Background

NFIP is a federal program created by the National Flood Insurance Act of  1968 that enables property owners in participating communities to  purchase insurance protection against losses from flooding. This program  is administered by FEMA. Participation in NFIP is based on an agreement  between local communities and the federal government. The federal  government makes flood insurance available to any community that  adopts and enforces a floodplain management ordinance to reduce future  flood risks to new construction in areas known as Special Flood Hazard  Areas (SFHA). Property owners located in the SFHA with mortgages from  federally regulated lenders are required to purchase and maintain flood  insurance policies. In these areas, new construction and substantial  improvements must conform to NFIP’s building standards. For example,  the lowest floor of a structure must be elevated to or above the base flood  elevation (BFE)—the level at which there is a 1 percent chance of flooding  in a given year.
NFIP offers two types of flood insurance premiums: subsidized and full  risk. The National Flood Insurance Act of 1968 requires that NFIP offer  subsidized premiums to owners of certain properties. These subsidized  rates are not based on flood risk and, according to FEMA, represent only  about 35 to 40 percent of the full flood risk. Subsidized properties account  for about 25 percent of all NFIP policies, while those with full-risk  premiums account for the remaining 75 percent. The type of policy and the  subsequent rate a policyholder pays depend on several property  characteristics—for example, whether the structure was built after or  prior to the development of the community’s Flood Insurance Rate Map  (FIRM) and where the structure is located relative to the floodplain. NFIP  studies and maps flood risks, assigning flood zone designations based on  the risk level for flooding. For our purposes, in this report we generally  refer to risk levels as moderate- to low-risk, high-risk, high-risk coastal,  and undetermined risk. Potential policyholders can purchase both  building and contents flood insurance for residential and commercial  properties (table 1).
Congress mandated the use of subsidized premiums to encourage  communities to join the program and mitigate concerns that charging rates  that fully and accurately reflected flood risk would be a burden to some  property owners. The Flood Disaster Protection Act of 1973 made the  purchase of flood insurance mandatory for the protection of properties  within SFHAs that are secured by mortgages from federally regulated  lenders, thus expanding the use of subsidized premiums. In addition, NFIP  was authorized to begin charging full-risk premiums for all construction  built after 1974 or the date of the community’s initial FIRM. According to  FEMA, Congress made these changes to encourage further participation in  NFIP through low premiums. More recently, legislation has been  introduced that would limit NFIP subsidies aimed at improving the  financial stability of the program.
Pre-FIRM structures generally are more prone to flood damage (that is,  riskier) than structures built later because they were not constructed  according to the program’s building standards. Owners of post-FIRM  structures generally are not eligible to receive subsidized rates. Largely  because subsidized properties tend to be riskier than properties insured at  full-risk premiums, in 2007, the average annual premium for a subsidized  policy was about $869, while the average annual premium for a full-risk  policy was about $378. Flood insurance rates are calculated for each  flood zone. However, as shown in table 2, flood insurance rates also  depend on flood zone.
The insurance operations of NFIP differ from those of most private  insurers in a number of ways. First, unlike private insurers that can reject  applicants with properties whose potential losses would not be offset by  premiums, NFIP is required to accept virtually all applications for  insurance. Therefore, NFIP is less able to offset the effects of adverse  selection—that is, the phenomenon that those who are most likely to  purchase insurance are also most likely to experience losses. Adverse  selection may lead to a concentration of policyholders in the riskiest  areas; the problem is compounded by the fact that those at greatest risk  are required to purchase NFIP insurance if they have a mortgage from a  federally insured lender.
Second, NFIP’s ability to adjust premiums is limited by statute. While most  states regulate premium prices, they tend to allow private insurers  considerable flexibility in their ability to set prices. Third, NFIP assumes  all the risks for the policies it sells. Private insurers typically retain only  part of the risk that they accept from policyholders, ceding a portion of the  risk to reinsurers. This mechanism is particularly important in the case of  insurance for catastrophic events, because the availability of reinsurance  allows an insurer to limit the possibility that it will experience losses  beyond its ability to pay.
Finally, NFIP is not authorized to charge premiums that are sufficient to  build the capital that most private insurers have to offset losses or  purchase reinsurance in the private global market. For example, private  insurers have a capital surplus that they use to pay expected claims. In  contrast, NFIP operates on a cash flow basis, backed by borrowing  authority from the U.S. Treasury. As a result, NFIP does not follow all of  the traditional accounting practices that private insurers use—for  example, NFIP reports using only Generally Accepted Accounting  Principles (GAAP ) accounting, which is an ongoing operations accounting  basis, while private insurers must report both GAAP and statutory  accounting basis.

	FEMA’s Method of Setting Full-Risk Premiums May Not Ensure That Rates Accurately Reflect Risk

FEMA uses a rate model to generate prices for flood insurance according  to flood risk and expected flood damage. However, we found that in some  cases these full-risk premiums may not accurately reflect actual risk  because of limitations in the data used as inputs for the model and the  effects of certain policy decisions. For instance:    Some data FEMA used in rate setting are outdated or inaccurate, including  data on flood probabilities, damage estimates, and flood maps.
FEMA allows some properties that were remapped into riskier flood zones  to keep their previous lower rates.
FEMA’s rate-setting process does not fully take into account ongoing and  planned development, long-term trends in erosion, and effects of global  climate change.
FEMA sets rates on a nationwide basis, combining and averaging across  many geographically diverse areas.
Furthermore, our analysis of the difference between claims payments and  premiums collected for all 50 states and the District of Columbia suggests  that NFIP’s pricing has not accurately reflected differences in flood risk.  Collectively, these factors increase the risk that premiums collected on  full-risk rates do not accurately reflect the risks of flooding and therefore  may not be sufficient to cover future losses.

		FEMA’s Rate-Setting Process Uses a Model That Is Based on Flood Risk and Expected Flood Damage

According to FEMA, rates that are based on the probability of a given level  of flooding, damage estimates based on that level of flooding, and  accepted actuarial principles are considered to be “full risk.” To set rates  for flood insurance that accurately reflect risk, information about the  differential risk of flooding is key, with greater flood risks resulting in  higher rates. Rates also vary depending on how much insurance is  purchased. As claims are more likely to be made against the first several  thousand dollars of coverage than against much higher levels of coverage  (that is, smaller dollar-value losses are generally expected to occur more  frequently than larger ones and thus pose a greater risk), rates per $100 of  insurance coverage are lower for higher levels of coverage. the Corps for a number of years. While the Corps has revised its model for  estimating flood damage, it still makes use of the hydrologic model to estimate  flood damage.
In the high-risk and high-risk coastal zones, the model combines estimates  of the frequency of flooding with estimates of the magnitude of damage  caused by flooding, producing “pure premium” costs intended to cover the  actual flood losses. FEMA uses such inputs as the elevation of the lowest  floor of the building, the type of building, the number of floors, the  presence of a basement, claims data, and mapping information to generate  the estimates. This pure premium amount is then adjusted to capture  certain program costs, compensate for underinsurance by policyholders,  and reflect the fact that the program has a deductible. For the moderate-  to low-risk and other full-risk premium zones, rates have been developed  based on actuarial and engineering judgments, using the rates generated  by the model and the historical experience of the high-risk zones as  benchmarks.
While other entities employing flood models may use more sophisticated  computer modeling techniques, the NFIP rate model is based largely on  the same principles. In 2000, FEMA completed a feasibility study on using  private market reinsurance to cover a portion of its flood risk that required  modeling the frequency and size of catastrophic flood events, and  determined that the results of the study were not inconsistent with the  results of NFIP’s rating structure. For other lines of catastrophe insurance,  private insurers rely heavily on computer models of simulated damage  over many possible events to price their products. Like NFIP, other  federal agencies and private insurers involved in flood modeling also rely  on flood maps and data on the likelihood of flooding and damages.  According to FEMA, it has contracted for actuarial services with an  external consultant to assess the current state of hazard modeling and the  possible applicability of those models to NFIP.

