Hinojosa/Hunter file bills that buttress TWIA by forcing non-coastal property holders to pay for coastal risk

State Senator Juan “Chuy” Hinojosa (D-McAllen) and State Representative Todd Hunter (R-Corpus Christi) have filed companion bills in the State Senate (SB 1089) and State House (HB 2352) that would buttress the resources available to the Texas Windstorm Insurance Association (TWIA) to pay claims in the event of a tropical cyclone hitting the Texas coast but would do so by placing most of the burden either directly or indirectly on policyholders living away from the Texas coast.  The bill, like the current system and as heralded in recommendations of the Coastal Windstorm Task Force, would rely primarily on post-event bonding as a way of financing catastrophic risk.  But, by impelling insurers statewide and coastal policyholders to increase the size of the catastrophe reserve that pays before any bonds are issued, the bill would make it less likely that this  system of “insurance in reverse” would need to be used. The new system would come into effect in September of 2013.  It would apparently leave the current system in place for much of this hurricane season.

In a nutshell, here’s how the Hinojosa/Hunter plan works.  TWIA builds up its catastrophe reserve trust fund (a/k/a CRTF, a/k/a “cat fund”) so that it equals 1.5% of its “direct exposure” for the prior year.  (Section 2210.456). Since TWIA lists its current direct exposure at $72 billion, this means the catastrophe reserve fund is supposed to grow to at least $1.08 billion. Catrisk’s earlier modeling suggests that such a catastrophe reserve fund would be able to cover something like a 1 in 20 year storm.

But just because TWIA’s catastrophe reserve fund could cover a 1 in 20 year storm, does not mean that TWIA’s policyholders would be paying to cover that risk.  That’s because under the Hinojosa/Hunter plan, the catastrophe fund is financed mostly with other money.  To get from the paltry $180 million that now stands in the fund to $1.08 billion, the plan would assess  property insurers statewide, regardless of the extent to which they choose to do business on the Texas coast, 1/10 of the desired amount of the catastrophe reserve fund each year.  (Section 2210.456(c) (0.15% of the direct exposure)).  As it stands, this would amount to  $108 million per year for many years into the future. These are real assessments, not compelled loans by the insurance industry.  The  assessments are not creditable against premium taxes otherwise owed and are not supposed to be passed on — at least directly — by a premium surcharge on policyholders. It would demean the insurance industry, however, to suggest that they will not be clever enough to find a way to pass much of this cost on to policyholders.

Coastal insureds — including non-TWIA homeowner insureds and coastal residents with automobile insurance or other forms of property insurance — also pay to protect TWIA policyholders from risk. Under the Hinojosa/Hunter plan, a 3.9% premium surcharge is issued on all such policies. How much would this surcharge bring in?  Unclear. I don’t have the data, yet, particularly on automobile policies along the coast.  But we do know how much TWIA policyholders would pay on their TWIA policies to increase the protection available to them: about $17 million (0.039 x $446 million in premium taxes).  And since TWIA reports that it 62% of the coastal homeowner wind market (measured by exposure and not premiums), one can approximate that non-TWIA homeowner insureds would pay roughly $11 million.  Thus, TWIA policyholders would, at most, pay about 13% of the amount it will take to strengthen the catastrophe reserve fund that would be exclusively available to those policyholders to pay claims in the event of a tropical cyclone. If, as I suspect, non-wind homeowner policies, automobile policy premiums and other property insurance premiums along the coast are at least as large as TWIA premiums, the surcharge on TWIA policies will, at least for a few years, in fact pay perhaps just 7% of the actual cost of this portion of the risk posed by such policies.

And even this last figure of somewhere between 7 and 13% potentially understates the degree to which TWIA policies will be funding the risk they pose.  This is because under section 2210.083 of the Hinojosa/Hunter bill, when the cat fund needs to be restocked following a disaster that wipes it out, insurers doing business anywhere in the state must promptly pay, in addition to the regular shortfall assessment and in addition to whatever else they may be paying their own policyholders, half the amount of any public securities (up to $1 billion) issued to pay TWIA policy losses and, as I read section 2210.084, the entirety (up to $900 million) of additional public securities issued to pay TWIA losses.  Thus, following a serious hurricane, even more of the money used to pay for future hurricane losses will be coming from sources other than TWIA policies. Of course, the Hinojosa/Hunter bill permits insurers to “reinsure” against these potential assessments (section 2210.088), but this just means that insurers will be paying cash for the risk imposed on them by the law rather than perhaps just making an accounting entry for contingent liabilities on their books.


