Ten fixes for TWIA: What I’m planning to say in Austin this week

I’ve been invited by the Governor’s office to testify this Wednesday in Austin before the The Joint Interim Committee to Study Seacoast Territory Insurance. Thoughtfully, they scheduled the hearing for a day I don’t teach class. Here’s what I’m planning on saying (along with the written supplementation).  By the way, if any readers have constructive suggestions on changes, please send them to me at chandler.seth@gmail.com.  And if anyone wants to attend the hearing, it’s in room E1.016 in the Capitol Extension at 10:30 a.m.

Hello, my name is Seth J. Chandler. I’m a professor of law at the University of Houston Law Center and Director of its Program on Law and Computation. I have studied the current Texas Windstorm Insurance Association funding mechanisms in depth for over five years, outlined Texas windstorm insurance issues in various op-eds and have my own blog on the topic before you, catrisk.net. The views here are my own.

Continuing with the current system of windstorm finance or merely tweaking it engineers a disaster waiting to happen. The 15% or so risk of TWIA insolvency over a ten year period, should leave every Texas legislator sleepless. The 50% risk over that time-frame that TWIA will need to resort to untested post-event bondings and surcharges or assessments is likewise disturbing. Endless reliance on costly reinsurance effectively traps TWIA in a cycle of inadequate capitalization.

But to leap from those woes to a new large government bureaucracy that socializes and further politicizes large segments of the insurance business is premature at best. The key idea now being floated surcharges all property and casualty policies in Texas (including auto, homeowner, business liability) some percentage of the premium to cover claims generated by a catastrophe. I don’t have details yet, but such a triggering catastrophe would likely be defined by insured claims from some single occurrence exceeding some amount. Now, if this scheme were consistent with the rest of the Texas insurance code, which permits geographic rating where actuarially justified, it might have some virtue as a risk diversification mechanism. But the key part of the proposal I have seen throws actuarial justification out the window. It insists that the surcharge rate should not depend — not even within some bounds — on the location of the property or the insured. So, even though insureds in Laredo or Huntsville or Garland might have a risk of making a defined catastrophe claim with only 1/10 an expected value as frequently as those in Galveston or Corpus Christi or Beaumont, all of them would be charged alike.

As many wiser than I have noted, “there is no greater inequality than the equal treatment of unequals.” Why is it just to permit high-risk and wealthy property owners in one part of Texas to get subsidized insurance paid for by low-risk and less wealthy property owners in other parts of the state? But, unfairness aside, there are problems with the proposal. Such a scheme enlists government to divert private resources to the riskiest parts of the state and thereby exacerbates future catastrophe losses. It will, unless there is, as I fear, an “individual mandate,” result in lower take-up rates in catastrophe-sparse regions than in catastrophe prone ones, which will further drive up surcharges and threaten a death spiral. And who here can contemplate the bureaucracy necessary to define occurrences and catastrophes, to determine when payments should be made from the state cat pool rather than conventional markets, to fund and monitor funding of a state-wide cat pool, and to prohibit insurers selling in catastrophe-sparse areas from undercutting the pool price?

So, before we kill TWIA and transition into the unknown perils of more government regulation and bureaucracy, I suggest we test more thoroughly whether and how the private insurance market will perform when the seacoast playing field is leveled. I do not share the article of faith among some that the private market will never work there. I say that faith has not been tested for decades because the playing field has been badly tilted. TWIA charges rates that protect against only a portion of the risk posed by its policyholders whereas we insist that private insurers charge rates sufficient to cover the entire risk. I would love to see Allstate come in to Commissioner Kitzman’s office and ask to continue selling policies in Texas when the odds of it failing over the next 10 years were acknowledged to be 15%. TWIA now gets special protection from lawsuits for improper claims handling. TWIA doesn’t do what I think most sensible insurers would do when we know that stronger building practices significantly reduce expected losses: charge modest coinsurance, particularly for claims in excess of actual cash value, but possibly waive coinsurance upon proof of extraordinary effort. Finally TWIA fails to do what we would require of private insurers: prominently disclose to policyholders the special insolvency, assessment and surcharge risks posed by its current funding structure.

Basically, I want Texas to transition to a market for windstorm insurance on the coast that is only different insofar as truly necessary from the market for property insurance generally. I want an expanded but monitored private market, with a level playing field and greater information to seacoast policyholders. The key to the proposal is a downwards shift in the absolute magnitude of risks faced by TWIA and a program that builds reserves within a smaller TWIA. Such a move will reduce the risk of post-event financing or the disaster of insolvency. The idea is to do so, however, in a way that protects basic insurance for coastal insureds, including those in the densely populated counties, and not to leave them in the lurch in the event, even with a level playing field, private insurance still will not do business on our coast. To those ends I have attached to my written testimony ten immediately doable and specific proposals that I believe you should study as part of your work plan.

Four of those specifics here. Lower the TWIA maximum policy limits so long as excess insurers come in to fill the void, which I believe they will if given underwriting freedom. Insist that TWIA not sell policies without at least modest coinsurance. Require policy premiums that, over a ten year period, build TWIA reserves to a level where it would take more than a 1 in 100 year storm to deplete them. Increase Class 3 assessments so that they would cover up to a 1 in 500 year storm.

Thank you for listening. Please read my expanded testimony involving all ten ideas and bookmark my blog, catrisk.net.

