When Your Math Is The Real Disaster

Most of you probably don’t know I was a math major. For those who had the opportunity in the past to see my prolific earnings models, that probably won’t surprise you.

My one true talent in life is that, from a very early age, I could do calculations in my head very quickly and accurately in a way most others can’t. Some people are natural athletes or naturally artistic or musical. I am none of those, but I was born with an innate ability to compute.

I don’t say that to brag, but rather as context for what follows. As expected, I took some heat last week from special interests in Florida for pointing out what they should have realized: The Florida Hurricane Cat Fund (FHCF) is likely in big trouble.

Their reaction was no surprise. When people feel threatened, they lash out at those who tell the truth.

What I didn’t expect was for the criticism to suggest I was bad at math. That’s a low blow. Especially when, in this case, it is verifiably false.

Thus, I thought this would be a good opportunity to do some math education based on the current state of the Florida insurance market.

FHCF Recap

Before we get into the calculations, I should probably do a quick review of last week’s lesson. Very simply, the FHCF has published information showing that if there are somewhere between $20-30B of homeowners losses from a hurricane, they will lose all of their $12.7B surplus.

I suggested, based on prior experience, a $50B insured loss would lead to about $30B of homeowners claims.

Math thus suggests if you start with $12.7B of surplus and you then subtract $12.7B of losses, you have $0 surplus. It is surprising how some people want to argue over this.

$12.7B – $12.7B = $0

In this case, the FHCF would need to issue bonds to create capacity for next year. They estimate they can raise $8B/yr (we’ll see…this estimate was made in a healthier bond market and this would be a gigantic offering for the municipal market). The maximum coverage they can offer carriers is $17B.

In theory, you could raise $8B now, promise to raise $8B next year, collect the projected $1.4B of premium next year and reach $17B. (There are some other possible permutations I will shelve now for simplicity.)

$8.0B + $8.0B + $1.4B > $17B

There are big problems with that though. The biggest is can they really raise that much and how would they plan to pay it back? This is debt, not equity. The only way to repay it is to assume no future losses before it’s due. Probability math suggests that’s unlikely.

Secondly, as I’ll show later, FHCF buyers will not value reinsurance funded solely by debt the same as that funded through equity. In other words, A does not equal B.

The FHCF itself suggests it would only have $9.4B of the $17B target available next year after a large storm and, again, that assumes a $8B bond raise is feasible.

There is no credible path given to rebuild surplus (remember, debt has to be paid back so all the annual insurance premium would realistically need to be set aside for future debt maturities leaving none to pay claims or build surplus = more unfortunate math).

Leverage Isn’t Limitless

The biggest misunderstanding about the FHCF is it acts like a money multiplier in banking terms or, for an insurance reference, the Lloyd’s Central Fund. In other words, it’s promise to pay something allows everyone else to lever up beyond what they would otherwise be able to.

The problem is if that central fund loses its capital than all of its customers have to deleverage. This is what almost happened in some of the past Lloyd’s spiral scares.

Florida insurers can’t be writing premium at 5X surplus without the FHCF’s backing (and cheap private reinsurance…that also is now going away). Without this support, they’d probably be writing at 0.5X which means they’d have to reduce their PIF by 90%!

I will reiterate what I said last week. The FHCF is the finger in the dam. Too many others have used its capacity to write business well beyond what their own capital can support.

It is not credible to suggest that the specialist carriers can adequately capitalize their business without a solvent FHCF. So if the FHCF can’t trade forward, there will be a cascading, spiral like effect on the rest of the market. That isn’t opinion. That’s how the math works.

Correcting the Record

Now, let’s turn to the fun part. I was accused of being bad at math! As some of you may have seen, my analysis from last week’s blog was featured in Insurance Journal.

If you read the story, you may have noticed all the Florida centric participants quoted for it claimed I was wrong to one degree or another. One even said I had “no idea what [I was] talking about” and my math “is completely off”.

Note, not one critic actually found a factual error, because the facts are the facts even if they are uncomfortable.

While me saying them out loud doesn’t make them more or less true, them attacking me out loud speaks volumes.

So what do they say I got wrong in my math? Let’s have a look.

True Or False: Does $2.0B = $3.8B?

