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Inside in Full: Hurricane Demotech: Forced crisis increases chance of second set of reforms

“It’s an execution event,” one source said of last week’s set of letters to 17 Florida insurers from Demotech advising them of a potential downgrade...

But as this publication broke the news of the shock letters, an extraordinary regulatory reaction against the threatened outcome was unleashed, creating significant uncertainty over the path forward.

Tomorrow marks the deadline that Demotech had outlined for publication of final ratings for the Floridian carriers, with the 17 at risk of downgrade representing around half of the domestics active in the state.

In terms of the upfront ratings action, clearly there are three high-level scenarios. Either all 17 groups are downgraded, a sub-set are downgraded, or Demotech – under huge pressure - walks back in full.

However, overlaid with those scenarios there are the differing regulatory reactions that may follow, both from the OIR/state bureaucracy and at the federal level.

It does not follow that these downgrades will immediately lead to insolvencies (as with prior downgrades), highlighted by the letter from Florida CFO Jimmy Patronis which states that impacted carriers are “not presently ‘impaired’ or ‘insolvent’ as those terms are defined in the Florida Insurance Code.”

If regulators do not choose to push downgraded insurers into receivership the reaction of 1) insurance agents and 2) government sponsored enterprises (GSE) Fannie Mae/Freddie Mac will determine the viability of such firms. Even if Demotech bars the gates to some carriers, acceptance of alternative standards by the GSEs could still open up an another trade-forward path for downgraded firms.

There are therefore various layers of dependencies that will determine how this plays out, all highly unpredictable given the complexities of Florida politics, Demotech’s perceived maverick status, and the incredibly high stakes for everybody at the table.



Leeway for reprieves unclear

The first critical question at stake is how much leeway remains in the Demotech process ahead of the anticipated July 26 publication of its ratings, though sources have said the date could now shift to month end.

Even setting aside the potential impact of additional pressure brought to bear on the agency by the Florida OIR and CFO, this is difficult to determine.

On the one hand, sources pointed out that the 17 insurance groups received individualized letters listing specific issues behind their pending downgrade, and some carriers at least have been able to have calls and back-and-forth with Demotech on the process to attempt to remedy the concerns raised, sources noted.

But on the other hand, some of the issues at stake are underlying issues with underwriting profitability and reserving trends. “These are not issues you can move in a few days of discussions”, as one source pointed out.

Crucially, the OIR letter backs up the view that the downgrades represent a fundamental shift in view from Demotech on the Florida market, as it suggests that many insurers were told adding more capital would not prevent the pending downgrade.

If Demotech does walk back from as many downgrades as have been floated, it will be impossible for outsiders to know to what extent this has been the result of political pressure. But the salvoes fired by the regulators must somewhat increase the chance of a climbdown, and Demotech of course already had a history of rowing back on threatened downgrades.

The OIR letter focused on asking Demotech to justify its process, stressing that the regular was “ any way...a request that Demotech deviate from its rating methodologies or as advocacy by OIR for or on behalf of any one or several insurance companies”.

The contrasting letter from the Florida CFO to Fannie Mae and Freddie Mac was more forthright, and underscored that this controversy could cost Demotech its privileged position in the Florida homeowners market.

CFO Patronis overtly referenced finding other providers to serve Florida insurers that would be acceptable to the housing financiers (rather than lobbying for them to accept Demotech’s S rating as an alternative, which some had speculated the ratings agency was hoping to force through in this fell swoop).

Demotech’s near-monopoly position has arisen not because it has been sanctioned as a key provider by state officials, but because in practice its methodology offered local domestic carriers ratings that held sway with the GSEs Fannie and Freddie.

This would be true of few other of the largest ratings agencies, although some select Floridians have historically held AM Best ratings as well. But as we explore below, there is at least one other option that has partial credit with the GSEs that some insurers might opt to pay for in lieu of Demotech if downgraded.

While Demotech may not have anticipated the degree of backlash, in preparing to downgrade 17 carriers it had already signalled that it was expecting to take a financial hit from lost business – as even if some survived the downgrade to an S rating through restructures, not all would have done so.



Moreover, others suggested that fresh from registering as a nationally recognized statistical ratings organization (NRSO), Demotech was now likely to take a harder line on its ratings decisions.

