An open letter to State Representative Todd Hunter

Dear Representative Hunter,

My purpose in writing is to urge you to consider the risk to your constituents by letting the fate of the many policyholders of the Texas Windstorm Insurance Association rest on a flimsy regulation that is likely to be the subject of a length court challenge. I understand your position that the statutes and regulations currently in place do not adequately share the risk of catastrophic events throughout Texas. But fundamental decisions on that matter will not be resolved by the Texas legislature before the 2014 hurricane season is well underway. You are widely considered a champion of Texas coastal interests. You have a responsibility to your constituents to think this matter through very carefully. And you need to do it now.

There is a short run emergency in the TWIA funding situation on which people, like me, and, more importantly, inland legislators might well be able to reach agreement with coastal interests on a tolerable fix.  I urge you therefore to put personalities and long-standing battles aside, and work together immediately.  You will need to plead with Governor Perry to call a short and limited special session of the Texas legislature in order to do so. I am not an expert on Texas politics, but my sense is that you will need to compromise in that request and not ask for any fundamental reforms of windstorm insurance systems; you may need to compromise further and accept a plan that at least temporarily hardens what you regard as an undue burden on the Texas coast.  The alternative, however, is so bad, that you would be doing your constituents a yet worse disservice by failure to make the request.

You asked in a recent television interview on KRIS-TV that people, and my impression from the report was that I was included, stop complaining, stop criticizing and start working together constructively.  I was a bit puzzled by this statement because I have heard such offers from you before only to find that, when I accepted, your staff informed me that your busy schedule did not permit you ever actually to talk, even by phone. Perhaps they misunderstood your desires. Not meeting is, of course, your privilege. But there is no legislative session going on right now that should prevent you from meeting now either by phone, Skype or in person. Although you and I are not likely ever to agree on the structure of windstorm insurance funding in Texas, I am definitely willing to work with you and other Texas legislators any time, any place, on either trying to find intelligent compromises or, as here, preventing absolutely needless disasters from happening.

Here’s the emergency. I know that TWIA funding is a contentious minefield, but I am going to describe it in a way on which I think everyone can agree.

1. TWIA does not and will not have enough cash on hand to pay for a significant tropical cyclone hitting Corpus Christi or other densely populated parts of the Texas coast during the 2014 hurricane season.

2. TWIA’s reinsurance is unlikely to attach at low enough levels so that it, if TWIA has difficulty borrowing, the reinsurers will provide the cash necessary to pay claims.

3. TWIA’s ability to borrow money following a tropical cyclone rests on a statute that has never been used before.

4. Lenders in the past have balked when asked whether they would loan TWIA up to $1 billion in “Class 1 Bonds” when the payback mechanism for those bonds are (heightened) premium revenues from TWIA policyholders. There is thus a substantial risk that not all of the Class 1 Bonds would be salable. The failure of Class 1 Bonds to sell, prior to 2011, would have toppled the entire post-event bonding scheme developed by the Texas legislature and would leave TWIA with no cash with which to pay claims following a significant storm.

5. In 2011, the Texas legislature considered this contingency and amended Chapter 2210 of the Texas Insurance Code to add section 2210.6136. It provides a contingency plan in the event that the Class 1 Bonds are unsalable.  The idea behind section 2210.6136 is to permit Class 2 Bonds to be issued through the Texas Public Finance Authority even if the Class 1 Bonds do not sell in full and to thereby permit Class 3 Bonds, which are repaid via assessments on insurers, to be sold if need be.

6. Given the high likelihood that Class 1 Bonds will not be fully salable and given the necessity of TWIA to borrow in order to be able to pay claims following a major storm, Texas depends on section 2210.6136 being a coherent statute, the type of statute that potential lenders believe will provide a legal basis for their claims to repayment.

7. The Texas Public Finance Authority had initial difficulty understanding section 2210.6136 based on its text and met with legislative staff in order to obtain an explanation of how it worked. TPFA described its staff and advisors as “struggling with the mechanics of financing” under section 2210.6136.

8. Legislative staff explained the intent of the statute as being one under which Class 2 Bonds would be initially paid 30% from assessments on insurers and 70% via surcharges on certain coastal insurance policies but under which TWIA policyholders would be required –insofar as possible — to repay the insurers and coastal insureds up to $500 million of their bond amortization payments.

