The vast majority of small insurers operating in Florida are considered so financially weak that they wouldn’t typically meet federal guidelines allowing them to back mortgaged homes.
That’s a central finding of a study that also suggests that Florida consumers are being led to believe their insurers are much healthier than they really are.
The study, by researchers at Harvard University, Columbia University and the Federal Reserve Board, has not yet been peer-reviewed. But it was posted on a website for scholarly papers in December and has caught the attention of national and state insurance officials and observers.
There are few independent studies of Florida’s insurance crisis, and the report offers insight into one of the state’s vulnerabilities: its reliance on about 50 small insurers, covering about 70% of policyholders, that are usually rated by a single company.
That ratings company, Ohio-based Demotech Inc., was the target of a round of public retribution in 2022, after Gov. Ron DeSantis’ administration accused it of threatening to downgrade 17 companies that year.
The downgrades posed a threat to the state’s housing market as DeSantis was seeking reelection and gearing up for a presidential run. The mortgage giants Fannie Mae and Freddie Mac require insurance from highly rated companies, such as those that receive an “A” from Demotech. If 17 insurers suddenly didn’t qualify, a million Floridians could have been left scrambling to seek insurance policies.
Demotech was accused of being a “rogue ratings agency” by Florida’s chief financial officer, and U.S. Sen. Marco Rubio wrote that its ratings were “dubiously based.” Neither produced evidence Demotech did anything improper. Ultimately, four insurance companies went insolvent, and Demotech continues to be the industry’s primary ratings agency.
In their study, researchers compared Demotech’s ratings to that of AM Best, a more tenured company that rates some insurers in Florida. To Fannie Mae and Freddie Mac, Demotech’s “A” is equivalent to AM Best’s “B” or “B+”.
Researchers found they were not equivalent. Their results showed that two-thirds of Demotech’s A-rated insurers would not meet Freddie Mac’s eligibility to insure mortgaged homes, and 21% would not meet Fannie Mae’s requirement, if they were rated by AM Best.
Overall, it indicates there are “inconsistencies” among ratings agencies that “could encourage ratings shopping” by lower-quality insurers, they write.
“The ratings are not as meaningful as you would hope them to be,” said Ishita Sen, a professor of finance at Harvard Business School and one of the authors of the report.
When asked for comment, Fannie Mae and Freddie Mac did not directly address the report’s findings. Both said in statements that they regularly review insurance rating requirements.
“We do not influence or opine on the rating methodologies developed and executed by these rating agencies,” a statement from Freddie Mac said. The authors presented the paper to a research group there during an academic seminar last week.
Joe Petrelli, the founder and CEO of Demotech, said the report was yet another unfounded attack on his company. He said he had other studies showing that Demotech’s ratings were accurate and reliable.
“It’s part of the hit job that began in July of 2022,” Petrelli said.
Higher default rates
The authors said they focused on Florida because its insurance market is a bellwether for the nation.
Unlike most states, Florida’s market is dominated by small startup insurers that sprang up as national carriers withdrew from the storm-prone peninsula.
Many of the new companies had relatively little money or experience; some were led by former politicians. No ratings agency was willing to evaluate them. Nearly all mortgage lenders require homeowners to have insurance through a carrier approved by Fannie Mae and Freddie Mac, which accepts only companies with high enough ratings.
Other states are seeing a similar dynamic as disasters strike around the country. Last year, State Farm and Allstate announced they were pulling back from California over increasing wildfire risk. They still write in Florida but under subsidiaries that mostly cover the safer parts of the state.
The study’s authors note that the small insurers are far less diversified than their large counterparts. They’re also far more prone to go out of business and more likely to receive consumer complaints.
About 19% of companies Demotech rated “A” and above went insolvent between 2009 and 2022. Between 2006 and 2016, the state was not hit by any named hurricanes.
Mortgage lenders seem to be aware that the smaller insurers are riskier, according to the study. Florida lawmakers have helped startup insurers by paying them to take policies out of state-run Citizens Property Insurance.
When that happens, lenders are more likely to offload those mortgages to Fannie Mae and Freddie Mac, placing the risk with federal taxpayers, according to the study. The two corporations were created by the federal government to buy mortgages from lenders, pool them and sell them as mortgage-backed securities, freeing up lenders to sell more mortgages. The two corporations guarantee the securities — Fannie Mae typically from larger banks and Freddie Mac from smaller banks.
“Our results suggest that the banks are aware that there is, sort of, good insurers and bad insurers, and are trying to limit their exposure to the high-risk insurers,” said co-author Parinitha Sastry, a professor of finance at Columbia Business School. Ana-Maria Tenekedjieva, a senior economist at the Federal Reserve Board, is the third co-author of the report.
Fragile insurers could also be causing Floridians to default on their mortgages after hurricanes strike. The authors found higher rates of mortgage delinquencies after storms in counties that were dominated by those insurers.
Despite the risks with Florida-based insurers, Florida regulators have been “lax,” they write. Under state law, small insurers’ finances must be reviewed once every five years, the same rate as larger national insurers. (One insurer that went insolvent in 2018 had not been reviewed in seven years, the Times/Herald found.)
“You want the low-quality ones to be examined a lot more,” Sastry said.
Study recommended changes
State lawmakers and regulators have been aware of the risks.
After 2022, when the governor and regulators publicly lashed out at Demotech, lawmakers commissioned a $750,000 study to explore alternatives to the company. The study’s authors recommended requiring that insurers be rated by two companies instead of one, and that the state create a program to encourage those insurers to improve their ratings over time.
Lawmakers did not publicly discuss the report or take up its recommendations.
Florida’s insurance market is stabilizing, and regulators recently approved eight companies to write policies, six of which are rated by Demotech. Some Florida-based insurers are also seeking ratings from another new agency, Kroll Bond Rating Agency, which was approved by Freddie Mac last year.
This session, state Rep. Spencer Roach, R-North Fort Myers, introduced a bill that would have required the state to seek independent ratings for insurers. It never received a hearing. He said the new study’s findings are “obvious.”
“Nevertheless I am surprised to see it in print,” he said in a text message.