Senate Banking Committee Issues Statement From Cato Institute Senior Fellow Van Doren
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Thank you for holding today's hearing, titled "Reauthorization of the National Flood Insurance Program: Protecting Communities from
Introduction
The
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On the international level, economists Paul Raschky and
Policymakers thus face what is known as the Samaritan's dilemma4: the choice to either render aid after catastrophes or else, seemingly heartlessly, withhold aid to incentivize people in calamity-prone areas to purchase disaster insurance, take preemptive private and local public measures to reduce losses, and build robust private charity systems for when catastrophe strikes. To achieve the latter, elected policymakers must effectively "precommit" to not rendering financial aid, warding against the temptation to be "time inconsistent" and backtrack when the public sees heart-rending images of disaster victims.
The National Flood Insurance Program
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3 Paul Raschky and
4 The Samaritan's dilemma was first formally framed in
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The NFIP is a government program, but lawmakers wanted it to charge most insureds roughly "actuarially fair" premiums. Though buildings constructed prior to the legislation would qualify for discounted rates (and thus receive public subsidy), owners of subsequently built structures who purchased coverage would de facto "prepay" the cost of restoring their properties following catastrophe. The program also requires that, for buildings in high-risk areas to qualify for coverage, those areas must be zoned to limit construction, and their building codes must include provisions to make new structures better able to withstand floodwaters, e.g., by requiring their main levels to be elevated above typical floodwaters.
Except for the "grandfathered" preexisting structures, lawmakers intended for the NFIP to be largely subsidy-free, protecting taxpayers. The 1966 task force report that gave rise to the NFIP originally estimated that federal subsidization of the cost of flood premiums for existing high-risk properties would be required for a limited period of time only--approximately twenty-five years--a prediction that would prove to be wildly optimistic.5 The percentage of subsidized policies has decreased over time, but now--after a half-century of the program--they have not disappeared. And in the past decade,
So, what should be done about flood disaster policy going forward? Though private flood insurance has entered the market in the last few years, there are serious questions whether it will persist over the long term. And elected policymakers are highly unlikely to ignore the plight of large groups of people whose homes are struck by floodwaters. Yet, a return to the ad hoc aid of the mid-20th century is undesirable. So, though flawed, the NFIP likely is the best policy response that is politically attainable. That said, the program can be improved, and the most important step
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Pre-NFIP Federal Disaster Policy
Between 1803 and 1947,
Until the 1960s, federal disaster policy mostly focused on engineering solutions rather than relief. For instance, in 1879
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The Great Mississippi
The History of
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8 Some 16.5 million acres of land (roughly the size of
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At various times in American history, private insurers have offered flood coverage. But the magnitude of losses from major floods frequently pushed insurers into bankruptcy, and until very recently, no reputable insurer had offered flood insurance since the 1927 Great Mississippi Flood. As
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With no private flood insurance available to property owners,
When
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17 Section 5 of the Southeast Hurricane Disaster Relief Act of 1965 directed the Secretary of
18 Even that subsidy was limited to the first
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But details of the 1968 legislation meant that even "unsubsidized" NFIP premiums do not fully cover the costs of the catastrophes striking those properties. For instance, the NRC report explains, "The legislation stipulated that the
Land-Use Controls
Actuarial fair rates were only one way the NFIP was supposed to reduce taxpayer exposure to losses. The statute also included zoning requirements to limit construction in flood-prone areas and building code requirements intended to make structures built in those areas less vulnerable to flood damage.
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Under the 1968 law, federal flood insurance is available only in communities that agree to land-use controls that limit construction in a high-risk area--a so-called "100-year floodplain,"22 known officially as a Special
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22 The 100-year high-risk delineation is an arbitrary cutoff in the continuous distribution of flooding events. Technically, these zones are defined as having an annual flooding probability of 1 percent. If Pc is the cumulative probability of a flood over some period of time, Pf is the probability per year expressed as a decimal, and n is the number of years considered, then
23 As of
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Making NFIP Subsidies Disappear?
The inclusion of these land-use and building code provisions in addition to true actuarial pricing has been justified historically as lawmakers attempting to curtail moral hazard.27 At least that was the thinking in 1968./28 But this justification does not make sense for two reasons.
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27 A presidential task force report in 1966 concluded that it would be proper for the federal government to subsidize flood insurance for existing floodplain property "provided owners of submarginal development were precluded from rebuilding destroyed or obsolete structures on the flood plain." As reported in
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First, if homeowners pay higher premiums that adequately cover the risk presented by their vulnerable, non-flood-proofed homes, there is no moral hazard, strictly speaking. The higher premiums incentivize structure owners to elevate their buildings if the cost of doing so plus the present value of the lower premiums associated with elevation is less than the present value of the premiums for un-elevated structures. Also, regardless of whether a structure owner elevates, if the premiums for pre-FIRM structures were not subsidized, the government and taxpayers should be indifferent to paying claims for repetitive losses.29 Second, moral hazard is an increase in the incidence of damages (by those who are insured) relative to the incidence used by insurance companies to calculate the rates because of unobserved behavior on the part of insureds that increases the incidence. But it is easy to observe whether a structure's first floor and important utilities (heating, air conditioning, hot water, and telecommunication and electrical interfaces) have been elevated above the BFE when assigning it to an actuarially fair rate class. Thus, though "moral hazard" is offered as a rationale for employing land-use and building-code controls in addition to actuarial prices, the term apparently is being used in a casual rather than rigorous fashion.
