TWIA Board tries to borrow $500 million and get $1.15 billion in reinsurance

The TWIA board met Friday.  I could not listen in on the meeting so my information is very limited.

Pre-Event Bonds

It appears that TWIA is going to seek $500 million in pre-event bonds for the 2013 hurricane season in order to augment its skimpy $180 million catastrophe reserve fund.  Although the total of $680 million is inadequate to address the $70 billion plus in total insured value, it is still an improvement over the $180 million that might be the only certain funding.  My AIR/RMS derived hurricane models  (CompoundPoissonDistribution[0.54, WeibullDistribution[0.42, 177000000]]) suggest this reduces the probability that TWIA will be unable to pay claims in full for hurricanes this year down from 14% to about 9%.  Yes, TWIA may be paying a high interest rate to engage in this sort of borrowing, and from what I understand the borrowing has yet to be consummated, but this is a significant step.

Reinsurance efforts

I also understand from a Rick Spruill Twitter post that TWIA is going to seek $1.15 billion in reinsurance.  What I can’t tell you right now is

  • at what level will the reinsurance attach, i.e. atop the Class 3 as I have recommended or inserted between Class 2 and Class 3 as a Guy Carpenter presentation suggested might occur
  • will the reinsurance “drop down” in the event any of the post-event bonds underlying it can not be sold; if not this reinsurance may well be worthless
  • what premium will TWIA pay for this reinsurance; TWIA in the past has paid very high rates for reinsurance that probably had higher attachment points
  • will the market in fact sell TWIA this much reinsurance; reinsurance capacity is not unlimited
  • is the reinsurance per occurrence or per year; it matters a lot if we have multiple storms
  • if per occurrence, what right of reinstatement will TWIA have and at what price

These are all very important questions in assessing the extent to which TWIA policyholders are at risk for this summer while the Texas legislature considers alternative short and long run fixes.

One additional note

Although the decrease from 14% risk of failure to a 9% risk of failure is significant, one must recognize that over a long period of time, 9% risks materialize.  There is, for example, an 85% chance that a 9% risk will materialize at some point during a 20 year period.  So, getting funds up to $680 million is a positive development, it is not by any means a long run solution.

TWIA Board to Consider 2013 Reinsurance, Bonds

With just 30 days to go before the start of hurricane season, the Board of the Texas Windstorm Insurance Association (TWIA) will meet tomorrow, Friday, May 3, 2013, in Austin to discuss issues critical to its survival.  Among the items on the agenda are purchases of reinsurance and attempts to sell both pre-event and post-event bonds.  Both of these items are likely to prove extremely difficult for TWIA to manage.  Not on the public agenda is any further consideration of having TWIA placed into receivership.

Reinsurance

Let’s look at the reinsurance issue first. TWIA will be receiving a presentation from its long time insurance broker, Guy Carpenter. You can get a copy of that presentation here. It’s a fascinating document. It rests on an awfully cheerful view of TWIA’s ability to sell post-event bonds.  That’s not a view shared by the Texas Insurance Commissioner or, for what it is worth, by me. It shows TWIA is considering a reinsurance purchase option that would help insurers but would hurt policyholders. And it exposes yet again the extent to which the never-ending need to purchase reinsurance created by the undercapitalization of TWIA, forces TWIA to pay extremely high rates for that protection. If one wanted Exhibit A for why TWIA should be substantially depopulated rather than propped up so it can expand, the material for this board meeting would not be a bad place to start.

WHY IS GUY CARPENTER ASSUMING REINSURANCE CAN ATTACH AT $2.3 BILLION?

The Guy Carpenter presentation proceeds on the dubious assumption that TWIA can sell post-event bonds and thus can attach as high as $2.3 billion in the funding stack.   Look at the following picture found on Slide 8. (You may need to click on it, which will cause it to zoom in).

Proposed reinsurance arrangement for 2013

Proposed reinsurance arrangement for 2013

 

Notice that it presupposes that TWIA will be able to sell $2 billion worth of Class 1, Class 2  bonds and thus explores attachment at the top of the Class 2 stack.  But this is a very strange assumption to make.  First, as the Texas Public Finance Authority and the Texas Insurance Commissioner have stated, and as seems clearly correct, TWIA will not be able to sell the full $1 billion of Class 1 bonds.  And has been discussed on this blog before, the Class 2 bonds can’t sell if the Class 1 bonds don’t sell out and the Class 2 Alternative bonds have difficulties as well. So, the whole discussion of reinsurance attaching no lower than about $2.3 billion rests on what sure looks like unwarranted optimism.

Now, to be sure, TWIA’s got a document in its packet for the meeting Friday that suggests it still thinks it can sell $500 in pre-event securities, $1 billion in Class 2 public securities and $500 million in Class 3 securities.  This document appears, however, to ignore section 2210.6136 of the Texas Insurance Code, which says that Class 2 Bonds can’t be issued unless the full $1 billion of Class 1 bonds sell out.  If the Class 1 bonds don’t fully sell, then one has to resort to the Class 2 Alternative bonds.  But as I’ve pointed out before, the Class 2 Alternative bonds may be almost as dubious as the Class 1 bonds. And the Class 3 bonds legally depend on all the Class 2 or Class 2 Alternative bonds selling out.  So, again it looks to me as if TWIA is still looking at this summer with very rosy glasses or has some interpretation of the Texas Insurance Code I don’t understand.

