The whirlwind demise of a California insurer in the aftermath of a deadly and devastating wildfire offers an important lesson for the property and casualty industry.
At a time of robust property catastrophe reinsurance capacity, increasingly sophisticated modeling software and a broad focus on enterprise risk management, the fall of the 112-year-old Merced Property & Casualty Co. shows that even the most solvent insurers, particularly those lacking geographic diversity, may not be immune to financial collapse under extreme scenarios.
Beset by claims from the Camp Fire, Merced went from overcapitalized to insolvent in an eight-week span. Although the California Department of Insurance characterized the company in a press release as a "small failing insurer," Merced's balance sheet was bereft of red flags prior to the Nov. 8 onset of the blaze in Butte County, Calif.
Rated A- by A.M. Best, the company's relative capitalization had been more than 1,662.2% of its authorized control level risk-based capital as of year-end 2017. Its premiums-to-surplus ratio was just 35.4%, as compared with 75.6% for the P&C industry as a whole. The company had not triggered an unusual value under the National Association of Insurance Commissioners' Insurance Regulatory Information System ratios, which include 13 measures of profitability, growth, liquidity and reserve adequacy to assist state insurance regulators in their oversight activities, since 2012.
The company positioned its 2013 demutualization and merger with United Heritage Mutual Holding Co. as a way for it to secure its future, not from a solvency standpoint but rather from a top-line perspective given the toll that economic woes in California's Central Valley, which includes Butte County, had taken on the former Merced Mutual. The company's direct premiums written had declined for eight consecutive calendar years through 2013.
Merced's fortunes abruptly turned, however, as its growth turned positive and accelerated in each of the past four years. The 23.8% growth in direct premiums written that the company achieved in 2017 marked its fastest rate of expansion in 14 years.
"Merced now has the ability to move forward in order to remain a viable and competitive company," the insurer said in its 2014 annual statement, citing entry into the personal auto insurance business and its ability to bundle personal lines products. More recently, the company received approval for a new manufactured housing product.
"Our expectations for positive sustainable growth are now a reality," Merced added in the 2014 filing. " ... [W]e are in business for the long haul."
Merced's direct premiums written in its core homeowners business rose 12.1% in 2017; the new auto business contributed premium volume of more than $1.6 million. Approximately 60.5% of Merced's year-end 2017 policies in force and 81.4% of its full-year 2017 direct premiums written came from the homeowners line, all from within California.
A 2016 rate filing offered a glimpse at the composition of the homeowners book as Merced sought to attract business at lower risk for wildfires and impose a surcharge on higher-risk insureds as measured by the ISO's FireLine model. While 51.9% of Merced's annualized homeowners earned premiums at the time came from properties with "negligible," "low" or "moderate" risk as measured by FireLine, 44.3% and 3.8% of those premiums, respectively, related to properties deemed to be at "high" or "extreme" risk. The filing did not provide additional detail about the geographic exposure of those risks, however.
The financial collapse of a relatively highly rated, but geographically concentrated, P&C insurer in the aftermath of a generational catastrophe is not without recent precedent. Losses from hurricanes Irma and Maria in 2017 eventually led to a rehabilitation order for Real Legacy Assurance Co. Inc., a Puerto Rico-domiciled company that A.M. Best also rated at A-.
Real Legacy Assurance, which generated virtually all of its business from Puerto Rico and the U.S. and British Virgin Islands, initially reported a net loss of $2.6 million for full-year 2017, but its situation deteriorated markedly thereafter. Its $80.5 million net underwriting loss included the impact of $68.3 million of unfavorable reserve development for accident year 2017, leading its policyholders' surplus to tumble to a deficit of $41.9 million from a positive sum of $38.4 million six months prior.
The insurer explained in its June 30 quarterly statement that claims from Hurricane Maria exceeded catastrophe reinsurance limits by approximately $70 million. Its reinsurance program provided coverage for an event with a return period of 100 years, but the company estimated that the return period for an event of the scale and scope of Maria ranged from 150 to 200 years. It issued a voluntary request to Puerto Rico regulators in July to initiate rehabilitation proceedings.
Merced appears to have faced a similar dilemma. California's state regulator estimated that the company's gross losses exceeded the sum of its expected reinsurance recoveries by more than $56.7 million at a time in which its surplus totaled $17.1 million. Its magnitude of its shortfall rapidly emerged as the company entered liquidation only days after the Camp Fire was fully contained.