Flood Insurance: Public Policy Goals Provide a Framework for Reform
Published: 2011-03-11T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The National Flood Insurance Program (NFIP) has been on GAO's high-risk list since 2006, when the program had to borrow from the U.S. Treasury to cover losses from the 2005 hurricanes. The outstanding debt is $17.8 billion as of March 2011. This sizeable debt, plus operational and management challenges that GAO has identified at the Federal Emergency Management Agency (FEMA), which administers NFIP, have combined to keep the program on the high-risk list. NFIP's need to borrow to cover claims in years of catastrophic flooding has raised concerns about the program's long-term financial solvency. This testimony 1) discusses ways to place NFIP on a sounder financial footing in light of public policy goals for federal involvement in natural catastrophe insurance and 2) highlights operational and management challenges at FEMA that affect the program. In preparing this statement, GAO relied on its past work on NFIP and on its ongoing review of FEMA's management of NFIP, which focuses on its planning, policies, processes, and systems. The management review includes areas such as strategic and human capital planning, acquisition management, and intra-agency collaboration.
section_title: What GAO Found
paragraphs: Congressional action is needed to increase the financial stability of NFIP and limit taxpayer exposure. GAO previously identified four public policy goals that can provide a framework for crafting or evaluating proposals to reform NFIP. These goals are: (1) charging premium rates that fully reflect risks, (2) limiting costs to taxpayers before and after a disaster, (3) encouraging broad participation in the program, and (4)encouraging private markets to provide flood insurance. Successfully reforming NFIP would require trade-offs among these often competing goals. For example, currently nearly one in four policyholders does not pay full-risk rates, and many pay a lower subsidized or "grandfathered" rate. Reducing or eliminating less than full-risk rates would decrease costs to taxpayers but substantially increase costs for many policyholders, some of whom might leave the program, potentially increasing postdisaster federal assistance. However, these trade-offs could be mitigated by providing assistance only to those who needed it, limiting postdisaster assistance for flooding, and phasing in premium rates that fully reflected risks. Increasing mitigation efforts to reduce the probability and severity of flood damage would also reduce flood claims in the long term but would have significant up-front costs that might require federal assistance. One way to address this trade-off would be to better ensure that current mitigation programs were effective and efficient. Encouraging broad participation in the program could be achieved by expanding mandatory purchase requirements or increasing targeted outreach to help diversify the risk pool. Such efforts could help keep rates relatively low and reduce NFIP's exposure but would have to be effectively managed to help ensure that outreach efforts were broadly based. Encouraging private markets is the most difficult challenge because virtually no private market for flood insurance exists for most residential and commercial properties. FEMA's ongoing efforts to explore alternative structures may provide ideas that could be evaluated and considered. Several operational and management issues also limit FEMA's progress in addressing NFIP's challenges, and continued action by FEMA will be needed to help ensure the stability of the program. For example, in previous reports GAO has identified weaknesses in areas that include financial controls and oversight of private insurers and contractors, and has made many recommendations to address them. While FEMA has made progress in addressing some areas, preliminary findings from GAO's ongoing work indicate that these issues persist and need to be addressed as Congress works to more broadly reform NFIP.
section_title: What GAO Recommends
paragraphs: GAO has made numerous recommendations aimed at improving financial controls and oversight of private insurers and contractors, among others.

section_title: Letter
paragraphs: I appreciate the opportunity to participate in today’s hearing on National  Flood Insurance Program (NFIP) reform. As you know, NFIP is the key  component of the federal government’s efforts to minimize the damage  from and financial impact of floods and is the only source of insurance  against flood damage for most residents in vulnerable areas. NFIP has  been on GAO’s high-risk list since March 2006 after incurring billions of  dollars in catastrophic losses from the 2005 hurricanes. Further  contributing to NFIP’s high-risk classification are operational and  management challenges that we have identified within the Federal  Emergency Management Agency (FEMA) that affect the program. As of  March 2011, NFIP still owed approximately $17.8 billion to the Department  of the Treasury (Treasury) for loans used to cover losses from the 2005  hurricanes. The magnitude of this debt highlights the many financial  challenges the program faces, including structural weaknesses in the way  it is funded, and the managerial challenges that have affected FEMA’s  administration of NFIP. Any efforts to help stabilize NFIP will require  addressing both the program’s financial challenges and its operational and  management issues.
