Date Issue Brief # ISSUE BRIEF
Reforming the National Flood Insurance Program Carolyn Kousky February 2010 Issue Brief 10‐01 Resources for the Future Resources for the Future is an independent, nonpartisan think tank that, through its social science research, enables policymakers and stakeholders to make better, more informed decisions about energy, environmental, natural resource, and public health issues. Headquartered in Washington, DC, its research scope comprises programs in nations around the world.
2 KOUSKY | RESOURCES FOR THE FUTURE Reforming the National Flood Insurance Program Carolyn Kousky1 The NFIP Although flood insurance is not widely available on the private market, the federal government has made it available since 1968 to participating communities through the National Flood Insurance Program (NFIP), now housed in the Federal Emergency Management Agency (FEMA). When a community joins the NFIP, it agrees to adopt minimum regulations in high flood‐hazard areas. In exchange, FEMA makes insurance available to the community’s residents. A Flood Insurance Rate Map (FIRM) is created, delineating flood risk in the community. Since 1973, flood insurance purchase has been mandatory for homeowners in 100‐year floodplains (called Special Flood Hazard Areas, or SFHAs) with a mortgage from a federally‐backed or regulated lender. Currently, around 20,000 communities participate in the program. As of October 2009, there were over 5.5 million active policies nationwide with over $1 trillion in exposure. The Need for Reform The NFIP is currently operating under a temporary extension until February 28, 2010. Many observers agree that the time has come to substantially reform the program. The 2005 flood season sent the program deeply into debt to the U.S. Treasury. As of January 2009, this debt was a little over $19 billion. At current premium levels, the NFIP is struggling to make its debt payments. This is only one of many challenges facing the program: take‐up rates in many floodplains remain low, despite a mandatory purchase requirement; discounts built into the program are not phasing out as quickly as predicted; maintaining up‐to‐date flood hazard information has been a challenge, partly because of the cost of mapping and partly due to local outcry when floodplain designations expand; and many homeowners believe the rates are too high, while risk experts argue they are too low. …………………………………. 1 Carolyn Kousky is a fellow at Resources for the Future. 1 KOUSKY | RESOURCES FOR THE FUTURE Renewal of the program has been postponed multiple times (it is currently operating on the third extension granted to it in 2009) in part due to a lack of consensus about what type of reforms to undertake. Two particular points of contention are whether to forgive the program’s debt and whether wind coverage should be added. This Issue Brief takes up these two issues and then discusses the following four broader potential reforms to the program (not all of which are mutually exclusive): 1.
Draw on resinsurance and insurance‐linked securities to raise catastrophe capital; 2.
Replace subsidies with rebates for low‐income households; 3.
Insure communities instead of individuals; and 4.
Offer reinsurance for flood claims instead of primary insurance. Forgiving the Debt NFIP policies are priced so that in the aggregate, premiums are sufficient to cover the “average historical loss year”—not catastrophic loss years. The program did not, therefore, have enough capital on hand to cover the 2005 claims resulting from Hurricane Katrina and will be unable to repay its debt to the treasury without increasing prices dramatically. FEMA estimates the current debt, of over $19 billion, is more than all claims payments made since the inception of the program. Given the historical design of the program, a large portion of this debt must be forgiven. If the NFIP debt was forgiven, it would mean that, to date, the NFIP has been less of an insurance program and more akin to a cost‐sharing of disaster aid. Homeowners paid some amount into the program, but this was not enough to cover all losses. Going forward, serious consideration needs to be given to the equity implications and the moral hazard of having general taxpayers subsidize those homeowners—by covering catastrophe losses—who choose to live in high hazard areas. Adding Wind Coverage Private insurers, through the write‐your‐own (WYO) program, write policies and process NFIP claims and, in exchange, receive a flat fee for this service. Many of these insurers write homeowners policies, which cover wind damage, for these same individuals. Following Katrina, there was concern that these insurers were shifting claims onto the NFIP by reporting damage as due to water instead of wind. Another concern for Gulf Coast residents post‐Katrina has been the use of “anti‐concurrent causation” clauses. This language lets insurers deny wind payments to any home that also sustained water damage simultaneously. Both issues have led some to advocate that the NFIP also offer wind coverage. 2 KOUSKY | RESOURCES FOR THE FUTURE This is not a sensible solution. First, previous experience suggests wind coverage could not be priced at risk‐based rates. Subsidies have been an intractable part of the NFIP and artificially low rates have plagued state insurance programs as well. Further, raising enough capital to cover catastrophic loss years for a wind and flood program would necessitate rates much higher than current NFIP rates, which already generate citizen outcry. Not pricing for catastrophic years would require taxpayer subsidies, as seen with the NFIP and Katrina. When not priced at risk‐based rates, federal wind coverage would introduce significant moral hazard to coastal homeowners, because where and how they build determines loss levels. Finally, a federal wind program could crowd out private insurers from the market, where many are operating quite soundly. To address the two concerns of claims shifting to