Flood Insurance: Opportunities Exist to Improve Oversight of the WYO Program
Published: 2009-08-21T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since 2004, private insurance companies participating in the Federal Emergency Management Agency's (FEMA) Write-Your-Own (WYO) program have collected an average of $2.3 billion in premiums annually and, of this amount, have been paid or allowed to retain an average of $1 billion per year. Questions have been raised about FEMA's oversight of the program in light of the debts FEMA has incurred since the 2005 hurricanes. GAO placed NFIP on its high-risk list and issued several reports addressing the challenges the program faces. This report addresses the methods FEMA uses for determining the rates at which WYOs are paid, its marketing bonus system for WYOs, its adherence to financial control requirements for the WYO program, and alternatives to the current system. To do this work, we reviewed and analyzed FEMA's data and policies and procedures and obtained the views of select WYOs and flood insurance experts.
section_title: What GAO Found
paragraphs: FEMA does not systematically consider actual flood insurance expense information when it determines the amount it pays the WYO for selling and servicing flood insurance policies and adjusting claims. Rather, since the inception of the WYO program, FEMA has used various proxies for determining the rates at which it pays the WYOs. Consequently, FEMA does not have the information it needs to determine (1) whether its payments are reasonable and (2) the amount of profit to the WYOs that are included in its payments. When GAO compared expense payments FEMA made to six WYOs to the WYOs' actual expenses for calendar years 2005 through 2007, we found that the payments exceeded actual expenses by $327.1 million, or 16.5 percent of total payments made. Considering actual expense information would provide transparency and accountability over payments to the WYOs. FEMA has not aligned its bonus structure with its long-term goals for the program. The WYOs generally offered flood insurance when requested but did not strategically market the product as a primary insurance line. FEMA has not set explicit marketing goals beyond a 5 percent goal of increasing policy growth each year, and the WYO program primarily rewards companies that are new to NFIP for sales increases that may result from external factors, including flood events. The Government Performance and Results Act states that when results could be influenced by external factors, agencies can use intermediate goals to measure contributions to specific goals. Paying bonuses based on such intermediate targeted goals could bring the bonus structure more in line with FEMA's goals for the NFIP program. FEMA has explicit financial control requirements and procedures for the WYO program but has not implemented all aspects of its Control Plan. FEMA provides guidance for WYOs that is intended to ensure compliance with the statutory requirements for the NFIP and contains checks and balances to help ensure that taxpayer funds are spent appropriately. FEMA did most of the required biennial audits and underwriting and claims reviews but did not do most of the required audits for cause; state insurance department audits; and marketing, litigation, and customer service operational reviews. In addition, FEMA did not systematically track the outcomes of the various audits, inspections, and reviews that it performed for the 10 WYOs included in this review of FEMA's oversight of the program. Because FEMA does not implement all aspects of the Control Plan, it cannot ensure that the WYOs are fully complying with program requirements. Three alternative administrative structures could replace NFIP's payment arrangement with a competitively awarded contract that could lower costs for selling and servicing flood insurance policies and administering claims: (1) contracting with one or more insurance companies, (2) contracting with a single vendor, or (3) contracting with multiple vendors and maintaining the WYO network. Each alternative involves trade-offs in terms of the impact on the program's basic operations that would have to be considered.

section_title: Letter
paragraphs: Private insurers sell and service policies and adjust claims for the National  Flood Insurance Program (NFIP) under an arrangement with the Federal  Emergency Management Agency (FEMA) of the Department of Homeland  Security. Under this program, known as the Write-Your-Own (WYO)  program, these companies have collected an average of $2.3 billion in  premiums annually since 2004 and have been paid or allowed to retain an  average of $1 billion for each of these years. These WYO companies— around 90 in 2008—are not only compensated for their services, but are  also paid a bonus for expanding NFIP’s policy base by increasing the  number of flood insurance policies they sell.
As we have previously reported, the amounts WYOs receive for their  services represent from one-third to two-thirds of the total NFIP premiums  collected annually, depending on the number of flood claims filed. In  fiscal year 2006, these payments peaked at more than $1.5 billion, or about  67 percent of WYO premiums collected, largely because of expenses  related to the 2005 hurricanes. The amount of payments and bonuses that  WYOs have received has led to increased scrutiny of FEMA’s oversight of  these insurance companies and its methods for determining the rates at  which they are paid.
At your request, we reviewed FEMA’s oversight of the WYO insurance  companies that sell and service NFIP policies. Our objectives were to (1)  assess FEMA’s practice of determining the amounts it pays WYOs for  selling and servicing flood insurance and adjusting claims; (2) examine  how FEMA evaluates the effectiveness of its WYO bonus incentive  structure and determine whether the bonuses it pays reflect actual efforts  to market flood insurance policies; (3) evaluate the extent to which FEMA  oversees the WYO companies, including reviewing external audits,  reinspecting flood claims, and conducting operational reviews; and (4)  evaluate the advantages and disadvantages of three alternative  arrangements for selling and servicing flood insurance policies and  adjusting claims using a competitively awarded contract.
