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.

 

Fixing TWIA for this hurricane season will require a two-thirds vote

Section 39 of Article III of the Texas Constitution reads as follows:

Sec. 39.  TIME OF TAKING EFFECT OF LAWS; EMERGENCIES; ENTRY ON JOURNAL. No law passed by the Legislature, except the general appropriation act, shall take effect or go into force until ninety days after the adjournment of the session at which it was enacted, unless the Legislature shall, by a vote of two-thirds of all the members elected to each House, otherwise direct; said vote to be taken by yeas and nays, and entered upon the journals.

 

This constitutional provision, which the legislature can not change, means that unless a windstorm bill is passed that is acceptable to two thirds of both houses, it will not take effect until about September 1, 2013, well into hurricane season.  And that means even if a bill is passed — but passed by less than the constitutionally required super-majority —  all that stands between the weather and a major problem in Texas between now and September could well be less than $1 billion.  If so, Texas runs the serious risk of an insolvent insurer that covers 62% of the exposure for real property — residences, businesses, government facilities — unable to pay claims.  Without making things too scary, it might not be able to pay even 50% of clams.

This means two things.

Thing 1) All sides of this debate need to have some flexibility and take very seriously their obligations as legislators.  If there is deadlock, or even if there is simply less than a super-majority in favor of one bill, legislators might consider lowering the stakes.  If you can’t get a really good bill — and I fear that is probably where we are right now — put something in place that people can be confident will not be etched in stone. I would suggest that either of the two alternative “minmalist, last-minute fixes” I proposed this month qualify. But there are alternatives that might also suffice.

Thing 2) If no bill passes or a bill passes without two-thirds support, we need to turn urgent attention to what is actually going on in TWIA.  It is attempting to obtain a pre-event “Bond Anticipation Note” so that they would at least have about $700 million with which to pay claims on their $70 billion plus of total exposure.  Without that, we are down to a Catastrophe Reserve Fund that stands at $180 million and possibly less in light of both continuing Ike litigation and some severe storms this past month. We also need to pay heightened attention to TWIA’s efforts to obtain reinsurance — and the terms of that reinsurance. The details matter here.  Where will the reinsurance attach?  Will it leave a gap?  Does the reinsurance cover one storm (occurrence) or does it permit “reinstatement” — an ability to cover multiple storms, although possibly for an additional premium.  And how much will an over-a-barrel TWIA have to pay to the reinsurance industry, which has historically charged prices of five times the expected value of risk assumed, under these circumstances?  Every dollar spent is one less dollar available for succeeding years.

So, high stakes in the days ahead. We’ll keep a watch out and I urge you to make sure your legislators understand the importance of the issues here both for the Texas coast and in the rest of the state.

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 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.

The destructive power of legislative fantasies

While fantasies may have their place in literature or otherwise, they are an unhealthy basis on which to premise legislative hearings. By distracting legislators from the real work that needs to be done before the end of session and providing false hope to constituents who need to take real action before the start of hurricane season, they are at least as destructive as any hurricane. That’s why the Corpus Christi Caller’s account this morning of yesterday’s meeting of the Texas Senate Committee on Business and Commerce should profoundly disturb residents of the Texas coast who depend on a viable windstorm insurance system. It should equally disturb those throughout the State of Texas whose fates are intertwined with their coastal friends. The meeting unfortunately perpetuates the absurdities of the meeting of the Texas Windstorm Insurance Association board that took place on Monday in which false villains were created and the very legislators who voted for the scheme that contributes to the current deplorable state of coastal windstorm insurance attempt through distraction to escape accountability.

Let’s identify the distracting fantasies.

Fantasy 1. TWIA can escape insolvency by assessing Texas insurers in 2013 for Hurricane Ike.

We’ve been through this before on this blog but let’s do it again now that we have an idea of the opposing arguments. The statute authorizing TWIA to assess insurers under former section 2210.058 of the insurance code was repealed in 2009 by section 44(2) of HB 4409. I’ll reprint that statute at the bottom of this post so you can see for yourself. Government can’t just take people or business’ property for the purpose of enriching others, no matter how worthy the cause, based on a repealed statute.  That’s called tyranny, and it is a violation of, among other things, the same Fifth Amendment protections that prevents the state from taking your house away to pay for worthy state expenditures and the same section 17 of the Bill of Rights contained in the Texas Constitution in which our state’s belief in those same principles is enshrined.

