Corpus Christi Caller details TWIA solvency problems

There’s a worthwhile article in the Corpus Christi Caller written by Rick Spruill. It addresses both the serious funding problem faced by TWIA today and the solutions being developed by coastal legislators and some coastal interest groups.  The article relies extensively from some of the blog entries here at http://catrisk.net, including ones here and here.

I’ve sent an e-mail to Mr. Spruill on the article and want to post that email here.

I agree that this (http://m.caller.com/news/2012/dec/26/texas-windstorm-insurance-association-could-face/) is an intelligent and important article.  Moreover, even though it contains some criticism of what I have said on http://catrisk.net, it is a balanced presentation.  Two comments, neither of which reflect negatively on Mr. Spruill’s article:

1)  I don’t think Todd Hunter’s comment that Chandler “wants TWIA policyholders to pay for everything ” is quite right.  I want TWIA policyholders to pay for a much larger proportion of the losses their insurer is likely to pay and for that coverage to either be real (i.e. backed up by viable financial structures) or for very clear warnings given by TWIA and TDI to policyholders about the probabilities and consequences of TWIA insolvency.  Although in concept I agree that TWIA policyholders should pay for TWIA risks — I understand that there will be a period of transition required. But the direction of the transition should be towards the assumption of responsibility, not towards shirking it.  I would not be averse, for example, to some sort of grants or subsidized credit being made available, for example, for hardening coastal properties (“mitigation”) and would much rather see money from people other than TWIA policyholders going to reduce the scope of the risk rather than used to bail them out after a fairly foreseeable disaster occurs. I agree that our Texas economy is all interconnected and that if the coast were to suffer a hurricane in which a substantial number of policyholders had large claims against an insolvent insurer, it would hardly be only the coast that suffered.

2) The article is correct  that my computations do not take account of the double dip that TWIA policyholders with automobiles (and non-wind policies) would incur. I don’t have the data that would permit quantification of this complication in part because the Zahn Coastal Taskforce plan is not explicit enough about what sort of insurance would be subject to surcharge. I wish I did have the data. If anyone (like TDI) does have relevant data and would share it, I’d be happy to revise my conclusions.  And I will add a caveat to the existing posts reflecting this matter.  I do not think, however, that inclusion of this complication will alter the fundamental conclusions of my analysis.

Best wishes to all for a happy, healthy and hopefully hurricane-free New Year.

Study shows Coastal Taskforce Plan requires more than 50% subsidization

The Coastal Taskforce Plan recently endorsed by several coastal politicians would require people other than TWIA policyholders massively to subsidize TWIA — perhaps paying more than 60% of expected losses from tropical cyclones. That is the result of a study I have conducted using hurricane modeling software. As shown in the pie chart below, the study shows that only about 38% of the payouts come from TWIA premiums. The rest comes 26% from Texas insurers, 21% from policyholders of all sorts in 13 coastal counties and Harris County, 8% from insureds located throughout Texas and 7% from the State of Texas itself. These figures are based on running a 10,000 year storm simulation based on data created by leading hurricane modeler AIR and obtained through a public records request.  The figures are also based on my best understanding of the way in which the Coastal Taskforce plan would operate, although certain aspects of the plan remain unclear and additional clarification would help.

Expected Distribution of Sources for TWIA Payouts Due to Losses from Tropical Cyclones

Expected Distribution of Sources for TWIA Payouts Due to Losses from Tropical Cyclones (Sharing)

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Who pays for hurricane losses under the Coastal Windstorm Task Force plan?

The plan put forward by the Coastal Windstorm Task Force led by Charles Zahn  and now endorsed by at least two Texas coastal politicians will likely cause much of the money paid out by the Texas Windstorm Insurance Agency to come not from premiums paid by TWIA insureds but from subsidies forcibly exacted from insureds throughout Texas and Texas insurers. Indeed, premiums paid by TWIA insureds may end up amounting to less than half of the money used to pay losses suffered by TWIA policyholders from tropical cyclones.

The chart below is my best understanding as to how the funding structure works.

