Citizens Property Insurance Corporation Management Discussion and Analysis for 2008 NAIC Group Code 0000 NAIC Company Code 10064

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1 Company Background This discussion provides an assessment by management of the current financial position, results of operations, cash flow and liquidity for Citizens Property Insurance Corporation ( Citizens or the Corporation ). Information presented in this discussion supplements the financial statements, schedules and exhibits in the 2008 Annual Statement. Citizens was established on August 1, 2002, pursuant to Section (6), Florida Statutes (the Act), to provide certain residential and non-residential property insurance coverage to qualified risks in the State of Florida under circumstances specified in the Act. The original intent of the legislation was that property insurance be provided through Citizens to applicants who are in good faith entitled to procure insurance through the voluntary market but are unable to do so. Citizens results from a combination of the Florida Residential Property and Casualty Joint Underwriting Association (the FRPCJUA) and the Florida Windstorm Underwriting Association (the FWUA). The FRPCJUA was renamed Citizens and the FWUA s rights, obligations, assets, liabilities and all insurance policies were transferred to Citizens. Unlike private insurers offering coverage through the admitted market, Citizens is not required to obtain or to hold a certificate of authority issued by the Florida Office of Insurance Regulation (the Office). In 2007, the Act was amended to recognize Citizens status as a governmental entity and the necessity of Citizens to provide insurance that was affordable. Citizens operates pursuant to a Plan of Operation that is approved by the Financial Services Commission and under the supervision of an eight member Board of Governors with two appointments each by the Governor of Florida, the Chief Financial Officer of Florida, the President of the Senate and the Speaker of the House. Pursuant to the Act, all revenues, assets, liabilities, losses and expenses of Citizens shall remain divided into three separate accounts as long as financing obligations entered into by the previous FWUA and FRPCJUA are outstanding. The debit issuances of the predecessor entities matured during The three separate accounts are Personal Lines Account ( PLA ), the Commercial Lines Account ( CLA ) and the High Risk Account ( HRA ). Citizens is a multi-line carrier underwriting commercial and personal residential property coverages as well as commercial non-residential property coverage. Significant lines of business and the amount of net earned premiums pertaining to each line of business as of December 31, 2008 are as follows: Lines of business 2008 Net premiums earned % (in thousands) 2007 Net premiums earned % (in thousands) Fire $ 97, % $ 191, % Allied* 1,282, % 1,676, % Homeowners multiperil 876, % 1,207, % Total $ 2,256, % $ 3,074, % * Includes wind only policies classified as Allied Lines. Page 1 of 11

2 Financial Position Citizens financial position at December 31 appears below: Assets (In thousands) Bonds $ 1,865,288 $ 2,510,723 Cash and short-term investments 5,461,322 7,306,998 Interest due and accrued 9,796 29,400 Agent's balances 184, ,630 Other receivables from reinsurance contracts 22,770 6,951 Reinsurance recoverable 37, ,405 Assessment receivable 619, ,222 Other admitted assets 9,440 11,979 Total assets $ 8,209,641 $ 11,022,308 Liabilities and surplus Unpaid losses and loss expenses $ 861,465 $ 725,400 Unearned premiums 1,087,189 1,487,146 Borrowed money 2,814,793 5,864,674 Remittance and items not allocated 87, ,535 Provision for reinsurance 10,585 17,085 Taxes, licenses and fees payable 4,651 11,856 Other liabilities 172, ,404 Total liabilities 5,038,867 8,379,100 Surplus (Deficit) 3,170,774 2,643,208 Total liabilities and surplus $ 8,209,641 $ 11,022,308 Assets Total assets decreased $2.8 billion, or 26%. This relates primarily to the decrease in cash and invested assets resulting from the redemption of the $4.75 billion of outstanding Auction Rate Securities (ARS) during the second quarter of 2008, the permanent markdown of certain distressed investments of $205.2 million and $275.2 million of non-admitted invested assets in 2008 offset by the $1.75 billion Page 2 of 11

