Expert Commentary

Windstorm Captives

Recently, the State of Alabama determined that the best course of action to provide relief for the high cost of property insurance along its coast was to promote and allow the formation of captives. This is a bold move, and bears examination.

April 2007

Windstorm coverage is a hot topic and will get hotter as the hurricane season approaches, June 1. In each previous year when hurricanes have wreaked heavy damage and large losses on the coastal United States, the subject of coverage through alternative risk, often captives, arose. Other options usually include some form of government support through so-called wind pools. This is a route chosen currently by Florida and South Carolina.

Alabama's approach is unique, although the outcome is yet to be tested. It actually allows the concerned property owner to finance their own risk. As of this writing, no property owners have availed themselves of a captive domiciled in Alabama, but that may change as June 1 approaches.

The legislation is in place and appears to be well crafted as far as captive legislation goes. Capital requirements are in a normally acceptable range of $250,000 to $1 million, depending on the exact structure chosen. Taxes and fees are in line with other domiciles. There are no surprises, good or bad.

There are the usual requirements of local involvement through an agent or manager. The use of a local attorney is recommended, as is the use of a local accountant. The tiresome requirement of a local director is also included, which I find disturbing because it is unnecessarily restrictive. It is difficult to find qualified directors in today's litigious climate. If a new jurisdiction is trying to attract participants from elsewhere, they need to recognize the realities of the situation. Putting a local attorney or captive manager on the board is not helpful, and they will likely decline the honor.

I admit to no local knowledge of Alabama or its captive scene. However I note that the Department of Insurance has not hired or retained any known expertise for captive regulation. This certainly does not mean that their existing staff is not sufficiently knowledgeable to provide competent captive regulation, but it does give one pause until more is ascertained about staff abilities. An all too familiar scenario is a newly minted domicile with no real expertise either handing out licenses freely or holding them back to no purpose, both due to a lack of experience on the part of the regulators.

In contrast to the Florida and South Carolina solutions where public funding is compelled, at least Alabama is offering a private, commercial market solution. It is yet to be seen if the legislature will support this effort over the necessary long term of any captive initiative. Nonpartisanship is essential to such an effort, and hard events can test that lack of partisan competition.

The public funding of losses from windstorm events for private home and property owners is one form of alternative risk financing. It is usually discriminatory in practice such as in Florida where nonresidents bear a disproportionate cost. It is interesting that anecdotally there is movement seen of Florida nonresidents to Alabama to avoid the increasing tax burden to support public insurance. But, in general, the windstorm risk is spread across the tax paying universe as in Louisiana. All we U.S. citizens get to kick in. Alabama's approach may limit the burden to the actual tax/property owners involved which is cause for close attention by itself.

This distinction between the sources of funding becomes important from a risk standpoint because the actual exposures are the problem and the funding a critical part of addressing the need. Steadily increasing costs driven by windstorm damage are caused by steadily increasing property values in windstorm prone locations. If the values are not removed, then the exposure will always exist. In classic risk management, one would transfer this risk to another party. Given the heightened ability of insurers to predict loss and to assess values by zip codes and model their cost of capital, it becomes clear that few real solutions are available. Captives may be one such solution.

It is not reasonable to ask shareholders of publicly traded companies to finance a risk that has a strong likelihood of failure. Note that elected leaders do feel that it is reasonable to ask otherwise uninvolved tax payers to fund a venture with a strong likelihood of failure. A good middle ground is the captive.

With a captive, of course, one finances one's own risk. Faced with the subjective criteria of home ownership in warm, sunny climes, and increasing those homes' values, self-finance may not be appealing, but may be the only option. While it may not be reasonable to ask public insurers to lose money or fund high hazard exposure, and while it may or may not be reasonable to ask tax payers to do so, it is quite reasonable to expect those most affected to construct their own risk finance solution. Alabama has provided that opportunity.

Residents of any jurisdiction can, of course, form a captive, and it can be in many domiciles. There is no real reason why an Alabama condo association cannot have a South Carolina captive. Perhaps that subject should be addressed by both of those domiciles. Given that lenders require windstorm coverage to support mortgages, the need for coverage persists and is unavoidable.

At the end of the day, forming a captive for windstorm risk for private property owners is appealing but does mean that the captive owners are declaring that they are willing to take a risk that the commercial market will not take. Perhaps the reinsurance market will look favorably on this step, but again, it does not change the basic equation: there are still high values in a dangerous spot. There is certainly no assurance that reinsurers will, in fact, support windstorm captives.

Alabama's move is interesting and may well help its homeowners manage and finance their risk better than is done today.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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