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Possible Reforms to the National Flood Insurance Program

By Shai Akabas

Friday, February 7, 2014

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The National Flood Insurance Program (NFIP) is in trouble. It currently insures approximately 5.5 million Americans for flood damage to their homes, businesses, and contents, but the program is approximately $24 billion in debt to the U.S. Treasury. Moreover, long-term imbalances between premiums and expected claims mean that further losses are inevitable.

The Biggert-Waters Flood Insurance Reform Act of 2012 (Biggert-Waters) attempted to move NFIP towards fiscal soundness through a number of steps. The most significant of these changes reduced subsidies for certain policyholders. The recent omnibus spending bill, however, eliminated funding to implement some of those subsidy reductions, and more may soon be effectively repealed by legislation that recently passed the Senate.

NFIP needs further reform; the Bipartisan Policy Center recommended that NFIP should increase rates to their full-risk (unsubsidized) level, thereby ending large implicit subsidies on some policies. Increasing rates remains the key reform to making NFIP fiscally sustainable.

At the same time, NFIP must meet significant affordability challenges. As such, separately administered means-tested subsidies should accompany premium increases. Phasing in a system where NFIP collects full rates and lower-income policyholders have part of their premiums paid by explicit subsidies will both maintain the affordability of the program and help NFIP be solvent in the long run.

Additionally, temporarily delaying the creation of an NFIP catastrophic loss reserve fund, replacing antiquated claims and policy management systems, testing innovative policy designs, and shifting some catastrophic loss risk to the private market could all improve the functioning and efficiency of NFIP.

These suggestions are not meant to be exhaustive and there are other proposals for reform that may be beneficial to the program now or in the future. We focus our attention narrowly on reforms that can be accomplished within the current scale and structure of the program.

Necessary Rate Increases Should Phase In and Be Accompanied by Means-Tested Subsidies

Biggert-Waters enacted immediate – and in some cases, drastic – rate increases for homeowners who had to buy a new policy after the enactment of the law.1 Such increases have proven overly burdensome on some homeowners and are facing repeal in the bill that passed the Senate last week.2

The prevalence of drastic rate increases on owners of primary residences, however, seems to be overstated. Only about 20 percent of the 5.5 million properties insured by NFIP had subsidies before the enactment of Biggert-Waters and only a relatively small percentage of those were primary homes subject to immediate rate increases. Under the legislation, a primary residence only immediately loses subsidies if the property owner sells the home, refuses an offer of a mitigation grant (that may supply funds for the owner to flood proof, elevate, or leave the home), or experiences a lapse in coverage.

The drastic rate increases on subsidized policies aside, other policyholders may gradually face higher rates as well, as Biggert-Waters ended the practice of “grandfathering,” where properties were held harmless for map updates that placed them into higher risk categories. But those rate changes are phased in and have not yet taken effect. If the Senate bill becomes law, those changes will not happen at all.

In order for NFIP to be fiscally sustainable, it must collect full-risk rates – using the most up-to-date maps – for all the policies it covers. Part of the problem with current NFIP subsidies is that they are implicit – subsidized policyholders are simply offered insurance with artificially low premiums. In order to make policyholders aware of their exposure to flood damage, all policies should be charged unsubsidized rates. But rates should increase slowly in order to allow homeowners time to anticipate higher premiums (and possibly either undertake mitigation efforts or relocate, if necessary). An approach along the lines of Senator Patrick Toomey’s (R-PA) proposal to limit these annual rate increases to 25 percent of current premiums seems reasonable.

Unlike Biggert-Waters, which exempts primary residences until they are sold or experience a lapse in coverage, we propose that all subsidized and grandfathered properties be charged rate increases immediately, but that those increases be capped at 25 percent annually for homes that are sold and at a lower rate (perhaps 15 percent) for those that are retained by the owner. Increases would cease when the proper rate is reached. Increasing rates on all homes, not just those that are sold, would help to minimize the difference in property values among properties with similar flood risks.

Subsidies to policyholders should be means-tested and provided through refundable, advanceable tax credits. This plan would allow individuals time to adequately prepare for rate increases or be held harmless if increased rates would prove prohibitively expensive.

Rate Increases Should Incentivize Data Collection

Currently, NFIP lacks essential data to determine full-risk (unsubsidized) rates for the vast majority of subsidized properties. For example, NFIP has no elevation data – one of the most important determinants of unsubsidized rates – for 97 percent of properties that receive subsidies, and it has no credible plan for obtaining that information as we explain below. Without those data, NFIP cannot calculate unsubsidized rates for currently insured houses and therefore cannot even estimate how large the implicit subsidies have historically been.

NFIP’s current plan to obtain elevation certificates rests on policyholders voluntarily procuring them. Unfortunately, policyholders have little incentive to do so; in fact, there are very clear disincentives. Obtaining an elevation certificate can be expensive – between $500 and $2,000, according to the Federal Emergency Management Agency (FEMA). Additionally, submitting elevation certificates often leads to an increase in premiums.

One way to incentivize the acquisition of elevation certificates would be to have premiums increase without bound (or to a very high level) according to the above formulas until the policyholder produces an elevation certificate, thereby allowing FEMA to calculate the accurate unsubsidized rate. Also, policyholders should be offered rebates on a means-tested basis for their costs to obtain elevation certificates.