3 Financial Position (Continued) pre-event bond issuance and 2008 net income. Certain investments, representing less than 4% of the portfolio are in defaulted Structured Investment Vehicles. While principal and interest payments are being made, there is a decline in market value which is being treated as a permanent decline in value for statutory accounting purposes. Full realization of the principal value is not readily determinable. Additionally, the Florida Statutes related to statutory accounting for investments requires that the majority of such assets are non-admitted. The Corporation s invested assets totaled $7.3 billion as of December 31, Because the primary purpose of the investment portfolio is to fund future claim payments, the Corporation employs a conservative investment policy. The Corporation s portfolio consists of debt instruments such as: US Treasury and US government securities and corporate bonds. During 2008, the Corporation received $241.6 million in interest earnings, which was offset by the markdown of certain distressed investments discussed above. Cash and invested assets decreased $2.6 billion, or 26%, during This decrease is due to the $4.75 billion redemption of the ARS, the permanent markdown of investments and non-admitted invested assets offset by net cash flow from 2008 operations, the collection of emergency assessment funds, the $1.75 billion HRA bond issuance and Florida Hurricane Catastrophe Fund ( FHCF ) reimbursements received during Approximately $58.2 million of the Corporation s operating funds are invested in the Florida State Board of Administration s Local Governmental Investment Pool ( LGIP ). The entire $58.2 million invested in the LGIP at December 31, 2008 is invested in Fund B, which has been frozen from investor withdrawals due to that portfolio s investment in distressed illiquid assets. As principal and interest payments are received, Citizens allocable portion is eligible for withdrawal and such withdrawals have been consistently made. Citizens recognized a permanent decline in value of $30.1 million resulting in realized capital losses on its holdings in 2008 (this amount is included in the $205.2 million of impairments discussed in the paragraph above). Full realization of the principal value of Pool B assets is not readily determinable. Citizens withdrew all monies in Fund A by December 31, Interest due and accrued at December 31, 2008 decreased $19.6 million, or 67%, as compared to yearend This decrease is attributed to the redemption of the ARS that occurred by May 21, 2008; as bond proceeds declined, the Corporation had significantly fewer funds invested. Agent s balances increased $57.7 million, or 46%, during This increase is primarily due to an increase in policyholder take up of the implementation of payment plans during the last six months of Citizens is required by statute to offer policyholders the option to pay their policy premium using the full payment plan, semi-annual payment plan or the quarterly payment plan. Pay plans were first offered during 2007; there are currently 205,275 policies utilizing our payment plans, representing 19% of Citizens policies. Page 3 of 11

4 Financial Position (Continued) Premium due from takeout companies increased $15.8 million, or 228%. Assumed policies are serviced by Citizens until expiration. Such servicing of polices includes cancellations and endorsements that could result in policyholder refunds. This increase is primarily due to the increase in policyholder opt outs after the policies have been assumed by the takeout companies, as compared to the prior year. Reinsurance recoverable decreased $84.8 million, or 69%. This has resulted mainly from the receipt of reimbursements of paid losses through December 31, 2008 in excess of new 2008 reinsurance recoverables resulting from reimbursable Hurricane Wilma claims. Citizens has recoverable losses of $3.8 million and $1.3 million from private reinsurance in the PLA and HRA accounts, respectively. In addition, Citizens has recoverable losses of $32.5 million from the Florida Hurricane Catastrophe Fund for paid Hurricane Wilma losses. Assessment receivables decreased $217.5 million, or 26%. This decrease is due to the collection of approximately $189.5 million of emergency assessment and approximately $28.0 million of FIGA assessment recoupment during Other admitted assets decreased $2.5 million, or 21%, during the year ended December 31, This decrease relates to a non-recurring accrual made at year end 2007 related to adjuster fees, which was repaid. Liabilities Total liabilities decreased $3.3 billion, or 40%, during The decrease is due primarily to the decrease of $4.75 billion in long-term debt relating to the redemption of the Auction Rate Securities offset by the issuance of the $1.75 billion HRA pre-event bond issuance. Loss reserves and loss adjustment expense ( LAE ) reserves are stated at the Corporation s estimate of the ultimate cost (as determined monthly by our in-house actuary and reviewed at year-end by an independent actuary) of settling all incurred but unpaid claims. Citizens does not discount liabilities for loss and LAE reserves. Page 4 of 11