The more likely reason for these requirements is to further protect lawmakers from the Samaritan's dilemma. Members of
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29 This analysis does not consider taxpayer subsidies for so-called catastrophic events, i.e., BFE with an annual probability of less than 1 percent. This includes so-called 500-year floods, which actually are flooding with an annual probability of 0.2 percent.
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And overall, this bit of political engineering appears to have been successful. The percentage of NFIP-covered structures receiving pre-FIRM subsidies fell dramatically over the first five decades of the program. Some 75 percent of covered properties received this subsidy in 1978, but only about 28 percent in 200430 and 13 percent in September 2018.31 It should be noted that the elevation requirement does not appear to be rigorously enforced. A 2020 New York Times investigation revealed there are 112,480 NFIP-covered structures nationwide with first floors below BFE paying premiums that are not reflective of that risk. The owners of those properties filed 29,639 flood insurance claims between 2009 and 2018, resulting in payouts of more than
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33 "Zone V designates a coastal area where the velocity of wave action adds at least 3 feet to the water level that is reached in a 100-year flood."
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Another instance involves the remapping of BFE levels. If an updated FIRM indicates that an elevated property now faces a higher risk of flooding--say, a property that was initially mapped as being 4 feet above BFE but is reappraised as being just 1 foot above BFE--the property owner can continue to pay the previous, lower-risk premium. As of
In 2012, lawmakers took a big step toward curtailing NFIP subsidies by enacting the Biggert-Waters Flood Reform Act. Under the legislation, premiums for non-primary residences, severe repetitive loss properties, and business properties (about 5 percent of policies) were to increase 25 percent per year until they reflected the
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But after Hurricane Sandy hit
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37 When FEMA released new maps in
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Despite the general lack of private flood insurance since the 1927 Great Mississippi Flood, some private insurance does exist in practice, primarily for commercial and secondary coverage above NFIP limits.43 The 2012 Biggert-Waters Flood Insurance Reform Act directed
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Arbitraging NFIP's Cross Subsidies
An important reason that private insurers are interested in offering flood insurance is the cross subsidies within the federal program. Originally, the subsidies for pre-FIRM structures were to come from taxpayers explicitly through appropriations, but that system was abandoned and replaced with cross subsidies from new structures to old--that is, post-FIRM structure owners paid a de facto "tax" as part of their premiums to cover pre-FIRM structures.46 And, as described earlier, some newer structures that undergo A to V zone or BFE transitions are also cross subsidized.
Private insurance allows those who would be overcharged in the federal program to escape from paying this "tax." A modeling exercise that examined premiums for single-family homes in
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Cross subsidies work only if entry is restricted, forcing people to pay the "tax."48 The most famous
As the CRS explains in a 2021 report:
For example, two properties that are rated as the same NFIP risk (e.g., both are one-story, single-family dwellings with no basement, in the same flood zone, and elevated the same number of feet above the BFE), are charged the same rate per
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In contrast, "NFIP premiums calculated under [a proposed new risk assessment formula] Risk Rating 2.0 will reflect an individual property's flood risk" using historical flood data as well as commercial catastrophe models.51 Risk Rating 2.0 took effect on
The Economics of Subsidies
If cross subsidies within the NFIP are eliminated either through competition from private provision or explicit change in the statute by
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One possibility is to limit the subsidies to those with limited income or wealth. In the typical means tested program, benefits (subsidies) are given to recipients whose income or wealth falls below a threshold set by
Alternative designs reduce subsidies gradually as income or wealth increases. Such designs reduce the gaming of the subsidy system through which recipients get full benefits as long as their market income remains just under the threshold. In the alternative designs, subsidies are reduced by some steady amount for every dollar increase in income or wealth. The lower the benefit-reduction rate the better the incentives to increase market income through work, but the total budget for transfers increases.
These tradeoffs are illustrated in the following figure. The subsidy amounts are listed along the y axis. The market income of the recipient is along the x axis. And the total expenditure for subsidies is indicated by the area within the rectangle or triangles in the figure. There are three variables in the policy design: the subsidy amount for those with the lowest resources (the intercept in the figure along the y axis where market income is zero), the rate at which subsidies decline as income increases (the slope of the rectangle or triangle in the figure), and the total expenditures on subsidies (the area within the rectangle and various triangles).
The
Recommendations for
Federal flood insurance arose as a policy device with two purposes: to reduce the use of post-disaster congressional appropriations for disaster relief and to impose the cost of rebuilding on the owners through premiums. The
Thank you again for the opportunity to testify before you and share my research on this important topic. I look forward to your questions.
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Original text here: https://www.banking.senate.gov/download/van-doren-testimony-6-16-22
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