Layering of Protections Under Hinojosa/Hunter Bill

Layering of Protections Under Hinojosa/Hunter Bill

The Hinojosa/Hunter provides for at least three heightened layers of protection in the event of a storm that pierces the catastrophe reserve fund.  Each of the layers is provided by bonds, issued after the disaster, by the Texas Public Finance Authority. The layers (Classes A, B and C) differ primarily in their amortization periods and in the source of money used to repay the debts. Up to the first $1 billion is to be provided by Class A securities with an amortization period of 10 years.  The money to repay this debt each year — probably about 1/8 of the amount borrowed — will come from TWIA itself.  If the full $1 billion were borrowed, this would likely amount to a charge of $125 million per year for 10 years, which in turn would increase existing TWIA premiums by 25%. It is not clear whether the market would trust the ability of TWIA to actually obtain these funds, since some TWIA policyholders might be reluctant to renew with TWIA in the event such a hefty increase were imposed. The Texas Public Finance Authority has published grave doubts about the ability to market similar bonds authorized by the current law. 

Class B bonds can be issued in an amount up to $900 million and likewise must be amortized in no more than 10 years.  The source of repayment, though, is different. Although TWIA premiums could in theory be used to repay this obligation — I rather suspect they will be tied up elsewhere — the vast bulk of the funding is likely to come from yet another surcharge: this one on all premiums on coastal property insurance, including non-TWIA wind insurance, conventional coastal homeowner insurance, automobile insurance, and other forms of property insurance. The surcharge won’t be another 25% because the base is bigger.  But since it will cost $110 billion or more each year to amortize the debt, I would not be surprised to see an additional 5 to 7% surcharge.

If the catastrophe reserve fund indeed bulks up to $1.08 billion and the Class A bonds are indeed marketable, the Class B bonds should cover TWIA against the 1 in 50 year storm.  For storms bigger than that, the Hinojosa/Hunter bill provides for $2.75 billion in Class C bonds.  These have an amortization period of 14 years.  They are to be paid by a surcharge on all premiums on property insurance statewide.  The rate will be about 1/10 of the amount borrowed divided by a denominator that I would love to know the value of: the amount of premiums on property insurance sold in this state. If you forced me to make an educated guess, however, I would guess that property insurance premiums in Texas are about $20 billion per year, which would put the needed surcharge at 1-2% per year for 14 years. Of course, if the amount borrowed were not the full $2.75 billion, the surcharge would be less.

There are two other sources of funds worth mentioning.  The Hinojosa/Hunter plan continues to permit TWIA to purchase reinsurance and imposes no price constraints upon their doing so.  Such reinsurance is notoriously expensive and often difficult to obtain.  There is no explicit provision or encouragement for other forms of protection such as pre-event catastrophe bonds. There are also, in theory, Class D securities that provide an unlimited amount of protection to TWIA policyholders.  The problem: no source of funds is identified to pay back the bonds. Section 2210.639 simply mentions that these borrowings could be paid by TWIA premiums (yeah, right) or “money received from any source for the purpose of repaying Class D public securities.”  In other words, no one has a clue.

There is more in the Hunter bills and the Hinojosa bill that Catrisk will try to address in the near future.  And there are some simulations we can run to get some better ideas of the relative burdens borne throughout Texas under this bill. But this should provide an explanation of the basics.


Footnote: I bet that I am going to hear the double dipping criticism of this post again.  The point of these critics is that TWIA policyholders also have conventional homeowner insurance and automobile insurance.  Thus, their burden is higher than I have reported because they get hit with a double or triple whammy.  There is some truth to this criticism.  My defenses are (a) I have tried to report data here as policy based rather than policyholder based; thus the conclusions reached here should be accurate; (b) I can;t find and no one has volunteered the data needed to make the needed computational adjustments; if I had them I could and would do so. My suspicion is that, while a few numbers would change, the themes of the Hinojosa/Hunter bills would not.  They believe coastal risk should be socialized and these bills very much reflects that philosophy.