the NFIP and denial of coverage, several other steps could be carefully considered instead. Anti‐concurrent causation clauses for wind and water damage could be regulated. The WYO insurers could be required to conform to the findings of an independent, NFIP‐certified, claims adjuster regarding the fraction of damage caused by wind and water. FEMA could make a priori agreements with private insurers regarding how to divide claims for homes damaged by both wind and water. FEMA could also add a coastal surcharge to recoup some of the costs of claim shifting. Draw on Reinsurance or Insurance‐Linked Securities to Raise Catastrophe Capital The NFIP was never designed to cover the losses from a catastrophic loss year. In part, this is because the program has other goals beyond fiscal sustainability: supporting floodplain management and encouraging widespread adoption of insurance. As a pricing strategy, the NFIP’s goal is to collect enough total premiums to cover operating costs and claims incurred in the “average historical loss year.” As previously noted, this left it unprepared to handle the 2005 losses. Within the NFIP portfolio, there exists a group of policies priced to cover the full range of possible loss scenarios (including catastrophes) and another group that is discounted (these are often referred to as subsidized policies but until the NFIP debt is forgiven by Congress, the general taxpayer has not covered the costs of these policies). The discounted policies are what prevent the NFIP from building catastrophe reserves, instead pricing for the “average” loss year. Since Katrina, however, in calculating the average loss year, the NFIP is only counting 1 percent of the claims from 2005. In order for the program to be able to have access to enough capital to cover catastrophic years, the discounted policies must be eliminated (this is discussed further in the next section). If the subsidies were eliminated, the NFIP could begin to build up a surplus that would be used to cover losses in catastrophe years. There are several difficulties with growing a reserve fund large enough to cover a year such as 2005 with only minimal borrowing. First, research shows that many people do not understand the nature of low‐probability, high‐consequence events, such that a large fund would create political pressure to lower rates. Consumers might not understand that having billions of dollars sitting in an account is necessary to cover the next flooding catastrophe and does not 3 KOUSKY | RESOURCES FOR THE FUTURE mean prices are too high. A second concern with a large fund is that it could be raided by Congress to pay for other, nonrelated costs. The NFIP is an independent program, so safeguards against such actions could potentially be developed. Still, given the concerns with amassing a large fund, the NFIP should consider making use of other mechanisms to have adequate access to catastrophe capital. One option is for the NFIP to purchase reinsurance. There is precedent for this. The California Earthquake Authority, which insures homeowners in California against earthquakes, purchases reinsurance to cover certain layers of potential losses. The NFIP could allocate a portion of premium revenue to the purchase of reinsurance on the private market to cover levels of loss in excess of the capital the program holds itself. Another option is for the NFIP to turn to the financial markets to access catastrophe capital. This can be done through the issuance of catastrophe (cat) bonds, which the NFIP would issue to investors. The principal would be invested in safe assets. The investors would get the returns from those safe investments as well as a portion of the premium revenue from the NFIP as a risk premium for investing in the cat bond. If the “trigger” for the bond occurs, say claims exceeding a specified threshold,2 then the principal would be given to the NFIP to cover claims. If the duration of the bond expires without the trigger occurring, the money is returned to the investors. Cat bonds are usually priced using catastrophe models, which simulate potential losses. FEMA could invest in building a public model for this purpose, building off their own mapping and claims experience, or could hire a catastrophe modeling company to do this for them. Replace Subsidies with Rebates for Low Income Households Currently, four groups of policyholders receive discounted rates.3 The largest group of discounted policies—over 21 percent of all policies in force, is for properties in place before flood maps for a community were released. The second group of discounted policies is for those that will be protected by a levee, but where the levee is currently under construction and not yet completed. The third group is policies behind a levee that has been decertified, but for which a restoration plan is in place. These last two are only responsible for 0.6 percent of all policies. The final group of subsidies, only 0.1 percent of all policies, is for properties in coastal zones built between 1975 and 1981, but after maps were adopted in a community. These properties receive lower rates that do not account for the threat of wave action. The first type of discount was adopted so as not to punish homeowners who built or chose to locate in a 100‐year floodplain without knowing the risk. The expectation was that, as the housing stock turned …………………………………. 2 In designing cat bonds in the private market, a trigger based on the firm’s losses would risk introducing moral hazard; that is, the firm might take on a riskier portfolio, knowing the bond would cover losses. To minimize this, the trigger is often industrywide losses or some physical threshold of the disaster—events over which the firm has less control. This, however, introduces basis risk, or the concern that the company’s losses will not be tightly correlated to the trigger. For the NFIP, moral hazard is less of a concern and a trigger based on NFIP’s actual claims could likely be used.
