Congressional Research Service: 'National Flood Insurance Program – Current Rating Structure & Risk Rating 2.0' (Part 2 of 2)

WASHINGTON, April 8 (TNSRep) -- The Congressional Research Service issued the following report (No. R45999) updated on April 4, 2022, entitled "National Flood Insurance Program: The Current Rating Structure and Risk Rating 2.0":

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(Continued from Part 1 of 2)

Proposed Rating Structure Under Risk Rating 2.0

How the NFIP Will Determine Flood Insurance Premiums

NFIP premiums calculated under Risk Rating 2.0 reflect an individual property's flood risk, in contrast to the current rating system in which properties with the same NFIP flood risk are charged the same rates. This involves the use of a larger range of variables than in the current rating system, both in terms of modeling the flood risk and also in assessing the risk to each property.

Risk Modeling

The current rating system includes only two sources of flood risk: the 1%-annual-chance fluvial flood and the 1%-annual-chance coastal flood./51 In contrast, Risk Rating 2.0 incorporates a broader range of flood frequencies and sources, including pluvial flooding (flooding due to heavy rainfall), flooding due to tsunami, Great Lakes flooding, coastal erosion outside the V zone, and flooding in leveed areas./52 Risk Rating 2.0 uses a multi-model approach to support the development of the new rates, with data from multiple sources including existing NFIP map data, NFIP policy and claims data, United States Geological Survey (USGS) 3-D elevation data,/53 National Oceanographic and Atmospheric Administration (NOAA) SLOSH/54 storm surge data, and U.S. Army Corps of Engineers data sets, particularly for areas behind levees.

According to FEMA, Risk Rating 2.0 uses three commercial catastrophe models to estimate future loss potential./55 The use of catastrophe models to estimate potential losses caused by events such as hurricane wind, storm surge, inland flooding, tornadoes, earthquakes, and wildfires has become a standard risk management practice in the insurance industry./56 Catastrophe models were initially developed to address the shortcomings inherent in using historical data to project potential losses from infrequent, severe events that impacted many properties that were not geographically diverse./57 While each peril model reflects factors specific to the peril being modeled, catastrophe models generally have similar components, including modules simulating (1) the probability of the particular catastrophe occurring; (2) the intensity of the catastrophe; (3) the damage to structures; and (4) the allocation of the amount of the loss among those responsible for payment.

The first stage of catastrophe modeling is to generate a stochastic event set, which is a database of simulated events. Each event is characterized by a probability of occurrence (event rate) and geographic area affected. Thousands of possible event scenarios are simulated, based on realistic parameters and historical data, to model probabilistically what could happen in the future. The hazard component of catastrophe models quantifies the severity of each event in a geographical area, once the event has occurred. An event footprint is generated, which is a spatial representation of hazard intensity from a specific event. For example, a model could calculate the peak wind speeds at each location affected by hurricane winds. Property vulnerability is modeled using mean damage ratios (MDRs), which are losses expressed as a percent of value, for a given hazard level (e.g., hurricane wind speed) and location. MDRs give the average percentages of damage that are expected for a structure with the characteristics input into the model. Finally, a financial or insurance module quantifies the financial consequences of each event from various financial perspectives. The policy terms such as deductibles, limits, and reinsurance are applied to the damage from each insured property from the vulnerability model to calculate the allocation of the loss amount./58

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51 FEMA defines the 1%-annual-chance flood as a flood that has a 1% chance of being equaled or exceeded in any given year. See FEMA, Flood Zones, at https://www.fema.gov/glossary/flood-zones.

52 FEMA, National Flood Insurance Program: Risk Rating 2.0 Methodology and Data Sources, pp. 4-10, April 16, 2021, at https://www.fema.gov/sites/default/files/documents/fema_risk-rating-2.0-methodology-data-sources_4-21.pdf (hereinafter Risk Rating 2.0 Methodology).

53 See United States Geological Survey, 3D Elevation Program, at https://www.usgs.gov/core-science-systems/ngp/3dep.

54 The National Oceanographic and Atmospheric Administration's Sea, Lake, and Overhead Surges from Hurricane (SLOSH) model is a numerical model developed by the National Weather Service to estimate storm surge heights resulting from historical, hypothetical, or predicted hurricanes. See National Hurricane Center, Sea, Lake, and Overhead Surges from Hurricane (SLOSH), at https://www.nhc.noaa.gov/surge/slosh.php.

