# A closer look at H.B. 3622

## Analysis

I have undertaken an analysis of H.B. 3622 that is going to be discussed in the House Insurance Committee at a hearing at 2 p.m. this Tuesday, April 30, 2013.  The one sentence summary is that, although it has some good features, H.B. 3622 is an economic disaster for the Texas coast and the rest of Texas because it does not create a high enough stack to protect against tropical cyclones. The probability of TWIA going bankrupt, even if it does not grow, over the next 20 years under this bill is about 22%. Here are the bullet points.

### Baseline scenario

I conducted 1000 simulations of H.B. 3622 over its plausible shelf life of 20 years using models based on data provided to TWIA by AIR and RMS. TWIA policyholders end up paying via operating funds, reinsurance premiums and contributions to the catastrophe reserve fund for about 66% of the amount of TWIA losses.  There is thus about 34% subsidization in H.B. 3622.  The remaining losses are paid for approximately as follows: 9% by coastal insureds for paying off 70% of the Class 2 bonds, 12% by insurers (and, derivatively, their insureds) by low attachment Class1 Funding assessments, paying off 30% of Class 2 bonds, and high attachment Class 3 Funding assessments, 3% by the State of Texas via premium tax credits given to insurers that partly offset assessments, and, a disturbing 11% absorbed without insurance by TWIA policyholders when TWIA lacks funds with which to pay claims due to an inadequate stack. The pie chart below illustrates this distribution. For some caveats on this computation, see the note below.

In 222 of those 1000 simulations, (22.2% of the time) TWIA became insolvent at some point during those 20 years. At first, I thought this had to be a mistake in my simulation. But, I did a back of the envelope computation that suggests it is an accurate result.  This high risk exists because, particularly over the next 5 years or so, the stack protecting TWIA policyholders is very low relative to potential losses.  Some depopulation of TWIA via, for example, lowering maximum policy limits or reducing moral hazard through higher deductibles and coinsurance would reduce this probability. My “envelope” containing the computation is set forth in the notes below.

### Low reinsurance scenario

Reductions in the purchase of reinsurance produce yet worse results.  The 20-year risk of insolvency is now 29%. And TWIA policyholders pay for even less of the risk they create.  The pie chart below shows the distribution.

Additional premiums paid in by TWIA policyholders could lower the risk of insolvency and increase their responsibility for losses. By increasing premiums 25%, the probability of insolvency is reduced to 21%, still far too high a number. The pie chart below shows, however, that TWIA policyholders now pay a larger proportion of losses suffered.

### Higher Maximum CRTF Payment Scenario

The rate of subsidization and the risk of insolvency would decrease significantly, if H.B. 3622 liberated the CRTF to do its job.  H.B. 3622 would be improved if the \$1 billion ceiling in its section 6 (amending section 2210.072) placed on CRTF payments were replaced with \$3 billion, as the maximum amount of CRTF funds that could be used to pay for losses. A conforming amendment should also be made to proposed section 2210. 4522. Such an amendment, although it would do little for the next 5 to 8 years, at least reduces the risk of insolvency in years down the road provided no major hurricane has previously hit the Texas coast.  Insolvency risk over the 20 year period would decline to 18% — still way too high but smaller.  And the distribution pie chart shows that now 73% of the losses are born through insurance by TWIA policyholders, though 9% is still unfunded.

The failure to index the parameters to H.B. 3622, such as the maximum amount of the catastrophe reserve fund that can be used to pay a claim or the maximum assessments against insurers means that the insolvency risk grows if, as coastal interests desire, the value of property on coast continues to grow.

