AAM’s Florida Homeowners Aggregate (“FHA”) experienced a moderate increase in catastrophe-related underwriting losses during 2016, resulting in a Last Twelve Months (LTM) combined ratio exceeding 100 for the first time since 2011. Total premium volume continued to grow, but at a significantly reduced rate compared to recent years. Meanwhile, underwriting leverage reversed its recent downward trend, posting the highest level since the 2013 peak. On the investment side the decline in investment yields seems to have finally bottomed out, with the unfortunate implication that portfolios have been fully turned over into the low prevailing rates of recent years. Exposure to common stock investments remain at record high levels (measured as a % of surplus), while cash holdings remain at a relatively low 21% of invested assets, down from 46% as recently as 2012. In this report we will review these and other developments in the Florida homeowners market, and look ahead to important developments in the coming year.

The FHA’s average loss ratio rose from 57.8 in 2015 to 66.0 for the LTM period ended 9/30/16 (all income statement items in this report are on an LTM basis, to compensate for significant seasonality effects present in this market). The first three quarters saw a modest increase in catastrophe losses, though expenses were largely flat. These figures do include the effects of Hurricane Hermine (the first hurricane to make landfall in Florida since Wilma in 2005), but exclude the impact of Hurricane Matthew, which struck the southeastern US in October and was the twelfth costliest storm ever in that region per National Oceanic and Atmospheric Administration (NOAA) calculations. Fortunately, Matthew ultimately caused much lower losses than initially feared and makes a good field test for the reinsurance and risk management programs of the many FL homeowner start-ups that have emerged in the past 10 years. Unfortunately, it will also likely lead to increased assignment-of-benefits activity, pending legislative relief for this ongoing issue in the Florida market. Between the effects of Matthew and the possibility of unfavorable reserve development in Q4, it appears that the recent era of relatively benign loss activity may finally be drawing to a close.

Premium growth declined for the LTM period, coming in at just 4.5% after consistently posting double-digit growth for many years. Although start-up activity remains robust as Citizens continues to shed premium, competition has intensified and placed downward pressure on prices in some markets. Meanwhile, the aforementioned assignment-of-benefits controversy has had a chilling effect on impacted markets, as private insurers grow wary of opening themselves up to lawsuits from contractors for denial of claims. Citizens’ CEO Barry Gilway commented in a September interview with the Sun-Sentinel that “Markets are shutting down in South Florida. New business has no place to go but us (sic). It would not be a smart decision on the part of a CEO to pick up South Florida business until we’ve got legislative remedies for [assignment of benefits].”

Anecdotal evidence also suggests that this practice is spreading into other parts of the state, suggesting that further declines in the rate of premium growth may be in the cards if nothing is done. This topic remains hotly contested between insurers and the litigators filing claims against them, and is likely to be examined by the Florida legislature during the upcoming session. Meanwhile the FHA’s retention ratio remained flat at about 48% of gross premium, virtually unchanged from the level of the past 3 years. Reinsurance pricing has been heavily pressured by the low claims activity of the last several years, and if 2016’s increased losses reverse this situation, it may create incentives for insurers to re-assess their reinsurance programs accordingly.

The average net yield on the FHA’s investments increased marginally during 2016, though the overall level remains largely flat since 2010. This reflects the impact of the FHA’s relatively short-duration bond investments (~70% of holdings in maturities of 5 years or less) and high cash holdings, both driven by a need for ready liquidity in case of sudden uptick in claims. Although it is welcome to see investment yields stable rather than declining, this is largely due to the fact that older investments predating the post-crisis low rate environment have mostly rolled off of insurers’ books, suggesting that even when rates do increase it will take a period of years for portfolio yields to fully adjust as lower-yielding bonds roll off. The rise in rates in late 2016—driven by expected higher inflation and the possibility of multiple Fed rate hikes in 2017—brought some relief, but also reduces the liquidity of existing holdings by moving bonds into an unrealized loss position.

