Insurance Commissioner tries to fix fatal bug in windstorm statute

Whether policyholders of the Texas Windstorm Insurance Association get paid following a significant storm during the coming summer of 2014 is likely to depend on a difficult legal question: whether the Texas Insurance Commissioner has the power to write regulations that clearly alter the language of a statute enacted by the Texas legislature where she believes, with reason, that the statute as written makes no economic sense.  The good news is that the new Texas Insurance Commissioner, Julia Rathgeber, agrees with an argument first propounded on this blog: there is a serious “bug” in the provisions of the Texas Insurance Code governing issuance of securities to pay for losses following a significant storm. That bug could jeopardize the entire system of post-event bonding that is supposed to cover for the shocking lack of cash TWIA, the largest windstorm insurer in Texas, actually has available to pay claims. Recognizing a problem exists is, after all, usually the first step for a cure.  It’s certainly better than pretending the problem doesn’t exist and hoping no injured party or judge will notice. The problem, however, is that it is not clear that the Commissioner, acting alone and without legislative action, has the power to cure this problem in a way that could cost other Texans considerable sums of money.

Matters would be far better if all sides in the enduring controversy over TWIA funding could agree to a minimalist statutory fix before the 2014 hurricane season begins.  The stakeholders could then then ask Governor Perry for a short special session to enact the fix as law.  The Governor might accommodate if almost all legislators agreed to the fix and the agenda were kept narrow.  Commissioner Rathgeber’s regulations contain one possible fix.  A blog entry I put forth last spring contains some others. None would “cure TWIA” — that’s a very hard problem that will likely take at least a legislative session. But at least the statutory scheme would function as well as was hoped for by the legislature. Right now it resembles a bad computer program that is about to crash from a giant bug if nature ever pushes the “Hurricane Key.” Unfortunately, for reasons that will be discussed below, it looks like getting agreement on even a simple statutory fix will be difficult.

Texas Insurance Commissioner Julia RathgeberAs a result of the Commissioner’s questionable authority to enact the changes she wants and the likelihood that a coastal resident hurt by her fix would challenge it in court (and refuse to pay in the interim), absent legislative action, it is unlikely that TWIA will have any ability swiftly to pay significant claims this summer. By “significant”, I mean those generated  by a respectable storm that causes insured losses in excess of TWIA’s cash position ($200 million to maybe $400 million) and whatever reinsurance, if any, drops down low enough to pay claims right above the cash reserve.  Lenders who just might otherwise be willing to advance TWIA money based on anticipated revenue from premium surcharges may be unwilling to do where there is no secure statutory basis for demanding at least some of the surcharges in the first place.

The problem

Let’s go through the problem that the Commissioner’s proposed regulations is intended to solve. The Commissioner actually outlines it quite well in her explanation of the proposed regulations now undergoing hearings, but I think my explanation is a bit more direct. The basic idea is that, following a tropical storm that wipes out TWIA’s cash position, TWIA can go to the borrowing market.  It can request issue three types of securities cleverly named Class 1, Class 2 and Class 3. The securities are actually issued by the Texas Public Finance Authority (TPFA), not TWIA itself. Even though TPFA issues the securities, under section 2210.615(a) of the Insurance Code they are explicitly not backed by the full faith and credit of Texas. Texas taxpayers are not on the hook to repay the borrowings if the statutory mechanism fails.

What distinguishes the three securities TWIA may issue when it runs out of money is mainly the source of repayment.  To oversimplify just a bit, Class 1 is to be repaid by TWIA policyholders through “net premium and revenue.” Class 2 is to be repaid 30% by assessments on the insurers that compose TWIA (people who write property/casualty insurance in Texas) and 70% via premium surcharges on most property insurance policies written on the Texas coast. This latter group includes not only TWIA policies but also non-TWIA homeowner or wind insurance policies, business fire insurance, personal automobile policies, and commercial automobile policies. Class 3 is to be repaid by assessments on the insurers that compose TWIA. Class 1 can be up to $1 billion. Class 2 can be up to $1 billion; and Class 3 can be up to $500 million. And the borrowings are supposed to take place in sequence.  No Class 3 before all Class 2 has been issued.  No Class 2 before all Class 1 has been issued.

There’s a big “however,” however. What happens if lenders are worried that TWIA policyholders won’t be able to pay enough in premium surcharges to amortize the loan?  In 2011, the legislature recognized this possibility and came up with a plan. You can find it in section 2210.6136 of the Texas Insurance Code, which the most recent regulatory proposal cites frequently. To the extent that the Class 1 bonds would not sell, what I have called “Class 2 Alternative” bonds can be issued. According to the statute — and this is the bug — the first $500 million (or, in some cases less) is to be repaid the same way Class 1 bonds are to be repaid: using premiums from TWIA policyholders.  The remainder of the $1 billion in Class 2 Alternative bonds are to be repaid the way ordinary Class 2 bonds are to be repaid.

The problem, as the Commissioner has recognized, is that, if the Class 1 Bonds won’t sell because lenders don’t trust TWIA policyholders to have the money to amortize the bonds, it is unlikely that they will trust “Class 2 Alternative” bonds that have exactly the same payment source. As the official explanation of the proposed regulations states, the statute has “the effect of treating class 2 public securities issued under Insurance Code §2210.6136 as class 1 public securities, which are repayable by premium and revenue assessments.

The paradox is well stated by the Commissioner:

If the association [TWIA] can issue Class 2 public securities that are to be repaid by premium, then this means the association is capable of issuing class 1 public securities. This eliminates the need for having an alternative to issue class 2 public securities when class 1 public securities.  It is not feasible to read the statute to require TPFA to issue all of the class 1 public securities it can based on the association’s net premium and other revenue, and then expect TPFA to issue additional public securities using the same funding sources simply because the name of the public security has changed.  Such a reading would render Insurance Code §2210.6136 meaningless.

The domino effect

The problem is even deeper, however, than this passage indicates. As I have previously noted and as the Commissioner’s explanation confirms: “TPFA cannot issue the class 3 public securities until after TPFA has issued $1 billion in class 2 public securities on behalf of the association for that catastrophe year.” In other words, if the Class 1 bonds fail, the Class 2 Alternative Bonds are likely to fail too.  And if the Class 2 Alternative Bonds fail, the Class 3 Bonds fail. There’s a domino effect. TWIA ends up with no cash to pay claims and no ability to borrow at all!

