For 48 states, flood insurance is a terrible deal

For 48 states, flood insurance is a terrible deal
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For decades, the National Flood Insurance Program (NFIP) met its original objectives. It provided consumers an affordable alternative for flood insurance if they lived in an area in which no private insurers offered coverage, or if the prices were unreasonable.

However, when natural disaster risks changed suddenly, beginning in 2005 with Hurricane Katrina, the program's pricing model failed to adjust as quickly as the risks being posed to homeowners. Property owners continued to pay rates actuarially built for a much less-risky environment, even as losses from severe storms mounted year-after-year.

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These changes in risk seem to have caught government actuaries off-guard, and now the program is underwater, with over $24 billion in debt, despite being forgiven $16 billion last year.

 

Insurance pricing could be called “pricing risk” — the amount of risk you pose to your insurer determines your rates. People tend to think of risks as stable. They aren't.

For example, your chance of dying in a car crash is 12-in-100,000. But in 1970, prior to state seat belt laws, it would have been 26-in-100,000.

Our world is ever changing and, therefore, so are our risks. Private insurers are constantly responding to this, filing rate changes regularly with the state departments of insurance. And some government programs are as well.

With the NFIP's most recent extension set to expire on July 31, a lot of focus has been given to the rate increases proposed by FEMA, the government branch overseeing the NFIP. However, the current state of the program and its history of lagging behind the nation's flood insurance needs have cast doubt on the NFIP's purpose and reliability.

It's less clear what our new objectives are for the National Flood Insurance Program and, therefore, whether the bill being considered by the Senate to reauthorize it contains sufficient provisions.

In fact, it's unclear whether the Senate will move to reauthorize the program at all, or if it will allow it to expire as it has done four times since 2008.

These uncertainties are a bad omen for homeowners in flood-prone areas.

Hazards of a program loss

All homeowners located in Special Flood Hazard Areas are required to have flood insurance if their mortgage is federally backed.

In theory, this protects many of the highest-risk homeowners from being in a financially troublesome position if a hurricane or flood event occurs. However, it nearly ensures that the properties most likely to face the greatest damages will be filing claims with the NFIP after a storm, putting a disproportionate burden on the federal program.

This also puts these properties at risk of being left without insurance in the event of a program expiration.

A program expiration could also prevent home buyers from closing on a new purchase, since coverage would likely be required by their mortgage lenders. The last time the NFIP expired, approximately 1,400 home closings were interrupted each day until the program was reinstated. Americans need a more reliable system.

The NFIP's pricing and process have worked well for decades and continue to perform well for the majority of policyholders across the United States. The program's losses and challenges have been primarily due to a few high-risk regions and homes that are hard to price accurately. However, this specific issue is one of the major reasons private insurers have been less interested in the flood insurance industry.

Fortunately, recent technological advancements have made determining a property's flood risk easier to accomplish. But these advancements play both ways: if a private company can determine which properties are riskiest to insure, why would they offer coverage on those homes?

This presents one of the greatest obstacles for extending and restructuring the program — how to incentivize private insurers to cover the riskiest properties, and how the NFIP can balance pricing these homes both reasonably and sustainably.

For instance, most states currently pay premiums into the NFIP that cover the payouts they've received over the past four decades.

Flood insurance payouts to Texas, one of the states hardest hit by recent hurricanes, have averaged $386 million, or 96 percent of what residents currently pay into the program. California homeowners have had an average payout of $14 million per year, representing just 7 percent of premiums for in-force policies.

In fact, homeowners in 48 states are overpaying for flood insurance and footing the bill for Mississippi and Louisiana, where homeowners have received more in claim payments than they pay for in flood insurance premiums.

Mississippi and Louisiana are the only two states that have received substantially larger payouts than their pricing would reflect, according to a report my team recently published for ValuePenguin.

Policyholders in Mississippi have been paid $1.76 in NFIP claims as compared to each dollar currently paid in premiums. In Louisiana, the state with the most insured losses from repetitive loss properties, policyholders have received an average of $1.42 per dollar paid.

Similarly, properties built before the initial flood insurance rate maps, often referred to as pre-FIRM properties, are effectively subsidized by the government, as their rates were grandfathered in when the program's pricing became responsive to flood zone risk.

Over 60 percent of claims are from pre-FIRM properties, and these claims are approximately 42 percent greater than those for post-FIRM properties relative to home value.

Though FEMA's proposed rate changes are addressing these groups, such as raising rates for certain pre-FIRM properties by up to 25 percent per year until their risk is accurately represented, questions remain as to whether this is enough and whether the price can be paid by homeowners.

And, while many agree that private flood insurance needs to play a larger role, will those in high risk flood zones be outpriced without lower risk homeowners to help subsidize their premiums?

Moving forward

With private insurance options unavailable or limited in many regions of both high and moderate risk, a discontinuation of the NFIP at this point would be severely disruptive to many homeowners.

Those purchasing properties which require coverage would be prevented from doing so. And even current homeowners would be without flood insurance once their policy is up for renewal.

But do lawmakers intend the NFIP to continue its dominance of the flood insurance market going forward? If so, whether changes to the program meet that objective have primarily to do with sustainability. And many think the price increase for this year is significantly below what is needed, given the magnitude of recent storms and scale of debt the program is in — even with further increases scheduled for 2019. "The [average] 8% increase is modest given the magnitude of the flood insurance payouts just last year," according to Michael Barry of the Insurance Information Institute.

If the long-term objective is, instead, for private flood insurers to own a greater portion of the market, the affordability of living in higher-risk regions and how to best incentivize insurers to cover these properties are still open questions.

Maxime Rieman is product manager at ValuePenguin focusing on insurance. ValuePenguin is is a personal finance website that conducts in-depth research and analysis on a variety of topics from insurance, to credit cards, to everyday spending.