Public Policy Analysis & Opinion

Consensus on flood insurance reform

Unusual congressional accord is expected

By Kevin P. Hennosy

Once again, Congress is considering a long-term extension of the National Flood Insurance Program (NFIP). Advocates for insurance carriers and producers are united in support of a long-term extension of the program.

In congressional testimony delivered in March, the Property Casualty Insurers Association (PCI) testified in support of the program. "Today, over 5.6 million Americans depend on the NFIP to protect their homes and businesses," said Donna Jallick, vice president of flood operations for Harleysville Insurance, who testified on behalf of PCI. "Last year, Congress allowed the NFIP to expire four times for a total of 53 days, and there have been 10 short-term extensions in less than three years. Lapses hurt consumers, millions of real estate professionals and our business."

GAO assessment

The hearing commenced with a report from the Government Accountability Office (GAO), which assessed the need for congressional action. The GAO recommends that Congress reform the program to lessen taxpayer exposure to flood disaster claims.

To design successful reform legislation, the GAO recommends that lawmakers focus on four policy aims:

• charging premium rates that fully reflect risks 

• limiting costs to taxpayers before and after a disaster

• encouraging broad participation in the program 

• encouraging private markets to provide flood insurance 

The report writers observed: "Successfully reforming NFIP would require trade-offs among these often competing goals. For example, currently nearly one in four policyholders does not pay full-risk rates, and many pay a lower subsidized or 'grandfathered' rate. Reducing or eliminating less than full-risk rates would decrease costs to taxpayers but substantially increase costs for many policyholders, some of whom might leave the program, potentially increasing post-disaster federal assistance." 

The GAO report examines several aspects of how efforts to reduce costs in the short term might increase costs in the long term and vice versa. For example, advocates argue for the government to take steps to mitigate flood risks through civil engineering projects to reduce the risk of future losses, but in the short term such an action would add to the program's budget problems.

In addition to the direct costs of the program, the GAO cited ongoing management problems in the Federal Emergency Management Agency (FEMA). These issues relate to FEMA's ability to conduct or direct strategic planning, human capital planning, intra-agency collaboration, records management, acquisition management, and information technology. 

The GAO identified several specific shortcomings in FEMA operations related to NFIP:

• lacks a strategic human capital plan that addresses the critical competencies required for its workforce 

• does not have effective collaborative practices that would improve the functioning of program and support offices

• lacks a centralized electronic document  system that would allow its various offices to easily access and store documents 

• has only recently implemented or is still developing efforts to improve some acquisition management functions, making it difficult to assess the effects of these actions 

• does not have an effective system to manage flood insurance policy and claims data, despite having invested roughly seven years and $40 million in a new system whose development has been halted. 

The GAO also recommended encouraging private insurers to assume more of the flood risk that currently resides with the taxpayers. The report notes that this is not the first time that the GAO has made this recommendation, and in the past insurance carriers have opposed the proposal.

"In 2007, we evaluated the trade-offs of having mandatory all-perils policies that would include flood risks. For example, it would alleviate uncertainty about the types of natural events homeowners insurance covered, such as those that emerged following Hurricane Katrina. However, at the time the industry was generally opposed to an all-perils policy because of the large potential losses a mandatory policy would entail."

The GAO assessors did recognize that transferring responsibility for flood-loss risk to the private sector included negative elements, such as allowing private insurers to cherry-pick desirable properties and to charge higher rates in order to drive less desirable properties into the federal program. Further, the GAO noted that a private market strategy did not respond to the significant affordability problems faced by poor property owners and businesses.

Still, the GAO encouraged Congress to consider means of expanding private market coverage of flood risk.

"Strategies to help mitigate these disadvantages could include requiring private market coverage for all property owners—not just those in high-risk areas—and, as described earlier, providing targeted assistance to help low-income property owners pay for their flood coverage. In addition, Congress could provide options to private insurers to help lower the cost of such coverage, including tax incentives or federal reinsurance."

Reinsurance

Franklin W. Nutter testified on behalf of the Reinsurance Association of America (RAA). Nutter told the hearing that there was no private insurance market available to accept flood risk; however, the federal government could better manage the finances of the program by purchasing private reinsurance and issuing catastrophe bonds.

The reinsurers' association recommended the application of "risk-based rates" to the NFIP, without mentioning that the recommendation would mean an aggressive premium increase for policyholders. The RAA made repeated statements that call into question the current pricing policies employed by FEMA. For example, "The Program unfortunately takes into account only 1% of the losses from the 2005 program year (Hurricanes Katrina, Wilma and Rita) and relies on the average annual loss model for its pricing. This ignores the fact that extreme event catastrophes must be financed." 