So, this is the disaster waiting for Texas if it does nothing.  It is the disaster the Commissioner is trying to avoid. Her proposal is effectively to rewrite section 2210.6136 of the statute and make all of the Class 2 Alternative Bonds payable the same way regular Class 2 Bonds would be repaid: 30% by assessments on the insurers that compose TWIA (people who write property/casualty insurance in Texas) and 70% via premium surcharges on most property policies written on the Texas coast.  To quote section 5.4127(a) of the proposed regulations:

(a) All Public Security Obligations and Public Security Administrative Expenses for Class 2 Public Securities issued under §5.4126 of this division (relating to Alternative for
Issuing Class 2 and Class 3 Public Securities) must be paid 30 percent from member assessments and 70 percent from premium surcharges on those Catastrophe Area insurance policies subject to premium surcharge under Insurance Code §2210.613.

 

The proposed regulations potentially rescue TWIA policyholders from disaster.  They provide a more plausible source of repayment and they don’t result in the Class 3 securities succumbing to the domino effect.

The Bên Tre analogy

There is only one problem.  The Commissioner has destroyed section 2210.6136 in order to save it. The law would be little different under the Commissioner’s proposal than if the legislature had never bothered with section 2210.6136 in 2011 and just kept things the way they were in 2009, except to say that Class 2 bonds can be issued first if the Class 1 bonds can’t be fully issued.  The two different subparts of section 2210.6136 elaborately specifying how each part of the money is to be repaid would appear to be unnecessary.

The legal issue

I’m not going to opine today on whether the Commissioner is within her rights in undoing a legislative enactment whose sense is indeed difficult if not outright impossible to discern. But this isn’t the somewhat simpler case of the Commissioner fixing a clearly omitted “not” in a statute or correcting some punctuation.  This is undoing an entire provision when the legislature has been alerted to the problem and has chosen to do nothing about it. Although a Texas court can choose to interpret a statute contrary to its actual words where doing so clearly fulfills the intent of the legislature, it must do so cautiously.  As set forth by the Texas Supreme Court in Presidio Independent School Dist. v. Scott, 309 S.W.3d 927 (Tex. 2010), “We thus construe the text according to its plain and common meaning unless a contrary intention is apparent from the context or unless such a construction leads to absurd results.” There are many cases, including Texas Department of Protective and Regulatory Services v. Mega Child Care, Inc., 145 S.W.3d 170 (Tex. 2004), that say about the same thing. Indeed, in my brief research I had to go back to 1898 and the case of Edwards v. Morton, 92 Tex. 152 (1898) to find a case in which the highest court found the requisite level of absurdity to exist. Perhaps there are more recent cases that some quick research did not disclose but I suspect there will not be many.

The United States Supreme Court summarizes prevailing judicial attitudes well on the subject.

Courts have sometimes exercised a high degree of ingenuity in the effort to find justification for wrenching from the words of a statute a meaning which literally they did not bear in order to escape consequences thought to be absurd or to entail great hardship. But an application of the principle so nearly approaches the boundary between the exercise of the judicial power and that of the legislative power as to call rather for great caution and circumspection in order to avoid usurpation of the latter. Monson v. Chester, 22 Pick. (Mass.) 385, 387. It is not enough merely that hard and objectionable or absurd consequences, which probably were not within the contemplation of the framers, are produced by an act of legislation. Laws enacted with good intention, when put to the test, frequently, and to the surprise of the lawmaker himself, turn out to be mischievous, absurd, or otherwise objectionable. But in such case the remedy lies with the lawmaking authority, and not with the courts.

Crooks v. Harrelson, 282 U.S. 55 (1930) (Sutherland, J.)

Clearly, what is good for the judiciary is probably good for the Insurance Commissioner as well. Commissioner Rathgeber no matter how outstanding her intentions and no matter how irksome her opposition will have an uphill battle defending her reconstruction of the statute governing the Texas Windstorm Insurance Association. She will surely face hostile judges when, contrary to the literal language of the statute, she seeks to impose an additional surcharge on some coastal Texas homeowner with insurance on a run down car who never bought a TWIA policy and indeed doesn’t even have a home to insure.

Residents of the coast have apparently caught on (see here, here and here) that the proposed regulatory change theoretically hurts them.  Under the statute as written, even if there were more than $1 billion in losses awaiting payment, insureds on the coast would be responsible for only 70% of about $500 million.  With the regulatory change, they are responsible for 70% of up to $1 billion.  So, basically, the non-TWIA insureds on the coast are objecting to helping their TWIA friends on the coast because they don’t think it’s their responsibility.

Conclusion

In a world of perfect political information, we might now see a battle between coastal residents, the non-TWIA policyholders battling the Commissioner’s proposal while the TWIA policyholders support it.  To date, however, such a lack of “coastal solidarity” has emerged.  And it is not clear what the alternative is. Where do political figures whipping up opposition to the Rathgeber plan think the money is going to come from if the Commissioner’s regulations are struck down, the goofy statute upheld as written, and TWIA finds itself following a significant storm with no money in the till? Surely they are still not marketing the elaborate fantasy that the current TWIA board can now assess insurers more money to pay for Hurricane Ike in 2008. If they really cared about the coast, they might agree to defer a fight about the perfect way to fund TWIA for a bit, and agree to a statutory fix that at least got rid of a fatal bug in the existing law which, if triggered, will devastate TWIA policyholders to be sure, but also those on the coast and off it who depend on a vibrant coastal economy.

 

Texas Public Finance Authority: Class 1 Bonds Won’t Sell

Thanks to a friend, we have new evidence today about how much money TWIA hopes to have to pay claims this summer.  The Texas Public Finance Authority, which has to deal with sober realities like the bond market, told the TWIA board back in March that its Class 1 post-event bonds won’t sell.  Since Texas Insurance Commissioner Eleanor Kitzman blocked issuance of pre-event bonds that TWIA sought as a substitute, that means that in the very best case, TWIA will have about $2.7 billion.  But even this rests on a House of Cards argument that is likely to topple and leave TWIA policyholders in the lurch.  Here’s why.