3 Discounted policies are also the majority of repetitive loss properties, which at only 1% of policies, are nevertheless responsible for 30% of claims.
4 KOUSKY | RESOURCES FOR THE FUTURE over, the subsidy would eventually be eliminated; yet a large fraction of policies still receive this discount. The original reason for the discount has little bearing all these years later. Homeowners in these properties have now long known about the flood risk and there is little justification for allowing them to continually jeopardize the financial sustainability of the program and force other policy holders (or the general taxpayer) to cover their costs. Eliminating discounted rates will be politically unpopular, but essential to creating a finically sustainable NFIP. To help reduce the burden, phasing out the Who Should Pay for Catastrophes? discount could be coupled with increased funding for Catastrophic losses are a function of FEMA’s mitigation grants program. If homes adopt where and how we build. Should those homeowners who make the mitigating actions, they would reduce their premiums. choice of where to locate and whether or not to adopt mitigating Phase out of discounted premiums could put a strain on actions bear the full costs of those some low‐ to moderate‐income families. Some families decisions? Or do we believe that the may not be able to afford the higher priced coverage at general taxpayer or other policy holders should subsidize the costs of all. Instead of keeping prices low for all policy holders, those in risky areas by covering some including affluent homeowners who can more than afford of the costs of catastrophic events? the coverage, an income‐based rebate system should be Should cost‐sharing be needs based or location based?
introduced. Rebates would be given on a sliding, income‐
based scale. Thus, instead of the premium discount being based on the property, it would be based on the need of the property owner. Such a discount structure could also distinguish between various types of residences. For instance, discounted premiums would not be available for vacation or second homes. As the U.S. Government Accountability Office has noted, this design for the discounts would have two advantages. First, fewer policies would be discounted, increasing the financial sustainability of the program. Second, all homeowners would be aware of the full risk rate, even if they received a discount. The government has a long history of implementing such needs‐based programs; doing so with the NFIP should not introduce any new challenges, although more investigation would be required to develop such a program. Howard Kunreuther notes that the design of an income‐based insurance voucher program could be modeled on current federal programs, such as the food stamps program.4 Research would need to be undertaken to determine the appropriate sliding scale of discounts to offer homeowners. A streamlined application process would need to be developed and FEMA would need to establish procedures for verifying applications and overseeing the program. One question that would need to be addressed is whether the income‐based discounts should be covered by other NFIP policyholders or by the general taxpayer, as is the case with many other needs based programs. …………………………………. 4 Kunruether, H. 2008. Reducing Losses from Catastrophic Risks through Long‐Term Insurance and Mitigation. Social Research 75(3): 905–
930. 5 KOUSKY | RESOURCES FOR THE FUTURE There is reason to be concerned that higher rates, even with discounts for those in need, will lead some homeowners to drop NFIP coverage, especially given findings from behavioral economics research that individuals often underestimate risk and do not understand the value of insurance. To counter this concern, and since uninsured homeowners put a strain on taxpayers when a disaster strikes, NFIP insurance could be made mandatory for all homeowners in floodplains and for those behind levees (although prices would be lower). This would require increased enforcement from the NFIP (something that has proved difficult with the less extensive current mandatory purchase requirement), and would likely receive significant outcry from local officials, but would have the advantage of spreading the risk over a larger group. Community Insurance Plans Many observers have voiced concern that NFIP take‐up rates are quite low in many places around the country. Homeowners often fail to purchase flood insurance, even when it is required, or quickly drop their policy after a short time without a flood. Many possible explanations for this have been discussed: homeowners underestimate the probability of a flood, they are overly optimistic about whether they will be the victim of a disaster, they do not understand that several years without a flood does not mean that a large flood will not occur, the mandatory purchase requirement is not enforced by lenders or by FEMA, WYO companies do not market NFIP policies to at‐risk homeowners, and homeowners expect federal disaster relief and therefore do not feel they need to purchase insurance. One way to ensure that all homeowners will be covered when a flood strikes is for the NFIP to insure communities instead of individuals. As Leonard Shabman has discussed,5 local governments or flood‐