Note 1: There is an alternative presentation on slide 13 in which Guy Carpenter explores the possibility of the reinsurance attaching at $1.7 billion, but even this is an awfully optimistic perspective on TWIA’s ability to sell post-event bonds.

Note 2: In fairness to Guy Carpenter, there is a footnote attached to the graph stating “Actual amounts of bond tranches are subject to marketability.” Yes. But unless there’s been some miraculous turn around in TWIA’s bonding ability, this seems like the main point, rather than a footnote.

Why is Guy Carpenter not having the reinsurance attach at the top of the Class 3 bonds?

If you’ve ready my blog entry on The Curious Matter of Reinsurance Attachment, you’ll know that the TWIA board has to make a crucial tradeoff in determining where any reinsurance should attach.  Inserting the reinsurance between the Class 2 and Class 3 bonds protects insurers from assessments but buys, dollar for dollar, less protection for TWIA policyholders. Inserting the reinsurance on top of the Class 3 bonds gives policyholders more protection but increases the likelihood that insurers will have to pay.

Most of the bills pending in the legislature would prohibit TWIA from doing exactly what the Guy Carpenter presentation appears to suggest: protecting insurers from having to pay back Class 3 bonds rather than maximizing policyholder protection. Given the incredibly precarious situation facing TWIA policyholders this summer — sorry insurers — but the reinsurance should attach at the highest level possible, buying the most protection for policyholders with a provision for drop down in the event the post-event bonds can’t be sold.

The pricing of reinsurance continues to be incredibly high

The Guy Carpenter proposal suggests that TWIA is again going to have to pay through the nose for reinsurance partly as a result of it never having an adequate internal catastrophe reserve trust fund.  As I’ve spoken about on many occasions, this reinsurance trap — almost like borrowing from payday lenders to address financial vulnerability — basically insures that TWIA never escapes its poverty.

How can I say this?  Look at the models AIR and RMS provide both Guy Carpenter and TWIA.  Here’s slide 6 of the presentation.

AIR and RMS risk estimates

AIR and RMS risk estimates

If one assumes that the distribution of annual losses is a Compound Poisson distribution, with the Poisson parameter being 0.54 (as found in this scholarly article) and one assumes that the underlying distribution is a Weibull with parameters 0.42 and 177,000,000, you can generate data that matches up extremely well with that found by AIR and RMS.  If you then run, say, 10,000 years of simulations using that distribution, you find that the mean losses to an insurer who writes a maximum of  $850 million worth of coverage over a $2.3 billion retention is only about $20 million.  That is 4-5 times less than what the reinsurers are apparently proposing to charge.  And, thus, the cost of having to reinsure rather than internally finance is something like $65-$75 million per year, or about 1/6 of all TWIA’s premiums. You dont, by the way, get qualitatively different results using the three parameter Weibull distribution that I’ve used on this blog before to replicate the AIR/RMS models.

There’s a lot more that is odd about the reinsurance pricing. If we think of the price as being composed partly of expected losses and partly of having to withdraw the maximum exposure from illiquid high-earning investments and place it in low return, highly liquid investments — this is the Wharton School model — the pricing only makes sense if reinsurers lose about 7.8% on their capital by having to make it particularly liquid. ((-expectedLosses + premiums)/maxExposure). Given the market right now, that’s a pretty high number.

There are a couple of explanations between the actual pricing for reinsurance and the pricing that the models would suggest.  One, which is rather scary, is that the reinsurance market is not behaving as competitively as one would like.  The other, scary for different reasons, is that the reinsurance market doesn’t trust the AIR/RMS model and thinks the risk of a major hurricane is considerably greater.  If that’s true, however, then even the dire warnings that I  and others have been sounding about TWIA are understated.

Bonds

The Bond Anticipation Note

The other main item on the agenda appears to be the issuance of bonds.  There is a a proposal from First Southwest that TWIA sell by June 27, 2013, a “Bond Anticipation Note” for $500 million that would basically be an advance on a hoped-for similar Class 1 post-event bond. First Southwest apparently believes these unrated bonds could be sold at between 4 and 6%. My own 2 cents is that if TWIA can get this loan, it should grab it.  Increasing the amount it has to pay claims from its CRTF funds of $180 million to something like $680 million will help.  And if all it has to pay is some interest, that’s a good deal. But there’s a lot to do before this money will be available to TWIA and it looks as if it is going to have go through at least the first month of the 2013 hurricane season without it.

Post-Event Bonds

There’s also apparently a resolution on the table authorizing TWIA to asks the Texas Public Finance Authority to issue post-event bonds. I’ll confess I don’t understand this one.  There haven’t been any tropical cyclones yet in Texas for 2013.  Maybe TWIA is getting this resolution done to see what can actually done for 2013?  Maybe it is an attempt to see if things are as bad as some people have been saying?

Conclusion

The TWIA board is in a very tough spot.  With fewer than 30 days to go in the legislative session and 30 days until the start of hurricane season, it doesn’t really know what its resources are to pay claims. It’s being (understandably) threatened with receivership by the Texas Insurance Commissioner. And its existing reinsurance expires on May 31, 2013, before the start of hurricane season.  If and until TWIA gets some legislative relief or is put partly out of its misery by a Texas shift to an assigned risk plan or other mechanism that deconcentrates risk, it doesn’t have many good options. My hope is that the board will have the courage to confront its moral and legal obligation to warn policyholders in the clearest possible terms of the risks that, unless powerful legislative relief swiftly occurs, their claims will not be paid fully should a significant hurricane hit this summer.