9. The Texas Department of Insurance has issued draft regulations that implement the interpretation of the statute offered by legislative staff but acknowledge in the preface the the regulations that this interpretation is impossible or difficult to reconcile with the language of the statute.

10. Insurance companies in Texas will be forced to pay more in assessments under the TDI interpretation of section 2210.6136 than under a literal reading of the statute. Certain coastal insureds will also have to pay more.

11. Insurance companies may have duties to their shareholders and/or it may be in their best economic interests to challenge regulatory interpretations of statutes that are contrary to the language of the statute and require them to pay more than they would under a literal reading of the statute. Sophisticated coastal insureds and/or those advised of the situation may likewise have an incentive to bring legal challenges to regulations requiring them to pay more than they would under the statute.

11a.  This is the one point that I acknowledge might be contestable.  It is unlikely that a court would swiftly dismiss the claims of those challenging regulations that are, at best, difficult to reconcile with the language of the statute. Those challenging the claim have a significant chance of prevailing.

12. Lenders who might otherwise loan TWIA money via Class 2 Bonds will be reluctant to do so if they are aware of items 1-10 above. They will not lend if they believe there is likely to be a length court challenge to the bond payment mechanism.

13. If lenders do not lend TWIA money, TWIA will not have enough money to pay claims following a major storm. If so, there will be devastation of TWIA insureds, great derivative harm to almost everyone on the Texas coast, and significant derivative harm to others in the Texas economy. Although the strength of interests may vary, it is not in anyone’s interest that the TWIA funding stack collapse due to a legal technicality.

I have thought about this for some time.  And the only point on which I believe some might disagree is item 11a. If you really believe that the risk of a serious challenge is extremely low, then there is no emergency. If, however, you believe as I do, that the risk of a serious challenge is significant, then indeed we have an emergency. There is a really serious risk that TWIA policyholders will not be paid any time soon following a significant storm this summer.

What bothers me most is that, unlike many problems, this one is very solvable. The Texas Insurance Commissioner, Julia Rathgeber, appointed by Governor Perry, has already come up with a solution. Simply turn the language of the law into what legislative staff believe it was supposed to say. That will require almost no effort.  One simply has to relabel the regulatory provisions she has proposed as a statute, get the legislature to pass it, and get the Governor to sign it and the situation is resolved.No more emergency.  Lenders should feel way more comfortable loaning TWIA the money.

Yes, some insurers may balk at the solution. But the very fact that one thinks they might do so is a sign that they will in fact litigate if no statute is passed and the same result occurs through an ultra vires regulation. By claiming that insurers will object to a legislative change that purports merely to clarify the status quo, one essentially acknowledges that the current situation is untenable.

And you, Representative Hunter, are likely to find the Rathgeber solution a difficult pill to swallow. It does burden the coast with 70% of the bill for Class 2 bonds. Some of your more militant constituents could be angry about this.  Here is what you need to explain to them.  I am optimistic that there will be enough reasonable people on the Coast that such an explanation will be satisfactory.  You are not bargaining from a position of strength.  The law already was intended to burden the coast with 70% of the bill for Class 2 bonds.  There is nothing knew with the proposed statute.  What it is doing is making sure that something even worse does not happen: TWIA collapsing due a technical glitch and blue roofs staying on coastal homes for a very, very long time.  You can assure your constituents that you will seek a better solution during the next regular session of the legislature but that, for now, improving the language of the statute without changing its meaning is a major improvement.

There are, of course, other solutions.  You could, for example, try to flip responsibility for Class 2 Bonds such that 70% of the burden is on insurers and only 30% on the coast.  There are lots of other mechanisms for spreading the risk of windstorm farther inland. But do you really think you will reach agreement on such a significant reform during a special session when you were unable to do so last session? The one “focal point equilibrium,” the one thing on which you and inland representatives might agree is to make the statute actually say what, supposedly, various staff members said it intended.

Finally, I suppose it is possible that you believe that the rest of Texas will come in and rescue the coast if TWIA collapses and that you should not accept a solution that solidifies a current scheme that you think is fundamentally unfair.  All I can say is that this is very high risk poker. Trying to resolve TWIA funding after a major storm in some special session of the legislature is likely to stalemate and also likely to result in statutes that are actually worse for the coast than the status quo. The process is not likely to be swift and the emotional and financial stress on the coast while the matter being debated is extraordinarily ugly.