My statement today discusses four public policy goals that GAO has  developed for evaluating federal involvement in the provision of natural  catastrophe insurance and identifies key program areas needing reform,  potential ways to better fulfill these goals, and the trade-offs that would be  required. This statement also sets out the operational and managerial  challenges facing NFIP that we have identified in past reports and are  examining in ongoing work. We performed our work 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 believe that the evidence we obtained  provides a reasonable basis for our findings and conclusions based on our  audit objectives.
subsections: section_title: Background
paragraphs: The National Flood Insurance Act of 1968 established NFIP as an  alternative to providing direct assistance after floods. NFIP, which  provides government-guaranteed flood insurance to homeowners and  businesses, was intended to reduce the federal government’s escalating  costs for repairing flood damage after disasters. FEMA, which is within the  Department of Homeland Security (DHS), is responsible for the oversight  and management of NFIP. Since NFIP’s inception, Congress has enacted  several pieces of legislation to strengthen the program. The Flood Disaster  Protection Act of 1973 made flood insurance mandatory for owners of  properties in vulnerable areas who had mortgages from federally regulated  lenders and provided additional incentives for communities to join the  program. The National Flood Insurance Reform Act of 1994 strengthened  the mandatory purchase requirements for owners of properties located in  special flood hazard areas (SFHA) with mortgages from federally  regulated lenders. Finally, the Bunning-Bereuter-Blumenauer Flood  Insurance Reform Act of 2004 authorized grant programs to mitigate  properties that experienced repetitive flooding losses. Owners of these  repetitive loss properties who do not mitigate may face higher premiums.
To participate in NFIP, communities agree to enforce regulations for land  use and new construction in high-risk flood zones and to adopt and  enforce state and community floodplain management regulations to  reduce future flood damage. Currently, more than 20,000 communities  participate in NFIP. NFIP has mapped flood risks across the country,  assigning flood zone designations based on risk levels, and these  designations are a factor in determining premium rates. NFIP offers two  types of flood insurance premiums: subsidized and full risk. The National  Flood Insurance Act of 1968 authorizes NFIP to offer subsidized premiums  to owners of certain properties. These subsidized premium rates, which  represent about 40 to 45 percent of the cost of covering the full risk of  flood damage to the properties, apply to about 22 percent of all NFIP  policies. To help reduce or eliminate the long-term risk of flood damage to  buildings and other structures insured by NFIP, FEMA has used a variety  of mitigation efforts, such as elevation, relocation, and demolition. Despite  these efforts, the inventories of repetitive loss properties—generally, as  defined by FEMA, those that have had two or more flood insurance claims  payments of $1,000 or more over 10 years—and policies with subsidized  premium rates have continued to grow. In response to the magnitude and  severity of the losses from the 2005 hurricanes, Congress increased NFIP’s  borrowing authority from the Treasury to $20.8 billion.
section_title: Efforts to Reform NFIP’s Financial Structure Will Require Balancing Public Policy Goals
paragraphs: We have previously identified four public policy goals for evaluating the  federal role in providing natural catastrophe insurance:    charging premium rates that fully reflect actual risks,   limiting costs to taxpayers before and after a disaster,    encouraging broad participation in natural catastrophe insurance    encouraging private markets to provide natural catastrophe insurance.
Taking action to achieve these goals would benefit both NFIP and the  taxpayers who fund the program but would require trade-offs. I will  discuss the key areas that need to be addressed, actions that can be taken  to help achieve these goals, and the trade-offs that would be required.