The most vocal critic said “[Ian’s] math is completely off because he’s not understanding how the FHCF provides only partial coverage to each company – there is private reinsurance coverage that goes below, around, and above the FHCF. So, for example, a $3.8 billion loss for Citizens does NOT mean that Citizens gets $3.8 billion from the FHCF, because the FHCF only covers a portion of the total loss of Citizens.”

OK, let’s be clear on a few things. First, I understand exactly how the FHCF structure works. Second, I never said anywhere Citizens would recover $3.8B from the FHCF or that the FHCF would cover all of Citizens losses from dollar one. That is demonstrably false.

In fact, what I actually said was “[a]ssuming Citizens takes a full loss below the FHCF (across both the PLA and coastal accounts) they are facing a $2B loss”.

The only reference to $3.8B was that the Citizens CEO has suggested their loss could potentially be that high. I clearly never said FHCF would pay the whole thing.

Now, Citizens does have $4.0B of potential losses they could recover from the the FHCF, but a) I never referred to that # in the post and b) that would require over $6B of gross losses which was never discussed.

So, what can we conclude?

a) I never made a math error and I never spoke to what I was accused of getting wrong.

b) if you are going to put words in my mouth, you should read what I actually said first because I’m going to respond and correct the record.

c) when someone knows you’re right and doesn’t want to admit it, they often resort to attacking your credibility as a distraction.

True or False: FHCF Future Losses = 0?

The other main criticism was that it doesn’t matter how much the ultimate losses are, only what FHCF has to pay each year. In other words, this person is suggesting the asbestos “pay as you go” approach.

Under this thesis, just because the FHCF has to pay $12.7B doesn’t mean they should recognize this in their financial statements because it might only pay say $3B annually for a number of years. The suggestion was this gives them time to rebuild capital through future premiums.

Now, to be fair, this approach at least sounds reasonable on the surface, but it does reflect some illogical math that makes it impractical.

Is it possible the state of Florida could try it anyway and direct the FHCF to pretend that unpaid claims don’t count when calculating its capacity for next year?

Sure, anything is possible. Is it a workable solution? No, not really, for a number of reasons.

First, it assumes there will be no future losses! Talk about bad math! The idea here is I guess if by the time the loss payments are complete you’ll have collected say $7B of future premiums and the other $6B you can pay with bonds. It all works out, right?

No. No, it doesn’t. This approach assumes there will be no more losses for years and years. Math suggests the odds are against that.

Furthermore, even if there were no losses for say five years, you’d have rebuilt only $7B of surplus and need $10B of bonds…with no plan to pay them back.

Second, while the FHCF can choose to not see unpaid claims, what about all their other stakeholders?

For example, the state likely needs to issue $8B of debt in the coming months! Don’t you think bond buyers will ask how you will pay all those unfunded losses before they write a check?

Or if you were an insurance company buying reinsurance from the FHCF, would you believe they could pay you if there was another hurricane?

Even if a carrier is willing to close its eyes too and pray for no losses, will Demotech give them full credit for this reinsurance?

If Demotech doesn’t believe the FHCF will have the resources to pay insurers, then they will likely pull ratings which effectively puts those carriers out of business.

Rebuilding Surplus

Let’s expand on a little of the above math. Let’s say the modelers are wrong and instead of $30B of personal lines losses, there are only $15-20B. What would happen then?

This would be similar to what happened in Irma which created $7.8B of losses to the FHCF which would reduce surplus to $5B. There are currently the $3.5B of bonds so that gets us to $8.5B of capacity or 50% of the desired $17B.

$5.0B + $3.5B = .5 * $17.0B

Annual premium, as noted, is about $1.4B. There would also be assessments. That amount depends on several factors, but an optimistic view is $600M/yr. That would mean cash flow in would be $2B/yr.

This would require a $6.5B bond raise which is feasible. The problem of course is there would be $10B of total debt. The repayment on prior issues was over 5 to 10 years. Let’s be optimistic and say 10 years. Thus, $1B/yr of the $2B cash coming in needs to be set aside for future debt service.

That means only $1B is actually rebuilding surplus so it would take seven years with NO claims to get back to $12B of surplus.