5 Financial Position (Continued) Activity with respect to unpaid losses and loss expenses for 2008 and 2007 is displayed below: Loss and Loss Expense Reserve Summary (In thousands) Unpaid at beginning of year $ 725,400 $ 587,606 Losses and LAE incurred in current year: Current accident year 839, ,583 Prior accident years 91, , , ,925 Losses and LAE paid in current year: Current accident year 413, ,312 Prior accident years 382, , , ,131 Unpaid losses and LAE at end of year $ 861,465 $ 725,400 Unpaid losses and loss adjustment expenses increased $136.1 million, or 19%, during 2008 as compared to Net reserves related to the 2004 and 2005 hurricanes and the 2008 Tropical Storm Fay increased from $290.0 million as of December 31, 2007 to $293.1 million as of December 31, 2008, as determined by our in-house actuary. Unpaid losses and loss adjustment reserves not related to hurricanes increased from $435.4 million as of December 31, 2007 to $568.4 million as of December 31, This increase is due largely to an increase in frequency and severity of sinkhole, fire, theft and water claims. Direct written premium decreased by 25% from Unearned premiums decreased $400.0 million, or 27%, which is primarily due to a reduction in premium written, coupled with growth in depopulation during Remittance and items not allocated decreased $42.8 million, or 33%, for the year ended December 31, This decrease in advanced premium and suspended cash is primarily attributed to timing of payments received, specifically related to the auto-renewal process that was implemented for the CLA policy processing system in These system enhancements reduced the amount of manual intervention required in the underwriting process, which significantly reduced the overall processing time to renew policies and shortened the timing of application of premium payments. Page 5 of 11

6 Financial Position (Continued) Provision for reinsurance decreased $6.5 million, or 38% as of December 31, This decrease is due mainly to the reduction of reinsurance recoverable on catastrophe claims as compared to Borrowed money decreased $3.0 billion, or 52%, during This decrease is due primarily to the $4.75 billion redemption of the ARS offset by the $1.75 billion pre-event bond issuance that occurred in June Taxes, licenses and fees payable decreased $7.2 million, or 61%. This decrease is attributed to a decrease in accrued premium taxes payable due to the decrease in taxable premium as well as an increased salary credit for 2008 as compared to Surplus increased $527.6 million, or 20%, at December 31, 2008 when compared to year end 2007, related to net income earned, which is discussed in detail below. The reduction in restricted surplus relates to prepaid Emergency Assessments that were earned during Results of Operations Citizens operating results and certain key financial ratios are presented below: (in thousands) Net premiums earned $ 2,256,628 $ 3,074,754 Losses and LAE incurred (931,636) (882,925) Underwriting expenses (399,390) (543,338) Underwriting gain (loss) 925,602 1,648,491 Investment income 43, ,683 Assessment income - 68,008 Interest expense (162,903) (309,826) LOC expense (17,768) (25,630) Depopulation expense 85 (4,531) Other income (expense) 3,817 (658) Income (loss) before taxes 792,792 1,541,537 Federal inc tax benefit - 2,744 Net income (loss) $ 792,792 $ 1,544,281 Policies in force 1,084,237 1,304,949 Page 6 of 11

7 Results of Operations (Continued) Net earned premiums decreased to $2.26 billion at December 31, 2008 as compared to $3.07 billion at December 31, 2007, a decrease of $818.1 million, or 27%. This decrease is a direct result of the following factors: Direct premium written declined 25% to $2.77 billion as of December 31, 2008 compared to $3.72 billion as of December 31, 2007 due to the decline of in force policy count by 17%, combined with the reduction in the average premium. The following factors are related to the decline in average premium: doubling of wind mitigation credits beginning in 2008; increased policyholder take up on wind mitigation credits; the presumed factor for sinkholes and the ability for certain policyholders to reduce their premium by excluding sinkhole coverage. Premiums ceded to the FHCF totaled $440.4 million and $488.3 million during 2008 and 2007, respectively, and are considered in net earned premiums. The decrease in FHCF premium is attributed to a decrease in exposure. Ceded premiums to private reinsurers were $105.1 million in The Corporation entered into excess of loss reinsurance agreements with private reinsurers in 2008, but not in 2006 or 2007, for the HRA. Ceded premiums to takeout companies during 2008 increased $100.4 million, or 37%, for $369.7 million was ceded to takeout companies during the year ended December 31, 2008 compared to $269.3 million ceded during the same period in Losses incurred increased $104.7 million, or 15% as of December 31, 2008, compared to the same period in However, the losses incurred for catastrophe (CAT) and non-catastrophe (Non-CAT) claims warrant individual review to discuss differences between years Losses incurred CAT $ million $ million Losses incurred Non-CAT million million Total losses incurred $ million $ million The loss incurred represents CAT and Non-CAT losses, as well as incurred but not reported (IBNR) reserves. The CAT component for the year ended 2007 of 7.70% is higher than the year ended 2008 of 6.08%, as there have been no storms in 2008 and less development on previous storm seasons. Citizens experienced substantial adverse development on CAT claims in Page 7 of 11

