Advanced Maps and Models: Changing the Tide of U.S. Flood Insurance
By John Elbl
Catastrophic floods have been damaging homes for as long as people have lived in dwellings. Floods can cause devastating losses to homeowners and businesses almost anywhere in the United States, both on and off established flood plains. Even so, flood insurance—the product that should serve as the primary backstop against these types of losses—is still not widespread. Outside of government-funded programs and a narrow set of specialty policies, available flood coverage remains extremely limited. In the event of a flooding disaster, only a fraction of residential and commercial properties exposed have any real source of financial protection.
At the time of its founding by Congress in 1968, the National Flood Insurance Program (NFIP) carried the best intentions of lawmakers. Previously, flooding had been a covered exposure in a typical homeowners policy. But as the result of a series of damaging floods during the 1950s and 1960s, claim payouts for flood losses consistently exceeded the coverage’s premiums. Flood coverage proved to be unprofitable and was almost entirely eliminated from homeowners policies.
To ease the burden of risk borne by homeowners in flood-exposed regions, the federal government established the NFIP. The program’s purpose was to enable homeowners to purchase insurance directly from the government for flood events. Originally intended as a way to lessen the burden on individuals by pooling flood risks nationally (while also incentivizing flood risk management by spreading the burden of the risk across a greater number of people and also encouraging more people to buy policies which could then be offered at much lower rates), the NFIP has since evolved away from serving its intended purpose.
National Program under Water?
This situation has led to a crisis, of sorts. Because its aim from the start was to provide affordable coverage for at-risk property owners, NFIP insurance has never been subject to actuarially sound rates. Presently, the NFIP covers more than 5 million properties, and as many as 1 million of them are subject to rates less than half the price a private insurer would charge. In fact, the NFIP was more than $20 billion in debt as of November 2012, according to a report from the Union of Concerned Scientists, a nonprofit research organization. Such debt has forced a program once intended to be self-sufficient to look for special subsidies and borrow heavily from the government.
Despite the admirable aims of lawmakers who enacted the NFIP, the goal of providing affordable insurance to homeowners and businessowners in some of the most flood-prone areas has resulted in a case of significant adverse selection—that is, a small percentage of covered properties are responsible for a disproportionately large number of payouts. Indeed, in some areas, individual properties that have been flooded more than a dozen times continue to receive federal aid without a commensurate increase in premiums. In this way, the NFIP has led to a large number of property owners living in flood-exposed regions while effectively receiving a government subsidy for doing so.
For the NFIP to conquer its mounting debt, “subsidies” to property owners in flood-exposed areas will likely have to end. Lawmakers have long recognized this problem and continue to seek ways to remedy the situation. To that end, the NFIP has undergone changes and improvements in recent years, starting with the Biggert-Waters Reform Act of 2012. Some notable changes include revising existing rates and updating mapping information, which together have changed flood classifications for some policyholders. In an effort to reduce deficits accrued by the NFIP, this new program requires the program’s rates to be actuarially sound. The end result has been that policyholders in some of the most at-risk locations are facing massive rate increases.
New Options for Coverage
Yet those increases are also providing the insurance industry an opportunity to step in and offer alternative coverage. In practice, this proposition has been fraught with complications. Some state insurance commissioners want private insurers to change policy terms to provide added protection (such as different deductibles or additional replacement cost protection), while others want to retain the NFIP’s terms entirely. Furthermore, some banks have not provided clear guidance as to what flood insurance they deem to be acceptable, and other banks have been reluctant to accept policy wording that is not identical to NFIP coverages. This uncertainty can restrict the ability of a customer to choose private coverage.
Fortunately, insurance companies have several tools at their disposal that were not available in the past, including:
- Federal Emergency Management Agency (FEMA) flood maps updated and converted into an electronic format, making zonal determination easier for agents
- improved mapping technology, which allows for an alternative (or updated) view of risk, especially in areas that may not have a recent FEMA evaluation
- probabilistic flood modeling that provides insurance companies with a capability to manage aggregate exposures and evaluate the impact of different financial structures
These tools enable insurers to assess a property’s inherent flood risk more accurately. In turn, such reviews can reveal opportunities for profitable expansion into areas that before had been deemed unacceptable due to the perceived risks from flooding. The coarsely defined flood maps previously used to determine rates made it difficult for insurers to intelligently select their risks. Now insurers have the tools necessary to assess risk at a finer granularity—potentially revealing undiscovered opportunities.
To help further ease regulatory restrictions, allow third-party insurers better access to this market, and give customers more choice in flood coverage beyond NFIP protection, U.S. Rep. Dennis Ross (R-FL) introduced a draft Flood Insurance Market Parity and Modernization Act to the House on June 25, 2015. U.S. Sen. Dean Heller (R-NV) submitted the sister bill in the Senate. Key provisions of both bills include the following:
- Banks would be allowed to accept flood policies from insurance companies to satisfy mortgage protection requirements.
- State insurance commissioners would approve policy wordings and rates, as already done for other insured perils.
- Both admitted and nonadmitted policies would satisfy the flood insurance requirement.
- The required flood insurance purchase would be lowered to the least of three values: the home’s value, outstanding mortgage loan balance, or the maximum NFIP policy limits available.
In effect, these bills would open the door for insurance companies to compete directly with the NFIP and might help guide the approvals of state insurance commissions. If the bills pass, insurance companies would be able to write stand-alone polices, include proper endorsements, allow customers to choose from a range of deductibles, and provide additional protections. All are issues that have plagued adjusters for years. Many in the insurance industry support this type of legislative reform, and their backing will be critical in helping to ensure that the bills are able to pass swiftly through Congress.
Testing the Waters
Some of these ideas are being tested in Florida’s insurance market. Florida represents about 40 percent of the NFIP’s total market and is composed primarily of property owners located off flood plains. To comply with legal provisions designed to restore the NFIP to solvency, some homeowners in Florida are facing increases as large as 80 percent above the rates of their current policies. Among this pool of policyholders, almost all of whom are located in eight coastal counties, the inception-to-loss ratio is a mere 15 percent of total premiums collected. While this loss ratio is due in part to a ten-year “hurricane drought,” it nonetheless represents a significant opportunity for private insurance companies to step in and profitably offer more affordable coverage—with the potential for providing even more comprehensive coverage—than the NFIP.
Although the situation may not be the same in every state, it provides a representative example of how insurance companies can use new tools and better data to supplement (or even replace) NFIP coverage without incurring an unacceptable amount of risk. Similar cases can be found throughout the Unites States; it’s only a question of when the federal government and state departments of insurance recognize there’s room for private insurers to compete with the NFIP, thereby reducing the burden placed on taxpayers in funding an unprofitable system.
Coming changes in flood insurance regulation may enable the insurance industry to provide coverage to a wide range of customers that it had previously been unwilling or unable to serve. As the choices available continue to expand, customers will probably seek out insurers that offer the best protection at the most competitive prices. Insurers looking for a competitive advantage in serving those customers may turn to a probabilistic inland flood model to provide them with a robust assessment of risk available. Using these analytics, the insurance industry can move forward more confidently to offer much-needed flood protection in the private market.