A simulation of H.B. 2352 and S.B. 1089

H.B. 2352, a bill to reform the Texas Windstorm Insurance Association (TWIA) from Corpus Christi Representative Todd Hunter, is scheduled for hearing in the Insurance Committee of the Texas House this Tuesday afternoon at 2 p.m. I do not know yet if my teaching obligations will permit me to travel to Austin and testify, but if they do, here is about what I will say. It’s based on a Mathematica simulation of 100 sets of 100 years of storms and draws on work I’ve discussed here, herehere and here.

My name is Seth Chandler. I am a law professor at the University of Houston Law Center and author of the blog catrisk.net, which addresses the law and finance of catastrophic risk with a focus on Texas. The views expressed here are my own and do not necessarily reflect those of the University of Houston.

I have attempted to simulate the effects of H.B. 2352 and its companion bill S.B. 1089. The details of that simulation, including the source code, are available in the written submission made to the committee and available at catrisk.net. Basically, I have run 100 100 year storm simulations using models calibrated to mimic those used by AIR and RMS, the two leading modeling companies on which TWIA has relied. Should members of the committee or staff have any questions on the technical details of the model or how variants of the law would affect the conclusons here, I am willing to try to assist.

Based on that research I find that over the initial 20 years of H.B. 2352 with a runoff, and assuming TWIA does not purchase reinsurance, TWIA policyholder premiums will cover about 68% of the losses suffered during that time period. The remaining losses will be paid 6% from replenishment of the catastrophe reserve fund, 8% from class A bonds, 5% from class B bonds, and 9% from class C bonds. Troublingly, 4% of the losses have no identified source of funding. If one assumes instead that TWIA purchases reinsurance at the top of the bonding stack in an amount equal to 1.4% of its direct exposure, as it has done in the past, TWIA policyholder premiums and reinsurance paid for by TWIA policyholder premiums cover a total of 61% of losses suffering during that time period. The remaining losses will be paid 8% from replenishment of the catastrophe reserve fund, 10% from class A bonds, 6% from Class B bonds, and 11% from class C bonds. The percent of losses that have no identified source of funding has decreased, but still rests at 3%. These numbers are, of necessity approximate, and they indeed vary based on a variety of assumptions that need to be made. I have not had the luxury of a large amount of time in which to refine the analysis. In general, however, I believe they accurately reflect the benefits and burdens of H.B. 2352 and S.B. 1089.

This simulation attempts to quantify the benefits and risks to TWIA policyholders created by H.B. 2352 as well as the burden it places on those not receiving direct benefit from TWIA policies. Personally, I do not like what occurs if H.B. 2352 were used to prop up a $72 billion TWIA. The concentration of correlated risk in that entity inevitably makes it an expensive proposition in which the organization either pays exorbitant prices to reinsurers or continues to run the risk of an inadequate stack of protection against larger storm. I believe there is much to the idea of significantly depopulating TWIA with an assigned risk plan or similar mechanism that decorrelates the risk by forced pooling with non-windstorm risk throughout Texas.

If, however, you want to persist with a large propped up TWIA but want to avoid otherwise inevitable biennial fights, it is crucial that the bonding limits contained in this bill with respect to Class A, B and C securities be stated not as absolute numbers, $1 billion, $900 million, $2.75 billion but, as you have wisely done in this bill with the CRTF, percentages of some measure of overall risk to the pool, perhaps direct exposure. Without this modification, the risk grows of storms overwhelming TWIA’s bonding capacity.

Finally, for reasons I have outlined elsewhere I persist in my view that wealthy people on the coast receive subsidized property insurance from poor people away from the coast. This bill continues that inequity although it masks the subsidization by terming what amounts to regional and statewide property taxes as premium surcharges or assessments on insurers. I would thus suggest that the bulking up of the CRTF that takes place in the early years of the HR 2352 plan be made less by non-TWIA policyholders on the coast and assessments on insurers, but more heavily by TWIA policyholders themselves, who will, notwithstanding the benefit that each part of Texas bestows on the other, be the primary beneficiaries of the CRTF protection.


