Senate Banking Committee Issues Testimony From R Street Institute Director Theodorou
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Thank you for the opportunity to offer testimony on the reauthorization of the National Flood Insurance Program (NFIP). My name is
We believe that a five-year reauthorization, instead of the current short-term sunsets, would afford
The NFIP was established in 1968 by the federal government with two main objectives:
1. To encourage state and local governments to constrict development of land exposed to flood hazards and guide future development away from such locations; and
2. To provide flood insurance through a cooperative public-private program with equitable sharing of costs between the public and private sectors.1
Attainment of the two objectives would reduce economic losses caused by flooding. The two objectives have not been met. First, development in flood-prone areas is not being restricted--rather, it is expanding.2 In the four decades following the NFIP's establishment, from 1970 to 2010, the
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1 42 US Code, Section 401;
2
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Regarding the second objective, there is no equitable sharing of costs between the public and private sectors. The private sector is only peripherally involved in bearing flood risk. The involvement of the private insurance sector is restricted to administration of the program, for which insurers are remunerated by the NFIP.4 The participation of private insurers in flood insurance as a risk-bearer is de minimis, writing less than a tenth the premium collected by the NFIP.
Instead of attaining the overarching goal of reducing economic losses caused by flooding, flood-related economic losses have increased. In the past decade,
In addition to its two foundational goals, other goals of the NFIP include making flood insurance affordable and making the NFIP solvent. These are competing goals. If flood insurance becomes more affordable and costs less than is actuarially sound, the finances of the NFIP are adversely impacted. If flood insurance is priced at the risk-appropriate level, it becomes more expensive and less affordable. Therefore, a balance between the two competing goals should be sought if both are desired.
The NFIP has focused more on affordability rather than program solvency, with the result that NFIP flood insurance has been historically underpriced, and the program has accumulated close to
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3
4
5 "Economic damage caused by floods and flash floods in the
6
7 "Budget Basics: The National Flood Insurance Program,"
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We are not alone in concluding that the NFIP, now in its 55th year, is in urgent need of review and reform. The NFIP has had an unenviably long-standing presence on the Government Accountability Office (GAO) High-Risk Report.9 The NFIP has been on the High-Risk list since 2006, because of its "financial and management challenges."10 The High-Risk report identifies government "programs and operations that are vulnerable to waste, fraud, abuse, or mismanagement, or in need of transformation."11 The GAO has found that the NFIP merits inclusion on the High-Risk list because
Structurally, the NFIP is positioned within
There are numerous aspects of the NFIP's operation that deserve scrutiny. In the analysis that follows, we focus on five salient areas where reform would improve management of flood risk and address problems facing the program that have made it unsustainable, and in need of reform. In one of the areas--actuarially sound rating (discussed in section 3 below)--progress has already been made. We encourage
1. Development of a Private Market for
The private insurance market for flooding is dwarfed by the NFIP's participation in the market. Private insurers are unable to compete effectively with the NFIP because NFIP policies are priced
below actuarially sound rates. If private market insurers were to compete with the NFIP on the basis of rates, they would operate at a loss. The NFIP's losses are borne by the
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8
9 "National Flood Insurance Program,"
10 "National Flood Insurance Program: Fiscal Exposure Persists Despite Property Acquisitions,"
11 Ibid.
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The Private Market in the History of the NFIP
Flood insurance was offered by private insurers between 1895 and 1927. Severe losses in 1927 and 1928 from flooding of the
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12 "
13 "Spotlight on:
14
15 Ibid.
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Following the exit of private insurers from the flood market in the 1920s, insurers refrained from re-entering for two reasons. First, they lacked sufficient data on flood risk to be able to price it correctly. Insurers rely on historical loss data for their ratemaking. When insurers lack sufficient historical loss data, they either refrain from offering coverage, or load the premium to account for uncertainty surrounding unmodeled risk. Second, insurance buyers knew more about their flood risk than insurers. This constitutes reversal of the information asymmetry in insurance--policyholders buy insurance because they do not know the precise magnitude of risk, whereas data-rich insurers have more information on risk, and can price policies with greater confidence. As a result, when private insurers offered flood insurance, it was on terms buyers were unwilling to accept.
Insurers have more tools at their disposal today to satisfactorily price flood risk than they did in the 1980s and prior. Since Hurricane Andrew in 1992, the insurance industry has benefited from the development of catastrophe risk modeling.16 Enabled by modern computing power, catastrophe risk models employed by insurers incorporate vast amounts of granular data on precise geographic, geological, climate and building factors to generate stochastic calculations of risk magnitude, allowing insurers to price risk with much greater confidence than possible without the model.
When modeled risk is higher than reflected in NFIP pricing, private insurers will refrain from competing with such underpriced NFIP policies. But when modeled risk is lower than reflected in NFIP pricing, private insurers will pursue such business, leaving the NFIP with a higher proportion of underpriced policies. This phenomenon is known as adverse selection, and to the extent that it occurs, the finances of the NFIP are adversely impacted.