Until Monday, I had not heard a single argument opposed to the proposition that section 2210.058 no longer justified assessments against insurers. And, until I heard the contrary arguments, I was not prepared to say with 100 percent certainty that I was correct. But in light of a letter from several state representatives submitted to the TWIA board and made public Monday and in light of Representative Eiland’s reported comments at the hearing yesterday, we now appear to know the arguments of those who would contradict this apparently evident proposition. All I can say is, “that’s your best shot?” Here’s what they are apparently saying. If there are other arguments that I am missing, bring them on.

Argument 1: The potential to assess insurers is an “obligation, or liability previously acquired, accrued, accorded, or incurred under [a repealed statute] and is thus saved from repeal by section 311.031 of the Texas Government Code.” This argument misunderstands the nature of an obligation and a liability. An obligation or liability refers to something already existing.  Thus, if State Farm did not pay an assessment already imposed prior to the repeal, HB 4409 did not eliminate the already existing powers to force State Farm to pay. But at the time when the repeal took effect, there was no “obligation,” there was no “liability” to pay an assessment based on Hurricane Ike beyond the $430 million the TWIA board did assess in 2008. The fact that TWIA might have made an assessment is no more an “obligation” or a “liability” than a tax that the legislature might have but did not impose or a penalty that a court might have but did not impose.

Argument 2: There is some sort of contractual right on the part of 2008 policyholders to an assessment. I teach contracts and I like creative arguments.  But there is no such contractual right.  I’ve looked at TWIA contracts and there is absolutely nothing in those contracts creating a right to an assessment. Zero. Would a Texas legislator please show the public a TWIA contract containing a right to an assessment.

It is particularly galling, I might add, to contend, as Representative Eiland apparently did at the hearing yesterday, that TWIA policyholders deserve such a right (even if they don’t actually have one?) because of the premium they paid. In fact, precisely because of actions by legislators such as Craig Eiland,TWIA policyholders were not asked to pay a premium that would permit their insurer to be capitalized adequately and that might have provided better protection against hurricanes such as Ike. Instead, those legislators forced TWIA policyholders to become dependent on the TWIA board — a politically constituted body significantly chosen from the insurance industry — exercising their discretion to assess Texas insurers adequately in the event of a major storm.

Now, it may (or may not) be that the TWIA board breached some sort of duty to policyholders by failing to assess. A letter sent by coastal legislators earlier this week contains a disturbing account of board inaction. Unfortunately, however, the choice not to include a right to an assessment in the contract takes the matter out of contract claims against TWIA itself and put it into the murky area of fiduciary duty claims against TWIA board members. And, with fiduciary duty rather than contract providing the source of rights, the remedies become far more limited. Yes, you can sue a board member for breach of fiduciary duty, but section 2210.106 of the Insurance Code promised those board members immunity from suit unless one can show bad faith, intentional misconduct, or gross negligence.  And even if you get over this qualified immunity hurdle, I doubt there are too many board members who have $400 million lying around, the additional amount that TWIA officials recommended be assessed to pay for Ike.

Fantasy 2. Going into receivership would make it harder for TWIA to borrow money either before a hurricane or after a hurricane.

A lot of people at the TWIA board meeting Monday testified about the terrible problems that would be created if TWIA were thrown into receivership: sending the wrong signals, threatening continued development, threatening mortgage covenants, and threatening  the Texas economy (even national security) by challenging energy production on the Eagle Ford Shale. Unfortunately, these people have confused treatment with either symptoms or disease.  It is fine to be angry about cancer, but anger at being treated for cancer after a positive test comes back is misplaced indeed. And it’s insolvency here that is causing the problems and that is going to cause more problems. Receivership is a treatment for the disease of insolvency (here a disease caused by a combination of legislative dysfunction, human greed and fallibility, and a Category 2 hurricane that hit in a particularly vulnerable spot). In fact, although perhaps the matter could be deferred for a week or two to get plans in order, receivership makes a lot of sense. It would likely, as Representative Taylor appears to recognize, actually help most TWIA policyholders.

