Flood Insurance
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THE TOPIC
DECEMBER 2008
Because of frequent flooding of the Mississippi River during the 1960s and the rising cost of tax-payer 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 and, despite efforts to publicize this, many people exposed to the risk of floods still fail to purchase a separate NFIP policy.
It was the widespread flooding associated with Hurricane Katrina in 2005 that drew attention to the program and set in motion debate about how to improve it. However, lawmakers in the House and the Senate could not agree on proposals for change and, with funding due to expire in September 2008, the NFIP was extended to March 2009 without any modifications.
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RECENT DEVELOPMENTS
- National: In a report published at the end of October, the Government Accountability Office (GAO) says that the National Flood Insurance Program’s (NFIP) rate-setting practices raise concerns about the program’s financial viability. In many cases the NFIP uses outdated estimates of risk and even when properties are reevaluated and put into a higher risk zones, premiums do not always reflect the increased risk because of the Federal Emergency Management Agency’s (FEMA) concern that a higher premium will cause policyholders to drop out of the program. Some 25 percent of policies have subsidized rates, the GAO estimates. Currently, the premiums collected do not cover the program’s operating expenses, claim costs and debt repayments to the U.S. Treasury. With the potential for more severe flooding in future, the federal government and ultimately the taxpayers are exposed to ever-greater financial risks, especially in years of catastrophic flooding. The GAO suggests that FEMA ensures that its rate-setting methods result in rates that accurately reflect flood risks and that it determines the impact of the newly subsidized properties on the NFIP.
- The National Association of Insurance Commissioners is proposing that insurers offer an “all-perils” insurance policy that includes coverage for flood damage. The federal government would act as a reinsurer, or backstop for the program, in much the same way as it does for commercial terrorism coverage under the Terrorist Risk Insurance Act, paying losses over a certain dollar threshold, see report on Terrorism Risk and Insurance. Thus the risk of catastrophic loss would remain with the federal government. The proposal is included in a white paper that the organization expects to complete by December 2008.
- An associate professor at the Washington and Lee School of Law in Virginia, Adam Scales, has also suggested that insurers sell a policy that covers both wind and flood. The federal government would reimburse insurers for the flood portion. One major homeowners insurer is considering such a concept. The company has not made a formal proposal to Congress but has discussed the plan with federal legislators, among others. The basic flood insurance portion of the policy would be sold at the same price as the federal program but policyholders would be able to buy additional flood coverage.
- Some have proposed the reverse: including wind coverage in the federal flood insurance program. A provision for optional wind coverage was passed by the House in May 2007 as part of a bill to reauthorize and reform the NFIP, but the Senate did not support the concept and the optional wind provision was omitted from its version of the reauthorization bill.
- A Government Accountability Office (GAO) report released in May 2008 underlined the difficulties in implementing an optional wind coverage provision. The GAO said that the homeowners most likely to purchase the optional wind coverage would be those with the highest likelihood of wind damage (a concept known as adverse selection in the insurance industry), making deficits likely; that a new distribution network would have to be created because insurers now sell most federal flood insurance through the ‘Write-Your-Own” public/private partnership, see Background section, and if wind coverage were added they would be undercutting the wind coverage in their own homeowners insurance business; and that the flood insurance program is already burdened by $17 billion in debt as a result of the 2004/2005 hurricanes, making it difficult to take on a new and volatile wind program.
- The optional wind provision was originally proposed by Rep. Gene Taylor, D-Miss, in response to litigation over wind/flood coverage issues following Hurricane Katrina. At a hearing on the bill that included the provision, 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 proposed, few homeowners will purchase it when they can obtain a much cheaper policy through the state. Although many in the insurance industry oppose Taylor’s wind/flood coverage proposal, several large homeowners insurers support the concept.
- 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 this year’s hurricanes revealed. In 2007 there were more than 5.6 million policies in force, compared with 5.5 million the previous year. Premiums grew to $2.85 billion in 2007 from $2.60 billion in 2006. With no major hurricanes hitting the United States that year, the number of claims dropped to 21,287 from 21,547 in 2006, also a year of no major hurricanes and the cost of flood losses decreased to $523 million from $553 million in the same year.
- State: 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.