## Conclusion

This bill, if were to be passed by a 2/3 majority, at least makes a dent in urgent crisis facing Texas for the 2013 hurricane season. It gets rid of the “bug” in current law that I have discussed in this blog recently. And it does away with the worst of post-event bonding as a funding mechanism. The bill, however, still suffers from several fundamental problems that threaten to destroy the Texas coast.  Unlike S.B. 18 that woud somewhat deconcentrate TWIA risk, it continues the concentration of correlated risk in a single entity. This placing of a lot of eggs in the single TWIA basket inevitably leads to extraordinarily high prices for reinsurance, which in turn prevents TWIA from building up adequate internal reserves in timely fashion. By insulating coastal Texas from market forces, the bill distorts development patterns and discourages risk mitigation. It perpetuates the economically unjustifiable large-scale subsidization from the poor in non-coastal Texas to the middle class and wealthy in coastal Texas. It continues to do so in an opaque manner by complexities such as insurer assessments and premium tax credits.  And it leaves the Texas coast and, derivatively, the rest of Texas extremely vulnerable over the reasonable lifespan of this bill to a devastating insolvency — a threat which itself is likely to retard coastal development.

## Assumptions and Qualifications

I assume the AIR and RMS models are reasonable.  There is some evidence to suggest that the reinsurance industry believes these models are optimistic about the risk of severe tropical cyclones in Texas.  If that is true, the insolvency problem highlighted here becomes yet more serious.

My original analysis contained some errors; I attempt to fix them here. Most relate to my prior lack of complete recognition that the bill does away with Class 1 post-event bonds, the alternative Class 2 post-event bonds, and with Class 3 post-event bonds and substitutes assessment mechanisms for them.

I assume that insurers pay for about 20% of that portion of assessments for which a premium tax credit is available.  This percentage is a crude estimate of the time value of money.

I assume that insurers incur no costs in having to stockpile money to pay assessments.  This is an assumption made for purposes of simplicity and is obviously false.  Taking risk costs into account would mean that insurers bear even more of the costs of a system such as H.B. 3622.

I use a model of reinsurance pricing consistent with that in the literature under which reinsurance prices are based on the sum of the expected claims costs and a fraction of the maximum exposure. I have attempted to calibrate the model, particularly with respect to the fraction used to multiply maximum exposure, by looking at the amount TWIA has paid for reinsurance in recent years.  I continue my concern that TWIA is paying too much for reinsurance and substitute mechanisms for catastrophic risk transfer ought to be explored.

A copy of the Mathematica notebook underlying the assertions in this blog post is available here. I have not had the time to annotate it fully, but am happy to explain it and run different simulations should any legislator desire.

## Three back of the envelope computations confirming a high probability that H.B. 3622 will leave TWIA insolvent over the next 20 years.

### Method 1

If you have a stack like this one for 2013 that is likely to be at best only \$2.98 billion high (\$180 million CRTF, \$800 million Class 1 Funding and \$1 billion Class 2 Bonds plus an optimistic \$1 billion in low attaching reinsurance) and you have roughly a 1.9% probability of a tropical cyclone losses that exceeds that sum, over 20 years, the cumulative probability of having at least one loss in excess of the stack is 31%.  (The survival function at 0 of a negative binomial distribution with 20 trials and a negative probability of 98.1% per trial).  It’s only because the stack can grow by perhaps \$100 million per year on average (due to increases in the CRTF) and the fact that there the probability in the simulation drops to a still frightening 21.3%.

### Method 2

I also performed a second simplified analysis in which one computed the height of the stack as a function of time under the optimistic assumption that TWIA suffered no major losses.  The height of the stack was set to increase as contributions to the CRTF increased.  I then computed the numeric probabilities for solvency each year.  I then multiplied these probabilities together.  By subtracting these values from 1, one obtains the probability at the end of each 20 year period that TWIA has become insolvent. I again see results between 15-25% depending on what assumptions are made.  These results are consistent with the findings made using the more elaborate methodology.

### Method 3

I generated 10,000 storms from the AIR/RMS derived distribution.  I then partitioned these storms into groups of 20 and found the largest storm.  I then plotted the “Exceedance Curve” or “Survival Function” of this empirical order distribution.  I show the results below.  As one can see the probability of the largest storm being more than \$3 billion is about 20%.  Even at \$5 billion, the probability is above 15%.