The document in question are the minutes of the Texas Windstorm Insurance Association meeting of March 21, 2013. It sheds some light on TWIA’s own thinking at that time about how much money it was going to have to pay claims. The first clue is contained in the excerpt below.

TWIA board minutes

TWIA board minutes acknowledging reinsurance would attach at $1.8 billion

Notice how TWIA says that if it does not approve — or, one assumes, is denied permission to get — the $500 million Bond Anticipation Note — the reinsurance would attach at $1.8 billion. Now why would TWIA pick such a low number?  In the past they have spoken about reinsurance attaching at around $3 billion.  The next excerpt explains it.  It rests on the advice of Bob Coalter, Executive Director of the Texas Public Finance Authority. Look at this excerpt.

Texas Public Finance Authority: Post-event Class 1 Bonds are doubtful

Texas Public Finance Authority: Post-event Class 1 Bonds are doubtful

“Mr. Coalter stated that TWIA could not reasonably rely on $500 million in class 1 bonds if the Association waited for post-event approval.” That’s prety clear. And it’s why, I am confident, why TWIA sought the pre-event Bond Anticipation Notes. And it explains very well the $1.8 million attachment point for the reinsurance.  TWIA likely thinks it will have $300 million in its Catastrophe Reserve Trust Fund and operating expenses; that’s a number that has been batted around in conversation.  It thinks it will have $1 billion in Class 2 Alternative Bonds under section 2210.6136 added by H.B. 4409 in 2011.  And it thinks it will have $500 million in Class 3 Bonds. That totals $1.8 billion, which is precisely where the reinsurance would attach.

So, if TWIA could get, say, $900 million of reinsurance for its authorized $100 million to attach at $1.8 billion, it would have $2.7 billion to pay claims this summer, one Ike’s-worth.  So, with some rounding, it could, I suppose be said that TWIA has $3 billion, but that’s a bit of an exaggeration.

In any event, let us not, however, quibble about a trifling $300 million.  Let’s instead focus our energies on scrutiny of TWIA’s logic of even thinking that it will have the $1.8 billion in funds at which the reinsurance could attach.  I say that the very reasons the TPFA is giving TWIA for why TWIA’s Class 1 Bonds won’t sell apply almost equally to the Class 2 Alternative Bonds.  Why?  See the next paragraph. In the mean time, recognize that the Class 3 bonds can not legally be sold unless TWIA/TPFA can sell $1 billion of Class 2 Alternative Bonds. If TPFA can only sell, say, $600 million in Class 2 Alternative Bonds, then TPFA can not sell Class 3 Bonds at all, and TWIA’s funding stack would be $900 million, not $1.8 million.  Yes, TWIA might have reinsurance that attached at $1.8 million, but for losses between $900 million and $1.8 million there would be no money. So, for a $1.5 million storm, TWIA would only have enough money to pay policyholders 60 cents on the dollar ($300 million in CRTF + $600 million in Class 2 Alternative Bonds all divided by $1.5 million in claims). And for a $3 billion storm, TWIA would likewise have 60 cents on the dollar. ($300 million in CRTF + $600 million in Class 2 Alternative Bonds + $900 million in reinsurance all divided by $3 billion in claims).

Why the Class 2 Alternative Bonds Are Almost As Bad As The Class 1 Bonds

OK, so why do I say — and why by the way did TWIA suggest in its report to the legislator — that the Class 2 Alternative Bonds are problematic?  Why did several bills in the legislature this session seek to abolish them?  Because their repayment source is largely the same problematic mammoth levy on TWIA policyholders that they might not well be able to pay. Here is section 2210.6136(b) of the Texas Insurance Code. It’s the key to understanding the urgency in calling a special session of the Texas legislature.

(b)  The commissioner shall order the repayment of the cost of Class 2 public securities issued in the manner described by Subsection (a) as follows:

(1)  in the manner described by Section 2210.612(a), in an amount equal to the lesser of:

(A)  $500 million; or

(B)  that portion of the total principal amount of Class 1 public securities authorized to be issued under Section 2210.072 that cannot be issued, plus any costs associated with that portion;

 

So, if the “portion of the total Principal amount of Class 1 public securities … that can not be issued” is, as TWIA itself has been told likely to be well north of $500 million, then the first $500 million of the Class 2 Alternative Bonds described in section 2210.6136 are to be paid off in the “manner described by Section 2210.612(a)” of the Texas Insurance Code.  But what section 2210.612(a) calls for is for the bonds to be paid out of TWIA premiums: “The association shall pay Class 1 public securities issued under Section 2210.072 from its net premium and other revenue.” And it is precisely because potential lenders have indicated their doubts that TWIA premiums could sustain the amortization payments that TWIA has been told it can’t sell the Class 1 bonds. I don’t see any reason why the market would be any more trusting of bonds that have “Class 2” labeled on them when they won’t buy similarly sourced bonds with a “Class 1” label on them.

What we have then is, as I said, a House of Cards. In order for TWIA to even have $2.7 billion in its stack, here is what would have to happen: (1) before a storm, TWIA gets $900 million in reinsurance that attaches at $1.8 billion; and (2) after a storm, all $1 billion of the Class 2 Alternative Bonds sell notwithstanding their problematic repayment source. If I were a betting man, I would not place the odds of that House of Cards staying intact very highly.  And when it tumbles, it will not be only be TWIA policyholders on the Texas coast who get hurt, but the economy of Texas as well.

Footnote for Experts

Some might object to my analysis on grounds that the repayment sources for the Class 2 Alternative Bonds set forth in section 2210.6136 are not identical to those set forth for the Class 1 bonds.  That’s true, but I don’t think it matters.  Read 2210.6136(b) carefully.

(2)  after payment under Subdivision (1), in the manner described by Sections 2210.613(a) and (b), in an amount equal to the difference between the principal amount of public securities issued under Subsection (a) and the amount repaid in the manner described by Subdivision (1), plus any costs associated with that amount.

