Florida’s Property Insurance Market: An Overview by Commissioner McCarty

By Kevin McCarty | April 24, 2009

It is always interesting, and frequently amusing, to read various “research” pieces on the Florida property insurance market. While I, like every other insurance regulator, industry professional and observer in the world, agree that the Florida property insurance market provides a challenging, to say the least, economic environment, I must also finally break down and respond to some of the more recent articles. Errors in fact and rhetorical assertions, unsubstantiated by objective empirical findings, are not only misleading to the public, they reflect a severe lack of understanding of both fundamental economics and the basics of insurance.

The basic premise of many of the articles generally seems to be that the solution to all of Florida’s property insurance challenges is to close Citizens Property Insurance Corporation (Citizens), cease operations of the Florida Hurricane Catastrophe Fund, deregulate rates and let the “free market” magically bring a stable equilibrium to the market.

Oh, how I wish that was true. I absolutely agree that, with the basic building blocks necessary for competitive markets in place, such a solution would yield the desired outcome. Unfortunately, the basic conditions necessary for such an outcome are structurally absent, and would be virtually impossible to introduce. Let me elaborate.

A competitive market requires freedom of entry and exit from the market. While of course, the process of admitting, licensing, and monitoring the financial condition of any company does create something of a barrier to entry, the evidence does not suggest that this process, by itself, is a meaningful barrier to entry. In terms of the Florida market, we have seen over 50 new companies and risk-bearing entities come into the market since Hurricane Andrew in 1992.

Yet interestingly, some individuals have chosen to denigrate rather than celebrate the fact that Florida provides an environment where the entrepreneurial spirit can grow. How many other markets in mature industries can point to new growth? Rather, much focus seems to be on the fact that the major companies are reducing or exiting the Florida market. As a research finding supposedly supporting competitive markets, this is troubling.

Apparently, a competitive market to some is one where a small handful of firms dominate a market, as is true in many of the rest of the property insurance markets across the states. In fact, when measured by market concentration, Florida is one of the most competitive markets in the country — even when Citizens’ market share is included. Granted, the new entrants are not of the size of the old-line, major property insurers; but then again, new firms generally do not start out as behemoths; they grow into it.

Moreover, decisions by the companies to reduce their exposure to, or exit from, the Florida market is a private business model decision these firms made to reduce their exposure to catastrophic risk of all types, across all markets as far back as 2006, or even earlier in some cases. These decisions predate any of the legislative activity of 2007 and 2008 that some often have demonized. In the name of competition, should the OIR have tried to prevent companies from executing their business models?

Along these lines, it is important to also note that the growth of the book of business in Citizens actually peaked before any legislative changes. That is, Citizens’ growth and size actually peaked during a period in which it was still mandated to have the highest rates in the market; and policyholders had to receive declinations from private insurers before they could get a policy from Citizens. Citizens grew to its maximum size when the private market did not want the risk. As most Floridians have no choice but to have comprehensive property insurance, Citizens was their only avenue for insurance. Even firms continuing to write in parts of Florida would only do so if they did not have to underwrite the hurricane risk; thus Citizens got the wind-only portion of those policies – even from the major insurance companies.

Florida’s “take-out” companies also frequently have been dismissed by the media and others as if they were not really true, new entrants into the market. I find this confusing. If a new firm wanted to deploy its capital to risk-bearing business quickly and efficiently, I cannot think of a quicker, more cost effective way to execute that strategy than by taking a block of existing business rather than by growing organically through traditional agent sales and referrals. Growth in this manner not only deploys capital quickly, it also takes residual risk off of the public at large and puts it back in the private market, where I assume most people believe it belongs. As an additional note, the fact that new private capital can be successfully deployed by taking risk off of Citizens’ book of business seems telling to me regarding the actual market conditions we face in Florida.

A competitive market requires willing buyers and sellers. A lot is discussed on the structural aspects of the supply side (insurers) of the property insurance market in Florida, yet little is openly discussed on the structural aspects of the demand (policyholder/consumer) side. Yet it seems that the demand side is where most of the structural limitations preventing a truly competitive market occur. Let me share a few observations here.

It seems to me that the most critical deterrent to a truly competitive market is the lack of any meaningful degree of “consumer sovereignty” in the purchase of property insurance in our economy. I do not purposely mean to drop economics jargon into the discussion, but the term consumer sovereignty has a significant meaning that is the key to achieving stable market equilibrium. Suppliers offer goods or services at their offer price. Consumer sovereignty means that consumers on the demand side have the ability to counteroffer their price or – if no meeting of the minds occurs – walk away from the transaction, if the deal does not suit their needs. In such a setting, consumers can then choose to purchase substitute goods or services or do without. This occurs in many markets every day, but is lacking in the purchase of insurance.

When I go to purchase or renew my property insurance policy, I am given a quote (or several if I am dealing with an independent agent who is representing several actively writing companies). What I am not given is any information on how I got rated to get that quote, or on what presumptions regarding loss the quote was built; nor am I given a chance to counteroffer. I do not see insurers voluntarily offering that information – freely and transparently. Underwriting is considered a key trade secret of the industry. And I certainly do not foresee insurers granting their agents the ability to negotiate on premiums.