On June 19, 2009, we briefed your staff on the results of our work. This  letter summarizes the briefing; the briefing slides are included in appendix  I of this report.
To assess FEMA’s method for determining the amounts it pays WYOs for  their services, we selected a sample of six WYOs that represented 53  percent of total WYO program net premiums written, 71 percent of total  WYO program claim losses paid, and 59 percent of total expense payments  FEMA made to the approximately 90 companies for fiscal years 2005 to  2007. We compared the payments FEMA made to these companies in  calendar years 2005 to 2007 with the actual flood insurance expenses the  companies reported to the National Association of Insurance  Commissioners (NAIC) for those years. We also interviewed officials from  FEMA, WYO companies, and NAIC. To address the remaining objectives,  we selected a sample of 10 WYOs that represented more than 50 percent of  the flood insurance premiums written in fiscal year 2007, including  companies of various sizes that incurred different levels of flood losses  and had different operating models. To assess the extent to which FEMA  evaluates the effectiveness of its WYO bonus incentive structure, we  discussed the bonus payment methodology with FEMA and WYO officials  and reviewed documents relating to the methodology and history of the  bonus payment system. To assess the extent to which FEMA was  implementing its oversight requirements for WYOs, we evaluated FEMA’s  Financial Control Plan Requirements and Procedures (Control Plan) and  requested and reviewed all documents that were required under the plan,  and discussed the plan and procedures with appropriate FEMA officials,  WYO insurers, and other stakeholders. To evaluate the advantages and  disadvantages of alternatives to the WYO program, we identified three  possible arrangements, all of which would incorporate a competitive  feature. We then discussed these alternatives with WYO insurers in our  sample; FEMA staff; and other stakeholders, such as flood insurance  vendors and consultants. Appendix II contains a more detailed description  of our scope and methodology.
We conducted this audit from December 2007 to July 2009 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 the evidence we obtained  provides a reasonable basis for our findings and conclusions based on our  audit objectives.
subsections: section_title: Background
paragraphs: Because of the catastrophic nature of flooding and the difficulty of  adequately predicting flood risks, private insurance companies have  largely been unwilling to underwrite and bear the risk of flood insurance.  Under NFIP, the federal government assumes liability for flood insurance  losses and sets rates and coverage limitations, among other  responsibilities. Since its inception, NFIP, to a large extent, has relied on  the private insurance industry to sell and service policies, as Congress  envisioned when it authorized the program in 1968. The authorizing  legislation provides broad authority for FEMA to work with the private  insurance industry, and over time, FEMA has utilized several  arrangements with private insurers, including with companies themselves  and with a single vendor. Because of customer complaints and stagnant  policy growth, in 1983, FEMA established the WYO program. According to  FEMA, the goals of the WYO program are to increase the NFIP policy base  and the geographic distribution of policies, improve service to NFIP  policyholders through the infusion of insurance industry knowledge, and  provide the insurance industry with direct operating experience with flood  insurance.
In 1986—the first year of the WYO program—48 WYO insurance  companies were responsible for about 50 percent of the more than 2  million policies in force. As of September 2008, about 90 WYO insurance  companies accounted for 97 percent of the nearly 5.6 million policies in  force at that time. Because WYOs are not risk-sharing insurers, they are  not paid an explicit profit percentage or amount.
Private insurers become WYOs by entering into an arrangement with  FEMA (the Financial Assistance/Subsidy Arrangement) to issue flood  policies in their own name. The insurers must have experience in property  and casualty insurance lines, be in good standing with state insurance  departments, and be capable of adequately selling and servicing flood  insurance policies. They must also comply with the provisions of FEMA’s  Control Plan, which outlines the companies’ responsibilities for program  operations, including underwriting, claims adjustments, cash management,  and financial reporting, as well as FEMA’s responsibilities for management  and oversight.
WYOs adjust flood claims and settle, pay, and defend all claims arising  from the flood policies. Insurance agents from these companies are the  main point of contact for most policyholders. Based on information the  insurance agents submit, WYOs issue policies, collect premiums, deduct  an allowance for commission and operating expenses from the premiums,  and remit the balance to NFIP. In most cases, insurance companies hire  subcontractors—flood insurance vendors—to conduct some or all of the  day-to-day processing and management of flood insurance policies.
When flood losses occur, policyholders report them to their insurance  agents, who notify the WYO insurance companies. The WYO companies  review the claims and process approved claims for payment. FEMA  reimburses the WYO insurance companies from the National Flood  Insurance Fund for the amount of the claims plus expenses for adjusting  and processing the claims, using rates that FEMA establishes. Claims  amounts may be adjusted after the initial settlement is paid if claimants  submit documentation showing that some costs were higher than  estimated.
section_title: FEMA Does Not Systematically Consider WYOs’ Actual Expenses When Setting Payment Rates
paragraphs: FEMA does not systematically consider actual flood insurance expense  information when it determines the amount it pays WYOs for selling and  servicing flood insurance policies and adjusting claims. Since the  inception of the WYO program, FEMA has used proxies to determine the  rates at which it pays WYOs. For example, payments for operating  expenses are determined annually based on the average industry operating  expenses for five lines of property insurance. WYOs’ actual flood  insurance expense information has been available since 1997, when the  companies began reporting the data to NAIC. However, FEMA has not  systematically considered these data when setting its payment rates, and  thus does not determine in advance the amounts built into payment rates  for estimated expenses and profit. Further, FEMA has not, after the end of  each year, compared the WYOs’ actual expenses to payments it makes to  the WYOs. Because FEMA does not routinely take WYOs’ actual flood  expenses into account when calculating payments and does not analyze  actual payments and WYO flood insurance expenses, it does not have the  information it needs to determine whether its payments are appropriate  and how much profit is included in its payments to WYOs.
