Interactively exploring TWIA funding reform

Here’s a Wolfram CDF document that let’s you explore the reforms to TWIA funding set forth in my earlier post.  To understand it, you must read this earlier blog entry. To interact with it, you will need to go to this website and download the Wolfram CDF player.  It’s easy — very similar to PDF. Once you have the plugin, you will be able to explore fully this and future interactive content. Your CDF plugin will work on this and other blogs and the Wolfram Demonstrations site. [WolframCDF source=”http://catrisk.net/wp-content/uploads/2012/08/s2210355a.cdf” CDFwidth=”740″ CDFheight=”700″ altimage=”file”]

By the way, if you want to see how to produce interactive widgets like this one in a WordPress document, take a look at this excellent and short video. And, to compare the premiums suggested by this document with those actually in use by the Texas Windstorm Insurance Association, take a look at this document and this document.

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.

The source of TWIA’s $800 million in cash on hand

In a previous post, I indicated that TWIA thought it would have $800 million in cash immediately available to pay claims. I was a bit skeptical of this number. But, an article in today’s Insurance Journal, a reputable trade publication, details that the money would come $300 million (0.3 billion) from real cash on hand and $500 million (0.5 billion) from a “bond anticipation note.” The latter is basically bridge financing that one can obtain quickly. The BAN would be repaid, one assumes, from Class 1 securities that TWIA would issue shortly thereafter.

Now, here’s the rub. According to the Insurance Journal article (which may not be fully reflecting what was said on this point), Commissioner Eleanor Kitzman believes that, with this BAN, TWIA would have $4 billion available to pay claims. Here’s the math. $4.15 billion = $0.3 billion real cash on hand + $0.5 billion BAN + $1 billion Class 1 + $1 billion Class 2 + $0.5 billion Class 3 + $0.85 billion reinsurance. If that’s what Commissioner Kitzman said, I have concerns because it looks like the math rests on double counting. $0.5 billion of the Class 1 securities couldn’t be used to pay claimants because it would have to be used to pay off the BAN. I am pretty confident that the BAN investors wouldn’t lend the money otherwise. Plus, according to other statements made at the last TWIA board meeting, it appears that TWIA might not be able to issue successfully the full $1 billion of Class 1 securities authorized. Readers of this blog will understand why that might be. And if all this is true, TWIA doesn’t have $4.15 billion, it has $3.15 billion. Here’s why.

$3.15 billion = $0.3 billion real cash on hand + $0.5 billion BAN + $0.5 billion Class 1 – $0.5 billion used to pay off BAN + $1 billion Class 2 + $0.5 billion Class 3 + $0.85 billion (hopefully collectible) reinsurance.

I hope we never have to figure out whether the difference in accounting is material or not. In the mean time, though, it might be prudent for TWIA and TDI to clarify the numbers.

Note: since the time of this blog entry I have had some private communications that lead me to believe the “best” number — and no one knows for sure — is probably between $3.15 and $3.65 billion.  It depends in part on how much in Class 1 securities can actually be sold.

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.

Quick blog entry on the TWIA meeting of August 6, 2012

I managed to watch most of the TWIA board meeting this morning. Thanks to TWIA for providing this additional form of access to its proceedings. I’m just going to do a quick bullet point list here of matters I found interesting. I’ll try to return to each of these in the days ahead.

1. TWIA has shifted its reinsurance strategy. Instead of a reinsurance attachment point that lay between Class 2 and Class 3 securities, TWIA has now put reinsurance at the top of the stack. It’s also managed to purchase more reinsurance by doing so, notwithstanding a “hardening” of the reinsurance market. This means more protection for policyholders in the densely populated counties but it also means that Texas insurers writing in Lubbock, Dallas, and other non-coastal areas plus non-TWIA policyholders on the coast will bear more of the burden of a large storm by having to repay bonds.