Ten Specific Proposals

  1. Reduce over a period of two years the maximum applicable policy limit for TWIA policies on residences. That limit should be reduced to $1 million for policies issued or renewed after May 31, 2013 and, subject to the certification described below, $500,000 (or the Federal Flood Limit, whichever is lower) for policies issued or renewed after May 31, 2014. The latter ceiling shall be in effect each year if and only if the Texas Department of Insurance certifies after an appropriate hearing that excess insurance was generally available at actuarially sound rates in the territory covered by TWIA during the preceding policy year for amounts in excess of the TWIA policy limits for the preceding year. Otherwise the maximum policy limit should revert to $1 million. Take proportional measures for non-residential properties.
  2. Prohibit TWIA from issuing or renewing policies after May 31, 2013, unless those policies contain, in addition to a deductible, a coinsurance requirement of not less than 5% on claims payments up to actual cash value and not less than 10% on payments in excess of actual cash value, provided that TWIA shall have discretion to waive such coinsurance where the property owner provides evidence that its insured property meets the strictest building codes adopted by any state for coastal property.
  3. Prohibit TWIA from entering into reinsurance arrangements in which the actuarial value of the risk transferred to the gross reinsurance premium is less than 20%. This computation should be made by TWIA actuaries using the best available historical evidence and contemporary models.
  4. Maximally protect TWIA policyholders by prohibiting TWIA from entering into reinsurance arrangements for each catastrophe year with an attachment point lower than the sum of (a) its projected catastrophe reserve fund, and (b) the amount TWIA believes it can raise using Class 1 Securities, Class 2 Securities and Class 3 Securities.
  5. Subject TWIA to the same geographic rating restrictions that other Texas insurers face pursuant to Chapter 544.002 of the Texas insurance code and clarify that it is equally protected by Chapter 544.053.
  6. Subject TWIA to the same provisions regarding suit, statute of limitations, and extra-contractual damages as other insurers doing business in the seacoast territory. This could be done either by eliminating TWIA’s current preferences or by according insurers selling primary or excess insurance in the seacoast territory the same preferences as TWIA, provided their policy form is substantially similar to that used by TWIA.
  7. Set premiums and adjust the catastrophe reserve fund in accord with the concepts set forth in “An Idea for TWIA Finance” (http://catrisk.net/?p=126), which basically calls for a reserve trajectory that hits 1 in 100 year adequacy within a ten year adjustment period. Factor in all the reforms set forth here (or otherwise enacted) in making this computation.
  8. Upon a certification from the Texas Department of Insurance at the start of each catastrophe year and based on the best available historical evidence and contemporary models, adjust the maximum amount of Class 3 securities that can be sold (and, correlatively, the maximum assessments on insurers) such that, after consideration of the catastrophe reserve fund, Class 1 securities, Class 2 securities Class 3 securities and any reinsurance or similar sources, the estimated risk of TWIA lacking funds to fully pay claims in the following catastrophe year is less than 1 in 500.
  9. To the extent of any inability to accomplish #8, and insofar as feasible, require TWIA to adjust premiums, based the best available historical evidence and contemporary models to take into account the probability, based on the geographic location(s) of the property insured, that TWIA would be unable pay claims fully during the following catastrophe year.
  10. Require prominent disclosure to TWIA policyholders created by the financing structure in place (as modified by the reforms suggested here or otherwise enacted). This disclosure should, at a minimum, advise policyholders of the approximate probability, computed using the best historical data and contemporary models, of the risk that TWIA will become insolvent, will be impelled to increase premiums to pay off Class 1 securities and will be impelled to impose surcharges to pay off Class 2 securities. Disclosure should be made (a) on a document signed by applicants for TWIA policies (new or renewal); (b) stamped (similar to surplus lines stamping) on policies issued by TWIA; and (c) on a web site one or fewer clicks from the main TWIA page.

An idea for future TWIA finance

Although they may thoroughly disagree on the direction in which reform should go, almost everyone agrees has come to agree with what I predicted in 2009:  TWIA finances are in serious need of reform.  This blog entry sketches out one direction in which TWIA might proceed.  The idea here is that TWIA should, in a steady state, have enough cash on hand in its catastrophe reserve fund to pay for insured losses and operating expenses, without having to borrow, with a high probability, say 99%.  Further TWIA should have borrowing capacity to address the rare situations (say 1% of years) in which its reserves would be inadequate. Those borrowings should be repaid by some percentage of TWIA policyholders, persons living on the coast, and Texans generally, perhaps collected through the proxy of insurers doing business in Texas.

Although people can quarrel about the precise parameters in this abstract statement of the goal, I have some hope that people could agree on the concept. Government-sponsored insurance companies that don’t have the right to draw on the government fisc, ought not to be relying heavily on post-event bonding as a way of paying claims; instead they need enough money in their piggy bank just as we require of their private insurer counterparts. But what if TWIA’s catastrophe reserve fund does not meet this lofty goal?  What then?  Especially given the magnitude of the current reserve shortfall and the current economy, matters can not be corrected overnight. There should, I say, be an adjustment period during which premiums are adjusted (either upwards or, at some hypothetical future time, downwards) such that, at the end of the adjustment period, things come into balance and the catastrophe reserve fund meets the goal.

How do we operationalize this idea? Here is the beginning of a statutory draft. I’ve put in dummy statute section numbers for ease of reference. Obviously, the real section numbers would have to be revised by legislative counsel. Also, we’re probably going to have to develop a more comprehensive process for 2210.355A(b)(1) and reconcile this provision with the alternative process currently set form in 2210.355A.