FEMA has occasionally modified its methods for determining the amount  of expense payments, but only the last of these modifications, made in  2008, has taken into account the amount of actual WYO insurance  expenses. In 2001, FEMA increased its payments to WYOs for servicing  flood policies by an additional 1 percent of written premiums after some  WYOs told FEMA that the payment amounts, based on the proxy used,  were not sufficient to cover their operating expenses. FEMA did not take  into consideration WYOs’ actual expenses in making these additional  payments, which continued each year since 2001 and totaled about $25  million in fiscal year 2007. However, we found that the payments to the six  WYOs we reviewed exceeded their actual operating expenses even before  these payments were increased by an additional 1 percent of written  premiums. FEMA did consider actual flood insurance expenses in 2008  when it changed its method of paying claims processing expenses.  Beginning in fiscal year 2008—in response to the significant increase in  total payments made to WYO companies in fiscal year 2005 and 2006  following the 2004 and 2005 hurricanes—FEMA changed its method for  paying claims processing expenses to take into account actual flood  expense data obtained from a selected number of WYO companies. These  examples illustrate the benefit of considering actual flood expense data in  administering the WYO program.
We recognize that the consistency of WYOs’ reporting to NAIC needs to be  improved in order for data on the companies’ expenses to be fully utilized.
For example, we found that, among other things, some companies  reported their flood insurance expenses to NAIC after offsetting them with  the payments they received from FEMA. We also found that the actual  expenses of one of the six companies we reviewed included payments  made under service agreements with an affiliated company that may  include profit distributions that should not be included in the expense  amounts considered when setting payment rates. Nevertheless, we were  able to use NAIC flood insurance data, supplemented with information  obtained from WYO company officials, to compare the actual flood  insurance expenses our six selected companies incurred and the payments  they received for calendar years 2005 through 2007. We found that FEMA’s  payments exceeded the companies’ actual expenses by $327.1 million, or  16.5 percent of total payments made.
Our results highlight the importance of FEMA’s considering actual flood  expense data in administering the WYO program. In accordance with our  Standards of Internal Control in the Federal Government, FEMA should  ensure that its payment rates to WYOs are appropriate by, for example,  comparing payments with actual flood insurance expenses. Further,  federal managerial cost accounting standards state that reliable cost  information is critical to the proper allocation and stewardship of federal  resources and that actual cost information is an important element agency  management should consider when setting payment rates.
section_title: FEMA Has Not Aligned Its Bonus Structure with Its Long-Term Goals for NFIP
paragraphs: FEMA has not aligned its bonus structure for WYOs with its goals for  NFIP, such as 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. Instead,  FEMA uses a broad-based distribution formula that awards a bonus of 0.5  percent to 2 percent of the premiums collected if WYOs achieve a 2  percent to 5 percent net growth in policies on an annual basis. This  formula primarily rewards companies that are new to NFIP, when it is  easiest to increase the percentage of net policies from a small base.  Further, we found that most WYOs generally offered flood insurance when  requested but did not strategically market the product as a primary  insurance line. As a result, any sales increases may in fact result from  external factors that are outside the companies’ control, rather than from  marketing efforts—factors such as flood events, changes in the housing  market, and economic developments. For example, sales of flood  insurance tend to rise after flooding events, and FEMA’s Floodsmart  media marketing campaign, which also has a goal of increasing flood  policies by 5 percent annually, may also impact flood insurance sales.  Moreover, FEMA does not review the WYOs’ marketing plans and  therefore lacks the information needed to assess the effectiveness of  either the WYOs’ efforts to increase participation or the bonus program  itself.
The Government Performance and Results Act of 1993 requires agencies to  conduct systematic studies to assess how well programs are working.  When program results could be influenced by external factors, agencies  can use intermediate goals to identify the program’s discrete contribution  to a specific result. Although a study funded by FEMA suggested that the  agency should focus on increasing market penetration in low-risk flood  zones, in targeted geographical areas, and in small, special high-risk flood  hazard areas, FEMA has not set targeted market penetration goals beyond  its 5 percent goal of increasing policy growth. Having intermediate  targeted goals could help expand program participation, and linking such  goals directly to the bonus structure could help ensure that NFIP and WYO  goals were in line with each other.
section_title: FEMA Followed Some but Not All of Its Internal Control Requirements and Procedures
paragraphs: FEMA has explicit financial control requirements and procedures for  overseeing the WYO program. FEMA’s Control Plan provides guidance for  WYOs that is intended to ensure compliance with the statutory  requirements for NFIP and that contains several checks and balances to  help ensure that taxpayers’ funds are spent appropriately. The plan has  four major components that include requirements for: (1) monthly data  and financial reporting, (2) claims reinspections by FEMA’s contractor, (3)  various audits by independent CPAs, including required biennial audits,  audits for cause, and state insurance department audits, and (4) triennial  operation reviews by FEMA staff. FEMA’s Standards Committee is  responsible for ensuring that participating companies are complying with  the requirements.