Further, I have little option as to the purchase or exclusion of the most critical and frequently most expensive elements of coverage. This is particularly acute for consumers facing the catastrophic risk of hurricane. Hurricane, or wind, coverage is a mandated part of the standard homeowner’s contract. Few lenders, and no federal mortgage entity, such as Fannie Mae or Freddie Mac, will let a mortgage holder have an insurance policy without hurricane or wind cover.

No one questions that the purchase of property insurance is a prudent decision by consumers. Practically, their only other real option is to forgo insurance and self insure – either by setting aside money for the potential loss or choosing to ignore it and hope the loss does not occur. This means that in and of itself, the demand for insurance is likely to be relatively price inelastic; consumers are not likely to be as price sensitive with regard to insurance as they are with most other purchases. If the requirements of mortgage contracts, neighborhood and condominium law and other enforceable mandates are overlain on top of this innate demand, the result is a market characterized by almost completely price inelastic demand.

Simply put, consumers must buy insurance at the prevailing prices offered. There is little room for the negotiating process between buyers and sellers that yields a true market clearing price or allocation.

There certainly are steps that could be taken to provide some degree of consumer sovereignty to the market. Some actions would require changes to federal mortgage guidelines, banking practices or local law. But, these would undoubtedly be difficult to achieve.

One other step that could be taken would be to give consumers facing exposure to the risk of hurricane the same options that all consumers in the United States have to the other major, potentially catastrophic, natural disasters. Either let the consumer choose to purchase the catastrophe cover or not (as we do with earthquake); or provide a heavily subsidized federal program like we do for flood with the National Flood Insurance Program (NFIP). Floridians know about the heavy subsidization; we provide it. Over the last 30 years Floridians have paid in around $10 billion more in flood premium than we have received in loss payments, a subsidy that is an order of magnitude larger than the next largest subsidy provider.

Now the public policy decisions get interesting. In the case of optional cover, at least the U.S. experience with earthquake suggests that most consumers would choose not to buy it, leaving a potential liability for U.S. taxpayers that will be beyond rational comprehension the next time a major earthquake occurs. Consumer choice in the short run might sound like a good thing, but it is perhaps not the best public financial management strategy. The heavily subsidized flood program is perennially in deficit, encourages rebuilding in flood prone areas and obviously misprices the relevant risk. Again, the liability falls on the taxpayer.

The structure developed by the Legislature in Florida seeks to find a balance. In contrast to the structure for other catastrophic risks, the market structure in Florida has been created to try and balance the needs of industry and the needs of the public. As a result, two public entities were created: the Florida Hurricane Catastrophe Fund and Citizens Property Insurance Corporation. I alluded to the role of Citizens earlier. Its intent is to provide insurance for those who cannot reasonably obtain the mandated coverage in the private market. As for its operational structure, some individuals are troubled by the fact that it is structured to resemble a private firm in terms of its operations and functioning. Yet, the basic premise
of free-market advocates is that the private market model is the best choice. I do not understand this dichotomy in such arguments.

For most of its history, Citizens was mandated to charge the highest rates in the market, and to accept only consumers who could not find coverage with private insurers. As well, they had to offer a wind-only policy in certain coastal areas of the state where private insurers would write the non-hurricane portion of a policy, but would not write the hurricane risk.

Following the 2004-2005 hurricane seasons, as insurers decided to retreat from catastrophic exposure and as the reinsurance industry, by its own admission, could not provide sufficient private capital, the policy count and resulting exposure in Citizens expanded dramatically. Given this, the Florida Legislature undertook the actions decried by the free-market advocates. It is important to note that the decisions were made in reaction to market conditions, not as on overt attempt to drive out the remaining private market.

The Florida Hurricane Catastrophe Fund was created in the aftermath of Hurricane Andrew, when reinsurance was unavailable in the traditional private market at any price. Contrary to some assertions, the Cat Fund is not the primary source of hurricane reinsurance. From its inception, the Fund was designed to provide some reinsurance coverage at stable prices as insurance for insurance companies for truly catastrophic hurricanes. For example, for the 2009 hurricane season, the fund will only trigger in the event that aggregate insured losses from a storm exceed $7.2 billion. That is, the first $7 billion in insured loss is paid out of insurance company capital and/or private reinsurance. The core layer of the Fund provides for reinsurance coverage for losses in excess of the trigger, up to losses of about $24.2 billion. While it is true that participation in the Fund is mandatory for insurers writing property insurance in Florida, it would seem that the participation is not as onerous as some have suggested. Insurers can choose to purchase coverage that pays as little as 40 percent of losses in the layer or up to as much as 90 percent of losses in the layer. Industry has spoken. More than 90 percent of the companies, representing well over 90 percent of Florida’s insured property, choose the 90 percent copay level. The remaining 10 percent, alongside the Fund layer, is placed in the private market, as is the layer above the Fund exhaustion point. The intent is to provide stability, while not “crowding out” the private reinsurers who play an integral role in the market.

