COMMENTARY: How to fix a broken system that fails flood victims

September 13, 2016

By Lawrence Hsieh, Practical Law for Thomson Reuters

(Thomson Reuters Regulatory Intelligence) – A homeowner’s insurance policy covers most disasters, but it won’t cover flood damage. Private insurers long ago deemed flood loss, which accounts for most disaster losses in the United States, as “too big to insure.” So people who live in a flood zone and have a federally-backed mortgage must purchase flood insurance through the National Flood Insurance Program (NFIP), which was established in 1968 to make flood insurance more affordable.

That program has significant flaws, but reform efforts are afoot and may gather steam as rising sea levels increase the potential for catastrophic flood losses.

The NFIP, which is operated by the Federal Emergency Management Agency (FEMA), has had its fair share of bad press. Frontline and NPRrecently reported on the plight of policyholders who are still fighting to have their claims paid, even as they continue to pay premiums on the empty lots where their homes once stood before Hurricane Sandy. Some blame waste and inefficiency, an instinctive reaction to government bureaucracy. Others fault private insurers who partner with the program, and assume no risk but earn fees by selling and servicing NFIP policies and making payout decisions on behalf of the program.

The real culprit is the distorted incentives created by basic structural problems with the program. These structural flaws cause homeowners to take excessive risk, artificially prop up coastal property values, and drive even more development in fragile ecosystems, which ultimately harm consumers and the taxpayers who bail everyone out.

In free-market theory, insurers compete for business and charge premiums based on the likelihood and severity of the insured event. Sound risk-pricing helps to ensure that the premiums collected are sufficient to pay policyholder claims. The NFIP, however, incorporates faulty risk-pricing. Only about 80 percent of NFIP policyholders pay premiums that actually reflect the full risk of anticipated flood losses based on the latest data on storm tides, river flow, and other measurements incorporated in flood hazard maps maintained and updated by FEMA.

The remaining 20 percent pay discounted rates. But the discounts are not pegged to income, which would at least be consistent with the NFIP’s goal of affordability. Rather, the discount is a subsidy for owners — rich or poor — of older buildings that were built before their communities received their first set of flood maps when they joined the NFIP. And grandfathering allows owners to keep paying existing lower rates even when new data shows increased flood risk in areas that were previously mapped.

People who live in flood zones already expect that when floods hit, the government will step in to repair public infrastructure and provide temporary shelter and other disaster relief. In recent years, however, they’ve also come to demand that extra tax dollars be diverted to reclaim and shore up vulnerable beachfront land where development always courted weather disruptions. Factor in the subsidies and grandfathered rates, and policyholders have even more incentive to take excessive risk and rebuild again on unsafe land.

In the meantime, the unsubsidized majority cannot shop around. Most private insurers have been priced out of the market because of the subsidies. They have little incentive to directly insure as long as they can profit with no risk by partnering with the NFIP. While the amount of profit is disputed, FEMA pays its private partners up to one-third of the premiums that FEMA collects from policyholders. In return, the partners sell and service NFIP policies, and make claim payout decisions on behalf of FEMA. If there is a dispute with a policyholder, FEMA pays the partner’s legal fees.

Since FEMA, not the private partners, are on the hook for paying out insurance claims, the private companies would seem to have little incentive to lowball those claims. But the Frontline/NPR investigation highlighted widespread lowballing by the partners on behalf of FEMA. Customer complaints led to FEMA’s decision to reopen thousands of claims for reevaluation. According to Frontline/NPR, some observers speculate that the private partners are motivated to keep NFIP expenses low on behalf of FEMA, which helps to keep the program solvent, and therefore, the partner’s service fee “gravy train” alive. It’s a pretty twisted theory, but hard to verify because one of the biggest problems with the program is the lack of transparency.

Secondary market for insurance risk

Consumers burned by the financial crisis typically look askance at secondary markets. That’s understandable. After all, the banks and their counterparties were neck-deep in the derivatives that spread the risk of bad loan originations across the entire financial system. But private insurers who maintain actuarially sound practices can harness the robust and beneficial secondary market for insurance risk, where commercial reinsurers and capital markets investors vie to reinsure insurance risk. This allows insurers to reallocate risk and manage their reserves. The resulting liquidity helps insurers maintain sound financial health so that they can pay policyholder claims. The competition also helps to lower premiums.

But reinsurers and investors won’t provide cheap liquidity unless the flood market becomes more transparent and adopts sound risk-pricing practices. Without the ability to tap the secondary market, the NFIP will continue to tap the U.S. Treasury any time claims overwhelm premiums like they did after Sandy. FEMA owed taxpayers $23 billion and counting as of November 2015.

Another unintended consequence of the government monopoly is that too many people now view flood insurance as an entitlement. Subsidized policyholders are indignant when the government tries to raise premiums. Most policyholders don’t want to hear that taxpayers absorb the shortfall when policyholders take out more in claim payments than they “pay into” the system in premiums.

The best way to view flood insurance is a cost of coastal living to be borne by the people who choose to live there. And the best solution to flood insurance reform is to follow calls to introduce risk-based pricing, such as those voiced by the head of the Association of Bermuda Insurers and Reinsurers. Risk-based pricing would encourage private insurers to enter the market and compete for our business, for example, by offering actuarially-based discounts to customers who mitigate flood risk. This will allow the government to concentrate on what it does best – provide disaster relief after an emergency.

Current regulatory initiatives

The Homeowner Flood Insurance Affordability Act of 2014 (HFIAA), which mollified constituents by softening some of the market-based reforms introduced in 2012 by the Biggert-Waters Flood Insurance Reform Act, still aims to eventually phase out most subsidies. Phasing out the subsidies will help to break the government monopoly for homeowners who must purchase flood insurance because they live in a designated flood zone and have a federally-backed mortgage.

But phasing out the subsidies will also entice private insurers to grow the market and offer policies to risk averse homeowners who want protection even though they might not have a federally-backed mortgage or might not currently live in a designated flood zone. Many of the areas severely impacted by the recent floods in Louisiana were outside of designated flood zones.

Another potential avenue for the development of a private market is the Flood Insurance Market Parity and Modernization Act (H.R. 2901), which was passed by the House of Representatives in April and awaits consideration in the Senate. The bill aims to foster the growth of the private market by leveling the playing field and allowing some private insurers to offer flood policies that meet the legal requirements for homes purchased with federally-backed mortgages.

Reform would necessarily involve trade-offs. Even if a lot of flood risk moves to the private market, substantial flood risk will remain in the NFIP or its successor as a safety net to help low-income residents in transition. This part of the market by definition will remain subsidized. But a move to actuarially sound risk pricing is the correct first step of the long journey towards flood insurance reform.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Sept. 2. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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