Breaking new ground: Alabama's captive plan aims to lower homeowners premiums in coastal areas and improve state tax revenues.

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Captive insurance companies traditionally insure commercial lines, but Alabama is on track to creating a new use--a captive that provides homeowners insurance to residents of its hurricane-exposed coastal municipalities.

"It's an interesting concept," said Denhis Harwick, president of the Minneapolis-based Captive Insurance Companies Association. "The nature of the beast is commercial lines rather than personal lines. I suspect that's something that regulators would be leery of. Their comfort level with captives involves the fact that they have sophisticated consumers who are essentially self-insuring, and that obviates a lot of the consumer-protection role that a regulator has."

Captives usually write the risks of parent corporations, and regulation is therefore solvency-based, said Ed Koral, senior manager in alternative frisk financing and captives at Deloitte

Consulting LLP. "So if you now have a situation in which a captive insurance company started issuing personal-lines insurance policies on a direct insurance basis, as compared with maybe acting as a reinsurer, you would need to introduce an aspect of consumer-based regulation that would allow it to operate in an ethical manner in dealing with unsophisticated buyers."

The driving force behind Alabama's plan, State Revenue Commissioner Tim Russell, understands he is breaking new ground. A 35-year veteran of the property/casualty insurance business, Russell was chairman of the National Association of Mutual Insurance Companies in 1991.

For many years, Russell served as company president of Baldwin Mutual Insurance Co., which his grandfather and 19 other farmers formed in 1921 when no insurer would write coverage for them.

Now residents face a homeowners insurance crisis in coastal Alabama. After Hurricane Ivan caused $1.8 billion in insured losses to the area in September 2004, Russell became one of 15 members of the insurance industry to serve on a task force requested by Congress. The next year, after Hurricane Katrina struck the Gulf Coast, the task force concluded that coastal insurance in America was going to be a challenge.

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"Because of all that, Gov. [Bob] Riley and our congressman from the area asked me to head up a task force on how to solve the insurance crisis in Alabama," said Russell. After an ethics riding, Russell resigned as mayor of Foley, a town a few miles north of the coast, to chair the task force. The governor subsequently appointed Russell revenue commissioner.

Russell and the task force propose formation of a captive insurer funded by proceeds from tax-free municipal bonds and backed by reinsurance. Russell calls it the only real solution.

"Until the catastrophic situation changes, it's going to take a government-owned and operated captive that's operating a tax-free mechanism to handle the risk in a way in which citizens can afford the coverage to continue to operate in a coastal area like Alabama's," he said.

Economic Harm

Russell focuses on a captive because homeowners insurance now averages some $4,000 to $5,000 a year as compared to $1,200 a year before the hurricanes. In March 2008, State Farm Insurance Group said it would not write new wind and hail policies for the most vulnerable homes in the area. The higher costs and availability problems diminish economic activity in the area, which reduces tax revenues in the state.

Only 12% of Alabama's population resides in the coastal area made up of Baldwin and Mobile counties. The area includes the port of Mobile, which Russell said is the 10th largest major port in America. But the coast traditionally generates a disproportionate share of tax revenues on a per-capita basis, thanks to a higher income-tax base and tourism dollars. Alabama depends largely on its income tax and retail sales tax, Russell said. Since Ivan and Katrina, tax revenues of all kinds from coastal Alabama are down by about 20%, Russell said.

In addition to the tax-free status of capital raised by municipal bonds, the proposed captive insurer also would benefit from a state law that provides a lower premium tax. Russell said Alabama's premium tax is 3.6%, but that the rate is only 0.4% for a captive. In the long term, he estimated, the tax advantages could reduce homeowners premiums 35% to 40% compared to standard market levels.

Cities and counties can issue municipal bonds to fund a captive if they have created tax-improvement districts. Russell said that seven cities and Baldwin County have unanimously voted to go into the captive. The city and county of Mobile had not yet voted as of late January, but Russell said he was optimistic they would.