 

The first $500 million in Class 2 Alternative bonds come from TWIA revenue (premiums). As the passage I’ve highlighted indicates, it’s only after that first $500 million is exhausted — and TWIA pays what some likely thought was its fair share — that others have to chip in.  Someone from those other payors (coastal non-TWIA policyholders and, more likely, the insurance industry) negotiated for that in 2011. The fact that those higher in the stack have money to pay won’t give any comfort to lenders who depend in substantial part on the dubiously sourced lower part.  And this is why I persist in saying that if the Class 1 Bonds can’t be sold, the Class 2 Alternative Bonds are in serious jeopardy too.

 

 

Troubling news: TWIA loses $500 million in anticipated funding

The short term finances of the already shaky largest property insurer on the Texas coast took an unanticipated and significant turn for the worse Monday.  Outgoing Texas Insurance Commissioner Eleanor Kitzman rejected Monday plans of the Texas Windstorm Insurance Association to borrow $500 million via a “Bond Anticipation Note” to help pay claims this hurricane season.  The Commissioner did not reject a plan to issue post-event bonds in the event of a significant storm this season.  As a practical matter, however, it may be difficult to persuade the market to loan money to TWIA after a storm due to peculiarities in the existing law that were not ironed out during the regular session of the Texas legislature.

The refusal to permit TWIA to borrow at this time, coupled with the announced $135 million settlement earlier this week of most of the remaining lawsuits against TWIA arising out of Hurricane Ike, probably cuts in half the amount of cash TWIA would have immediately available to pay claims in the event of a storm this summer without having to rely on untested, legally questionable and potentially slow efforts at “post-event” borrowings.  The action leaves both the cash position and the long run finances of the troubled insurer in question.

My best guess is that without the Bond Anticipation Note (BAN), and including its Catastrophe Reserve Trust Fund (CRTF), TWIA probably has between $400 to $700 million in cash with which to pay claims.  That’s not much when your direct exposure is over $75 billion, your total exposure is over $80 billion and a Category 2 or 3 hit at a bad spot on the Texas coast could easily cause losses of over $2 billion. The Bond Anticipation Note would have doubled the amount of cash available to pay claims.

As it stands, and as set forth below, I now believe it is not unduly pessimistic to set the odds of a TWIA insolvency this summer at 10%. If we consider two summers until the next regular legislative session, this risk roughly doubles. Given the grave effects of a TWIA insolvency on the entire Texas economy, this is way, way too high a risk.

Cash position

To understand this, take a look a TWIA’s 2012 Annual Statement. TWIA ended 2013 with about $430 million in cash (Assets, line 5; column 1) and total admitted assets (including the cash) of about the same amount, $430 million. (Assets, line 28, column 3) It has agreed to pay about $135 million in cash to settle the bulk of the Ike lawsuits. How much that will reduce the $323 million in loss reserves (Liabilities, Surplus and Other Funds, line 1, column 1) is unclear.  Because lawsuits remain, it is unlikely to reduce those reserves down to zero.  It will, however, likely reduce TWIA’s cash position by the full $135 million in relatively short order, depending on the details of the settlement. That would leave TWIA with just $295 million in cash.

Of course, it’s a little more complicated.  I don’t have access to TWIA’s financial statements for the first quarter of 2013 or thereafter. TWIA has likely earned some cash since January 1, 2013. It has been earning and collecting premiums, although it has had to pay off about $50 million on a thunderstorm in Hitchcock.  So, let’s be generous and credit TWIA with about $120 million more in new cash. This brings a guesstimate of its cash levels back up to around $415 million.

The problem is that not all of this cash is available to pay policyholder claims.  Some of it will be used to pay for operations, for commissions, and for other matters, including the Ike claims not resolved earlier this week.  So, I would be surprised if someone were to audit TWIA today and found it had more than $400 million in cash available to pay claims before resort to the CRTF. I would not be surprised if the number actually came out in the $300 million range.  And both of these figures will be reduced by $100 million or so less if TWIA succeeds in its plan to purchase reinsurance.

So, without the hoped-for borrowings, TWIA might have had $300 million to pay claims out of operating funds and another $180 million out of its CRTF.  TWIA might have had a total of $500 million.  (If the settlement came out of the CRTF rather than operations, the total would stay the same).  If the BAN had been approved, at least in the short run before TWIA had to pay the loan back, TWIA might have had $1 billion.  Both sums are, of course, grossly inadequate to deal with the $80 plus billion in TWIA exposure. Nonetheless, $1 billion in cash would have left TWIA in a better short run position.

Long run finances

Perhaps the greater impact, however, of the BAN ban is on the ability of TWIA to sell post-event bonds following a storm.  We’ve been through this matter before on this blog, but it is worth repeating because it is so very important.  The short version is, however, that there is a significant risk that very little in post-event bonds will actually be able to be sold.  And, thus, TWIA may very well have less than $1 billion with which to pay claims even after borrowing.  I would not be surprised if it ended up with as little $700 million.  The probability of such losses occurring this summer would be about 7-9% if this were a normal hurricane season.  If, as climate experts agree, however, this proves to be a bad hurricane season the probability of TWIA going broke and unable to pay claims fully could rise to 10-14%.

Here’s the longer version.  I, by the way, am not alone in my alarm on this matter. TWIA itself raised the issue in its submission to the Texas legislature.  the Texas Public Finance Authority (TPFA) had trouble last year trying to help TWIA borrow. And several of the pieces of proposed legislation this session would have fixed this particular problem.  But all of these bills failed during the regular session. Governor Perry has thus far resisted calls that he add windstorm insurance reform to the agenda for a special legislative session.

if there is a storm that pierces the CRTF, TWIA will need to rely on post-event Class 1 bonds.  But, unless something has changed, per the Texas Public Finance Authority they won’t sell, at least not up to $1 billion authorized.  But if the Class 1’s don’t fully sell, then TWIA/TPFA is prohibited from selling the regular Class 2 bonds. (Section 2210.073). Instead, we go to the Class 2 Alternatives under section 2210.6136.  But if less than $500 million of Class 1 bonds have sold — which is likely to be the case —  the first $500 million of the  Class 2 bonds  are paid in the same problematic way as the Class 1 bonds (surcharges on TWIA policyholders).  (Section 2210.6136(b)(1)). And there is a serious question as to whether anyone will loan TWIA money on those terms. Why? Because as soon as substantial policy surcharges are issued on TWIA policies, some TWIA policyholders will either find other insurance, reduce the sizes of their policy, or simply choose to go bare.  This is particularly likely if a storm has impoverished many TWIA policyholders. And if enough TWIA policyholders reduce their premiums, the percent surcharge will need to go up to compensate in order to pay off the bonds.  But if the surcharge rate goes up, more TWIA policyholders will drop out.  And, we get into a death spiral.

