Establishing a Sinkhole Facility

The growth of sinkhole claims within certain regions in Florida and the high cost associated with investigating and paying these claims appear to be related to an increase in the number of policyholders obtaining residential property insurance outside of the private insurance market. Section V reviews the options available and the factors that should be considered if the Legislature determines that the creation of a sinkhole facility in Florida is desirable.

The history of state responses to insurance market problems related to automobile insurance, worker’s compensation insurance, property and windstorm insurance, earthquake insurance, flood insurance, and mine subsidence insurance provides examples of different approaches to the structure of residual market mechanisms. Traditionally, most residual market mechanisms have been established as free-standing insurance operations, organizationally separate from the state government that created them. On the other hand, most of the mine subsidence funds were established within state agencies, although they typically outsource certain functions. As such, these are both options to be considered in the creation of a sinkhole facility in Florida. Another approach would be to establish a sinkhole facility as a component of an existing entity to gain access to its administrative resources. Each of these options has both benefits and drawbacks, as discussed in Section V.

While the governing boards of most residual market mechanisms have traditionally been comprised entirely or primarily of insurance company representatives, several of the mine subsidence funds are under the control of either:

1. The insurance commissioner or another state official;
2. Entities such as the state board of risk and insurance management or the state risk and insurance division housed within the insurance department; or
3. Boards made up of state officials including the secretary of environmental resources, the director of natural resources, the 7 Executive Summary-The Creation of a Florida Sinkhole Insurance Facility insurance commissioner, and the state treasurer. In order to qualify for an exemption from federal taxation, the sinkhole facility must demonstrate that it is an integral part of the state. As such, the governance issue is critical as the Internal Revenue Service (IRS) will look carefully at the nature and degree of control that the state has over the sinkhole facility. Section V provides the specific information that is considered by the IRS in making this determination.

Another issue to consider is financing. A determination must be made regarding the facility’s initial funding as well as options for assuring the facility’s long-term financial capability to meet its claim obligations during periods of financial distress. The state can decide not to assume responsibility for financial shortfalls in a residual market mechanism as it has in the past. Alternatively, like some of the mine subsidence funds, the state can decide not to require payment of claims by an insurance company if there is insufficient cash available to reimburse the insurer for losses ceded to the facility. The financing options available and their advantages and disadvantages are discussed in detail in Section V.

If a sinkhole facility is established, it must be determined if the facility will operate as a direct insurer or as a reinsurer. Generally, in the case of facilities operating as reinsurers, the facilities reimburse insurers for covered losses paid as a result of the insured peril. In the case of the facilities operating as primary insurers, the facilities take on the role of writing coverage directly for insureds without using the resources of primary insurers. In each case, the scope of responsibilities and the services provided by the facility can vary. A careful analysis of the nature and size of the tasks to be performed is needed before a final decision on the structure of a facility can be made.

Another important set of issues relates to coverage options, coverage availability, and pricing. Each of the states with mine subsidence funds has had to address:

1. Whether the policy 8 Executive Summary-The Creation of a Florida Sinkhole Insurance Facility will provide coverage for the dwelling only (Coverage A), structures only (Coverages A and B), or all property losses (Coverages A, B, C, and D) and if coverage for repairs to the land will be provided;
2. Whether the property will be covered on a replacement cost or actual cash value basis;
3. What amounts of coverage can be purchased;
4. Whether coverage will be available in all or part of the state and whether the coverage will be mandatory or optional;
5. Whether damaged properties that are not repaired will be considered insurable. This report reviews some of these options and their implications regarding subsidization, adverse selection, and cost of coverage.

This report uses homeowners’ insurance policy and loss data for the period 1997 through 2003 in order to:

1. Eevaluate sinkhole loss costs trends;
2. Develop expected loss costs related to sinkhole losses;
3. Evaluate the funding options and costs of operating a facility to cover sinkhole losses;
4. Provide an estimate of premiums to cover sinkhole losses. The data come from a group of insurers that represent over forty-five percent (45%) of the residential homeowners’ insurance market in Florida. The data used in trending loss costs are from the period 1999 through 2003. Additionally, maps provided in Appendix M show sinkhole activity from the United States Geological Survey (USGS) and Florida Geological Survey (FGS) databases as well as the insurance sinkhole loss data used in this study.

During this period, the number of sinkhole claims grew from 348 in 1999 to 1,018 in 2003. The severity of sinkhole losses is even more significant. Total sinkhole loss payments increased from just over $22 million in 1999 to in excess of $65 million in 2003. In addition, statewide loss cost estimates for masonry construction increased each year and are projected to reach $.398 in 2006. This represents a fifty-five percent (55%) increase in trended loss cost over the 10-year period. 9 Executive Summary-The Creation of a Florida Sinkhole Insurance Facility.

This report also provides smoothed loss costs where zip codes are placed into loss cost groups based upon the magnitude of the individual zip code loss cost. This is meant to reduce potential problems with individual zip code experience caused by low frequency, moderate-to-high severity events like sinkhole losses. Grouping by high to low loss cost also shows the significance of these losses when they do occur. Assuming a Coverage A limit of $200,000, the additional charge to premium for the high cost group would be $1,970 (as compared to $79 using the statewide average loss cost). The loss cost estimates should be considered as a starting point in effectively determining future sinkhole loss costs.

In order to provide additional information on the feasibility of operating a sinkhole facility, cost estimates for a facility were obtained from Citizens’ Property Insurance Corporation (Citizens). Based on 2,000 sinkhole losses, cost estimates were provided for:

1. A reinsurance facility where the insurers would cede one hundred percent (100%) of the sinkhole coverage to the facility;
2. A direct sinkhole insurance facility where the insurers would write coverage without the sinkhole exposure and the facility would write the sinkhole exposure. Assuming 2,000 sinkhole claims, an amount of approximately $9,944 per claim would initially be needed for loss adjusting expenses associated with adjusting sinkhole claims. Using this loss adjustment expense and the statewide loss costs estimates, the statewide average premium per $1,000 of coverage was calculated to be $.553 for masonry construction and $.195 for frame construction.

In reviewing the sinkhole losses in map form, it appears that there are differences between the pattern of geological sinkholes and insured sinkholes. Differences even appear in sections of the state where there are known sinkholes and sinkhole losses. Three possible explanations for these differences exist:

1. The losses may result from sinkholes that are not in either the USGS or FGS databases;
2. The insurance loss may be incomplete due to the lack of
   10 Executive Summary-The Creation of a Florida Sinkhole Insurance Facility
   participation of some insurers in the data call; and/or
3. The differences may reflect the underlying inconsistency between the geological definition of a sinkhole and how it is defined in the insurance contract. Assuming that the insurance and geological samples are representative of trends, the latter explanation is possible, especially considering the concerns raised by representatives of the geoscience community over the definition of sinkhole activity. These issues are more fully discussed in Section VI.