2. One issue TWIA better think long and hard about now that it has placed reinsurance at the top of the stack is how it is going to collect that reinsurance. Traditionally, reinsurers require the insurer to pay the claims first and then to seek reimbursement. But, before this reinsurance will kick in, TWIA will have exhausted its statutory borrowing capabilities of Class 1, 2 and 3 securities. So, does that mean TWIA will have to wait years collecting premiums hopefully in excess of receipts before it can actually get the reinsurance money? How much would it cost TWIA to negotiate a waiver of the indemnity nature of the arrangement? If it’s not a lot, I’d pay!

3. There was talk about how, with $800 million in cash available (source?), TWIA would have months before it would need to raise money from Class 2 and Class 3 securities. I know I’m the gloomy sort, but I have concerns about whether (a) $800 million is enough cash-on-hand for a major storm and (b) whether a few months will be sufficient to raise the extra funding.

4. Uh oh. I learned today that TWIA doesn’t think it can actually raise the $1 billion in Class 1 securities it is authorized to issue following a significant storm. It may only be able to raise half of that. Why? Well, they didn’t say but I assume it is because the market is leery of the ability of TWIA policyholders to actually pay back that money via future increases to their policies. Some TWIA policyholders will likely drop out (or have had their insurable property eliminated). On the one hand, I will confess to deriving some satisfaction from having been proven right that the $1 billion in Class 1 securities was very iffy money On the other hand, it is kind of horrifying to discover that TWIA’s ability to raise money is even more limited that previously asserted.

5. TWIA is evidently going to consider whether to ask the legislature to reduce the maximum policy limit from about $1.8 million for a residential structure down to a lower number. Some board members noted that there was private insurance coverage available for such risks and that other government coastal insurers were not so generous. Representative Craig Eiland from Galveston objected saying that such exposures constituted a small part of the TWIA portfolio and that no one would build large homes on the coast if they couldn’t get TWIA insurance. I’ve advocated in the past that, so long as TWIA policyholders are being subsidized by the rest of the state, that subsidy should not extend to very expensive properties, particularly if private excess insurance is available.

6. TWIA has formed a 10-12 member legislative committee chaired by Mike O’Malley to make recommendations to TWIA regarding recommendations TWIA should make to the Texas legislature on reform. The committee will apparently focus — as it should — on finance issues. Two items of note: only six of the committee members will be TWIA board members. One of the members will be a private advocacy group, the Coastal Coalition. I’m not sure why this advocacy group, which I believe is now renamed the “Don’t Kill The Texas Coast” group gets a privileged position. There was also a discussion of voting rights on the committee. I’m not sure this was resolved, but it strikes me as bizarre that TWIA would delegate voting authority to people not charged with the responsibilities of board members.

P.S. Just fixed a typo in paragraph. It said “not” but it mean “now.” Big difference. Sorry.

TWIA meeting happening now; you can watch it in action

9:03 am Central time August 7, 2012. Just go to TWIA.org and click on the right side where it says “click here to watch the broadcast.” Here’s the agenda for the meeting.

Interesting points from the meeting thus far. TWIA apparently does not a complete “contingency plan” in place yet to deal with how to make partial payments to policyholders when it does not have enough cash on hand. That’s a little scary. TWIA is not sure how it is going to collect on its reinsurance given that reinsurance operates on an “indemnity basis,” meaning that TWIA has to pay out first and then get reimbursed from the reinsurer. An interesting and difficult issue. Where is TWIA getting the money from in order to get reimbursed? Could TWIA negotiate a waiver of the “indemnity aspect” of the reinsurance contract? Did it try?

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.

To fix the TWIA mess, focus on the fundamentals

This op-ed is reprinted from the Houston Chronicle

To fix TWIA mess, focus on the fundamentals
By Seth J. Chandler
Updated 06:52 p.m., Friday, July 27, 2012

Texas has been spared a major tropical storm so far this hurricane season, but that doesn’t diminish the fact that the state is woefully unprepared to deal with potential losses. If a significant fraction of possible Category 4 or Category 5 hurricanes were to strike, the Texas Windstorm Insurance Association (TWIA) would not be able to fully pay claims in Harris, Galveston, Brazoria and possibly other Texas counties. Since 2009, neither the state of Texas nor insurers in Texas are legally responsible to make up the shortfall. In 2013, let’s hope the Legislature stops rearranging deck chairs on the Titanic and explores more fundamental reform.