subsections: section_title: Charging Full-Risk Rates Would Improve NFIP’s Financial Soundness but Could Reduce Program Participation
paragraphs: As I have noted, NFIP currently does not charge all program participants  rates that reflect the full risk of flooding to their properties. First, the act  requires FEMA to charge many policyholders less than full-risk rates to  encourage program participation. While the percentage of subsidized  properties was expected to decline as new construction replaced  subsidized properties, today nearly one out of four NFIP policies is based  on a subsidized rate. Second, FEMA may “grandfather” properties that are  already in the program when new flood maps place them in higher-risk  zones, allowing some property owners to pay premium rates that apply to  the previous lower-risk zone. FEMA officials told us that they made the  decision to allow grandfathering because of external pressure to reduce  the effects of rate increases, and considerations of equity, ease of  administration, and the goals of promoting floodplain management.  Similarly, FEMA recently introduced a new rating option called the  Preferred Risk Policy (PRP) Eligibility Extension that in effect equals a  temporary grandfathering of premium rates. While these policies typically  would have to be converted to more expensive policies when they were  renewed after a new flood map came into effect, FEMA has extended  eligibility for these lower rates. Finally, we have also raised questions  about whether NFIP’s full-risk rates reflect actual flood risks. Because  many premium rates charged by NFIP do not reflect the full risk of loss,  the program is less likely to be able to pay claims in years with  catastrophic losses, as occurred in 2005, and may need to borrow from  Treasury to pay claims in those years.
Increasing premium rates to fully reflect the risk of loss—including the  risk of catastrophic loss—would generally require reducing or eliminating  subsidized and grandfathered rates and offers several advantages.  Specifically, increasing rates could:  result in premium rates that more fully reflected the actual risk of loss;    decrease costs for taxpayers by reducing costs associated with  postdisaster borrowing to pay claims; and    encourage private market participation, because the rates would more  closely approximate those that would be charged by private insurers.
However, eliminating subsidized and grandfathered rates and increasing  rates overall would increase costs to some homeowners, who might then  cancel their flood policies or elect not to buy them at all. According to  FEMA, subsidized premium rates are generally 40 to 45 percent of rates  that would reflect the full risk of loss. For example, the projected average  annual subsidized premium was $1,121 as of October 2010, discounted  from the $2,500 to $2,800 that would be required to cover the full risk of  loss. In a 2009 report, we also analyzed the possibility of creating a  catastrophic loss fund within NFIP (one way to help pay for catastrophic  losses). Our analysis found that in order to create a fund equal to 1  percent of NFIP’s total exposure by 2020, the average subsidized  premium—which typically is in one of the highest-risk zones—would need  to increase from $840 to around $2,696, while the average full-risk  premium would increase from around $358 to $1,149. Such steep increases  could reduce participation, either because homeowners could no longer  afford their policies or simply deemed them too costly, and increase  taxpayer costs for postdisaster assistance to property owners who no  longer had flood insurance.
However, a variety of actions could be taken to mitigate these  disadvantages. For example, subsidized rates could be phased out over  time or not transferred with the property when it is sold. Moreover, as we  noted in our past work, targeted assistance could be offered to those most  in need to help them pay increased NFIP premiums. This assistance  could take several forms, including direct assistance through NFIP, tax  credits, or grants. In addition, to the extent that those who might forego  coverage were actually required to purchase it, additional actions could be  taken to better ensure that they purchased policies. According to RAND  Corporation, in SFHAs, where property owners with loans from federally  insured or regulated lenders are required to purchase flood insurance, as  few as 50 percent of the properties had flood insurance in 2006.
section_title: Limiting Taxpayer Costs Could Be Achieved by Increasing Premium Rates, but Further Mitigation Efforts Could Incur Up- Front Costs
paragraphs: In order to reduce expenses to taxpayers that can result when NFIP  borrows from Treasury, NFIP needs to be able to generate enough in  premiums to pay its claims, even in years with catastrophic losses—a goal  that is closely tied to that of eliminating subsidies and other reduced rates.  Since the program’s inception, NFIP premiums have come close to  covering claims in average loss years but not in years of catastrophic  flooding, particularly 2005. Unlike private insurance companies, NFIP does  not purchase reinsurance to cover catastrophic losses. As a result, NFIP  has funded such losses after the fact by borrowing from Treasury. As we  have seen, such borrowing exposes taxpayers to the risk of loss. NFIP still  owes approximately $17.8 billion of the amount it borrowed from Treasury  for losses incurred during the 2005 hurricane season. The high cost of  servicing this debt means that it may never be repaid, could in fact  increase, and will continue to affect the program’s solvency and be a  burden to taxpayers.