The amount of insurance then underwritten would be proportionate to the capital provided to the company. The governments would appoint members to a board of directors--a mix of professional people and representatives of each government. The board would hire insurance professionals, especially those with catastrophe experience, to manage the captive.

Limitations to coverage would be set by the board. "I see it starting off with standard homeowners coverage," he said. "High limits would be on a facultative basis." Rates would be higher than those inland. "We're not saying rates won't be actuarially sound, but the tax-free, long-term value of money is significant"

Koral said that because of the municipal-bond differentiator, the captive could succeed. "And then the issue would turn to making sure that a captive that is selling to the general public is regulated in the same way that a traditional insurance company is regulated," he said, referring to consumer-based regulation in addition to solvency-based.

Reinsurance Required

Russell said that, having spent 35 years buying catastrophic reinsurance, he would never have thought that market would be receptive to requests by a captive. "That was until I went to Bermuda and visited the top 12 reinsurers, who overwhelmingly supported the idea," he said. Reinsurance would provide a backstop against the concentration of risk in a small geographic area.

Another important factor in the potential strength of a captive is that most of Alabama's coastal jurisdictions have implemented stronger building codes on new construction, to protect buildings against winds as high as 140 miles per hour. "Most of the less-fortified buildings from when I was a boy are gone," Russell said. "They've been destroyed or torn down for bigger, more-expensive housing."

That means the area's biggest exposure may now be from flood rather than wind, and the captive will require federal flood insurance to be written on every participating homeowner. Meanwhile, the state "beach pool" of coverage from the Alabama Insurance Underwriting Association would continue to cover homes right on the beach.

Before Hurricane Ivan, AIUA had issued only 3,000 policies, but now is up to about 36,000 policies. The coverage indemnifies standard fire and other perils, though less extensively than what is insured by traditional homeowners policies, Russell said. Also in effect on coastal properties is a wind deductible that excludes coverage for the first 5% of damage costs.

Asked whether local governments would be on the hook for claims from a bad storm, Russell said the plan's intent is to make the capital finite, with participating local governments backing the municipal bonds. But that risk is small compared to the economic loss a region bears if it can't insure buildings to generate retail sales and taxes, he said.

Citizens elsewhere in the state would not be exposed, he added. That is significant because 88% of the state population lives outside the coastal area. Russell said the state does not have the political clout to form a state-sponsored program such as Florida's, where 78% of the population lives in coastal areas.

Municipal Power

Koral said the captive plan is distinct from plans that issue catastrophe bonds in that the municipal bonds are actually backed by local governments. "That means the investors in the bonds are not necessarily at risk for the principal in the event of a catastrophe," he said. "As a result, the amounts that the governments need to pay the investors are probably a lower yield, and probably a good thing for this company."

However, if reinsurance should become expensive for the captive, the company could issue catastrophe bonds as a substitute for traditional reinsurance, he said.

Using tax-exempt municipal bonds as a borrowing mechanism that subsidizes the cost of coverage for the insureds is a very innovative use of a whole collection of tools available to insurance professionals and public policymakers, Koral said. "One could almost say that they were almost meant for each other in solving this problem."

Russell also played a role in the formation in 1989 of the Alabama Municipal Insurance Corp., when cities in the state had a major problem obtaining police liability insurance. It, too, is a tax-free entity that has added general liability and property coverage. "Their rates, nobody can even touch them," said Russell.

"It's exposed in just one state. When we formed it, there were a lot of skeptics. Our city had to do a test case to get it formed. Now there are 458 cities in Alabama, and the last time I checked, I think 300 are insured by AMIC. I think the new captive would catch on in a very similar way."

* The News: Alabama leaders are creating a captive insurance company to provide personal lines insurance in coastal areas.

* The Significance: A major component of the plan calls for local governments to fund the captive by issuing tax-free municipal bonds.

* What's Next: If the plan flies, it could become a template for insuring residences and restoring economic vitality in hurricane-prone regions.

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