An interactive hurricane damage model for Texas

For most people, hurricane modeling is kind of a black box. Various experts set forth figures on the distribution of losses or statistics derived from those distributions. You pretty much have to take their word on it. I think policy discussions are better when the data is more transparent. So, a few weeks ago I sent a public information request to the Texas Windstorm Insurance Association asking for the raw data that they used to model hurricane losses. TWIA cooperated and send back about 30 megabytes worth of data.

So, I’m now able to create an interactive tool that lets you model the losses suffered by the Texas Windstorm Insurance Association from tropical storms. To run the tool, you will need to get the free CDF plug in from Wolfram Research. Once you have the plugin, you can run any CDF file. CDF is basically like PDF except that it permits interaction.

[WolframCDF source=”http://catrisk.net/wp-content/uploads/2012/12/analyzing-air-2011-data-for-catrisk.cdf” CDFwidth=”630″ CDFheight=”790″ altimage=”http://catrisk.net/wp-content/uploads/2012/12/air-data-static.png”]

Once you have the tool, you can do many things.

You can use the landfall county control to choose a county in which the storm first makes landfall. Notice that some of the counties are outside Texas because storms may first make landfall in, say, Louisiana but then go on to go over Texas and do damage here.

You can restrict the storms under consideration to various strength levels. I’m not sure, honestly, how AIR classifies tropical storms that don’t make hurricane strength. Perhaps they list them as Category 1. Or perhaps — and this would result in an underestimate of damage — they don’t list them at all.
You can also limit yourself to major hurricanes (category 3 or higher) or non-major hurricanes (categories 1 and 2).

You then get some fine control over the method of binning used by the histogram. If you’re not an expert in this area, I’d leave these two controls alone. In the alternative, play with them and I think you will get a feel for what they do. Or you can check out documentation on the Mathematica Histogram command here.

You then decide whether you want the vertical scale to be logarithmic or not. If some of the bin heights are very small, this control helps you see them. If you don’t remember what a logarithm is, you might leave this control alone.

Finally, you choose what kind of a histogram you want to see. Common choices might be a Count or an Exceedance Curve (Survival Function).

The tool then produces the histogram you have requested and generates a number of useful statistics. Here’s a guide to the six rows of data.

Row 1: This is the mean loss from storms meeting your selection criteria.
Row 2: This is the mean annual losses from the types of storms you have selected. This number will be lower than the mean storm loss because Texas (and all of its subdivisions) average less than one storm per year. Many years there are no storms.
Row 3: This is the worst loss from 100 storms. Note again, this is NOT the mean loss in 100 years. Some years have no storms; occasionally some years feature multiple storms.
Row 4: The AIR method for generating storms can be well approximated by a Poisson distribution. Here, we find the member of the Poisson family that best fits the annual frequency data for the selected storms.
Row 5: The AIR method for generating storms can be decently approximated most of the time by a LogNormal distribution. Here, we find the member of the LogNormal family that best fits the loss data for the selected storms.
Row 6: I can create a new distribution that is the product of a draw from the Poisson distribution and the LogNormal distribution. I can then take 10,000 draws from this distribution and find the size of the annual loss that is higher than 99% of all the annual losses. This lets me approximate the 1 in 100 year loss. Notice that this number will move around a bit every time you tinker with the controls. That’s because it is using an approximation method based on random draws. Every time you change a control, new random draws occur. Still, it gives you a feel for that dreaded 1 in 100 year annual loss.

If people have additional features they want added to this tool, please let me know. I may be able to modify it or build a new tool with related capabilities.

Ten fixes for TWIA: What I’m planning to say in Austin this week

I’ve been invited by the Governor’s office to testify this Wednesday in Austin before the The Joint Interim Committee to Study Seacoast Territory Insurance. Thoughtfully, they scheduled the hearing for a day I don’t teach class. Here’s what I’m planning on saying (along with the written supplementation).  By the way, if any readers have constructive suggestions on changes, please send them to me at chandler.seth@gmail.com.  And if anyone wants to attend the hearing, it’s in room E1.016 in the Capitol Extension at 10:30 a.m.

Hello, my name is Seth J. Chandler. I’m a professor of law at the University of Houston Law Center and Director of its Program on Law and Computation. I have studied the current Texas Windstorm Insurance Association funding mechanisms in depth for over five years, outlined Texas windstorm insurance issues in various op-eds and have my own blog on the topic before you, catrisk.net. The views here are my own.