55 Risk Rating 2.0 Methodology, pp. 8-10.

56 American Academy of Actuaries, Uses of Catastrophe Model Output, Washington, DC, July 2018, p. 3, at https://www.actuary.org/sites/default/files/files/publications/Catastrophe_Modeling_Monograph_07.25.2018.pdf.

57 Ibid.

58 Ibid., pp. 9-10.

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In the first stage of Risk Rating 2.0 modeling, FEMA conducted probabilistic flood risk analyses, in which structures are assigned specific annualized probabilities of being impacted by flood, and to validate these results with NFIP historical data. The next step compared the results of this analysis with the output of commercial catastrophe models. Finally, FEMA generated average annual loss values for certain geographies, focusing particularly on leveed areas, including levee quality,/59 and complex flooding hazards.

Geographic and Structural Variables

Geographical variables used in Risk Rating 2.0 include the distance to water and the type of water (e.g., river, lake, or coast), the drainage area of the river, whether or not the structure is on a barrier island or behind a levee, and the elevation of the structure relative to the flooding source.

The structural variables used by FEMA in Risk Rating 2.0 include the foundation type of the structure, the height of the lowest floor of the structure relative to BFE, and the replacement cost value of the structure./60

Replacement Cost Value

In the current NFIP rating system, rates are based on the amount of insurance purchased for a structure/61 rather than the replacement cost of that structure. For most actuarially-rated structures, the NFIP classifies the first $60,000 of building coverage for single-family residences ($175,000 for businesses) and $25,000 of contents coverage as the basic limit. It charges higher rates for coverage below this amount, because losses are more likely to occur in this range. Rates for additional coverage above the basic limit are lower. The basic and additional rates are weighted to account for the average tendency to buy less insurance than the replacement value. For example, a post-FIRM single-family property in Zone AE,/62 with the elevation of the lowest floor at the BFE and no basement, would currently pay a basic rate of 2.21% per $100 coverage on the first $60,000 and an additional rate of 0.26% per $100 of coverage over $60,000./63

The two-tiered rating structure was used by the NFIP for two reasons. First, it ensured that the premium collected is sufficient to cover the typical claim, even if a policy is under-insured; according to FEMA, most NFIP claims are below $60,000./64 By charging a high rate for coverage up to $60,000, a policyholder's premium is likely to be sufficient to cover a typical claim.

Secondly, it encouraged policyholders to insure their structure fully. By charging a low additional rate, policyholders are encouraged not just to insure a typical claim, but to insure against the unlikely but possible higher claim.

For much of the NFIP's existence, the two-tiered rating structure operated with minimal inequity. However, as the range of replacement values widened, particularly through the 2000s, the potential for inequity caused by rating based on coverage instead of structure value grew.

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59 Risk Rating 2.0 Methodology, p. 16.

60 Risk Rating 2.0 Methodology, pp. 11-14.

61 The maximum coverage offered by the NFIP for single-family dwellings (which also includes single-family residential units within a 2-4 family building) is $100,000 for contents and $250,000 for buildings coverage. The maximum available coverage limit for other residential buildings is $500,000 for building coverage and $100,000 for contents coverage, and the maximum coverage limit for nonresidential business buildings is $500,000 for building coverage and $500,000 for contents coverage.

62 Flood zone AE is the area subject to inundation by the 1% annual-chance-flood when information about the BFE is available. See FEMA, Zone AE and A1-30, at https://www.fema.gov/glossary/zone-ae-and-a1-30.

63 FEMA, Flood Insurance Manual, Rate Tables, Revised April 2021, p. J-7, at https://www.fema.gov/sites/default/files/documents/fema_fim-appendix-j-rate-tables_apr2021.pdf.

