# 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.

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.

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.

### 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.

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

# 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.

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.

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]

# Drop down Class 3 bonds: a bandaid for TWIA

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

## History

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

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

## The current situation

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

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

## The bandaid

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

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

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

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