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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 the local government bodies have adopted adequate floodplain 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 non-federally 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. Hiigh-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 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 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. In January 2006, FEMA estimated an annual shortfall in premium income of $750 million due to these subsidies. Some subsidized properties also suffer repetitive losses. Repetitive loss properties accounted for about $4.6 billion in claims payments between 1978 and 2004. The AIR report acknowledged that the current system is not eliminating existing damage-prone buildings as quickly as expected.
Lawmakers considering legislation to renew authorization of NFIP in 2007 and 2008 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 premium increases of up to 15 percent from the current 10 percent.
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.
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NATIONAL FLOOD INSURANCE PROGRAM, 1980-2007
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Losses paid |
Year |
Policies in force
at end of year |
Number |
Amount ($000) |
| 1980 | 2,103,851 | 41,918 | $230,414.3 |
| 1985 | 2,016,785 | 38,676 | 368,238.8 |
| 1990 | 2,477,861 | 14,766 | 167,919.6 |
| 1995 | 3,476,829 | 62,441 | 1,295,581.5 |
| 2000 | 4,369,087 | 16,361 | 251,719.2 |
| 2001 | 4,458,470 | 43,562 | 1,276,963.3 |
| 2002 | 4,519,799 | 25,287 | 433,603.9 |
| 2003 | 4,565,491 | 36,716 | 778,793.9 |
| 2004 | 4,667,446 | 55,669 | 2,214,303.5 |
| 2005 | 4,962,011 | 210,893 | 17,575,118.0 |
| 2006 | 5,514,895 | 24,457 | 632,688.5 |
| 2007 | 5,653,949 | 21,287 | 523,219.6 |
| Source: U.S. Department of Homeland Security, Federal Emergency Management Agency. |
| - In 2007 the average amount of flood coverage was $201,598 and the average premium was $505.
- The average flood claim in 2007 was $24,579, down from $25,869 in 2006.
- NFIP premiums written rose from $1.7 billion in 1999 to $2.9 billion in 2007.
- Flood loss payments totaled $523 million in 2007. In 2005 loss payments totaled $17.6 billion, the highest amount on record, including losses from hurricanes Katrina, Rita and Wilma.
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TOP TEN SIGNIFICANT FLOOD EVENTS, RANKED BY NATIONAL FLOOD INSURANCE PROGRAM PAYOUTS (1)
Rank |
Event |
Location |
Date |
Number of paid losses |
Amount paid
($ millions) |
Average paid loss |
| 1 | Hurricane Katrina | AL, FL, GA, LA, MS, TN | Aug. 2005 | 166,210 | $15,959 | $96,016 |
| 2 | Hurricane Ivan | AL, DE, FL, GA, LA, MD, MS, NJ, NY, NC, OH, PA, TN, VA, WV | Sep. 2004 | 27,557 | 1,567 | 56,865 |
| 3 | Tropical Storm Allison | FL, LA, MS, NJ, PA, TX | Jun. 2001 | 30,662 | 1,104 | 35,997 |
| 4 | Louisiana Flood | LA | May 1995 | 31,343 | 585 | 18,667 |
| 5 | Hurricane Isabel | DE, MD, NJ, NY, NC, PA, VA, WV | Sep. 2003 | 19,844 | 491 | 24,736 |
| 6 | Hurricane Floyd | CT, DE, FL, GA, MA, ME, MD, NH, NJ, NY, NC, PA, RI, SC, VA, VT | Sep. 1999 | 20,439 | 462 | 22,617 |
| 7 | Hurricane Rita | AL, AR, FL, LA, MS, TN, TX | Sep. 2005 | 9,462 | 461 | 48,691 |
| 8 | Hurricane Opal | AL, NC, PR, SC, TN | Oct. 1995 | 10,343 | 406 | 39,208 |
| 9 | Hurricane Hugo | GA, NC, PR, SC, VA, U.S. Virgin Islands | Sep. 1989 | 12,843 | 376 | 29,315 |
| 10 | Hurricane Wilma | FL | Oct. 2005 | 9,591 | 362 | 37,700 |
(1) Includes events from 1978 to June 30, 2008. Defined by the National Flood Insurance Program as an event that produces at least 1,500 paid losses. Stated in dollars when occurred.
Source: U.S. Department of Homeland Security, Federal Emergency Management Agency. |
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