confidential documents were leaked to the
Herald Tribune in 2011 and revealed that for that particular year UVE had coverage to about 1
in 80 event, putting the company in direct violation of its surplus note covenants. The
insurance commissioner refused to comment saying “to do so could imperil the
company.”
112


As the table below highlights, not only was UVE in violation of its covenants but the company
would have been insolvent had one storm occurred with a first event representing 145% of the
company’s surplus at the time. Based on our analysis, the book was largely uninsurable in an
economic way at the time which UVE tried to circumvent by employing segregated cell T25 to

110
In Major Hurricane, Insurers Face Huge Risk, by Paige St. John, The Herald Tribune, July 24
th
, 2011
111
FLOIR database as of Q4/2013
112
Ibid.


33
reinsure itself. The OIR questioned the practice and more specifically the provision of a
guaranteed profit of 25% to the captive reinsurer in a filing but ultimately chose not to act.

Universal Insurance Surplus and 1
st
Event Exposure 2008-2014

Jun-14 Jun-13 Jun-12 Jun-11 Jun-10 Jun-09 Jun-08
Surplus $180,220 $151,894 $144,668 $108,611 $106,714 $103,100 $87,862
Exposure
1st Event
$23,500 $30,000 $129,470 $157,600 $73,000 $75,000 $70,000
% of
Surplus
13% 20% 89% 145% 68% 73% 80%
PML freq.
TradeSecret TradeSecret TradeSecret
1 in 80 1 in 127 1 in 114 1 in 145
Model
TradeSecret TradeSecret TradeSecret AIRv.12.04 AIR v.11.0 TradeSecret TradeSecret
Note: The 2014 statutory surplus data as of March 2014
Source: OIR, SEC filings and estimates

We understand the OIR’s hesitation in creating a tenuous situation at the state’s largest private
insurer in the middle of a hurricane season. However, we believe UVE’s level of risk should not
have been acceptable to any insurance regulator. Finally, the OIR addressed some of these and a
laundry list of other issues (such as post claim underwriting, excessive junior mining stock
trading, losses and commissions, etc.) in a May 2013 order and imposed a $1.26M administrative
fine on the company. Four months before the order was issued, Bradley Meier – the UVE’s
largest shareholder, as well as chairman, CEO and President – resigned.

UVE’s current reinsurance program (outside of a broad outline filed as an 8K with the
SEC) as well as the model the company uses to calculate hurricane risk remains trade
secrets. We are at a loss why the company should be permitted to hide this information from its
customers and the general public. We also think that the SEC should require such critical
information for the assessment the company’s exposure be disclosed.

However, it appears that UVE was able to take full advantage of the newly available alternative
reinsurance capital and place a reinsurance program that just a few short years ago was
uninsurable. We argue that this is “as good as it gets” for the DFIs with a couple of years of
rate increases combined with subsidies and extremely low reinsurance costs create the
illusion of a functioning private market.

The current very low reinsurance prices have made the DFI model seem plausible. However, it
should be clear that the problems of Florida’ market aren’t the result of rapacious offshore
reinsurance companies but, rather, a system that has persistently overregulated the rates while
abdicating the state’s responsibility to ensure that those same insurers remain solvent and
able to pay claims. Florida’s insurance system is badly broken
113
, but offshore reinsurers aren’t
the problem but rather an enabler of an unsustainable business model.

113
Report: Bermuda Insurers Not to Blame, Bernews, November 10, 2010

34
CONCLUSION

The current condition of the Florida property insurance market has developed from a confluence
of natural and man-made events that have taken place in the last three decades. Hurricane
Andrew in 1992 and the combined effects of the 2004/2005 storm seasons, population growth
and changing demographics, the evolution of the catastrophe modeling industry, management of
catastrophe exposure by insurers/reinsurers, and legislative/regulatory actions in Florida have all
contributed to the current market conditions. The dependence on coastal development as an
economic driver and the potential impact of climate change on storm activity and damages are all
challenges facing the marketplace.
114


In the 22 years since Hurricane Andrew, many have sought solutions to the challenges of the
Florida marketplace and the right formula has not yet been found. The market is now much more
reliant on governmental entities and capital market conditions than ever before. However, in the
final analysis, the issue at heart is quite simple – an inadequate level of premiums.
115
The
efforts to “hide” or “avoid” this issue have led to significant market distortions as well as
unsustainable business models that will ultimately need to be corrected. Real estate
development plans will have to adapt to the underlying realities of Florida risk instead of
“socializing” the cat losses.

