THE TOPIC

APRIL 2011

Because of frequent flooding of the Mississippi River during the 1960s and the rising cost of taxpayer funded disaster relief for flood victims, in 1968 Congress created the National Flood Insurance Program (NFIP). It has three mandates: to provide residential and commercial insurance coverage for flood damage, to improve floodplain management and to develop maps of flood hazard zones.

While the comprehensive section of an auto insurance policy covers flood damage to vehicles, there is no coverage for flooding in standard homeowners, renters or commercial property insurance policies. It is available in a separate policy from the NFIP and from a few private insurers. Despite efforts to publicize this, many people exposed to the risk of floods still fail to purchase flood insurance.

It was the widespread flooding associated with Hurricane Katrina in 2005 that drew attention to the NFIP and set in motion debate about how to improve it. So far, Congress has not taken steps to significantly revamp the program. 

RECENT DEVELOPMENTS

• Reform Proposals, 2011: Two measures to extend and reform the flood insurance program have been introduced in Congress One, HR 1026, was drafted by Rep. Maxine Waters, D.–Calif., who introduced similar legislation in the last Congress. Last year’s bill passed the House but was never put to the vote in the Senate. The other piece of legislation was proposed by Rep. Judy Biggert, R. –Ill., who chairs the Insurance, Housing and Community Opportunity Subcommittee of the House Financial Services Committee. The measure aims to reduce rate subsidies and make the program ultimately actuarially sound, extends the program for five years to September 30, 2016, adds optional coverage for extra living expenses coverage to compensate policyholders forced to move out of their homes and adds business interruption (income) coverage to help flooded businesses survive a shut-down period, among other provisions. The draft bill makes no mention of forgiving the NIFP’s debt. However, it would require both the Controller General and FEMA to conduct studies on the privatization of the federal program and to report to Congress within 18 months.
• The Federal Emergency Management Agency (FEMA), which runs the program, sought input last year on various alternatives from reform of the current program to dropping federal involvement in flood insurance altogether. It also met with stakeholders, including insurers who currently participate in the “Write-Your-Own” flood insurance program, to ascertain whether they would be willing to shoulder some or all of the risk. Under the “Write-Your-Own” program, private insurers issue policies and adjust claims but the federal government retains responsibility for actual losses. 
• The insurance industry is divided on this issue. For example, the National Association of Mutual Insurance Companies (NAMIC), an organization that represents many property/casualty insurance companies, suggests that the best option would be to keep the current system but institute certain reforms, among them long-term reauthorization of the program to remove uncertainty and lapses in coverage; expansion of education and outreach programs to increase the percentage of homeowners living in flood-prone areas that purchase coverage; and actuarially sound rates to keep the program solvent. On the other hand reinsurers, the companies that insure insurance companies, and some large property/casualty insurers, have made a strong case for privatizing the NFIP. The Reinsurance Association of America suggests that the private sector could assume flood risk over time, possibly through a consortium of private sector underwriters supported by private reinsurance or by using the NFIP to issue and adjust policies but at actuarially sound rates. The actual risk of loss would then be transferred to the private reinsurance sector and capital markets instead of to the federal government as it is now. 
• Earlier Reform Proposals: In the absence of any legislative agreement between the House and the Senate on funding the program for the long term, the NFIP was reauthorized for short periods of time under a series of continuing resolutions that extended funding for many different programs. After allowing the program to lapse four times, during which new policies could not be issued, leaving homeowners without the option of buying coverage and delaying thousands of real estate closing per day in flood-prone regions, in September 2010, as the last extension was close to its expiration date, both the House and the Senate extended the program for one year to September 30, 2011. Insurers hope that during this longer extension period Congress will take time to make significant and long-term changes in the program. 
• Adding Coverage For Wind Damage: Legislators who promoted adding wind coverage to the NFIP’s policies as an option to reduce disputes over wind versus flood losses were defeated in the November 2010 election. The Obama administration, leading environmental groups, consumer advocates and taxpayer watchdogs were all opposed to the proposal. 
• At hearings, insurers stressed that most government-run property insurance programs aimed at providing coverage to high-risk policyholders, such as coastal property owners, operate at a deficit. Regulators are under political pressures to keep rates down in both the private market and state-operated pools, which, in turn, leads to larger pools, as private insurers withdraw from high-risk areas, and to higher deficits. If rates for wind coverage are commensurate with the risk and wind coverage is optional, as was proposed, few homeowners would purchase it when they could obtain a much cheaper policy through the state.
• Mandatory Flood Insurance: As a possible solution to the question “was the damage caused by wind or water?” South Carolina started requiring wind pool policyholders to purchase flood insurance in January 2008. Without it, they may not receive reimbursement for the full replacement cost of repairing storm damage. About 70 percent of wind pool policyholders already had flood coverage. As a result of the new law, several thousand additional residual market policyholders have now purchased it. Wind pool officials say the new mandate is designed to avert disputes about the exact cause of damage, a situation that may have held up some claim settlements after Hurricane Katrina. Most of the state is susceptible to flooding, they said. Several other states require that policyholders in state-sponsored property insurance programs purchase flood insurance.
• Government Accountability Office Studies: The Government Accountability Office (GAO) has published several studies on the federal flood insurance program. The latest, published as part of its High Risk series, says that the NFIP is not likely to be able to repay the $18.5 billion owed to the U.S. Treasury because it is not structured to build a capital surplus and its premium rates do not reflect the actual “flood risk.” Nearly one in four policyholders pay subsidized rates and since it cannot deny insurance on the basis of frequent losses, it covers repetitive loss properties, which represent 1 percent of the policies issued but 25 to 30 percent of the claims.  
• This critique follows another GAO report, issued at the end of October 2008, that focused on the National Flood Insurance Program’s (NFIP) rate-setting practices. In many cases the NFIP uses outdated estimates of risk and, even when properties are reevaluated and put into higher risk zones, premiums do not always reflect the increased risk because of FEMA’s concern that a higher premium will cause policyholders to drop out of the program, the GAO noted.
• Policies in Force: While the number of flood policies in force is growing, a significant portion of the population at risk of flooding still is not insured for flood damage, as the flooding in the Midwest in the spring of 2008 and after Hurricane Ike revealed. The latest available data show that in 2009, there were more than 5.7 million policies in force, compared with 5.0 million in 2005, the year of Hurricane Katrina, and 4.3 million in 1999. Premiums grew to $3.2.billion in 2009 from $2.2 billion in 2005. In 2009, 24,417 claims were paid even though no major hurricane struck the U.S. mainland, compared with 212,518 in 2005 and the cost of claims was $618 million, compared with $17.7 billion in 2005. Forecasters expect a higher than average number of storms in the 2011 hurricane season, raising the potential for a large number of flood claims. 
  

