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

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]