“We don’t believe that the U.S. has the balance between industry and government intervention
right, “said Sean McGovern, Lloyds director of North America. “The cost to the U.S. taxpayer is
huge and is not sustainable.”
116
A.M. Best study covering 1969-2010 examined the main drivers
behind U.S. insurer insolvencies. Notably, the largest single reason of insurer insolvency over
this time horizon is deficient loss reserves and inadequate pricing, representing 40 percent of
all insolvencies.
117
These two factors remain the highest risk for Florida insurers today.

What makes that insurance model seem possible and even profitable right now is the influx of
capital from pension and hedge funds into the ISL space. However, there is the issue of
information asymmetry as most investors neither have the expertise nor avenues available to
critically assess the pricing methodologies behind cat bonds and other structures, with most being
wowed by ‘road shows’ displaying the high degree of sophistication and rigor behind the
analyses, or simply relying on an alphabetical rating.

When it comes to Florida property insurance, political realities in Tallahassee are clashing head
on with traditional industry standards of fiscal responsibility. The homeowner is caught in the
middle. Florida’s property insurance system remains broken and in need of significant changes. It
poses a large risk to the state’s economy both through a direct threat to the government’s fiscal
situation and through the risk of multiple assessments after a major storm or a series of smaller
events.
118


114
The State of Florida’s Property Insurance Market, The Florida Cat Storm Risk Management Center, January 2013
115
According to Dowling&Partners, rates in Florida need to increase over 50% to reach adequate double digit ROE
over time; Perspectives on the Florida (Re)insurance Market 13
th
Annual Participating Insurers Workshop, 2013
116
Climate, Insurance and the Next Financial Meltdown, January 6, 2012
117
Credit Risk of Property Catastrophe Reinsurers, Aon Benfield, Summer 2012
118
Ten Reforms to Fix Florida’s Property Insurance Marketplace, The James Madison Institute, Backgrounder, Issue
74, November 2013

35
RECOMMENDATIONS

The incentive structures associated with the limited liability corporate form are not conducive to
the sound provision of catastrophe insurance. The companies can (and do) simply distribute their
earned catastrophe premiums as dividends (or other payments) if there is no loss, then declare
insolvency if a catastrophe hits.
119


History shows that private marine insurance, a market with many catastrophe-like features, was
viable because it solved what is the catastrophe markets fundamental problem, a mismatch
between the size of annual premiums and the size of maximum annual losses. The industry
accomplished that by advancing all of the capital at risk to the insured at the beginning of the
policy, forgiving the loan if a loss occurred or by arranging access to a large pool of capital (the
unlimited wealth of the Lloyds Names) with which to pay losses after the event.

Some of the newfound bonanza of low priced CAT reinsurance is a welcome step towards
prefunding parts of the catastrophic risks. On the other hand, FHCF and Citizens, when managed
properly, provide the access to a large pool of capital. The value-add of the DFIs is limited or
non-existent as they “siphon” away a great portion of the premiums through related companies.
Florida’s politicians should stop pouring incentives into private pockets while at the same time
subsidizing losses when dealing with the state’s property insurance system.

We believe the dual goals of sustainability and risk diversification can be best achieved though
a program that involves Citizens’ and FHCF’s active participation in the private reinsurance
markets. It is in Citizens’ best interest to transfer a meaningful amount risk to the private market.
The best evidence is the 2014 private Citizens reinsurance program that transfers $3.1 billion of
risk for premium of $300M, compared to risk transfer of $1.85B for a cost of $304M in 2013, so
securing 68% more protection at a lower cost.
120
There is a much bigger player willing to take
a lot of risk on the reinsurance block.

The OIR should develop pricing estimates that reflect the true risks of different
locations/structures in the state of Florida and a clear “glidepath” should be put in place for
premiums to reach those levels over time. As politically painful as that might be, it will put an
end to the subsidies to coastal properties and will over time discourage coastal development while
creating more opportunities inland. Further, the taxpayers of Florida will no longer be responsible
for supporting ultimately uneconomical projects.

We believe those steps will also limit the politicians’ ability to interfere and use the property
insurance market for political favors and voter pleasing experiments. What is necessary is not
short-term populist rhetoric but sustainable long-term solutions for the citizens of Florida. We
hope the people of Florida will assert their rights and demand a fair solution to the property
insurance problem from their elected representatives.

119
Catastrophe Insurance, Dynamic Premium Strategies and the Market for Capital, Russell, Jaffee, Alternative
Approaches to Insurance Regulation, National Association of Insurance Commissioners, 1998
120
http://www.artemis.bm/blog/2014/04/28/florida-citizens-buys-68-more-reinsurance-for-2014-at-less-cost/

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