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.
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.
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.
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.
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”]
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.
This entry presents an interactive tool by which you can study the effects of “coinsurance” on expected losses from catastrophe. The short version is that coinsurance can, under the right circumstances, significantly reduce expected losses from tropical cyclones. As such, legislatures in coastal states, including Texas, should strongly consider prohibiting subsidized insurers such as TWIA, from selling windstorm insurance policies unless there is a significant amount (say 10%) coinsurance. The rest of this blog entry explains why and demonstrates the tool.
People need to read with great care the document posted in the last email from the Texas Public Finance Agency. I’m reprinting it below for convenience. Basically what it says is that the bond market is dubious about the ability of the Texas Windstorm Insurance Agency to pay back the $500 million it borrowed recently and, as a result, the interest rate TWIA pays will go up. The outlook is so bleak that Texas isn’t apparently even going to waste money in a futile gesture to try to get the bonds rated. The resulting increase in the interest rate isn’t in and of itself a gigantic problem — unless, of course, a surprise storm means TWIA doesn’t have the cash next summer to pay it back in full (in which event the interest rate on $500 million jumps to 8%.)
What is a huge problem, however, is the growing evidence that TWIA will be hard pressed to borrow under the existing statutory scheme the money it will need to pay back claims following a major storm. Just to repeat, no ability to borrow, no ability to pay claims, at least not in full. That means many households and businesses on the Texas coast who were banking on TWIA will not be able to rebuild and may not be able to pay their mortgages. If first line bondholders are demanding 8%, what higher rate are second and third line bondholders likely to demand following a storm? Conceivably the market will have more confidence in Class 3 assessments because those are paid by insurers, but I doubt they will feel any better about Class 2 assessments paid mostly by coastal policyholders than they do about the Class 1 bonds, which the market apparently does not regard as investment grade.
And those with cash are going to be able to put the squeeze on TWIA following a storm. That’s because an additional consequence of an inability to borrow is that TWIA won’t be able to access the large reinsurance policy it spent $100 million on this year. The reinsurance contract is written so that it doesn’t matter if TWIA is liable to pay its policyholders. Ours, like most reinsurance policies, is an indemnity policy. The reinsurers don’t pay until TWIA pays. But if TWIA can’t borrow then TWIA can’t pay. So, unless TWIA is willing to kiss a $100 million premium goodbye, it’s going to have to take what the unfeeling bond market offers.
So maybe some coastal politicians are right that we don’t need to worry much about all this because, after all, the odds of a serious storm hitting the Texas coast are just as remote as, why, a hurricane hitting New York City. On the other hand …
Thanks again to David Crump who has brought this document to my attention.
Loren Steffy, a blogger for the Houston Chronicle has an interesting entry today. You can read it here.
He gets a B+. He’s right on the following points:
1. The Texas Windstorm Insurance Association should be warning policyholders that they may be subject to assessment in the event of a significant storm and that TWIA may not be able to pay claims fully in the event of a major hurricane. That way policyholders would be able to make better choices about (a) whether to invest in coastal property in Texas and (b) about whether to go with TWIA or to purchase, where available, an often-more-expensive-but-possibly-more-secure policy from a private insurer.
I and many others have proposed that TWIA reduce the maximum policy limits on residential properties from the current $1.8 million to some substantially lower figure as a way of reducing the likelihood of post-event bonding and insolvency. Such a reform would also have the effect of reducing subsidization of individuals who have more expensive homes than the average Texan paying for the subsidy. As shown in the recently released Alvarez & Marsal report It would also bring TWIA more in line with other coastal windstorm programs such as Alabama’s $500,000 or Florida’s $1.000,000 dwelling limit.
But, a legitimate question is how much value would this reform really create? The case for the reform is somewhat stronger if it would reduce TWIA exposure by, say, 20% than if it would do so by just 1%. One statistic advanced by Representative Craig Eiland (D. Galveston) is to note that only 1% of residences insured by TWIA are valued at over $1 million. This statistic needs to be augmented, however, by an appreciation that the more valuable the residence, the more it contributes towards the risks of TWIA. All residences should not count alike.
Data provided by TWIA permits a first stab at a better answer. I’ve presented it in the chart below. It shows that reducing limits to $1 million for residences will have only a 1% effect on TWIA’s total insured value. Somewhat disappointing. If we’re serious about cutting TWIA exposure, we have to dig deeper. Going to $500,000 gets about a 5% reduction in total residential insured value. A reduction to $250,000 (the federal flood limit) creates the big gain, reducing TWIA’s residential TIV by 29%.