risk management districts could purchase a policy from the NFIP that would cover all the structures in the jurisdiction, for all flood risk and not just 1 percent, up to the NFIP coverage limit ($250,000 building coverage for residences and $500,000 building coverage for businesses). The local entity would recover the cost by assessing each property, perhaps as an incremental increase to the property tax. The local jurisdiction could decide how to allocate costs, whether based on FEMA rates or otherwise. As a result, any cross‐subsidization in prices would become a local issue, not a federal one. This approach would ensure that all property owners in risky areas are insured. It would also spread risk more broadly, lowering the overall cost of the program, and would eliminate the WYO insurers. FEMA would take on additional administrative costs as the sole entity writing the policies, but these would be much lower than the costs of WYO companies administering individual policies. These savings could be passed on as premium reductions. Because all homeowners would be insured in any community that joined, disaster aid would also be lowered, since the individual assistance FEMA provides for repair and replacement of uninsured structures would no longer be needed. Emergency …………………………………. 5 Shabman, L. 2009. A New Approach to Reforming the National Flood Insurance Program. RFF Weekly Policy Commentary. Available at: http://www.rff.org/Publications/WPC/Pages/New‐Approach‐to‐Reforming‐National‐Flood‐Insurance.aspx 6 KOUSKY | RESOURCES FOR THE FUTURE response measures, such as temporary housing, would, of course, still be required in the event of a disaster. The Community Rating System (CRS) of the NFIP could be further expanded were the NFIP to write community‐level policies. Under the CRS, when a community adopts certain mitigating activities, premiums in that community are correspondingly reduced because the risk is reduced. One danger, though, is that lower premiums may make it more attractive to build and locate in high‐risk areas. With community‐level policies, this potential increase in development in risky areas would translate into higher premiums for the community, internalizing the costs. Limiting development in areas at highest risk of floods and/or buffering rivers and streams with wetlands and open space might be more attractive as it would lower premiums through the CRS and also lower the total exposure and thus, the premium of the community. Turn the NFIP into a Reinsurance Program A final reform option is for the NFIP to stop writing primary coverage altogether and instead offer reinsurance for flood losses to private insurance companies. Reinsurance from the federal government would be cheaper than from private reinsurers as the federal government does not seek a profit and has a better ability to smooth losses over time. This cheaper reinsurance for flood losses could translate into lower premiums for flood coverage on homeowners policies. To ensure that homeowners did not simply drop flood coverage, forcing taxpayers to pay more when a disaster strikes, flood coverage could be mandated as part of homeowners coverage. With federal reinsurance for flood claims, primary insurers might be more willing to write this policy. Having flood coverage wrapped into a homeowners policy would also ensure that all homeowners were fully covered against hurricane losses. After Katrina, it was observed that many people did not realize they needed both a homeowners policy for wind coverage and a NFIP flood policy. Having both perils covered in one policy would be easier on the homeowner. There is some indication private insurers might be amenable to this. Insurance provider Nationwide proposed a voluntary, multiperil homeowners policy, where flood and wind damage would be reinsured by the NFIP.6 There is also precedent for a reinsurance approach. For example, in France, public reinsurance has been operational for decades. Insurers are offered voluntary proportional or stop‐loss contracts. The French example demonstrates that premiums for reinsurance must be enough to cover catastrophes, as it almost went bankrupt and had to raise rates. Reinsurance should not be extended to wind coverage, however, as Nationwide suggested, or for all natural disasters, as is done in France. Federal reinsurance could displace the private market and there is no reason to do this for other perils. The 2005 hurricane season demonstrated that private insurers …………………………………. 6 Gordon, A. K. and J. R. Booth. 2009. How the NFIP, Insurance Law and Climate Change Could Cause the Perfect Storm. Risk & Insurance, March 3. Online at: http://www.riskandinsurance.com/story.jsp?storyId=174286003
7 KOUSKY | RESOURCES FOR THE FUTURE and reinsurance can handle losses of that magnitude: new insurers entered the market, new capital was raised, and capacity grew. Rates for policies along the Gulf coast can be expensive because the risk in this area is so great. Instead of suppressing these rates and driving companies from the region, as has occurred in some states, income‐based programs could be developed to offer rebates to low‐
income households facing high insurance rates, as discussed above. Further Reading Cooke, Roger M. and Carolyn Kousky. 2009. Are Catastrophes Insurable? Resources 172 (Summer). Kousky, Carolyn and Howard Kunreuther. 2009. Improving Flood Insurance and Flood Risk Management: Insights from St. Louis, Missouri. Discussion paper 09‐07. Washington, DC: Resources for the Future. Michel‐Kerjan, E. and C. Kousky. 2010. Come Rain or Shine: Evidence on Flood Insurance Purchases in Florida. Journal of Risk and Insurance forthcoming. Shabman, L. 2009. A New Approach to Reforming the National Flood Insurance Program. RFF Weekly Policy Commentary. Online at: http://www.rff.org/Publications/WPC/Pages/New‐Approach‐to‐
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