NFIP: The test before the flood

The NFIP was established in 1968 to help offer flood insurance to homeowners, renters, and business owners and is the primary underwriter of flood insurance policies in the United States.

“For most of the 20th century U.S. flood has been considered by many insurers and reinsurers to be ‘uninsurable’,” says Pete Thomas, chief risk officer at Willis Re.

“The NFIP was a congressional response to a private market failure that was in part driven by the state of science and technology at the time and in part by insurer concerns about adverse risk selection and the belief that regulators would not permit them the necessary underwriting and rating flexibility to achieve a reasonable expectation of profit,” Thomas says.

The NFIP is part of Federal Emergency Management Agency (FEMA) and has relied on the US Treasury to fund deficits when losses have exceeded the programme’s claims. NFIP has accrued $23 billion in losses to the U.S. Treasury.

Hurricane Katrina which hit the US in 2005, for example, resulted in the payout of $16.32 billion; Superstorm Sandy, which stroke the US in 2012 caused payouts of $8.33 billion, according to an October 2016 Guy Carpenter report named ‘Partnerships: A Compendium of Perspectives on PublicSector Risk Financing’.

NFIP has never used a financial risk transfer mechanism. A recent test consisted of a $1 million limit to protect against flood claim losses to the NFIP that exceed $5 million in order to examine FEMA’s ability to receive reinsurance claim payments and process reinstatement premium, according to Guy Carpenter. Once that $1 million limit is exhausted, the reinsurance will be reinstated for an additional $1 million limit to protect against large flooding events that generate losses to the NFIP in excess of $5.5 billion. Given the geographic spread of NFIP policyholders, such events would most likely result from flood losses that were related to a large tropical storm or hurricane.

The reinsurance treaty is designed to transfer risk while simultaneously providing FEMA with a vehicle to live-test the systems, protocol and processes required to execute a broader scale program across the global reinsurance market.

“The test was successful,” says Tom Larsen, chief product architect for CoreLogic, an information intelligence provider. It was set up to validate the market appetite to accept this risk and to see that the systems were in place allowing NFIP to cede it, Larsen explains.

NFIP READY TO BUY REINSURANCE

Reinsurers can now prepare to underwrite larger volumes of the US flood programme. Total earned premium of the NFIP was $3.45 billion in 2015.

“The NFIP has already submitted a budget request to allow for the payment of reinsurance premiums,” says Thomas.

The demand for reinsurance cover from the NFIP programme will come to the market at a time when the property/casualty business is suffering from overcapacity. A historically low interest rate environment has attracted capital to the sector as investors were seeking for yield. In addition, comparatively low losses have added to the current soft market. The increased reinsurance demand from the NFIP programme should therefore be welcomed by the industry.

“When we discuss growth strategies with reinsurers, flood risk is nearly always a main topic of discussion,” says Bill Fleischhacker, Aon Benfield executive managing director and treaty reinsurance broker. “With today's available analytics, which are evolving to reduce uncertainty and sharpen confidence, many major reinsurers are pursuing flood opportunities through dedicated resources that contemplate all aspects of the US floodmarket, including opportunities to support FEMA on a risk bearing basis,” Fleischhacker explains.

The privatization of the US flood risk is likely to be a long process. “It will take many years to build up a reinsurance program in which the reinsurance markets bear a significant portion of the NFIP risk,” FEMA says. The NFIP will continue to bear the majority of its risk for some time, according to the agency.

CHALLENGES FOR REINSURERS

The transfer of US flood risk to the private sector is also likely to be long because of the complexity of the process.

“The main challenge, which is at the core of any reinsurance transaction, will be data quality and control,” says Neal Reeves, Aon Benfield managing director and treaty reinsurance broker. “While there is a hungry reinsurance market, there will likely be minimum standard expectations as to the transparency and granularity of the data available to reinsurers to shape and refine pricing, Reeves notes.

Because there is no precedent in the US for the flood risk transfer, market participants will require a lot of data to be able to assess and price the risk. “Currently you can place small risk with flood in the US, but you can’t place a large monoline portfolio,” Larsen says, pointing to the need of several players participating in such a placement and the fact that there is no established price.

