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Expansion of Private Flood Insurance – Caution on Making the National Flood Insurance Program the Insurer of Last Resort

June 22, 2017

Since 1978, the National Flood Insurance Program (NFIP) has enlisted private insurers, with their market presence, to sell and service policies under the auspices of the Federal Emergency Management Agency.

The NFIP provided consumers access to flood insurance, a product that historically was not available through private insurers due to an inability to make a profit. [1] For the last 50 years, the NFIP’s underpriced policies were the major inhibitor to the sales of private flood insurance as private insurers were unable to compete with the subsidized rates. [2] In recent years, as the NFIP has begun to raise rates on homeowners and businesses, the private market sees an opportunity to compete. While there is room for the private sector in the flood insurance market, a robust NFIP program is still necessary. The private market is not likely to insure the highest risk properties at a rate that moderate- and low-income consumers could afford.  

Competitive Rates

The NFIP is a United States Government program with private sector partners that provide the vast majority of flood insurance coverage in the United States. Impacts from the 2005 Hurricane Season necessitated massive borrowing from the United States Treasury and “characteristic of a catastrophic risk, the NFIP paid out more in claims after Katrina than it had over the life of the program to that point.” [3] In response to the NFIP’s fiscal insolvency, Congress in 2012 dramatically amplified rate increases that got the attention of the private market, since premiums began to be competitive. Even with a rollback on primary home rate increases in 2014, through the Homeowner Flood Insurance Affordability Act, the program is steadily moving to risk-based premiums.

Post-flood damage. Source: John Miller.Post-flood damage. Source: John Miller.

Vulnerabilities of Increasing Private Market Share

Currently, the lending industry sees few private flood insurance policies; according to GAO, less than 5 percent of policies are written by the private sector. [4] Private insurance companies claim that they are being undercut by the NFIP’s cheaper policies which are subsidized ultimately through taxpayer money. The private market wants the NFIP to open its claim data because they would like to avoid insuring repetitive loss properties. [5] Properties in this category represent one percent of policies but 25 to 30 percent of all NFIP claims. [6] Further, private market insurers are advocating for conditions such as continuous coverage which would allow policyholders to rejoin the NFIP, with preserved prior subsidized or grandfathered rates, if the private insurer raised its rates following a claim after a flood event. [7]

The sharing of policy claim information with competitors would weaken the NFIP. Sharing of data—which would be unheard of between private sector competitors—could encourage private insurers to compete for properties that currently have no history of a loss, also known as “cherry picking.” This would create a concentration of high risk in the NFIP since private companies can manage against adverse selection, while the NFIP cannot. Continuous coverage, or allowing homeowners and businesses to rejoin the NFIP and retain the discounted rate after leaving for private coverage, would further distress the financial stability of the NFIP. [7]

Hurricane Sandy aftermath. Source: John Miller.Hurricane Sandy aftermath. Source: John Miller.

Affordable Coverage

The NFIP expires September 30, 2017, and needs Congressional reauthorization that private insurance advocates see as a mechanism to influence the expansion of private flood insurance. In the reauthorization, the concept of fairness and affordability must be incorporated to provide flood insurance coverage for the population in need that cannot afford risk-based premiums. According to GAO, “…providing means-tested subsidies to some property owners would allow Congress to address affordability concerns associated with premium rate increases.” [8] The NFIP has always had a balancing act of keeping premiums low enough to encourage participation while charging rates that cover an average year. Since national standards did not exist before the NFIP, “The program was structured to subsidize the cost of flood insurance on existing homes, in order to maintain property values, while charging actuarially fair rates on new construction.” [9] Any movement to private flood insurance must not tip the shaky equilibrium of the program. Insensitivity to affordability could lead to policyholders dropping coverage limits, increasing deductibles beyond their means, and possibly increasing dropped policies. [10] In addition, the NFIP is not only an insurance product but has concurrent objectives in providing mapping, regulations for new construction and reconstruction, and mitigation of at-risk structures. It is unclear how those important elements of the NFIP would continue if the private market displaces the NFIP.

More images from the aftermath of Hurricane Sandy. Source: John Miller.More images from the aftermath of Hurricane Sandy. Source: John Miller.