Fox 26 Stays on the Story

Greg Groogan of Fox 26

Greg Groogan of Fox 26

Fox 26 Houston news with its reporter Greg Groogan has run another story on the problems facing the Texas Windstorm Insurance Association (TWIA).  I’m quoted again in this story (accurately, just like last time).  The story very well encapsulates the problem. TWIA does not have enough money to pay claims. Coastal residents don’t want their economy hurt by paying higher insurance premiums. And Texas taxpayers and property owners not on the coast don’t want to continue to pay wind and fire premiums not just on their own house but also help subsidize wind premiums on the homes of coastal residents, many of which are more expensive than theirs.  As a result, most involved are in one of the Kubler-Ross stages of grief: (1) denial, (2) anger; (3) bargaining; (4) depression; or, possibly (5) acceptance. And I agree with the realtor quoted in the story: as it stands Texas catastrophic risk system is pretty much prayer based.

P.S. Houston Chronicle: anybody home?

The “Committee Substitute” to H.B. 3622 is a very different animal

I have now received a copy of the “Committee Substitute” to H.B. 3622 (CSHB 3622 Bill Text). This committee substitute house bill is a very different animal than the original H.B. 3622.

Changes to the Funding Structure in the Committee Substitute House Bill

Here are the changes to the funding structure that I note.

1. Under original H.B. 3622 (and the status quo), Class 2 post-events would be repaid 70% by coastal insureds via premium surcharges and 30% by insurers by assessment. The maximum amount of Class 2 bonds was $1 billion.  Now, the insurers are simply supposed to pay 30% of the bill up front via assessment and coastal insureds are supposed to repay up to $700 million in borrowings through premium surcharges.

2. TWIA is required, apparently no matter what the price and no matter what its financial condition, to purchase a base level minimum of $1 billion in reinsurance at the top of its stack.  I would be pleasantly surprised if such reinsurance could be purchased for less than $100 million. This is so because of the low attachment point  for the reinsurance that will now exist in light of the depleted Catastrophe Reserve Trust Fund, the fact that the mandate puts TWIA over a barrel, and the historic pricing evidence. Standing alone, this reinsurance requirement should, however, bring the height of the stack for 2013 to about $2.98 billion ($180 million in CRTF, $800 million in assessment on insurers ($300 million interest free loan repaid by Texas through premium tax credits and $500 million true payment), $300 million in Class 2 assessments on insurers, $700 million in Class 2 post-event bonds paid for by coastal policyholders, and $1 billion in reinsurance)

3. If the catastrophe reserve fund has less than $1 billion in it, TWIA is required to purchase additional reinsurance so that the total height of its stack is the probable maximum loss for a 1 in 75 year storm.  By my calculations this will be a stack of roughly $3.7 billion. This provision thus requires TWIA to buy an additional $700 million in reinsurance. I would expect this extra level of reinsurance to cost between 50 and 70% of the cost of the first layer. Why so much?  Much of the premium for reinsurance is to pay the reinsurer for having to actually have ready access to its maximum exposure.  Moreover, the purchase of the first $1 billion will have shrunk limited global reinsurance capacity,

4. If the catastrophe reserve fund has more than $1 billion it, TWIA is required to purchase additional reinsurance so that the total height of its stack is the probable maximum loss for a 1 in 100 year storm.  By my calculations, this will be a stack of roughly $4.4 billion. If the CRTF has $1 billion, then the height of the stack with baseline reinsurance will be about $3.8 billion (see note below). TWIA will thus be required to purchase $600 million in additional reinsurance. I would expect this extra level of reinsurance to cost between 40 and 60% of the cost of the first layer.  Why?  Again, much of the premium for reinsurance is to pay the reinsurer for having to actually have ready access to its maximum exposure. And, again, there is not an unlimited supply of catastrophe reinsurance money.    The purchase of the first $1 billion will have shrunk limited global reinsurance capacity

5. The cost of the baseline reinsurance is borne by TWIA policyholders.  The cost of additional reinsurance, however, is borne by insurers in Texas, who will presumably figure out a way to pass the cost on. This, I now understand, is what insurance lobbyist Floyd Beamon was complaining about at the hearing yesterday.

Visualizations of the Funding Stack in the Committee Substitute House Bill

Here are some pictures of what the TWIA stack would look like under the Committee Substitute to H.B. 3622. Clearly there is a lot of “Piggy Pink” in these pictures — the color code for Texas insurers — and not very much “Teal Blue” — the color code for TWIA insureds. You’ll also notice some ‘Burnt Orange,” which, apologies to other Texas schools in advance, is the color code for the Texas fisc.  I hope to be able to post a more detailed analysis later today. My interim suspicion is that the Committee Substitute significantly decreases the risk of insolvency below that of the original bill (look at the last graph in this post). It does so, however, by forcing insurers to endure a far greater amount of what is euphemistically called “lift.”  In plain English, TWIA is yet again propped up for yet further expansion by using other people’s money. But at least it is made somewhat solvent for the near future and the reliance on the worst of the post-event bonds is eliminated.