For the 10 WYOs in our sample, FEMA followed some but not all of the  requirements and procedures of the Control Plan and did not  systematically track the outcomes of the various audits, inspections, and  reviews. Our review of FEMA’s records for these WYOs showed the  following:    FEMA collected nearly all of the required monthly data submissions.
WYOs from our sample whose claims were selected for reinspections were  reinspected according to the Control Plan’s methodology, and evidence of  these activities was provided.
Biennial audits and underwriting and claims triennial reviews were also  mostly implemented. FEMA officials said that they focused on claims and  underwriting reviews because these areas were the most important to  determining whether claims reimbursements to WYOs were appropriate.
Other audits, including audits for cause, state insurance department  audits, and marketing, litigation, and customer service triennial operation  reviews, were rarely or never implemented. FEMA officials said that they  no longer performed marketing, litigation, and customer service  operations reviews because each of these functions were being reviewed  by other means. However, FEMA could not provide us with evidence that  these reviews met the Control Plan’s requirements.
In addition, we found that WYO compliance with each component of the  Control Plan was the responsibility of multiple units, and FEMA did not  maintain a single, comprehensive monitoring system that would allow it to  ensure compliance with all components of the plan. That is, FEMA did not  centrally store WYO-specific evaluations, inspections, audits, or reviews  that were to be performed in accordance with the Control Plan. FEMA  officials told us that various staff within FEMA or its contractor was  responsible for ensuring that appropriate documentation of oversight  efforts were maintained. These officials told us that there was no  centralized access, either physical or electronic, to all of the  documentation produced in overseeing WYOs under the Control Plan.
Systematically tracking compliance with the Control Plan could ensure  that participating WYOs are collecting appropriate premiums and making  appropriate claims payments. Since most payments made to WYOs are  based on premiums collected and claims paid, adequate enforcement of  the Control Plan is important to ensuring that WYOs are being  compensated appropriately. Because FEMA does not implement all  aspects of the Control Plan, it cannot ensure that the WYOs are fully  complying with program requirements.
section_title: Alternative WYO Program Administrative Structures Could Be Used to Incorporate Competition into the Payment Process
paragraphs: FEMA’s current relationship with WYOs facilitates insurance companies’  participation in NFIP. But, as previously discussed in this report, this  relationship is based on a payment structure that may not reflect the  actual expenses these companies incur. We examined three alternative  administrative structures that could replace NFIP’s payment arrangement  with a competitively awarded contract that could lower costs for selling  and servicing flood insurance policies and administering claims:    contracting with one or more insurance companies,    contracting with a single vendor (similar to the NFIP Direct program), or    contracting with multiple vendors and maintaining the WYO network.
Each of these alternatives has advantages and disadvantages in terms of  the potential impact on the basic operations of administering flood  insurance policies and adjusting claims, as well as on FEMA’s oversight of  the program and its contractors. For example, contracting with one or  more insurance companies might lower FEMA’s costs for the program  through competitive bidding. But most insurance company officials we  spoke to said that they did not want to be federal contractors because of  the regulations that would apply and emphasized that they had agreed to  participate in the WYO program only because it was not based on an  explicit federal contract. Further, contracting with a single vendor, as  FEMA does under the current NFIP Direct program, might be less  expensive but would almost completely eliminate insurance companies’  participation and their network of insurance agents. Experts we spoke  with also pointed out that using a contractor to administer the flood  program failed in the early 1980s due to the contractor’s lack of  experience in administering insurance policies. Finally, contracting with  multiple vendors to service flood policies would allow FEMA to keep the  WYO network and might make oversight more effective because FEMA  would have a contractual relationship with significantly fewer companies.  But experts we spoke to said that this structure would encroach on WYOs’  ability to use a subcontractor to administer their flood line. Flood  consultants, vendors, and trade groups we spoke to were more receptive  to exploring an alternative structure using multiple vendors.