Continuing with the current system of windstorm finance or merely tweaking it engineers a disaster waiting to happen. The 15% or so risk of TWIA insolvency over a ten year period, should leave every Texas legislator sleepless. The 50% risk over that time-frame that TWIA will need to resort to untested post-event bondings and surcharges or assessments is likewise disturbing. Endless reliance on costly reinsurance effectively traps TWIA in a cycle of inadequate capitalization.

But to leap from those woes to a new large government bureaucracy that socializes and further politicizes large segments of the insurance business is premature at best. The key idea now being floated surcharges all property and casualty policies in Texas (including auto, homeowner, business liability) some percentage of the premium to cover claims generated by a catastrophe. I don’t have details yet, but such a triggering catastrophe would likely be defined by insured claims from some single occurrence exceeding some amount. Now, if this scheme were consistent with the rest of the Texas insurance code, which permits geographic rating where actuarially justified, it might have some virtue as a risk diversification mechanism. But the key part of the proposal I have seen throws actuarial justification out the window. It insists that the surcharge rate should not depend — not even within some bounds — on the location of the property or the insured. So, even though insureds in Laredo or Huntsville or Garland might have a risk of making a defined catastrophe claim with only 1/10 an expected value as frequently as those in Galveston or Corpus Christi or Beaumont, all of them would be charged alike.

As many wiser than I have noted, “there is no greater inequality than the equal treatment of unequals.” Why is it just to permit high-risk and wealthy property owners in one part of Texas to get subsidized insurance paid for by low-risk and less wealthy property owners in other parts of the state? But, unfairness aside, there are problems with the proposal. Such a scheme enlists government to divert private resources to the riskiest parts of the state and thereby exacerbates future catastrophe losses. It will, unless there is, as I fear, an “individual mandate,” result in lower take-up rates in catastrophe-sparse regions than in catastrophe prone ones, which will further drive up surcharges and threaten a death spiral. And who here can contemplate the bureaucracy necessary to define occurrences and catastrophes, to determine when payments should be made from the state cat pool rather than conventional markets, to fund and monitor funding of a state-wide cat pool, and to prohibit insurers selling in catastrophe-sparse areas from undercutting the pool price?

So, before we kill TWIA and transition into the unknown perils of more government regulation and bureaucracy, I suggest we test more thoroughly whether and how the private insurance market will perform when the seacoast playing field is leveled. I do not share the article of faith among some that the private market will never work there. I say that faith has not been tested for decades because the playing field has been badly tilted. TWIA charges rates that protect against only a portion of the risk posed by its policyholders whereas we insist that private insurers charge rates sufficient to cover the entire risk. I would love to see Allstate come in to Commissioner Kitzman’s office and ask to continue selling policies in Texas when the odds of it failing over the next 10 years were acknowledged to be 15%. TWIA now gets special protection from lawsuits for improper claims handling. TWIA doesn’t do what I think most sensible insurers would do when we know that stronger building practices significantly reduce expected losses: charge modest coinsurance, particularly for claims in excess of actual cash value, but possibly waive coinsurance upon proof of extraordinary effort. Finally TWIA fails to do what we would require of private insurers: prominently disclose to policyholders the special insolvency, assessment and surcharge risks posed by its current funding structure.

Basically, I want Texas to transition to a market for windstorm insurance on the coast that is only different insofar as truly necessary from the market for property insurance generally. I want an expanded but monitored private market, with a level playing field and greater information to seacoast policyholders. The key to the proposal is a downwards shift in the absolute magnitude of risks faced by TWIA and a program that builds reserves within a smaller TWIA. Such a move will reduce the risk of post-event financing or the disaster of insolvency. The idea is to do so, however, in a way that protects basic insurance for coastal insureds, including those in the densely populated counties, and not to leave them in the lurch in the event, even with a level playing field, private insurance still will not do business on our coast. To those ends I have attached to my written testimony ten immediately doable and specific proposals that I believe you should study as part of your work plan.

Four of those specifics here. Lower the TWIA maximum policy limits so long as excess insurers come in to fill the void, which I believe they will if given underwriting freedom. Insist that TWIA not sell policies without at least modest coinsurance. Require policy premiums that, over a ten year period, build TWIA reserves to a level where it would take more than a 1 in 100 year storm to deplete them. Increase Class 3 assessments so that they would cover up to a 1 in 500 year storm.