Here’s why.

Reason 1: Without receivership, there will be even less money available to pay claims for any hurricanes that hit this season. TWIA is being picked apart by claims for Hurricane Ike that are still pending.  Projections are that, even if no serious hurricane hits, TWIA will have even less money by the time the year ends. Thus, if Tropical Storm Barry or Hurricane Rebekah hits this season, there is going to be even less money around to pay the new claimants.  This is particularly true, if, as many fear, the recapitalization structure envisioned by the current Texas Insurance Code, is not going to work and if one of the bills pending in the legislature continues not to address issues for 2013. Those whose houses are decimated this summer by a storm are very much going to wish that someone through TWIA into receivership this spring so that 2008 policyholders and 2013 policyholders were treated more equally. So equity among TWIA claimants is one good reason for a receivership.

Reason 2: The recapitalization structure envisioned by the current Insurance Code may well  be more likely to work with a receivership than without one. Someone who lends money to TWIA now has to be concerned that their claims will be paid out of the same pot as Ike claimants or other TWIA creditors. Given TWIA’s insolvency, that is worrying. It’s likely to cause lenders to demand a particularly high rate of interest if they are willing to lend at all.  Although I am not certain of this, if Texas receivership is like federal bankruptcy, post-receivership financing even in a rehabilitation case can be separated out and given a higher priority that other claims.  That appears to be true in Texas insurance liquidation (section 443.154(j)) and I would be surprised if it were not true in a rehabilitation as well. Now, if the rehabilitation failed, such a refinancing might hurt existing (Ike) claimants of TWIA, and one can see how they might oppose a cavalier refinance on that basis, but if one wants to give TWIA some hope or making it through another hurricane season, giving new lenders some additional protection makes a lot of sense.  I don’t see how that can be done absent a receivership.

Reason 3: The parade of horribles brought forth by representatives of the coast at the hearing Monday was mostly about the problems created by insolvency, not by receivership.  Mortgage companies who have imposed covenants to maintain insurance on their borrowers don’t care as much about whether the insurer is in receivership as whether that insurer has enough money to pay claims that threaten their collateral. And, yes, workers in the Eagle Ford Shale and elsewhere will be hurt if their windstorm insurance premiums go up and their corporate employers don’t respond with higher wages, but what happens to premiums is not particularly dependent on a receivership.  It is dependent on an understanding of why TWIA went insolvent and the proposals pending in Austin to reform TWIA.

At best, the argument against receivership is thatTWIA, a so-called “residual market” carrier, was not really “insolvent” in the same way a private insurer would be if its liabilities exceeded its assets. That’s because, this point proceeds, TWIA has a statutory right to recapitalize through assessment and surcharge that other insurers do not following a major disaster.  So, it is true that, at least for a while TWIA will be able to pay its bills. But inability to pay bills is not and should not be the only basis to justify a receivership.  Another reason is equal treatment of claimants.  The recapitalization mechanism was never very solid and is now so dubious that there is a serious question whether TWIA can treat current policyholders fairly.

Fantasy 3: Resolutions of the receivership issue and assessment issue are very important.

Receivership is an issue, but it is not the main issue. It will just determine at the margin how current and future TWIA claimants get paid and may have some effect on solvency this summer.  Even an assessment of another $400 million or $500 million to fully pay for Ike, though it would help current TWIA claimants, will do little to fix the most fundamental problems with that entity, which include its perpetual undercapitalization and the instability and unfairness of its funding mechanisms. Even with an assessment and with or without a receivership, the current law means that TWIA is running a very substantial risk of going insolvent this year from another serious storm. Or, in plain English, if you own property on the coast and it is hit by a tropical cyclone this summer, there is a troubling chance TWIA will not actually be able to pay what it owes you and you may have trouble rebuilding.

