Towards a Private Flood Insurance Market

The federal-government-managed National Flood Insurance Program (NFIP) is $25 billion in debt, stokes moral hazard, and entails a regressive wealth transfer that favors coastal areas. The NFIP is set to expire at the end of September, offering policymakers an important chance to rethink the program. The House Financial Services Committee is considering the Flood Insurance Market Parity and Modernization Act Wednesday, the current version of the bill takes important steps in moving the U.S. towards a private flood insurance market. Private insurance would improve upon the NFIP by ending transfers from the general taxpayers to the wealthy and the coasts and by limiting moral hazard.

Private insurance functions as a market-driven regulator of risk. Private insurers devise premium payments to accurately reflect risk, forcing economic agents to internalize the risk they choose to assume. For instance auto insurance premiums depend both on a driver’s performance as well as other factors that correlate with risk, such as age or area of the country.

The enactment of the NFIP in 1968 reflected a belief that a centrally planned insurance program could better fulfill the regulatory function of insurance than the private market. Government-managed insurance could, it was held at the time, “limit future flood damages without hampering future economic development” and “prompt an adjustment in land use to reduce individual and public losses from floods,” reported a Housing and Urban Development study integral to the program’s design.

However, the NFIP’s fifty-year record shows why the reasoning behind the creation of the program was misguided. The NFIP is beset by many design flaws, especially in terms of how premiums are priced. About 20% of all NFIP policies are explicitly subsidized and receive a 60-65% discount off the NFIP’s typical rate. These subsidies are in no way a subsidy to poor homeowners but instead relate to the age of a property. They turn out to be wildly regressive.

Even the 80% of the NFIP’s so-called “full risk” properties are not priced accurately. For instance, despite their name the full risk rates do not include a loading charge to cover losses in especially bad years, so even these insurance policies are money-losers in the long run.

Moreover, the NFIP’s rates are not set on a property-by-property basis. Instead, they reflect average historical losses within a property’s risk-based categories. As a result, while the subsidies and lack of loading charge mean that the NFIP generally undercharges risk, in some instances premiums are actually overpriced.

Debt is not the only consequence of the NFIP’s misguided premiums. The systemic underpricing of insurance causes moral hazard, by masking the cost of flood risk and encouraging overdevelopment in flood-prone areas. Because the average home in the NFIP is much more valuable than an average American home, the program is regressive on the whole. And since a disproportionate number of properties in the NFIP are on the southeastern coast, wealth is transferred from the rest of the country to homeowners near the coast in those states.

Congress could, theoretically, fix some of these design problems, but past attempts to reform the NFIP to more closely resemble a private insurance company failed miserably, and exemplify why in practice government rarely succeeds in competently managing what should be private business. For instance, in 2012 Congress passed the Biggert-Waters Flood Insurance Reform Act, which required the NFIP to end subsidies and to begin including a catastrophe loading surcharge. However, due to interest group pressure Congress reversed itself just two years later, halting some reforms and getting rid of others outright. The quick backtrack was a classic example of government failing to act in the public interest due to concentrated benefits and diffused costs.

However, one positive aspect of the 2012 reforms has persisted. The Biggert-Waters law ended the NFIP’s de-facto monopoly by allowing property owners to meet mandatory purchase requirements with private market insurance. Private insurers have since returned to the market, successfully competing with the NFIP.

Recent innovations in catastrophic modeling and catastrophic risk hedging mean that private market flood insurance is more viable than ever. Insurance industry experts suggest that private insurers can cover most properties in the NFIP and note that U.S. flood risk is the largest growth area for world-wide private reinsurers.

A forthcoming Cato Policy Analysis discusses technological innovations in the private flood insurance industry and the social benefits of moving to private flood insurance and terminating NFIP. If that is politically impossible, it suggests that any reauthorization of the NFIP should at least include measures that level the playing field between the NFIP and private alternatives.

Measures to encourage private competition include allowing a more flexible array of private coverage terms to meet mandatory purchase requirements, mandating that FEMA release property-level flood data to private insurers, and allowing firms that contract with the NFIP to also issue their own insurance plans. The Flood Insurance Market Parity and Modernization Act contains many of these measures, and would represent an excellent step towards ending a system that subsidizes wealthy coastal homeowners to take imprudent risks.

Special thanks to Ari Blask, who co-authored the forthcoming report and provided copious assistance on this blog post as well.