To fix the TWIA mess, focus on the fundamentals

This op-ed is reprinted from the Houston Chronicle

To fix TWIA mess, focus on the fundamentals
By Seth J. Chandler
Updated 06:52 p.m., Friday, July 27, 2012

Texas has been spared a major tropical storm so far this hurricane season, but that doesn’t diminish the fact that the state is woefully unprepared to deal with potential losses. If a significant fraction of possible Category 4 or Category 5 hurricanes were to strike, the Texas Windstorm Insurance Association (TWIA) would not be able to fully pay claims in Harris, Galveston, Brazoria and possibly other Texas counties. Since 2009, neither the state of Texas nor insurers in Texas are legally responsible to make up the shortfall. In 2013, let’s hope the Legislature stops rearranging deck chairs on the Titanic and explores more fundamental reform.

It’s not just a major hurricane problem or a Galveston problem. Right now, TWIA will not be able to pay with cash on hand or reinsurance funds many claims throughout Texas – not just the most densely populated counties – in the event of a serious storm. Instead, TWIA will be forced to borrow a limited sum, possibly at high rates, to pay the claims. The state will then have to impose significant surcharges on various forms of insurance over a number of years to pay the loans back. Running insurance in reverse and forcing policyholders to pay higher premiums just when they have been hit with losses is seldom a recipe for economic stability.

Unfortunately, as many coastal states are learning, there is no easy solution to this problem. Even those who like the free market must admit past difficulties in providing complete insurance along the coast for windstorm at rates that homeowners and businesses find tolerable. Special and explicit government subsidization of more complete windstorm insurance for the coast has its own financial costs, political problems and moral shortcomings. And the underinsurance engineered into the current law, coupled with some disguised subsidization, leaves Texas insureds at serious risk, particularly in the more densely developed areas of our coast.

The problem is tough because insurance works best where risks are known and uncorrelated. The fact that A has a fender bender with his car in Galveston County provides no information as to the likelihood that neighbor B will have an accident with her car at the same time. So auto insurance works well. Uncorrelated risk means that insurers do not have to stockpile a lot of liquid capital in order to pay expected claims. Something known in mathematics as the law of large numbers makes it unlikely that the amount of revenue an automobile insurer takes in won’t be enough to pay claims.

Windstorm risk along the Texas coast, by contrast, involves correlated risk with uncertain magnitudes. The fact that A’s house in Galveston is blown down by a hurricane informs greatly the likelihood that neighbor B’s house will be similarly destroyed. When insured risks are correlated, insurers and reinsurers have to stockpile lots of safe, liquid assets in order to pay claims in timely fashion. And keeping assets under the mattress hurts insurers and reinsurers in providing a decent return to their shareholders.

There are fundamental ways of addressing high magnitude, correlated risk that can be more successful. One solution is to reduce the magnitude of correlated risks. There is an awful lot of research showing that we can lessen the damage hurricanes cause through hardening: very tough building codes and other infrastructure improvements. A hardened site in Galveston, after all, is currently considered safe enough to house the smallpox virus. Burying power lines allows people to return to their homes sooner, which reduces the losses from a storm. Limiting publicly subsidized insurance plans to lower levels of coverage and requiring individuals to obtain private insurance for the excess also reduces the magnitude of correlated risk held by government plans. Lessening the economic consequences of hurricanes could attract private insurers back to the Texas coast, make state schemes less expensive, and make people feel more secure. The biggest bang for the buck will come from hardening the densely populated counties.

A second approach is to try to decorrelate the risks. Texas could pool its windstorm risk with California’s earthquake risk, Washington state’s volcano risk or windstorm risk from another region. Alternatively, Texas could pool its risk in, say, 2013 together with its risks in 2014 and 2015 by requiring coastal residents who purchase insurance from TWIA to commit to three-year contracts. There are many challenges with each of these plans, but given the absolute magnitude of the issue, even modest gains are worth exploring.

And the third approach is, frankly, to develop a greater tolerance for the high rates that come with insuring correlated risk. Hardening the coast and looking for opportunities to pool our catastrophe risks with uncorrelated catastrophes will help. But Texans on our coast need to let it sink in that they are holding property that is unavoidably expensive to insure and budget for the higher premiums that result. And their legislators who deny this reality do their constituents no service by leaving them catastrophically underinsured.

Chandler is Foundation Professor of Law at the University of Houston Law Center, former co-director of its Health Law and Policy Institute and director of its Program on Law and Computation.

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