As I indicated in a somewhat similar open letter to Governor Perry this past week, I know that you can not trust me on critical item 11a. But you are a lawyer and you certainly know lots of open minded lawyers.  You also know, I suspect, lots of insurance representatives.  Ask them if they believe the regulation enacted by the Texas Insurance Commissioner on which the TWIA funding stack depends is unlikely to be challenged in court.  Ask them if they believe such challenges would survive, for example, a motion to dismiss. Or go find institutional lenders.  See if they would be willing to lend if they got wind that insurers or some coastal interests might challenge the pay back mechanism.  If all you get are assurances that the University of Houston professor is off his rocker or just scaring people, then, fine, ignore me.  I am sincerely sorry for what would be a false alarm.  My strong suspicion, however, is that these people are going to tell you that I have a serious point.

One way or another you need — right now, before hurricane season hits full swing — to be assured that lenders will loan TWIA funds on Class 2 Bonds when the Class 1 Bonds can’t issue.  Maybe there are ways of getting this other than a special session of the legislature. I am not sure what these methods would be.  But until you have that, as a champion of the Texas coast, you need to be on the front lines, making common cause with whomever you can, saying that this provision of the law needs to be fixed by the Texas legislature right now.

 

Disclaimer

The views expressed here are my own and do not necessarily reflect those of the University of Houston.

 

 

Drop down Class 3 bonds: a bandaid for TWIA

A lot of ink has been spilled on this blog about fixing TWIA in the long run.  Having attended the hearing this past week in Austin and looking at my calendar, which shows 41 days until hurricane season, I am becoming less hopeful that a good long-run fix is in the works.  Moreover, two of the leading bills (S.B. 18 and H.B. 2352) do nothing to address the desperate situation for 2013.  I thus offer up the following as a minimalist bandaid for TWIA.  It will not by any means solve TWIA’s problems.  If, however, a solid solution can not be found, what I offer here may at least provide some assistance and, in my naive view, should be politically feasible. The Executive Summary is that the legislature needs to repeal the provisions prohibiting the Class 3 bonds from dropping down and instead permit them to drop down in the event the Class 2 Alternative bonds fail to sell, offering insurers a premium tax credit to the extent the drop down Class 3 bonds increase their subsidization of tropical cyclone losses along the Texas Gulf Coast.

History

I start with some history to explain the current problem.

In 2011, the legislature recognized that the system of post-event bonds it had established in 2009 as the means of recapitalizing TWIA following a significant storm was extremely vulnerable to a cascade of failures. Lenders could refuse to purchase the Class 1 bonds on whose sale higher levels of bonds legally depended and thus leave TWIA with only the money it had in its Catastrophe Reserve Trust Fund to pay the claims of its policyholders. And lenders might very well refuse because repayment of the Class 1 bonds depended on TWIA policyholders remaining with TWIA even after it raised its premiums (perhaps 25%) to pay off the bonds. So, the legislature developed this complex scheme now codified in section 2210.6136 of the Insurance Code.

Unfortunately, the fix, which appears to have been developed deep into the legislative session, suffers a risk of the same infirmity as the legislative provisions it attempted to supplement. Class 1 bonds remained theoretically available but a contingency plan was developed: the Class 2 Alternative Bond (my name). This Class 2 Alternative Bond could be sold in the event that the entire $1 billion authorized in Class 1 bonds failed to sell in whole or in part. But, as with the Class 1 bonds, the Class 2 Alternative Bonds contained in the fix depend for their repayment in significant part in extracting large sums of money from a TWIA pool of insureds (a) after a significant hurricane has struck and (b) who can and may leave the pool if insurance premiums get too high. And while coastal residents and insurers share partial responsibility for the repayment and thus reduce the size of the TWIA premium increase, it is unclear if that contribution will be enough to persuade lenders that TWIA policyholders will remain in the pool and pay enough to amortize the bonds. Moreover, the legislation provided that Class 3 bonds, which provide an additional $500 million of borrowing capacity to pay for windstorm damages, can not be sold — repeat, can not be sold — unless every dime of borrowing capacity under the Class 2 Alternative Bonds is exhausted.