Reserve Fund Should Wait For Rate Reform Accompanied by Debt Forgiveness

Biggert-Waters mandated that NFIP create a plan to pay off its remaining debt and build up a reserve fund to help pay any claims that exceed annual premiums. Realistically, NFIP is unlikely to ever be able to fully pay back its current debt burden and probably will not be able to build up a meaningful reserve fund absent an increase in rates.

NFIP has yet to submit a plan for repaying its debt to Treasury. No such plan will be credible until premiums are increased to levels sufficient to cover future losses. Paying off the NFIP debt and interest would require unsustainably large hikes in premiums – a problem that will only be worsened as interest rates rise over the coming years. Given that NFIP will likely never be able to pay off its debts, pairing rate reform with an appropriation to erase past NFIP debt seems to be a reasonable approach.

While NFIP added a small margin to most premiums to help finance the reserve fund, such a fund is an exercise in futility when premiums are already insufficient to cover expected future losses. A reserve fund could be an important component of making the program secure in the long run, but trying to build up a fund before increasing premiums to full-risk levels is unlikely to be successful.

Outdated Computer Systems Need Updating

NFIP also faces significant challenges in policy and claims management and data collection. An effort to update the NFIP’s policy and claims management system was aborted in 2009 after seven years and $40 million was expended, and NFIP has no updated plan to acquire a functioning system. Without one, NFIP remains stuck with inefficient 30-year-old technology. Successfully upgrading this technology is an essential step towards making NFIP a well-functioning organization. Policymakers should look to provide adequate funding and oversight to make this a reality.

Improve Uptake and Retention through Innovative Policy Structures

Despite the fact that anyone who holds a federally regulated mortgage in a high-risk area is legally required to hold a flood insurance policy, enforcement has proven quite difficult and a 2006 RAND Corporation report found that fewer than half of property owners in high-risk areas held policies. One reason for this is that homeowners often purchase insurance after a flood and then cancel it within two to four years, once the immediacy of the risk fades.

Long-term and community contracts for flood insurance are two approaches that could help solve this problem. Contracts of 5, 10, or 20 years – rather than the single-year policies that are currently issued – would ensure that property owners do not allow coverage to lapse as soon as the immediacy of flood risk fades from memory. Furthermore, allowing multi-year contracts to remain with a home when it is sold would help ensure coverage continuity. Packaging those long-term contracts with loans for mitigation efforts, including elevation and flood proofing, may be an effective nudge to help homeowners reduce flood losses. Community policies would be purchased by a community on behalf of all the members and could be funded through property taxes or utility fees. The bill that recently passed the Senate would require that FEMA conduct a study on how NFIP could make voluntary community-based flood insurance policies available.

Use the Private Sector to Hedge against Catastrophic Losses

As mentioned, Biggert-Waters requires that NFIP build up a reserve fund for future loss years. Depending on the timing of large floods, however, even a reasonably financed reserve fund could prove an insufficient hedge against large losses. Therefore, the NFIP should consider using the private market to protect against catastrophic claims.

Two options for private-market involvement are catastrophe bonds and reinsurance. Catastrophe bonds are financial products that pay a healthy return in normal circumstances, but require that investors sacrifice the principal if certain catastrophic conditions are met. NFIP could sell these bonds in the private market and, for example, pay a coupon on the bonds unless losses in a single year exceeded the reserve fund, in which case investors would not get paid back and NFIP could make use of those funds. Reinsurance is offered by a number of different private companies that may be willing to bear some of the risk of catastrophic losses by the NFIP – if the program can acquire the data to accurately price such coverage.

Private-market solutions could prove unrealistic if they turn out to be overly expensive or if private reinsurance issuers have stringent data requirements that NFIP cannot meet for technical or privacy reasons. As part of the suite of reforms that includes technological updates, a reserve fund, and unsubsidized rates, however, private-sector involvement might be more feasible than it has been in the past because of better data availability, a lower probability of catastrophic losses that require the private sector to pay out, and a better long-term fiscal trajectory for the program.

The Big Picture

NFIP is badly in need of reform, and BPC has outlined this set of changes to improve both the program’s finances and its operation. However, the most important part of these reforms is the rate increases. Absent premiums that reflect the actual risk of flood damage, NFIP is almost guaranteed to rack up further debt that will eventually have to be paid for by taxpayers.

A functioning, efficient, fair, and financially sound flood insurance program is a goal that deserves support from policymakers on both sides of the aisle, and a slow transition to unsubsidized rates with relief for lower-income homeowners is a great way to start towards that outcome.

In writing this post, the authors consulted a report by CBO, several reports by GAO, and a report by the Center for Climate and Energy Solutions.

View the summary of BPC’s proposals

Alex Gold and Brian Collins contributed to this post. 

1 Reasons could include: the policy wasn’t purchased at the time of the law’s passage, the policy lapsed after passage, or the property was sold after passage.

Rate increases for non-primary residences and business properties enacted under Biggert-Waters are not facing repeal – all of those policies will soon have full-risk premiums.