Environmental Valuation & Cost-Benefit News

Link: http://www.cbo.gov/ftpdocs/106xx/doc10620/11-04-FloodInsurance.pdf

Introduction and Summary:
The main source of insurance against flood damage in the United States is the National Flood Insurance Program (NFIP), administered by the Federal Emergency Management Agency (FEMA). Some 21,000 communities, covering about 98 percent of the U.S. population, participate in the program. Almost all buildings in participating communities are eligible to be insured through the NFIP, except for structures that are built entirely over water or largely below ground. Certain buildings, such as those with a mortgage from a federally regulated lender, must be insured if they are located in areas at high risk of flooding, though compliance with that requirement is incomplete.

In all, the NFIP had 5.6 million policies in force as of July 31, 2009, with a total insured value of $1.2 trillion and total annual premiums of $3.1 billion. The program encompasses three main activities:
1) Offering insurance for flood risks—coverage is available in amounts up to $350,000 for residential properties ($250,000 for the structure and $100,000 for the contents) and up to $1 million for nonresidential properties ($500,000 each for the structure and contents);
2) Mapping flood hazards—for each participating community, FEMA creates a flood insurance rate map that documents areas at risk of flooding; and
3) Setting minimum requirements for building codes and floodplain management practices in participating communities.

Together, those components of the NFIP address the interrelated goals of reducing exposure to flood damage, allowing floodplains to play their natural beneficial roles, making it easier for flood victims to recover when damage occurs, and reducing federal costs (by charging premiums for flood insurance rather than providing isaster aid after a flood at no charge to the recipients).

Most NFIP policies are issued at “full-risk” premium rates that FEMA considers actuarially sound—that is, sufficient on average to cover the total flood claims and administrative costs for those policies based on the agency’s maps and its estimates of the frequency of different size floods. However, for more than 1 million policies—about one-fifth of the total—premium rates are explicitly subsidized. Those policies mainly cover older structures in areas at high risk of flooding.

The subsidized policies give the NFIP a built-in actuarial deficit, which the Congressional Budget Office (CBO) currently estimates at about $1.3 billion per year. That actuarial deficit was somewhat obscured for many years by the program’s operating results. In 2005, however, the NFIP experienced an unprecedented volume of claims resulting from Hurricanes Katrina, Rita, and Wilma. Total payments on those claims were greater than the total for all of the program’s previous years combined and led the NFIP to borrow about $17 billion from the Treasury, an amount roughly equal to the program’s net loss on insurance operations for that year.

The 2005 loss highlighted a number of factual and policy questions about the NFIP’s financial position. This CBO paper addresses two sets of factual questions.

First, does evidence suggest that the program’s full-risk premium rates are actuarially sound, or does it suggest that those rates implicitly carry hidden subsidies from taxpayers? Historically, the NFIP’s full-risk premiums have been too low to cover the flood claims and administrative costs of the policies insured at those rates. Even before the 2005 hurricanes, the program’s total claims and expenses on full-risk policies since 1978 exceeded its total premium income from those policies by about 5 percent. Taking into account the large 2005 losses, cumulative costs on those policies are almost twice the size of total income from the policies. That experience does not directly imply that current premium rates are too low, however, because rates have risen over time and because the frequency of future catastrophic years like 2005 is highly uncertain. In part because of that uncertainty, CBO does not have enough information about the current distribution of flood risks to calculate whether the present full-risk premiums are actuarially adequate.

Analyzing the methods that FEMA uses to set the full-risk rates does not yield definitive answers either. Some aspects of those methods tend to contribute to an actuarial surplus—the primary one being the additional 10 percent that FEMA includes in the rates in high-risk areas (20 percent in some high-risk coastal areas) as a safety margin for uncertainty. Other aspects of the agency’s ratesetting methods tend to contribute to an actuarial deficit.

FEMA is not reviewing its flood maps every five years as required by law, and some older maps do not reflect significant changes in local conditions that tend to increase the risk of flooding, such as coastal erosion, increases in sea level, land development, and reductions in the capacity of river channels. In addition, evidence suggests that climate change has increased the risk of flooding from rivers and perhaps also from coastal storms, making FEMA’s models of flood frequencies out of date. Those issues may warrant attention regardless of the overall adequacy of the program’s full-risk rates.

Second, to what extent are the NFIP’s losses attributable to properties that have experienced multiple floods? How is FEMA responding to the risks posed by such properties? Currently insured repetitive-loss properties (RLPs)— defined by FEMA as properties that have been the subject of two or more flood-claims payments greater than $1,000 apiece in any 10-year period—account for 2 ercent of current policies and 3 percent of current premiums but about 12 percent of total claims since 1978.

More than half of the roughly 71,000 RLPs that are now insured have had only two losses leading to such payments, and their experience may reflect random chance rather than truly above-average risks.

However, about 23,000 RLPs nationwide have been the subject of at least four claims payments while insured, and 10,000 of those properties have prompted six or more payments.

FEMA’s approach to reducing the cost of repetitive-loss properties focuses more on taking steps to mitigate the worst flood risks—such as elevating, relocating, floodproofing, or demolishing properties—than on charging higher premiums for flood insurance. Indeed, more than half of the policies covering RLPs in high-risk areas have rates that are explicitly subsidized. Policies covering RLPs in low- to moderate-risk areas do have higher average premiums than non-RLPs in those areas (because they are ineligible for the lower-priced “preferred-risk policy” rates that FEMA charges on most policies in those areas). Even those higher average rates, however, are not based directly on the claims experience of individual properties or of repetitive-loss properties as a whole.

The Congressional Budget Office (CBO) www.CBO.gov
November, 2009