Thank you for listening. Please read my expanded testimony involving all ten ideas and bookmark my blog, catrisk.net.

Ten Specific Proposals

  1. Reduce over a period of two years the maximum applicable policy limit for TWIA policies on residences. That limit should be reduced to $1 million for policies issued or renewed after May 31, 2013 and, subject to the certification described below, $500,000 (or the Federal Flood Limit, whichever is lower) for policies issued or renewed after May 31, 2014. The latter ceiling shall be in effect each year if and only if the Texas Department of Insurance certifies after an appropriate hearing that excess insurance was generally available at actuarially sound rates in the territory covered by TWIA during the preceding policy year for amounts in excess of the TWIA policy limits for the preceding year. Otherwise the maximum policy limit should revert to $1 million. Take proportional measures for non-residential properties.
  2. Prohibit TWIA from issuing or renewing policies after May 31, 2013, unless those policies contain, in addition to a deductible, a coinsurance requirement of not less than 5% on claims payments up to actual cash value and not less than 10% on payments in excess of actual cash value, provided that TWIA shall have discretion to waive such coinsurance where the property owner provides evidence that its insured property meets the strictest building codes adopted by any state for coastal property.
  3. Prohibit TWIA from entering into reinsurance arrangements in which the actuarial value of the risk transferred to the gross reinsurance premium is less than 20%. This computation should be made by TWIA actuaries using the best available historical evidence and contemporary models.
  4. Maximally protect TWIA policyholders by prohibiting TWIA from entering into reinsurance arrangements for each catastrophe year with an attachment point lower than the sum of (a) its projected catastrophe reserve fund, and (b) the amount TWIA believes it can raise using Class 1 Securities, Class 2 Securities and Class 3 Securities.
  5. Subject TWIA to the same geographic rating restrictions that other Texas insurers face pursuant to Chapter 544.002 of the Texas insurance code and clarify that it is equally protected by Chapter 544.053.
  6. Subject TWIA to the same provisions regarding suit, statute of limitations, and extra-contractual damages as other insurers doing business in the seacoast territory. This could be done either by eliminating TWIA’s current preferences or by according insurers selling primary or excess insurance in the seacoast territory the same preferences as TWIA, provided their policy form is substantially similar to that used by TWIA.
  7. Set premiums and adjust the catastrophe reserve fund in accord with the concepts set forth in “An Idea for TWIA Finance” (http://catrisk.net/?p=126), which basically calls for a reserve trajectory that hits 1 in 100 year adequacy within a ten year adjustment period. Factor in all the reforms set forth here (or otherwise enacted) in making this computation.
  8. Upon a certification from the Texas Department of Insurance at the start of each catastrophe year and based on the best available historical evidence and contemporary models, adjust the maximum amount of Class 3 securities that can be sold (and, correlatively, the maximum assessments on insurers) such that, after consideration of the catastrophe reserve fund, Class 1 securities, Class 2 securities Class 3 securities and any reinsurance or similar sources, the estimated risk of TWIA lacking funds to fully pay claims in the following catastrophe year is less than 1 in 500.
  9. To the extent of any inability to accomplish #8, and insofar as feasible, require TWIA to adjust premiums, based the best available historical evidence and contemporary models to take into account the probability, based on the geographic location(s) of the property insured, that TWIA would be unable pay claims fully during the following catastrophe year.
  10. Require prominent disclosure to TWIA policyholders created by the financing structure in place (as modified by the reforms suggested here or otherwise enacted). This disclosure should, at a minimum, advise policyholders of the approximate probability, computed using the best historical data and contemporary models, of the risk that TWIA will become insolvent, will be impelled to increase premiums to pay off Class 1 securities and will be impelled to impose surcharges to pay off Class 2 securities. Disclosure should be made (a) on a document signed by applicants for TWIA policies (new or renewal); (b) stamped (similar to surplus lines stamping) on policies issued by TWIA; and (c) on a web site one or fewer clicks from the main TWIA page.

