Get ready for rising premiums on flood insurance

Heading into 2014, policyholders are bracing for unexpected increases in the cost of their insurance due to a recent major reform. Understandably, they’ve taken to local news and Congressional offices to voice their displeasure. Evening news stories abound.

Though all this could be a familiar retelling of the Affordable Care Act rollout, it’s actually the story of a long overdue reform of the National Flood Insurance Program (NFIP).

The creation of the NFIP followed a previous attempt by Congress – the Federal Flood Insurance Act of 1956 – to facilitate a private flood insurance market. Unfortunately, the peculiarities of disaster insurance resulted in little private market interest.

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Unlike, say, health insurance, where one person’s heart disease is unrelated to his neighbor’s, a flood at my house is very much predictive of damage to my neighbor’s. Moreover, major natural disasters – Hurricane Katrina for instance – don’t occur at predictable intervals: an insurance fund may go years, even decades, without major payouts, and then suddenly have to entirely deplete reserves. Finally, most of the country doesn’t worry much about flood damage. Without the benefit of low-risk policies (the equivalent of “young invincibles” in ACA nomenclature) the only policies written are for the highest risk properties.

Thus Congress created the NFIP in 1968, but as a Government Accountability Office (GAO) report put it, “the program was, by design, not actuarially sound.” Premiums were meant to fund the program, but the government underpriced the insurance. The program now owes the taxpayers approximately $20 billion.

In addition to subsidized premiums, the NFIP grew inexorably larger since the beginning: the total number of policies, coverage per policy, and losses per policy all grew substantially faster than population or inflation. Over the last 34 years, the program’s exposure increased by $1.24 trillion. Premiums simply haven’t come close to keeping up. Again, from the GAO: the NFIP “has continuously been running a deficit since its inception in 1968.”

But the real problem with the NFIP isn’t just a matter of fiscal imbalance. The underpricing of risk itself leads to decisions which further put an inefficient amount of value at risk, encouraging development and population in high risk areas. As economist Donald Boudreaux put it, “allowing premiums to rise to unsubsidized levels would – by encouraging people to make more prudent decisions regarding where to live and about how to protect their properties – reduce both the property damage and the number of fatalities.”

All of which is why, amidst an otherwise gridlocked and hyperpolarized Congress, passage of a bipartisan NFIP reform came as welcome news. The Biggert-Waters Insurance Reform Act of 2012 set out to improve the long-term viability of the program along primarily two margins: updating and making more accurate the flood maps used in assessing underlying risk; and adjusting premiums to better reflect risk.

Congress recently convened a hearing to consider the effects of the recent reform legislation, but mostly to voice constituent concerns about rate increases. Some members of the committee seemed legitimately shocked by letters indicating how high an unsubsidized insurance premium would actually be. Even the bill’s nominal co-author, Rep. Maxine Waters (D-CA), verged on apoplectic as she grilled the hearing’s witnesses about why some policyholders would be forced to pay such high rates.

Extreme cases of rate shock notwithstanding, the reform legislation allows for various timetables and applicability, such that the program doesn’t come into solvency all at once. That said, there are other ways Congress could consider amending the bill to mollify opposition and prevent an all out reversal of the policy change. For instance, existing policies could be grandfathered (the “if you like your flood insurance, you can keep it” approach), with future buyers of new and existing homes subject to the full, unsubsidized rates. Also, premium increases could be means-tested, or otherwise scaled to property value. Finally, consider credits on rates or deductibles with proof of having taken steps toward risk mitigation.

The hard work of necessary reform is done. But the effect of that reform is just now beginning to be felt, threatening to undo beneficial changes to the NFIP—some 45 years overdue. Congress should resist the urge to reverse course. Rather, they should consider modest changes to the legislation that considers those who will be most impacted, but continues the move toward long-term sustainability. After all, the program’s deficits are paid one way or another, either by policyholders or taxpayers.

Thallam is director of Financial Services Policy at the American Action Forum, a center-right policy institute located in Washington, D.C.