The issues with heavy reliance on pre-event bonds

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

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

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

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

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

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

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

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

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Quick blog entry on the TWIA meeting of August 6, 2012

I managed to watch most of the TWIA board meeting this morning. Thanks to TWIA for providing this additional form of access to its proceedings. I’m just going to do a quick bullet point list here of matters I found interesting. I’ll try to return to each of these in the days ahead.

1. TWIA has shifted its reinsurance strategy. Instead of a reinsurance attachment point that lay between Class 2 and Class 3 securities, TWIA has now put reinsurance at the top of the stack. It’s also managed to purchase more reinsurance by doing so, notwithstanding a “hardening” of the reinsurance market. This means more protection for policyholders in the densely populated counties but it also means that Texas insurers writing in Lubbock, Dallas, and other non-coastal areas plus non-TWIA policyholders on the coast will bear more of the burden of a large storm by having to repay bonds.

2. One issue TWIA better think long and hard about now that it has placed reinsurance at the top of the stack is how it is going to collect that reinsurance. Traditionally, reinsurers require the insurer to pay the claims first and then to seek reimbursement. But, before this reinsurance will kick in, TWIA will have exhausted its statutory borrowing capabilities of Class 1, 2 and 3 securities. So, does that mean TWIA will have to wait years collecting premiums hopefully in excess of receipts before it can actually get the reinsurance money? How much would it cost TWIA to negotiate a waiver of the indemnity nature of the arrangement? If it’s not a lot, I’d pay!

3. There was talk about how, with $800 million in cash available (source?), TWIA would have months before it would need to raise money from Class 2 and Class 3 securities. I know I’m the gloomy sort, but I have concerns about whether (a) $800 million is enough cash-on-hand for a major storm and (b) whether a few months will be sufficient to raise the extra funding.

4. Uh oh. I learned today that TWIA doesn’t think it can actually raise the $1 billion in Class 1 securities it is authorized to issue following a significant storm. It may only be able to raise half of that. Why? Well, they didn’t say but I assume it is because the market is leery of the ability of TWIA policyholders to actually pay back that money via future increases to their policies. Some TWIA policyholders will likely drop out (or have had their insurable property eliminated). On the one hand, I will confess to deriving some satisfaction from having been proven right that the $1 billion in Class 1 securities was very iffy money On the other hand, it is kind of horrifying to discover that TWIA’s ability to raise money is even more limited that previously asserted.

5. TWIA is evidently going to consider whether to ask the legislature to reduce the maximum policy limit from about $1.8 million for a residential structure down to a lower number. Some board members noted that there was private insurance coverage available for such risks and that other government coastal insurers were not so generous. Representative Craig Eiland from Galveston objected saying that such exposures constituted a small part of the TWIA portfolio and that no one would build large homes on the coast if they couldn’t get TWIA insurance. I’ve advocated in the past that, so long as TWIA policyholders are being subsidized by the rest of the state, that subsidy should not extend to very expensive properties, particularly if private excess insurance is available.

6. TWIA has formed a 10-12 member legislative committee chaired by Mike O’Malley to make recommendations to TWIA regarding recommendations TWIA should make to the Texas legislature on reform. The committee will apparently focus — as it should — on finance issues. Two items of note: only six of the committee members will be TWIA board members. One of the members will be a private advocacy group, the Coastal Coalition. I’m not sure why this advocacy group, which I believe is now renamed the “Don’t Kill The Texas Coast” group gets a privileged position. There was also a discussion of voting rights on the committee. I’m not sure this was resolved, but it strikes me as bizarre that TWIA would delegate voting authority to people not charged with the responsibilities of board members.

P.S. Just fixed a typo in paragraph. It said “not” but it mean “now.” Big difference. Sorry.

TWIA and the quiet matter of reinsurance attachment

Could there be anything duller than a long blog entry about reinsurance attachment points? I want to argue here that there could. In fact, I want to argue here that understanding reinsurance attachment is critical to understanding the problems facing the Texas Windstorm Insurance Association — and its policyholders.