2210.355A

(a) Definitions

(1)  The “Exceedance Function for the catastrophe year” is a function that approximates the probability that insured lossses and operating expenses in the catastrophe year will exceed a specified dollar amount. Insured losses shall be computed on a net basis after consideration of any reinsurance or other sources of recovery.

(2) The term “Loss PDF” means the probability distribution function mathematically associated with the Exceedance Function.

(3) The term “Century Storm Reserve Adequacy” means having a catastrophe reserve fund at the start of each catastrophe year such that this fund would be able, without additional borrowing, to fully pay insured losses and operating expenses in the following catastrophe year with a 99% probability as computed using the Exceedance Function for the catastrophe year.

(4) The term “Reserve Adjustment Period” means ten years.

(b)

(1) The Association shall, prior to the start of each catastrophe year, use the best historical and scientific modeling evidence with considerations of standards in the business of catastrophe insurance, to determine the Exceedance Function and associated Loss PDF for the catastrophe year.”

(2) If, at any time, the Association finds that its catastrophe reserve fund at the start of a catastrophe year does not achieve Century Storm Reserve Adequacy,  the Association shall adjust the premiums to be charged in the following year either downwards of upwards as appropriate such that, were:


(A) such premiums to be charged for the Reserve Adjustment Period on the base of currently insured properties;

(B) insured losses and operating expenses of the Association to be for the Reserve Adjustment Period at the mean of the Loss PDF for the catastrophe year; and

(C) the Association were to earn on any reserve balances during the Reserve Adjustment Period the amount of interest for reasonably safe investments then available to the Association,

the catastrophe reserve fund at the end of Reserve Adjustment Period would achieve Century Storm Reserve Adequacy.

(c) By way of illustration, if the Exceedance Function takes on a value of 0.01 when the size of insured losses and operating expenses is a equal to 440 million dollars and the mean of the Loss PDF for the catastrophe year is equal to 223 million, the initial balance of the catastrophe reserve fund is 100 million dollars and the amount of interest for safe investments then available to the Association is equal to 2% compounded continuously, then the premiums charged for the following calendar year should be equal to $614,539,421.

And what happens, by the way, if a storm hits that exceeds the size of the catastrophe reserve fund?  Stay tuned.  I’ve got an idea there too.

How do we keep premiums low under this scheme?  Likewise, stay tuned.  Hint: think about coinsurance requirements and lower maximum policy limits.  Think about carrots to get the private insurance industry writing excess policies on the coast with ever lower attachment points.

  • Footnote for math nerds only. Anyone seeing the implicit differential equations in the model and the applications of control theory?
  • Footnote for Mathematica folks only. Here’s the program to compute the premium. Note the use of polymorphic functions.

p[\[Omega]_, \[Mu]_, q_, c_, r_, z_] :=
x /. First@
Solve[Quantile[\[Omega], q] ==
TimeValue[c, EffectiveInterest[r, 0], z] +
TimeValue[Annuity[x – \[Mu], z], EffectiveInterest[r, 0], z],
x];
p[\[Omega]_, q_, c_, r_, z_] :=
With[{m = NExpectation[x, x \[Distributed] \[Omega]]},
p[\[Omega], \[Mu], q, c, r, z]]

  • Footnote for statutory drafters. Note the use of modular drafting such that one can change various parameters in the scheme (such as the 10 year adjustment period) without having to redraft the whole statute.

The chart TWIA isn’t sure you should see

Attached to this post is a chart prepared by TWIA for its August 7, 2012, board meeting. I didn’t make this chart up.  TWIA did. At the August board meeting, it was discussed whether this chart should be made more prominently available to the public via the internet. There was an initial suggestion that it should.  At the end of a two minute discussion, TWIA apparently decided that, instead, the information contained in the chart would be subsumed into some sort of “contingency plan narrative” that would, eventually, go on the web.  (Don’t believe me?  Listen to minutes 16:30 through 18:46 on the archived recording of the meeting). And if anyone can find that contingency plan (with or without the narrative) please let me know.

Projected Funding Structure Under Different Loss Scenarios

Exhibit for the tWIA board meeting

I don’t think the chart is too difficult to understand. The “problem” with the chart is that it is too easy to understand. The chart makes clear that TWIA faces a significant risk of insolvency. It shows that TWIA does not have enough money to pay for 1 in 100 year events and does not have enough money to pay for a modest storm plus a 1 in 60 year event occurring in the same hurricane season.

The chart depicts how TWIA would pay policyholders in two different scenarios.  The scenario on the left is one giant storm.  The scenario on the right is a small storm followed by a big storm.  In the giant storm scenario, TWIA suffers $4.5 billion in losses.  This is identified as a one in one hundred year event.  If that’s true, it happens about 10% of the time during any 10-year stretch. According to the chart, TWIA would fund be able to fund a total of $3.15 billion of the $4.5 billion loss: $300 million (green) out of premium revenue and the catastrophe reserve trust fund, $500 million (aqua) out of bond anticipation notes (later refinanced via Class 1 securities), $1 billion (turquoise) out of Class 2 securities, $500 million (gray) out of Class 3 securities, and $850 million (purple) out of reinsurance.  TWIA would have no available funds to pay the remaining $1.35 billion (yellow) of claims (and possibly loss adjustment expenses).  So, on average, policyholders would get 70 cents on each dollar that TWIA owed them.

