Fixing the National Flood Insurance Program

Hurricanes Harvey and Irma have exposed the flaws of the National Flood Insurance Program (NFIP) in the US. This should trigger an overhaul of how the programme operates by US Congress but some re/insurers also hope this could mean opportunities for re/insurers to participate in the programme and take on more flood risk in the US.

The US Congress has extended the deadline to renew or repeal the NFIP to December 8, 2017.

The NFIP was established in 1968 to enable homeowners in flood-prone areas to purchase property insurance. At that time, the private sector had little appetite or capacity to address the risk of flooding, although in its original format the programme did include a risk-sharing mechanism with a number of insurers; this later stopped after disputes over the way the scheme was administered.

Based on technologies, engineering practices, and business models of the time, the NFIP became the primary underwriter of flood insurance in the US. The NFIP is now under the jurisdiction of the Federal Emergency Management Agency (FEMA).

The NFIP offers two channels for the distribution and servicing of flood insurance policies. Consumers can either establish a relationship with private market insurers that have contracted with the NFIP or they may go directly to the programme itself to purchase the flood coverage.

The programme is in need of a significant overhaul. It has accumulated more than $24 billion in debt, and the situation is set to deteriorate further before it can be fixed. The combined claims from Irma and Harvey will ultimately exceed NFIP’s spending authority, according to NFIP director Roy Wright.

Insured flood losses stemming from Hurricane Harvey for homes in the affected areas in Texas and Louisiana may reach $9.5 billion. Insured flood losses from Hurricane Irma may reach $16 billion for both residential and commercial properties, but the estimates vary and more accurate numbers may be available only in the coming months.

The hidden protection gap

Record-breaking flooding is set to generate a high number of claims for those with NFIP coverage, says Pete Dailey, vice president global flood models of data provider RMS. He believes that the events will place the issue of the “protection gap” back on top of political agendas.

Insured losses for Harvey are expected to be only a fraction of a total $70 billion to $90 billion economic losses. Similarly, for Irma, total economic losses are estimated significantly higher than the insured losses. Uninsured residential flood losses from Irma could reach $30 billion.

Although the rainfall caused by Irma wasn’t nearly as extreme as in Harvey, many areas across north central Florida and portions of Georgia and South Carolina experienced heavy rainfall and localised flooding, Dailey explains. “Therefore, Irma also highlights the need for expanded flood coverage, whether it be from the NFIP or from an expanded market of private insurers.”

In recent years, technological improvements have made it easier to manage and predict risks, which is likely to make the flood insurance market more attractive to the private sector. But flood maps used in the NFIP are deemed out of date and needing to be improved.

Accurate information should allow property owners and property buyers to clarify what risks they face while helping local and state governments to better address flooding, Dailey says.

“Many homeowners are either unaware of their flood risk or lack flood coverage if their home lies outside the highest-risk flood zones,” he adds.

In addition to an increase of the geographic coverage of the NFIP, the programme may need to be expanded to also include lower-risk property owners, Tom Wilson, CEO of The Allstate Corporation, told a group of investors in New York on September 19.

“Not enough people buy it, and the people who do buy it use it more than they should,” he said, adding that the coverage is limited and sold for less than it is worth.

Dailey notes that for the NFIP to be solvent in the long-term, the risk will need to be shared with private industry and the rates will need to be more compatible with the risk to decrease the NFIP’s annual expenditures and limit its current debt.

Premiums for the NFIP are highly subsidised and may have to be adjusted in order to better reflect the risk. Annual premiums add up to about $3.5 billion a year, but programme costs run to $5 billion, according to some estimates—even before accounting for catastrophic losses like those from Hurricanes Harvey and Irma.

“Increasing the number of NFIP policyholders would generate more revenue into the programme and increase compliance within Special Flood Hazard Areas (SFHAs),” Dailey says.