64 Email correspondence from FEMA Congressional Affairs staff, July 19, 2017.

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Two groups are most subject to inequity. First, structures whose value is closer to the $60,000 basic limit pay more than they would if their rate was based on their structure value because their entire rate is mainly comprised of the higher basic rate. Second, structures whose value is above $250,000 pay less than they would if their rate was based on structure value, because their rate is based on an average structure value that is much less than their actual structure value. In addition, high-valued structures can produce much higher claims than lower valued structures with the same intensity of damage./65

When replacement cost value is used in setting NFIP premium rates, it is anticipated that those structures with higher replacement costs than current local or national averages would begin paying more for their NFIP coverage than those structures that are below the average, which would pay less. According to FEMA, the replacement cost value of a single-family structure is based on zip code, square footage, the number of stories, and the year it was built./66

Mitigation Credits in Risk Rating 2.0

According to FEMA, Risk Rating 2.0 would initially provide credits for three mitigation actions:

1. installing flood openings according to the criteria in 44 C.F.R. Sec.60.3;/67

2. elevating onto posts, piles, and piers; and

3. elevating machinery and equipment above the lowest floor./68

Currently the only mitigation activities for which the NFIP gives premium credit are elevating a structure and flood-proofing under certain circumstances./69

Risk Rating 2.0 could encourage

individual policyholders to do more to mitigate the flood risk for their property by introducing credit for a wider range of mitigation activities.

Risk Rating 2.0 and Flood Zones

Flood zones will not be used in calculating a property's flood insurance premium following the introduction of Risk Rating 2.0; instead, the premium is calculated based on the specific features of an individual property. However, flood zones will still be needed for floodplain management purposes; for example, all new construction and substantial improvements to buildings in Zone V must be elevated on pilings, posts, piers, or columns./70 The boundary of the SFHA will still be required for the mandatory purchase requirement. The FIRM map appeal/71 process will still exist, but once Risk Rating 2.0 begins, map appeals are not to have any effect on the premium that a policyholder pays.

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65 Ibid.

66 Email from FEMA Congressional Affairs staff, October 1, 2021.

67 44 C.F.R. Part 60, Criteria for Land Management and Use, at https://www.govinfo.gov/content/pkg/CFR-2012title44-vol1/pdf/CFR-2012-title44-vol1-sec60-3.pdf.

68 CRS briefing from FEMA staff, May 8, 2019.

69 See FEMA, Flood Insurance Manual, 3. How to Write, pp. 3-67 to 3-70, revised April 2021, at https://www.fema.gov/sites/default/files/documents/fema_fim-3-how-to-write_apr2021.pdf.

70 44 C.F.R. Sec.60.3(e)(4).

71 See FEMA, Appeals and Protests, at https://www.fema.gov/sites/default/files/2020-05/FactSheet_FIMA_Appeals_RID_SC_101415.pdf.

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Although FEMA has not yet given specific details of how grandfathered properties will be affected by Risk Rating 2.0, other than to say that "all properties will be on a glide path to actuarial rates,"/72 the implication of the fact that flood zones will no longer be used to set premiums appears to indicate that zone grandfathering, at least, will no longer be relevant.

In addition, the category of Preferred Risk Policy (PRP) is being retired under Risk Rating 2.0. When a PRP policy is renewed under Risk Rating 2.0, if the full risk-based rates are greater than the PRP rate, the premium will begin increasing until it reaches the full risk-based rate. If the new rate under Risk Rating 2.0 is less than the PRP rate, the lower premium will be charged at renewal./73

Maximum Premium Increases Under Current Statute

FEMA has statutory authority to set premium rates./74 The limitations on annual premium increases are also set in statute,/75 and Risk Rating 2.0 will not be able to increase rates annually beyond these caps. HFIAA set allowable rate increases for primary residences at 5-18% per year.

The changes introduced in HFIAA permit individual property increases of up to 18%, but limits the rate class/76 increases to 15% per year./77 In other words, the average annual premium rate increase for primary residences within a single risk classification rate may not be increased by more than 15% a year, while the individual premium rate increase for any individual policy may not be increased by more than 18% each year./78 Other categories of properties are required to have their premium increased by 25% per year until they reach full risk-based rates: this includes (1) nonprimary residences; (2) nonresidential properties; (3) business properties; (4) properties with severe repetitive loss;/79 (5) properties with substantial cumulative damage;/80 and properties with substantial damage81 or substantial improvement after July 6, 2012.

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72 CRS briefing from FEMA staff, May 8, 2019.

73 See National Flood Services, Risk Rating 2.0: What Is Changing, https://nationalfloodservices.com/wp-content/uploads/2021/06/Risk-Rating-2.0-What-is-Changing.pdf.