Preparing for a large flood risk placement to reinsurers does present a challenge for the NFIP. “Developing scalable reinsurance accounting, claims and reinsurance can be complex and is often very different than one’s existing insurance operations,” Thomas says. “This challenge is particularly acute for a federal agency, with significant fiduciary responsibilities, branching out into the reinsurance market for the first time,” he notes.

One question that needs to be resolved is which reinsurers will be allowed to participate in the risk transfer to the private sector. In the test transfer, the NFIP was careful to partner with U.S. companies or U.S. subsidiaries of foreign companies from designated countries, Thomas explains. It is so far unclear how the Trade Agreements Act (TAA) and the various free trade agreements apply, Thomas notes.

“In considering the global reinsurance market it is our understanding, for example, that Bermuda, China, India, Malaysia, Thailand and Taiwan are not ‘designated countries’ under TAA,” Thomas says. It is also not clear if FEMA and the NFIP will cede reinsurance to the U.S. subsidiaries of Bermudian domiciled companies, he adds.

The risk transfer process is being complicated further due to the fact that the NFIP is subsidizing flood risk cover.

“The $23 billion accrued deficit does indicate that in the past they had some pricing challenges,” Larsen notes. Within the programme there is a large consortium of very well priced risk and then there are some risks that are getting subsidies, he explains. “The NFIP will be challenged to be more explicit on identifying these subsidies,” Larsen says.

There is also a political component influencing the process of privatizing the flood risk. New legislation will clarify the nature and conditions of acceptable private market flood risk coverages and will help establish a clear understanding of what is to be considered an acceptable private market alternative, Reeves says. “These actions will go a long way to furthering the already accelerating pace of the private flood market,” he notes.

Currently any mobile, home or personal property located in an area designed as a special flood hazard that is financed by a federally backed mortgage must have flood insurance, most of which is provided by NFIP.

PROTECTION GAP OFFERS ADDITIONAL POTENTIAL

But, there may be more flood risk business looming outside the NFIP programme in the US for insurers and reinsurers.

“A large portion of people who are seeing losses from flood are not buying insurance for a variety of reasons such as that rates are too high or that policies aren’t complete enough,” Larsen says. He suggests that the market could be much bigger than the $3 billion to $5 billion from the NFIP personal lines and could instead potentially be worth $15 billion. “NFIP focused on the highest risks. It’s a much bigger market if we include all the people that are at risk in the US,” Larsen says.

Thomas agrees that there is significant business potential for re/insurers outside the NFIP programme. “There is an increased need for insurance to protect from both coastal and riverine flooding. While federal disaster programs excel at helping communities recover, such programs do not meet the rebuilding needs of individual homeowners or small businesses,” he says.

It might be the right moment to close the flood risk protection gap in the US.
Property owners could benefit from the recent influx of alternative capital in property/casualty. A relatively benign history of catastrophe losses has allowed re/insurers to release reserves and bolster retained earnings.

Facilitating the process of moving more flood risk to the private sector is the availability of improved risk assessment tools, driven by technological advances. The release and continued advancement of third partyflood models is making flood insurance “insurable” as insurers and reinsurers now have a suite of tools to manage and price flood exposure, Thomas says.

“The advancements in underwriting and modeling will continue to reduce barriers to entry and ultimately increase the supply of capacity available to support primary flood exposures,” Thomas says. Some primary insurance companies have started to prepare to grow their property exposures by expanding into the private flood market, he notes.

While analytics tools may be available on the market, the insurance industry nevertheless needs to rebuild its flood underwriting expertise and train a new generation of underwriters, Thomas suggests.

But investing in flood risk capabilities is likely to pay off as similar opportunities may appear elsewhere.

“We are entering a period of history where debt-laden governments all around the world are looking to create public – private partnerships,” Thomas says. “The opportunities for insurers, reinsurers, ILS markets and brokers are significant and growing,” he notes.