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Why a company in Bermuda can raise your rates

Tallahassee Bureau Chief

Security First Insurance Co. is headquartered in a nondescript office building in Ormond Beach.

But when a Security First customer writes a check for property insurance, a big chunk of the money ends up in places like Bermuda and London instead of the offices on South Atlantic Avenue.

For insurance executives such as Security First President Locke Burt, sending millions of dollars to far-flung companies is simply part of doing business in Florida.

They are buying reinsurance — backup coverage to help pay hurricane claims — that keeps Florida’s property-insurance market functioning.

But for Florida homeowners, hidden costs of reinsurance are one of the biggest factors that drive up insurance rates in the hurricane-prone state.

Consider this: Despite no hurricanes hitting Florida since 2005, reinsurance costs increased about 15 percent this year. That forces property insurers to either try to pass on rate hikes to customers — or eat the reinsurance costs.

James Graganella, president of the Tallahassee-based Capitol Preferred Insurance Co. and Southern Fidelity Insurance Co., likened the situation for many insurers to “bleeding without a storm.”

And other than state government taking on huge financial risks, Florida can do little about it.

The reinsurance industry is based heavily in places such as Bermuda and England and does not face the rate regulations imposed on regular insurance companies. Most reinsurance firms are little-known to consumers, with a few exceptions, such as Lloyds of London.

But Florida property insurers need to buy large amounts of reinsurance because of the threat of devastating hurricanes. Insurance Commissioner Kevin McCarty said the state is subject to the “vagaries of the marketplace.”

“Reinsurance plays a larger role in Florida than any other state,” he said.

The details of reinsurance can get numbingly complicated and have spurred repeated controversies during rate cases — including a State Farm case in which a judge raised questions about “sham” transactions. But Security First offers an example of how it affects customers’ pocketbooks. For every $100 that Security First customers pay for insurance, Burt said about $40 of it goes to reinsurers.

And when no major catastrophes hit, reinsurance firms get to keep the money.

“All the guys in Bermuda are reporting great earnings,” Burt, a former state senator, said recently.

Spreading the risk

Reinsurance is a global business that goes far beyond Florida’s hurricane risks. The Reinsurance Association of America, an industry group, says the roots of reinsurance date to the late 14th century and that an early focus was on marine and fire insurance.

But the pivotal role that reinsurance plays in Florida became apparent after eight hurricanes slammed the state in 2004 and 2005. Homeowners’ insurance rates soared in the aftermath, at least in part, because insurers passed on higher reinsurance costs.

In 2007, lawmakers and Gov. Charlie Crist stepped in and expanded the Florida Hurricane Catastrophe Fund, a state program that sells lower-cost reinsurance. That move led to insurers reducing homeowners’ rates — but also created billions of dollars in financial risks for the state.

The basic concept of reinsurance is that insurers want to get rid of part of their liability for paying catastrophe claims. At a simple level, insurance companies are buying insurance coverage.

Just like a homeowner who has to pay a deductible, insurers must pay a minimum amount of losses before reinsurance kicks in. But after that, through often-dizzying arrays of contracts, reinsurers pay large portions of damages.

Florida insurance companies — particularly smaller companies — would likely find it impossible to squirrel away enough money to pay all the claims resulting from a major hurricane.

Reinsurers, meanwhile, are willing to pick up certain amounts of that liability because they also are collecting money and covering different kinds of risks all over the globe.

“Literally, it’s risk spread around the world,” said economist Robert Hartwig, president of the Insurance Information Institute, an industry-backed organization.

As an illustration of the importance of reinsurance, Allstate’s Florida subsidiary did not buy private reinsurance in 2004 because it thought it had enough money to meet its obligations.

But four hurricanes in 2004 exhausted the money and forced Allstate’s parent company to inject more than $380 million into the subsidiary to maintain solvency, a company official testified last year before a Senate committee. Reinsurance could have helped offset at least some of the company’s losses.

Sham transactions?

While state and insurance-industry officials agree on the importance of reinsurance, details of the issue have spurred debates and controversy during the past three years.

A key debate has centered on the Florida Hurricane Catastrophe Fund, the state program that sells low-cost reinsurance.