With all that said, bond portfolios are in general prudently invested, with broad diversification across sectors, and duration and quality buckets. Exposure to tax-exempt municipal bonds have grown, with tax-exempt income growing from 6.9% of investment income in 2011 to 14.9% in 2015. Spreads on such bonds exploded higher after the election, and while they’ve reversed much of the move since then, the prospects for changes in corporate tax rates in 2017 suggest that more volatility lies ahead for this important investment sector.

The FHA’s average exposure to unaffiliated common stock investments rose slightly through 9/30 to 10.5%, the highest in recent years. While lower than the overall industry average, this is in keeping with the P&C industry trend towards increased equity exposure.  The strong stock market returns since 2008 have greatly benefited insurers and helped to replace surplus lost in the financial crisis, though the combination of Fed rate hikes, a volatile political environment, and elevated valuation measures suggest that downside risks may finally be lurking below the surface after the seemingly unstoppable rally from the 2009 lows.

Although common stocks are the most common risk asset type held by P&C insurers, Florida homeowners companies prudently hold only about one-third of the exposure of the broader industry, as the elevated risk of concentrated underwriting losses in catastrophe lines is best offset by reduced exposure to relatively volatile investment categories. Conversely, FHA companies hold significant amounts of cash on hand for ready liquidity, with 9/30 exposure little changed at just over 20%. This figure has dropped significantly in recent years, from over 60% in 2007 to the current level. Reasons for such a reduction include improved risk and liquidity management programs, increased participation in the Federal Home Loan Bank (FHLB) system for short-term cash needs, and an attempt to increase investment income and offset low yields by putting idle cash to work during periods of low loss activity.

Between unfavorable loss experience and the ongoing low level of investment yields, the FHA achieved a return on equity of just over 1% for the LTM period through 9/30/16. Additional underwriting losses in Q4 may push this figure below zero for the calendar year, though strong equity market returns may partially offset such losses. The period from 2012-2015 was very strong for this industry, thanks to modest storm activity and a booming stock market. Now it appears these tailwinds are fading, and challenges like the assignment-of-benefits controversy and increased pricing pressure from the influx of market entrants could mean a period of lean years lie ahead.

As always, a customized, diversified, and prudently balanced investment strategy is key to both supporting profitable underwriting through stable, predictable interest income, while also growing long-term surplus through strategic allocations to non-core asset classes. AAM has extensive experience advising Florida homeowners insurers on every aspect of investment strategy, and are available to provide a variety of complimentary analyses to companies interested in finding ways to refine and sharpen their portfolios.

AAM’s Florida Homeowners Aggregate is a collection of 28 Florida-domiciled P&C insurers writing primarily Homeowners coverage in the US Southeast region. All financial statement data is sourced from SNL.

Written by:

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees.  This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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AAM continues to monitor important regulatory changes affecting the insurance industry. Below we summarize recent developments on policies currently facing significant changes:

NAIC RBC Changes

The NAIC had their latest meeting in December and discussed the status of their plan to increase the number of ratings categories for bonds for RBC calculation purposes. Here are some highlights:

• After many months of discussion, there does now appear to be a consensus that the granularity of Life bond RBC factors will increase, in the form of an electronic-only column added to Schedule D
• The specific factors to be used are still subject to revision, but are likely to be broadly in line with those proposed by the American Academy of Actuaries
• It is likely (though still not finalized) that the increased granularity will also be applied to P&C and Health insurers, though they may have somewhat different factors
• Beyond the change in factors, the second step in determining bond RBC involves an adjustment based on the number of bonds/issuers in the portfolio. The details of this second step are also being reviewed, and are likely to be changed from the current form to more accurately reflect the impact of diversification on risk of credit losses
• The NAIC is still targeting year-end 2017 to implement the changes, though some in the industry view this as ambitious
• The ACLI proposed a materially different (mostly lower) set of expanded factors based on a study they did of historical default and recovery rates, including a recommendation to provide different factors for different bond types (e.g. corporate, muni, etc). This will be reviewed and discussed in future meetings