Coastal Task Force Responsibility Chart Assuming Sharing within Layers

Coastal Task Force Responsibility Chart Assuming Sharing within Layers

The horizontal axis on this graph shows responsibility for each size loss potentially suffered by TWIA  policyholders as the result of a tropical cyclone. The vertical axis on the graph shows the percentage of responsibility.  Thus, non-TWIA policyholders in the 13 coastal counties and Harris County, which is apparently lumped in, pay for significant portions of losses less than about $2.6 billion. Insureds throughout Texas pay via premium surcharges for all losses in excess of about $4.4 billion.  See the little blue rectangles? Those are the relatively small amounts that TWIA policyholders actually pay for tropical cyclone losses. The rest is paid for by people who are not necessarily TWIA insureds. They pay it regardless of whether they are — as will frequently be the case — significantly poorer than people owning homes on the coast and regardless of whether they own a home or not.

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Some coastal politicians endorse Coastal Task Force Plan

A news story in The Brownsville Herald today indicates that some coastal politicians are lining up behind the plan released recently by the Coastal Task Force and Port Aransas attorney Charles Zahn to improve the solvency of TWIA by forcing Texans away from the coast to pay substantial parts of serious losses caused by larger tropical cyclones. Under the plan, the Catastrophe Reserve Fund will be infused with cash partly from existing premiums of TWIA policyholders but also (1) via surcharges on insurance premiums paid (on a variety of insurance policies) by non-TWIA policyholders throughout 14 “coastal” counties and (2) assessments on the Texas insurance industry that will likely be passed on one way or another to Texas insureds. Losses in excess of the Catastrophe Reserve Fund will be paid for by post-event bonds that will be repaid partly by TWIA policyholders but, again, substantially, by entities that TWIA does not insure: policyholders of all sorts in the 14 “coastal” counties, Texas insurers, who will likely figure out a way to pass costs on to their insureds, and, ultimately through a premium surcharge on insureds across Texas, including those hundreds of miles from the coast. The State of Texas will itself be financially responsible for paying TWIA policyholders for the most catastrophic hurricanes, though no funding source is identified for these payments.

The most telling quote comes from State Representative Todd Hunter out of Corpus Christi. He is quoted as telling his coastal audience: “It’s wrong to set up a hurricane system that only you pay for.” Some people, of course, would say just the opposite.

The reason, by the way, that I have put “coastal” in quotes is that TWIA really insures only 13 counties that lie on the Gulf of Mexico. The 14th “coastal county” is the presumably the non-coastal, but giant, Harris County (home of Houston). Residents of the southern portions of Harris County are eligible for insurance from TWIA. But surcharging policies in Harris County hugely increases the amount of TWIA funding that comes from people with no eligibility to purchase TWIA policies and correlatively decreases the responsibility TWIA coastal insureds take for the risks posed to their property from tropical cyclones.

The issues with heavy reliance on pre-event bonds

Pre-event bonds. They sound so good. And they may well be an improvement over reinsurance and other alternatives for raising money. But there is no free lunch and its worth understanding some of the issues involving with reliance on them. In short, while pre-event bonds can work if TWIA stuffs enough money annually into the CRTF — and has the premium income and reduced expenses that permits it to do so. If TWIA lacks the will or money to keep stuffing the CRTF, however, pre-event bonds become a classic debt trap in which the principal balance will grow until it becomes unmanageable. Let’s see the advantages and disadvantages of pre-event bonds by taking a look at the Crump-Norman plan for TWIA reform.

A key concept behind the Crump-Norman plan is for TWIA immediately to bulk up its catastrophe reserve trust fund (CRTF) to a far larger sum than it has today — $2 billion — and to keep its value at that amount of higher for the forseeable future. That way, if a mid-sized tropical cyclone hits, TWIA does not to resort to post-event bonds. It already has cash on hand. The problem, as the Zahn plan, the Crump-Norman plan and any other sensible plan would note, however, is that TWIA simply can not snap its fingers today and bulk up its CRTF to $2 billion without asking somebody for a lot of money. Policyholders would probably have to face a 400% or 500% premium surcharge for a year in order to do so and I can’t see the Texas legislature calling for that. But perhaps TWIA can prime the CRTF by borrowing the money from investors by promising them a reasonable rate of return (maybe 5%) and assuring investors that TWIA will be able to use future premium income to repay the bonds. Each year, TWIA commits insofar as possible to stuff a certain amount of money from premium revenues– perhaps $120 million — into the TWIA, earn interest on the fund at a low rate (maybe 2%) and pay the bondholders their 5% interest and amortize the bonds so that the bonds could be paid off in, say, 20 years. If there are no major storms, the CRTF should grow and there is no need to borrow any more money. The strategy will have worked well, providing TWIA and its policyholders with security and at a cost far lower than it would likely get through mechanisms such as reinsurance. If there are major storms, however, then the CRTF can shrink and TWIA can be forced to borrow more to pay off the earlier investors and restore the CRTF to the desired $2 billion level. The Outstanding Principal Balance on the bonds grows. And, of course, if there are enough storms, the Outstanding Principal Balance can continue to grow until it basically becomes mathematically impossible for TWIA to service the debt out of premium income. And even before that point, investors are likely to insist on higher interest rates due to the risk of default. In the end, however, TWIA is insolvent, its policyholders left to mercy rather than contract.