But first I must warn you of a need for some rather extensive background. You can skip ahead to the “main point,” and then come back and read the background if you prefer. Or you can just read the one sentence summary here.

The Texas Windstorm Insurance Association has selected low attachment points for its reinsurance which places the interests of Texas insurers and non-TWIA coastal insureds above the interests of its policyholders in densely populated areas of the Texas coast such as Galveston and Brazoria counties.

The Background

The Texas Windstorm Insurance Association is a state-chartered and state-regulated insurer “of last resort” for property along the Texas coast. Unfortunately, the “last resort” part has become somewhat of a joke. I won’t discuss here why this might be the case, but TWIA has for many years been the largest insurer of homes and business property on the Texas Coast.  As of April 2012, TWIA insured about $72 billion worth of property under about 260,000 policies.

So, how is this governmental creation to pay for losses?  TWIA collected about $450 million in premiums in the most recent hurricane season. But, even in a year in which Texas suffered no hurricanes and only two minimally damaging tropical storms, various expenses meant that TWIA did not add greatly to its $250 million (ish) catastrophe reserve fund.  And so, $250 million is about all that is sitting in the TWIA piggy bank available immediately to pay claims.  It might grow a bit this year, but no matter how you slice it, the catastrophe fund will not have enough money for TWIA to pay losses following many storms hitting the Texas coast.

What kind of storm does it take to cause TWIA to run out of cash  To calibrate matters, TWIA suffered losses of more than $2 billion following Hurricane Ike in 2008, which though it hit Texas in a densely propertied spot, was only a Category 2 storm. Anyone still remember Hurricane Chantal in 1989?  Track of Hurricane ChantalThat was a category 1 storm.  Experts say that if Chantal hit today, it would like cause $290 million in damages, a good chunk of which would be insured by TWIA. Or going back further, how about Hurricane Fern?  Also just a category 1 storm.  If that hit today, it would cause $500 million in damages of which TWIA would insure a high proportion.  So, it doesn’t take a monster storm to cause TWIA to run out of cash.

Beyond something like $250 million, TWIA has four sources of funds it can use before it has to confess to devastated policyholders that there isn’t enough money to pay claims fully.  The sources are stacked. Except in unusual circumstances, TWIA can’t use a source higher on the stack until it has exhausted the lower sources.

The first source is basically to take out a loan from the public.  TWIA is authorized to issue up to $1 billion in “Class 1” securities.  The owners of these “post-event bonds” get paid back by TWIA raising premiums on its policyholders.  The extra premiums get used not to protect against future hurricanes, but to pay off debts TWIA incurred because it didn’t have enough saved up to pay for a past one.

Running insurance in reverse can cause serious problems.  Purchase of TWIA policies is, after all, largely voluntary, and there are often private market competitors. If, for example, TWIA had to sell $1 billion worth of these securities and could do so at 4% with an amortization period of 10 years, TWIA policyholders would see an increase in their premiums of about 25% just to repay the borrowings.  Matters might be even worse because (a) 4% might be a low estimate given that the securities are not backed by the full faith and credit of Texas; (b) some policyholders might drop out of TWIA with a 25% increase, which would mean the remaining policyholders would face a yet-higher increase; and (c) we are talking about just one policy year here — TWIA might have to borrow yet again and charge policyholders yet more if another significant storm hit before the original Class 1 securities were paid off.

Section 2210.615 of the Texas Insurance Code

Section 2210.616 of the Texas Insurance Code. Note: no full faith and credit.

Hurricane 5 Tracking Chart

Hurricane 5 Tracking Chart

But we’re not nearly done.  After all, as proven by Hurricane Ike, Texas can certainly face storms that cause more than $1.2 billion in damages.  In fact, my own reverse engineering of work done by the two hurricane modelers on which TWIA relies, AIR and RMS, suggests that they think the annual probability of such an event is about 5% and the ten-year probability of one or more such storms occurring is about 42%. What kind of hurricane are we talking about.  “Hurricane 5” in August 1945, which hit near Port Aransas and went up the coast towards Houston, would have caused about $2.1 billion in damages if it hit today. Again, TWIA would “own” a significant portion of those damages.