But here’s the catch.  Under section 2210.6136(c), if TWIA/TPFA can’t sell every dollar of the $1 billion in Class 2 Alternatives, then TWIA/TPFA can not issue the class 3 bonds of $500 million.  The statute is crystal clear on this point.  And this means that TWIA has no Class 1 bonds, no Class 2 bonds, little or no Class 2 Alternative bonds and no Class 3 bonds.  The system has completely collapsed in a cascade of failures.  TWIA basically has no money beyond cash on hand, and the CRTF. That means policyholders will not be paid in full.  If the storm is bad enough, they won’t be paid even half of their legitimate claims.

Reinsurance — assuming that TWIA can get it — will not help a lot. The reinsurance will not kick in until losses exceed the “reinsurance attachment point.”  But the reinsurance attachment point is likely to be set on the false assumption that the post-event securities will succeed.  So, for losses less than the reinsurance attachment point, the reinsurance won’t pay at all.  TWIA will be just as bankrupt as if it did not have reinsurance at all.  Actually, it will be more bankrupt because  it will have paid $100 million in premiums.  And even if the storm is so bad that the reinsurance kicks in, there is still a gap between the top of the CRTF plus any post-event bonds and the reinsurance attachment point.  So, TWIA won’t have enough money to pay claims fully.

Why would Commissioner Kitzman do such a thing?

I’m not privy to her reasoning or all the facts, but there are concerns we have outlined before about pre-event borrowing such as a Bond Anticipation Note.  The problem with loans is that you have to pay them back — and at interest.  Thus, in the long run, particularly if interest rates rise or if TWIA is deemed high risk and thus charged high rates even now, borrowing perpetuates your insufficient capitalization.  Whatever the benefits in the short run — and there may have been many here that incoming Commissioner Julia Rathgeber will want to examine — it is not the ideal long run solution for insurance risk. It may well be that Commissioner Kitzman refused as her final act to be complicit in the bandaiding of TWIA in the hopes that a sufficiently obvious problem would spur the Governor to call a special session and the legislature to develop a sustainable fix.  If so, let us hope that gamble proves correct.

 

A minimalist last-minute fix for TWIA

It looks as if we are down to the wire in the Texas legislature on reforming the state’s public system for addressing catastrophic risk.  No one has developed a solution that is economically sensible and politically acceptable.  This leaves Texas in an extremely difficult position.  One alternative is to just leave the status quo in place. This choice subjects coastal residents to a substantial risk of a cataclysmic failure of their insurance system. Derivatively, it leaves the rest of Texas vulnerable to a Herculean task of picking up the huge financial pieces after a major tropical storm. The failure of the legislature to act also gives the Texas insurance commissioner extra cause to throw TWIA into receivership. The other alternative is to burden Texas for years with a very bad bill, S.B. 1700, which is the only proposal to emerge from a committee thus far. I thus offer a minimalist last-minute fix for TWIA.  Actually, I offer two.

This chart summarizes the situation today.

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)

Texas must somehow get out of this trap between rotten choices. It should not permit exploitation of a largely self-created crisis by coastal legislators to hurt the rest of the Texas economy for years to come. Here is my suggestion.  It is not what I would want.  It is not a very good scheme.  But it is better than the status quo and it is better than SB 1700, which perpetuates morally unjust and sneaky wealth transfers, makes a mockery of commitments to the free market, and has, in the end and notwithstanding its innovative use of the word “must” in various provisions, no real plan to end the cycle of dependency on government mandated subsidies, often from poor to rich. My hope is that this suggestion can be politically acceptable if a lot of people suck up their pride and think about their constituents, both within their district and outside it.  In fact, I will offer two schemes. I am hardly expert on parliamentary procedure in Texas, but I am hopeful that both could be implemented through amendments to SB 1700. I am even hopeful that both schemes might conjure up the ⅔ vote necessary to get this bill in place in time for the 2013 hurricane season, which starts essentially as soon as the 83rd Texas Legislature recesses.

TWIA Fix 1: The absolute minimalist fix.

1. Fix the worst bugs in the system of post-event bonds in place.  Reduce the Class 1 Funding scheme to a $200 million maximum. Such a bond could probably be amortized by  only a 5% surcharge on TWIA policyholders after a major storm.  Those policyholders would grumble about being kicked when they were down, which would be true, but most could probably pay.  Their ability to pay provides the needed foundation for Class 1 Bonds to be marketable. Keep Class 2 Bonds in place and raise 70% of $1 billion from coastal insureds (including TWIA policyholders) via a premium surcharge and raise 30% of $1 billion from insurers.  If the Class 1 bonds fail, just start with Class 2.  Ditch the buggy and unworkable Class 2 Alternative Bond scheme in section 2210.6136. Keep Class 3 funding in place to raise an additional $500 million.  This will create something like a $2 billion stack for the 2013 and 2014 hurricane seasons. Maybe a little more for 2014 if we are lucky in 2013.

2. Require TWIA to put at least two dollars into its CRTF off the top for every dollar that it spends in reinsurance. That will make TWIA think carefully about the costs of purchasing reinsurance in a system where reinsurers charge about 5 times the expected risk and instead consider more carefully putting that money into the CRTF where there is close to dollar for dollar return.

3. Tell policyholders in the most forceful way about the risks posed to them by TWIA’s funding problem. Tell them with actual numbers derived from the best models available what the risk is that TWIA will not have enough money to pay claims and what the expected shortfall is likely to be.  If, for example, TWIA’s stack for 2013 is $2 billion, then advise policyholders that the risk of their insurer being insolvent is about 3-4% per year.  Tell them further that if TWIA becomes insolvent, they are most likely to get only 50 cents for each dollar that TWIA owes them. (My calculation). Finally, let them know that neither the state of Texas nor the Texas Property and Casualty Insurance Guaranty Association has any legal obligation to pay for losses not covered by TWIA. It reeks of Enron not to be as explicit as one can about the special risks TWIA policyholders face.