		Some Key Data Elements Used in the Rate-Setting Model Are Outdated or Based on Erroneous Information

Questions remain about the age and quality of the underlying data FEMA  uses in its model to calculate full-risk premiums. The NFIP model for  setting full-risk premium rates relies on flood probability estimates and  expected damage data, which rely in part on outdated or potentially  inaccurate information, including outdated FIRMs. As discussed more  fully below, flood probability estimates have not been updated since the  1970s and 1980s, most FIRMs are out of date despite FEMA’s recent  modernization efforts, and the claims data used to calculate full-risk  premiums may be inaccurate. As a result, the premium rates set by NFIP  may not fully reflect the risk of loss due to flooding.

			Data Used to Determine Flood Probabilities Have Not Been Updated since the 1970s and 1980s

FEMA’s estimates of probabilities that floods of different severities  (relative to the BFE) will occur in a given year, or “probability of  elevation” (PELV) values, were generated in the 1970s. Within any zone,  the risk that floodwaters will reach the BFE in any year is 1 percent, but  across zones the likelihood that floodwaters will reach a foot above or  below that level varies. PELV tables provide detailed information, by zone,  about the frequency with which floods of different elevations are expected  to occur. These data were generated using detailed engineering studies,  available flood data, simulations, and professional judgment and were  established for each flood zone to meet generally accepted scientific  parameters and legal considerations of the time. FEMA later concluded  that flood probabilities were likely underestimated in some cases because  of the short flood histories used in some of the studies. As a result,  according to FEMA officials, some of the original PELV values were  modified in the early 1980s to account for this statistical bias. They have  not been revisited or updated since that time.
FEMA currently uses both the original and modified PELV values in the  rate-setting process. The original PELV values contribute 80 percent to the  ultimate results and the modified values 20 percent, reflecting weights set  out by policies from the early 1980s, according to FEMA officials. Flood  risk experts have suggested that flood probabilities (and thus flood  insurance rates) are likely to change as land use (such as urban or  suburban development), infrastructure (such as new bridges and culverts),  and weather patterns change. FEMA could capture such changes by  updating its flood probability data but has not done so.
FEMA officials also acknowledged that the weighting for the original and  modified PELV values was likely out of date but said that other competing  priorities, including supporting post-Katrina-related activities and other  studies had been given priority. Moreover, a FEMA official noted that the  weighting might introduce a degree of “conservatism” to the rate-setting  process because it would lead to higher rather than lower premium rates.  Further, according to the officials, the geographic mix of NFIP policies  had become more concentrated in Florida and other communities where  the PELV values were more accurate. Nevertheless, FEMA has not  updated the PELV data since the 1980s or updated the weighting of the  original and modified PELV data. As a result, the accuracy of the flood  probability estimates and the probability of elevation values are uncertain,  and we could not determine whether the rates based on such data were  accurate. Moreover, FEMA was not able to provide any analysis that it had  done to determine that the current weighting remained appropriate or that  the probabilities had not changed in over 30 years.

			The Claims Data Used in the Model May Be Inaccurate

In addition, some claims data—which are updated on a periodic basis— may suffer from errors and thus misinform damage estimates and, in turn,  the rates generated by the model. FEMA relies on estimates of the  percentage of the value of a structure that is expected to be damaged  when a flood occurs, or the “damage by elevation” (DELV) values. DELV  information is measured in 1-foot increments of the flood level within the  structure and is expressed as the expected percentage of the property’s  value that will be damaged by a flood of that elevation. As with the PELV  data, information used in establishing DELV values was obtained primarily  from engineering studies. In 1973, data for DELVs were selected on the  basis of studies done by the Corps and available flood claims at that time.  Currently, FEMA modifies the Army Corps DELV values based on its NFIP  claims experience. When FEMA determines that its own loss data are  “credible,” it uses these data rather than the original data generated by the  Corps. However, FEMA also currently uses updated Corps damage data  to supplement NFIP claims data where it lacks sufficient credible loss  data. According to a FEMA official, for the most common type of property  insured by NFIP, the claims process has become fully credible for a wide  range of water depths in the structure.
However, evidence suggests that there are inaccuracies in the actual  claims data used to update the DELV values. An external study noted some  internal control problems with NFIP’s claims database. For instance,  claims records were often incomplete because the claims data had been  collected in the field by local adjustors for purposes of processing claims.  As a result, many records did not indicate BFE or depth of flooding,  clearly differentiate between wind and water losses, or capture losses  above the insurance limit when damage exceeded coverage limits. In  addition, Corps officials told us that they had reviewed FEMA’s claims  between 1998 and 2000 databases and found the data to be unreliable for  their purposes. For example, according to the Corps, in some cases the  claims data indicated flood damage, but flood height data were missing.  FEMA’s database recorded these missing height data as a flood height of  zero. Our analysis of NFIP claims paid between 1978 and 2007 further  supports what the Corps told us. We found an increasing percentage of  claims with “0” water depth until they leveled off at between 44 and 49  percent from 1998 until 2004. In 2005 when the Gulf Coast hurricanes  occurred, this percentage dropped to about 13 percent, but has risen  above 22 percent in the more recent years. Thus, an erroneous data  combination of positive flood damage and zero flood height was being  used to develop damage curves. As a result, the Corps began to collect its  own damage data, which FEMA now uses to supplement its own data.
While FEMA has acknowledged that some problems exist, it believes that  these types of errors relate primarily to the most severe flooding events,  which have a lower probability of occurring, involve greater water depths,  and would contribute only marginally to insurance rates. FEMA officials  said that they had reviewed the possible impact of such data errors and  did not consider them to be significant because they believed that the  zero-elevation water depth errors would overstate the amount of damage  from zero amount of water in a property. However, this analysis is  incomplete because it does not evaluate the impact of omitting these  damage amounts from the actual flood depth levels. As a result, FEMA  may be unable to fully assess the overall impact of these errors or  omissions on its full-risk rates, creating a risk that these premiums may  not accurately reflect the actual risk of flood loss.