An idea for future TWIA finance

Although they may thoroughly disagree on the direction in which reform should go, almost everyone agrees has come to agree with what I predicted in 2009:  TWIA finances are in serious need of reform.  This blog entry sketches out one direction in which TWIA might proceed.  The idea here is that TWIA should, in a steady state, have enough cash on hand in its catastrophe reserve fund to pay for insured losses and operating expenses, without having to borrow, with a high probability, say 99%.  Further TWIA should have borrowing capacity to address the rare situations (say 1% of years) in which its reserves would be inadequate. Those borrowings should be repaid by some percentage of TWIA policyholders, persons living on the coast, and Texans generally, perhaps collected through the proxy of insurers doing business in Texas.

Although people can quarrel about the precise parameters in this abstract statement of the goal, I have some hope that people could agree on the concept. Government-sponsored insurance companies that don’t have the right to draw on the government fisc, ought not to be relying heavily on post-event bonding as a way of paying claims; instead they need enough money in their piggy bank just as we require of their private insurer counterparts. But what if TWIA’s catastrophe reserve fund does not meet this lofty goal?  What then?  Especially given the magnitude of the current reserve shortfall and the current economy, matters can not be corrected overnight. There should, I say, be an adjustment period during which premiums are adjusted (either upwards or, at some hypothetical future time, downwards) such that, at the end of the adjustment period, things come into balance and the catastrophe reserve fund meets the goal.

How do we operationalize this idea? Here is the beginning of a statutory draft. I’ve put in dummy statute section numbers for ease of reference. Obviously, the real section numbers would have to be revised by legislative counsel. Also, we’re probably going to have to develop a more comprehensive process for 2210.355A(b)(1) and reconcile this provision with the alternative process currently set form in 2210.355A.

2210.355A

(a) Definitions

(1)  The “Exceedance Function for the catastrophe year” is a function that approximates the probability that insured lossses and operating expenses in the catastrophe year will exceed a specified dollar amount. Insured losses shall be computed on a net basis after consideration of any reinsurance or other sources of recovery.

(2) The term “Loss PDF” means the probability distribution function mathematically associated with the Exceedance Function.

(3) The term “Century Storm Reserve Adequacy” means having a catastrophe reserve fund at the start of each catastrophe year such that this fund would be able, without additional borrowing, to fully pay insured losses and operating expenses in the following catastrophe year with a 99% probability as computed using the Exceedance Function for the catastrophe year.

(4) The term “Reserve Adjustment Period” means ten years.

(b)

(1) The Association shall, prior to the start of each catastrophe year, use the best historical and scientific modeling evidence with considerations of standards in the business of catastrophe insurance, to determine the Exceedance Function and associated Loss PDF for the catastrophe year.”

(2) If, at any time, the Association finds that its catastrophe reserve fund at the start of a catastrophe year does not achieve Century Storm Reserve Adequacy,  the Association shall adjust the premiums to be charged in the following year either downwards of upwards as appropriate such that, were:


(A) such premiums to be charged for the Reserve Adjustment Period on the base of currently insured properties;

(B) insured losses and operating expenses of the Association to be for the Reserve Adjustment Period at the mean of the Loss PDF for the catastrophe year; and

(C) the Association were to earn on any reserve balances during the Reserve Adjustment Period the amount of interest for reasonably safe investments then available to the Association,

the catastrophe reserve fund at the end of Reserve Adjustment Period would achieve Century Storm Reserve Adequacy.

(c) By way of illustration, if the Exceedance Function takes on a value of 0.01 when the size of insured losses and operating expenses is a equal to 440 million dollars and the mean of the Loss PDF for the catastrophe year is equal to 223 million, the initial balance of the catastrophe reserve fund is 100 million dollars and the amount of interest for safe investments then available to the Association is equal to 2% compounded continuously, then the premiums charged for the following calendar year should be equal to $614,539,421.

And what happens, by the way, if a storm hits that exceeds the size of the catastrophe reserve fund?  Stay tuned.  I’ve got an idea there too.

How do we keep premiums low under this scheme?  Likewise, stay tuned.  Hint: think about coinsurance requirements and lower maximum policy limits.  Think about carrots to get the private insurance industry writing excess policies on the coast with ever lower attachment points.

