New technologies and a better understanding of flood risk may have increased private insurers’ interest in providing flood insurance but real obstacles remain to the private sector getting involved.
The obstacles include political and consumer resistance to full cost-based pricing of flood risks, a resistance demonstrated by the current attempts in the Senate and the House to roll back rate increases called for under the Biggert-Waters Flood Insurance Reform Act of 2012.
The efforts to delay Biggert-Waters “may reinforce private insurers’ skepticism that they would ever be permitted to charge adequate rates and make their participation unlikely in the foreseeable future,” a new Government Accountability Office (GAO) report concludes.
The recent government spending plan approved by Congress includes a provision to delay some of the Biggert-Water premium increases. The Senate is expected to vote next week on a bill to delay more of the increases for four years.
The GAO report, “Strategies for Increasing Private Sector Involvement,” finds that even if private insurers can be brought into the flood insurance market, the government will still have to play a role or several roles as reinsurer, residual market, subsidy provider or mitigation enforcer. (See copy of report below.)
The National Flood Insurance Program (NFIP) has built up a $24 billion debt, causing some to suggest shifting exposure to the private sector and eliminating subsidized premium rates, so that property owners rather than taxpayers pay for their risk of flood loss.
But, the GAO report notes, the NFIP was originally created in part because private insurers have been unwilling to insure against flood damage.
Eliminating subsidies was part of the intent of the Biggert-Water reforms. That law also requires the GAO to conduct a study on increasing private sector involvement in flood insurance, something GAO also did back in June 2011. In the latest report, the GAO reiterates its previous recommendations that Congress consider eliminating subsidized rates, charge full-risk rates to all policyholders, and provide funds for premium subsidies targeted to eligible policyholders to address affordability concerns.
GAO held a roundtable with 14 stakeholders including state insurance regulators; a catastrophe modeling firm; an academic; and individuals representing associations of private insurers, reinsurers, actuaries, consumers, and floodplain managers. It supplemented the roundtable with interviews with Federal Insurance Office officials; state residual insurance programs; and groups representing insurance adjusters, insurance agents, realtors and mortgage bankers.
Historically, NFIP premiums do not cover costs because the program was not designed to be actuarially sound. The National Flood Insurance Act of 1968 authorized subsidized rates to encourage participation in NFIP, especially for properties in high-risk locations that were built before Flood Insurance Rate Maps (FIRM) became available.
About 1.1 million of 5.5 million NFIP policies—about 20 percent—have subsidized rates. The discounted premiums encourage property owners to join the program but do not cover potential losses, and many subsidized policies have had high losses, according to GAO.
“Flood insurance reform involves the question of who should be responsible for paying to insure against the flood risk that arises from living in a particular location—the individual property owners themselves, taxpayers, or some combination of the two,” GAO said in a letter to House and Senate leaders accompanying the report.
Conditions for Private Sector
According to the report, several conditions must be present to increase private sector involvement in the sale of flood insurance:
First, insurers need to be able to accurately assess risk to determine premium rates. For example, stakeholders told GAO that access to NFIP policy and claims data and upcoming improvements in private sector computer modeling could enable them to better assess risk.
Second, insurers need to be able to charge premium rates that reflect the full estimated risk of potential flood losses while still allowing the companies to make a profit, as well as be able to decide which applicants they will insure. However, such rates might seem unaffordable to many homeowners.
Third, insurers need sufficient consumer participation to properly manage and diversify their risk, but many property owners do not buy flood insurance.
Strategies for Private Involvement
The report identifies several strategies that could help create the conditions needed for sale of flood insurance by the private sector:
NFIP charging full-risk rates. Congress could eliminate subsidized rates, charge all policyholders full-risk rates, and then provide funds for a direct means-based subsidy to some policyholders. The thinking behind this strategy is that full-risk NFIP rates would encourage private sector participation because they would be much closer to the rates private insurers would need to charge. The explicit subsidy would address affordability concerns. The Biggert-Waters Act eliminates some subsidized rates, but some in Congress and affected states have proposed delaying these rate increases.
NFIP providing residual insurance. The federal government could also encourage private sector involvement by providing coverage for the highest-risk properties that the private sector is unwilling to insure. Providing residual coverage could increase the program’s exposure relative to the number of properties it insured, but NFIP would be insuring fewer properties, and charging adequate rates could reduce taxpayer costs, according to the report.
NFIP as reinsurer. Alternatively, the federal government could serve as a reinsurer, charging a premium for assuming the risk of catastrophic losses. However, the cost of reinsurance premiums would likely be passed on to consumers, with higher rates potentially decreasing consumer participation, the report notes.
The report offers additional strategies including mandatory coverage requirements to ensure broad participation, NFIP purchasing reinsurance from the private sector rather than borrowing from the U.S. Treasury, and NFIP issuing catastrophe bonds to transfer risk to private investors.