The main issue is how to address windstorm insurance on the coast both for the coming hurricane season and thereafter. There are two serious proposals before the legislature. One basically proposes depopulating TWIA and moving toward a market-based system backstopped by an assigned risk plan for those areas in which the market fails to provide insurance close to some affordability threshhold. Under this system, although people across Texas very definitely help, coastal policyholders bare most the burden of the risk posed to their property. Coastal propertyholders get the benefits of owning real estate near the Texas coast, but they also pay for it. The second proposal continues to force people — poor people and rich people alike, Amarillo residents, El Paso residents and Nacogdoches residents — to subsidize risk along the coast even more than has been done before. While this system at least reduces the risk of a hurricane leaving insureds with claims only against an insolvent insurer, it sends bad signals to the development market and, gallingly, frequently transfers money from the poor to the wealthy. I have my own views on how that debate should come out but respect the view of others.  I just wish it was that debate that was preoccupying the Texas legislature and not a judicial remedy for addressing the existing insolvency.

Here’s what Representative Craig Eiland reportedly said yesterday:

“I see no way you could ever say that’s there no assessment authority with TWIA based on the contractual rights the 2008 policyholders have for the premium they paid for the coverage they purchased,” he said. “Why are we dancing around the question? If we go into receivership the judge is going to assess the companies and have an answer. Why are we not trying to have an answer? Before you make the decision that we cannot assess, how about go assess and find out the final answer.”

 

Text of section 44 of HB 4409 (found here)

 SECTION 44.  The following laws are repealed:
             (1)  Subdivisions (5) and (12), Section 2210.003,
Insurance Code;
             (2)  Sections 2210.058 and 2210.059, Insurance Code;
             (3)  Sections 2210.205 and 2210.206, Insurance Code;
             (4)  Sections 2210.356, 2210.360, and 2210.363,
Insurance Code; and
             (6)  Subchapter G, Chapter 2210, Insurance Code.

Craig Eiland: TWIA can still assess for Ike

According to ABC-13, State Representative Craig Eiland of Galveston also thinks I’m wrong about whether TWIA can still assess insurers for damages caused by Hurricane Ike in 2008.  I’ve stated here and here in this blog that the repeal of section 2210.058 of the Texas Insurance Code in 2009 certainly seems to have ended that authority.  But Rep. Eiland states: “The board can reassess the companies now — today, tomorrow, next week — for the money and premiums they paid out in claims since Hurricane Ike.” TV stations don’t usually include footnotes, so I’m genuinely curious about what Rep. Eiland’s legal authority is for his assertion.

I’m also curious to see what would happen if TWIA followed Representative Eiland’s assertion and actually tried to reassess insurers around the state to pay for persistent Ike claims.  My guess is that it would not provide cash in time for the 2013 hurricane season. I suspect that many Texas insurers would file a lawsuit before they wrote a check.

A second look at S.B. 18

 

In a post yesterday, I provided some preliminary analysis of S.B. 18, a bill filed by Texas State Senator John Carona that would completely overhaul the system by which most coastal Texans transfer the risk of windstorm.  Basically, the Texas Windstorm Insurance Association (TWIA) is phased out by 2015 as an insurer of residential coastal property and replaced with an assigned risk plan, the Texas Property Insurance Program (TPIP) that will ultimately charge “market” rates and will be administered by a Managing General Agent. In the interim, TWIA finances are shored up with statewide insurance surcharges to build up the catastrophe reserve fund, potential assessments on insurers of $2 billion in the event of a storm, and actual assessments on insurers of whatever it takes to to purchase $2 billion of reinsurance. (Insurers mostly recoup any storm assessments with premium tax credits but do not recoup reinsurance assessments).  Many TWIA policyholders are somewhat protected for a few years by a requirement that TPIP market rates be phased in, with the public effectively paying for the continued subsidization via likely insurer pass throughs and further premium tax credits.

 

The first page of S.B. 18

The first page of S.B. 18

I did a second read this morning and found several matters on which I had not previously focused.  I suspect I and others will find more in the days ahead or find areas in which these findings need clarification or correction.