  • Footnote for math nerds only. Anyone seeing the implicit differential equations in the model and the applications of control theory?
  • Footnote for Mathematica folks only. Here’s the program to compute the premium. Note the use of polymorphic functions.

p[\[Omega]_, \[Mu]_, q_, c_, r_, z_] :=
x /. First@
Solve[Quantile[\[Omega], q] ==
TimeValue[c, EffectiveInterest[r, 0], z] +
TimeValue[Annuity[x – \[Mu], z], EffectiveInterest[r, 0], z],
x];
p[\[Omega]_, q_, c_, r_, z_] :=
With[{m = NExpectation[x, x \[Distributed] \[Omega]]},
p[\[Omega], \[Mu], q, c, r, z]]

  • Footnote for statutory drafters. Note the use of modular drafting such that one can change various parameters in the scheme (such as the 10 year adjustment period) without having to redraft the whole statute.

The source of TWIA’s $800 million in cash on hand

In a previous post, I indicated that TWIA thought it would have $800 million in cash immediately available to pay claims. I was a bit skeptical of this number. But, an article in today’s Insurance Journal, a reputable trade publication, details that the money would come $300 million (0.3 billion) from real cash on hand and $500 million (0.5 billion) from a “bond anticipation note.” The latter is basically bridge financing that one can obtain quickly. The BAN would be repaid, one assumes, from Class 1 securities that TWIA would issue shortly thereafter.

Now, here’s the rub. According to the Insurance Journal article (which may not be fully reflecting what was said on this point), Commissioner Eleanor Kitzman believes that, with this BAN, TWIA would have $4 billion available to pay claims. Here’s the math. $4.15 billion = $0.3 billion real cash on hand + $0.5 billion BAN + $1 billion Class 1 + $1 billion Class 2 + $0.5 billion Class 3 + $0.85 billion reinsurance. If that’s what Commissioner Kitzman said, I have concerns because it looks like the math rests on double counting. $0.5 billion of the Class 1 securities couldn’t be used to pay claimants because it would have to be used to pay off the BAN. I am pretty confident that the BAN investors wouldn’t lend the money otherwise. Plus, according to other statements made at the last TWIA board meeting, it appears that TWIA might not be able to issue successfully the full $1 billion of Class 1 securities authorized. Readers of this blog will understand why that might be. And if all this is true, TWIA doesn’t have $4.15 billion, it has $3.15 billion. Here’s why.

$3.15 billion = $0.3 billion real cash on hand + $0.5 billion BAN + $0.5 billion Class 1 – $0.5 billion used to pay off BAN + $1 billion Class 2 + $0.5 billion Class 3 + $0.85 billion (hopefully collectible) reinsurance.

I hope we never have to figure out whether the difference in accounting is material or not. In the mean time, though, it might be prudent for TWIA and TDI to clarify the numbers.

Note: since the time of this blog entry I have had some private communications that lead me to believe the “best” number — and no one knows for sure — is probably between $3.15 and $3.65 billion.  It depends in part on how much in Class 1 securities can actually be sold.

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.

The Op Ed on TWIA run by the Austin American Statesman

This op ed was run by the Austin American Statesman on July 10.  I am reprinting it here.

Leaving denser coastal counties out to dry if major windstorms strike

Seth J.Chandler, Special Contributor

Published: 7:11 p.m. Tuesday, July 10, 2012

 

The biggest windstorm in Texas so far this summer has been generated not by the warm waters of the tropics but by the courage of Texas Insurance Commissioner Eleanor Kitzman.

In June, Kitzman responded to a request from state Rep. John Smithee, R-Amarillo, by stating that the Texas Windstorm Insurance Association would be unable to pay claims fully if some Category 4 or higher hurricanes hit.

The state-created operation provides insurance against tropical storms and hurricanes on $72 billion worth of property owned by 259,000 people living on the Texas coast.

Kitzman further said the law did not require the State of Texas to rescue either an insolvent TWIA or Texas homeowners and businesses left with incompletely paid claims.

For this statement, Kitzman has been vilified by some coastal media outlets and by some coastal politicians, culminating in a call this week by state Rep. J.M. Lozano, R-Kingsville, for Texas Attorney General Greg Abbott to investigate her for breaking Texas law.

What was Kitzman’s possible crime? Lozano says her letter may have made a “misleading representation regarding the financial condition of an insurer” or somehow violated a state pledge not to impair collection of assessments on bonds that TWIA might issue following a major hurricane.

Kitzman’s real crime was daring to tell the truth to people who do not want to be confronted, now that hurricane season has started again, with the consequences of an irresponsible decision. In summer 2009, the Texas Legislature, to much praise, did fix a flaw in the old system of insulating Texas coastal residents from the cruelties of the private insurance market.