Under every scenario, the government would still have a role, according to the GAO.
“As the private sector increases its role in providing flood coverage, the federal government could collaborate with state and local governments to focus on other important roles, including promoting risk awareness among consumers, encouraging mitigation, enforcing building codes, overseeing land use agreements, and streamlining insurance regulations,” the report says.
Private insurers say they would need more information and more sophisticated modeling to assess flood risk before they could begin providing flood insurance. At the same time, risk modelers question the reliability of FEMA’s flood risk zones, which in many areas were determined using a less sophisticated methodology than what is available today.
GAO roundtable participants said that risk modeling firms would be releasing new flood models in the next several years, which could help private insurers evaluate flood risk. Also, a growing private market for flood insurance would likely create a market for modeling flood risk, attracting many companies to fill that need, they said.
In addition to better computer modeling, insurers say they would want access to NFIP policy and claims data. However, FEMA officials said the Privacy Act prohibits the agency from releasing detailed data. While the agency could release data in the aggregate, some information could not be provided in detail. For example, FEMA said it could provide zip-code level information to communities but would need to determine how to release property-level information while protecting the privacy of individuals.
Freedom to Rate, Underwrite
Insurers would want to charge adequate rates that reflect the full estimated risk of flood loss plus allow for profit. According to the report, these rates would be higher than present NFIP rates for many properties and could present affordability challenges for consumers.
Participants in the GAO report expressed concern that the political environment could prevent insurers from setting adequate rates, that higher prices could lead some homeowners to purchase lower amounts of coverage or choose not to purchase flood insurance at all, and that higher flood insurance rates could also affect property owners’ home values and ability to sell their properties.
Different insurance regulations across states could further complicate insurers’ ability to underwrite flood insurance and insurers would need clarity on the political and regulatory environment before entering the flood market, according to GAO. Some participants said that state insurance regulators lack knowledge about flood policies.
In addition, private insurers would need freedom in their underwriting of policies so that they could accept and reject applicants as necessary to manage their risk portfolios. For example, insurers might determine that they need to limit the number of policies in a geographic area. Incentives would be needed to encourage insurers to assume greater risk, particularly in flood-prone areas.
Insurers need a large, diverse risk pool so they can better estimate losses based on loss data collected over time and so they can spread the losses over a large number of properties. Broad consumer participation in the market would also be necessary to address adverse selection—the phenomenon that occurs when only those most in need typically purchase insurance, creating a pool of only the highest-risk properties. In this case, insurers sad they must be confident that homeowners other than those in the highest-risk areas will obtain flood insurance, because adverse selection can hamper an insurer’s efforts to manage its risk.
A 2006 study estimated that NFIP participation rates were as low as 50 percent in Special Flood Hazard Areas (SFHAs), where property owners with loans from federally insured and regulated lenders were required to purchase flood insurance. The study also found that participation rates outside of SFHAs were as low as 1 percent. Another study found that homeowners both within and outside SFHAs who did obtain flood insurance when purchasing their homes typically kept it for 2 to 4 years before canceling their policies.
Affordability and Risk Perception
The GAO report identifies affordability as one of the key challenges to providing flood insurance. This could be a particularly difficult issue for low- and moderate-income homeowners, as evidenced by complaints surrounding rate increases under the Biggert-Waters Act, according to the GAO.
Many property owners have an inaccurate perception of their risk of flooding and thus do not buy flood insurance. For example, GAO said a 2012 study suggested that some property owners believe that only properties in SFHAs are in a flood zone and that properties located outside of SFHAs are not at risk of flooding.
Also many consumers mistakenly assume that their homeowners insurance policies include flood coverage while some lending institutions do not require flood coverage at mortgage origination, according to the report.
Finally, stakeholders suggested that many consumers do not obtain flood insurance because they assume they would receive federal or state disaster assistance after a flood event even though federal disaster assistance to individuals is limited and primarily consists of loans.
The report ends with a warning that delaying Biggert-Waters could be a setback for efforts to bring private insurers into the market:
“While a number of conditions are important to attract private sector participation in the flood insurance market, key among them is the ability to charge rates that fully reflect the estimated risk of flooding. The Biggert-Waters Act includes a number of provisions that begin moving NFIP toward full-risk rates for some properties, a critical first step. Delaying or repealing rate increases in the Biggert-Waters Act may address affordability concerns but would likely continue to increase NFIP’s long-term burden on taxpayers. Further, it may reinforce private insurers’ skepticism that they would ever be permitted to charge adequate rates and make their participation unlikely in the foreseeable future.”
The report recommends that Congress consider continuing with the Biggert-Waters plan to eliminate widespread subsidies while creating means-based premium subsidies for certain eligible policyholders who need help. Some insurer and taxpayer groups have urged Congress to pursue this strategy of targeted subsidies also.