Another way to limit costs to taxpayers is to decrease the risk of losses by  undertaking mitigation efforts that could reduce the extent of damage  from flooding. FEMA has taken steps to help homeowners and  communities mitigate properties by making improvements designed to  reduce flood damage—for example, elevation, relocation, and demolition.  As we have reported, from fiscal year 1997 through fiscal year 2007, nearly  30,000 properties were mitigated using FEMA funds. Increasing  mitigation efforts could further reduce flood damage to properties and  communities, helping to put NFIP on a firmer financial footing and  reducing taxpayers’ exposure.
FEMA has made particular efforts to address the issue of repetitive loss  properties through mitigation. These properties account for just 1 percent  of NFIP’s insured properties but are responsible for 25 to 30 percent of  claims. Despite FEMA’s efforts, the number of repetitive loss properties  increased from 76,202 in 1997 to 132,100 in March 2011, or by about 73  percent. FEMA also has some authority to raise premium rates for  property owners who refuse mitigation offers in connection with the  Severe Repetitive Loss Pilot Grant Program. In these situations, FEMA  can initially increase premiums to up to 150 percent of their current  amount and may raise them again (by up to the same amount) on  properties that incur a claim of more than $1,500. However, FEMA cannot  increase premiums on property owners who pay the full-risk rate but  refuse a mitigation offer, and in no case can rate increases exceed the full- risk rate for the structure. In addition, FEMA is not allowed to discontinue  coverage for those who refuse mitigation offers. As a result, FEMA is  limited in its ability to compel owners of repetitive loss properties to  undertake flood mitigation efforts.
Mitigation offers significant advantages. As I have noted, mitigated  properties are less likely to be at a high risk for flood damage, making it  easier for NFIP to charge them full-risk rates that cover actual losses.  Allowing NFIP to deny coverage to owners of repetitive loss properties  who refused to undertake mitigation efforts could further reduce costs to  the program and ultimately to taxpayers.
One disadvantage of increased mitigation efforts is that they can impose  up-front costs on homeowners and communities required to undertake  them and could raise taxpayers’ costs if the federal government elected to  provide additional mitigation assistance. Those costs could increase still  further if property owners who were dropped from the program for  refusing to mitigate later received federal postdisaster assistance. These  trade-offs are not insignificant, although certain actions could be taken to  reduce them. For example, federal assistance such as low-cost loans,  grants, or tax credits could be provided to help property owners pay for  the up-front costs of mitigation efforts. Any reform efforts could explore  ways to improve mitigation efforts to help ensure maximum effectiveness.  For example, FEMA has three separate flood mitigation programs.  Having multiple programs may not be the most cost-efficient and effective  way to promote mitigation and may unnecessarily complicate mitigation  efforts.
section_title: Depending on How They Were Implemented, Efforts to Encourage Broader Participation Could Reduce Costs
paragraphs: Increasing participation in NFIP, and thus the size of the risk pool, would  help ensure that losses from flood damage did not become the  responsibility of the taxpayer. Participation rates have been estimated to  be as low as 50 percent in SFHAs, where property owners with loans from  federally insured and regulated lenders are required to purchase flood  insurance, and participation in lower-risk areas is significantly lower. For  example, participation rates outside of SFHAs have been found to be as  low as 1 percent, leaving significant room to increase participation.
Expanding participation in NFIP would have a number of advantages. As a  growing number of participants shared the risks of flooding, premium  rates could be lower than they would be with fewer participants.  Currently, NFIP must take all applicants for flood insurance, unlike private  insurers, and thus is limited in its ability to manage its risk exposure. To  the extent that properties added to the program were in geographic areas  where participation had historically been low and in low- and medium-risk  areas, the increased diversity could lower rates as the overall risk to the  program decreased. Further, increased program participation could  reduce taxpayer costs by reducing the number of property owners who  might draw on federally funded postdisaster assistance.