So, how does TWIA cobble together more than $1.2 billion in a year?  It can borrow another $1 billion via “Class 2 Securities.”  And how are these security holders to be paid back?  Under section 2210.613 of the Texas Insurance Code it’s a 30/70 split.  Thirty percent of the debt gets paid back by TWIA “member insurers” — basically meaning any insurance company selling property/casualty insurance in Texas.  Now, in the past, insurers just fronted TWIA assessment payments; they got “paid back” via a pretty full credit against premium taxes they otherwise owed the state.  Since 2009, however, insurers really have to pay.  No tax credit to soften the blow. Presumably, therefore, up to $300 million will come partly out of the hide of private insurer shareholders and partly out of the hide of its policyholders, particularly those in Texas.Texas Insurance Code 2210.613

The remaining 70% of Class 2 repayments will be paid for by a surcharge not just on TWIA policyholders, but on anyone with virtually any form of property or casualty insurance — including automobile insurance — living in the areas TWIA protects. Thus a renter in Corpus Christi could see her automobile insurance premiums go up following a hurricane in Freeport.  So too could a small business in Harlingen which had property and liability insurance with a non-TWIA insurer.  I don’t have the data to say what percentage increase in premiums this repayment obligation would entail, but I don’t think a 5% increase in premiums for ten years would be a bad guess. And for TWIA policyholders, this increase would come on top of that required to pay off the Class 1 securities. Basically, the risk is socialized 30% throughout Texas and 70% throughout the Texas coast.

Now we get into really scary hurricanes: those that cause more than $2.2 billion in damages to TWIA.  We don’t have to talk Galveston 1900 or Carla 1961 to get there. The “Surprise Hurricane of 1943” might fit the bill.  Experts estimate this hurricane — advance information about which was suppressed due to the war — would have caused over $4 billion in damages as its winds slowed from less than105 miles per hour beating a nasty path from the Bolivar Peninsula up through the Houston Ship Channel.Damage from Surprise Hurricane of 1943

Until we introduce the complication of reinsurance — I warned you this was a long piece of background — the top of the stack is the $500 million more that TWIA has access to.  These are “Class 3 Securities” that TWIA may issue following a storm.  TWIA member insurers have to repay this tier of borrowings, which again presumably means the real cost will be borne in part by shareholders of these insurers but significantly by insureds throughout Texas from El Paso to Amarillo to Texarkana to Beaumont to Harlingen. This tier of coastal risk is almost 100% socialized. After this stack is exhausted, unless there is reinsurance, TWIA is out of money and, however much we might wish to the contrary, has no legal claim on the state or the federal government.

The Main Point

So, it’s now time to get back to reinsurance.  Under section 2210.075 of the Texas Insurance Code, TWIA can increase the amount of money it has available following a major storm (and lessen the amount it can stuff into its catastrophe fund) by purchasing reinsurance each hurricane season. It can do this quietly without legislative approval or guidance. The way reinsurance works, TWIA pays a premium to some reinsurer and, in turn, the reinsurer reimburses TWIA for certain losses that TWIA incurs.  So, for example, TWIA might have spent money so that if TWIA incurs more than, say, $2.7 billion in losses from a tropical cyclone, the reinsurer pays for certain losses above that amount.  Reinsurance thus could protect TWIA policyholders from some large losses.

But reinsurance comes in many flavors and the Texas Insurance Code does not tell TWIA what kind of reinsurance (if any) it should obtain.  A key factor that defines a reinsurance arrangement is the “attachment point.”  This is a generally stated as a dollar figure.  It’s where reinsurance inserts itself into the stack of resources available to TWIA.  If the insurer (TWIA) incurs losses that are less than the attachment point, the reinsurer pays nothing. If the losses are above the attachment point, the reinsurer pays until either all the insurer’s damages are paid off or the limits of the reinsurance policy are exhausted.  Whichever comes first. Thus, if TWIA’s reinsurance of, say, $600 million “attached” at $2.7 billion and TWIA had losses of, say, $2.6 billion in a given year, TWIA’s reinsurers would owe nothing.  TWIA policyholders would instead be paid out of the proceeds from TWIA’s catastrophe fund and the issuance of Class 1, 2 and 3 securities.