The private market for flood insurance can be encouraged by the NFIP pricing its policies at actuarially sound rates. If NFIP rates were risk-based, private insurers could compete on the basis of service and product offerings. NFIP policies are relatively rigid. For example, the limit of insurance for homeowners is a flat
2. Reduction of Subsidies
The NFIP practice of subsidizing policies is a driver of rate inadequacy in the program. Policies with subsidies, or discounts, do not reflect the full risk of flooding. The aggregate value of NFIP discounts is
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16 "Catastrophe modeling: A vital tool in the risk management box,"
17 "A Brief Introduction to the National Flood Insurance Program." https://sgp.fas.org/crs/homesec/IF10988.pdf.
18 "Budget Basics: The National Flood Insurance Program." https://www.pgpf.org/budget-basics/the-national-flood-insurance-program; "The National Flood Insurance Program: Financial Soundness and Affordability,"
19
20 "
21 "National Flood Insurance Program: The Current Rating Structure and Risk Rating 2.0,"
22 "The National Flood Insurance Program: Financial Soundness and Affordability." https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53028-nfipreport2.pdf.
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The practice of subsidizing policy premiums sends false price signals to the market, which not only distorts the market, but also encourages unsound behavior, such as building in coastal areas. Most NFIP policies are priced below the level of actuarial soundness. The CBO defines actuarial soundness to mean: adequacy of premiums charged by the National Flood Insurance Program (NFIP) to cover both the expected costs of flood claims and the administrative costs associated with issuing and servicing flood insurance policies. When income from premiums is too low to cover those costs, an actuarial shortfall is said to exist.23 Full-risk premium rates would remove subsidies from those who do not require them. Furthermore, they would help improve solvency, and send more accurate price signals on true flood risk levels to property owners. We recommend that
It is recommended that
3. Introduction of Actuarially Sound Rates
The NFIP practice of underpricing its policies dates back to the early days of the program. Initial growth of the program was slow, with limited uptake of policies by homeowners and modest partnership with communities. Because the main focus of the program was to increase the number of participating communities and the number of policyholders, the program reduced rates three times from 1972 to 1974 as a stimulus to increase the size of the insurance premium pool.24 The most significant development in the recent history of the NFIP is the introduction of Risk Rating 2.0./25 Risk Rating 2.0 replaces the NFIP's legacy rating methodology. Risk Rating 2.0 was introduced for new business on
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23 Ibid.
24
25
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With the introduction of Risk Rating 2.0, the NFIP has stronger tools at its disposal to address inherently overpriced and underpriced business by incorporating more flood risk variables into rate calculations. Among the variables used in the Risk Rating 2.0 methodology are flood frequency, multiple flood types--river overflow, storm surge, coastal erosion and heavy rainfall--and distance to a water source, in addition to property-specific characteristics such as elevation and cost to rebuild.26 Policyholders with lower-valued homes currently pay more than the actuarially determined rate, while policyholders with higher-valued homes pay less than actuarially sound risk-adjusted rates. Risk Rating 2.0 considers rebuilding costs, allowing
4. Addressing Repetitive Losses
Properties that have had numerous losses are one of the most significant contributors to the NFIP's poor financial results. Properties that have experienced multiple flood losses account for a disproportionately large component of overall NFIP losses.29 Historically, repeatedly flooded properties have accounted for only one percent of properties with NFIP policies, but absorb close to 40 percent of flood loss dollars. Cumulatively, repeatedly flooded properties have cost the NFIP more than
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26 Ibid.
27 Ibid.
28 Author correspondence with
29 "National Flood Insurance Program: Fiscal Exposure Persists Despite Property Acquisitions." https://www.gao.gov/assets/gao-20-508.pdf.
30 "Repeatedly Flooded Properties Cost Billions"
31
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The NFIP has not satisfactorily dealt with repetitive loss properties. An extreme example of a property with numerous losses is a
Properties with Repeated Flooding, 2009-2018
If flood insurance were provided to the above-referenced
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32 "Repeatedly Flooded Properties Cost Billions." https://www.pewtrusts.org/-/media/assets/2016/10/repeatedly_flooded_properties_cost_billions.pdf.
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The NFIP and
The most recent reauthorization of the NFIP was in 2012.35 The NFIP's five-year reauthorization ended on
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33
34 "National Flood Insurance Program: Fiscal Problems Persist Despite Property Acquisitions." https://www.gao.gov/products/gao-20-508#:~:text=From%201989%20to%202018%2C%20FEMA,Mitigation%20efforts%20varied%20by%20state.
35
36 "What Happens If the National Flood Insurance Program (NFIP) Lapses?,"
37
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Thank you again for the opportunity to testify. I look forward to answering any questions you may have.
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Original text here: https://www.banking.senate.gov/download/theodorou-testimony-6-16-22
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