Historic Hurricane Year Puts the Spotlight on Federal Flood Insurance

Hurricanes Katrina and Rita affected the Gulf Coast as some of the strongest storms to hit the United States during the last 100 years, causing widespread devastation and flooding. In mid-January the country saw more than $150 million in damages caused by flooding in southwestern Utah. Florida of course was hit again this year and President Bush declared a major federal disaster in the New England area affected by floods.

With this historic hurricane-year possibly indicating a trend of increased duration and strength in hurricanes, and the National Flood Insurance Program faced with the prospect of borrowing an estimated $10 to $30 billion from the U.S. Treasury to meet its fiscal-year-2005 obligations (having collected only $2 billion in premiums in 2004), the spotlight is on. Some feel now is a good time to review the entire flood program and see how it might be ended or improved.

According to a statement on federal flood insurance after Katrina released by the Center on Federal Financial Institutions, flood insurance participation rates in flood prone areas of New Orleans, La., Mobile, Ala., and Gulfport, Miss. are less than 30 percent, despite mandatory flood insurance for holders of mortgages from federally-regulated lenders. Voluntary purchase rates are even less, around 10 percent.

Though experts agree the participation rates are low, not all agree on the causes. Some argue that homeowners are reacting to economics, saying the cost of flood insurance exceeds its value and policies with strong limits on payouts are often avoided. Others say people are biased in their decision making by underestimating the chances of being hit by a flood. Ignorance, misunderstanding and poverty stand as arguable causes as well.

In written testimony on the future of the NFIP, Dr. Robert Hartwig, senior vice president and chief economist for the Insurance Information Institute stated, “There is a widespread belief that large amounts of government aid will be made available to disaster victims after an event and so there is little point in buying flood coverage if largely the same benefit is available for free.” He added that this perception would be reinforced if property owners were allowed to buy into the NFIP retroactively.

Universal questions
Any of these theories is likely and perhaps it’s a case of some combination therein. But, while each theory implies a different solution, some universal questions arise upon review. Should the government provide flood insurance? Should homeowners be required to buy it? Should there be subsidies? Should development or rebuilding be limited or restricted? Should the government require other risk reduction measures? Is the current division of public and private roles appropriate?

Supporters of the idea that the government should provide flood insurance argue that private insurance was inadequate before the NFIP and that insurers may not be willing to take on certain risks. They also say that the government is likely to soak up a majority of the losses even without a federal insurance program and the NFIP encourages flood resistant land management.

Dr. Robert Detlefsen, director of public policy for the National Association of Mutual Insurance Companies said, “Given the nature of the risk, it’s not clear that many insurers would want to offer flood coverage. Historically they haven’t been willing to do so, which is why the National Flood Insurance Program was established in the first place.”

Patrick O’Brien, director of federal government affairs for the Independent Insurance Agents and Brokers of America agreed. “We feel the government is probably the only sufficient resource to deliver this type of a program,” he said. “If you look at what occurred in the aftermath of hurricane Katrina and Rita and the damage coming through Florida, the idea of the private market having to deal with all of that is just a complete train wreck in the making.”

Critics counter by saying federal flood insurance may encourage risky development. Taxpayers will likely pay for large floods and federal premiums may not sufficiently reflect risk differentials.

Mandated flood insurance for homeowners is favored by those who feel premium income would partly offset federal flood losses and see it as a fair way to spread the cost. But critics say taxpayer funding is a better way to spread catastrophe costs and mandatory insurance is not only difficult to enforce, but unfair to the poor.

“Homeowners carrying a mortgage regardless of whether it is federally backed or not, at this point in the game, should be carrying flood insurance. At least those who have been identified as being in vulnerable areas like flood plains,” O’Brien said. “I think that by requiring flood insurance you’re not only protecting the investment by the homeowner, but also by the bank who owns the leans.”

Detlefsen offered a different perspective. “Americans value their freedom, and in a free society the government doesn’t ordinarily require people to buy things,” he said. “An exception of course is automobile insurance, but in that instance the only requirement is that drivers purchase liability insurance so that others are protected from loss or harm caused by the driver. That’s very different from requiring people to insure their own property against potential losses that they alone would bear.”

What about subsidies?
Some say there should be subsidies on grandfathered structures as was the case in the original construct of the NFIP. They see subsidies as the carrot on the stick that lures communities and homeowners into the system and feel taxpayer financing is the best method to spread costs.

“Notwithstanding what occurred down in the Gulf, this program has shown us that subsidies play a very important role in offsetting the cost of flood insurance for those who would otherwise not be able to afford it,” O’Brien said.

On the other hand, others feel premiums are the best way to spread costs and that subsidies could encourage development in risky areas, thereby increasing the overall cost of subsidies. They argue there are better uses for taxpayer money.

“This is a question that should be answered through the legislative process,” offers Detlefsen. “However, if policymakers do decide to subsidize the purchase of flood insurance, they should do so in a manner that makes the subsidies transparent and direct.”

Currently the NFIP limits development and rebuilding in participating communities deemed “flood hazard areas” by requiring buildings to comply with flood damage resistance standards when improving or repairing after a flood if costs are more than 50 percent of the structure’s market value. Still some call for stronger restrictions to reduce federal disaster costs and benefit homeowners, businesses and the environment.

Given the choice
Others see these types of restrictions interfering with potentially large private gains from development. They argue Americans should have the right to choose for themselves where they want to build and how they want to improve their own homes. They say more restrictions would be a disadvantage to poor people, unable to afford the cost of compliance.

Other risk reduction measures might include mitigating major risks to the NFIP like multiple-loss structures, requiring either a remedy to the risk or the owner to bear the full brunt of the cost of coverage.

O’Brien supported this idea. “If you’ve suffered numerous losses over the course of the last decade, you should be forced to accept mitigation to your property, or start paying non-actuarial and non-subsidized rates for your flood insurance,” he said.

Assuming there should be a federal flood program, is the current division of public and private roles appropriate? According to the Center on Federal Financial Institutions, “The main public roles at present are in structuring the policies, establishing pricing rules, publicizing the program and bearing the ultimate cost. Therefore the private sector could not likely do anything more than consulting without compromising the federal insurance mission.”

O’Brien feels the roles are sufficiently divided, but said the private sector is doing the majority of the work. “The federal government is there to stand in as a backstop, but the private sector is doing almost 95 percent of the policy work … I certainly don’t think you should reduce the role of the public sector in the administrative funding mechanism because what I think you’ll find is less companies and agents willing to write this program,” he said.

Federal catastrophe risk plan
One idea is to restructure the public-private relationship with a federal mandate eliminating the exclusion flood insurance from homeowners’ policies in flood hazard areas; combined with a federal reinsurance program that would bring the financial risk to the government.

“I would say that it’s appropriate for each sector–public and private–to play a role in providing coverage for losses caused by natural disasters. Whether the current division should be adjusted, or in what way, are questions that should be studied and publicly debated,” NAMIC’s Detlefsen said.