On the other hand, if TWIA had reinsurance of up to $600 million “attach” lower in the stack, at, say, $1.25 billion, the other layers of protection (Class 2 and 3) move up in the protection stack. TWIA losses would be paid first by TWIA’s catastrophe fund ($250 million), then by Class 1 securities ($1 billion), then by the $600 million in reinsurance, and then by $750 million in Class 2 securities.  The insurance industry would be spared having to repay Class 3 securities.  The diagram below recapitulates how these two attachment points affect the financial burden from hurricanes.

Diagram comparing two stacks of protection

Comparison of reinsurance attachment at $2.7 billion v. $1.25 billion

What I hope this makes clear is that the point at which reinsurance attaches distributes the cost of hurricanes among different groups.  High attachment points means that the folks ultimately responsible for Class 1, 2 and 3 securities (TWIA policyholders, Texas insurers, and coastal insureds) end up paying one way or the other for most serious tropical cyclones.  Lower attachment points tend to protect Texas insurers and coastal insureds from assessments and surcharges but do so substantially at the expense of TWIA policyholders. Thus, TWIA has the discretion under the law to decide whether it wants to place the interests of its policyholders first, the interests of the coast first, or the interests of Texas insurers first.  Not an easy choice.

But reinsurance attachment points are more important still.  This is so because the amount of reinsurance one can purchase depends heavily on the point at which reinsurance attaches.  And from a policyholder’s perspective –TWIA policyholders in Galveston, Brazoria and other heavily populated areas, take special note! — what matters is the overall height of the protection stack. Reinsurance purchased with a low attachment point buys a smaller layer (or costs more) than reinsurance purchased with a high attachment point.  You can buy more reinsurance when it has a higher attachment point because the most damaging sorts of hurricanes occur less frequently than hurricanes that cause intermediate damage.  Thus, if TWIA buys reinsurance with a lower attachment point, it provides less protection of TWIA policyholders and creates a greater risk of insolvency than when it buys reinsurance “at the top of the stack” with a higher attachment point.

To put matters as simply as possible, the higher the attachment point, the taller the stack. The taller the stack, the less TWIA policyholders (and their lenders!) in densely populated areas need worry.

To be sure, the precise relationship between the amount of reinsurance protection that can be purchased and the attachment point is a complex.  It’s tricky because the cost of reinsurance includes not just the expected losses the reinsurer faces (average loss) and some profit but also reflects the amount of money the reinsurer has to set aside to cover the worst cases.  Economically it’s almost as if there was a special tax on reinsurance purchases. Still, I believe it is reasonable to assume that the relationship looks something like the graphic below. The bottom line is that higher attachment points means significantly more reinsurance protection can be purchased for the same amount of money.

Graph showing reinsurance attachment point v. layer size

Graph showing reinsurance attachment point v. layer size

And what did TWIA do in 2011-12?  It did not purchase a reinsurance policy at “the top of the stack.”  Instead, without a lot of fanfare it purchased a policy with an intermediate $1.6 billion attachment point and got $636 million worth of protection. (I’ll have another post on why it may TWIA paid an awful lot for this policy).  TWIA thus decided, implicitly or explicitly, that saving Texas member insurers and non-TWIA coastal residents from the expense of having to pay back Class 2 and Class 3 securities was more important than providing TWIA policyholders with maximum protection.  In particular, it compromised the interests of its policyholders in the most densely populated counties: Galveston, Brazoria (and to a lesser extent Nueces and Harris) because they are the ones who could most use the extra protection high-attachment reinsurance could have purchased.

On the one hand, I understand this decision:  I have argued before that TWIA policyholders should bear most of the risk they accept by owning property or running a business on the coast.  Yes, the coast provides benefits to the rest of Texas, but, frankly so does Lubbock and so does El Paso.  But Lubbock and El Paso and most of the rest of Texas do not get to socialize their property risk onto the rest of Texas. I fully understand wanting to protect middle class Larry in Lubbock from having to subsidize insurance risk created by Gary in Galveston who owns a million dollar beach home there.

texas constitution section 3

On the other hand, I have doubts that this balancing of interests against each is one that TWIA should be undertaking.  I have doubts that coastal Brownsville in Cameron County is more important than coastal Galveston. And yet, the current scheme protects Brownsville well and Galveston less so. No one elected TWIA board members or technocrats to make this choice.  Fundamentally, then, the issue of reinsurance attachment strikes me not as a matter of “expertise” but as a matter for legislative judgment.