8 Results of Operations (Continued) CAT Only: Adverse development was $84,318,785 and $87,871,077 gross and net of reinsurance, respectively for the 12 months ended 12/31/2008. CAT Only: Adverse development was $498,737,268 and $113,748,897 gross and net of reinsurance, respectively for the 12 months ended 12/31/2007. CAT and Non-CAT Combined: Adverse development was $92,901,435 and $96,453,727 gross and net of reinsurance, respectively for the 12 months ended 12/31/2008. CAT and Non-CAT Combined: Adverse development was $636,920,809 and $251,932,438 gross and net of reinsurance, respectively for the 12 months ended 12/31/2007. The Non-CAT loss ratio (net Non-CAT losses incurred divided by net earned premium) has grown over the last several years. This development relates to the following: a. An increase in Non-CAT losses that relate to water, sinkhole and fire claims. The frequency and severity of such claims has increased in 2008, as compared to 2007, and b. A reduction of net earned premium due to a 17% decrease of policies in-force, rate freeze, presumed factor, and increased wind loss mitigation credits. Loss adjustment expenses were $115.7 million at 12/31/2008 as compared to $171.7 million at 12/31/2007. This decrease of $56.0 million, or 33%, is mainly due to a decrease in new and reopened CAT claims in 2008, as well as improved oversight of claims processing and increased in-house claims processing. Underwriting expenses decreased $143.9 million, or 26%, in Certain expenses are percentages of written premiums; therefore, as written premium decreases, these expenses would decrease proportionately. Thus, the decrease in written premiums is driving the decrease in producer commissions (agents are paid a percentage of commissionable premium ranging from 10% to 14% depending on the type of business) and taxes & assessments (premium taxes are 1.75% of certain premium and State Fire Marshal tax is 1% of certain premiums). During 2008, commission and premium tax expenses consisted of 55% and 11% of total underwriting expense. During 2007, commission and premium tax expenses consisted of 54% and 24% of total underwriting expense. Additionally, taxes and assessments were unusually high in 2007 as a result of the $68.0 million assessment by the Florida Insurance Guaranty Association. Administrative and other underwriting expenses include typical administrative costs, professional fees which include servicing carrier fees, and underwriting costs such as inspection fees, and ISO participation fees. Administrative and other underwriting expenses increased $8.6 million, or 10%, in 2008 when compared to the same period in The increase is primarily related to an increase in full time employees and related expenses thereof and depreciation. Page 8 of 11

9 Results of Operations (Continued) Non-operating income (expenses) consists mainly of assessment income, net investment income, and interest expense. During 2008, non-operating income decreased $30.3 million, or 29%. Assessment income decreased by $68 million, or 100%. The 2007 calendar year included assessment income of $68 million, which is related to the FIGA emergency assessment recoupment compared to the 2008 calendar year, which had no assessment income. Investment income decreased $121.7 million, or 73%, in 2008 due primarily to the decline in overall cash and invested assets. Additionally a permanent markdown on investments of $205.2 million was recognized in 2008 related to distressed investments purchased on Citizens behalf by a former money manager. During 2008, interest expense decreased $146.9 million, or 47%. This decrease relates primarily to the redemption of $4.75B of Auction Rate Securities by May 21, 2008 and issuance of $1.75B of fixed rate bonds on June 30, Line of credit fees and note issuance costs decreased to $17.8 million at December 31, 2008 as compared to $25.6 million at December 31, 2007, a decrease of $7.9 million, or 31%. Citizens had both a pre-event and a post-event bond issuance in 2007 and one pre-event debt issuance in As such, the cost of financing declined. Additionally, both issuances in 2007 included bond insurance while bond insurance was not purchased for the 2008 bond issue. Takeout bonus expense decreased 102% in 2008 when compared to the period in The takeout bonus program was not in effect during However, an adjustment of the 2007 takeout bonus expense calculation occurred in 2008, creating an expense for In addition, there were escrow monies returned to Citizens as an audit result of takeout company policies retained in 2008 in excess of those in 2007, resulting in an overall takeout bonus credit in Net income decreased $751.5 million, or 49% in 2008 when compared to the same period in 2007, primarily related to a reduction in underwriting income coupled with an increase in other expenses as described above. Page 9 of 11