The current situation

The result of all this is a potential catastrophe. If, as many observers, including the Texas Insurance Commissioner expect, the Class 1 bonds fail in whole or in part because the market won’t accept them, the Class 2 Alternative Bonds may fail too. Why? Because their repayment source is infected — not as badly, but still infected — with the same problem as the Class 1 bonds. And if the Class 2 bonds fail even a little bit, the Class 3 bonds fail. And if the Class 3 bonds fail, there may well not even be any reinsurance protection. This is so because, if TWIA is not careful and does not purchase reinsurance — at a higher price — that drops down in the event the Class 2 and/or 3 bonds don’t sell, the reinsurer isn’t obligated to pay a dime. The $100 million of policyholder money dumped into reinsurance will have been 100% wasted. (I sure hope TWIA’s lawyers and reinsurance brokers understand this last point.). And so, TWIA will have only the $180 million or so in its Ike-depleted, failure-to-properly-assess-depleted Catastrophe Reserve Trust Fund to pay claims. As my friend David Crump has pointed out, it may not even take a named tropical storm to generate damages of that magnitude to the $72 billion TWIA pool.

We thus end up with a short run problem in addition to a long run problem with TWIA. The long run problem is that the system of post-event bonds on top of a thin Catastrophe Reserve Trust Fund is extremely unstable and potentially depends on massive subsidization by people other than policyholders to prop it all up. That is a hard problem to fix. Perhaps, as been suggested here, an assigned risk plan would be a better alternative. Perhaps, as others believe, the funding structure can be made more stable with yet greater subsidization. Those are hard and politically contentious issues. I am not certain they will be ironed out this legislative session before hurricane season begins in 41 days. And, sorry to say to, but it is a bit irksome to have to bail TWIA out yet again when doing so also rescues from humiliation the legislators who have shortsightedly engineered a system that beautifully served the short run interests of their constituents by underfunding their insurer but that has predictably betrayed those same constituents long run interests. Still, one can not help feeling a bit sorry for those on the coast who may have been fooled, perhaps eagerly so, by these false heroes.

The bandaid

What to do? Triple the minimum amount available for this summer. How?

1. Permit the Class 3 bonds to drop down. Repeal section 2210.6136(c), which currently prohibits the issuance of Class 3 bonds until all the Class 2 or Class 2 Alternative Bonds are sold. Instead, permit the Texas Insurance Commissioner to authorize sale of Class 3 bonds notwithstanding the failure of all Class 2 or Class 2 Alternative Bonds to sell if, in the opinion of the Commissioner, the failure to do so would reduce the amount available to pay claims of TWIA policyholders.

2. To the extent that Class 3 bonds drop down, make the assessments that are required to repay them simply a no-interest loan from insurers to the state rather than an outright payment. This can and has been done by making providing a premium tax credit for the assessments.  I dislike this philosophically because it is less transparent than simply taxing Texans and potentially reduces the amount available for government programs, but it is one way to raise money. To do this will require repeal of section 2210.6135(c) of the Insurance Code and perhaps some other statutory tinkering. The idea, however, is that to the extent an extra obligation has been imposed on the insurers of the state, it is one they should bear only as a vehicle for fronting money rather than in any ultimate sense. I believe sensible insurers should be willing to go along with this alteration. Moreover, as the state bears actual responsibility for up to $500 million, the costs of having the rest of the state subsidize TWIA will be more apparent to the electorate. It will thus be a great — albeit costly — learning opportunity.

Will this solve the TWIA problem for 2013. Absolutely not. This is a bandaid on a gaping wound. $680 million ($180 million in CRTF plus $500 million in dropped down Class 3) is not nearly enough to protect TWIA policyholders from even a minor tropical cyclone. Even $1.68 billion ($180 million in CRTF plus $500 million in Class 2 Alternative plus $500 million in dropped down Class 3 plus maybe $500 million in incredibly costly reinsurance) is not enough. At its current $72 biliion girth, TWIA at a minimum needs a $5 billion stack. But if you don’t have the time, will or ability to do major surgery, a bandaid is better than watching the patient bleed dry in front of you.  So, if the long run problem can not be solved before the start of hurricane season, or if the long run fix starts only in 2014, this extra money this bandaid creates for 2013 should be sorely appreciated when the wind and water starts roiling in the Gulf.