In the small + big scenario depicted on the right, the losses from the small ( $500 million) storm are funded fully. $300 million (green) is paid out of premium revenue and the catastrophe reserve trust fund and the remaining $200 million (aqua) is paid out of bond anticipation notes (later refinanced via Class 1 securities).  But when the big $2.5 billion once every sixty years)  storm then hits in the same hurricane season, TWIA has a serious problem.  It can pay another $300 million out of bond anticipation notes, $1 billion (turquoise) out of Class 2 securities and $500 million (gray) out of Class 3 securities.  That leaves TWIA policyholders with claims from the second storm initially getting only 72 cents on every legitimate dollar of claims.  (And good luck to TWIA trying to get claimants from the first storm to pay back a portion of their claims so that both sets of policyholders are treated equally)

The source of the remaining $700 million under the small + big scenario is unclear.  If TWIA could somehow scrape up an additional $500 million (yellow), it would then arguably trigger the obligations of the reinsurance it purchased.  TWIA policyholders would ultimately be made whole in this case. But, apparently, if TWIA could not scrape up $500 million — and no one has any idea where the missing $500 million would come from —  TWIA would not be entitled to any money from the reinsurance policy for which it paid $100 million in premiums. Thus, TWIA policyholders would be stuck with, say, being paid only $144,000 on a legitimate $200,000 claim.

Footnote: Part of the problem exists because TWIA’s reinsurance is apparently “occurrence based” rather than based on aggregate losses.  Apparently such occurrence based policies are “industry standard” for reinsurance though not for catastrophe bonds.  My bet, though, is that a sophisticated reinsurance broker could negotiate with a sophisticated reinsurer for an aggregate loss trigger on reinsurance.

So, is the chart scary?  Should it be prominently displayed on the TWIA web site and by TWIA agents? Yes.  Sure, being too scared of hurricane risk a problem.  But being insufficiently scared is perhaps an even greater problem.  I would not want to be the homeowner with a destroyed house or a destroyed business holding a TWIA policy that provided “coverage” on paper, but that did not actually get me the money to rebuild. And I wouldn’t want to be the agent that sold such a policy having not disclosed by every reasonable means — including the use of charts where appropriate — the risks involved.

Why do coastal politicians urge low TWIA rates?

The title of this blog entry may seem a particularly dumb question. Coastal legislators, the simple answer proceeds, want the Texas Windstorm Insurance Association to keep rates low because it helps their constituents’ pocketbooks. But is that really true? Or, more precisely, under what circumstances would that be true?

The first thing to recognize is that low premiums have a somewhat different effect when they go to Allstate than when they go to TWIA. One can quite understand policyholders not wanting to pay Allstate very much money because its profits simply go for the benefit of Allstate’s shareholders. TWIA, on the other hand, has no shareholders. To the extent TWIA collects “too much” in premiums, that is extra money available to pay future claims of future coastal policyholders. Over collection by TWIA favors future coastal residents in a way that over collection by Allstate does not.

One can get at a better answer to this question by asking why TWIA insists that policyholders pay much or, indeed, anything in advance premiums at all. Since the risk of tropical cyclones is difficult to quantify, why not just have a post-disaster assessment scheme? It would work as follows: when we know how large the damages are from some hurricane relative to TWIA cash on hand (which might be zero if there were no premiums), TWIA simply “post-assesses” its policyholders to pay in that much money over some period of time. We wouldn’t need no stinkin’ models; we’d just see what happens. Take imaginary Hurricane Barry that creates claims (plus lost adjustment expenses) of $1 billion above any cash TWIA happens to have on hand. Because TWIA has about $70+ billion of property under its control, if TWIA could spread the payback period over 5 years, some back of the envelope math suggests that the consequence of this scheme would be that someone with $200,000 worth of coverage would have to pay roughly $571 per year to take care of the claims caused by Barry.

This proposed post-assessment alternative sounds pretty good. I bet many TWIA policyholders with $200,000 properties would be delighted to pay only $571 per year for tropical cyclone coverage.

Unfortunately, the proposed alternative won’t work as inexpensively as described. This baseline figure of $571 is a significant underestimate. There are two reasons: interest expenses and post-assessment shrinkage.

The interest issue is easy to understand. Few policyholders with demolished properties want to wait 5 years living in a tent or in a home decorated with blue tarp until all the assessments are collected before getting their claims paid. So, to pay for Barry, TWIA has to borrow the $1 billion. But now TWIA policyholders don’t have to just pay back $1 billion, they have to pay it back with interest. Interest expenses alone can raise the annual payback amount substantially.

There’s also a shrinkage problem. Once the price of being a TWIA policyholder jumps due to the assessment, TWIA will no longer be assessing the amount of property it did prior to the storm. Thus, to continue with our example, to compute the necessary assessment, TWIA won’t be dividing the amount of damages by the $70+ billion; the denominator will be smaller. And this means that the assessment, because it will be spread over less property, will have to be larger. But the larger assessment means that yet more people will drop out of TWIA, which means that the assessment will have to be yet larger. One can’t easily say whether and if this spiral will stop, but one can be confident that the size of the assessment will increase significantly due to both the interests costs on the loan and due to the reduced size of the TWIA pool.

