A 1.5-2% risk per year of losing your home with inadequate insurance is a serious risk

For the 2011-12 hurricane season, the Texas Windstorm Insurance Association managed to purchase $636 million in reinsurance coverage for a net cost of about $83 million.  As a result of this purchase, having about $150 million in a piggybank, and the legality of TWIA borrowing about $2.5 billion following a serious loss, this means that TWIA had — roughly $3.2 billion — available to pay claims.  TWIA admits and my own computations based on the Weibull Distribution confirm that this leaves a 1.5-2% chance that TWIA, even with a lot of borrowing, will not have enough money to honor its obligations in full.

Here’s a picture of the TWIA funding stack.

TWIA Funding Stack

One and a half to two percent may not sound that awful.  That’s what some coastal Texas Representatives such as Todd Hunter are asserting. But their reassurances should not bring much comfort nor deflect attention from the serious problem facing Texas.

First — one and a half to two percent risks in fact occur. The fact that the risk is relatively small does not mean you should not insure against it.  Would you, for example, tell a 65 year old with a family to support not to worry about life insurance for the next year because there was only a 1.5% chance or so of dying during that time period  Would you, for example, tell a homeowner not to worry that their automobile insurance policy did not cover them for, losses during three months of each year because only about 1.5% of homeowners make claims during any three month period? (http://research3.bus.wisc.edu/file.php/129/Papers/PredModelHomeowners21July2010.pdf).  Or, let’s play a game.  Flip a coin six times in a row.  If it comes up all heads, you lose your house.  That’s about a 1.5% risk.  Want to play?  Perhaps you are all more courageous than I am, but I would worry.

Second, although a 1.5-2% risk may be unlikely to occur in any given year, just looking at a one year period is a strange way of thinking about it.  Say you own your home for 10 years or are thinking of investing in a business in Galveston.  If TWIA does not mend its ways, suddenly the risk of TWIA suffering a bankrupting loss during your period of investment jumps to 14-18%.  That’s calculated using something called the binomial distribution. Would you worry that if you rolled a single die and it came up 6 you would lose your house.  Again, maybe some politicians are particularly courageous, but I would be concerned.

Third, the 1.5-2% risk of TWIA going insolvent in any year is not the only risk created by the current funding structure.  There is something like a 15% chance that the next year will bring a storm large enough to force TWIA to borrow.  And the way TWIA first pays that money back is first by raising premiums on TWIA policyholders, pure and simple. The statute I’ve set forth below (section 2210.612 of the Texas Insurance Code makes that clear).  If we expand to our 10 year time horizon, the probability that TWIA will have to borrow goes into the 70% range.

Section 2210.612 of the Texas Insurance Code

And it gets worse.  If TWIA raises premiums substantially to pay off these “Class 1 Public Securities,”  some people will drop out of TWIA and find alternatives.  This means the rates TWIA will need to charge go up even more.  And more people drop out.  Reverse funding insurance creates a risk that TWIA will unravel — a risk lenders will surely take into account in figuring out what interest rate to charge TWIA in the event it has to borrow.

Actually, it gets yet worse, but I will save that and one other matter for other posts.