A few more points.
1. Just because the reduction is smaller than ideal does not mean we should not do it. Every little bit helps. And, as I have said ad nauseum, the economic and moral case for subsidizing expensive beach homes seems rather small. It’s all the more so where we condition the continued reduction in maximum policy limits, as I have proposed, on a finding that excess insurance is available.
2. For actuarial math nerds only! The figures I’ve put up, although the best I can do with the data I have, are still not ultimately what one would want. What really needs to be done by organizations such as AIR, RMS and others that have better access to the underlying storm data, is to determine the effect of right-censoring the loss distribution on homes on the overall distribution of losses faced by TWIA after a correlative premium reduction is taken into account. One can then use the survival function of the transformed aggregate insured loss distribution to recompute the probability of TWIA needing to resort to various classes of securities and its risk of insolvency. My guess is that the relationship is somewhat sublinear because losses to the left of the censor point are more common than losses to the right. So, even though I am showing a healthy 29% reduction in TIV from a $250,000 cap, that will likely not reduce of TWIA insolvency by 29%. If you asked me for a wild guess, I’d guess 15%. That’s still good. Every little bit helps.
3. The data here is one reason I really like coinsurance as a way of limiting TWIA exposure. (See suggestion # 2 of my 10 point proposal here). It has a more direct effect than right-censoring individual loss distributions, makes it less necessary for people to purchase multiple insurance policies, and may result in greater mitigation.
4. In the spirit of transparency, I’m posting the spreadsheet that underlies this analysis here, along with a Mathematica notebook used to conduct the analysis.
One of the arguments I heard repeatedly at yesterday’s hearing of the Joint Interim Committee on Seacoast Territory Insurance is that the coast isn’t a bunch of rich people with fancy beach homes. Rather, the mean income on the Texas coast is in fact lower than the mean income in the rest of Texas.
Let’s stipulate that this is true. On average, the Texas coast may well be poorer than the rest of Texas. Many parts of it may have a higher proportion of minorities. But of what import should mean or median incomes be in considering the finances of the Texas Windstorm Insurance Association? TWIA does not “means-test” in deciding who gets its subsidized insurance. Instead, wealthy and poor alike receive the benefits of TWIA subsidies. In fact, wealthy TWIA homeowners receive a far larger subsidy than poor TWIA homeowners. I bet not too many of them are minorities. So while it is the case that someone with a $80,000 house in Willacy County living on a $35,000 income gets a subsidy, it’s also the case that the person with an $80,000 home in Nacogdoches living on a $30,000 income there ends up subsidizing the person with a $1.2 million house in Galveston living (possibly in Houston) on a $300,000 income. Indeed, just to rub sand in my point, the $1.2 million Galveston estate might be a second home. Where’ s the justice in that?
So, when people who advance the “but the coast is poor” argument join me in advocating lowering the TWIA policy limits or placing other means-based limits on TWIA eligibility and stop saying — “but it will only save a few percent” — I’ll feel a lot better about a redistributive argument in favor of TWIA subsidies. A windstorm insurance policy that focused on poverty (or ethnicity) would look a heck of a lot different than the current system. So, until we get to fundamental TWIA reform — one that might begin with the administratively trivial step of lowering maximum limits — you’ll forgive me if I think justifications of anything resembling the current system based on the relative poverty of the coast should be met with “Oh, please!”
P.S. I’d feel those folks were being yet more consistent if their arguments in favor of income and wealth redistribution weren’t curiously focused on windstorm insurance.
P.P.S. It’s those poor, by the way, who are going to be most hurt when TWIA goes insolvent or has to issue post-event assessments after a large storm.
Footnote: I did some research tonight on wealth in the TWIA counties. Probably I should not have stipulated that the TWIA counties are materially poorer than the rest of the Texas, although they are no wealthier. The population weighted mean of median household income in those counties (excluding Harris, which is only partly TWIA) is about $46,824. For the rest of Texas, the median household income is $49,646. So, the TWIA counties are a little poorer, but, on balance, not much. The two exceptions, by the way are Cameron County and Willacy County, both of which are indeed quite poor. Chambers and Galveston Counties have median incomes well above the Texas median.