			Maps That Provide Information for Base Flood Elevations Remain Substantially Out of Date despite Modernization Efforts

FIRMs provide the information that determines BFEs, a key input in the  rate-setting model. FEMA formally undertook map modernization efforts  in fiscal year 2003. According to FEMA, the agency undertook map  modernization for several reasons:    Flood hazard conditions are dynamic, and many NFIP maps may not  reflect recent development and/or natural changes in the environment.
Updated NFIP maps can take advantage of revised data and improved  technologies for identifying flood hazards.
Up-to-date maps support a flood insurance program that is more closely  aligned with actual risk, encourages wise community-based floodplain  management, and improves citizens’ flood hazard awareness.
Local communities and various stakeholders want more timely updates of  flood maps and easier access to the flood hazard data used to create the  maps.
In 2005, FEMA adjusted its goals and currently expects to provide updated  flood boundaries for 75 percent of stream miles reflected on FEMA’s  issued maps and 0.30 percent of those mapped stream miles will be based  on new or updated engineering studies by the end of the program in 2010.  FEMA also revised its goal of having digitized maps that covered 100  percent of the population to having digitized maps for 92 percent of the  population so that it could better focus its efforts and thus improve map  quality. FEMA undertook these changes in response to concerns  expressed by Congress and DHS’s Inspector General’s office and in  response to our prior work on this issue. FEMA officials stated that  changes in land use and structural development that had occurred over  time would be captured when FEMA updated the FIRMs, each of which is  required to be reassessed every 5 years.
According to FEMA, as of May 2008, approximately 4 percent of U.S.  counties had maps that accurately reflect the current risk of flooding (fully  updated) and were newly digitized and 2 percent had old maps that may or  may not accurately reflect the actual risk of flooding but were newly  digitized. For the remaining 94 percent of U.S. counties, the maps were a  combination of new and old mapping data that were in production or have  not yet begun the process. According to FEMA officials, although maps for  94 percent of U.S. counties had not been fully updated or newly digitized,  all counties had received a partial update to their flood hazard information  and more than a third had received updates that exceeded one of FEMA’s  national map quality targets.  FEMA further stated that in March 2008,  approximately 68 percent of the nation’s population had received a map  that met, exceeded or at least approached map quality targets of map  modernization.  An additional 27 percent of the population has received a  preliminary map.  FEMA informed us that it anticipates that 92 percent of  the nation’s population will have a modernized map by 2010.
However, although FEMA has been working to update FIRMs and improve  their quality, a significant portion of the maps reflect data at least 15 years  old, which may or may not accurately reflect actual risk of flooding. As of  April 2008, 50 percent of the nation’s approximately 105,700 flood maps  were at least 15 years old, 58 percent were more than 10 years old, and 70  percent were at least 5 years old. To the extent that these older maps are  inaccurate and the risk of flooding has changed, reliance on these older  maps could lead to inaccurate flood risk assessments, which in turn could  lead to inaccurate premium rates.

		FEMA Does Not Track the Number or Location of Remapped Grandfathered Properties That Pay Less than Full-Risk Premiums

FEMA made a policy decision to grandfather into the program certain  properties, that is, it allowed properties that have been remapped into  riskier flood zones to keep their previous lower rates. FEMA is in the  process of updating FIRMs through its Map Modernization program, but  these new maps may not lead to more accurate pricing due to this policy  decision, which was based primarily on concerns about the affordability of  the resulting rates. FEMA documents state that properties are  grandfathered in order to recognize policyholders who have complied with  their original FIRM, have remained loyal NFIP customers, or both. In  general, two categories of buildings may be grandfathered into the  program: (1) those built in compliance with the FIRM that was in effect at  the time of construction and (2) those built before a FIRM was in effect or  that were not in compliance at the time of construction. For those  buildings in compliance at the time of construction, property owners need  to provide documentation of the date of the original FIRM and the  property’s flood zone, BFE, and other map-related information. Properties  that were not in compliance generally can be grandfathered if they have  had continuous flood insurance and if the building has not been altered in  certain ways. FEMA officials told us that while grandfathering can work as  a disincentive for sound floodplain management, the decision to  grandfather rates was based on consideration of (1) equity, (2) ease of  administration, and (3) goals of promoting flood plain management.
While FEMA does not consider the premiums on these properties to be  subsidized because they are based on the average risk for the whole class  to which they had been assigned previously, they share two characteristics  with subsidized rates. First, rates based on new FIRMs should more  accurately reflect flood risk, but grandfathered properties will not be  charged those rates. Second, the grandfathered status of a property  continues indefinitely, even when the property is sold. FEMA officials  acknowledged that property owners that obtain grandfathered rates for  their homes are being cross-subsidized by other policyholders in the same  zone that are paying higher rates. For example, under grandfathering,  repetitive loss properties remapped into a higher-risk zone instead would  pay a rate generally charged to lower-risk properties.
While grandfathered rates are used to keep existing policyholders, FEMA  has not taken steps to measure the impact of these rates on the program’s  financial condition. FEMA officials said that they currently had limited  data on new or existing grandfathered properties and are just beginning to  explore ways to track these properties. For example, they had not tracked  the number of grandfathered properties or calculated how much lower  grandfathered premiums are than the actual rates. As a result, they did not  know the effect of grandfathered properties on the program’s total  premium collection and the extent to which these rates deviate from fully  risk-based rates. Without this information, FEMA’s ability to address the  financial impact of such properties on NFIP’s financial health is limited.  FEMA officials acknowledged the importance of tracking information  related to grandfathered properties and told us they plan to start a  tracking process in May 2009. However, they said that this process will  not capture the inventory of existing grandfathered properties.

		FEMA Does Not Consider Risk Factors Such as Erosion and Climate Change when Setting Flood Insurance Rates