section_title: Conclusions
paragraphs: Given the significant risk exposure to the federal government, it is  imperative that FEMA carry out its stewardship responsibilities by  effectively and efficiently overseeing the WYO program and the more than  90 participating insurance companies. FEMA has taken some steps to  address these issues, including taking into consideration the actual  expenses of a selected number of WYOs before changing its method for  paying claims expenses and preparing a revised draft of its Control Plan,  which had not been updated since 1999. Additional opportunities exist for  FEMA to improve its oversight of the WYO program and ensure that  payments to the participating insurance companies are based on actual  company expenses, thereby improving the program’s cost-effectiveness.  However, our review demonstrates the following:    FEMA sets rates for paying WYOs for their services without knowing how  much of its payments actually cover expenses and how much goes toward  profit. Specifically, it does not determine in advance the amounts built into  the payment rates for estimated expenses and profit; annually analyze the  amounts of actual expenses and profit in relation to the estimated  amounts used in setting payment rates; or consider the results of the  analysis of payments, actual expenses, and profit in evaluating the  methods for paying WYOs. Moreover, it does not have a sound basis for its  practice of paying WYOs an additional 1 percent of written premiums for  operating expenses. As a result, FEMA does not have the information it  needs to determine whether its payments to WYOs are reasonable.
FEMA has not tied its bonus structure to the long-term strategic goals for  the program. As a result, it cannot be assured that the WYO program is  achieving its intended goals in the most cost-effective manner. Moreover,  FEMA does not collect the information on the WYOs’ marketing efforts,  which is needed to determine whether the companies’ marketing efforts  are aimed at helping to promote increased participation among targeted  groups and in targeted areas in line with NFIP goals.
FEMA has not consistently implemented all aspects of its current Control  Plan and does not systematically track WYOs’ compliance with the plan’s  requirements. As a result, FEMA cannot ensure that the WYOs are fully  complying with NFIP requirements, including oversight of the various  payments that depend on accurate premiums collected and appropriate  claims made.
section_title: Recommendations for Executive Action
paragraphs: To provide transparency and accountability over the payments FEMA  makes to WYOs for expenses and profits, we recommend that the  Secretary of Homeland Security direct the Under Secretary of Homeland  Security, FEMA, to    determine in advance the amounts built into the payment rates for  estimated expenses and profit;    annually analyze the amounts of actual expenses and profit in relation to  the estimated amounts used in setting payment rates;    consider the results of the analysis of payments, actual expenses, and  profit in evaluating the methods for paying WYOs; and  in light of the findings in this report, immediately reassess the practice of  paying WYOs an additional 1 percent of written premiums for operating  expenses.
To increase the usefulness of the data reported by WYOs to NAIC and to  institutionalize FEMA’s use of such data, we recommend that the  Secretary of Homeland Security direct the Under Secretary of Homeland  Security, FEMA, to  take actions to obtain reasonable assurance that NAIC flood insurance  expense data can be considered in setting payment rates that are  appropriate, including identifying affiliated company profits in reported  flood insurance expenses, and    develop comprehensive data analysis strategies to annually test the quality  of flood insurance data that WYOs report to NAIC.
If FEMA continues to use the WYO bonus program, we recommend that  the Secretary of Homeland Security direct the Under Secretary of  Homeland Security, FEMA, to improve it by considering the use of more  targeted marketing goals that are in line with FEMA’s NFIP goals.
To improve oversight of the WYO program and compliance with program  requirements, we recommend that the Secretary of Homeland Security  direct the Under Secretary of Homeland Security, FEMA, to    consistently follow the Control Plan and ensure that each component is  implemented;    ensure that any revised Control Plan include oversight of all functions of  participating WYOs, including customer service and litigation expenses;  and    systematically track insurance companies’ compliance with and  performance under each component of the Control Plan and ensure  centralized access to all the audits, reviews, and data analyses performed  for each participating insurance company under the Control Plan.
section_title: Agency Comments and Our Evaluation
paragraphs: We received written comments on a draft of this report in a letter from the  Department of Homeland Security’s Director, Departmental GAO/OIG  Liaison Office, which is reproduced in appendix III. FEMA concurred with  our recommendations regarding (1) the usefulness of the data that WYOs  report to NAIC, (2) the alignment of the bonus structure with long-term  NFIP goals, and (3) the oversight of the WYO program. First, the letter  noted that FEMA would work with NAIC to improve the quality of the  flood expense data that WYOs report and would include the data as an  additional item in determining the annual WYO expense allowance.  Second, the letter stated that FEMA planned to examine the incentive  bonus prior to making arrangements with WYOs for 2010 and 2011. FEMA  said that this examination is to include an assessment of the incentive’s  effectiveness in increasing policies; the need for such an incentive; and  possible alternatives to it, including identifying target markets where  penetration is low and providing incentives for increasing policies in those  markets only. Third, FEMA concurred with our recommendations  regarding WYO program oversight, although it stated that the litigation,  marketing, and customer service reviews were no longer included in the  revised Control Plan because they were completed in other ways. Given  the newness of these changes, this review did not include an assessment  of FEMA’s compliance with these alternative methods or their robustness  relative to the Control Plan. Finally, the letter stated that FEMA had  implemented new processes to improve the monitoring of WYOs’  compliance with the Control Plan and would continue to look for ways to  improve oversight in the future. While the letter did not provide details  about the new monitoring processes, we are encouraged by these new  steps and will be following up on these activities in our ongoing work.