74 42 U.S.C. Sec.4015(a).

75 42 U.S.C. Sec.4015(e).

76 A single rate class (or risk classification) is a group of properties with the same flood risk classification; for example, pre-FIRM properties or properties with the newly mapped subsidy.

77 The chargeable risk premium rate for any property may not be increased by more than 18% per year (except in certain circumstances, which are listed); see 42 U.S.C. Sec.4015(e)(1). The chargeable risk premium may not be increased by an amount that would result in the average of such rate increases for properties within the risk classification exceeding 15% of the average of the risk premium rate for properties within the risk classification; see 42 U.S.C. Sec.4015(e)(3).

78 For example, the average annual premium increase for pre-FIRM primary residences cannot be more than 15%, but an individual pre-FIRM primary residence could have an increase of up to 18% due to particular characteristics of the structure.

79 Severe repetitive loss properties are those that have incurred four or more claim payments exceeding $5,000 each, with a cumulative amount of such payments over $20,000; or at least two claims with a cumulative total exceeding the value of the property. See 42 U.S.C. Sec.4014(h) and 44 C.F.R. Sec.79.2(h).

80 A property with substantial cumulative damage is any property that has incurred flood-related damage in which the cumulative amounts of payments under the NFIP equaled or exceeded the fair market value of such property. See 42 U.S.C. Sec.4014(a)(2)(C).

81 44 C.F.R. Sec.59.1 defines "substantial damage" as damage of any origin sustained by a structure whereby the cost of restoring the structure to its before-damaged condition would equal or exceed 50% of the market value of the structure before the damage occurred. For additional discussion of substantial damage, see FEMA Fact Sheet, NFIP "Substantial Damage"--What Does It Mean? at https://www.fema.gov/press-release/20210318/fact-sheet-nfip-substantial-damage-what-does-it-mean-0.

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It is notable, however, that FEMA does not consider everything that policyholders pay to the NFIP to be part of the premium and therefore subject to these caps. When premium rates are calculated for compliance with the statutory caps, FEMA only includes the building and contents coverage, the Increased Cost of Compliance coverage, the reserve fund assessment, and the SRL premium if applicable./82 Other fees and surcharges are not considered part of the premium and therefore are not subject to the premium cap limitations, including the Federal Policy Fee, the HFIAA surcharge and, if relevant, the probation surcharge./83

Table 1 shows the effects of a maximum statutory increase on the national average premium for a Standard Flood Insurance Policy (SFIP) subject to an 18% increase and a 25% increase, respectively. This figure includes the amounts charged to provide building coverage, contents coverage, Increased Cost of Compliance (ICC) coverage, and SRL premium if applicable. It also reflects any optional deductibles the policy selected, Community Rating System discounts where applicable, and the severe repetitive loss premium where applicable./84 According to FEMA, the national average for policies subject to 25% rate increases is $5,878.15 and the national average for all other policies (i.e., not subject to the 25% rate increase requirement) is $730.34. The national average premium for all NFIP policies is $818.70./85

For an SFIP primary residence, the maximum 18% increase would be calculated on the premium of $730.34, leading to an increase of $131.46 and a new premium of $861.80. However, an SFIP primary residence would also pay an FPF of $50 and a HFIAA surcharge of $25, so the total amount due to the NFIP after an 18% increase would be $936.80.

An SFIP for a property subject to a 25% increase on the initial premium of $5,878.158, would lead to an increase of $1469.54 and a new premium of $7,347.69. Costs for such a policy for a nonprimary residence would also include an FPF of $50 and a HFIAA surcharge of $250, so the total amount due to the NFIP after a 25% increase would be $7,647.69.

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82 Email from FEMA Congressional Affairs staff, January 19, 2020.

83 FEMA, April 1, 2021 and January 1, 2022 Program Changes, W-20020, pp. 1-2, at https://nfipservices.floodsmart.gov/sites/default/files/w-20020.pdf.

84 Ibid. Please note that according to FEMA guidelines, when premium rates are calculated for compliance with the statutory caps, FEMA only includes the building and contents coverage, the Increased Cost of Compliance coverage, and the reserve fund assessment. The Federal Policy Fee, the HFIAA surcharge, and the probation surcharge, if applicable, are not considered premium and are therefore not subject to the premium rate cap limitations.