BACKGROUND

The National Flood Insurance Program: Before Congress passed the National Flood Insurance Act in 1968 after frequent widespread flooding along the Mississippi River, the national response to flood disasters had been to build dams, levees and other structures to hold back flood waters, a policy that may have encouraged building in flood zones.

The National Flood Insurance Act created the National Flood Insurance Program (NFIP), which was designed to stem the rising cost of tax-payer funded relief for flood victims and the increasing amount of damage caused by floods. The NFIP has three components: to provide flood insurance, floodplain management and flood hazard mapping. Federal flood insurance is only available where local governments have adopted adequate flood plain management regulations for their floodplain areas as set out by NFIP. About 20,400 communities across the country participate in the program. NFIP coverage is also available outside of the high-hazard areas.

The law was amended in 1969 to provide coverage for mudslides and again in 1973. Until then, the purchase of flood insurance had been voluntary, with only about one million policies in force. The 1973 amendment put constraints on the use of federal funds in high-risk floodplains, a measure that was expected to lead to almost universal flood coverage in these zones. The law prohibits lenders that are federally regulated, supervised or insured by federal agencies from lending money on a property in a floodplain zone when a community is participating in the NFIP, unless the property is covered by flood insurance. The requirement for flood insurance also applies to buildings that receive financial assistance from federal agencies such as the Veterans Administration. However, because the initial mortgage on the property is frequently sold by the originating bank to another entity, enforcement of this law has been poor.

Legislation was enacted in 1994 to tighten enforcement of flood insurance requirements. Regulators can now fine banks with a pattern of failure to enforce the law and lenders can purchase flood insurance on behalf of homeowners who fail to buy it themselves, then bill them for coverage. The law includes a provision that denies federal disaster aid to people who have been flooded twice and have failed to purchase insurance after the first flood.

Buildings constructed in a floodplain after a community has met regulations must conform to elevation requirements. When repair, reconstruction or improvement to an older building equals or exceeds 50 percent of its market value, the structure must be updated to conform to current building codes. A 2007 NFIP study on the benefits of elevating buildings showed that due to significantly lower premiums homeowners can usually recover the higher construction costs in less than five years for homes built in a “velocity” zone, where the structure is likely to be subject to wave damage, and in five to 15 years in a standard flood zone. The Federal Emergency Management Agency (FEMA) estimates that buildings constructed to NFIP standards suffer about 80 percent less damage annually that those not built in compliance.

How It Works: The NFIP is administered by FEMA, now part of the Department of Homeland Security. Flood insurance was initially only available through insurance agents who dealt directly with the federal program. The "direct" policy program has been supplemented since 1983 with a private/public cooperative arrangement, known as "Write Your Own," through which a pool of insurance companies issue policies and adjust flood claims on behalf of the federal government under their own names, charging the same premium as the direct program. Participating insurers receive an expense allowance for policies written and claims processed. The federal government retains responsibility for underwriting losses. Today, most policies are issued through the Write-Your-Own program but some nonfederally backed coverage is available from the private market.

The NFIP is expected to be self-supporting (i.e., premiums are set at an actuarially sound level) in an average loss year, as reflected in past experience. In an extraordinary year, as Hurricane Katrina demonstrated, losses can greatly exceed premiums, leaving the NFIP with a huge debt to the U.S. Treasury that it is unlikely to be able to pay back. Hurricane Katrina losses and the percentage of flood damage that was uninsured led to calls for a revamping of the entire flood program.