I’m showing below a condensed version CDF on which this analysis depends.  You can get the full version here. If you don’t see anything substantive, you need to download the free CDF player so that you can interact within your browser with the model I have created.

[WolframCDF source=”http://catrisk.net/wp-content/uploads/2013/04/HB-2352-Analysis.cdf” CDFwidth=”600″ CDFheight=”1600″ altimage=”http://catrisk.net/wp-content/uploads/2013/04/overview-getplayer_off.png”]

Some further caveats and comments

  1. I am fully aware that this work done on short notice by an individual and not one certified as an actuary, though I do believe I have the skills to produce what I have done. As I have written elsewhere, the Texas legislature should seriously consider establishing an insurance think tank to help it with issues like this.
  2. The premiums in this model are static.  There is some possibility that as the size of the catastrophe reserve fund grows and TWIA is better able to handle storms without resort to post-event bonding, the premiums could decline.
  3. The basic problem with TWIA is that its risk is correlated.  If it were decorrelated, the premiums policyholders pay would likely be adequate to cover its losses and no cross subsidization would be needed.  The problem is that TWIA needs to build up its catastrophe reserve fund to the point where it is no longer dependent on the risks of post-event bonding or the expense of reinsurance.  Until it does this, a system that bundles up correlated risk is going to remain either really expensive or run a risk of insolvency.


An urgent problem on the coast

The coming hurricane season poses exceptional risk for Texas, mostly to persons and businesses insured by the Texas Windstorm Insurance Association but also among those who will end up picking up the pieces after a major storm.  The most recent data shows that going into the 2013 hurricane season, which is less than three months away, the Texas Windstorm Insurance Association has about $180 million in cash available from which to pay claims, access to $1 billion through issuance of Class 2 securities and access to $500 million through Class 3 securities.  There is some possibility of additional funds if TWIA can market its Class 1 securities or obtain another “bond anticipation note” as it did in 2012. This would give it another $500 million.  And, if TWIA can afford to purchase reinsurance, it might — just might — be able to squeeze out $1 billion more on top of the stack.  Thus, the best case is that TWIA’s stack will be $3.18 billion.  A more realistic assessment is that TWIA’s stack with which to pay claims will be $2.68 billion. And a pessimistic assessment is that the stack will be a scant $1.68 billion, perhaps even less if the catastrophe fund keeps bleeding from Ike claims or the Class 2 bonds prove difficult to market.  The major bill pending in the Texas legislature, S.B. 18, has many virtues but in its present form does nothing to change these computations for most of the 2013 hurricane season.

The problem is that the risk of losses greater than this amount in 2013 are considerable. No one knows the exact probabilities, but based on my modeling, which is in turn based on TWIA’s commissioned studies from experts, the probability of losses to TWIA that are greater than its funding stack range from about 2% on the most optimistic views about the funding stack to 4% on the more pessimistic views about the funding stack. Those are about the same probabilities as the risk of death in the coming year for your average 67 to 75 year old. It’s roughly the same probability of flipping five heads in a row.

It could be even worse.  David Crump noted in response to an earlier version of this post that we may not even have Class 2 securities because, as a result of the 2011 legislation (section 2210.6136), if the Class 1 securities don’t sell, the first $500 million of Class 2 securities appear to rely on the same funding method as the failed Class 1 securities.  (Who thought of that?)  Only after that do we get to the more reliable method of surcharges on all coastal property insurance and an assessment on insurers.  I certainly hope David is wrong in his estimation of the Class 2 securities but, on mature reflection, he has a point. So, we need to add an additional category of gloom: “Crump gloomy.”  And, if he’s right there is about an 8% chance that the top of the TWIA stack will be lower than the amount of the claims. That is very scary indeed.

