The issues with heavy reliance on pre-event bonds

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

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

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

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

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

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

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

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

Some notes on the simulation. Annual losses are drawn from the Weibull Distribution previously discussed in this blog. When more recent data submitted by AIR and RMS is analyzed more fully, we may be able to change the distribution from which the losses are drawn. In the mean time, however, I believe my methodology is reasonable and exposes the issues. I assume that losses are paid in full at the end of the year in which they are incurred. Obviously this is unrealistic. As we have seen from Hurricane Ike losses in 2008, claims can dribble in long after the storm and litigation delays may mean payouts continue over time. Moreover, hurricane losses are not all paid on the last day of the year. Still, I doubt very much whether this simplification materially affects the simulation’s main results. I have made some simplifying assumptions about how much money TWIA takes from premiums and puts into the CRTF each year. Basically, TWIA tries to make up the shortfall between the current balance of the CRTF and the required CRTF level, which is $2 billion under the Crump-Norman plan. The amount is clipped, however, to lie between a minimum premium infusion amount and a that minimum plus an extra premium infusion limit.

And a final note. This post may be seen as being negative on pre-event bonds. And, to be sure, it does not constitute a full blown endorsement. But the real issue is — compared to what? Compared to post-event bonds? Compared to reinsurance? Compared to letting TWIA policyholders bear a very large risk of insolvency if the CRTF is not augmented? Ultimately, the real issue is one of risk reduction and risk mitigation. When we get the risk down — as the Crump-Norman and Zahn plan both attempt to do, a lot of the financing problems get easier.

2 thoughts on “The issues with heavy reliance on pre-event bonds

  1. Seth, I am glad to have this level on analysis.

    The Front-Loading of our CTRF with a 20 year payoff financial instrument is like buying a mortgage on your house instead of renting. If renting (reinsurance scheme), you flush the money every year and don’t accrue any future benefit. If you are buying via a mortgage (pre-event / 20 year amortization), you are gaining equity each year (paying off part of your hurricane risk funding). I see a much bigger “debt trap” with post-event bonding scheme because you are not making progress every year on paying off the cost of your risk. Image a series of hurricane seasons each with a major loss that triggers post-event bonds for each event. Each round of post-event bonds build a bigger “debt trap”. The Front-Loading concept would still be challenged and have to reset but your would make progress during any year without a major storm loss. You would also, have some equity (some of the risk cost paid off) going into the storm series.

    Also, note that the TWIA II Concept has a two-stage approach with the post-event bond layer for a catastrophic event (Category 4 strike on Galveston for example), covered via a different risk pool (statewide surcharges to pay off post-event bonds). This will limit the “debt-trap” to the refiling of the $2 billion CTRF target balance.

  2. Luck Helps!

    We have had four lucky years since Hurricane Ike and Dolly without any significant tropical cyclone strikes. Have we made any progress? If anything, we are losing a lot of ground. The original TWIA has died due to ongoing litigation costs and its already inadequate financial structure, has now collapsed. The only way to get Texas safe is to have an new entity in place by 6/1/2013. This is impossible but it is the only path forward that will get us safe.

    TWIA is dead. Only a new entity can escape the litigation that has killed the original TWIA. TWIA is dead because the Class 1 post-event bonds ($1 billion gone) are unmarketable and lawsuits are draining most current funds. Massive default of claims is certain if a either Galveston or Corpus Christi have a major hurricane strike in 2013. Even a modest hurricane will put TWIA into insolvency with it remaining claims capacity of approximately $1.8 billion (this assumes that the $1 billion Class 2 post-event bonds are marketable but they are half paid by TWIA revenues and that could also make them unmarketable since all the revenues are being drained by lawsuits). We are “Running Naked Down the Seawall”!

    We are going into a hurricane season with a neutral Pacific temperature oscillation. This means that the big high pressure dome that has shielded Texas (and caused our drought) the last couple of years won’t be there to keep hurricanes away from Texas in 2013. We need to be prepared for a major hurricane strike.

    Hope for luck … with a dead TWIA – significantly unable to fund its claims (shortfall up to about $5 billion!), luck is all we have for next year.

    Dave Norman and I have put forward our ideas. At best, it is a “Conceptual Outline” and not finished policy. We think it has some innovative components and an overall structure that would be far better than our current collapsed “house of cards” (unmarketable post-event bonds, etc.). The greatest compliment we both could have is for someone to come up with a better plan and get Texas safe!

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