The issues with heavy reliance on pre-event bonds

Pre-event bonds. They sound so good. And they may well be an improvement over reinsurance and other alternatives for raising money. But there is no free lunch and its worth understanding some of the issues involving with reliance on them. In short, while pre-event bonds can work if TWIA stuffs enough money annually into the CRTF — and has the premium income and reduced expenses that permits it to do so. If TWIA lacks the will or money to keep stuffing the CRTF, however, pre-event bonds become a classic debt trap in which the principal balance will grow until it becomes unmanageable. Let’s see the advantages and disadvantages of pre-event bonds by taking a look at the Crump-Norman plan for TWIA reform.

A key concept behind the Crump-Norman plan is for TWIA immediately to bulk up its catastrophe reserve trust fund (CRTF) to a far larger sum than it has today — $2 billion — and to keep its value at that amount of higher for the forseeable future. That way, if a mid-sized tropical cyclone hits, TWIA does not to resort to post-event bonds. It already has cash on hand. The problem, as the Zahn plan, the Crump-Norman plan and any other sensible plan would note, however, is that TWIA simply can not snap its fingers today and bulk up its CRTF to $2 billion without asking somebody for a lot of money. Policyholders would probably have to face a 400% or 500% premium surcharge for a year in order to do so and I can’t see the Texas legislature calling for that. But perhaps TWIA can prime the CRTF by borrowing the money from investors by promising them a reasonable rate of return (maybe 5%) and assuring investors that TWIA will be able to use future premium income to repay the bonds. Each year, TWIA commits insofar as possible to stuff a certain amount of money from premium revenues– perhaps $120 million — into the TWIA, earn interest on the fund at a low rate (maybe 2%) and pay the bondholders their 5% interest and amortize the bonds so that the bonds could be paid off in, say, 20 years. If there are no major storms, the CRTF should grow and there is no need to borrow any more money. The strategy will have worked well, providing TWIA and its policyholders with security and at a cost far lower than it would likely get through mechanisms such as reinsurance. If there are major storms, however, then the CRTF can shrink and TWIA can be forced to borrow more to pay off the earlier investors and restore the CRTF to the desired $2 billion level. The Outstanding Principal Balance on the bonds grows. And, of course, if there are enough storms, the Outstanding Principal Balance can continue to grow until it basically becomes mathematically impossible for TWIA to service the debt out of premium income. And even before that point, investors are likely to insist on higher interest rates due to the risk of default. In the end, however, TWIA is insolvent, its policyholders left to mercy rather than contract.

On what does this risk of insolvency depend? There certainly can be a happy ending. Basically it depends on three factors: (1) the amount TWIA stuffs into the CRTF each year, (2) the spread between the interest TWIA earns on the CRTF and the interest rate it pays to bondholders; and (3) the claims TWIA has to pay due to large storms. I’ve attempted to illustrate these relationships with the several interactive elements below. Of course, you’ll need to download the free Wolfram CDF Player in order to take advantage of their interactive features. But once you do, here is what I think you will see.

(1) Pre-event bonds are risky. Different 100 year storm profiles result in wildly different trajectories for the CRTF and Outstanding Principal Balances. That’s perhaps why they are cheaper than reinsurance because the risk of adverse events is borne by the policyholder (here TWIA) rather than swallowed up by reinsurer. If the reinsurance market is dysfunctional enough — as indeed I have suggested it may be in this instance — then self-insurance through pre-event bonds may indeed be preferable to alternatives.

(2) Little changes in things such as the interest rate end up making a big difference in the expected trajectories of the CRTF and Outstanding Principal Balance. For simplicity, I’ve modeled those interest rates as constants, but in reality one should expect them to change in response to macro-economic forces as well as the perceived solvency of TWIA.

(3) Little changes in the commitment TWIA makes to the CRTF matter a lot. A few percent difference ends up having the potential for a large effect on whether the Outstanding Principal Balance on the pre-event bonds remains manageable or whether they become the overused credit card of the Texas public insurance — world — a debt trap. Pre-event bonds may work better where policyholders understand that they may be subject to special assessments — unfortunately following a costly storm — in order to prevent a deadly debt sprial from resulting. So long as we want to rely heavily on pre-event bonds, laws need to authorize this harsh medicine. Ideally, careful actuarial studies should be done — by people who make it their full time job — to try and get the best possible handle on the tradeoffs between the amount put in and the risks of insolvency. The unfortunate truth, however, is that some of the underlying variables — such as storm severity and frequency — is sufficiently uncertain that I suspect no one will know the actual values with way greater certainty than I have presented.

(4) Luck helps. My interactive tool provides you with 20 different 100-year storm sets. They’re all drawn from the same underlying distribution. They are just different in the same way that poker hands are usually different even though they are all drawn from the same deck. If storms are somewhat less than predicted or the predictions are too pessimistic, pre-event bonds have a far better chance at succeeding than if one gets unlucky draws from the deck or the predictions are too optimistic. Unfortunately, as the debate over climate change shows, disentangling luck from modeling flaws is difficult when one only has a limited amount of history to examine.

[WolframCDF source=”http://catrisk.net/wp-content/uploads/2012/12/crtfopbcrumpnorman.cdf” CDFwidth=”550″ CDFheight=”590″ altimage=”file”]

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Two early plans emerge to reform TWIA

Over the past week, two draft plans have emerged to restructure the Texas Windstorm Insurance Agency. The first plan, a copy of which may be found here, comes from a collaboration between David Crump, a citizen with a long time interest in windstorm reform, and Dave Norman, a recent candidate for the Texas State Senate. The second plan, a copy of which may be found here, comes from Port Aransas attorney Charles Zahn, and a group called the Coastal Task Force. I’ll be examining each of these plans in the days ahead but a theme of both is to reduce the now-serious risk that TWIA policyholders will go unpaid in the event of a serious storm.

At first glance the Zahn Coastal Windstorm Plan appears to place more emphasis on subsidization of risk by non-TWIA policyholders along the coast and insurers throughout Texas (and, derivatively, their insureds). The Zahn plan also makes the state of Texas ultimately responsible for losses in excess of what TWIA can pay. So, Texas taxpayers will be subsidizing coastal risk in the event of a giant storm and Texas insureds of all sorts located far from the coast will be paying to build up a catastrophe reserve fund even if no storm occurs and helping to pay TWIA policyholders in the event a significant storm occurs. But the Zahn plan also tries to reduce the growth in TWIA exposure through hardening the coast. It calls for new residential construction to meet the WPI-8 standard and grants or credits for hardening existing structures.It also seeks to extend the protections of HB3 (which currently protects just TWIA) to all wind policies on the coast — an idea for which I may take some credit.

The Crump-Norman plan appears to place more emphasis on reducing TWIA’s exposure through benefit limitations and risk reduction by increasingly premiums significantly on buildings that do not comply with certain building codes. It does not appear to place Texas taxpayers directly on the hook in the event of a giant storm. Both plans attempt to avoid the costly reinsurance that is currently helping to gut TWIA. My guess is that there will be more plans to come.