Warning : The Texas Windstorm Insurance Association is not expected \ to have adequate funds to pay claims in years where total losses \ exceed about $2 billion. There is about a 4% risk of this occurring \ in 2013. In such circumstances you may receive 50 cents or less for \ each legitimate dollar of claims you file. Neither the State of Texas \ nor the Texas Property Casualty Insurance Guaranty Association has \ any legal obligation to pay claims for which the Texas Windstorm \ Insurance Association lacks adequate funds.

TWIA warning label

Will this scare lenders? Only dumb ones that haven’t been following the situation.  It will, however, alert TWIA policyholders to the desirability of at least seeing if other insurance alternatives are available and, in any event, taking every possible precaution against loss if a storm approaches.

4. Eliminate this nonsense in SB 1700 of shielding the entities running TWIA from public scrutiny by giving them special exemption from disclosure laws.  If there were ever an entity affecting the public trust that ought to be subject to public information requests, which already have protection from undue burdens built in, it is TWIA.

TWIA Fix 2: A minimalist fix

1. Scrap the whole opaque layering scheme for post-event bonds.  It just disguises the foundation of wealth transfers on which the whole current scheme rests. If we are going to use post-event bonds to fund storm losses above the catastrophe reserve fund, have them paid for explicitly and transparently by insureds throughout the state. Pay for losses in excess of the TWIA CRTF  by permitting the Texas Department of Insurance to impose a premium surcharge on essentially all property/casualty insurance sold in Texas sufficient to amortize an aggregate $3 billion over 10 years.  The surcharge should be clearly labeled “to subsidize coastal property windstorm insurance” so that insureds throughout the state know exactly why they are paying this extra money.  Depending on interest rates, a $3 billion initial principal balance will require a payment of about $380 million per year, which I believe is on the order of a 1% premium surcharge for 10 years.  (Computation based on http://www.naic.org/state_report_cards/report_card_tx.pdf (page 6)). TWIA policyholders pay a double surcharge.

2. Start pre-funding this potential $3 billion obligation.  Create some sort of trust fund akin to the TWIA CRTF and fund it by imposing a 0.5% premium surcharge starting as soon as possible on the same set of Texas property/casualty insurance policies that would have to pay the surcharge described in paragraph 1. Again, the surcharge should be clearly labeled “to provide a reserve fund that subsidizes coastal property windstorm insurance.” That way, insureds throughout the state would know why their hard-earned dollars are being taken away.  Use these dollars to reduce initial principal balance on post-event bonds that will need to be issued (up to $3 billion) to pay for storm losses suffered by TWIA policyholders.

3. Again, tell policyholders in the most forceful way about the risks posed to them by TWIA’s funding problem. Tell them with actual numbers derived from the best models available what the risk is that TWIA will not have enough money to pay claims and what the expected shortfall is likely to be. If, for example, TWIA’s stack for 2013 is $3.2 billion, then advise policyholders that the risk of their insurer being insolvent is about 2% per year.  Tell them further that if TWIA becomes insolvent, they are most likely to get about 90 cents for each dollar that TWIA owes them. (My calculation). Finally, let them know that neither the state of Texas nor the Texas Property and Casualty Insurance Guaranty Association has any legal obligation to pay for losses not covered by TWIA.

4. Again, require TWIA to put at least two dollars into its CRTF off the top for every dollar that it spends in reinsurance. That will make TWIA think carefully about the costs of purchasing reinsurance in a system where reinsurers charge about 5 times the expected risk and instead put it into the CRTF where there is close to dollar for dollar return.

 5. Give inland interests more substantial representation on the TWIA board and give the TWIA board authorization to reduce its exposure (and therefore reduce the risk of insolvency) through a variety of steps, including placing a limit lower than currently exists on the maximum limit on residential properties (primary and secondary), imposition of higher deductibles or coinsurance than currently exists and ability to place different restrictions on policies on new properties than policies on existing properties. This will impel the TWIA board to do what it should have been doing all along — prioritize between affording higher and better coverage to people but running a substantial risk of insolvency, or providing more moderate coverage — perhaps with a focus on the less wealthy — for which money will actually exist in the event of a major storm.

Final Thoughts

I’ve been writing a lot over the past 10 months about ways of addressing the system of catastrophic risk insurance in place for the Texas coast.  It’s not so hard to be an academic theorist in which one can assume away the world of political constraints. But now, at the least, we have those realities to face and some scary deadlines coming up.  Maybe what I am proposing comes too late.  I hope not.  Because while my proposals are hardly perfect — indeed they should sunset by the 84th legislature — I do think each of them is considerably better than the horrible choice now facing the Texas legislature.  Maybe some future session will feature less inflammatory and unproductive bombast, fewer attempts at special interest legislation and more serious and informed reflection about ways in which mechanisms thought good enough for the rest of Texas and its insurance markets can again be made the primary method of catastrophic risk transfer along the Texas coast. In the mean time, you have my thoughts on what might currently be achieved.

 

TWIA validates risk of insolvency and threat of small weather events

A letter from TWIA in response to a public information request validates the methodology used on this blog to assess alternative legislative proposals to fund catastrophic risk in Texas. This response to a public information request also shows that, given TWIA’s thin capitalization and growing exposure, even small weather events can have a serious effect. A redacted copy of that response is provided in the link below. The redaction is to protect the identity of the requestor (not me) who fears retaliation for having submitted it.

[Copy of letter temporarily deleted until redaction can be improved]

May 8, 2013 letter from TWIA

May 8, 2013 letter from TWIA

Insolvency Risk

Here is TWIA’s risk of insolvency based on what it apparently believes it can achieve in pre-event funding, post-event bonding and reinsurance.  For reasons I have set forth elsewhere, I believe these estimates of how much funding TWIA can receive are financially and legally unrealistic.