“Proper risk management requires policies to be appropriately priced based on the actual flood risk and incentives to be provided to homeowners for mitigation efforts. This will lead to more effective risk transfer and allow FEMA to pay claims while managing its debt.”

A targeted approach

Properties included in the NFIP are often million-dollar homes with high flood risk. Some politicians believe that some properties and their owners should be moved out of the NFIP so that it subsidises only owners who really need it.

In addition, a number of high-risk properties may have to be relocated. Some politicians believe that the government should stop paying to repeatedly rebuild flood-prone properties. In some cases, property owners are paid as much or more than their insured properties are worth. At the same time as this may be threatening the solvency of the NFIP, it also keeps people living in dangerous situations with little incentive to protect their homes better or move.

If home/business owners are going to build in flood-prone areas, they should do so resiliently, carefully considering how to build to mitigate future potential losses, Dailey notes.

“One of the best ways to protect property in areas prone to flood (and other natural hazards) is through strict adherence to building codes.

“Insurance is one way to manage risk, but successful risk management means leveraging all available mitigation strategies.”

Property along the coast can, for example, be elevated to reduce flood risk and water damage or have its first occupied floor on the second storey.

If lawmakers address the NFIP shortcomings appropriately, there may be a business opportunity for the private re/insurance sector.

“With the upcoming reauthorisation, there are opportunities for private insurers to provide primary coverage to policyholders,” Dailey says.

“Harvey provides direct evidence that NFIP’s reinsurance programme is a critical part of an overall risk management strategy.”

The NFIP placed its first significant reinsurance programme in January 2017, ceding $1.04 billion of coverage to a group of 25 reinsurers and Lloyd’s syndicates in an effort to reduce the accumulation of future debt to the Treasury. Reinsurers take part in the NFIP by covering 26 percent of NFIP losses between $4 billion and $8 billion. The reinsurers are expected to face a total loss given the magnitude of Harvey flooding, according to ratings agency Fitch.

Nevertheless, further privatisation of flood risk may be on the cards.

“Going forward, NFIP may consider more reinsurance on its own, and more reinsurance companies may be interested in participating in the programme,” says Dailey.

“In addition, private insurers and NFIP could jointly underwrite primary coverage and combine reinsurance. There is also an opportunity for excess coverage given most NFIP policies have a $500,000 limit,” he adds.

“There is no question that growth of the private flood insurance market would benefit home and business owners, generate competition and offer a wider range of insurance products, and speed the recovery process after major flood events.”

To expand the participation of the private sector, prices may have to be adjusted.

“Best practices in risk management dictate that there be reasonable compatibility between the risk and the premium in order for insurance programmes to remain solvent while paying claims,” Dailey says.

It may be a long list of issues that Congress will have to tackle in order to bring the NFIP on to a sustainable path, but there is reason for optimism not least because Irma and Harvey have reinforced the need to improve the programme and over time reduce its deficit, Dailey notes.

Steps to sustainability according to the Reinsurance Association of America

The Reinsurance Association of America’s president Frank Nutter explains what he believes should happen to the National Flood Insurance Program if it is to become sustainable.

US Congress has extended the deadline by which it must decide what to do with the National Flood Insurance Program (NFIP) until December 8—a three-month extension of its original expiry date.

Their first task may be to establish the extent of the programme’s claims and potential shortfall. The consensus seems to be that Hurricane Harvey could result in around $12 billion of claims and Irma a further $8 to $10 billion (at the time of writing, halfway through the hurricane season).

The programme has a total borrowing authority of $31 billion and $24 billion of that is already used thanks to hurricanes Katrina and Sandy. One of the first things Congress will have to do is extend its borrowing authority if it is to remain liquid.

Frank Nutter, president of the Reinsurance Association of America (RAA), says these figures illustrate the fact that the programme is unsustainable. “It covers very high risk properties and is underfunded. There will likely be a very lively debate as to whether it is sustainable given its constant need for borrowing.”