 

TWIA Stack Under HBCS 3622 for various CRTF values

TWIA Stack Under HBCS 3622 for various CRTF values

 

 

H.B. 3622: the hearing yesterday. And is it getting worse?

Here’s a link to the House Insurance Committee hearing of April 30, 2013. My extensive fan network can skip to minute 10 and watch until minute 26 as I take on the Bonnen Brothers and discuss H.B. 3622 with the rest of the committee. Actually, it’s worth watching the whole thing, particularly the dance around the issue of whether H.B. 3622 mandates “actuarially sound rates.”  Answer: it does not.

Dennis Bonnen

Dennis Bonnen

Greg Bonnen

Greg Bonnen

 

 

 

 

 

 

A few quick observations:

  • Unconfirmed, but there is apparently a major change in H.B. 3622 that makes the bill worse than I thought.  In fact, if what I am hearing is true, I might now answer the question posed to me by Representative Greg Bonnen yesterday somewhat differently about which was better, his bill, which I did not like, or the status quo, which I also do not like.  If it is true, as I heard after the meeting, and as Beamon Floyd, a lobbyist for major Texas insurers suggested during his testimony, that a modified version of the bill relieves TWIA policyholders from the obligation of actually paying for the reinsurance that protects them but foists that $100 millionish burden onto insurers statewide, that makes H.B. 3622 even more problematic. If that’s true — and I hope to find out later today — my better answer might then be: “I can’t say: they are both awful in different ways. The status quo is awful because it does not create a high enough stack to protect TWIA policyholders from insolvency. HB 3622 is awful because it makes non-coastal residents pay even more of the burden of insuring on the coast and thereby sends even worse signals about development patterns and hurts the poor off the coast even more.”
  • It is apparently very common practice in the Texas legislature for there to be proposed changes to a bill — a “Committee Substitute” that are not posted to the otherwise wonderful Texas legislative website.  As a result, “outsiders” such as me find themselves testifying about provisions that have either been replaced or supplemented.  Apparently, one can usually get the committee substitute by asking the bill proponent, but it might enhance democracy — and make testimony more relevant — if these substitutes were available electronically or in some regularized procedure.
  • I think I now understand Representative Craig Eiland’s ideas on trying to assess insurers for Hurricane Ike.  He doesn’t want to assess under the old law.  What he seems to suggest is a new law that would assess insurers for anything up to $600 million “for Ike” and to justify that assessment on grounds that the insurers “escaped” that responsibility under the old law when TWIA messed up and failed to assess adequately.  It’s an interesting idea and I too am troubled by the failure to assess under the old law. It is partly responsible for the current deficiency in the Catastrophe Reserve Trust Fund. But it is not an idea without legal risks. Although the ex post facto clause of the United States Constitution applies only to retroactive imposition of criminal liabilityHarisiades v. Shaughnessy, 342 U.S. 580, 594 (1952), that rule has some qualifications (Burgess v. Salmon, 97 U.S. (7 Otto) 381, 384 (1878)). Moreover, although what Representative Eiland is proposing isn’t quite a classical taking, it is a little disturbing.  The idea of taking money, even if for the public good, not as a condition of continuing to have an insurance business in Texas but as punishment for having previously done business in Texas and legally escaping what some wanted you to pay, may come close to constitutional prohibitions.  Make that assessment heavy enough and its relation to prior conduct or past legislative advocacy for the repeal of the old assessment law clear enough, and it might inspire the insurance industry to go out and find a good lawyer.
  • The Bonnen Brothers are both clearly intelligent people.  The absence of bombast in their tone is refreshing.

There will be more later today or tomorrow on the whole TWIA situation. Stay tuned as we head into the homestretch.

A closer look at H.B. 3622

Analysis

I have undertaken an analysis of H.B. 3622 that is going to be discussed in the House Insurance Committee at a hearing at 2 p.m. this Tuesday, April 30, 2013.  The one sentence summary is that, although it has some good features, H.B. 3622 is an economic disaster for the Texas coast and the rest of Texas because it does not create a high enough stack to protect against tropical cyclones. The probability of TWIA going bankrupt, even if it does not grow, over the next 20 years under this bill is about 22%. Here are the bullet points.

Baseline scenario

I conducted 1000 simulations of H.B. 3622 over its plausible shelf life of 20 years using models based on data provided to TWIA by AIR and RMS. TWIA policyholders end up paying via operating funds, reinsurance premiums and contributions to the catastrophe reserve fund for about 66% of the amount of TWIA losses.  There is thus about 34% subsidization in H.B. 3622.  The remaining losses are paid for approximately as follows: 9% by coastal insureds for paying off 70% of the Class 2 bonds, 12% by insurers (and, derivatively, their insureds) by low attachment Class1 Funding assessments, paying off 30% of Class 2 bonds, and high attachment Class 3 Funding assessments, 3% by the State of Texas via premium tax credits given to insurers that partly offset assessments, and, a disturbing 11% absorbed without insurance by TWIA policyholders when TWIA lacks funds with which to pay claims due to an inadequate stack. The pie chart below illustrates this distribution. For some caveats on this computation, see the note below.

