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									Is the Fox Back in the Chicken Coop?
By Frank Cacchione

“Those who do not learn from history are doomed to repeat it”- G.Santayana .

While the influx of some 24 new entrants into the Florida homeowners’ insurance market since
2006 is certainly welcome news, as consumers and industry people, we need to ask ourselves
some basic questions. First, how can we — and insurance regulators — be certain that all of
these recent entrants have the financial security and underwriting discipline to be there if and
when they are most needed? Second, does this concentration of new entrants compound the risk
to the overall market in any way?

Certainly the current global financial crisis raises further concerns regarding the need for
increased regulatory controls and diligence along with the potential cost and availability of capital
should the state of Florida ever need to tap into the bond market to cover catastrophe losses.
One of the critical issues of the current financial crisis has been the lack of government regulatory
oversight of the non-insurance subsidiaries of insurance holding companies.

A very hard lesson the insurance industry learned a few years back was the need to provide
significant oversight and control over certain Managing General Agency (MGA) programs. Back
then, a number of MGAs launched their own underwriting companies to provide specialty
coverages through various fronting arrangements and what turned out to be inadequate
reinsurance security arrangements. While these MGAs secured significant management fees for
underwriting, claim handling, and other services, the underwriting companies themselves suffered
substantial and ultimately unsustainable losses, resulting in the collapse of many of these firms.

The primary reasons for calamities of the past had to do with the basic business strengths of
MGAs versus underwriting companies, and the difficulty the regulatory system has in monitoring
the economics of the complex organizational structure of some of those businesses.

MGA Strengths
MGAs have demonstrated remarkable abilities in developing strong sales engines through agent
and broker networks. They also are adept at securing relationships with capable insurance
companies who underwrite the risk or provide tight guidelines regarding acceptable risks, pricing,
and reinsurance security.

The “lowest risk/highest return” economics of the MGA come from a growing and continuous
stream of commission revenue and service fees. The insurer must control the underwriting risk of
writing business at a price that will generate an adequate return and maintain sufficient capital
and reinsurance protection against catastrophic losses.

Historically, MGAs have played a major and important role in providing needed markets for
unique or difficult underwriting risks. Similar to the Florida homeowners’ insurance market, when
conventional insurance markets retrench or create availability problems, MGAs may develop
effective programs that satisfy customer needs and do so often at more favorable prices than
standard coverages.
MGAs can provide valuable service and support to their agent networks and their customers with
special products and services not offered by the agents’ traditional markets. The problems in the
past have arisen when MGAs and major brokers have assumed control of the underwriting risk of
some of these programs.

Reasons for Concern
The conflicts within MGAs remind me of the proverbial “fox in the chicken coop.” There are
fundamental, basic differences between underwriting skills and management and agency skills
and management.

Starting with economics, the largest portion of an MGA’s profit is derived from commissions and
management fees, with possibly some contingent profit provided by the insurer from superior
underwriting results, although these contingencies have been under fire in recent years.
Therefore, the MGA has a significant vested interest in generating high levels of premium in
support of its agent network.

It is the responsibility of the insurance company to exercise underwriting discipline in risk
selection, pricing adequacy and quality reinsurance protection. In the past, shifting of these
responsibilities to the exclusive control of the MGA frequently has created poor underwriting
results and, in some instances, significant cost to the consumer in the form of insurer insolvency,
related delays in claim payments, and increased unavailability or price increases of insurance

The greater current economic value to the MGA of continuing sales and service revenue can lead
to disastrous underwriting results when the decision resides with the same person, a person
grounded more in sales skill than the discipline that comes with extensive underwriting training
and experience.

The lack of adequate capital and reinsurance protection has also led to many of these historic
problems. Since most of these programs began with limited or borrowed capital in the form of
surplus notes (loans) and/or fronting arrangements with larger carriers, they relied heavily on

In many instances, the reinsurers were not of the highest quality and could not ultimately pay their
share of the losses. In other instances, where the reinsurers were sound financially, they provided
further fuel to continued sales in the face of mounting losses or charged so much to the insurer
that an underwriting profit was not achievable.

The Financial Monitoring Issue
Compounding the basic issue of where the greatest economic gain was derived, the
organizational structure of these programs made it very difficult for regulators to have a
transparent view of cash flow and profit. Most of these programs had multiple companies that
were being compensated by the MGA-owned insurance company. In addition to the MGA itself
receiving sales commissions, there may have been underwriting and administrative service
companies receiving management fees. There likely was a claim service company paid to
administer claims.

The regulator would have difficulty seeing or assessing the underlying costs and profitability of
each of these entities that were being paid by the MGA-owned insurance company. In the end,
while the insurance company might ultimately fail, it would have generated considerable profit
with limited downside financial exposure to the MGA.

Safeguarding the Florida Consumer
This lesson in history certainly can and should be avoided as we look at the current situation in
Florida. While there is no basis to believe that any of the new entrants will follow down this
unfortunate path, the adage of one of our late, great Presidents, “trust but verify,” will serve the
state well. What are some of these lessons that will help Florida safeguard against these past
industry problems?

    1. Confirm that there are significant checks and balances between the underwriting and
       sales functions through rigorous and frequent underwriting audits. Reinsurers do this
       regularly to ensure conformity of their clients through underwriting, claims, and financial
       audits of the entire organization, not just the insurance entity where management
       companies are involved.

    2. Be as concerned with unreasonably low pricing as with scrutiny of proposed rate
       increases. Immediate satisfaction can place a heavy price on future costs. While
       extremely difficult to do when prices are rising dramatically, challenging highly
       competitive prices is as important as regulatory pressure on unreasonable rate increases.
       Unbelievably low prices can be just that, unbelievable and unsustainable.

    3. Place strict transparent financial reporting requirements on all controlled entities of the
       organization, especially any insurers that have obtained favorable loans, reinsurance
       protection or other state funding. Regulatory focus must extend to all controlled entities
       and not just the insurance company in the group.

    4. Place restrictions on how much profit can be generated in the non-underwriting
       companies until sufficient surplus is generated by the underwriting company — i.e., keep
       the management company’s skin in the game. Like other kinds of business loans and
       investments, controls and restrictions can and should be placed on any organization
       receiving favorable terms from the state.

    5. Provide an open consumer forum to educate and receive feedback on specific company
       practices, advertising accuracy and relative stability. Let the consumers know the value of
       endorsement from the various rating agencies in making their decisions. Pay close
       attention to any early warning signs of questionable management practices.

These are some of the steps that can be taken to assure Florida homeowners that their insurer
will be there when needed most and that the ultimate burden will not fall back on them after
paying for their insurance. Let us hope that the skies are clear and that no one need worry about
maintaining protection at a reasonable cost. But given the unique nature of insurance availability
in Florida and the current global financial crisis, it does not hurt to remain diligent so as not to
repeat the past.

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