When Crist and lawmakers dramatically expanded the fund in 2007, the move saved money for insurers because they no longer had to buy as much reinsurance in the private market.

In exchange, insurers were required to pass along the savings to homeowners through rate reductions that ranged from the single digits to more than 20 percent.

The expansion added billions of dollars in potential risks for the fund, which was expected to be able to issue bonds to cover its obligations if a big hurricane hit. But, then, the nation’s credit markets collapsed, raising the possibility the fund would not be able to borrow enough money.

Worried about those risks, lawmakers this spring approved a plan to start scaling back the size of the fund. In doing so, they allowed insurers to seek rate increases to pay for replacing the catastrophe fund coverage.

Some insurers also have faced questions during the past three years about whether they are buying excessive amounts of reinsurance and trying to pass along the costs to homeowners.

The insurance industry uses complex computer models to estimate potential losses from hurricanes. A relatively minimum amount of reinsurance would cover losses from what is described as a 1-in-100-year event — a hurricane that has a 1 percent chance of happening in any year.

But some insurers have proposed rates that included buying far more reinsurance, up to a level as high as a 1-in-250-year event.

Regulators questioned such proposals during rate cases last year, including a high-profile case in which State Farm Florida unsuccessfully sought a 47.1 percent rate increase.

The state Office of Insurance Regulation accused State Farm of buying increased reinsurance rather than passing along savings to customers from the expansion of the Florida Hurricane Catastrophe Fund.

Adding to the dispute was that State Farm Florida bought part of its reinsurance from its Illinois-based parent company rather than from global reinsurers.

An administrative-law judge went so far as to raise the possibility that the reinsurance arrangements between State Farm Florida and its parent could be “sham transactions.”

But State Farm officials blasted the arguments of regulators and the administrative-law judge. They said, for example, that the Florida subsidiary saved money by purchasing reinsurance from its parent company instead of on the open market.

“There is no evidence that the parent/subsidiary relationship between State Farm Florida and State Farm Mutual is a ‘sham’ transaction,” the company said in a legal document.

Company official Dave Hill also pointed to hurricane losses in Florida as he defended the amount of reinsurance State Farm Florida bought.

“It’s incredible to me that people are suggesting companies are buying too much reinsurance,” Hill told lawmakers last year.

How Reinsurance Works

Reinsurance is a backbone of Florida’s property-insurance system. Essentially, it is backup coverage that insurers buy to help pay claims if a major hurricane hits.

A common measurement is for insurers to buy enough reinsurance to cover a “100-year” event. That translates into coverage for a hurricane that has only a 1 percent chance of occurring in a year.

Here is a step-by-step example of how reinsurance works, using information from Ormond Beach-based Security First Insurance:

1. A hurricane hits, damaging homes insured by Security First.

2. Security First must pay claims up to an amount of money known as a “retention.” For insurance companies, a retention is similar to a deductible that a homeowner would pay on damages.

3. Security First’s retention amount is $5 million. But because of a type of coverage it has purchased from reinsurers, Security First only has to pay 40 percent — or $2 million — of the retention amount, with reinsurers paying the rest.

4. If claims top $5 million, another type of reinsurance kicks in. This coverage will pay up to an additional $47 million in claims.

5. If storm damages grow, Security First can tap into the Florida Hurricane Catastrophe Fund, a state program that sells low-cost reinsurance coverage to insurers.

6. Security First can begin receiving money from the catastrophe fund after losses reach $43.3 million. The catastrophe fund, supplemented by relatively small amounts of private reinsurance, will cover up to $181.1 million in additional hurricane losses.

7. Additional private reinsurance would cover claims from a single hurricane that cost Security First more than $181.1 million.

8. In all, computer models approved by the Florida Commission on Hurricane Loss Projection Methodology estimate that Security First would face an estimated total of $225 million in claims from a 100-year event. The combination of reinsurance arrangements would allow it to cover those claims.

9. Just in case Florida gets hammered by repeated hurricanes, Security First also has reinsurance to cover up to four smaller storms in a year.

SOURCE: Security First Insurance