Some experts with whom we spoke have suggested that incorporating  ongoing and planned development, erosion trends, and climate change  into flood risk modeling would more fully capture longer-term flood risk  exposure, but FEMA does not take these variables into account. FEMA’s  present policy is to map SFHAs based on current development conditions.  However, as floodplains are developed and more ground surfaces are  paved or made impervious (nonabsorbent), the risks and expected  elevations of flooding increase. As the predicted elevation of the base  flood increases, SFHAs subsequently spread beyond mapped boundaries.  As a result, in rapidly developing watersheds or where characteristics  change significantly due to flood control projects or other natural events,  some FIRMs may become outdated shortly after their completion. In  addition, some properties could be constructed without proper protection  from the flood hazard they may face throughout their life span, and others  could be uninsured or subject to insurance rates that do not accurately  reflect flood risk.
FEMA’s current flood hazard mapping procedures for coastal areas  incorporate storm-induced coastal erosion but not long-term erosion.  While shorelines, dunes, and bluffs can retreat during a single storm, long- term erosion at a shoreline is the net result of a variety of factors such as  sediment losses from storms and inundation from sea level rise, averaged  over several decades. A 2000 study conducted for FEMA by the H. John  Heinz Center estimated that over the next 60 years, losses due to the  effects of coastal erosion would average $80 million annually. If coastal  development continues at its current pace, or if sea levels rise as some  scientists have predicted, such losses could be even greater. In the  absence of the authority needed to establish erosion zones, FEMA has  taken action based on the results of the study, namely, a steady annual  increase in rates for the high-risk coastal zone at a pace it says is  commensurate with the study’s projections. In addition, according to  FEMA officials, they formed an internal working group to determine  additional actions that could be taken to implement the report’s  recommendations under the existing laws and regulations that govern  NFIP. The working group concluded that because of the statutory  limitations, implementing the recommendations would require direct  congressional authorization. Therefore, FEMA, which does not currently  map erosion hazard areas, is unable, through its rate-setting process, to  inform policyholders of the risk to their property from erosion.  Consequently, in some cases flood insurance rates may send a false signal  that understates the risk exposure faced by current policyholders or  prospective development.
FEMA also does not incorporate the potential effects of climate change  into its rate-setting considerations. Our 2007 report on climate change  discussed the effects of climate change on weather-related events and,  subsequently, insured and uninsured losses. We found that leading  scientific bodies expect warmer temperatures to increase the frequency  and severity of damaging extreme weather-related events. In addition,  population growth in hazard-prone areas and the resulting development  and increasing real estate values have increased the exposure of federal  and private insurers. In particular, heavily populated areas along the  Northeast, Southeast, and Texas coasts, which are at the highest risk for  major hurricanes, also have some of the highest value properties in the  United States. Because of these and other factors, our report estimates  that NFIP’s exposure has grown substantially, quadrupling since 1980 and  nearing $1 trillion.
While many private insurers are beginning to take climate change into  account, FEMA has done little to develop the kind of information needed  to understand the long-term exposure of NFIP to climate change for a  variety of reasons. For instance, NFIP’s goals are fundamentally different  from those of private insurers. Specifically, private insurers stress the  financial success of their business operations, but the law authorizing the  federal flood insurance program promotes affordable coverage and broad  participation by individuals at risk. In addition, although FEMA manages  its risk within statutory guidelines, unlike private insurers, NFIP is neither  required nor permitted to limit its catastrophic risk strictly within its  ability to pay claims on an annual basis. One important implication of this  lack of limits on managing catastrophic risk is that FEMA has little reason  to develop information on NFIP’s long-term exposure to the potential risk  of increased low-frequency, high-severity weather events associated with  climate change. NFIP’s risk management processes adapt to near-term  changes in weather as they affect existing data. As a result, NFIP is  designed to assess and insure against current—not future—risks and  currently does not have the information necessary to adjust rates for the  potential impacts of events associated with climate. FEMA told us that it  has commissioned a study to assess the long-term exposure to climate  change that will investigate changes in sea levels, intensity and frequency  of hurricanes, and precipitation patterns.

		FEMA’s Rating System Combines and Averages Many Different Risks to Create Nationwide Rates

FEMA classifies properties according to flood risk using a single,  nationwide class-rating system rather than an individual property or  community-by-community rating system. That is, all properties grouped  into a class—based on structure type and elevation relative to the BFE— are assumed to have the same risk. Further, FEMA charges the same rate  for a given class in the high-risk zone (or separately, in the high-risk  coastal zone) regardless of location within the zone. Thus, two properties  in the same class but located on vastly different terrain—for example, one  in a shallow floodplain and the other in a steep and narrow mountain  valley—are charged the same rate per $100 of insurance coverage despite  the fact that they may have different expected loss.
The NFIP model can incorporate specific topographic (that is, flood zone)  information in rate setting. However, according to FEMA, it was  determined that more averaging could be justified, because the differences  in rates across flood zones were not significant enough to warrant that  level of detail. According to FEMA officials, the class-rating approach  balanced the need to recognize significant differences in risk with a  simplified process for determining rates that was easier for the sales force  and others to use. FEMA has not revisited its class-rating approach since  its inception although certain program elements have changed since that  time. For example, program participation has more than doubled from just  over 2 million policies to more than 5.2 million from the late 1980s to 2007  and increased numbers of properties have been constructed on SFHAs. As  a result of the growth in the program, the rate classes may not accurately  reflect the actual flood risk to individual properties and averaging may no  longer accurately reflect differences in rates within zones.

		Our Analysis of Historical Claims and Premium Data Raises Questions about a Potential Mismatch between Rates and Risk

We analyzed 30 years of NFIP data on claims and premiums and found  patterns based on differences among states indicating that NFIP rates may  not have always accurately reflected differences in flood risk. As we have  seen, FEMA sets premium rates that apply nationwide. Our state-by-state  analysis of annual claims and premiums data dating back to 1978 showed  that some states consistently had more years in which claims exceeded  premiums than did other states over this period, raising questions about a  potential mismatch between rates and risk. It is important to note that  claims equaling premiums in a given year would not indicate a break-even  year, because in addition to covering expected claims in a year, a portion  of premiums is also intended to cover expenses necessary to operate  NFIP. For example, in the year ending May 1, 2008, NFIP projects about 53  percent of its total expenses would pay for claims, while the rest would  cover other expenses such as interest on debt, loss adjustment expense,  and agents’ commissions. For the purposes of this report, we assigned the  title of high-loss year to any year in which a state’s claims exceeded its  premiums, because in these years, these states would not have had any  premium dollars left over to contribute toward administrative expenses  once claims had been paid.
On an annual basis, we found that for 1978-2007, nine states had high-loss  years more often than once every 4 years (table 3). Missouri and West  Virginia had the most high-loss years, with 11; Alabama, Illinois, Louisiana,  Mississippi, New Hampshire, Ohio, and Texas followed, with from 8 to 10  such years. Other states had very few high-loss years, and some had none.  For example, Alaska, Colorado, and New Mexico had no high-loss years,  while Florida, Idaho, Oregon, South Carolina, and Vermont had 1, and  Nevada, Utah, and Wyoming had 2. The consistency with which some  states were at one extreme of the high-loss-year distribution or the other  since the late 1970s suggests that NFIP’s method of setting flood insurance  rates on a nationwide basis may not accurately reflect differences in flood  risk among states, because rates for similar properties do not vary by  state.
We recognize that flooding is a highly variable event, with losses varying  widely from year to year, and that even an analysis of nearly three decades  of historical data could lead to unreliable conclusions about the actual  flood risk faced by a given state. In addition, we note that Florida, Texas,  and Louisiana are among the states with the most NFIP policies, and  therefore have a more significant impact on the amount of premiums  collected than other states. Some discrepancies in high-loss years among  states are to be expected and do not necessarily indicate that NFIP  premium rates are mispriced. However, if some states frequently have  high-loss years or rarely or never have such years, questions arise about  the rate structure, because policyholders in states with frequent high-loss  years are paying the same rates as policyholders with similar properties in  states with fewer losses.
Additional study would be required to determine whether policyholders in  some states with lower losses are paying a higher premium than is  appropriate for their risk, and others paying too little. For example, our  analysis did not control for differences in the type of policy purchased,  such as the mix of certain property types across states and insurance  coverage amounts, which could affect both premiums and claims. In  addition, we did not control for differences in the mix of subsidized and  full-risk policies or the impact of subsidized premiums on our results,  which could also affect the results. Despite these limitations, however,  this analysis raises a number of questions that may warrant further study  that could provide useful insights into the use of nationwide rates as well  as other aspects of the program.
Collectively, these factors raise questions about FEMA’s rate-setting  process and increase the risk that NFIP full-risk premiums rates may not  accurately reflect the underlying risk of flood loss. As a result, the  premiums collected by FEMA for full-risk policies may not be sufficient to  cover the risks associated with those policies. If the premiums are not  sufficient, FEMA will likely have to continue to borrow from the Treasury  and could face a future of financial instability because of its ongoing  inability to cover claims and expenses.