However, efforts to expand participation in NFIP would have to be  carefully implemented, for several reasons. First, as we have noted, NFIP  cannot reject applicants on the basis of risk. As a result, if participation  increased only in SFHAs, the program could see its concentration of high- risk properties grow significantly and face the prospect of more severe  losses. Second, a similar scenario could emerge if mandatory purchase  requirements were expanded and newly covered properties were in  communities that did not participate in NFIP and thus did not meet  standards—such as building codes—that could reduce flood losses. As a  result, some of the newly enrolled properties might be eligible for  subsidized premium rates or, because of restrictions on how much FEMA  can charge in premiums, might not pay rates that covered the actual risk of  flooding. Finally, historically FEMA has attempted to encourage  participation by charging lower rates. However, doing so results in rates  that do not fully reflect the risks of flooding and exposes taxpayers to  increased risk.
Moderating the challenges associated with expanding participation could  take a variety of forms. Newly added properties could be required to pay  full-risk rates, and low-income property owners could be offered some  type of assistance to help them pay their premiums. Outreach efforts  would need to include areas with low and moderate flood risks to help  ensure that the risk pool remained diversified. For example, FEMA’s goals  for NFIP include increasing penetration in low-risk flood zones, among  homeowners without federally related mortgages in all zones, and in  geographic areas with repetitive losses and low penetration rates.
section_title: Encouraging Private Market Participation Could Reduce the Federal Government’s Exposure but Could Also Decrease NFIP’s Stability if Only High-Risk Properties Remained
paragraphs: Currently, the private market provides only a limited amount of flood  insurance coverage. In 2009, we reported that while aggregate information  was not available on the precise size of the private flood insurance market,  it was considered relatively small. The 2006 RAND study estimated that  180,000 to 260,000 insurance policies for both primary and gap coverage  were in effect. We also reported that private flood insurance policies are  generally purchased in conjunction with NFIP policies, with the NFIP  policy covering the deductible on the private policy. Finally, we reported  that NFIP premiums were generally less expensive than premiums for  private flood insurance for similar coverage. For example, one insurer  told us that for a specified amount of coverage for flood damage to a  structure, an NFIP policy might be as low as $500, while a private policy  might be as high as $900. Similar coverage for flood damage to contents  might be $350 for an NFIP policy but around $600 for a private policy.
Given the limited nature of private sector participation, encouraging  private market participation could transfer some or all of the federal  government’s risk exposure to the private markets and away from  taxpayers. However, identifying ways to achieve that end has generally  been elusive. In 2007, we evaluated the trade-offs of having a mandatory  all-perils policies that would include flood risks. For example, it would  alleviate uncertainty about the types of natural events homeowners  insurance covered, such as those that emerged following Hurricane  Katrina. However, at the time the industry was generally opposed to an all- perils policy because of the large potential losses a mandatory policy  would entail.
Increased private market participation is also not without potential  disadvantages. First, if the private markets provide coverage for only the  lowest-risk properties currently in NFIP, the percentage of high-risk  properties in the program would increase. This scenario could result in  higher rates as the amount needed to cover the full risk of flooding  increased. Without higher rates, however, the federal government would  face further exposure to loss. Second, private insurers, who are able to  charge according to risk, would likely charge higher rates than NFIP has  been charging unless they received support from the federal government.  As we have seen, such increases could create affordability concerns for  low-income policyholders. Strategies to help mitigate these disadvantages  could include requiring private market coverage for all property owners—  not just those in high-risk areas—and, as described earlier, providing  targeted assistance to help low-income property owners pay for their flood  coverage. In addition, Congress could provide options to private insurers  to help lower the cost of such coverage, including tax incentives or federal  reinsurance.
section_title: FEMA’s Operational and Management Issues May Limit Progress in Achieving NFIP Goals
paragraphs: As Congress weighs NFIP’s various financial challenges in its efforts to  reform the program, it must also consider a number of operational and  management issues that may limit efforts to meet program goals and  impair NFIP’s stability. For the past 35 years, we have highlighted  challenges with NFIP and its administration and operations. For example,  most recently we have identified a number of issues impairing the  program’s effectiveness in areas that include the reasonableness of  payments to Write-Your-Own (WYO) insurers, the adequacy of financial  controls over the WYO program, and the adequacy of oversight of non- WYO contractors. In our ongoing work examining FEMA’s management of  NFIP—covering areas including strategic planning, human capital  planning, intra-agency collaboration, records management, acquisition  management, and information technology—some similar issues are  emerging. For example, preliminary results of our ongoing work show that  FEMA:    does not have a strategic plan specific to NFIP with goals, objectives, and  performance measures for guiding and measuring the program;  lacks a strategic human capital plan that addresses the critical  competencies required for its workforce;    does not have effective collaborative practices that would improve the  functioning of program and support offices;  lacks a centralized electronic document management system that would  allow its various offices to easily access and store documents;    has only recently implemented or is still developing efforts to improve  some acquisition management functions, making it difficult to assess the  effects of these actions; and    does not have an effective system to manage flood insurance policy and  claims data, despite having invested roughly 7 years and $40 million on a  new system whose development has been halted.
