Commentary

The Private Alternative to the National Flood Insurance Program

The National Flood Insurance Program, which offers over $3 trillion in coverage to about 5 million policyholders, is scheduled to expire in September. The program is widely understood to be beset by significant design flaws but has evaded reforms throughout its fifty years of existence. Will anything be different during this year’s reauthorization debate? As of now, the House Financial Services Committee led by Chairman Jeb Hensarling (R-Texas) has put forth reform legislation, but key coastal senators including Marco Rubio (R-Fla.) and Elizabeth Warren(D-Mass.) seem resistant to meaningful change.

There may be a less controversial legislative solution that allows private insurers to make the most of recent advances in catastrophic modeling and financial risk sharing technology. Bolstering the private insurance market should not elicit the same pushback as past attempts to change the program itself.

President Lyndon Johnson signed the NFIP into law in 1968. At the time, policymakers believed that government insurance could do a better job than the private sector of encouraging the right mix of economic development and mitigation in flood prone areas.

Congress could theoretically could fix some of these flaws, but past efforts at reform have been stymied by the homeowners who benefit from the program’s current design.

The track record of the NFIP to date demonstrates that this belief was misguided. The program’s largest problems stem from its irrational and inaccurate pricing method that stokes moral hazard and has led to its accrual of $24 billion in debt. Premiums do not reflect assessments of risk at the property level but are instead based on average historical losses within a property’s risk zone. Risks can vary greatly within a given zone so these averages are of limited use, and the floodplain maps determining the zones are often decades out of date. All in all, premiums are only tangentially related to the risk of flooding.

In addition to the inaccuracy, premiums do not include a loading charge to build reserves for especially bad years. About one in five policies receive a 60-65 percent discount off the full risk premium price. These explicit subsidies have nothing to do with financial need, but instead relate to the age of a property.

Congress could theoretically could fix some of these flaws, but past efforts at reform have been stymied by the homeowners who benefit from the program’s current design. In fact, Congress passed reforms in 2012 that would have introduced loading charges and ended subsidies, only to repeal or pause these measures in 2014 after an intense lobbying effort.

So long as some homeowners receive a significant financial benefit from the program, it will be difficult to reform it so that it operates in a sustainable way. This dynamic is compounded by the fact that the NFIP’s beneficiaries are disproportionately wealthy and thereby are more likely to have politicians’ ears. A Congressional Budget Office study found that a NFIP insured home’s median value is double that of a typical American home and that 25 percent of explicitly subsidized properties near coasts are vacation homes.

The best steps Congress can take this time around are measures that encourage the growth of a private insurance market. Advances in catastrophic modeling and insurance-linked securities mean that private insurers are interested in flood and can price the risk accurately. Wharton School researchers found that the NFIP’s inaccurate pricing method means that the program overcharges many policyholders, who therefore would save money with private insurance.

Private insurance would better meet the ideal of a sensible balance between development and risk mitigation that motivated the creation of the NFIP in 1968. That’s because market based insurance rates force households and businesses to internalize the true risk of owning property in a flood-prone area. Private insurers reward steps taken to limit risk with lower premiums. The NFIP’s premiums distort these price signals and on the whole lead to overdevelopment in floodplains.

Full privatization is unlikely to be politically feasible as of now, but policymakers should attempt reforms that allow private insurers to compete with the NFIP on a level playing field. Measures that mandate FEMA to release property level flood insurance data and make it easier for private plans to meet mandatory purchase requirements have passed the House Financial Services Committee. The full House of Representatives is set to vote on these bills by late August.

One of the reasons it has been so difficult to reform the NFIP’s premium structure in the past is the influence of Southeast Atlantic Coast senators, who oppose measures that would force their constituents to pay more. Allowing for a private market to operate in tandem with the NFIP might be a more palatable reform option for these lawmakers.

The National Flood Insurance Program has avoided significant reform to date despite its perverse effects because of an entrenched group of politically connected beneficiaries. By allowing a private market to flourish, Congress will have laid the groundwork for a more sustainable and fair flood insurance system.

Ike Brannon is a visiting fellow at the Cato Institute and Ari Blask is a research assistant at Cato’s Center for Monetary and Financial Alternatives.