AM Best BCAR

In November AM Best released their intended adjustments to the BCAR formula for P&C companies. These were largely in line with those described for Life companies earlier in the year (using factors based on DFA modeling, reporting 5 BCAR scores based on confidence intervals instead of a single one, removing the suggested guidance for BCAR vs rating, etc). They intend to collect comments on this release over the winter, make any additional needed adjustments over the summer, and start implementing the new system in late 2017. The bottom line continues to be that in general they do not expect this new process to change existing ratings, though rare exceptions may exist. One notable investment-related feature of the new system is that bond ratings will now be based on a mix of rating and maturity bucket instead of rating alone, though we continue to believe that the most important BCAR contribution of an investment portfolio is through losses of surplus (if any), not the direct impact of the factors themselves.

Tax Reform

It is fairly likely that a federal tax reform bill will be passed in 2017. The single likeliest feature of such a bill is a reduction in corporate rates, and elimination of the AMT is also a possibility. This has already caused some volatility in the muni market, and will likely cause more in the future. We do not recommend accelerating realization of gains/losses as mechanisms exist to carry gains back to previous years anyway, even if 2017’s tax rates decline. We expect to learn more about the shape of this proposal shortly and will provide commentary at that time.

Schedule D Treatment of ETFs

In past NAIC meetings there was debate about the possibility of breaking ETF holdings out into a separate schedule in financial statements, with a field designating the underlying security type. This was resisted as insurers prefer to be able to keep reporting approved bond ETF’s in Schedule D. As a compromise, the current proposal is to show bond ETF’s as a separate bond subgroup on Schedule D. Relatedly, there has been debate about what book value should be for such ETF’s. Both historical cost and market value are viewed as inappropriate. The prevailing proposal is to use a measure called “systematic value”, which may entail somewhat complex calculations. Blackrock has released a paper offering a suggested form of this calculation, but it is possible that the standard could ultimately vary somewhat from state to state. This project is ongoing but could ultimately see adoption in 2017 or 2018.

Somewhat relatedly, a proposal has been made to institute an abbreviated and electronic-only collection of holdings data at mid-year (currently holdings data is only collected at year-end, with trades reported quarterly). This also appears to be acceptable to the industry and likely to be implemented within a year or two. In AAM’s view this will be very helpful for providing up-to-date industry and peer analytics.

Principles-Based Reserving

Although AAM is primarily focused on regulations with direct investment implications, this one is worth noting here given how significant and long-awaited it’s been. Briefly, this is a regulatory change going into effect in 2017 that will allow life insurers broader discretion in how they calculate reserves for life lines (over time the new rules will be extended to cover other lines), in contrast to the current formulaic approach. Among the various goals of the change is to remove the incentives for complex life reinsurance (“XXX/AXXX”) transactions, which were undertaken due to previous formulaic reserving requirements being viewed as punitive by insurers, but also tended to make the industry more opaque and challenging to regulate. Additionally, the greater flexibility of the new rules should make it easier to accommodate new product designs without needing to constantly alter state laws. This change is probably most material for very large life insurers, but over time will likely impact virtually the entire industry.

Solvency II

This is the recently-implemented European insurer risk-based capital regulation, somewhat comparable to NAIC RBC in the US. While we mainly focus on domestic regulation, we mention this here because the Federal Insurance Office announced in September that the US does not intend to modify our own regulation to be able to apply for Solvency II “equivalence” (which, for example, Bermuda has done), putting speculation to rest on this issue. While US and EU insurance regulation may still converge over time, this will only be to the extent that regulators in each country view it as best for their own domestic jurisdiction. That said, in January the US and EU reached an accord on several key areas of insurance regulation, including ending “local presence” requirements for insurers operating outside their home country, and a reduction in collateral requirements for reinsurers conducting cross-border transactions.

Written by:

Peter Wirtala, CFA
Insurance Strategist

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training.  This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.