	FEMA’s Process for Setting Subsidized Rates May Further Compromise the Ongoing Financial Stability of the Program

FEMA’s rate-setting process for subsidized properties, which depends in  part on the accuracy of the full-risk rates, has evolved over time.  Currently, to determine subsidized rates, FEMA first subtracts the total  amount that it expects to collect on full-risk rate premiums from the  average historical loss year target—the minimum amount of premiums the  program needs to collect to cover at least average annual losses based on  historical loss data. The amount remaining from this calculation is the  aggregate target amount of subsidized premiums that the program needs  to collect. Then to set individual subsidized rates, FEMA officials consider  their knowledge of flood risks, previous rate increases for various areas,  and statutory limits on rate increases. Currently, the annual amount that  NFIP collects in both full-risk and subsidized premiums is not enough to  cover its operating costs, claim losses, and principal and interest payments  to the Department of the Treasury. Without changes to its current rate- setting processes, NFIP premiums will be unlikely to be able to cover the  program’s claims, expenses, and debt, exposing the federal government  and ultimately taxpayers to ever-greater financial risks, especially in years  of catastrophic flooding.

		The Process Used to Set Subsidized Rates Has Evolved over Time

In designing NFIP, Congress required that premiums for certain properties  be offered at prices below those for full-risk premiums to encourage  participation in the program and to ensure that premiums were affordable  for existing structures in the floodplain. However, the statute does not  provide a formula or methodology for setting the subsidies, leaving it up to  the program to develop one. When the program began, NFIP  administrators set the subsidized rates on the basis of what they believed  would be affordable, but this process resulted in losses that had to be  covered by borrowings as discussed previously. Some of the resulting  deficit was later forgiven by Congress.
In 1981, NFIP administrators, after discussions with Congress, started  setting NFIP’s subsidized premium rates based on the average historical  loss year calculations. According to FEMA, this change allowed the  agency to resist external pressures in setting premium rates and provided  a more objective standard for determining subsidized rates. FEMA  documents from most years between 2001 and 2006 state that the average  historical loss year target, which is based on losses from previous years  averaged over time, generally is considered a floor for premium collection.  To account for the potential of catastrophic losses, and the additional  funds required to pay such losses, FEMA sets premium rates so that the  total premiums collected will be approximately 15 to 25 percent greater  than the average historical loss year estimate.
However, FEMA can adjust, and has recently adjusted, the way it  calculates the average historical loss year. Although loss years can vary  markedly, none of those taken into account before 2005 included the kinds  of catastrophic losses seen after Katrina, Rita, and Wilma. According to  FEMA officials, including the 2005 losses in calculations of the average  historical loss year would have resulted in premium increases well above  the 10 percent statutory limit. As a result, FEMA officials instituted a  weighting factor for the 2005 losses, and as a result the full amount of the  losses was not incorporated into the rate-setting model. According to  FEMA officials, they incorporated losses of $2.1 billion of the estimated  $23.2 billion in losses from 2005. NFIP set the 2007 and 2008 flood  insurance rates based on this modified methodology.
Although FEMA has incorporated more objective criteria against which to  set rates for subsidized premiums, the process also depends on the  accuracy of calculations for full-risk premiums. After FEMA derives the  full-risk premiums, it deducts the total amount of full-risk premiums that it  expects to collect from the average historical loss year target; the  remainder is the amount in premiums that it needs to collect from  subsidized policies. Subsidized rates are then set based on this amount.  Thus, the level of subsidized rates charged to policyholders depends, in  part, on the full-risk premiums determined by FEMA. For example, if full- risk premiums are too low because they do not accurately reflect flood  risk, the total amount FEMA will need to collect from subsidized policies  will be higher, resulting in higher subsidized premiums.
Finally, according to FEMA, the rate-setting process for subsidized  premiums also involves other considerations. Officials said once they had  calculated the aggregate amount of subsidized premiums they would need,  they determined the subsidized rate increases and ultimately the rates for  the individual zones based on their knowledge and understanding of flood  risks. FEMA officials told us that their decisions on how much to raise  rates on various zones took into account concerns about the effect of  increases on policyholders, the level and extent of past rate increases, and  knowledge of relative flood risks in those areas. FEMA did not provide us  with any written documentation describing how these decisions were  reached. As mentioned previously, by law FEMA can raise rates on each  zone by no more than 10 percent a year. Our review of FEMA documents  show that FEMA raised rates significantly for a small number of policies  and by very little for a large number of policies from 2002 through 2006.  For example, FEMA raised rates by an average of more than 9 percent on  about 1 percent of all NFIP policies—specifically, on certain subsidized  policies located in high-risk coastal zones. In contrast, FEMA raised rates  by an average of around 2 percent on 40 percent of total policies in high- risk zones that were paying full-risk rates. Ultimately, the generally small  increases will not help ensure NFIP’s financial stability and may in fact  decrease it by adding to its operating deficit.

		NFIP’s Current Rate- Setting Processes Result in Premiums That Are Not Sufficient to Cover Current Debt and Future Claims

The processes and policies that FEMA uses to set both full-risk and  subsidized premium rates have contributed to NFIP’s inability to generate  enough in premiums to cover the program’s operating costs, claims losses,  and debt to the Treasury. From 1978 through 2004, NFIP had a net loss of  $2 billion. These years had historically low flooding, but NFIP had yearly  deficits for about half of these years. Over that period, Congress retired  about $1.2 billion of this total debt. However, the introduction of average  historical loss year targets in the 1980s resulted in a series of rate  increases that contributed to a sizeable reduction of the net loss.
The 2005 hurricanes significantly altered NFIP’s financial landscape. The  2005 hurricanes, especially Katrina, left the program with debt of more  than $17.4 billion as of June 2008. To service the debt to the Treasury,  FEMA owes two annual interest payments of around $365 million that are  generally due in April and October of each year. FEMA officials told us  that they were able to make the two payments in 2007 without borrowing  because, according to FEMA documents, NFIP faced unusually light  flooding in 2006 and 2007. In addition, FEMA made an unscheduled  principal payment of $225 million in November 2007. However, in April  2008, FEMA borrowed $50 million to pay the $364 million interest payment  owed to the Treasury. FEMA estimates that it will owe a total of $734  million in interest charges in fiscal year 2008.
FEMA officials informed us that they did not know whether NFIP would  be able to make future interest payments without borrowing because of  uncertainty about future flooding. According to FEMA documents, FEMA  has paid $1.6 billion in interest to the Treasury since 2005. NFIP currently  has about 5.6 million policies in force, resulting in approximately $2.6  billion in total premium. Historically, program expenses (excluding loss  and allocated loss adjustment expenses) have averaged around 38 percent  of premiums, or $1 billion of current total premium collection. As of June  2008, NFIP’s average noncatastrophic historical loss year (which excludes  Hurricanes Katrina, Rita, and Wilma) is about $1.3 billion. The combined  outlays for loss and loss adjustment expenses of around $1.3 billion,  administrative expenses of approximately $1 billion, and interest  payments of approximately $0.7 billion exceed the program’s current  premium collection of approximately $2.6 billion. Under current  conditions, it is unlikely that NFIP will be able to meet its interest  payments in most years, and the program’s debt will likely grow as the  program borrows to meet the interest payments.