On what does this risk of insolvency depend? There certainly can be a happy ending. Basically it depends on three factors: (1) the amount TWIA stuffs into the CRTF each year, (2) the spread between the interest TWIA earns on the CRTF and the interest rate it pays to bondholders; and (3) the claims TWIA has to pay due to large storms. I’ve attempted to illustrate these relationships with the several interactive elements below. Of course, you’ll need to download the free Wolfram CDF Player in order to take advantage of their interactive features. But once you do, here is what I think you will see.

(1) Pre-event bonds are risky. Different 100 year storm profiles result in wildly different trajectories for the CRTF and Outstanding Principal Balances. That’s perhaps why they are cheaper than reinsurance because the risk of adverse events is borne by the policyholder (here TWIA) rather than swallowed up by reinsurer. If the reinsurance market is dysfunctional enough — as indeed I have suggested it may be in this instance — then self-insurance through pre-event bonds may indeed be preferable to alternatives.

(2) Little changes in things such as the interest rate end up making a big difference in the expected trajectories of the CRTF and Outstanding Principal Balance. For simplicity, I’ve modeled those interest rates as constants, but in reality one should expect them to change in response to macro-economic forces as well as the perceived solvency of TWIA.

(3) Little changes in the commitment TWIA makes to the CRTF matter a lot. A few percent difference ends up having the potential for a large effect on whether the Outstanding Principal Balance on the pre-event bonds remains manageable or whether they become the overused credit card of the Texas public insurance — world — a debt trap. Pre-event bonds may work better where policyholders understand that they may be subject to special assessments — unfortunately following a costly storm — in order to prevent a deadly debt sprial from resulting. So long as we want to rely heavily on pre-event bonds, laws need to authorize this harsh medicine. Ideally, careful actuarial studies should be done — by people who make it their full time job — to try and get the best possible handle on the tradeoffs between the amount put in and the risks of insolvency. The unfortunate truth, however, is that some of the underlying variables — such as storm severity and frequency — is sufficiently uncertain that I suspect no one will know the actual values with way greater certainty than I have presented.

(4) Luck helps. My interactive tool provides you with 20 different 100-year storm sets. They’re all drawn from the same underlying distribution. They are just different in the same way that poker hands are usually different even though they are all drawn from the same deck. If storms are somewhat less than predicted or the predictions are too pessimistic, pre-event bonds have a far better chance at succeeding than if one gets unlucky draws from the deck or the predictions are too optimistic. Unfortunately, as the debate over climate change shows, disentangling luck from modeling flaws is difficult when one only has a limited amount of history to examine.

[WolframCDF source=”http://catrisk.net/wp-content/uploads/2012/12/crtfopbcrumpnorman.cdf” CDFwidth=”550″ CDFheight=”590″ altimage=”file”]

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Two early plans emerge to reform TWIA

Over the past week, two draft plans have emerged to restructure the Texas Windstorm Insurance Agency. The first plan, a copy of which may be found here, comes from a collaboration between David Crump, a citizen with a long time interest in windstorm reform, and Dave Norman, a recent candidate for the Texas State Senate. The second plan, a copy of which may be found here, comes from Port Aransas attorney Charles Zahn, and a group called the Coastal Task Force. I’ll be examining each of these plans in the days ahead but a theme of both is to reduce the now-serious risk that TWIA policyholders will go unpaid in the event of a serious storm.