However, the timing of its recent $1 billion reinsurance purchase is somewhat fortunate, according to Nutter. Not only does it help pay recent claims, it also represents a timely reminder of the value of reinsurance.

“That $1 billion will be fully collected, highlighting the value of risk transfer,” he says. “But when you also consider the size of the protection gap this has demonstrated, it also might encourage Congress to seek private sector solutions to complement and support the NFIP.”

Nutter says that the number of policies backed by the NFIP has fallen in recent years, to around 5 million from 5.6 million, but the head of the programme has previously discussed doubling the number of homes insured. “The only way this would be achievable would be with the support of the private sector,” he says.

In theory, he says, this would be welcomed by reinsurers, many of which want to write more flood business as it represents a good source of diversification away from windstorm risk, which many have high exposures to.

“They are seeking growth and anything that offers diversification away from windstorm risk,” he says. “They also are rewarded by ratings agencies and regulators for that diversification.”

A wish list for Congress

Nutter says that the RAA would like Congress—and in some cases state governments—to consider implementing a number of measures that would help facilitate the involvement of the private sector in this market.

It wants Congress to encourage banking regulators to accept private sector insurance policies when lending against properties in a flood zone. At the moment, such properties must be insured against flood but lenders do not accept private sector policies, meaning the NFIP is their only option.

“We are optimistic this will be taken on board by Congress and this will help encourage private sector participation,” Nutter says.

The second thing the RAA wants is the legislative framework underpinning the NFIP to be tweaked to allow different pools of risks to be created that could then facilitate involvement from the private sector. In fact, the existing framework enables risk-sharing with the private sector as that was the structure of the pool when it was first created. Nutter says tweaking this would allow more flexibility in the way the private sector might engage with the scheme.

“The legislative framework is there but we want to change it so that FEMA has the authority to create different pools and create relationships with insurers. This could be on a quota share basis, for example, allowing a sharing of risk. You could do it by geographical area or by the type of risk but it requires a change by Congress for this to be made possible.”

This also potentially allows reinsurers to get more involved, leading Nutter to his third point. He notes that the more the pool works with reinsurers, the more that allows the private sector to have access to the data underpinning the pool’s policies. This will help insurers and reinsurers gain a better understanding of the risk.

“Until now, the NFIP has been unwilling to share its data—yet that is pretty much the only dataset available on US flood risk,” Nutter explains.

“By working with reinsurers, especially now there have been claims, that means the reinsurers also gain the benefit of that loss experience and the data connected with that. I guess that is something of a silver lining for having to pay a billion-dollar claim.”

A new approach

Nutter also wants state governments to consider relaxing the rules around how the rates on flood insurance are set. In Florida, he notes, the state changed the laws so that insurers can set their own rates for flood insurance and file those rates with the information that justifies that rate—as opposed to the state having to approve the rate in advance, as is the case with other forms of insurance.

“This shifts the burden of checking from the insurer to the state. It was designed to encourage more experimentation and the take-up of flood insurance,” Nutter explains. “We would encourage other states to consider this approach.”

Nutter stresses that while the NFIP wants to expand the programme, this is unlikely to happen under the current system. All parties understand that structural changes need to be made to price the risks more appropriately and involve the private sector.

He adds that while reinsurers are keen to get more involving in taking on flood risk, insurers are more reticent. None of the nationwide players is actively seeking a move into this market; some of the smaller players are showing an interest, but on a regional basis.

The appetite for this risk could be stimulated, however, by improvements that have been made in risk models in recent years. Nutter notes that the risk modelling companies and brokers have invested huge sums in recent years towards a better understanding of flood risk, something that will help the private sector feel more comfortable pricing this peril.

“Much remains to be seen,” he says. “It could be that losses from Harvey and Irma make companies take a step back, despite the fact that it highlights that a new solution is needed. They were pretty extraordinary events and that could mean companies become more cautious, but it should not discourage risk modelling companies or brokers from working on this risk and getting a better handle on it.”