	Conclusions

Over the years, FEMA has taken a number of steps to improve the rate- setting process, which was established more than two decades ago, but a  number of factors raise questions about whether the resulting rates reflect  the actual flood risk. First, potentially outdated and inaccurate data about  flood probabilities, damage claims, and flood maps are increasing the risk  that full-risk premiums do not reflect actual risk of flooding. Second,  unlike many insurers in the private sector, FEMA has done little to  understand the long-term impact of planned and ongoing development on  damage estimates. While this is due, in part, to the fact that FEMA lacks  the authority to factor potential or long-term development into potential  flood damage, FEMA has not, for example, evaluated how such  developments could affect the accuracy of its maps. Finally, FEMA’s  continued use of a nationwide rating structure that combines zones across  geographic areas despite the substantial growth of the program introduces  additional uncertainties. While additional analysis of the data is needed,  our analysis found that some patterns in historical claims and premiums  collected raise questions about whether this approach is still appropriate  and reasonable given the growth in the program. Collectively, these  factors call into question the accuracy of the full-risk rates generated by  FEMA’s rate model. By updating elements of its flood rate model and  certain rate-setting policies, FEMA could help ensure that data used in its  model such as flood probabilities, damage estimates, and information from  flood maps are as accurate as possible. In addition, by reconsidering risk  aggregation across flood zones and the effects of development and climate  change into the rate-setting process, FEMA has the opportunity to make its  model more robust and increase the accuracy of its rates.
Similarly, FEMA’s policy of allowing properties that have been remapped  to higher-risk zones to retain lower rates results in rates that do not  accurately reflect flood risk. Because the premiums are not based on the  actual risk of flooding, these policyholders are receiving a subsidy from  other policyholders in the same zone and the federal government—and  ultimately from taxpayers. We are encouraged that FEMA plans to  implement a monitoring process for grandfathered properties, which  would allow it to better determine the impact of these properties on the  program’s financial stability. However, because FEMA plans to track only  grandfathered properties in the future, not existing properties, it will not  be able to fully evaluate whether grandfathering actually is fulfilling the  desired goals in a cost-effective way. Unless there is a full accounting of  grandfathered properties, these properties expose the program to an  unknown level of risk. Prompt attention to this issue could allow NFIP to  refine its rate-setting process in the short term and provide valuable  information on the effects of its policy decision on the financial stability of  the program.
Finally, FEMA’s rate-setting process for subsidized properties depends in  part on the accuracy of full-risk rates, raising concerns about how these  rates are calculated as well. While FEMA is statutorily required to  subsidize rates, the method used for setting subsidized rates has evolved  from one that is based largely on affordability to one based on the average  historical loss year estimate. The resulting subsidized premiums continue  to be a financial strain on NFIP and contribute to its ongoing financial  instability. Based on NFIP’s current premium collections, it is not only  unlikely that NFIP will be unable to repay its debt but also unlikely that it  will be able to make interest payments in years with any significant  amount of flood activities, and the program’s debt will likely grow as it  borrows to meet the interest payments, as was the case in mid-2008.  Unless NFIP addresses issues with its rate-setting processes, premiums  collected will remain insufficient in the face of future flood losses—even  in average flood loss years—leaving both the program and taxpayers at  increased financial risk. While a robust rate-setting process that accurately  reflects underlying flood risk is a key step in helping to improve the long- term financial stability of NFIP, no process can ensure that premiums will  always cover losses because of the potential for large claim losses  associated with catastrophic events. However, any efforts to improve the  accuracy of the premiums charged by the program will help reduce the  financial risk to which the federal government and, ultimately, taxpayers  are exposed from the flood insurance program.

	Recommendations for Executive Action

We recommend that the Secretary of the Department of Homeland  Security direct FEMA to take steps to ensure that its rate-setting methods  and the data it uses to set rates result in full-risk premiums rates that  accurately reflect the risk of losses from flooding. These steps should  include, for example, verifying the accuracy of flood probabilities, damage  estimates, and flood maps; ensuring that the effects of long-term planned  and ongoing development, as well as climate change, are reflected in the  flood probabilities used; and reevaluating the practice of aggregating risks  across zones.
We also recommend that the Secretary of the Department of Homeland  Security direct FEMA to ensure that information is collected on the  location, number, and losses associated with existing and newly created  grandfathered properties in NFIP and to analyze the financial impact of  these properties on the flood insurance program.

