Extreme Measures

The beginning of the 2017 North Atlantic hurricane season is a good time to think about various government pools designed to address catastrophic losses from tropical cyclones. The Florida property insurance system has evolved in recent decades to become a stable public-private partnership capable of withstanding one or more strong hurricanes, as was demonstrated in 2004 and 2005. Aspects of its design illustrate the important tradeoffs that public policymakers face when enacting frameworks to deal with extreme events, such as hurricanes, floods and earthquakes, at both the state and federal levels. This article will examine one part of Florida’s hurricane financing system, the Florida Hurricane Catastrophe Fund (FHCF or “Cat Fund”).

The current reauthorization process for the National Flood Insurance Program (NFIP) provides an example of how Florida’s experience can inform public policy analysis for other programs. The NFIP faces a number of challenges similar to those in Florida, including how to depopulate a large government program through increased private sector participation, how to balance affordability for consumers buying policies with protection for taxpayers’ funding deficits, how to utilize private reinsurance in a government program, and how to interpret a mandate to implement actuarially sound rates in a government program, which can draw upon funding sources unavailable to private insurers, such as post-event bonding or similar borrowing schemes.

Background

Florida has dramatically improved its hurricane resilience since the early 1990s by enacting tougher building codes, improving emergency management, and having stronger financial mechanisms in place to fund rebuilding. Florida has also been fortunate to have only experienced one landfalling and one bypassing hurricane (Hermine and Matthew, respectively) since 2005, both of which occurred in 2016. This allowed for a significant buildup of resources. The legislative environment has now stabilized and placed the state on a path to a financially stronger insurance system. Risk transfer products have also become more competitively priced, with contract terms and conditions resulting in an abundance of competitive options.

One critical part of Florida’s hurricane loss financing system is the Cat Fund, which was enacted in a special session of the legislature in 1993 following the near meltdown of the property insurance market after Hurricane Andrew. Though less visible to consumers than its cousin, Citizens Property Insurance Corporation (Citizens), the Cat Fund is the lynchpin of the state’s property insurance system, a statutorily mandated program that provides a type of low-cost coverage similar to private reinsurance to all companies (including Citizens) writing residential property insurance in the state.

If you have a residential property insurance policy in Florida, the Cat Fund is designed to provide a significant part of the funding to pay claims after a hurricane. Also, and less well understood, if you have almost any kind of property and casualty insurance (such as an automobile policy), you may be subject to paying assessments (surcharges) for decades after an event to retire bonds issued by the State Board of Administration Finance Corporation (a single-purpose public benefits corporation) on behalf of the Cat Fund to pay hurricane claims. Thus, the Cat Fund can affect almost every Floridian, whether or not the person experiences a hurricane loss.

The ability to draw upon assessments from a broad base of policyholders is one of the primary reasons for the low price charged to insurers for Cat Fund coverage, and it was also an essential factor in achieving federal tax-exempt status. The U.S. Internal Revenue Service recognizes the Cat Fund as an instrumentality of the state that serves a major purpose of not only providing resources for the payment of claims to rebuild after a catastrophic hurricane, but also serving to stabilize the economy by managing hurricane risk for the state of Florida under the executive leadership of its top elected officials—the governor, the chief financial officer and the attorney general.

In government and academic circles worldwide, the Cat Fund is often cited as an example of a sound public-private partnership created to tackle the very complicated problem of funding extreme event losses in a fair and efficient manner over time. While the details of its structure are complex and beyond the scope of this article, the following summary illustrates some of the important public policy choices its creators made.

In simple terms, it is a statutorily-created “reinsurance type” facility, providing for reimbursement to insurance companies for catastrophic hurricane losses. Insurers pay the Cat Fund a premium for this coverage, which becomes part of the cost of covered policies insurers sell to consumers. The Cat Fund is a nonprofit state facility exempt from federal income taxes and is able to pay its claims through tax-exempt bonds issued on its behalf by a special purpose finance corporation if its cash resources are insufficient. As such, it generally can offer prices far lower than private reinsurance alternatives, which results in reducing residential property insurance rates for Florida consumers.