At first glance the Zahn Coastal Windstorm Plan appears to place more emphasis on subsidization of risk by non-TWIA policyholders along the coast and insurers throughout Texas (and, derivatively, their insureds). The Zahn plan also makes the state of Texas ultimately responsible for losses in excess of what TWIA can pay. So, Texas taxpayers will be subsidizing coastal risk in the event of a giant storm and Texas insureds of all sorts located far from the coast will be paying to build up a catastrophe reserve fund even if no storm occurs and helping to pay TWIA policyholders in the event a significant storm occurs. But the Zahn plan also tries to reduce the growth in TWIA exposure through hardening the coast. It calls for new residential construction to meet the WPI-8 standard and grants or credits for hardening existing structures.It also seeks to extend the protections of HB3 (which currently protects just TWIA) to all wind policies on the coast — an idea for which I may take some credit.

The Crump-Norman plan appears to place more emphasis on reducing TWIA’s exposure through benefit limitations and risk reduction by increasingly premiums significantly on buildings that do not comply with certain building codes. It does not appear to place Texas taxpayers directly on the hook in the event of a giant storm. Both plans attempt to avoid the costly reinsurance that is currently helping to gut TWIA. My guess is that there will be more plans to come.

An interactive hurricane damage model for Texas

For most people, hurricane modeling is kind of a black box. Various experts set forth figures on the distribution of losses or statistics derived from those distributions. You pretty much have to take their word on it. I think policy discussions are better when the data is more transparent. So, a few weeks ago I sent a public information request to the Texas Windstorm Insurance Association asking for the raw data that they used to model hurricane losses. TWIA cooperated and send back about 30 megabytes worth of data.

So, I’m now able to create an interactive tool that lets you model the losses suffered by the Texas Windstorm Insurance Association from tropical storms. To run the tool, you will need to get the free CDF plug in from Wolfram Research. Once you have the plugin, you can run any CDF file. CDF is basically like PDF except that it permits interaction.

[WolframCDF source=”http://catrisk.net/wp-content/uploads/2012/12/analyzing-air-2011-data-for-catrisk.cdf” CDFwidth=”630″ CDFheight=”790″ altimage=”http://catrisk.net/wp-content/uploads/2012/12/air-data-static.png”]

Once you have the tool, you can do many things.

You can use the landfall county control to choose a county in which the storm first makes landfall. Notice that some of the counties are outside Texas because storms may first make landfall in, say, Louisiana but then go on to go over Texas and do damage here.

You can restrict the storms under consideration to various strength levels. I’m not sure, honestly, how AIR classifies tropical storms that don’t make hurricane strength. Perhaps they list them as Category 1. Or perhaps — and this would result in an underestimate of damage — they don’t list them at all.
You can also limit yourself to major hurricanes (category 3 or higher) or non-major hurricanes (categories 1 and 2).

You then get some fine control over the method of binning used by the histogram. If you’re not an expert in this area, I’d leave these two controls alone. In the alternative, play with them and I think you will get a feel for what they do. Or you can check out documentation on the Mathematica Histogram command here.

You then decide whether you want the vertical scale to be logarithmic or not. If some of the bin heights are very small, this control helps you see them. If you don’t remember what a logarithm is, you might leave this control alone.

Finally, you choose what kind of a histogram you want to see. Common choices might be a Count or an Exceedance Curve (Survival Function).

The tool then produces the histogram you have requested and generates a number of useful statistics. Here’s a guide to the six rows of data.

Row 1: This is the mean loss from storms meeting your selection criteria.
Row 2: This is the mean annual losses from the types of storms you have selected. This number will be lower than the mean storm loss because Texas (and all of its subdivisions) average less than one storm per year. Many years there are no storms.
Row 3: This is the worst loss from 100 storms. Note again, this is NOT the mean loss in 100 years. Some years have no storms; occasionally some years feature multiple storms.
Row 4: The AIR method for generating storms can be well approximated by a Poisson distribution. Here, we find the member of the Poisson family that best fits the annual frequency data for the selected storms.
Row 5: The AIR method for generating storms can be decently approximated most of the time by a LogNormal distribution. Here, we find the member of the LogNormal family that best fits the loss data for the selected storms.
Row 6: I can create a new distribution that is the product of a draw from the Poisson distribution and the LogNormal distribution. I can then take 10,000 draws from this distribution and find the size of the annual loss that is higher than 99% of all the annual losses. This lets me approximate the 1 in 100 year loss. Notice that this number will move around a bit every time you tinker with the controls. That’s because it is using an approximation method based on random draws. Every time you change a control, new random draws occur. Still, it gives you a feel for that dreaded 1 in 100 year annual loss.

If people have additional features they want added to this tool, please let me know. I may be able to modify it or build a new tool with related capabilities.