	Agency Comments and Our Evaluation

We provided the Secretary of Homeland Security with a draft of this report  for review and comment. On October 14, 2008, FEMA provided written  comments on a draft of this report. FEMA generally concurred with both  of the report’s recommendations but had two reservations about our  recommendation to ensure that FEMA’s rate-setting methods result in full- risk rates that accurately reflect the risk of losses from flooding.   Moreover, while FEMA noted that the report makes a number of  constructive suggestions, it took exception to some of our analyses and  characterizations, which it believes overstate their potential impact on the  accuracy of the rate-setting process. These comments are summarized  below and FEMA’s letter is reprinted in appendix III. FEMA also provided  us with technical comments, which we incorporated as appropriate.
FEMA generally concurred with our recommendation that it take steps to  ensure that FEMA’s rate-setting methods result in full-risk rates that  accurately reflect the risk of losses from flooding, but expressed two  reservations.  First, it said that the report taken as a whole presents a view  of the accuracy of the current FEMA rate-setting process that is “far too  negative,” especially given the complexity and difficulty of setting flood  insurance premium rates. We recognize that determining full-risk  premium rates for flood insurance is an inherently challenging process,  especially given the potential for catastrophic losses in any given year.   However, in objectively reviewing the rate-setting process and applying  generally accepted principles of insurance and actuarial rate setting, we  found a number of areas that, when considered collectively, raise  questions about the accuracy of the resulting rates and highlight areas that  warrant additional analysis by FEMA.  For example, for the period of 1978- 2003, prior to the catastrophic losses resulting from the hurricanes of 2005,  the low to moderate full-risk zones had a cumulative deficit of  approximately $685 million.  This deficit would seem to indicate that the  rates for these risk classes were not adequate to cover the expected  losses—a basic actuarial principle.  And while the entire full-risk portion  of the program did have an overall surplus of approximately $382 million  over the same period, this would appear only to indicate the existence of a  large cross subsidy between the rated zones, which reinforces our  recommendation that FEMA revisit its nationwide class-rating system.
Second, FEMA said that the report does not accurately present the status  of its map modernization efforts and their impact on premium rates.   Specifically, with respect to map modernization, FEMA stated that (1) our  characterization of the progress on the updating of flood maps was  misleading; (2) we overstate the impact of older maps on rate setting; and  (3) we failed to note that FEMA allows communities to reflect future  conditions in flood maps the communities help develop.  With respect to  the progress of map modernization, FEMA provided the data that we  presented in the report, which represents a status of modernization efforts  to date.  FEMA appears to take issue with measuring the status of map  modernization in terms of the number of flood maps that had been  updated.  We note that in its comment letter, FEMA analyzed progress in  terms of the population living within areas covered by updated maps.   Each form of analysis provides a different picture of the progress of map  modernization, and we have now added FEMA’s data to reflect population  measures in order to present an additional perspective.  With respect to  the impact of older maps on rate setting, FEMA states that older maps are  not always outdated, and that in many areas the flood hazard has not  changed or is possibly decreasing.  While some maps may not have  changed over the past 10 to 15 years, it is uncertain how many maps fall  into this category and FEMA provided no analysis to support this  contention.  In addition, as we note in our report, FEMA stated that it  undertook map modernization for several reasons, including that flood  hazard conditions are dynamic and many flood maps may not reflect  recent development or environmental changes; updated maps can take  advantage of revised data and improved technologies for identifying flood  hazards; and up-to-date maps support a flood insurance program that is  more aligned with actual risks. These reasons would seem to reflect a  concern that older maps can become outdated.  Moreover, we also note  that FEMA plans to update its maps every 5 years to make sure they  remain accurate. With respect to allowing communities to voluntarily  reflect future conditions in flood maps, we were not made aware of these  efforts in time to evaluate them for inclusion in this report but we plan to  review these efforts in future work. FEMA had additional comments on  how we characterized its rate-setting process. We address these  comments below.
First, FEMA stated that our finding that probability curves for floodwaters  exceeding a specific elevation had not been updated since the 1980s was  unfounded because these probabilities are relative to the base flood  elevation (BFE), and BFEs are revised as flood maps are updated.  As we  noted in our report, flood risk experts told us that flood probabilities are  likely to change as land use, infrastructure, and weather patterns change.   As a result, even if the probability curves are adjusted to reflect a new  BFE, other changes since the 1980s could result in the probability curves  themselves no longer being accurate.  FEMA stated that it prepared a  sensitivity analysis that showed that reestimating the probability curves  would have a minimal impact on rates. We were not provided this analysis  until FEMA gave us its comments on this report, and therefore cannot  comment on the accuracy of the analysis.  Nonetheless, it illustrates the  type of analysis that FEMA should perform periodically to ensure the  integrity of its rate-setting process and are encouraged by this effort.   Finally, while we understand that the data used to develop probability  curves were based on detailed engineering studies, available flood data,  simulations, and professional judgments, neither FEMA nor the Corps was  able to provide us with the specific data set used to develop the original  probability curves.  As a result, we could not review the reliability of those  data.
Second, in response to FEMA comments about the Corps’ use of the  hydrologic model that underlies FEMA’s flood insurance rate-setting  process, we have clarified the language in our report to make clear that  while the Corps has revised its model for estimating flood damage, it  continues to use the hydrologic model.
Third, FEMA stated that we dismissed its contention that it is adequately  pricing the premiums for the class of business that includes grandfathered  properties. Considering the class of grandfathered properties as a subset  of policyholders, owners of grandfathered properties pay less than full-risk  premiums. Although FEMA may raise premiums for others to compensate  for the potential shortfall from this subset, the extent and effect of this  cross-subsidization deserves scrutiny and should be analyzed.  FEMA  concurred with our recommendation to gather additional information on  grandfathered properties and analyze their financial impact on NFIP.
Fourth, FEMA challenged our discussion about the number of risk groups  used for rate setting and contended that we failed to consider the  complexity and cost of using more refined risk classifications. We did  recognize and consider the challenges associated with using more refined  risk groups and therefore did not specifically recommend that FEMA  change its risk rating system. Instead, we recommended that FEMA  reevaluate its practice of aggregating risks across zones in light of the  program’s expansion to determine whether the current risk groups are still  relevant.  As we noted in our report, FEMA has not revisited its class  rating approach since its inception, when it had around 2 million  policyholders. The program currently has over 5.5 million policyholders.   Since then, there have been significant changes in both the number and  location of properties insured by NFIP that would warrant revisiting of  FEMA’s approach to aggregating risks.
Finally, concerning our analysis of historical claims data, FEMA  commented that we did not compare historical losses across states to a  theoretical distribution and stated that it believed that the distribution we  observed could be explained by analyzing the interaction of the variability  of flood risk and the declining number of policyholders receiving  discounted premiums. However, FEMA provided no analytical basis for  this belief and has not conducted any such analysis to support this  assertion. Moreover, FEMA also commented that until such analysis is  done, it cannot be sure of the results.  We would encourage FEMA to build  upon our analysis and continue to explore ways to leverage existing data  to evaluate the effective of its rate-setting process and identify ways to  strengthen the process.  In addition, FEMA expressed its disappointment  that we did not include the results of our analysis of losses across states in  our report.  While we included a shorter version of this analysis in the  body of the report, we continued to present the full results of our analysis  in appendix II of the report.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution of this report until 30  days from the report date. At that time, we will provide copies to the  Chairman, Senate Committee on Banking, Housing and Urban Affairs; the  Chairman and Ranking Member of the Senate Committee on Homeland  Security and Governmental Affairs; the Chairman and Ranking Member of  the House Committee on Financial Services; the Chairman and Ranking  Member of the House Committee on Homeland Security; and other  interested committees. We are also sending a copy of this report to the  Secretary of Homeland Security and other interested parties. In addition,  the report will available at no charge on our Web site at  http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-8678 or williamso@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix IV.