It is important to note that this benefit is not “free”—those lower rates are made possible by exposing almost all Floridians to the risk of significant assessments in the future. This is an important (and sometimes controversial) aspect of many government insurance programs, which can spread losses across both space and time. Private sector (re)insurers must hold capital or reinsurance before policies are issued, limiting their ability to diversify risk to spreading losses across space (e.g., using the reinsurance system to diversify risk globally). Government entities, due to their ability to hold “negative capital” in the form of bonds secured by their ability to compel payment of assessments in the future, can also spread losses across time. This can allow government entities to reduce price volatility and lower upfront costs.

Efficient and Fair by Design

Since the FHCF serves to lower premiums for high-risk policies by providing a partial subsidy from nonproperty sources and defers part of the cost to the future, it may dampen incentives for risk mitigation. The Cat Fund’s unique design results in a number of efficiencies that result in cost savings, including:

• Not needing to charge a cost of capital—it benefits from its ability to assess or “tax” a broad base of policyholders
• Having no underwriting cost since it is a mandatory program
• Having no brokerage commissions
• It writes only one product (a reimbursement contract) where coverage is standardized with a clearly defined retention and limit of coverage for each participating insurer based on its residential property exposure in Florida.

In periods of benign hurricane activity (like the most recent decade), the Cat Fund accumulates funds and invests them, building capacity to pay claims when a storm hits. If its claims exceed assets, it can issue bonds, which are paid off by assessments on a wide range of policies written in Florida over many years. It can buy reinsurance or use capital market products to finance claims, a topic that is sometimes controversial because it shifts who pays for storms among various groups (such as today’s policyholders versus future ones).

The Cat Fund’s success over many years reflects some important aspects of its design, specifically:

• It was carefully designed and has a very technical statutory framework that has evolved over time. Generally, changes are made after thorough study.
• It achieved federal tax-exempt status to build cash balances more quickly, saving Florida’s consumers billions of dollars.
• It had strong governance by being part of the State Board of Administration, and it follows a transparent rulemaking process “in the sunshine” to implement legislative directives with input from various stakeholders.
• It used a sophisticated premium formula reflecting hurricane risk.
• It set the retention and limit for insurers as a multiple of Cat Fund premium, creating incentives to write in riskier areas.
• It provides coverage subject to clear limits, retaining an important role for private reinsurance and limiting assessment exposure.
• Its design aligns private insurer incentives with public policy goals.

One aspect of its design is critically important. How should the Cat Fund’s limited resources be apportioned between today’s claims and those in future years? This question drives critical public policy choices that directly affect consumers. It also illustrates how program design, either explicitly or implicitly, can affect various stakeholders. This is an important insight about how government programs generally affect different groups in society.

For example, assume the Cat Fund has $35 billion of capacity from accumulated premiums, investment income, and potential bonding. It could offer the full $35 billion as coverage in the current year. Since the Cat Fund’s cost to insurers is far lower than alternatives like private reinsurance, this would lower consumer rates by a significant amount. Unfortunately, doing so exposes those consumers to a “triple whammy” when a storm hits.

First, private reinsurance costs almost always increase after large events. But because the Cat Fund used all of its capacity in the current event, its coverage level for the next year would drop considerably, to perhaps $2 billion. This leads to the second “whammy,” as insurers would then need to buy a large quantity of additional private reinsurance at precisely the worst time, driving up rates even more. Finally, the Cat Fund would begin imposing assessments in the following year, further increasing cost to consumers.

This scenario leads to low premiums in the current year and a rate explosion in following years, threatening a replay of the market turmoil following Hurricane Andrew. It should be remembered that the major problems after Andrew were rate increases and nonrenewals in subsequent years, not paying the claims due to the storm.