Footnote here. There is another way to run an assessment scheme: don’t assess future policies; assess policies in place at the time the disaster struck. Such a method avoids shrinkage as I’ve described it, but it creates another problem: collection. Instead of just cancelling policies that don’t pay assessment, TWIA now has to actually track down over a period of many years former policyholders some of whom just will not have the money to pay what is due. That’s expensive and will not yield a 100% recovery rate. And, as I read the Texas statute, it’s not what’s contemplated in the event of a large storm. Anyway, whether done by assessments on future or in-place policies, post-assessment has problems.

I don’t think it’s unreasonable to believe that for something like Hurricane Barry, interest and shrinkage would raise the post-assessment by about 25% over its baseline cost. But no one knows this number with any certainty. And this means that there is a substantial risk that the scheme won’t work or, that conservative lenders, will worry that it won’t work and will accordingly charge very high interest rates. Indeed, TWIA appears to have discovered that, although the Texas statute will let it borrow $1 billion following a disaster to be repaid with policyholder assessments, the market appears willing only to lend $500,000. So, post-assessment schemes are risky.

There’s an additional problem, however. And, this one is a killer. I just provided an example with a $1 billion Hurricane Barry. If we start increasing the size of the storm to, say $2 billion (over cash on hand) hypothetical Hurricane Tanya (or we add another smaller hurricane in the year such as $1 billion hypothetical Chantal), the shrinkage problem starts to grow. Indeed, with a more serious storm such as Tanya (or Barry + Chantal), there is a significant risk of a death spiral in which there are not enough TWIA policyholders left to repay the assessment.

What this means is that a sensible insurance scheme has to balance at least two factors: you don’t want insureds paying too much because — well — that’s money out of the hands of insureds and doing so could needlessly depress the coastal economy. On the other hand, you don’t want insureds paying too little because that creates the risk of a storm large enough to plunge any assessment scheme into a death spiral.

So, what an intelligent discussion of this issue needs to do is to discuss a balance of these two problems with actuarial and climate science in mind. By focusing only on the over-collection issue, certain coastal legislators are sadly distorting and deterring an intelligent political debate. The consequence of this distortion could be quite serious for coastal residents. They may find that the assessment scheme they counted on to help TWIA pay for losses just does not work. They will then need to come begging to the state or Uncle Sam for a bailout. Indeed, that is precisely what the latest actuarial study engaged by TWIA/TDI predicts will occur a substantial percentage of the time if coastal premiums are not raised substantially.

Now, what I could imagine a coastal politician saying in response to this blog (I do hope they read it — and read it all the way to the exciting end), is that the post-assessment problem is overstated because the Texas statute limits the size of assessments that can be made. Moreover, they might say, TWIA does not depend exclusively on policyholder assessments to pay for tropical cyclones that cause damages in excess of cash on hand. And, to some extent, this rebuttal is true. But, if we break it down, what the politicians are really saying then is that small premiums aren’t a problem because they expect someone else to pick up the pieces if a big storm hits. That is, TWIA policyholders aren’t to be treated like ordinary policyholders who are in serious difficulty if their insurer (predictably) goes insolvent after charging too low premiums; TWIA policyholders stand in a privileged position relative to other Texans.

I have a lot of problems with this rebuttal. First, there is still a problem because, as I have pointed out at some length, the other sources (limited assessments on non-TWIA coastal policies; limited assessment on Texas insurers) will not yield enough cash to pay fully for losses incurred after serious storms in the densely populated parts of the Texas coast. Even the coastal politicians now appear to recognize this fact but poo-poo what they believe is a 1.5% annual risk of this occurring. But even if there were zero risk of a TWIA default, the rebuttal rests on the dubious premise that coastal residents are entitled to some special privilege that the rest of Texas does not enjoy.

And, here, we get to the core of the issue. After you put all the smokescreen rhetoric aside, what certain coastal politicians are really saying is that the coast is indeed special. But why? Yes, many find the coast lovely, but so too do many find the Texas Hill Country or even the stark beauty of the northern panhandle with its silos, vistas and hints of ancient vulcanism. Yet neither Kerrville nor Dumas insureds have the benefit of getting full insurance on their $200,000 property while paying the premiums sufficient to cover only a policy with a $50,000 limit. If the preference for the coast is based on aesthetics, then let us be explicit and subsidize coastal beauty. Yes, the coast contributes to the Texas economy. But so does Houston, so does Dallas, so does El Paso, so does Stephenville and so does Dalhart and Childress and Texarkana. Dollars are dollars. Should Galveston residents assume the risks posed by locating property in Dallas because Dallas contributes greatly to all of us here in Texas?

So, in my opinion, the “coast contributes” justification is completely bogus.

Are coastal residents disproportionately afflicted by some imperfection in the insurance market from which the rest of Texas is exempt? Might that justify the privilege? I see no evidence of any special, irrational animus towards the Texas coast on the part of the insurance industry. Greedy insurers would as much enjoy profiting from coastal consumers as they do profiting from those in Stephenville. Why, if they could do so at a rate they thought profitable, would insurers collectively sit back and let a government entity take over the coastal insurance business? The fact that many (and not all) companies won’t write on the coast is more easily explained by the low prices of its publicly subsidized competitor — TWIA — or by feared regulatory price constraints than by some vast conspiracy. The most likely reason prices are high on the coast is because risks there are particularly uncertain and particularly correlated and because stockpiling the requisite cash to pay for large claims is expensive.