Appendix I: Scope and Methodology

To assess the Federal Emergency Management Agency’s (FEMA) rate- setting process and determine whether it produces rates that accurately  reflect the risk of flooding for properties that do not receive subsidies, we  reviewed and analyzed FEMA’s model for evaluating potential flood  damage to properties as well as the methods used for assessing risk and  setting premium rates for policyholders. We discussed FEMA’s method for  rate setting with officials from FEMA, the National Oceanic and  Atmospheric Administration, U.S. Army Corps of Engineers (the Corps),  and the U.S Geological Survey. We met with risk-modeling agencies,  academics and the American Academy of Actuaries to obtain views on  FEMA’s model and information on private sector flood-risk-modeling  methods and data sources. We met with FEMA officials to obtain relevant  information and data on FEMA’s Map Modernization program. We  reviewed FEMA documents and met with FEMA officials in order to  understand FEMA’s process and policies for grandfathering properties and  the impact on the program. We analyzed FEMA’s premiums and claims  data to determine the number of high-loss years on a state-by-state basis in  order to assess each state’s financial impact on NFIP. In order to conduct  the state loss analysis, we reviewed the claims and premium data from  NFIP’s BureauNet database. For premium data, we used “Historical Policy  Summary” and “All States” each year, individually from 1978 through 2007.  For the claims data, we used “Claims Data Summary” and obtained Closed  Claims, CWOP, and Open Claims by using the “State Name” and “Calendar  Year” sort fields. These numbers were then adjusted for inflation using  historic calendar year gross domestic product (GDP) data. Finally, we  subtracted claims values from the premiums values, and sorted the states  by the number of years in which each state experienced a high-loss year,  or a year in which claims exceeded premiums. We also calculated  aggregate inflation adjusted claims amounts for each state. Because of the  catastrophic effects of the 2005 hurricanes, we also calculated pre-Katrina  (1978 through 2004) numbers, which were displayed in table 3. To assess  the impact of the rate-setting process and other factors on NFIP’s long- term financial stability, we interviewed officials to obtain specific  information on NFIP’s current and past financial status. We also collected  and analyzed information on NFIP’s financial status and reviewed existing  FEMA documents.
To evaluate the process that NFIP uses to set subsidized rates, we  interviewed officials from FEMA to obtain the methodology used to assess  total premium needs and set subsidized rates. We collected and analyzed  information on FEMA’s process for setting rates for subsidized flood  insurance and reviewed documents on NFIP program subsidies and  recommendations to eliminate them. We also reviewed academic and  other studies of studies of flood risk and flood insurance including reviews  from the Congressional Research Service and the Congressional Budget  Office.
We conducted this work from December 2007 to September 2008 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We note that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.

Appendix II: State-by-State Analysis of Claims and Premiums Data

Because rare but large events can account for a large portion of the long- term aggregate experience, we supplemented the aggregate data analysis  with the annual high-loss year analysis. Nevertheless, on a cumulative  basis for 1978-2004, a period before Hurricanes Katrina and Rita  policyholders in several states received markedly more in claims paid out  than NFIP collected from them in premiums. Five of the nine states with  at least 8 high-loss years—Alabama, Missouri, Mississippi, Texas, and West  Virginia—had more in aggregate claims than policyholders paid out in  aggregate premiums. Five other states—Kentucky, Minnesota, North  Carolina, North Dakota, and Oklahoma—had aggregate claims exceeding  aggregate premiums, all of them experiencing between 5 and 7 high-loss  years. By expanding the totals to include all years through 2007, Louisiana  joins the other nine states with aggregate claims exceeding aggregate  premiums, primarily because of Hurricanes Katrina and Rita. On the other  extreme, three states—California, Florida, and New Jersey—had aggregate  premiums exceed aggregate claims by more than $1 billion, with Florida  having an $8 billion surplus.
As noted in the report, additional study would be required to determine  whether policyholders in some states with lower losses are paying a higher  premium than is appropriate for their risk, and others paying too little. For  example, our analysis did not control for differences in the type of policy  purchased, such as the mix of certain property types across states and  insurance coverage amounts, which could affect both premiums and  claims. In addition, we did not control for differences in the mix of  subsidized and full-risk policies or the impact of subsidized premiums on  our results, which could also affect the results. For example, some states  have a relatively large number or proportion of subsidized properties  (including grandfathered properties) that generally would lead to higher  expected claims relative to premiums, but we were unable to link the  separate NFIP claims and premiums data at the state and zone levels in a  way that would allow us to perform a more refined analysis. The  limitations in setting full-risk rates that we have discussed could result in  systematic mispricing relative to risk that becomes apparent only over  long periods; however, our analysis included both subsidized and full-risk  properties, and so the results should be considered in this context.

Appendix III: Comments from FEMA

Appendix IV: GAO Contact and Staff Acknowledgments

	Staff Acknowledgments

In addition to the contact named above, Lawrence Cluff (retired) and  Patrick Ward, Assistant Directors, Nima Patel Edwards, Christopher  Forys, Emily Chalmers, Martha Chow, Melvin Thomas, Joseph Applebaum,  Tania Calhoun, Christopher Krzeminski and Rudy Chatlos and Richard  Vagnoni made significant contributions to this report.

Summary:
Why GAO Did This Study

Questions about the financial status of the National Flood Insurance Program (NFIP) have increased since the 2005 hurricanes, which left the program with an unprecedented $17.4 billion deficit--a debt that resulted in GAO placing NFIP on its high-risk list in March 2006. Among the concerns are the subsidized rates NFIP must provide for about 25 percent of the policies, mostly for older buildings in high-risk flood zones. And although fully risk-based rates are supposed to reflect actual flood risk, concerns have been raised that they do not. This report evaluates (1) the Federal Emergency Management Agency's (FEMA) process for setting full-risk rates to determine whether it produces rates that accurately reflect the risk of flooding and (2) the process that FEMA uses to set subsidized rates and their effect on the financial condition of NFIP. To do this work, GAO evaluated the NFIP rate model, examined data from FEMA, surveyed relevant literature, and interviewed other relevant agencies and risk-modeling firms.

What GAO Found

FEMA's method for setting its full-risk rates may not ensure that the rates accurately reflect the actual risk of flood damage. The NFIP model combines estimated flood risk with expected flood damage, but a number of factors may affect the accuracy of the rates the model generates. First, some data inputs are outdated or inaccurate. FEMA relies on flood probabilities from the 1980s and damage estimates that do not fully reflect recent NFIP damage experience. Moreover, while FEMA has made updating its flood maps a priority, most of the maps used in rate setting have not yet been updated. Second, FEMA does not require all properties remapped into higher-risk areas to pay rates based on the new designation. This policy, known as grandfathering, erodes NFIP's ability to charge rates that reflect the risk of flooding. The policy is intended to increase participation, but FEMA does not track the number of grandfathered properties and cannot determine their financial impact on the program. Third, FEMA uses a nationwide rating system that combines flood zones across many geographic areas, so individual policies do not always reflect topographical features that affect flood risk. In fact, some patterns in historical claims and premium data suggest that NFIP's full-risk rates may not always reflect actual flood risk. Collectively, these factors increase the risk that premiums collected on full-risk policies may be insufficient to cover future losses, adding to concerns about NFIP's financial stability. FEMA's rate-setting process for subsidized properties depends in part on the accuracy of the full-risk rates, raising concerns about how these rates are calculated as well. To set subsidized rates, FEMA first subtracts the total amount it expects to collect in full-risk premiums from the average historical loss year--that is, the minimum (target) amount that the program needs to collect from all premiums to cover at least average annual losses, as determined by historical data. The remainder becomes the aggregate target amount the program must collect in subsidized premiums. To set individual subsidized rates, FEMA officials then consider their knowledge of flood risk, previous rate increases for various locations, and statutory limits on increases. The resulting subsidized premiums continue to be a financial strain on the NFIP and contribute to its ongoing financial instability. Evidence suggests that flooding is likely to become more severe in the future, resulting in increased risk exposure, the potential for more catastrophic losses, and ongoing financial instability for the program. Currently, the annual amount that NFIP collects in both full-risk and subsidized premiums is not enough to cover its operating costs, claim losses, and principal and interest payments to the Department of the Treasury, thereby exposing the federal government and ultimately taxpayers to ever-greater financial risks, especially in years of catastrophic flooding.