FEMA did not concur with our recommendations on improving the  transparency and accountability of payments made to WYOs, specifically  our recommendation that FEMA consider WYOs’ actual expenses and  profits when setting its payment rates. In its response, FEMA provided its  views on issues that it believes impacted our analysis and the conclusions  we drew from our work. Also, FEMA discussed why it does not consider  actual flood insurance expense information. We disagree with FEMA’s  assertion that the issues it raised resulted in our reaching misleading  conclusions, and we continue to recommend that when setting payments  rates, FEMA should consider actual flood insurance expenses and the  profits that result from its payments to WYO companies.
Specifically, FEMA stated that our review was limited to only six  companies, which FEMA believes are the low-cost operators for the five  other lines of insurance used to determine the WYO expense allowance.  FEMA stated that it seems reasonable that these companies would also  have some of the lowest flood operating expenses and, therefore,  conclude that the results of our analysis can be expected to significantly  understate the operating expenses of the WYO companies as a whole. Our  analysis of the expenses and profits of these companies, which  represented 53 percent of total net premiums written, 71 percent of total  claims losses paid, and 59 percent of total expense payments made by the  WYO program for fiscal years 2005 to 2007, demonstrates the importance  of information that FEMA does not have about actual expenses and profits  that it was paying—information that we consider critical for making  decisions regarding the proper administration of NFIP.
FEMA stated that we did not perform a review of the stability of the  federal flood expenses because the results for other years were not  available to us. FEMA also stated that a review of the stability of federal  flood expenses would show the inadvisability of reaching any conclusions  from just 1 year of data and that basing compensation on a single year of  data is always questionable, especially since our analysis, and the  adjustments and assumptions we made in conducting our analysis, have  not been vetted. However, our analysis showed that variances in profit  over the 3 years we reviewed were caused by, among other things,  variations in the expenses incurred to adjust and pay claims losses that  also fluctuated from year to year. Moreover, we recognize that setting  payments based on a single year of data may not be appropriate. Our  recommendation that FEMA consider actual flood insurance expenses and  profits in setting payment rates would not limit FEMA’s consideration of  actual expenses and profits to a single year of data. We anticipate that  FEMA would annually perform an analysis of actual expenses and profits  for the current year, and then incorporate that result into its analysis of  these data covering the number of years that may be appropriate in the  view of FEMA management. The results of the longitudinal analysis would  be used to evaluate the rates being used and to determine in advance if a  change to the rates is needed. Moreover, we agree that time should be  allowed for others, such as the WYO companies and NAIC, to weigh in on  the methodology for analyzing payments to the WYOs and their actual  flood expenses. Importantly, however, any adjustments we made to the  flood expenses reported by the WYOs for the purpose of our analysis were  the result of information we obtained from and numerous discussions with  WYO company officials.
FEMA stated that actual expenses will be as much of a lagging indicator as  the current methodology that uses A.M. Best numbers. FEMA also stated  that even if actual expense data is considered to be completely reliable, by  the time NFIP could use it to lower expense ratios, about 2 to 3 years  would have lapsed. FEMA uses the average expenses for five lines of  property insurance other than the federal flood line for setting the  operating expense payment rate. We recognize that considering WYOs’  actual flood expenses will be a lagging indicator of the costs to service  flood insurance policies. However, it will be a better indicator than  FEMA’s current methodology precisely because it will not reflect the trend  of expenses for other lines of property business. Importantly, data now  used to set payment rates based on other lines of business are subject to  events and market forces that affect their expense ratios, but which are  not relevant to the WYO program. Our recommendation that FEMA use  actual flood expenses to set payment rates would differ from its current  methodology in one important aspect: actual expenses and not a proxy  would be used to set those rates.
FEMA stated that our analysis assumes that actual WYO company  expenses are stable, which FEMA concludes could yield misleading  results. FEMA also stated that during the last 5 years insurance companies  have managed to significantly reduce their operating expenses in other  lines, and suspects that many of those efficiency gains also made it into  companies’ flood insurance operations. Our analysis was not based on any  assumptions about the trends in WYO company expenses, in general, or  flood expenses, in particular. Rather, we analyzed the actual flood  expenses of selected companies over a 3-year period and compared the  payments to the companies’ actual flood expenses. As previously  indicated, we observed fluctuations from year to year in actual flood  expenses—in particular, expenses for adjusting and processing claims.  Our recommendation that FEMA consider actual flood expenses and profit  when setting payment rates will move FEMA from not knowing  (“suspecting”) the trend in actual flood expenses to considering those  trends when setting rates, and not continuing to utilize proxies of other  lines of business and the trends in those other lines that may not be  relevant to the WYO program. Whether actual expenses are stable or  otherwise is not relevant.
FEMA stated that while we acknowledge in the body of our report that the  years we reviewed—2005 to 2007—included the heaviest loss years in the  history of the program and that these years are not indicative of typical  years for loss adjustment expenses, we do not carry these caveats forward  to our conclusions. FEMA stated that this results in a significant distortion  of the expense reimbursement to WYO companies for the loss adjustment  expenses. We did consider the unusually high losses in 2005 and 2006  when reaching our conclusion that FEMA sets rates for paying WYOs for  their services without knowing how much of its payments cover expenses  and how much is for profit. An analysis of actual expenses over time  would enable FEMA to identify and correlate trends in actual WYOs’ flood  expenses to flood events and related claims losses. In fact, such an  analysis could have helped FEMA to determine before the hurricanes of  2004 and 2005 that its method for paying claims processing expenses  would result in significant payments in excess of actual expenses in heavy  loss years.
