In a long over-due change, FEMA plans to update the way it prices flood insurance in the fall. Some members of Congress have recently expressed concern that this new approach might hurt middle-class families. Opposing rating reform is not the way to protect these families; instead, it would prevent more equitable rates from being charged and ignore the realities of climate change.
We can better help households at risk who cannot afford flood insurance — and adapt to climate change — by allowing rate modernization, while simultaneously adopting a means-tested disaster insurance program for those in need. Such a program would provide targeted assistance to low- and moderate-income households that would otherwise struggle to afford flood insurance, offering them critical financial resilience in the face of growing flood risks.
FEMA’s current approach to pricing flood insurance is decades out of date and full of hidden cross-subsidies, including a regressive component that has low-value homes paying too much and high-value homes paying too little. FEMA’s new pricing approach—referred to as Risk Rating 2.0 — will fix this regressive cross-subsidy, as well as harness improved data and advanced modeling capabilities to better assess flood risk for each property. It will also make the policies easier to understand — a critical component.
Climate change is escalating flood risk around the country. Failure to update pricing, though, effectively hides this risk from the market and limits financial incentives for risk reduction. Blocking modernization of rate-setting is not going to make the flood risk disappear and it could perversely make us less prepared by not appropriately pricing that risk.
After repeated calls from GAO and other stakeholders, FEMA began the process to modernize premium-setting. We know, from a robust body of research, that insurance is vital to disaster recovery. Yet, households who need this coverage the most are the least able to afford it—with or without rating reform. This needs to change.
Instead of opposing Risk Rating 2.0, Congress should pass a means-tested flood insurance affordability program. Such a program has already been deeply analyzed by FEMA, the National Academy of Sciences, and RAND, among others. It would help those who need the protection of insurance the most, yet struggle to pay for it, with the costs of flood insurance premiums. It could also be tied to risk reduction measures.
This should be done in parallel with Risk Rating 2.0.
What many people don’t realize is that Risk Rating 2.0 will also make rates more equitable by undoing a regressive cross-subsidy that currently exists in the program from low-value to high-value homes. Right now, low-valued homes pay too much for flood insurance and high-value homes too little. When a private insurance company determines their prices, they account for the replacement value of the home. For the vast majority of NFIP policies, however, FEMA does not. This means that someone in a $100,000 home and someone in a $1 million home pay the same amount for $100,000 of flood insurance coverage (all else equal). To understand why that doesn’t make sense, think about flood claims.
For the $100,000 property owner to file a claim for that much money, it would mean the house was completely destroyed in a flood. That is really rare. But for the $1 million property owner to file a $100,000 claim, it would only mean 10% of the home was damaged — which happens much more frequently. So the risk is greater for the $1 million owner and any private insurance company would, therefore, charge more.
But not FEMA. In the NFIP, high-value homeowners get a sweet deal and low-value homeowners are penalized. FEMA knows this and is on track to fix it in Risk Rating 2.0.
The new Risk Rating 2.0 effort is also being designed to make the writing of flood insurance easier on agents. This change would help consumers. A pilot study in Portland, Oregon, for example, found that pricing in the program is so confusing right now that agents often make mistakes that end up costing policyholders more money. Yet another reason to support this new pricing scheme.
Risk Rating 2.0 will also make rates more reflective of actual flood risk for a given property, including the full range of flood risks from heavy rainfall, rivers overflowing, and coastal flooding. This is an improvement, as prior zone-based pricing often neglected rainfall-related risk, which is getting worse in many places due to climate change.
Better preparing the NFIP for the realities of climate change is an important policy task in the coming years. Risk Rating 2.0 is the first critical step. However, it should be accompanied by a congressionally-established affordability program for those in need. After that, Congress can turn to several other remaining challenges in the program: the debt, repetitive loss structures, communicating future risk, and helping communities with more aggressive risk reduction. For today, though, let’s at least not undo the hard work it took to get to Risk Rating 2.0.
Carolyn Kousky is the executive director at the Wharton Risk Management and Decision Processes Center at the University of Pennsylvania.