While FEMA has begun to acknowledge and address some of these  management challenges, additional work remains to be done to address  these issues. Our final report will include recommendations to address  them.
section_title: Closing Comments
paragraphs: Congressional action is needed to increase the financial stability of NFIP  and limit taxpayer exposure. GAO previously identified four public policy  goals that can provide a framework for crafting or evaluating proposals to  reform NFIP. First, any congressional reform effort should include  measures for charging premium rates that accurately reflect the risk of  loss, including catastrophic losses. Meeting this goal would require  changing the law governing NFIP to reduce or eliminate subsidized rates,  limits on annual rate increases, and grandfathered or other rates that did  not fully reflect the risk of loss. In taking such a step, Congress may  choose to provide assistance to certain property owners, and should  consider providing appropriate authorization and funding of such  incentives to ensure transparency. Second, because of the potentially high  costs of individual and community mitigation efforts, which can reduce  the frequency and extent of flood damage, Congress may need to provide  funding or access to funds for such efforts and consider ways to improve  the efficiency of existing mitigation programs. Moreover, if Congress  wished to allow NFIP to deny coverage to owners of properties with  repetitive losses who refused mitigation efforts, it would need to give  FEMA appropriate authority. Third, Congress could encourage FEMA to  continue to increase participation in the program by expanding targeted  outreach efforts and limiting postdisaster assistance to those individuals  who choose not to mitigate in moderate- and high-risk areas. And finally,  to address the goal of encouraging private sector participation, Congress  could encourage FEMA to explore private sector alternatives to providing  flood insurance or for sharing insurance risks, provided such efforts do  not increase taxpayers’ exposure.
For its part, FEMA needs to take action to address a number of  fundamental operational and managerial issues that also threaten the  stability of NFIP and have contributed to its remaining on GAO’s high-risk  list. These include improving its strategic planning, human capital  planning, intra-agency collaboration, records management, acquisition  management, and information technology. While FEMA continues to make  some progress in some areas, fully addressing these issues is vital to its  long-term operational efficiency and financial stability.
Chairman Biggert, Ranking Member Gutierrez, and Members of the  Subcommittee, this concludes my prepared statement. I would be pleased  to respond to any of the questions you or other members of the  Subcommittee may have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this statement. For further  information about this testimony, please contact Orice Williams Brown at  (202) 512-8678 or williamso@gao.gov. This statement was prepared under  the direction of Patrick Ward. Key contributors were Tania Calhoun, Emily  Chalmers, Nima Patel Edwards, and Christopher Forys.
section_title: Related GAO Products
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Financial Management: Improvements Needed in National Flood  Insurance Program’s Financial Controls and Oversight. GAO-10-66.  Washington, D.C.: December 22, 2009.
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High-Risk Series: An Update. GAO-09-271. Washington, D.C.: January  2009.
Flood Insurance: Options for Addressing the Financial Impact of  Subsidized Premium Rates on the National Flood Insurance Program.  GAO-09-20. Washington, D.C.: November 14, 2008.
Flood Insurance: FEMA’s Rate-Setting Process Warrants Attention.  GAO-09-12. Washington, D.C.: October 31, 2008.
National Flood Insurance Program: Financial Challenges Underscore  Need for Improved Oversight of Mitigation Programs and Key Contracts.  GAO-08-437. Washington, D.C.: June 16, 2008.
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Formidable Administrative Problems Challenge Achieving National  Flood Insurance Program Objectives. RED-76-94. Washington, D.C.: April  22, 1976.
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