Baseline distribution of payments under H.B. 3622

In 222 of those 1000 simulations, (22.2% of the time) TWIA became insolvent at some point during those 20 years. At first, I thought this had to be a mistake in my simulation. But, I did a back of the envelope computation that suggests it is an accurate result.  This high risk exists because, particularly over the next 5 years or so, the stack protecting TWIA policyholders is very low relative to potential losses.  Some depopulation of TWIA via, for example, lowering maximum policy limits or reducing moral hazard through higher deductibles and coinsurance would reduce this probability. My “envelope” containing the computation is set forth in the notes below.

Low reinsurance scenario

Reductions in the purchase of reinsurance produce yet worse results.  The 20-year risk of insolvency is now 29%. And TWIA policyholders pay for even less of the risk they create.  The pie chart below shows the distribution.

HB3622PieChartLowReinsurance

Higher Premium Scenario

Additional premiums paid in by TWIA policyholders could lower the risk of insolvency and increase their responsibility for losses. By increasing premiums 25%, the probability of insolvency is reduced to 21%, still far too high a number. The pie chart below shows, however, that TWIA policyholders now pay a larger proportion of losses suffered.

HB3622PieChartPremiumHike

Higher Maximum CRTF Payment Scenario

The rate of subsidization and the risk of insolvency would decrease significantly, if H.B. 3622 liberated the CRTF to do its job.  H.B. 3622 would be improved if the $1 billion ceiling in its section 6 (amending section 2210.072) placed on CRTF payments were replaced with $3 billion, as the maximum amount of CRTF funds that could be used to pay for losses. A conforming amendment should also be made to proposed section 2210. 4522. Such an amendment, although it would do little for the next 5 to 8 years, at least reduces the risk of insolvency in years down the road provided no major hurricane has previously hit the Texas coast.  Insolvency risk over the 20 year period would decline to 18% — still way too high but smaller.  And the distribution pie chart shows that now 73% of the losses are born through insurance by TWIA policyholders, though 9% is still unfunded.

HB3622PieChartBaselineWith3MCRTF

The failure to index the parameters to H.B. 3622, such as the maximum amount of the catastrophe reserve fund that can be used to pay a claim or the maximum assessments against insurers means that the insolvency risk grows if, as coastal interests desire, the value of property on coast continues to grow.

Conclusion

This bill, if were to be passed by a 2/3 majority, at least makes a dent in urgent crisis facing Texas for the 2013 hurricane season. It gets rid of the “bug” in current law that I have discussed in this blog recently. And it does away with the worst of post-event bonding as a funding mechanism. The bill, however, still suffers from several fundamental problems that threaten to destroy the Texas coast.  Unlike S.B. 18 that woud somewhat deconcentrate TWIA risk, it continues the concentration of correlated risk in a single entity. This placing of a lot of eggs in the single TWIA basket inevitably leads to extraordinarily high prices for reinsurance, which in turn prevents TWIA from building up adequate internal reserves in timely fashion. By insulating coastal Texas from market forces, the bill distorts development patterns and discourages risk mitigation. It perpetuates the economically unjustifiable large-scale subsidization from the poor in non-coastal Texas to the middle class and wealthy in coastal Texas. It continues to do so in an opaque manner by complexities such as insurer assessments and premium tax credits.  And it leaves the Texas coast and, derivatively, the rest of Texas extremely vulnerable over the reasonable lifespan of this bill to a devastating insolvency — a threat which itself is likely to retard coastal development.

Assumptions and Qualifications

I assume the AIR and RMS models are reasonable.  There is some evidence to suggest that the reinsurance industry believes these models are optimistic about the risk of severe tropical cyclones in Texas.  If that is true, the insolvency problem highlighted here becomes yet more serious.

My original analysis contained some errors; I attempt to fix them here. Most relate to my prior lack of complete recognition that the bill does away with Class 1 post-event bonds, the alternative Class 2 post-event bonds, and with Class 3 post-event bonds and substitutes assessment mechanisms for them.

I assume that insurers pay for about 20% of that portion of assessments for which a premium tax credit is available.  This percentage is a crude estimate of the time value of money.

I assume that insurers incur no costs in having to stockpile money to pay assessments.  This is an assumption made for purposes of simplicity and is obviously false.  Taking risk costs into account would mean that insurers bear even more of the costs of a system such as H.B. 3622.

I use a model of reinsurance pricing consistent with that in the literature under which reinsurance prices are based on the sum of the expected claims costs and a fraction of the maximum exposure. I have attempted to calibrate the model, particularly with respect to the fraction used to multiply maximum exposure, by looking at the amount TWIA has paid for reinsurance in recent years.  I continue my concern that TWIA is paying too much for reinsurance and substitute mechanisms for catastrophic risk transfer ought to be explored.

A copy of the Mathematica notebook underlying the assertions in this blog post is available here. I have not had the time to annotate it fully, but am happy to explain it and run different simulations should any legislator desire.

Three back of the envelope computations confirming a high probability that H.B. 3622 will leave TWIA insolvent over the next 20 years.