$5B + 7 * ($2B – $1B) – 0 * ($7.8B) = $12B < $17B

But do you really want to bet on seven years without a storm in Florida? It could be as soon as next year. What then? And again, this section assumes Ian is no worse than Irma which is a pretty optimistic view.

Citizens Loss Estimate Extrapolation

However, if you want to be optimistic look to Citizens. They’re suggesting this is no worse than Irma using their current estimate of $2.3-2.8B of losses.

What’s the math to support that? Total homeowner’s premium in Florida is ~$15B. Citizens is currently at $2.4B, so they’re basically saying losses will equal premium which suggests homeowners losses overall are $15B, or better than Irma’s $20B (admitted homeowner’s only).

$15B * (2.4B/$2.4B) = $15B <$20B

This seems unlikely and Citizens original number of up to $3.8B feels more realistic as this would assume more like $25B of admitted homeowner’s losses which would be more consistent with the $50B industry loss estimates and wipe out most of FHCF’s surplus.

$15B * ($3.8B/$2.4B) = $23.75B

The Cost of Other Reinsurance

I haven’t even mentioned the rising cost of private reinsurance. Even if the critics are right and the FHCF has no issues, private reinsurance costs will likely go up 50+%. What does that mean for the local home insurers?

We can solve that with math! Let’s say the cost of reinsurance today is 30% of premium. At a 50% price increase, that rises to…45%! What does that do to your profit?

If you can write at a 80% CR in a no cat year (which is historically a very optimistic result due to AOB), then that extra reinsurance cost alone takes you to a 102%.

To show our work, $100M of gross premium, used to be $70 after reinsurance with $56 of loss + expense. The $56 doesn’t change but the $70 drops to $55 yielding a 102% CR.

$56/($100 – $45) = 1.02

This means there is no path to profit in NO storm years. So how do you pay for the future hurricane losses? The math suggests you run out of capital.

Demotech certainly can understand this math and downgrade you. So even if I am wrong about FHCF, the local carriers are still going to be incredibly challenged. If I’m also right about FHCF, it’s hard to see how most of them continue to write new business.

The Transitive Property

Let’s bring out some more fun math! Do you remember the transitive property from like fourth grade? If A = B and A = C, then B = C. Well, the state of Florida might resort to the transitive property to pass along the cost of higher insurance losses.

Could the state recapitalize the FHCF out of general revenues? Sure, it could. But would it make sense?

The big reason the insurance market is broken is because Floridians refuse to pay a market rate for insurance. If you raise their taxes to pay for it (I’m not suggesting they will start a state income tax but it will be funded one way or the other), how is that any different than asking them to pay more insurance premium?

In other words, if higher insurance premiums cost me money and higher taxes cost me money, then higher taxes are just as bad as higher insurance premiums.

I guess you can fool yourself into thinking the state can borrow more forever rather than raise revenue to pay for insurance bailouts, but eventually the bill comes due.

The simplest way to pay it is let insurance premiums rise to an actuarially fair value that will bring new entrants into the market so the state doesn’t have to keep funding the losses.

But if you’re a resident of Florida, you’re paying for this one way or the other.

Zero Sum Game

Here’s some more math. Over the last 30 years, homeowners insurers have cumulatively lost money in Florida. That is true over most shorter time periods as well.

There is a very simple reason for this. Insurance premiums are not high enough to cover losses and expenses.

If that is the case (and you can check the math if you doubt it), why are there so many local insurance companies eager to write the business? Because, as I have pointed out previously, the executives at these companies often get paid handsomely.

This means, mathematically, if they are the winners, then everyone else – the insureds, the investors, the taxpayers – are the losers.

Summing It Up

Yeah, I groaned at that too, but how else could I end this?

OK, I covered an awful lot of ground, so I will leave it there. As events continue to develop, I’ll be sure to return with more math you can trust.

I still have to explore what this all means for reinsurance pricing and profits next year among other things.

So what is the takeaway from all this math? First, people whose opinions I respect and who understand the Florida market well have agreed with my analysis, so that’s encouraging.

Second, there is no formula that can solve the Florida insurance crisis that doesn’t include higher prices for homeowners.

Third, there is a significant probability of a capacity crisis where homeowners can not find insurance for next summer because many primary carriers will be unable to keep their Demotech rating due to the combination of reduced FHCF capacity and the increased price of private reinsurance.