From a process point of view, NRSO agencies are required to block off their business development arms from the ratings process and analysis. And from a reputational point of view, one source suggested that Demotech might have felt that a crunch point had emerged in terms of systemic risk that it did not want to face the criticisms levelled at other agencies for missing weaknesses in the structured finance world ahead of the 2008 crisis.

Ultimately, while there are political ramifications at stake here, no party can deny the problems facing Florida insurers, who have been heavily loss-making since 2016 (see graph). Some insurers who have not been downgraded expressed support for the ratings agency’s stance, with one dismissing critics of Demotech as “shooting the messenger”.

The main challenge for regulators is therefore just how much disruption can be avoided as the industry staggers through this hurricane season and attempts to rebuild.



GSE stance critical

Two of the key factors that will influence the next steps are how insurance agents and GSEs respond.

Other than Demotech, Kroll is seen as the next most likely ratings agency option that Florida’s insurers could turn to – but it is only currently accepted by Fannie Mae and it can take six to eight weeks to secure a rating.

The GSEs are so crucial because while Florida law does not require an insurance company to be rated, the secondary mortgage market, dominated by Fannie Mae and Freddie Mac, which back roughly 62% of all residential mortgages, does.

“Because most banks and lending entities adopt the standards set by the secondary market, no rating agencies meant no mortgage loans could be originated in Florida,” the Florida Association of Insurance Agents (FAIA) explained in a letter to members, referencing the historic market panic that set in following 1992 Hurricane Andrew.

“If the estimates of how many carriers could be downgraded are accurate (17 companies), millions of homeowners may find themselves insured by a company that doesn't have a financial strength rating suitable to Fannie or Freddie,” it continued. (Higher reports of 27 companies at risk of downgrade is understood to include all subsidiaries within groups often treated by the (re)insurance market as a single entity).

In the event homeowners cannot find alternative coverage – such as from Citizens – then their lender could move to put a force-placed coverage in place (which typically only provides limited coverage to protect the bank’s outstanding loan).

The trade body’s letter also highlighted the risk to insurance agents who may not be covered under professional indemnity insurances for errors and omissions if they recommend an “S” rated carrier to their clients.

Solvent but impaired?

It is possible that the OIR will not automatically place carriers who get moved to an S rating into insolvency immediately.

The letter from CFO Jimmy Patronis drew out a line of argument that the regulator could use to keep impacted insurers afloat, as he argued that the “extreme outcomes are not necessary given the fact that all Florida insurance companies being downgraded were able to obtain reinsurance and are not presently “impaired” or “insolvent” as those terms are defined in the Florida Insurance Code.”

However, sources said even without regulatory action, carriers with an S rating could struggle in the longer-term depending on agent behaviour. If E&O concerns drive agents to move business, the loss of premium income could ultimately further weaken wavering insurers.

Even if officials "huff and puff” and the Demotech downgrade threat is blown away, brokers and agents are going to be a lot pickier about where they place clients after this experience, one capital market source forecast.

With that said, there are increasingly few places for agents to place clients – earlier this month Citizens said the market was effectively “75% shut down” due to the number of carriers calling a halt to new business. A new exit from the state’s residential market – that of Bankers Insurance, which previously had stopped accepting new homeowners’ business – emerged just at the end of last week.

Citizens will weigh heavy on public purse

One factor that will minimize immediate disruption for homeowners compared to the post-Andrew turmoil is that Florida already has state-backed insurance fallback infrastructure in place.

Florida Citizens is now set to become an even bigger “parking lot” for risk, as one commentator put it.

While some private carriers may pick up extra business, it is not obvious that there will be any other significant route for policies into the E&S or other markets. This presents a daunting prospect for the extent of Citizens’ potential growth – particularly given the timing of the insurer having cut back its reinsurance coverage.

The carrier is already a “gigantic contingent liability on the state [and only] half-reinsured,” one source noted. Any major hurricane loss in the near future will result in [a] “hidden tax [emerging] to bail out Citizens.”

Florida Citizens is a gigantic contingent liability on the state [and only] half-reinsured.

Another tipped that the state insurer could quickly double in size to two million policies, versus the 1.2 million it was expecting by year-end.