Now, is it the “fault” of a Galveston policyholder that they live in a place subject to uncertain, correlated risk? No. There is no moral failing. Is it a “choice?” That depends. For some, such as the owner of a second home, quite probably. Moreover, even for a first home, people choose to have a million dollar home rather than a $500,000 home. For others, however, less so. The current scheme in Texas, however, treats TWIA insureds as special regardless of the degree to which their ownership of property is a choice. In general, it’s a good idea for insurance prices to reflect risk accurately because that, in the long run, encourages intelligent investment decisions. Societies that subsidize risky activities for long periods of time end up with more risky activities and become, as the pandering of some coastal politician suggests, addicted to them at great expense to the rest of society.

The better rebuttal — and the one I actually hope starts to gain prominence — is that giving TWIA lots of money has enabled it to waste money purchasing incredibly expensive reinsurance in a market whose competitiveness is open to question. Because reinsurance has cost TWIA something like six times the actuarial value of the risk it assumes, policyholders would do better, this argument proceeds, for TWIA to charge less in premiums or to charge the same in premiums, pray for a few good years, and to stockpile the extra funds. This argument, by the way, has some support in the recent report of TWIA’s actuarial consultants. But, if wasting money on reinsurance is the issue, the better solution is to restrict TWIA’s discretion in using its funds for this purpose. TWIA could, after all, buy reinsurance even if premiums were reduced. Now, how exactly to intelligently restrict TWIA’s discretion in reinsurance purchasing is the subject for another day. In the mean time, however, the purported advocates of coastal policyholders had best be very careful lest their concerted advocacy in support of what they wish for, lower premiums, succeeds and a large insurer has insufficient resources to pay claim as a result. Pity the coastal politician seeking another term after they deprived the insurer of residents in their districts the resources that insurer needed to pay claims fully.

TWIA and the quiet matter of reinsurance attachment

Could there be anything duller than a long blog entry about reinsurance attachment points? I want to argue here that there could. In fact, I want to argue here that understanding reinsurance attachment is critical to understanding the problems facing the Texas Windstorm Insurance Association — and its policyholders.

But first I must warn you of a need for some rather extensive background. You can skip ahead to the “main point,” and then come back and read the background if you prefer. Or you can just read the one sentence summary here.

The Texas Windstorm Insurance Association has selected low attachment points for its reinsurance which places the interests of Texas insurers and non-TWIA coastal insureds above the interests of its policyholders in densely populated areas of the Texas coast such as Galveston and Brazoria counties.

The Background

The Texas Windstorm Insurance Association is a state-chartered and state-regulated insurer “of last resort” for property along the Texas coast. Unfortunately, the “last resort” part has become somewhat of a joke. I won’t discuss here why this might be the case, but TWIA has for many years been the largest insurer of homes and business property on the Texas Coast.  As of April 2012, TWIA insured about $72 billion worth of property under about 260,000 policies.

So, how is this governmental creation to pay for losses?  TWIA collected about $450 million in premiums in the most recent hurricane season. But, even in a year in which Texas suffered no hurricanes and only two minimally damaging tropical storms, various expenses meant that TWIA did not add greatly to its $250 million (ish) catastrophe reserve fund.  And so, $250 million is about all that is sitting in the TWIA piggy bank available immediately to pay claims.  It might grow a bit this year, but no matter how you slice it, the catastrophe fund will not have enough money for TWIA to pay losses following many storms hitting the Texas coast.

What kind of storm does it take to cause TWIA to run out of cash  To calibrate matters, TWIA suffered losses of more than $2 billion following Hurricane Ike in 2008, which though it hit Texas in a densely propertied spot, was only a Category 2 storm. Anyone still remember Hurricane Chantal in 1989?  Track of Hurricane ChantalThat was a category 1 storm.  Experts say that if Chantal hit today, it would like cause $290 million in damages, a good chunk of which would be insured by TWIA. Or going back further, how about Hurricane Fern?  Also just a category 1 storm.  If that hit today, it would cause $500 million in damages of which TWIA would insure a high proportion.  So, it doesn’t take a monster storm to cause TWIA to run out of cash.

Beyond something like $250 million, TWIA has four sources of funds it can use before it has to confess to devastated policyholders that there isn’t enough money to pay claims fully.  The sources are stacked. Except in unusual circumstances, TWIA can’t use a source higher on the stack until it has exhausted the lower sources.

The first source is basically to take out a loan from the public.  TWIA is authorized to issue up to $1 billion in “Class 1” securities.  The owners of these “post-event bonds” get paid back by TWIA raising premiums on its policyholders.  The extra premiums get used not to protect against future hurricanes, but to pay off debts TWIA incurred because it didn’t have enough saved up to pay for a past one.

Running insurance in reverse can cause serious problems.  Purchase of TWIA policies is, after all, largely voluntary, and there are often private market competitors. If, for example, TWIA had to sell $1 billion worth of these securities and could do so at 4% with an amortization period of 10 years, TWIA policyholders would see an increase in their premiums of about 25% just to repay the borrowings.  Matters might be even worse because (a) 4% might be a low estimate given that the securities are not backed by the full faith and credit of Texas; (b) some policyholders might drop out of TWIA with a 25% increase, which would mean the remaining policyholders would face a yet-higher increase; and (c) we are talking about just one policy year here — TWIA might have to borrow yet again and charge policyholders yet more if another significant storm hit before the original Class 1 securities were paid off.

Section 2210.615 of the Texas Insurance Code

Section 2210.616 of the Texas Insurance Code. Note: no full faith and credit.

