With proposals for a federal catastrophe facility in the US, what can we learn from the Florida story? asks Lindsey Rogerson.

Governments and insurers the world over will be keeping a close eye on the progress of the national catastrophe fund bill through the US legislature. The bill, the brainchild of three Florida congressmen, is intended to act as a protector of last resort for homeowners whose properties are destroyed by catastrophic events. This includes hurricanes of a similar magnitude to Hurricane Katrina in 2005 and a severe California earthquake.

Florida already has its own statewide reinsurance backstop – the Florida Hurricane Catastrophe Fund (FHCF). Aware of the potentially devastating effect of a hurricane season as destructive as that of two years ago, Ron Klein, Tim Mahoney and Robert Wexler are keen to see that model expanded nationwide.

The Florida fund is not without its critics. When governor Charlie Crist introduced new legislation in February, which essentially doubled the FHCF’s capacity, he was accused of socialising insurance in the state. Bermuda reinsurers, which collectively provide 35% of homeowners’ reinsurance cover in the state, prepared to take a hit to underwriting profits. Initial fears were unfounded however and there was still plenty of business available to the private market come the mid-year renewals. In June, RenaissanceRe even announced it was launching a sidecar for the Florida market, signalling some opportunities for new capacity still existed.

FHCF also has its advocates. With more and more homeowners being dumped by their insurance carriers, they say FHCF along with insurer-of-last-resort Citizens Property Insurance Company, is plugging a gaping hole left by the market. At the time of writing, some 39,000 homeowners across the state were being notified by their insurer, Nationwide, that it would not be renewing their policies when they lapse this Autumn. This is on top of the near 160,000 homeowners already dumped by insurers Allstate Floridian Insurance and State Farm Florida Insurance earlier in 2007.

UK parallels

Academics can argue about the merits of politicians interfering in the market, but as long as homeowners are voters, politicians will feel the need to intervene. This is not just the case in Florida, where even those who have been kept on by their insurer have seen their premiums rise significantly. It is also the case in the UK. After widespread summer flooding there have been media reports that not only will affected households see their premiums rise, but also that clauses are being inserted into contracts at renewal, excluding payouts where the government has not acted to build adequate flood defences.

In the aftermath of the floods Gordon Brown promised to look into the issue of homeowners and tenants being unable to afford insurance. It was suggested on the floor of the House of Commons that UK house builders should be forced to insure all new-build properties in flood areas for 20 years. With the hunt now on for a solution, there will be a keen interest in what is happening stateside.

A spokeswoman for the Association of British Insurers (ABI) admitted as much to Global Reinsurance. “The ABI and insurers in the UK are keeping a close eye on what is going on abroad – Hurricane Katrina is a strong case study. But insurance traditions and practices vary significantly, and it is important to keep in mind those local differences. Whenever such a state insurance scheme is set up it shows that the risk management has not worked and that government has not been able to implement successful measures to reduce or control risks.”

The ABI points out that several forerunners of the Florida scheme have gone bust, and said that it would prefer to see action from government focused on tougher building controls alongside improved flood defences. But crucially, with a nod towards sabre rattling, the spokeswoman adds: “If government does not implement adequate risk management measures it could well be that insurers decide to stop providing flood cover in the UK – or at least for certain high risk areas. So this is a possible scenario, but financially it would be very ineffective and would end up costing the taxpayer a lot of money.”

“As long as homeowners are voters, politicians will feel the need to intervene

Pricing the risk

Insurers refusing to renew cover in an effort to reduce their exposures was, of course, what sparked the intervention in the US. Insurers cut cover, homeowners complained to their elected representatives and the state fund was set up.

However the fund has not prevented rising premiums for hurricane-exposed properties. “It gets back to the problem that the price is too high – that’s the basic complaint,” Bob Hartwig, president of the Insurance Information Institute told GR in August. “In Florida and other states there is an absolute unwillingness to accept that the cost of the risk must be reflected by the cost of insurance.” This has lead to the attempt to get a national fund off the ground, in the hope that pooling risk further will bring down premiums to an affordable level.

Indeed, insurers and politicians in Florida are fighting an increasingly bitter battle about exactly what level premiums should be set at. After a hearing into the latest round of hikes last month, William Stander, assistant vice president of the Property Casualty Insurers Association of America (PCI) criticised Bob Hunter of the Florida Office of Insurance Regulation for misleading the public. Stander said the insurance industry critic, who was hired to determine rate reductions, was being unrealistic. “As we have stated before, state officials and regulators failed to realistically portray the reductions consumers could expect,” he said.