10 Cash flow and Liquidity Operating activities (in thousands) Premiums collected $ 1,741,800 $ 3,067,608 Net investment income received (69,581) 470,426 Losses and expenses paid (1,202,259) (1,289,936) Federal income taxes - 173,304 Other - net 76,949 47,772 Net cash (used) provided 546,909 2,469,174 Investing activities Proceeds from sale of long-term invested assets 4,142,875 4,045,998 Cost of long-term investments acquired (3,562,652) (2,954,279) Net cash (used) provided 580,223 1,091,719 Financing activities Increase (decrease) in borrowed money (3,050,000) 62,540 Other cash provided (applied) 6,607 46,876 Net cash (used) provided (3,043,393) 109,416 Net increase in cash and short-term investments $ (1,916,261) $ 3,670,309 Cash flows from operations decreased by $1.92 billion, or 78%, in This decrease was largely due to multiple factors, including a $1.33 billion, or 43%, decrease in premiums collected during 2008 coupled with a reduction in net investment income received. The decline in premium collected is attributable to the following factors: a decline in policies in force, a decline in average premium, and implementation of pay plans in which policyholders may make quarterly or semi-annual payments for policies. Net investment income received during 2008 decreased $540.0 million, or 115%. This decrease is primarily the result of the redemption of the Auction Rate Securities (ARS) in 2008, which provided less cash for investing during Additionally bond proceeds related to ARS were invested in taxable investments while bond proceeds for the 2008 bond series were invested in tax exempt investments which yield a lower return than taxable investments. This decrease in overall cash flows from operations was partially offset by a $29.2 million, or 61%, increase in other income received. This increase is the result of reinsurance recoveries received during Page 10 of 11

11 Cash flow and Liquidity (Continued) Cash flows from financing activities decreased $3.15 billion, or 2,881%, during This decrease is primarily due to the $4.75 billion redemption of the ARS offset by the HRA 2008 pre-event tax exempt bond issuance of $1.75 billion. Cash flows from investing activities decreased $511.5 million, or 47%, during Citizens has a conservative investment policy that requires all securities in its portfolio to be rated A2/A or better by Moody s and S&P at the time of purchase. Citizens engages independent investment managers to invest bond proceeds and certain operating cash pursuant to the investment policy. In 2008, Citizens owned certain investments that were downgraded as a result of the credit and liquidity crises that began in The investments continued to experience a lack of liquidity and pricing distress through all of 2008, and as a result, Citizens recognized realized capital losses of $205.2 million for the year ended December 31, The write down included $156.2 million in short-term investments and $49.0 million in bonds. The amortized cost of these assets was reflected at the permanently marked down value in the accompanying financial statements. Most of the assets that were impaired are the remnants of Structured Investment Vehicles (SIV) and Citizens is receiving principal and interest for these securities, though ultimate realization of par is uncertain. Citizens modified its Investment Policy in January of 2008 and January of 2009 to ensure a conservative investment policy which is focused on principal preservation and in response to the volatility of the global financial markets. Citizen s invests excess operating funds in various AAA rated money market funds and other high quality fixed income securities. Citizens short-term investments also include shares held in the LGIP administered by the Florida State Board of Administration. Citizens source of funds consists primarily of premium revenue, investment income and operating surplus accumulated from prior years. In the event that a catastrophe, the Corporation has the ability to obtain additional funds from Florida Hurricane Catastrophe Fund reimbursements, use of pre-event bond proceeds, and draws on existing Letters of Credit. If such a catastrophe occurs in which a deficit in an account is created, the deficit would be reduced by any potential recoveries from the FHCF as well as assessments to Florida carriers and policyholders up to a statutorily determined amount. In 2007, Citizens assessment base was increased to include substantially all Property and Casualty lines of business, excluding medical malpractice, workers compensation, and accident and health coverage. As a result, the assessment base grew from approximately $9.8 billion to approximately $37 billion. Additionally, Citizens participated to the fullest extent in the additional coverage offered by the FHCF in both 2008 and 2007 as a result of the 2007 legislation. Page 11 of 11