In recent years, there has been significant growth of risk assumed by U.S. personal lines residual market bodies, particularly in coastal states. Policyholders and P&C insurers in these states, and their supporting reinsurers, are often ultimately responsible for the risk carried by these insurers of last resort - as evidenced following recent significant catastrophes. Using the Texas Wind Insurance Association (TWIA) as an example, we examine some of the uncertainties facing the re/insurance community as a result of the changing funding structures of these carriers.

TWIA – The history
TWIA is a 'pool' of all property and casualty (P&C) insurance companies authorized to write coverage in Texas.   The Association was established by Texas Legislature after the state was hit by Hurricane Celia in 1970, causing $500m of damages and leading to the withdrawal of many voluntary companies from the insurance market.  Its purpose is to act as the insurer of last resort and to provide basic wind and hail insurance to property owners along the Gulf Coast of Texas who might otherwise be left uninsured. Losses covered under the policies of TWIA are to be paid by premiums and other sources of revenue as directed by the legislature. In the past, this has included resources from the Catastrophe Reserve Trust Fund (CRTF), payments from reinsurance purchased, and assessments payable by the TWIA member companies.

In 2008, Hurricane Ike devastated the Gulf Coast of Texas, resulting in total insured losses of over $8 billion¹ - wiping out more than 30 years of TWIA’s premium reserves and depleting the CRTF. Insurance companies were impacted twice - not only did they pay losses on the property they directly insured, but they were also assessed amounts to satisfy the full limit losses that TWIA was obligated to pay. These assessments totaled $300 million² which are not recoverable from the state or policyholders, and an additional $230 million³, which can only be recovered over time from premium tax credits. As insurers can only recover up to 20% of their total assessment in any one year, and then only up to the amount of premium taxes they pay on property lines, it could take some companies more than 20 years to recover their pool assessments.

Concern about TWIA’s ability to place an unlimited amount of assessments on the local P&C industry, along with the need to recapitalize its depleted reserves, prompted a complete rethink of how TWIA should be funded. The result was a revision of the legislation in the form of House Bill (HB) 4409, which came into effect on June 19, 2009.
 
HB 4409 - Key legislative changes
Several issues were successfully addressed by HB 4409. To be eligible for insurance coverage from TWIA during and after construction, new buildings must now be built according to the windstorm building code. In addition, TWIA can now use rating territories and catastrophe models to set its rates – something it was previously unable to do. This allows TWIA to move away from a “one size fits all” pricing approach towards setting rates that are more reflective of risk.
 
But some of the changes have raised questions in the re/insurance industry - the most significant is the new funding structure of TWIA. The legislation succeeded in eliminating funding through unlimited assessments at the upper end of the TWIA funding structure. Today, TWIA’s funding is supported in part by post-event bonding. HB 4409 provides that up to $2.5 billion can be funded annually through post-event bonds to pay for TWIA’s losses in excess of those paid by premiums and any on-hand reserves from the CRTF. Financial support for TWIA’s bonds is derived from TWIA revenues, surcharges on policyholders and member assessments. While TWIA is still authorized to purchase reinsurance under this legislation, it is no longer required to do so, freeing up funds to support the bonds.

Challenges of the new funding approach
Uncertain borrowing costs
The terms at which TWIA would be able to issue bonds are far from certain; not only will they be affected by the perceived uncertainty of TWIA’s future cash flow post-event, but also by the state of the bond market at that time. As evidenced by events of the last two years, open access to the capital markets, even for credit-worthy borrowers, cannot always be assumed. 
  
Increased volatility of assessments costs
Since the CRTF was completely depleted following Hurricane Ike, TWIA may have to access the capital markets following even a moderately sized loss event. This increases the likelihood that assessments would be associated with bond offerings related to a second or possibly third event for which the terms would include a significant risk premium. This adds volatility to the cost of member and policyholder assessments. Also, in this scenario, the debt service ability of TWIA may require an extended amortization period, beyond the 10 years originally assumed.
 
Increased exposure to assessments
There may also be a “bonding gap” in the post-event funding. Under the new legislation, TWIA and the Texas Public Finance Authority is able to seek to issue three classes of bonds to pay losses. However, if TWIA are unable to issue some of the first $1 billion (Class I) bonds, which are supported by its own revenues, then the Class II and Class III bonds, which are supported by policyholder surcharges and member assessments, may be deployed, or drop down to fill the funding gap. As a result, the maximum loss that could be supported under the new legislation might not be as great as the $2.5 billion and members may be more exposed to assessments than originally envisaged.

Assessments “tail”
The new legislation has raised a number of other questions for both member insurers and their reinsurers. Under many traditional per event catastrophe reinsurance contracts, coverage for residual market body assessments is contractually included in the Ultimate Net Loss contained within the Pools and Associations clause. While it is expected that TWIA will report losses to insurers on a per event basis, there is no reference in the legislation to the division of annual assessments per event. This disconnect, between the TWIA legislation and the assessments, may be best resolved by a revision of the Pools and Associations clause language in advance of being tested by a loss. Furthermore, there is no explicit limit in HB 4409 on assessments for bonds issued in, perhaps multiple, subsequent years to pay for the losses arising out of one large event. The ability to assess insurers to support up to 10 year duration bonding in years subsequent to a loss implies a significant potential “assessments tail”.

Loss payments include expenses
The inclusion of “financial costs” in the assessments in addition to the payment of indemnified losses is also causing some concern in the industry. Financial costs include payment of the operating expenses of TWIA for purchasing reinsurance, issuing and administering public securities, interest on securities and funding of catastrophe reserves for future loss occurrences. These expenses would normally fall outside the scope of an excess of loss reinsurance agreement.

Dealing with uncertainties
Revised funding approaches for residual market bodies present associated uncertainties. While the impact of the new funding approach for TWIA will likely be greatest for smaller member insurers, where assessments may form a larger part of the net retained loss, the uncertainties make it difficult for the re/insurance industry in general to assess and evaluate the risks, impacting both risk appetite and capital requirement.

It is now incumbent upon insurers, brokers and reinsurers to address catastrophe excess of loss contract language to accommodate, and where necessary limit, the coverage afforded by the legislation and for insurers to consider the extended tail of catastrophe losses implicit in funding assessments for multi-year bonding.