There’s [reinsurance] capital that has looked at it and stepped back.

But there will also be the question of how many downgraded carriers manage to salvage some business on an ongoing basis, either through restructuring or sourcing a Kroll rating.

“There is a playbook,” one source said, pointing to the potential for groups with multiple operating entities to keep afloat part of their business by pushing capital and their most attractive policies to the surviving entity.

Recent examples include FedNat’s sale of a majority stake in Monarch after the FedNat brand was downgraded to an S, or in a similar vein but through a different setup, the transfer of St John’s book to Slide.

Even if there is no further movement from the GSEs and the best that can be achieved for domestics is use of an acceptable grade Kroll rating, recognised only by Fannie Mae, this should soften the blow of the downgrades and keep some business in the private markets.

A source estimated it could save over half of the total policies at risk.

Fundamental reforms now critical

The focus will now also be drawn to what must be done in order to attract capital back to the market.

On top of its lobbying of the GSEs, the state’s officials and politicians will now have to turn to legal reform that cuts to some of the fundamental problems ailing Florida insurers.

Politicians have long been chary of delivering major insurer-friendly step-changes in order to protect homeowners’ rights to use AOB providers and due to the heavy lobbying from the legal industry. But the extent of the coverage drought facing Florida’s homeowners now makes it likely that reform will really step up a gear.

Lawmakers already expanded the state reinsurance scheme, if by a small sum, this year. Could they consider new left-field ideas – perhaps giving insurance agents a shield from E&O suits or additional capital support for carriers – as the crisis worsens?

Although Florida made up just 7% of homeowner claims opened nationwide in 2021, it represented 76% of homeowner lawsuits against insurers.

The challenge is that the state’s insurance problems are “deep and hard to fix”, as one source said. Top among the industry’s complaints has always been the amount of litigation filed against insurers and one way attorney fee expenses, which this year’s reforms only went partway to addressing.

As an updated OIR report on the sector has laid bare, Florida insurers paid $3.1bn in legal expenses related to homeowner claims in 2021.



Meanwhile, although Florida made up just 7% of homeowner claims opened nationwide in 2021, it represented 76% of homeowner lawsuits against insurers.

This has contributed to ongoing issues with reserve deterioration. In 2020, insurers hiked their 2019 underwriting year reserves by $256mn, and to $481mn in 2021.

In terms of increased reinsurance costs, the OIR found that Florida insurers spent 54% more on coverage in 2020 than a year earlier, but secured only 15% more protection. Moving into 2021, coverage rose 19% but costs were up 28% from 2020.

The potential pathways

As this publication had reported ahead of reinsurance renewals, some commentators were already calling this year’s operating environment the most challenging since Hurricane Andrew.

It now seems a remote chance that the shockwaves from “Hurricane Demotech” will fully dissipate. Even if no downgrades occur, carriers and agents will be on guard. And it is hard to envisage Demotech rowing back completely on its threat to downgrade the most vulnerable carriers.

The greater the number of companies downgraded, the higher grade the damage will be in terms of disruption to homeowners and the ballooning risk taken directly by the state.

If political leverage can achieve a quick fix with the GSEs in terms of alternative ratings recognition, this should step down the state’s risk of a non-functioning market in the short term. If not, the OIR may still be able to permit some carriers to service existing business with an S rating, or the state may provide support that helps slow the influx to Citizens.

Florida’s public market infrastructure, combined with the potential “band aid” of Kroll ratings or restructures of some groups, make it more likely that that it will be a case of heightened market dislocation rather than the meltdown that followed Hurricane Andrew.

But with that said, this publication has argued that the Florida market has got away with a free insurance lunch (or roof) for too long. In signalling this more negative stance on a larger swathe of the sector, Hurricane Demotech could arguably force a crisis that makes reform and remediation achievable faster than a staggered picking-off of the weakest carriers and corresponding incremental changes.

The state’s legislators can no longer be under any illusion that quick fixes will do to patch up this market – as ultimately, the final factor that will determine how much havoc 2022 wreaks on the Florida insurance scene, (and the Sunshine State’s taxpayers), are the weather gods.

Additional reporting: Martha Muir, Farhin Lilywala


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