Method 1

If you have a stack like this one for 2013 that is likely to be at best only $2.98 billion high ($180 million CRTF, $800 million Class 1 Funding and $1 billion Class 2 Bonds plus an optimistic $1 billion in low attaching reinsurance) and you have roughly a 1.9% probability of a tropical cyclone losses that exceeds that sum, over 20 years, the cumulative probability of having at least one loss in excess of the stack is 31%.  (The survival function at 0 of a negative binomial distribution with 20 trials and a negative probability of 98.1% per trial).  It’s only because the stack can grow by perhaps $100 million per year on average (due to increases in the CRTF) and the fact that there the probability in the simulation drops to a still frightening 21.3%.

Method 2

I also performed a second simplified analysis in which one computed the height of the stack as a function of time under the optimistic assumption that TWIA suffered no major losses.  The height of the stack was set to increase as contributions to the CRTF increased.  I then computed the numeric probabilities for solvency each year.  I then multiplied these probabilities together.  By subtracting these values from 1, one obtains the probability at the end of each 20 year period that TWIA has become insolvent. I again see results between 15-25% depending on what assumptions are made.  These results are consistent with the findings made using the more elaborate methodology.

Method 3

I generated 10,000 storms from the AIR/RMS derived distribution.  I then partitioned these storms into groups of 20 and found the largest storm.  I then plotted the “Exceedance Curve” or “Survival Function” of this empirical order distribution.  I show the results below.  As one can see the probability of the largest storm being more than $3 billion is about 20%.  Even at $5 billion, the probability is above 15%.

Exceedance Curve for Largest Storm in 20 years

Exceedance Curve for Largest Storm in 20 years

Unfortunately for Texas, the Fox 26 story quoted me correctly

I received an email Friday afternoon from an insurance agent.  It concerned the recent story on Fox 26 Houston TV in which I appeared.  Here’s what the letter said:

I believe  the  reporter in this publication has misquoted you or misunderstood what he was told.   It has been my understanding as a professional  agent for many years, and  also that of my associates,  that should TWIA become insolvent that insurance companies doing business in Texas will be assessed for millions of  dollars and  losses that then exceed those sums will be paid from the General Funds of the State of  Texas.  To rely on such a system is totally unacceptable—the delays in claim payments to policy holders would be unacceptable.  However, the statement that the State has no obligation to pay those claims remaining after the assessment is totally false.
If I am misinformed, please let me know the error of my ways.  I am correct, please ask  the reporter to print a correction.   If I am correct,  this misstatement is not only confusing but can do irreparable damage in further confusing the buying public.   The matter is already complicated enough .
I read the email while I was walking the dog. And, for a moment, I was unhappy.  It was, after all, being suggested that I had misled the public in a way that could do irreparable damage.  Falsely asserting an insurer is in deep trouble can create runs.  If publicized widely and treated as credible, such assertions become somewhat of a self-fulfilling prophesy.  Plus, the email author was incorrect in his understanding of how TWIA has worked since at least 2009. That probably meant that a large segment of the public — and even the insurance public — were not up to date on what has been going on in Texas for the past five years. Depressing. But, on reflection and return from my canine adventure, I recognized that this meant that the Fox 26 story by reporter Greg Groogan had an impact and that I had an opportunity here to do some targeted education.
Here’s what I wrote back.

Thanks for your interest in this topic and your taking the time to send me a polite email. I was walking the dog when I received your email so I just tapped out a brief reply.  I would be delighted to speak with you by phone at your convenience. You can reach me on my cell at xxx-xxx-xxxx. The short version, however, is that the Fox 26 reporter basically got it right and, unfortunately, I can not claim to have been misquoted.   I would be happy to  explain this to you in more detail. To get you started, you might want to look at any of the following:

David Crump, another Texas citizen interested in these issues, and an insurance agent also sent my emailer a polite and helpful response.

Later Friday night I received a reply from the insurance agent. Here’s what he said.

Dr Chandler, thank you for all the information you have provided.  I am embarrassed that my understanding is so outdated.  Armed with this information I am at least better equipped to explain to our clients the problems they face when the next hurricane comes.  We can only hope and pray that our Texas legislators find the wisdom and political courage to do whatever is necessary to resolve this issue–and do so in time.  At the moment it is difficult to place adequate coverage for our clients, but that is better than the impossibility that it may become without a resolution.

Again my sincere thanks for taking the time to correct my misinformed understanding.

I then felt really good.  First, a civil exchange between two people who might initially have been taking adverse positions had ended in some agreement.  Second, I’d educated someone who sells insurance to the public. That agent and his colleagues are now in a position to give the public better guidance in their choices.  And third, I recognized that I’d actually covered a lot of ground in this blog and that it was a very useful source of information and education.  The only sad part was that what the agent wrote back was precisely correct: “We can only hope and pray that our Texas legislators find the wisdom and political courage to do whatever is necessary to resolve this issue–and do so in time.  At the moment it is difficult to place adequate coverage for our clients, but that is better than the impossibility that it may become without a resolution.”

An analysis of S.B. 1700 and H.B. 3622

Note: I’ve taken a second look at this bill and done a better job in analyzing it. Look here.