It’s not just a major hurricane problem or a Galveston problem. Right now, TWIA will not be able to pay with cash on hand or reinsurance funds many claims throughout Texas – not just the most densely populated counties – in the event of a serious storm. Instead, TWIA will be forced to borrow a limited sum, possibly at high rates, to pay the claims. The state will then have to impose significant surcharges on various forms of insurance over a number of years to pay the loans back. Running insurance in reverse and forcing policyholders to pay higher premiums just when they have been hit with losses is seldom a recipe for economic stability.

Unfortunately, as many coastal states are learning, there is no easy solution to this problem. Even those who like the free market must admit past difficulties in providing complete insurance along the coast for windstorm at rates that homeowners and businesses find tolerable. Special and explicit government subsidization of more complete windstorm insurance for the coast has its own financial costs, political problems and moral shortcomings. And the underinsurance engineered into the current law, coupled with some disguised subsidization, leaves Texas insureds at serious risk, particularly in the more densely developed areas of our coast.

The problem is tough because insurance works best where risks are known and uncorrelated. The fact that A has a fender bender with his car in Galveston County provides no information as to the likelihood that neighbor B will have an accident with her car at the same time. So auto insurance works well. Uncorrelated risk means that insurers do not have to stockpile a lot of liquid capital in order to pay expected claims. Something known in mathematics as the law of large numbers makes it unlikely that the amount of revenue an automobile insurer takes in won’t be enough to pay claims.

Windstorm risk along the Texas coast, by contrast, involves correlated risk with uncertain magnitudes. The fact that A’s house in Galveston is blown down by a hurricane informs greatly the likelihood that neighbor B’s house will be similarly destroyed. When insured risks are correlated, insurers and reinsurers have to stockpile lots of safe, liquid assets in order to pay claims in timely fashion. And keeping assets under the mattress hurts insurers and reinsurers in providing a decent return to their shareholders.

There are fundamental ways of addressing high magnitude, correlated risk that can be more successful. One solution is to reduce the magnitude of correlated risks. There is an awful lot of research showing that we can lessen the damage hurricanes cause through hardening: very tough building codes and other infrastructure improvements. A hardened site in Galveston, after all, is currently considered safe enough to house the smallpox virus. Burying power lines allows people to return to their homes sooner, which reduces the losses from a storm. Limiting publicly subsidized insurance plans to lower levels of coverage and requiring individuals to obtain private insurance for the excess also reduces the magnitude of correlated risk held by government plans. Lessening the economic consequences of hurricanes could attract private insurers back to the Texas coast, make state schemes less expensive, and make people feel more secure. The biggest bang for the buck will come from hardening the densely populated counties.

A second approach is to try to decorrelate the risks. Texas could pool its windstorm risk with California’s earthquake risk, Washington state’s volcano risk or windstorm risk from another region. Alternatively, Texas could pool its risk in, say, 2013 together with its risks in 2014 and 2015 by requiring coastal residents who purchase insurance from TWIA to commit to three-year contracts. There are many challenges with each of these plans, but given the absolute magnitude of the issue, even modest gains are worth exploring.

And the third approach is, frankly, to develop a greater tolerance for the high rates that come with insuring correlated risk. Hardening the coast and looking for opportunities to pool our catastrophe risks with uncorrelated catastrophes will help. But Texans on our coast need to let it sink in that they are holding property that is unavoidably expensive to insure and budget for the higher premiums that result. And their legislators who deny this reality do their constituents no service by leaving them catastrophically underinsured.

Chandler is Foundation Professor of Law at the University of Houston Law Center, former co-director of its Health Law and Policy Institute and director of its Program on Law and Computation.