Pricing of the coverage is not flat. Rates are based on actuarial loss estimates across the state, where 26 categories of risk levels exist. If an insurer does not write in coastal areas, but in the more inland areas, its rate will reflect its book of business.

The biggest difference, aside from taxation, that distinguishes the Fund rates from the private sector is the lack of a risk load. The Fund charges based on expected losses; the private market bases its charges on expected losses plus a risk load for profit. These risk loads in a good market are four to five times expected losses; and in stressed markets, they have sometimes exceeded 10 times expected losses. The Fund uses its loss estimates and its assessment base to smooth out the cost of coverage over time.

Following the market contraction resulting from the 2004-2005 hurricane season, the Florida Legislature, at the request of the insurance industry, offered the Temporary Increase in Coverage Layer (TICL) above the mandatory Fund level. The key here is the word temporary. It was authorized for a three-year period — no more. During the 2009 session, the Florida Legislature is looking in a reasoned fashion at whether there is a need for any continuance of this higher layer and what modifications are in order.

The mandatory layer of the Fund is defined formulaically in statute; the TICL layer was enabled by statute. The mandatory layer is designed to grow in proportion to the exposure in the state; yes, it has grown considerably since 1995, and so has Florida’s insured exposure. The operational model, for both the mandatory and TICL layers, of collecting premium and then assessing and bonding is a mechanism designed to smooth out the cost of loss over time. The model has become a critical issue for Floridians in 2009 – not because of any new features of the Fund, but because of the global collapse of the financial markets necessary for the operating model to work. If the markets were working in anywhere near normal fashion, so too would the Fund.

Rate deregulation may not achieve the alleged outcome. Not surprisingly, I frequently hear comments about rate regulation. What is interesting is the information I get when I engage in dialog with the industry, both insurers and reinsurers, as I do on a regular basis. When I pointedly ask industry representatives how much more business they would write if they could get any rate they wanted, the serious answers I get back range from marginally more to none. Again, because of the moderate to severe hurricane risk across the entire state of Florida, the risk of ruin from catastrophic loss outweighs any potential premium income in their management models.

That said, we continue to look into this issue. Proponents of complete rate deregulation assert that it would provide a better competitive outcome. Following basic economic theory, therefore, markets with rate deregulation should exhibit lower prices and a lower degree of market concentration, all else being equal. These are easily verifiable empirical results, and there is plenty of data available with which to test this hypothesis. I would encourage the competitive market advocates to undertake such an analysis. Our own internal looks at the potential effects of market deregulation have not found support for the proposition.

Prior to Florida’s legislative changes of 2007, the rate review process for property insurance was identical to the process used for all other property/casualty lines of business — about which there is no industry outcry. The biggest difference, yet again, is the pricing of the catastrophic component of hurricane risk embodied in property insurance. This component of pricing is what makes underwriting hurricane exposed property such a challenge for insurers, regulators and the public.

Clearly, historical loss estimates — the staple of most insurance underwriting — are not sufficient as population demographics, building technology and the type of property insured changes over time. Responding to this inadequacy, catastrophe models were developed in the private sector. Florida was among the first states to allow the output from these models to be used as factors in rate determination. At the same time, the catastrophe models are stochastic estimates which, for the same exposures, vary wildly in loss estimates from model to model. I have yet to find an actuary who is willing to attest that these models provide actuarially credible estimates of future loss. The use of model output in ratemaking is still very much an art, as well as a science, when all stakeholders have to be considered.

To comments I have heard that the Office [of Insurance Regulation] has overly wide latitude in rate approval, I would have to disagree. I would encourage those who feel this way to look at the very thorough statutes governing how the Office is to review rates and at the actuarial best practices that guide the rate determination process. In fact, the Office has much less latitude than is commonly believed. Moreover, under the legislation passed in 2007 and 2008, insurers have expedited access to legally binding administrative hearings should they not agree with our decisions on rate issues.

Some closing thoughts on the Florida market. A wise industry veteran once told me that the problem with insurance is that the issues do not fit on a bumper sticker. If there were easy answers, we would have acted on them by now.

I encourage industry followers and all industry professionals to continue to work to find mechanics, structures and policies that improve the market. I do not think anyone is happy where we are now. I just would encourage the work to include meaningful, objective analysis that reflects the economic realities of the Florida marketplace.

Some things we all can agree on: mitigation, building codes and land-use policies come to mind. Florida has taken the lead in adoption and enforcement of building codes for hurricane resistance. This will take time, however, as there are over four and a half million homes in Florida that are, on average, 24 years old. It will take time to mitigate or replace those that are vulnerable.

As commissioner, I will continue to professionally and impartially enforce the laws that are enacted. I will also continue to engage the debate on the role of the private sector and the role of government in the provision of catastrophic property insurance. Clearly, we as Americans can devise a system much better than our current, uneven, patchwork of state and federal programs.

Topics Florida Carriers Trends Catastrophe USA Legislation Profit Loss Flood Reinsurance Hurricane Property Market

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