Balancing the interests of different parts of the coast against each other and balancing the interests of TWIA policyholders against Texas insurers and other coastal insurers is also an issue for the voters.  The voters should be able to decide through their election of representatives if they like the regime we have ended up with.  The current regime gives TWIA policyholders in sparsely populated Refugio, Kennedy and other more rural Texas counties far greater protection against hurricane risk.  There will never be a TWIA-busting $3 billion hurricane limited to Kleberg County because TWIA insures less than $500 million of property there. Moreover, partly because of the current reinsurance attachment point chosen by TWIA, the current regime insulates Texas insurers and non-TWIA coastal insureds from what would be a higher risk of assessments and surcharges. Many Texas voters might actually like that.

Subject to Texas and federal constitutional dictates about equal protection of the laws, the voters should also decide, however, through election of representatives whether they like the downside of the legal and financial regime that now exists.  The current statutory regime and its implementation should create massive insomnia among TWIA policyholders in Galveston and other densely populated counties every time their fate from a serious tropical cyclone depends on the vicissitudes of Gulf steering currents. And, while I would hate to emphasize the point, the inadequacy of coverage should make many current and future lenders in the densely populated counties anxious as well. Their collateral is at risk of being impaired following a major storm. Many voters might find it unacceptable that TWIA has gotten to choose low reinsurance attachment points that place the finances of Texas insurance companies above that of some TWIA policyholders.

It is probably too late to fix any of this for the 2012-13 hurricane season.  But tropical cyclones will not stop after this season is over.  There are plenty of storms ahead against which Texas can better and more transparently protect.

Note: I have attached here a PDF export of a Mathematica notebook exposing the calculations and diagrams underlying this post.

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.

It’s a Weibull

To understand the premiums charged by the Texas Windstorm Insurance Association and the current legal and financial issues being debated in Austin, you have to get your hands a little dirty with the actuarial science.  You need to have some ability to model the damages likely to be caused by a tropical cyclone on the Texas coast.  Now, to do this really well, it might be thought you need an awful lot of very fine data.  In fact, however, you can do a pretty good job of understanding TWIA’s perspective by just reverse engineering publicly available information.

What I want to show is that the perceived annual exposure to the Texas Windstorm Association can be really well modeled by something known in statistics as a Weibull Distribution. To be fancy, it’s a zero-censored three parameter Weibull Distribution: 

CensoredDistribution[{0, ∞},
 WeibullDistribution[0.418001, 1.26765*10^8, -4.81157*10^8]]

We can plot the results of this distribution against the predictions made by TWIA’ s two consultants: AIR and RMS. The x-axis of the graph are the annual losses to TWIA.  The y-axis of the graph is the probability that the losses will be less than or equal to the corresponding amount on the x-axis. As one can see, it is almost a perfect fit.  For statisticians, the “adjusted R Squared” value is 0.995. 



How did I find this function? Part of it is some intuition and some expertise about loss functions.  But a lot of it comes from running a “non-linear regression” on data in the public domain.  Here’s a chart (an “exceedance table”) provided by reinsurance broker Guy Carpenter to TWIA.  It shows the estimates of two consultants, AIR and RMS, about the losses likely to be suffered by TWIA.  Basically, you can use statistics software (I used Mathematica) to run a non-linear regression on this data and assume the underlying model is a censored Weibull distribution of some sort.  And, in less than a second, out pop the parameters to the Weibull distribution that best fit the data. As shown above it fits the AIR and RMS data points really well.  Moreover, it calculates the “AAL” (the mean annual loss to TWIA) pretty well too.



In some forthcoming posts, I’ m going to show what the importance of this finding is, but suffice it to say, it explains a lot about the current controversy and suggests some matters to be examined with care.