The Legislature saved Texas insurers, even ones not writing insurance near the coast, from the potential of unlimited assessments to pay for a major hurricane. But in doing so, it deliberately chose to reject a competing plan that would have forced TWIA to use actuarially sound rates and that took modern science on global warming into account.

The state Legislature instead used two sleights of hand in 2009 to make the tough medicine go down.The first was to keep current premiums lower by running insurance in reverse. Rather than forcing TWIA to collect enough premiums now to have cash on hand in the event of a major hurricane, the legislators chose to rely on “post-event bonding” vehicles called Class 1, 2 and 3 Securities.

Texas insurers will raise premiums and not just on windstorm insurance and not just on the coast after a hurricane, when people would already be hurting, to pay for these classes of securities that it assumes it will be able to sell following a major storm.

Texas’ second trick was to choose not to insure fully against the costliest hurricanes, such as a Category 4 or 5 hitting Galveston County. As TWIA itself puts the matter, “currently, there is no funding for TWIA losses in excess of Class 3 public securities” or about $3.6 billion.

The Texas Legislature saved money the same way you could if you insured your $8,000 or your $32,000 car for a maximum of $8,000 loss with the thought that fender-benders are frequent, but really catastrophic events seldom happen.

Such a system would indeed lower your premiums, and it might fully protect the less expensive car. And, if all went well, such a policy might even protect the more expensive car. But it still places your expensive car at risk.

Whether consciously or not, in 2009 the less-propertied Texas coastal counties, such as Kleberg and San Patricio, from which Lozano hails, hornswoggled the rest of the state into accepting a system that probably can pay even their major claims fully (like totaling the $8,000 car) but left the more propertied coastal counties, Galveston and Brazoria, at risk for major claims or totals.

So, if we’re shooting messenger, Kitzman, for telling Texas the truth about its underfunded public windstorm insurance system or, possibly worse, for promoting its restructuring, shoot me, too.

I declare again, as a law professor who has studied TWIA’s statutes and its finances for many years: The Texas Windstorm Insurance Association does not have the financial capacity to pay claims fully in the event a major hurricane strikes a property-rich Texas county and neither the state nor anyone else is under any current legal obligation to make up the difference.

Perhaps you should shoot me first because, unburdened by whatever political constraints may keep Commissioner Kitzman more polite, I further declare that the coastal counties, having deliberately chosen to underinsure and reap the benefits of lower premiums, have no moral claims on Texas, either.

Chandler is Foundation Professor of Law at the University of Houston Law Center and director of its Program on Law and Computation; schandler@uh.edu.

Why I blog on Texas Windstorms

I am blogging because Texas, and other coastal states, have set themselves up for disaster by engineering flimsy legal and financial regimes to address the risks of tropical cyclones.  I read accounts in the press or on the Internet that are based on incredible misinformation and wishful thinking that nature will not respect. I see many politicians in a cycle of untruths with their constituents that leave coastal residents and businesses at significant risk of a catastrophe. Selfishly, I know that I, a semi-coastal resident, will be asked, one way or another to help pick up the pieces in an expensive way if a major storm hits a densely populated part of the Texas Coast.

I am also blogging because, immodestly, I have considerable expertise in this area and can’t just submit every thought to the Houston Chronicle and hope that they publish it. As a law professor at the University of Houston Law Center with a deep interest in actuarial science and finance, I’ve studied the legal and financial operations of the Texas Windstorm Insurance Association for many years.

Finally, I guess I am blogging because I want to give some courage to people who want to look at the Texas insurance scene with an open mind.  I have seen one Texas political figure, Insurance Commissioner Eleanor Kitzman, vilified by many coastal politicians and residents for daring to tell the truth about the risks now being run.  That is just wrong.   We say we want politicians to tell us the truth.  But do we really?  So, my hope is to give useful information and analysis to people who dare to look without prejudice at Texas windstorm situation. 

I’ll be using several tools to present information.  WordPress supports text and pictures and all the usual stuff.  I’ll  use those modes of expression to the best of my ability. But it also supports interactive tools (CDF technology) that let you, the reader, really explore the situation and make up your own mind.  And, ultimately, I suspect that is how we will all learn best.

So, enjoy, read and think.