FEMA also stated that it addressed the problem that led to outsized WYO  compensation by changing how WYOs are paid for claims processing  expenses—referred to as Unallocated Loss Adjustment Expenses (ULAE).  As support, FEMA cited the fact that WYOs’ compensation for ULAE  would have been $29 million less and $267 million less in fiscal years 2005  and 2006, respectively, and would have been $9 million more in 2007. This  would have been a combined decrease of $287 million for the 3 years had  this new payment schedule been in place then. Further, FEMA said that  had the new payment schedule been in place in those years, it is likely that  most, if not all, of the $155 million in profit from claims adjusting and  processing that we reported for the six companies we reviewed would  disappear. Prior to 2008, FEMA paid WYOs 3.3 percent of claim losses  incurred for claims processing expenses. Beginning in 2008, FEMA began  paying the WYOs 1 percent of net premiums written and 1.5 percent of  claim losses incurred for their claims processing expenses. Our analysis  showed that for the years 2005 to 2007 FEMA paid the six WYOs in our  analysis profits of $327.1 million, including $155.2 million for claims  adjusting and processing expenses, without knowing the actual flood  expenses of any of these companies. FEMA’s statements that it is not clear  how much of its “savings” would have been borne by the six WYOs we  reviewed and that FEMA can only speculate as to the effect the change  would have on the companies’ profit support our finding that FEMA does  not know how much of its payments are for actual flood expenses and  how much are for profit. Our point is that FEMA should know how much it  is paying for expenses and for profit.
In our judgment, considering actual expenses and profit in setting payment  rates would result in a fair and equitable treatment of policyholders and  the WYO companies over time, as well as serve to better protect the  interests of taxpayers who ultimately bear the risk of losses from the WYO  program. In discussing why it does not consider actual flood insurance  expenses in setting payment rates, FEMA said that the WYO flood  insurance program is based on companies’ applying their normal business  practices to NFIP and that these practices are bound to vary from  company to company, and that it would be impossible for NFIP to  accurately calculate actual expenses for 90 companies. FEMA also said  that because of these two factors, and the fact that in the early years of the  program actual flood insurance expenses of the companies’ were not  available, the decision was made to use information on other lines of  insurance business from A. M. Best as a proxy in setting rates for  payments to NFIP companies. FEMA also stated that even now, when  some WYOs’ flood insurance expense information is available, FEMA is  not certain how accurate this information is, and that its management is  skeptical that using actual flood insurance expenses, as GAO  recommends, would yield lower payment rates than would result from the  proxies that the program uses to set payment rates. FEMA further stated  that it will work with NAIC to improve the quality of the flood expense  data.
We agree that business practices will vary among the participating  companies and we agree with FEMA’s statement that actual flood  insurance expenses of WYOs were not readily available 25 years ago, when  the program started. However, the National Association of Insurance  Commissioners (NAIC) began requiring that companies report financial  information on their federal flood insurance business in 1997. Therefore,  continuing to use other lines of business as proxies for setting WYO  program payment rates is no longer necessary. Moreover, continuing with  the same practice without assessing the reasonableness of the payments  made to WYOs by comparing those payments to the WYOs’ actual  expenses does not provide sufficient justification or accountability for  hundreds of million of dollars in federal program expenses.
We are encouraged by FEMA’s statement that, in the future, it will  consider actual flood insurance expenses WYOs report to NAIC as an  additional item when determining the annual WYO expense allowance,  which is intended to cover the companies’ operating, marketing, and  administrative expenses. While this is a positive step, given the changes in  the program and available information, we continue to recommend that  FEMA consider all categories of expenses when setting payment rates,  including payments for commissions, claims adjusting, and other claims- related expenses. Consideration of all categories of actual flood insurance  expenses reported by WYOs in setting payment rates for these expenses,  as well as the profits that the program pays to the companies for their  participation in NFIP, is necessary for FEMA to know whether its  payments to the WYOs are reasonable.
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 of the 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 be available at no charge on our Web site at  http://www.gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.
If you or your staff has any questions about this report, please contact  Orice Williams Brown at (202) 512-8678 or willamso@gao.gov, or Jeanette  M. Franzel at (202) 512-2600 or franzelj@gao.gov. GAO staff who made  major contributions to this report are listed in appendix IV.
section_title: Appendix I: Briefing Slides
subsections: section_title: Opportunities Exist to Improve Oversight of the
subsections: section_title: We provided a draft of this presentation to FEMA for its
paragraphs: review and they agreed with the content.
section_title: Appendix II: Scope and Methodology
subsections: section_title: WYO Expenses
paragraphs: To assess FEMA’s practice of determining the amounts it pays to WYO  insurance companies for their services without considering the  companies’ actual expenses, we compared the payments FEMA made to  six WYO companies to the companies’ actual flood insurance expenses.  Insurance companies report flood insurance expense data in annual  statements that are submitted to NAIC, which also include expenses for  the companies’ other property and casualty lines of business. The six  WYOs we selected wrote flood insurance policies whose premiums totaled  approximately 53 percent of the total WYO program premiums in fiscal  year 2007. Our sample is not a representative sample of all WYOs, so the  results of our analysis cannot be generalized to the universe of WYOs.