Hurricane 5 Tracking Chart

Hurricane 5 Tracking Chart

But we’re not nearly done.  After all, as proven by Hurricane Ike, Texas can certainly face storms that cause more than $1.2 billion in damages.  In fact, my own reverse engineering of work done by the two hurricane modelers on which TWIA relies, AIR and RMS, suggests that they think the annual probability of such an event is about 5% and the ten-year probability of one or more such storms occurring is about 42%. What kind of hurricane are we talking about.  “Hurricane 5” in August 1945, which hit near Port Aransas and went up the coast towards Houston, would have caused about $2.1 billion in damages if it hit today. Again, TWIA would “own” a significant portion of those damages.

So, how does TWIA cobble together more than $1.2 billion in a year?  It can borrow another $1 billion via “Class 2 Securities.”  And how are these security holders to be paid back?  Under section 2210.613 of the Texas Insurance Code it’s a 30/70 split.  Thirty percent of the debt gets paid back by TWIA “member insurers” — basically meaning any insurance company selling property/casualty insurance in Texas.  Now, in the past, insurers just fronted TWIA assessment payments; they got “paid back” via a pretty full credit against premium taxes they otherwise owed the state.  Since 2009, however, insurers really have to pay.  No tax credit to soften the blow. Presumably, therefore, up to $300 million will come partly out of the hide of private insurer shareholders and partly out of the hide of its policyholders, particularly those in Texas.Texas Insurance Code 2210.613

The remaining 70% of Class 2 repayments will be paid for by a surcharge not just on TWIA policyholders, but on anyone with virtually any form of property or casualty insurance — including automobile insurance — living in the areas TWIA protects. Thus a renter in Corpus Christi could see her automobile insurance premiums go up following a hurricane in Freeport.  So too could a small business in Harlingen which had property and liability insurance with a non-TWIA insurer.  I don’t have the data to say what percentage increase in premiums this repayment obligation would entail, but I don’t think a 5% increase in premiums for ten years would be a bad guess. And for TWIA policyholders, this increase would come on top of that required to pay off the Class 1 securities. Basically, the risk is socialized 30% throughout Texas and 70% throughout the Texas coast.

Now we get into really scary hurricanes: those that cause more than $2.2 billion in damages to TWIA.  We don’t have to talk Galveston 1900 or Carla 1961 to get there. The “Surprise Hurricane of 1943” might fit the bill.  Experts estimate this hurricane — advance information about which was suppressed due to the war — would have caused over $4 billion in damages as its winds slowed from less than105 miles per hour beating a nasty path from the Bolivar Peninsula up through the Houston Ship Channel.Damage from Surprise Hurricane of 1943

Until we introduce the complication of reinsurance — I warned you this was a long piece of background — the top of the stack is the $500 million more that TWIA has access to.  These are “Class 3 Securities” that TWIA may issue following a storm.  TWIA member insurers have to repay this tier of borrowings, which again presumably means the real cost will be borne in part by shareholders of these insurers but significantly by insureds throughout Texas from El Paso to Amarillo to Texarkana to Beaumont to Harlingen. This tier of coastal risk is almost 100% socialized. After this stack is exhausted, unless there is reinsurance, TWIA is out of money and, however much we might wish to the contrary, has no legal claim on the state or the federal government.

The Main Point

So, it’s now time to get back to reinsurance.  Under section 2210.075 of the Texas Insurance Code, TWIA can increase the amount of money it has available following a major storm (and lessen the amount it can stuff into its catastrophe fund) by purchasing reinsurance each hurricane season. It can do this quietly without legislative approval or guidance. The way reinsurance works, TWIA pays a premium to some reinsurer and, in turn, the reinsurer reimburses TWIA for certain losses that TWIA incurs.  So, for example, TWIA might have spent money so that if TWIA incurs more than, say, $2.7 billion in losses from a tropical cyclone, the reinsurer pays for certain losses above that amount.  Reinsurance thus could protect TWIA policyholders from some large losses.

But reinsurance comes in many flavors and the Texas Insurance Code does not tell TWIA what kind of reinsurance (if any) it should obtain.  A key factor that defines a reinsurance arrangement is the “attachment point.”  This is a generally stated as a dollar figure.  It’s where reinsurance inserts itself into the stack of resources available to TWIA.  If the insurer (TWIA) incurs losses that are less than the attachment point, the reinsurer pays nothing. If the losses are above the attachment point, the reinsurer pays until either all the insurer’s damages are paid off or the limits of the reinsurance policy are exhausted.  Whichever comes first. Thus, if TWIA’s reinsurance of, say, $600 million “attached” at $2.7 billion and TWIA had losses of, say, $2.6 billion in a given year, TWIA’s reinsurers would owe nothing.  TWIA policyholders would instead be paid out of the proceeds from TWIA’s catastrophe fund and the issuance of Class 1, 2 and 3 securities.

On the other hand, if TWIA had reinsurance of up to $600 million “attach” lower in the stack, at, say, $1.25 billion, the other layers of protection (Class 2 and 3) move up in the protection stack. TWIA losses would be paid first by TWIA’s catastrophe fund ($250 million), then by Class 1 securities ($1 billion), then by the $600 million in reinsurance, and then by $750 million in Class 2 securities.  The insurance industry would be spared having to repay Class 3 securities.  The diagram below recapitulates how these two attachment points affect the financial burden from hurricanes.