He also expressed his disgust at the Florida Commission’s decision to ignore the evidence suggested by a risk model submitted by Risk Management Solutions. The near-term model suggested the risk of severe hurricanes making landfall had increased and therefore the insurance rates should be higher. It was rejected in favour of an older model, based on the historical average, where the risk is not deemed to be as great, and therefore the price is lower. “Florida was a triumph of politics over reason,” Hemant Shah, CEO of RMS told Global Reinsurance at the Monte Carlo Rendez-Vous.

Stander agreed with Shah’s assessment: “The state spent millions of taxpayer dollars to commission a public model in an effort to debunk the findings of the private models. To the dismay of our critics, the public model came in higher than the private models. While not perfect, risk models provide the most accurate information on the projected damage a future storm will cause and the financial resources that a company must have on hand to pay for all its expected losses.”

public private solution

On paper, if the need for state intervention is accepted, a national fund makes sense. Without wanting to become a hostage to fortune, it is highly unlikely that multiple catastrophic events would strike multiple states in any one year. So by pooling risks premium could, so the theory goes, be reduced. The proposals allow for the ultimate risk to be packaged and transferred to the private sector via cat bonds.

The bill will not make it compulsory for every state to sign up. The decision to opt in or out will be left up to individual states, a move that makes it different from previous, unsuccessful attempts to get a national catastrophe fund off the ground. However, the drafting of the proposals, which allow for the risk to ultimately be passed back to the market, has plenty of critics. Not least President Bush who believes the very existence of such a fund would infringe on the insurance market.

“The ABI pointed out that several forerunners of the Florida scheme have gone bust

Bush has also warned he could oppose another government backstop – this one for terrorism reinsurance. The Bush camp has already made it clear that it does not support the renewal of the Terrorism Risk Insurance Act. If the current version of the bill – proposing a 15-year extension – reaches President Bush, his advisers will recommend a veto, the White House Office of Management and Budget said in a statement.

Some of Bush’s concerns about federal-backed liquidity pools are shared by Bob Milligan, Florida’s insurance consumer advocate. “From an economic policy viewpoint, I don’t believe government performs well as a retailer,” he explains. “Government is good at collecting money and appropriating money. As a result, a government run primary insurance company does not fit my paradigm.

“The Governor and Legislature tried to address a property insurance crisis by expanding the role of the state-sponsored insurer and freezing the hurricane insurance rates that Citizens could charge. What had been the primary insurance company of last resort has now become the insurance company of choice. Citizens is now the largest insurance company in Florida and the fourth largest in the United States.

“The failure of the private market and the state’s response by expanding Citizens, freezing its rates, making the cat fund’s reinsurance available at both lower and higher limits etc, have all created a scenario that puts taxpayers and consumers of Florida at considerable risk.”

The retired general points out that a similar state fund, established by the Hawaiian state government after Hurricane Iniki in early 1990s, was wound up in 2000 after the insurers who were paying into it realised it would be more economical for them to insure homeowners against hurricanes themselves. At present, with insurers still pulling homeowners policies in Florida, it seems unlikely that the private market will step up and plug the gap. But there is nothing to say that if a few more hurricane seasons pass without incident, they might not reach the same conclusion as those in Hawaii.

Of course the proposals for the national fund do allow for the private sector to profit. This is something the Florida scheme, which is funded by a levy on insurance companies, does not. For this reason it is not beyond the realms of possibility that the private markets might welcome a national catastrophe fund. Indeed, given the current popularity of cat bonds, it is likely that traders in the capital markets would show interest in those offered by state administrations.

Christopher McGhee, head of Guy Carpenter’s investment banking specialty practice, certainly thinks they could appeal to investors. “Some aspects of US government-sponsored cat bonds would likely make them particularly attractive. Specifically, all credit risk of the sponsor is removed by having a ‘AAA’ sponsor. In addition, the presumably very large and ongoing nature of the issuance should assist in developing a deep and liquid market, which while likely to result in spread compression, is nevertheless attractive to the investor community as a whole.”

However McGhee says it will come down to how the bonds are structured. “Structure of the bonds could result in negative attractiveness to investors,” he explains. “For example, if the bonds are structured in such a way as to create the potential for significant moral hazard (eg there is little rigor in claims management and settlement), then this could make the bonds relatively less attractive to investors.”