If the losses are greater than the funding stack, TWIA policyholders are likely not to be paid in full, and certainly not in a timely way. If, for example an average Category 4 storm were to hit Corpus Christi the damages would be about $4 billion.  (EMail of March 14, 2013 from Jennifer Armstrong of TWIA to David Crump).  Policyholders in that part of the coast would thus be paid between 17 cents and 80 cents on the dollar, leaving many unable to rebuild well. If a 3% deductible is going to lead to “blue roofs,” as was suggested by opponents of such an idea at the hearing of the Senate Business and Commerce committee earlier this week (because policyholders won’t be able to find the money to rebuild), consider what an effective 20% – 83% deductible is going to do.

Even losses in 2013 smaller than the full stack are going to cause trouble for TWIA.  A smaller storm in 2013, say, a half-Ike, could wipe out the catastrophe reserve fund and the Class 2 securities.  This means there would be just a very, very small stack to protect TWIA for 2014 and beyond.  The only good news is that legislation pending in the Texas legislature does try to address those later hurricane seasons.

TWIA stacks for 2013

TWIA stacks for 2013


There are several ways the situation could be improved for the coming 2013 hurricane season.  First, TWIA could attempt to make another assessment under the pre-2009 law to cover Ike losses that have continued to drain the catastrophe reserve fund.  (Clearly TWIA does not have authority to make such assessments for post 2009 storms). It appears, at least with the benefit of hindsight, that the $430 million assessment that occurred following 2008 Ike was inadequate to cover TWIA’s responsibility for Ike after the litigation dust has settled. But whether TWIA has the legal authority to do this — and don’t expect the insurance industry to take any such supplemental assessment sitting down — is still not clear. And I would not be surprised to see any litigation on this topic take considerably longer than the hurricane season to get resolved.

Second, the legislature could develop an alternate funding source for the Class 1 bonds for just the coming season.  Indeed, not that I would ever suggest such a thing, but given the somewhat desperate situation that exists, the insurance industry might acquiesce to this burden in exchange for relief from some of the responsibility it is supposed to bear under S.B. 18 for hurricane risk in 2014 and forward. The insurance industry could, for example, bear assessment risk or partial assessment risk for the Class 1 securities that now appear unmarketable since investors understandably mistrust whether TWIA policyholders will stick around and pay the huge surcharges that will be required to pay off the bonds.

Third, the legislature could actually raise explicit taxes [laughter] to pay for reinsurance that might reduce the risk.  Or maybe it could use some of the Texas budget surplus to  pay?  While this will rightly gall Texas taxpayers, particularly once the reinsurers smell blood in the water and charge accordingly, it may still be a prettier picture than picking up the pieces after TWIA goes insolvent.

Fourth, and this may be what coastal residents are counting on, is to just wait and see and try to bail out TWIA policyholders after the fact when a big hurricane strikes.  This will be galling to all.  It will be galling to those on the coast because the fight to get such relief will be slow and tough.  It will be galling to those away on the coast because the taxes that will need to be imposed either directly or indirectly to pay for the losses will be high. The taxes will be the engineered result of problematic legislation passed in 2009 and the steadfast refusal of some on the coast to accept financial responsibility for the true risk of hurricanes there. There is, of course, Uncle Sam, but somehow I would not count on Washington to be as generous following 2013 hurricane Chantal that devastates red Texas as it was to residents of the bluer northeast following Superstorm Sandy.  Besides, with the sequestration and all, it does not appear Washington is going to be eager to spend money on much of anything.

This leaves Texans with prayer as the final alternative. If, however, as many suspect, God helps those who helps themselves, it might be a good investment to deal in a more secular way, right now, with the 2013 risk.

Note: My thanks to David Crump for (1) making the public records request that generated the most recent information on this point; (2) sharing it with me; and (3) pointing out that my original post may have actually been too optimistic.

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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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.