What could be done to avoid this problem? To take an opposite extreme, assume the Cat Fund offered no coverage for the current year, saving all of its capacity for the year after a storm hits. This would drive up premiums in the current year, as inexpensive Cat Fund coverage would need to be replaced by more expensive private coverage, but then would significantly reduce or eliminate rate increases in the years after a storm hits when inexpensive Cat Fund coverage could flood the market and replace more expensive private reinsurance. This would also eliminate consumer assessments in the year after a storm hits and beyond.

How should public policymakers choose between these options? Before outlining how the Cat Fund addresses this dilemma, a comment about which consumers are affected most by these scenarios is important. If losses are funded by rates based solely on the policies offering hurricane coverage, consumers will pay according to their risk. If bonds and assessments fund the losses, consumers will pay regardless of their risk (as the assessments are across policies like auto, business, etc.). Thus, one would expect consumers in Miami-Dade to prefer that the Cat Fund charge low rates with potentially high assessments, and consumers in North Florida to want aggressive rates and potentially low assessments. This dynamic also applies to how much consumers pay today versus how much debt is left to future generations. Finally, the mix of rate and assessment affects economic incentives for mitigation and construction in high-risk places.

Florida’s public policymakers have adopted a balanced approach to addressing this conundrum. The statute caps the amount available for the current season and provides a mechanism to fund subsequent seasons. In 2016, there was approximately $17 billion of coverage available, with a potential $17 billion limit available for subsequent seasons depending on the size of an initial season hurricane event (e.g., the Cat Fund’s maximum ability to fund a subsequent season was estimated to be $11.3 billion assuming a full loss in 2016, according to its May 2016 claims paying capacity estimates). This provided significant rate relief in 2016, minimized assessment risk from a first event (most of the $17 billion can be funded from accumulated premium and investment income), and provided a potential for reinstating a significant part or all of the coverage in 2017. While not eliminating post-event rate increases, this approach will significantly reduce them, versus a case where the entire resources of the FHCF were used in 2016.

Subsequent season coverage is an example of a tradeoff of somewhat higher consumer premiums in the short run in exchange for market stability in the long run. The same considerations apply if the Cat Fund buys private reinsurance to spread risk across the global financial system. Current private reinsurance rates are quite low by historical standards, and if the Cat Fund takes, say, $60 million and buys $1 billion of private reinsurance, it lowers its cash by $60 million but reduces assessment exposure by $1 billion. Of course, if there is no covered hurricane loss during the period, the $60 million is “lost,” but that is the nature of risk transfer. As with subsequent seasons, buying private reinsurance will tend to increase cost for current high-risk policyholders in exchange for protecting low-risk policyholders from future assessments.

What Lies Ahead

As we look to the future, remember that the Cat Fund is designed to handle relatively infrequent events; the recent lack of storms should not lull Florida to sleep. The state could easily experience a repeat of the 2004–2005 experience in coming years.

Public officials entrusted with managing the Cat Fund face choices about who pays for hurricanes and when. Do we want the lowest possible consumer rates now, without regard to post-event disruption or incentives to mitigate? Do we want long-term market stability, including limiting post-event rate shocks for consumers? Do we want to reduce assessment exposure to the lowest level possible? Florida cannot have the lowest possible short-term rates, market stability, and minimized assessments all at once; choices need to be made.

To date, the Cat Fund has struck a balance between these policy options. It has helped stabilize the residential property insurance market from its inception and funded all of its obligations after the losses in 2004–2005. Its currently strong financial position makes it financially sustainable if it continues the course it has taken to date.

Similar choices face most government catastrophe programs, such as the Federal National Flood Insurance Program and the Federal Terrorism Risk Insurance Program. When governments form such catastrophe programs, it is important for public policymakers to understand how various groups are affected (and when). Only then can the government program be properly evaluated as to its fairness and economic efficiency. The Florida Cat Fund provides a useful example to illustrate how choices made in program design can be studied.