Flood adjusters must be trained and certified to work on NFIP claims. NFIP general adjusters typically reexamine a sample of flood settlements. Insurers that fail to meet NFIP requirements must correct problems; otherwise they can be dropped from the program.

As with other types of insurance, rates for flood insurance are based on the degree of risk. FEMA assesses flood risk for all the participating communities, resulting in the publication of thousands of individual flood rate maps. High-risk areas are known as Special Flood Hazard Areas or SFHAs.

Flood plain maps are redrawn periodically, removing some properties previously designated as high hazard and adding new ones. New technology enables flood mitigation programs to more accurately pinpoint areas vulnerable to flooding. As development in and around flood plains increases, run off patterns can change, causing flooding in areas that were formerly not considered high risk and vice versa.

People tend to underestimate the risk of flooding. The highest-risk areas (Zone A) have an annual flood risk of 1 percent and a 26 percent chance of flooding over the lifetime of a 30-year mortgage, compared with a 9 percent risk of fire over the same period. In addition, people who live in areas adjacent to high-risk zones may still be exposed to floods on occasion. Ninety percent of all natural disasters in this country involve flooding, the NFIP says. Since the inception of the federal program, some 25 to 30 percent of all paid losses were for damage in areas not officially designated at the time of loss as special flood hazard areas. NFIP coverage is available outside high-risk zones at a lower premium.

Flood insurance covers direct physical losses by flood and losses resulting from flood-related erosion caused by heavy or prolonged rain, coastal storm surge, snow melt, blocked storm drainage systems, levee dam failure or other similar causes. To be considered a flood, waters must cover at least two acres or affect two properties. Homes are covered for up to $250,000 on a replacement cost basis and the contents for up to $100,000 on an actual cash value basis. Replacement cost coverage pays to rebuild the structure as it was before the damage. Actual cash value is replacement cost minus the depreciation in value that occurs over time. (Excess flood insurance is available in all risk zones from some private insurers for NFIP policyholders who want additional coverage or where the homeowner’s community does not participate in the NFIP.) Coverage for the contents of basements is limited. Coverage limits for commercial property are $500,000 for the structure and another $500,000 for its contents.

To prevent people putting off the purchase of coverage until waters are rising and flooding is inevitable, policyholders must wait 30 days before their policy takes effect. In 1993, 7,800 policies purchased at the last minute resulted in $48 million in claims against only $625,000 in premiums.

Proposals for Change: The NFIP has four major goals: to decrease the risk of flood losses; reduce the costs and consequences of flooding; reduce the demand for federal assistance; and preserve and restore beneficial floodplain functions. In a final report published in 2006 by the American Institutes for Research (AIR), which conducted an evaluation of the federal flood insurance program, AIR said that although much had been accomplished, the program fell short of meeting its goals in part because the NFIP did not have the ability to guide development away from floodplains and cannot restore beneficial floodplain functions once they have been impaired. In addition, AIR said, many people still are not covered or not adequately covered for flood damage. AIR also noted that the NFIP was hampered in reaching its goals by insufficient Congressional funding, lack of pertinent data, misperceptions about the nature of the program and the breakdown in coordination among its three major sectors.

A report published by FEMA in 2007 suggests that development patterns should be changed to protect environmentally sensitive areas and that communities in the flood program should be encouraged or required to ban development in these locations.

Another criticism of the NFIP is that it does not charge enough for coverage. Among the reasons for the premium shortfall is that the cost of coverage on dwellings that were built before floodplain management regulations were established in their communities is subsidized. As a result, the premiums paid for flood coverage by the owners of these properties reflect only 30 to 40 percent of the true risk of loss. 

Lawmakers considering legislation to renew authorization of NFIP have proposed many changes that would have increased the NFIP’s future income, including making owners of property subject to repetitive flooding pay premiums that more closely reflect the true cost of their losses and gradually eliminating the flood insurance subsidy for vacation and second homes. In addition, they would have allowed higher premium increases to make the program eventually self-sustaining.

Flood Coverage in Other Countries: There are two basic methods of providing flood insurance in developed countries. Under the first, the optional system, insurers extend their standard policy to include supplemental coverage for flood damage on payment of additional premium. The coverage tends to be expensive due to the fact that only those most likely to be flooded, and therefore to file claims, purchase it, a situation known in the insurance industry as adverse selection. Among the countries with optional coverage are Germany, Italy and the Netherlands. The other method is “bundling.” Under this system, flood coverage is combined with coverage for other perils such as fire and windstorm, thus spreading the risk of flood losses across a large geographical area and greatly increasing the percentage of the population covered for flood damage. Countries that have adopted this method include the United Kingdom, Spain and Japan. In addition, in some countries such as France and Spain there are government compensation programs for major disasters, including flooding, that take effect when the cost of a disaster reaches a certain level. The system in the United States is unique in that the government underwrites the coverage and private insurers act as administrators bearing no actual flood risk.