Summary

As NFIP premiums increase, the private flood insurance market has growing interest in competing with the government program. The NFIP must be maintained as the program provides coverage for policyholders that have no alternative in a private marketplace, and as such, the private market does not equal the NFIP’s role in fairness and affordability. Importantly, the NFIP’s standards, hazard mapping, and mitigation and better practice tools, through the Community Rating System, are essential in keeping check on expanding the nation’s flood vulnerability and provide a buffer to the United States taxpayer in disaster assistance payments to the most vulnerable.

As with any policymaking, all externalities must be considered. The NFIP is a sensitive system that can be toppled with seemingly minor changes. The private market can coexist with the NFIP if modifications are contemplated holistically and supported by more than a Congressional Budget Office score. As stated in the Guy Carpenter Study “…under current circumstances it would be politically and administratively infeasible to be able to achieve a relatively immediate transition from the current system to anything drastically different.” [11]  Legislative language to promote a private flood insurance market must examine the impacts to the NFIP, the Federal taxpayer, and the policyholder. Great care should be exercised in creating conditions of making the NFIP the insurer of last resort as it hard to conceive how the program would be financially sustainable if its portfolio becomes a concentration of the highest risk policies. As the Guy Carpenter Study well notes “In many ways, the complexities of identifying a path to privatization for the flood insurance system in the U.S. are similar to that of solving the American health care system – there is no single, clear solution, it is heavily politicized, and harsh criticism of any change is inevitable.” [12]

 

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  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

 

References

  [1] United States Government Accountability Office, “Flood Insurance - Potential Barriers Cited to Increased Use of Private Insurance,” GAO-16-611, July, 2016, https://www.gao.gov/assets/680/678414.pdf and United States Government Accountability Office, “Flood Insurance - Strategies for Increasing Private Sector Involvement,” GAO-14-127, January 2014, http://www.gao.gov/assets/670/660309.pdf.

  [2] United States Government Accountability Office, “Flood Insurance - Comprehensive Reform Could Improve Solvency and Enhance Resilience,” GAO-17-425, April, 2017, https://www.gao.gov/assets/690/684354.pdf.

  [3] Kousky, C., “Revised Risk Assessments and the Insurance Industry,” Resources For the Future Discussion Paper 13-35, November, 2013, http://www.rff.org/files/document/file/RFF-DP-13-35.pdf.

  [4] United States Government Accountability Office, “Flood Insurance - Potential Barriers Cited to Increased Use of Private Insurance,” GAO-16-611, July, 2016, https://www.gao.gov/assets/680/678414.pdf.

  [5] Kousky, C. & Shabman, L., “Pricing Flood Insurance - How and Why the NFIP Differs from a Private Insurance Company,” Resources For the Future Discussion Paper 14-37, October, 2014, http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-14-37.pdf.

  [6] United States Government Accountability Office, “Continued Actions Needed to Address Financial and Operational Issues,” GAO-10-631T, April 21, 2010, http://www.gao.gov/assets/130/124468.pdf.

  [7]  United States Department of Homeland Security, “National Flood Insurance Program - Report to Congress on Reinsuring NFIP Insurance Risk and Options for Privatizing the NFIP,” August 15, 2015, https://www.floods.org/ace-files/documentlibrary/2012_NFIP_Reform/Reinsuring_NFIP_Insurance_Risk_and_Options_for_Privatizing_the_NFIP_Report.pdf.

  [8] United States Government Accountability Office, “Flood Insurance - Strategies for Increasing Private Sector Involvement,” GAO-14-127, January 2014, http://www.gao.gov/assets/670/660309.pdf.

  [9] Michel-Kerjan, E. O., “Catastrophe Economics: The National Flood Insurance Program,” Journal of Economic Perspectives, Volume 24, Number 4, pp. 165–186, 2010, http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.24.4.165.

  [10] United States Government Accountability Office, “Flood Insurance - Strategies for Increasing Private Sector Involvement,” GAO-14-127, January 2014, http://www.gao.gov/assets/670/660309.pdf.

  [11] United States Department of Homeland Security, “National Flood Insurance Program - Report to Congress on Reinsuring NFIP Insurance Risk and Options for Privatizing the NFIP,” August 15, 2015, https://www.floods.org/ace-files/documentlibrary/2012_NFIP_Reform/Reinsuring_NFIP_Insurance_Risk_and_Options_for_Privatizing_the_NFIP_Report.pdf.

  [12] Ibid.

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