Source of FundingAmountCumulative AmountProbability Exceedance
Source of FundingAmountCumulative AmountProbability Exceedance
Premiums and CRTF$200 million$200 million17.4%
Class 1 Bonds$500 million$700 million7.7%
Class 2 Bonds$1 billion$1.7 billion3.2%
Class 3 Bonds$500 million$2.2 billion2.5%
Reinsurance$1.15 billion$3.35 billion1.5%

Regular readers of this blog — actually an impressively growing number — will note two things.  First, these estimates are close to estimates I have made of the risk to TWIA.  I have not been crying “wolf” or (needlessly) imitating Chicken Little on this topic for these many months. There is a very serious problem on the coast of Texas and, derivatively, a very serious problem for the rest of Texas. Also, since my estimates of the burden on various constituencies posed by various legislative proposals are based on these same models (see here, here and here for examples), the TWIA data tends to validate my estimates.  Bills such as SB 1700 indeed force non-TWIA policyholders to pay a stunningly large portion of the claims of TWIA policyholders.

Second, these estimates are one year values.  If one looks at the risk of insolvency over longer period of time, the risk increases significantly.  So, for example, if TWIA is not substantially fixed until the 84th legislative session and its catastrophe reserve trust fund does not grow, there is about a 32% probability that TWIA will have to go beyond its catastrophe reserve fund in order to pay claims.

Reinsurance

TWIA confirms in its response that it is trying to obtain $1.15 billion in reinsurance. Its hope is to spend $106 million and get an attachment point atop Class 3 bonds of $2.2 billion. It confirms that it may be able to get between $900 million and $1.1 billion of insurance coverage for this money.

There is, however, a troubling paragraph in the public information request response. The one contingency mentioned in the response is that TWIA might not be possible to sell the Bond Anticipation Notes (BAN) and thus might need an attachment point on the reinsurance of $1.7 billion. Fair enough. But the problem is actually considerably more serious. If the BAN does not sell — indeed if any of the authorized $1 billion in Class 1 Securities can not fully be issued — then TWIA can not issue $1 billion in regular Class 2 Securities.  It has to issue what I have called Class 2 Alternative Securities.  But the Class 2 Securities depend on the same dubious funding source as the Class 1 Securities, so the market might not buy those either.  And, if the Class 2 Alternative Securities don’t sell the Class 3 Securities can not be sold.

TWIA actually noticed at least part of this problem back in December when it made its recommendations to the Texas legislature.  Read pp. 30-32 of this TWIA document. Six months later, however, TWIA appears to be ignoring that major problem even though the law under which it operates remains unchanged.   If TWIA and/or its reinsurance broker is not paying attention to this point, it could be about to make dubious use of $106 million in TWIA policyholder money.  Because if TWIA buys reinsurance with an attachment point of $1.7 billion or $2.2 billion and it has only, say, $900 million in actual cash available to pay claims, TWIA will have no money to pay losses between $900 million and the attachment point. There’s a gap. It’s like buying catastrophic health insurance with a big deductible when you don’t even have enough money to pay for modest claims. The reinsurance will not kick in and it will not “drop down.” And so, TWIA will be able to pay only a small fraction (perhaps as little as 50%) of its losses with unusable reinsurance just sitting there.

For what it’s worth,  I’ve talked about all this before (here and here, for example, and here too).  And its a bug that many of the proposals now floating about the legislature fix.  But who knows if any of these proposals will actually become law.

The CRTF

TWIA confirms that at the end of March it stood at $180 million. At least it has not gone down more since the beginning of the year.

Recent Hailstorms

A friend has stated that “TWIA doesn’t even have enough to pay for a thunderstorm.” I had always taken this to be an exaggeration.  But the Public Information Request confirms that a thunderstorm in Santa Fe and Hitchcock on April 2, 2013 — a localized non-catastrophic weather event —  generated about $50 million in losses (what would be 28% of its CRTF). Fortunately, this storm did not get beyond the budgeted amount for 2013 non-catastrophe losses and did not require a dip into the CRTF. But think about it.  This moderate weather event cost TWIA more than 10% of its premiums.  What if there’s another severe thunderstorm or two this year?  What does this say about premiums?  What does it say about the needed capitalization of a bulked up TWIA?

The problem is one of exposure.  TWIA now insures so much property and the coast — thanks partly to TWIA subsidized insurance rates — has become sufficiently developed  that even moderate or localized weather events can potentially wipe out TWIA’s Ike-depleted catastrophe reserve trust fund and force TWIA onto the uncharted waters of post-event financing.

Thanks

Maybe TWIA isn’t this helpful all the time to everybody, but in my experience TWIA has made an effort to provide timely and reasonable responses to reasonable public information requests.  So, a thanks to Jennifer Armstrong and the staff there on this point.

Caveats

It might be worth repeating that the views expressed on this blog are my own and do not necessarily reflect those of the University of Houston.

Also, the views expressed in this posts do not necessarily reflect those of the recipient of the public information request at issue.

Breaking News: Major TWIA Bill Approved by Senate Committee

According to a reliable source, a highly amended S.B. 1700 that resembles somewhat the committee substitute HB 3622 has been voted favorably out of the Senate Business and Commerce Committee.

Here’s a link to the bill. Senate Bill 1700 approved by Business and Commerce

I’ll try to provide a detailed analysis in the next 24 hours.  The short version, however, is this bill looks like a masterpiece of special interest legislation that current TWIA policyholders on the coast should love. It gets rid of the worst problems in post-event bonds that have been around since 2011. Everyone off and on the coast should be glad that this problem is eliminated. The SB 1700 voted out of committee favorably reduces the probability of a storm that would gravely injure TWIA policyholders and, derivatively, the rest of Texas. It requires little if any sacrifice from TWIA policyholders in terms of mitigation and asks rich and poor insureds throughout Texas to subsidize property along the coast even more so than before. That subsidization continues even if the owners of coastal property are wealthy and don’t need or deserve the subsidy. But it continues extracting this money in a way that is very hard for the average insured to understand or see.  If you live off the coast, your 3% higher insurance bill won’t have a picture showing you the lovely beach home or modest coastal property you are now subsidizing more than before with your hard earned money, but you’ll be doing it nonetheless.