  1. This particular bill does not appear to touch TWIA’s ability to sell policies that cover property other than residences (either owned or tenanted). Thus, unless I am missing something or there is a companion bill ahead, it appears TWIA will persist as an insurer that offers coastal businesses and government windstorm coverage for commercial structures. and public buildings. Currently, since “non-dwellings” comprise just 1/6 of TWIA’s exposure, such a reduction in the exposure of TWIA would likely make a buttressed catastrophe reserve fund, $2 billion in potential storm assessments, and $2 billion in reinsurance fully adequate to pay the remaining TWIA policyholders even in the worst cases — a welcome change from the status quo. The mandatory migration described in sections 2210.212 and 2210.213 speaks in terms of “residential structures” and “dwellings.” The provisions governing liability limits and deductibles in section 2210.507 likewise speak about residential properties.
  2. The bill does away with the system of post-event bonding that exists under the current law and whose functionality has been called into serious question.  Section 3 of the bill amends section 2210.056 to eliminate the ability of TWIA to use its assets to pay obligations incurred under Subchapter B-1, which is where the authority to actually repay bonds appears. Various other provisions of the bill likewise delete references to the post-event bonding program.
  3. Even during the transition period, TWIA will not be adjusting as many claims on future storms as it is currently required to do. Instead of keeping TWIA on perpetual standby for large scale adjusting requirements following a storm, the bill piggybacks on the claims adjusting stables of the major insurers and requires them to adjust claims on TWIA losses after June 1, 2013 acting as agents for TWIA. (Section 2210.5725).  If a private insurer covers a coastal homeowner for fire but a hurricane damages that homeowner’s residence, it appears as if the private insurer must adjust the claim unless — and I believe this would be quite unusual — that particular insurer provides windstorm coverage on 90% or more of the policies it writes on the coast. Otherwise, I assume TWIA continues to adjust the claim.
  4. It is not clear to me if and how the private insurers get paid for undertaking this expensive obligation or whether this is going to be just a cost of writing conventional property insurance along the coast.  If the latter, be prepared for attempts at rate increases by the private insurers or reduced willingness to sell even conventional policies in that area. I suppose insurers could also recoup these costs if they offered windstorm coverage in addition to conventional coverage.
  5. One upside for undertaking claims adjustment on behalf of TWIA is that, under the Carona bill, private insurers doing so will gain the protections of existing section 2210.014 of the Insurance Code, which protects TWIA from lawsuits brought by policyholders (or other private entities) under the unfair trade practices provision of Chapter 541 of the Insurance Code, which provides for treble damages, and Chapter 542 of the Insurance Code, which imposes penalty interest of 18% for statutorily described delays in claims adjusting. Private insurers adjusting claims on behalf of TWIA also gain the protections of existing section 2210.572 of the Insurance Code, which provides more favorable to them than the otherwise existing substantive and procedural rules in Texas for breach of contract and bad faith claims against an insurer.  Presumably, although it is not clearly stated in the draft Carona bill, they also gain the protections of the rest of Subchapter L-1 of the Insurance Code to which section 2210.572 makes reference. For an earlier discussion of this point, look here.
  6. The Managing General Agent, who basically runs the new insurance program, is neither elected nor appointed in the traditional sense.  Rather the MGA is awarded a contract to run the new TPIP for a period of up to five years. Section 2214.151. There is not much detail in the Carona bill on how the award of this contract is to be made.

 

Study shows Coastal Taskforce Plan requires more than 50% subsidization

The Coastal Taskforce Plan recently endorsed by several coastal politicians would require people other than TWIA policyholders massively to subsidize TWIA — perhaps paying more than 60% of expected losses from tropical cyclones. That is the result of a study I have conducted using hurricane modeling software. As shown in the pie chart below, the study shows that only about 38% of the payouts come from TWIA premiums. The rest comes 26% from Texas insurers, 21% from policyholders of all sorts in 13 coastal counties and Harris County, 8% from insureds located throughout Texas and 7% from the State of Texas itself. These figures are based on running a 10,000 year storm simulation based on data created by leading hurricane modeler AIR and obtained through a public records request.  The figures are also based on my best understanding of the way in which the Coastal Taskforce plan would operate, although certain aspects of the plan remain unclear and additional clarification would help.

Expected Distribution of Sources for TWIA Payouts Due to Losses from Tropical Cyclones

Expected Distribution of Sources for TWIA Payouts Due to Losses from Tropical Cyclones (Sharing)

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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.