The RAA testimony decried the current system, which provides subsidized rates for second homes and vacation properties and thus necessitates higher rates for primary homes and structures in less flood-prone areas. 

The RAA proposal for reinsurance support for the NFIP focused both on transactional reinsurance treaties coupled with catastrophe bonds and the reauthorization of a reinsurance pool. According to the RAA testimony, "Both markets have significant capacity and an appetite to take flood risk."

The testimony stressed the flexibility offered by the reinsurance/catastrophe bond approach: 

"Like any catastrophe reinsurance and cat bond program, it would transfer catastrophe risk from taxpayers and the Treasury to the capital markets. Should the NFIP find the bids unattractive on a price or coverage basis, it would not go forward with the placement. The NFIP would, therefore, be in the same place as it is now: dependent on public debt. If the placement were successful, the private sector would provide financial relief to taxpayers." 

In addition, the RAA called for the reauthorization of a reinsurance pool, which the original NFIP legislation created and the program operated from 1968 to 1978. The pool would reinsure 

"the NFIP— capitalized by those insurers that voluntarily wish to provide capacity. By doing so, these insurers would have access to the NFIP's flood insurance coverage and underwriting data. The Director and those participating insurers would enter into negotiations over the risk sharing formula and could individually subscribe capacity on an annual basis."

The Big "I"

The Independent Insurance Agents and Brokers of America (Big "I") testified that the NFIP is "virtually the only way for people to protect against the loss of their home or business due to flood damage."

Spencer M. Houldin, an independent agent from Connecticut who is chairman of the IIABA government affairs committee and serves as the Connecticut representative on the IIABA Board of Directors, represented the association. Houldin is president of Ericson Insurance, an independent agency with offices in Connecticut and New York.

Houldin addressed the Write Your Own (WYO) program, which operates under the NFIP:

"Independent agents serve as the sales force of the NFIP and the conduits between the NFIP, the WYO companies, and consumers. This relationship provides independent agents with a unique perspective on the issues surrounding flood insurance, yet also makes the role of the independent agent in the delivery process of flood insurance considerably more complex than that of many traditional property/casualty lines.

The Big "I" testimony offered similar perspectives to that of the RAA with regard to risk-based pricing and privatization of flood insurance coverage. The Big "I" did offer unique perspectives on the modernization of NFIP coverage and the issue of repetitively flooded properties.

Ultimately, the Big "I" recommends that the NFIP become a larger risk repository by expanding the kinds of coverages offered under the program. The association supports provisions of the reform legislation under consideration that will increase coverage limits, allow for optional business interruption insurance, and create a personal living expense benefit. According to the Big "I" testimony:

"The modernization of coverages will hopefully have three positive effects on the NFIP as a whole. First, it will allow consumers to more adequately insure their properties and valuables against their true risks. This will in turn make the NFIP as a whole a more attractive product for consumers, thereby increasing participation in the program. And also, as optional purchases that are sold at actuarial rates, the optional business interruption and additional living expenses additions in particular will result in an NFIP that is closer to being on actuarially sound footing."

The Big "I" testimony noted that the inclusion of optional business interruption coverage not only will make the product more attractive to consumers but also will have a positive impact in terms of Keynesian economics. Business interruption benefits provide a counter-cyclical stimulus to depressed local commerce after a disaster. 

"The inclusion of an optional business interruption provision will provide stability to the local economies in the areas affected by flood damage and will offset government disaster relief payments should the flood peril result in widespread destruction across a region."

With regard to repetitive-loss properties, the Big "I" testimony noted that the GAO has reported on this problem and Congress has taken steps in recent years to try to address the issue; however, the number of repetitive loss properties continues to increase.

From a Missouri perspective, after the 1993 Missouri Basin Flood, many localities strictly enforced flood plain no-build zones for a year or two after the disaster. Then localities granted exemptions for one property or another, which placed pressure on neighboring communities to grant similar exemptions. Today very few localities take the prohibitions against flood-plain construction very seriously. According to the Big "I" testimony:

"Repetitive loss properties—currently defined as those that have had two or more flood insurance claims payments of $1,000 or more over 10 years—continue to put a significant drain on NFIP resources. These properties account for about 1% of all policies but are estimated to account for up to 30% of all NFIP losses." 

Part of the problem relates to NFIP premium subsidies on these properties. The Big "I" spoke in support of congressional action to eliminate these subsidies, but the agents' group asked for more. 

"For example, if a repetitive loss property continues to experience a certain number of losses within a specific time frame, Congress could require that property to either take stringent mitigation measures or to be disqualified from participating in the NFIP altogether." 

The House Financial Services Committee has made the NFIP reform legislation a priority for this legislative session. Observers expect passage of the bill soon, and anticipate no problem in obtaining the president's signature.