85 Email from FEMA Congressional Affairs staff, January 19, 2021.

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[See link at end of text for Table 1. Maximum Increases on an Average NFIP Premium]

Source: Calculated by the Congressional Research Service. National average NFIP premium provided by FEMA Congressional Affairs staff, January 19, 2021.

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Risk Rating 2.0 and NFIP Cross-Subsidies

The current three categories of properties which pay less than the full risk-based rate (pre-FIRM, newly-mapped, and grandfathered) are determined by the date when the structure was built relative to the date of adoption of the FIRM, rather than the flood risk or the ability of the policyholder to pay. As proposed, the new rating system will not eliminate the three categories, nor the process of phasing out subsidies which began with BW-12, but rate changes will not necessarily be uniform within each category. Premiums for individual properties will be tied to their actual flood risk rather than the flood zone, but the maximum rate at which the subsidies will be phased out will continue to be constrained by law.

In general, Risk Rating 2.0 is expected to lead to the reduction of cross-subsidies between NFIP policyholders, and the eventual elimination of premium subsidies and cross-subsidies once all properties are paying the full risk-based rate. However, certain noninsurance activities of the NFIP are funded by cross-subsidies from NFIP policyholders' premiums. For example, through a program called the Community Rating System (CRS), FEMA encourages communities to improve upon the minimum floodplain management standards that are required to participate in the NFIP./86 Policyholders in communities which participate in the CRS can get discounts of 5% to 45% on their flood insurance premiums. These discounts are determined by the activities carried out by the community to reduce flood and erosion risk and adopt measures to protect natural and beneficial floodplain functions./87 The CRS discount is cross-subsidized into the NFIP program, such that the discount for one community ends up being offset by increased premium rates in other communities across the NFIP. As of the 2019 NFIP actuarial rate review, an average 13.3% discount for CRS communities is cross-subsidized and shared across the remaining NFIP communities through a cost (or load) increase of 15.3%./88 FEMA has confirmed that discounts to policyholders in communities that participate in the CRS will continue, with this discount uniformly applied to all policies in the community regardless of whether the structure is inside or outside the SFHA./89 In addition, approximately 36.4% of the funding for flood mapping and floodplain management is collected from NFIP policyholders in the form of the FPF./90

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86 42 U.S.C. Sec.4022(b)(1).

87 See FEMA, NFIP Community Rating Coordinator's Manual 2017, at https://www.fema.gov/sites/default/files/documents/fema_community-rating-system_coordinators-manual_2017.pdf.

88 Email correspondence from FEMA Congressional Affairs staff, October 22, 2020.

89 FEMA, Risk Rating 2.0: Equity in Action, at https://www.fema.gov/flood-insurance/risk-rating. Previously only properties in the SFHA received the CRS discount.

90 Email correspondence from FEMA Congressional Affairs staff, January 25, 2021.

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About 72% of the resources from the FPF are allocated to flood mapping, with floodplain management receiving about 18% of the overall income from the FPF./91

Initial Information on Impact of Risk Rating 2.0

FEMA has released some details of the projected impact of Risk Rating 2.0 on premiums nationally and for percentage changes in premiums for each individual state./92 (See Figure 1.)

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91 Email correspondence from FEMA Congressional Affairs staff, October 21, 2020.

92 FEMA, Risk Rating 2.0 State Profiles, at https://www.fema.gov/flood-insurance/risk-rating/profiles.

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[See link at end of text for Figure 1. Percentage Change in NFIP Premiums by State Under Risk Rating 2.0]

Source: Calculated by CRS from state profiles at https://www.fema.gov/flood-insurance/risk-rating/profiles.

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According to FEMA, at the national level, 23% of policyholders would see immediate decreases in their premiums./93

For the first year of Risk Rating 2.0 implementation, FEMA has set an annual cap of $12,125 as the maximum amount that any single-family primary residence would be required to pay.