Diagram comparing two stacks of protection

Comparison of reinsurance attachment at $2.7 billion v. $1.25 billion

What I hope this makes clear is that the point at which reinsurance attaches distributes the cost of hurricanes among different groups.  High attachment points means that the folks ultimately responsible for Class 1, 2 and 3 securities (TWIA policyholders, Texas insurers, and coastal insureds) end up paying one way or the other for most serious tropical cyclones.  Lower attachment points tend to protect Texas insurers and coastal insureds from assessments and surcharges but do so substantially at the expense of TWIA policyholders. Thus, TWIA has the discretion under the law to decide whether it wants to place the interests of its policyholders first, the interests of the coast first, or the interests of Texas insurers first.  Not an easy choice.

But reinsurance attachment points are more important still.  This is so because the amount of reinsurance one can purchase depends heavily on the point at which reinsurance attaches.  And from a policyholder’s perspective –TWIA policyholders in Galveston, Brazoria and other heavily populated areas, take special note! — what matters is the overall height of the protection stack. Reinsurance purchased with a low attachment point buys a smaller layer (or costs more) than reinsurance purchased with a high attachment point.  You can buy more reinsurance when it has a higher attachment point because the most damaging sorts of hurricanes occur less frequently than hurricanes that cause intermediate damage.  Thus, if TWIA buys reinsurance with a lower attachment point, it provides less protection of TWIA policyholders and creates a greater risk of insolvency than when it buys reinsurance “at the top of the stack” with a higher attachment point.

To put matters as simply as possible, the higher the attachment point, the taller the stack. The taller the stack, the less TWIA policyholders (and their lenders!) in densely populated areas need worry.

To be sure, the precise relationship between the amount of reinsurance protection that can be purchased and the attachment point is a complex.  It’s tricky because the cost of reinsurance includes not just the expected losses the reinsurer faces (average loss) and some profit but also reflects the amount of money the reinsurer has to set aside to cover the worst cases.  Economically it’s almost as if there was a special tax on reinsurance purchases. Still, I believe it is reasonable to assume that the relationship looks something like the graphic below. The bottom line is that higher attachment points means significantly more reinsurance protection can be purchased for the same amount of money.

Graph showing reinsurance attachment point v. layer size

Graph showing reinsurance attachment point v. layer size

And what did TWIA do in 2011-12?  It did not purchase a reinsurance policy at “the top of the stack.”  Instead, without a lot of fanfare it purchased a policy with an intermediate $1.6 billion attachment point and got $636 million worth of protection. (I’ll have another post on why it may TWIA paid an awful lot for this policy).  TWIA thus decided, implicitly or explicitly, that saving Texas member insurers and non-TWIA coastal residents from the expense of having to pay back Class 2 and Class 3 securities was more important than providing TWIA policyholders with maximum protection.  In particular, it compromised the interests of its policyholders in the most densely populated counties: Galveston, Brazoria (and to a lesser extent Nueces and Harris) because they are the ones who could most use the extra protection high-attachment reinsurance could have purchased.

On the one hand, I understand this decision:  I have argued before that TWIA policyholders should bear most of the risk they accept by owning property or running a business on the coast.  Yes, the coast provides benefits to the rest of Texas, but, frankly so does Lubbock and so does El Paso.  But Lubbock and El Paso and most of the rest of Texas do not get to socialize their property risk onto the rest of Texas. I fully understand wanting to protect middle class Larry in Lubbock from having to subsidize insurance risk created by Gary in Galveston who owns a million dollar beach home there.

texas constitution section 3

On the other hand, I have doubts that this balancing of interests against each is one that TWIA should be undertaking.  I have doubts that coastal Brownsville in Cameron County is more important than coastal Galveston. And yet, the current scheme protects Brownsville well and Galveston less so. No one elected TWIA board members or technocrats to make this choice.  Fundamentally, then, the issue of reinsurance attachment strikes me not as a matter of “expertise” but as a matter for legislative judgment.

Balancing the interests of different parts of the coast against each other and balancing the interests of TWIA policyholders against Texas insurers and other coastal insurers is also an issue for the voters.  The voters should be able to decide through their election of representatives if they like the regime we have ended up with.  The current regime gives TWIA policyholders in sparsely populated Refugio, Kennedy and other more rural Texas counties far greater protection against hurricane risk.  There will never be a TWIA-busting $3 billion hurricane limited to Kleberg County because TWIA insures less than $500 million of property there. Moreover, partly because of the current reinsurance attachment point chosen by TWIA, the current regime insulates Texas insurers and non-TWIA coastal insureds from what would be a higher risk of assessments and surcharges. Many Texas voters might actually like that.

Subject to Texas and federal constitutional dictates about equal protection of the laws, the voters should also decide, however, through election of representatives whether they like the downside of the legal and financial regime that now exists.  The current statutory regime and its implementation should create massive insomnia among TWIA policyholders in Galveston and other densely populated counties every time their fate from a serious tropical cyclone depends on the vicissitudes of Gulf steering currents. And, while I would hate to emphasize the point, the inadequacy of coverage should make many current and future lenders in the densely populated counties anxious as well. Their collateral is at risk of being impaired following a major storm. Many voters might find it unacceptable that TWIA has gotten to choose low reinsurance attachment points that place the finances of Texas insurance companies above that of some TWIA policyholders.

It is probably too late to fix any of this for the 2012-13 hurricane season.  But tropical cyclones will not stop after this season is over.  There are plenty of storms ahead against which Texas can better and more transparently protect.

Note: I have attached here a PDF export of a Mathematica notebook exposing the calculations and diagrams underlying this post.