S.B. 1700 from Senator Larry Taylor of  Friendswood and its House cognate, H.B. 3622 from Representative Dennis Bonnen of Brazoria/Matagorda are the only bills among the major contenders in the legislature this session that addresses the short run problem with the Texas Windstorm Insurance Association.  And H.B. 3622 is set for a hearing in the Texas House Insurance Committee this April 30, 2013, at 2 p.m.  As with H.B. 2352 from Representative Todd Hunter and its cognate S.B. 1089 from Senator Juan “Chuy” Hinojosa, however, the Taylor/Bonnen bills prop up TWIA largely with money from people other than TWIA policyholders. In this instance, the entities that pay for much of the windstorm risk on the Texas coast are (1) Texas taxpayers via a reduction in otherwise owing premium tax revenue and (2) owners of insured homes, autos and other insured property (or liability insurance) throughout Texas via an assessment on insurers likely to be passed on in higher premiums. Here’s a legislative analysis.

The key to S.B. 1700 and H.B. 3622 is to make sure that no storm that causes less than about $1 billion in losses to TWIA needs to try to use post-event Class 1 Bonds to pay claims — a good idea considering that these bonds have been found to be unrateable and probably could not be issued in a large amount. Right now, it only takes a storm causing more than $180 million before TWIA will first look to Class 1 Bonds in order to pay claims. The padding between storms and the tenuous Class 1 Bonds is, at least for the 2013 hurricane season, not additional money from TWIA policyholders but instead an assessment on property and casualty insurers statewide. This assessment could be up to $800 million.

The bill softens the blow of this $800 million exposure in two ways.  First, up to $300 million of such an assessment could be credited against premium taxes the insurers would otherwise owe to Texas.  This crediting would take place in installments, however, lasting a minimum of 5 years.  Thus, in essence, Texas insurers are compelled to fork over up to $500 million and to front an interest-free $300 million loan to the state in order to pay clams.  (And even if they never pay, they will have to stockpile some reserves to address this contingent liability.) I have suggested elsewhere that it would insult the insurance industry to suggest that they will not find a way to get this money back. An obvious target will be Texas policyholders. Second, for each dollar the insurers pay at the lower attachment point (just above the end of the Catastrophe Reserve Trust Fund) they reduce the exposure they now have at a higher attachment point, one that lies above the top of the Class 2 Bonds or the Class 2 Alternative Bonds.  And the insurers no longer have to really pay fully for Class 3 assessments. Instead, up to $300 million, they just make an interest-free loan to the state that gets paid back over a minimum of 5 years via a reduction in otherwise owing premium taxes.

Here’s an interactive visualization of the effect of S.B. 1700. You’ll need to obtain and install the free CDF player to actually be interactive with this medium.

[WolframCDF source=”http://catrisk.net/wp-content/uploads/2013/04/SB-1700.cdf” CDFwidth=”560″ CDFheight=”800″ altimage=”http://catrisk.net/wp-content/uploads/2013/04/SB-1700.png”]

 

So, if I had to guess at the realistic size of the TWIA stack today, I would say it was perhaps  $600 million: $180 million in CRTF, perhaps a sale of 25% of the amount authorized in Class 1 Bonds, and perhaps 25% of the amount authorized in Class 2 Alternative Bonds. If S.B. 1700 were to pass, the stack would grow to perhaps $1.5 million: $180 million in CRTF, $800 million in insurer assessments (some of which would just be an interest free loan), and, again, perhaps  sale of 25% of the amount authorized in Class 1 Bonds, and perhaps 25% of the amount authorized in Class 2 Alternative Bonds. Due to the bug in the existing statute — one that is not (yet) fixed in the Taylor bill — it’s my opinion that no Class 3 securities are likely to be issued. I also have doubts that useful reinsurance can currently be purchased by TWIA due to confusion about the appropriate attachment point.

A few additional comments.

1. I’d like to run analysis similar to that done on H.B. 2352 about how much of the expected risk of tropical cyclones is born by each group under S.B. 1700 and H.B. 3622. My suspicion is that a great deal will be borne by insureds statewide due to the low assessment attachment point. A great deal will be eaten by TWIA policyholders themselves in uninsured losses because, unless pieces of the statute are fixed, the realistic height of the stack is not the touted $4 billion but a number far lower than that.  In other words, S.B. 1700 and H.B. 3622, though they raise the height of the TWIA stack, still leaves a substantial risk of insolvency.

2. The bill has a provision I like: it prohibits TWIA from purchasing reinsurance with low attachment points.  This prohibition prevents TWIA from deciding to sacrifice policyholder interests in favor of insurance company interests.  How to trade these two interests off is a matter that should be resolved, as this bill does, by the legislature.

3. This bill does nothing to address major structural problems with TWIA.  These include:

  • low deductibles and no coinsurance that lead to problems of moral hazard
  • failure to warn TWIA policyholders about the risk of insolvency
  • continued subsidization by poor people throughout Texas of million dollar homes on the Texas coast
  • continued concentration of risk in a single entity that invariably leads to a difficult tradeoff between paying extremely high rates for reinsurance — and thereby preventing growth of an internal catastrophe reserve fund — or subjecting policyholders to a substantial risk of insolvency
  • fails to address the needless fragility of Class 3 Bonds. [This is not right, see my update]

 

 

 

Fox 26 Houston Story on TWIA Tonight

Fox-26 Houston (KRIV) is doing a story for their 5 p.m. news today, April 25, 2013, on the problems facing the Texas Windstorm Insurance Association. I was interviewed in connection with the story. Although I spent much of the time engaging the special insurance mythology of the Texas coast, my hope is that this story brings attention to the immediate problems facing both coastal Texans and the rest of the state this summer.  I am very glad at least one Houston media outlet is covering this urgent issue. The legislature may well need some prodding in order to act before the current session expires in 32 days.