According to FEMA, the maximum that a single-family primary residence currently pays is $45,925./94 This is the first time that NFIP premiums will be subject to a cap. According to FEMA, 75% of primary residences would see an increase greater than 18% if the statutory limit did not exist. FEMA estimates that 50% of policies will be at their full risk rate after 5 years and after 10 years, 90% of policies will be at their full risk rate./95 Renewing policyholders could choose between the new and old rating methods until April 1, 2020, giving policyholders whose premiums decrease under Risk Rating 2.0 the option to move to the new lower premiums on renewal. Since April 1, 2022, all policies are priced using Risk Rating 2.0 methodology./96

Concluding Observations

FEMA believes that the more transparent and accurate flood insurance pricing in Risk Rating 2.0 will lead to better risk communication and an increase in flood insurance take-up rate. FEMA has provided information on premium level changes at the county level and zip code level, with downloadable data./97 Certain types of properties may be more likely to be affected by Risk Rating 2.0, either positively or negatively. These may include zone-grandfathered properties, properties which are currently on the border of flood zones, properties currently outside the SFHA at risk of pluvial flooding, and properties with above-average or below-average replacement cost values.

For example, the use of distance to water, rather than flood zone, may mean that premiums for properties at the landward boundary of an SFHA could go down, while premiums for a property at the water boundary could go up./98

Risk Rating 2.0 is projected to lead to premium increases for 77% of NFIP policyholders,/99 which could raise questions of affordability. When the Biggert-Waters Flood Insurance Reform Act of 2012 went into effect, constituents from multiple communities expressed concerns about the elimination of lower rate classes, arguing that it created a financial burden on policyholders, risked depressing home values, and could lead to a reduction in the number of NFIP policies purchased./100 Similar concerns may be expressed with Risk Rating 2.0. Although risk-based price signals could give policyholders a clearer understanding of their true flood risk, charging actuarially sound premiums may mean that insurance for some properties is considered unaffordable, or that premiums increase at a rate which may be considered to be politically unacceptable.

FEMA does not currently have the authority to implement an affordability program, nor does FEMA's current rate structure provide the funding required to support an affordability program. Affordability provisions are included in the two bills which have been introduced in the 117th Congress for long-term reauthorization of the NFIP: National Flood Insurance Program Reauthorization and Reform Act of 2021 (S. 3128) and its companion bill in the House (H.R. 5802). A draft bill posted by the House Financial Services Committee in association with a hearing on May 4, 2021, includes provisions for a demonstration program for policy affordability./101 As Congress considers a long-term reauthorization of the NFIP, a central question may be who should bear the costs of floodplain occupancy in the future and how to address the concerns of constituents facing increases in flood insurance premiums.

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93 FEMA, Risk Rating 2.0--National Rate Analysis, at https://www.fema.gov/sites/default/files/documents/fema_riskrating-2.0-national-rate-analysis.pdf.

94 Provided by FEMA Congressional Affairs staff for CRS briefing on Risk Rating 2.0, March 29, 2021. Note that these numbers include premium fees, assessments, and surcharges.

95 Email from FEMA Congressional Affairs staff, April 16, 2021.

96 Email from FEMA Congressional Affairs staff, October 7, 2021.

97 FEMA, Risk Rating 2.0 State Profiles, at https://www.fema.gov/flood-insurance/risk-rating/profiles.

98 For example, imagine a hypothetical V zone which starts at the ocean front and extends to two miles inland, with the boundary between the A zone and the V zone at the two-mile mark. A property that is 1.95 miles inland which was mapped in the V zone should see its premium go down, whereas a property that is 2.05 miles inland, and mapped in the A zone, should see its premium go up.

99 FEMA, Risk Rating 2.0--National Rate Analysis, at https://www.fema.gov/sites/default/files/documents/fema_riskrating-2.0-national-rate-analysis.pdf.

100 National Research Council of the National Academies, Affordability of National Flood Insurance Program Premiums: Report 1, 2015, p. 2, at http://www.nap.edu/catalog/21709/affordability-of-national-flood-insuranceprogram-premiums-report-1.

101 National Flood Insurance Program Reauthorization Act of 2021, at https://financialservices.house.gov/uploadedfiles/bills-117pih-nationalfloodinsuranceprogramreauthorizationactof2021.pdf; posted by U.S. Congress, House Committee on Financial Services, Subcommittee on Housing, Community Development, and Insurance, Built to Last: Examining Housing Resilience in the Face of Climate Change, 117th Cong., 1st sess., May 4, 2021, at https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=407747.

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View figure, table and report here: https://crsreports.congress.gov/product/pdf/R/R45999