Exceedance Curve for Largest Storm in 20 years

# 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 (Sharing)

# The chart TWIA isn’t sure you should see

Attached to this post is a chart prepared by TWIA for its August 7, 2012, board meeting. I didn’t make this chart up.  TWIA did. At the August board meeting, it was discussed whether this chart should be made more prominently available to the public via the internet. There was an initial suggestion that it should.  At the end of a two minute discussion, TWIA apparently decided that, instead, the information contained in the chart would be subsumed into some sort of “contingency plan narrative” that would, eventually, go on the web.  (Don’t believe me?  Listen to minutes 16:30 through 18:46 on the archived recording of the meeting). And if anyone can find that contingency plan (with or without the narrative) please let me know.

Exhibit for the tWIA board meeting

I don’t think the chart is too difficult to understand. The “problem” with the chart is that it is too easy to understand. The chart makes clear that TWIA faces a significant risk of insolvency. It shows that TWIA does not have enough money to pay for 1 in 100 year events and does not have enough money to pay for a modest storm plus a 1 in 60 year event occurring in the same hurricane season.

The chart depicts how TWIA would pay policyholders in two different scenarios.  The scenario on the left is one giant storm.  The scenario on the right is a small storm followed by a big storm.  In the giant storm scenario, TWIA suffers \$4.5 billion in losses.  This is identified as a one in one hundred year event.  If that’s true, it happens about 10% of the time during any 10-year stretch. According to the chart, TWIA would fund be able to fund a total of \$3.15 billion of the \$4.5 billion loss: \$300 million (green) out of premium revenue and the catastrophe reserve trust fund, \$500 million (aqua) out of bond anticipation notes (later refinanced via Class 1 securities), \$1 billion (turquoise) out of Class 2 securities, \$500 million (gray) out of Class 3 securities, and \$850 million (purple) out of reinsurance.  TWIA would have no available funds to pay the remaining \$1.35 billion (yellow) of claims (and possibly loss adjustment expenses).  So, on average, policyholders would get 70 cents on each dollar that TWIA owed them.

In the small + big scenario depicted on the right, the losses from the small ( \$500 million) storm are funded fully. \$300 million (green) is paid out of premium revenue and the catastrophe reserve trust fund and the remaining \$200 million (aqua) is paid out of bond anticipation notes (later refinanced via Class 1 securities).  But when the big \$2.5 billion once every sixty years)  storm then hits in the same hurricane season, TWIA has a serious problem.  It can pay another \$300 million out of bond anticipation notes, \$1 billion (turquoise) out of Class 2 securities and \$500 million (gray) out of Class 3 securities.  That leaves TWIA policyholders with claims from the second storm initially getting only 72 cents on every legitimate dollar of claims.  (And good luck to TWIA trying to get claimants from the first storm to pay back a portion of their claims so that both sets of policyholders are treated equally)

The source of the remaining \$700 million under the small + big scenario is unclear.  If TWIA could somehow scrape up an additional \$500 million (yellow), it would then arguably trigger the obligations of the reinsurance it purchased.  TWIA policyholders would ultimately be made whole in this case. But, apparently, if TWIA could not scrape up \$500 million — and no one has any idea where the missing \$500 million would come from —  TWIA would not be entitled to any money from the reinsurance policy for which it paid \$100 million in premiums. Thus, TWIA policyholders would be stuck with, say, being paid only \$144,000 on a legitimate \$200,000 claim.

Footnote: Part of the problem exists because TWIA’s reinsurance is apparently “occurrence based” rather than based on aggregate losses.  Apparently such occurrence based policies are “industry standard” for reinsurance though not for catastrophe bonds.  My bet, though, is that a sophisticated reinsurance broker could negotiate with a sophisticated reinsurer for an aggregate loss trigger on reinsurance.

So, is the chart scary?  Should it be prominently displayed on the TWIA web site and by TWIA agents? Yes.  Sure, being too scared of hurricane risk a problem.  But being insufficiently scared is perhaps an even greater problem.  I would not want to be the homeowner with a destroyed house or a destroyed business holding a TWIA policy that provided “coverage” on paper, but that did not actually get me the money to rebuild. And I wouldn’t want to be the agent that sold such a policy having not disclosed by every reasonable means — including the use of charts where appropriate — the risks involved.