Here’s a link to the story.

Unfortunately, it looks like the reporter got an earful of the usual from some coastal residents before interviewing me.  He heard, for example, the myth of how the coast subsidizes the rest of Texas’ hailstorms and tornados so it’s only fair that the rest of Texas subsidizes coastal windstorms.  This is wrong in so many ways. First, Texas does not relieve Northern Texans from paying for the full cost of homeowner insurance by establishing a state-created insurer and saying that, when that insurer runs short, it can hit up people other than policyholders to pay claims and recapitalize the insurer. If and when Texas does this, I’m willing to listen with greater attentiveness to the “we are all in this together” song. For now, I regard it as a guise for geographic wealth redistribution that frequently hurts the poor. Second, while it is true that Texas insurers pay out over the long run a lot in hail and tornado claims, it’s also true that the denominator — the value of property insured along non-coastal Texas — is a lot bigger than the value of property insured along the coast.  So the risk of hail and tornados is not the same as the risk of tropical cyclones. It is less. Third, Texas insurers are permitted by the Insurance Code (544.003(b)) to price on the basis of geographic risk, provided they can establish it is real.  I am aware of no evidence indicating that Texas insurers have not taken advantage of that opportunity and have failed to charge northern Texans a fair risk for the special risks they pose by virtue of the somewhat higher risk of hail and tornados in those regions relative to coastal Texas.  I have never yet seen an actual relevant number from any proponent of the cross subsidization myth.

The reporter also heard the usual comments about how the coast is some exaggerated percentage of the Texas economy. If the only purpose of this remark is to urge legislators to find a good solution to the problems of catastrophe insurance along the Texas coast, I agree 100 per cent.  And the fact that they exaggerate the numbers a little bit might count as a white lie. Usually, however, these utterances with exaggerated percentages are instead justification for continued subsidization — a system, by the way, that has not worked out very well for the coast.

Of course the coast is important to the Texas economy.  No one I know is saying anything to the contrary.  And lest there be any doubt, I agree that the Texas coast is very important to the Texas economy. That’s just another reason that getting its property insurance market in good shape is all the more important.  But first of all to say that it is 40% or 50% of the Texas economy because 40 or 50% of business is indirectly tied to the coast is not the right measure.  Once we start using indirect ties, the total percentages are going to add to way more than 100%. I venture to say that 50% of the Texas economy is tied directly or indirectly to Dallas, and another 50% to Houston and another 40% to Austin and another 40% to San Antonio, and so forth.  But so what? The fact that we are all interdependent is simply not a logical argument that one part of that interdependent system should subsidize another. Probably 100% of the Texas economy is tied to Texas cities. Does that mean that rural folk should subsidize my urban homeowner insurance?

Here are the points I tried to make.  They will be familiar to readers of this blog. I have spoken with this reporter before on other insurance topics and he does a good and fair job whittling down longer comments to the limits of television news.  So, I hope some of them survive.

  • TWIA has just $180 million left in its Catastrophe Reserve Trust Fund. It was thought as recently as a few months ago that TWIA would have access to at least $3 billion with which to pay claims. The issue was whether $3 billion was too little.  But after looking at the financial environment and taking a close look at the TWIA finance law, including a possible bug, there is now serious doubt that there will be much more available to pay policyholders than the $180 million in the Catastrophe Reserve Fund.

  • The state is not legally obligated to pay claims if TWIA is insolvent.  If there is a large storm this summer, there is a serious risk that TWIA policyholders will get only pennies on the dollar.

    • What can TWIA policyholders do?

  • (1) Extreme vigilance in protecting their homes.  There are lots of mitigation steps that can be taken, particularly with older homes.  Some need to be taken right now.  Others can be taken if a storm approaches.  But act as if you have a huge copay on your policy

  • (2) Some TWIA policyholders may have alternatives.  It may be more expensive.  Consider whether you want to pay more but sleep better this summer

  • (3) Urge your legislators to treat this problem seriously.  32 days left in session.  Bills pending that address the issue. There is both a short run problem and a long run problem.

     

 

The TWIA Status Chart

Aside

IssueAnswer
IssueAnswer
Days until the start of hurricane season1
Days until the end of the legislative session0
Next hearing of Senate Business and Commerce Committee None scheduled
Next hearing of House Insurance CommitteeNone scheduled
Size of Catastrophe Reserve Trust Fund$180 million
Bond Anticipation Notes (pre-event bonds)None. Approval refused by Commissioner Eleanor Kitzman
Reinsurance sought$1.15 billion at an attachment of $2.2 billion (not yet obtained)
Probability of TWIA losses in 2013 exceeding size of Catastrophe Reserve Trust Fund and Bond Anticipation NotesTWIA Estimate: 7.7% My Estimate: 10%-- could be higher if forecasts of active-hyperactive hurricane season prove accurate Estimates for 2013 and 2014 seasons are between 15-18% assuming no growth in Catastrophe Reserve Trust Fund
Bills enacted addressing TWIA problems for 2013 hurricane seasonNone
Bills enacted addressing TWIA problems for hurricane season past 2013S.B. 1702 (still requires signature of Governor Perry and does very little)

Last updated 5/30/2013