Also, the bill (section 2210.212) says that TWIA “must” reduce its potential exposure quite substantially both over the next few years and over the next decade.  In theory this means that TWIA will have to drop policyholders and private insurers will have to pick them up. It looks, however, as if all that “must” means is that Texas insurers, if they don’t write insurance on the coast as desired by TWIA, will have to collectively fork over $200 million.  I have serious doubts this provision means much more than that Texas insurers can look forward to passing on a $200 million bill to their non-coastal policyholders every several years — how, exactly, is Allstate supposed to compete with subsidized TWIA? —  but perhaps if Allstate (just to pick on one large insurer arbitrarily) were to sell in the least vulnerable parts of the coast, it might be able to do so at only a modest loss and avoid being hit by the stick that this bill gives TWIA.  Anyway, more on this and other interesting bill features soon.

Oh, and I almost forgot.  If this bill passes it won’t be TWIA anymore.  It will be TRIP, the Texas Residual Insurance Plan.

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.

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

A statute implementing drop down of Class 3 bonds

The concept

In a post yesterday, I suggested that the Texas legislature needs to prevent a needless insurance catastrophe this summer involving the Texas Windstorm Insurance Association. The catastrophe would be triggered by the inability of the Texas Public Finance Authority to issue Class 2 Alternative post-event bonds following a significant tropical cyclone. As the current law is drafted, such an inability would cascade into an inability to issue any Class 3 post-event bonds and, unless the contract was carefully drafted in an unusual way, jeopardize the ability to collect on any of the expensive reinsurance TWIA had purchased. I thus suggested repeal of current provisions prohibiting the Class 3 bonds from dropping down. I suggested instead that these bonds be permitted to “drop down” in the event the Class 2 Alternative bonds fail to sell and that insurers be given 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.

Today, I want to post some statutory language that would actually implement this idea. I make this foray into statutory drafting because I regard the issue as one of extreme importance and would not like to see thousands of coastal Texans needlessly crippled financially following a significant hurricane because I did not make the effort. I am hardly expert in Texas statutory drafting but believe my skills in contract drafting, a subject I teach with some passion to students at the University of Houston Law Center, might transfer over to this domain. I also do so because I believe, perhaps naively, that this is a component of windstorm reform on which most politicians could actually agree, a matter that has become more imperative in my mind after having attended the most recent legislative hearing on windstorm reform. Of course to the extent that reform legislation is passed in the next 40 days (one day less than yesterday — tick, tick, tick) that would provide both for this summer and for hurricane seasons thereafter, the bandaid suggested here might well not be necessary.

In any event, here is some proposed language that would permit the drop down of Class 3 bonds as a bandaid for the upcoming hurricane season. Additions are underlined; deletions are struck through. The language could be added to many of the bills now pending in the legislature that reform TWIA. At the moment, the proposed legislation permits the drop down to occur at any time, but the permissible period could be restricted to calendar years 2013 and 2014. The bill might also need something like the following to ensure that it takes effect as soon as possible: “This Act takes effect immediately if it receives a vote of two-thirds of all the members elected to each house, as provided by Section 39, Article III, Texas Constitution. If this Act does not receive the vote necessary for immediate effect, this Act takes effect on the 91st day after the last day of the legislative session.”

The statutory language

Sec. 2210.6135. PAYMENT OF CLASS 3 PUBLIC SECURITIES. (a) The association shall pay Class 3 public securities issued under Section 2210.074 as provided by this section through member assessments. The association, for the payment of the losses, shall assess the members of the association a principal amount not to exceed $500 million per catastrophe year. The association shall notify each member of the association of the amount of the member’s assessment under this section.

(b) The proportion of the losses allocable to each insurer under this section shall be determined in the manner used to determine each insurer’s participation in the association for the year under Section 2210.052.

(c) Except to the extent permitted under Section 2210.6136, a member of the association may not recoup an assessment paid under this section through a premium surcharge or tax credit.

Sec. 2210.6136. ALTERNATIVE SOURCES OF PAYMENT. (a) Notwithstanding any other provision of this chapter and subject to Subsection (b), on a finding by the commissioner that all or any portion of the total principal amount of Class 1 public securities authorized to be issued under Section 2210.072 cannot be issued, the commissioner, by rule or order, may cause the issuance of Class 2 public securities in a principal amount not to exceed the principal amount described by Section 2210.073(b).

(b) The commissioner shall order the repayment of the cost of Class 2 public securities issued in the manner described by Subsection (a) as follows:

(1) in the manner described by Section 2210.612(a), in an amount equal to the lesser of:

(A) $500 million; or

(B) that portion of the total principal amount of Class 1 public securities authorized to be issued under Section 2210.072 that cannot be issued, plus any costs associated with that portion; and

(2) after payment under Subdivision (1), in the manner described by Sections 2210.613(a) and (b), in an amount equal to the difference between the principal amount of public securities issued under Subsection (a) and the amount repaid in the manner described by Subdivision (1), plus any costs associated with that amount.

(c) If Class 2 public securities are issued in the manner authorized by this section, Class 3 public securities may be issued only after Class 2 public securities have been issued in the maximum amount authorized under Section 2210.073.

Sec. 2210.6137. BACKUP ALTERNATIVE SOURCE OF PAYMENT. (a) Notwithstanding any other provision of this chapter, on a finding by the commissioner that all or any portion of the total principal amount of Class 2 public securities authorized to be issued under Section 2210.072 or Section 2210.6136 cannot be issued, the commissioner, by rule or order, may cause the issuance of Class 3 public securities in a principal amount not to exceed the principal amount described by Section 2210.074(b).

(b) The commissioner shall order the repayment of the cost of Class 3 public securities issued in the manner described by Section 2210.074.

(c) An insurer may credit the “applicable fraction” as defined in subsection (d) of an amount paid in accordance with this Section in a calendar year against the insurer’s premium tax under Chapter 221. The tax credit authorized under this subsection shall be allowed at a rate not to exceed 20 percent per year for five or more successive years beginning the calendar year that the assessments under this section are paid. The balance of payments made by the insurer and not claimed as a premium tax credit may be reflected in the books and records of the insurer as an admitted asset of the insurer for all purposes, including exhibition in an annual statement under Section 862.001.

(d) For purposes of this section, the term “applicable fraction” means the ratio of

(1) the portion of the total principal amount of Class 2 public securities authorized to be issued under Section 2210.072 or Section 2210.6136 that cannot be issued to

(2) the initial principal amount of any Class 3 public securities issued pursuant to this section.

[Special Note: This post was edited at 6:30 p.m. on Monday to address some crucial formatting errors]