We reviewed NAIC and FEMA flood financial information to assess the  reliability of the information for our purposes. Because FEMA’s payments  to WYOs are determined by applying various proxies to premiums written  or claim losses, we identified differences between the written premiums  and claim losses that the companies reported to FEMA and NAIC. We  obtained from WYO company officials explanations of these differences  and determined that they would not significantly impact the companies’  flood expenses. Further, to review the payments and expenses for the six  companies selected, we    converted FEMA’s fiscal year WYO payment data to calendar year  amounts for comparison to calendar year actual expenses reported to  NAIC;  recalculated the expense payments reported by the six WYOs to FEMA on  a test basis, using the written premium and claim losses incurred amounts  the WYOs reported to FEMA and FEMA’s payment rates, all without  exception; and  interviewed officials of the WYOs regarding their flood operations,  accounting for and assignment of expenses to the flood line, and reporting  of flood line data to NAIC.
To assist in comparing actual expenses to the expense payments, we  adjusted the WYOs’ reported flood expenses in cases where, for example,  companies offset their expenses incurred with the payments they received  from FEMA. We found that the data the six companies submitted to NAIC  and FEMA were, as adjusted by us, sufficiently reliable for our purposes.
For the purposes of this audit, we considered profits to be to the  difference between the amounts paid to the WYO companies and the  companies’ actual flood expenses on a pretax basis. In determining profits,  we excluded miscellaneous other companywide income and expenses.
We did not audit the financial data the six WYOs submitted to FEMA,  NAIC, or to us. However, the federal flood financial information the  companies submitted to NAIC was included in financial statements  prepared in accordance with statutory accounting principles that were  audited by independent certified public accounting firms, which expressed  unqualified opinions for those years covered by our review. We compared  amounts in the audited financial statements for calendar year 2005 to 2007  to amounts the companies reported in their annual statements for earned  premiums, losses incurred, and underwriting and loss adjustment  expenses incurred for all lines of property and casualty insurance. The  differences we identified did not significantly impact our analysis. Further,  the federal flood financial information the companies submitted to FEMA  was included in biennial financial statements prepared in accordance with  generally accepted accounting principles that were also audited by  independent certified public accounting firms who expressed unqualified  opinions. We reviewed the audited biennial financial statements for four of  the six companies that had submitted separately audited statements to  FEMA. The differences we identified did not significantly impact our  analysis.
section_title: Marketing and Bonuses
paragraphs: To evaluate the extent to which bonus payments to WYOs for increasing  the number of flood policies they sell were based on WYOs’ actual  marketing efforts, we discussed the bonus payment methodology with  FEMA staff, WYOs, and other stakeholders and reviewed documents  relating to the methodology used to make the bonus payments. We  analyzed the bonus payments and evaluated the extent to which they  could be attributed to the marketing efforts of WYOs or to other external  factors, such as flood events and economic conditions. To determine  whether the existing bonus formula benefited WYOs with fewer policies  and years in NFIP, we compared those WYOs by size and year in the  program to those receiving top bonuses.
For the 10 WYOs that we selected to interview, we identified those that  had submitted marketing plans or undergone a marketing operations  review. We also asked whether the bonus was a major factor in their  marketing efforts and whether they considered flood insurance to be a  primary insurance line.
section_title: Program Oversight
paragraphs: To evaluate FEMA’s compliance with the Control Plan, we discussed  procedures with appropriate FEMA staff, requested and reviewed all the  documents that were required under the plan, and discussed these  requirements with the WYOs and other stakeholders. To address FEMA’s  oversight of the WYOs, we selected a sample of 10 WYOs that  administered over 50 percent of the flood insurance policies written for  the year 2007. Our sample included companies that covered the spectrum  of WYOs—for instance, they differed in size based on premiums written,  losses incurred, and overall rank in market share and included companies  that did and did not use a vendor.
We used a data collection instrument to review the required documents for  the 10 WYOs selected for our review. Our data collection instrument  included the four major components of FEMA’s Control Plan: (1) monthly  data and financial reporting ; (2) claims reinspections performed by  FEMA’s contractor.; (3) various audits by independent CPAs, including  required biennial audits, audits for cause, and state insurance department  audits; and (4) triennial operation reviews performed by FEMA staff. We  used the 1999 Control Plan that was being used at the time of our review  NFIP has a draft plan that it began developing in 2007.
section_title: Alternative Administrative Structures
paragraphs: In consultation with congressional staffers, we identified three possible  alternatives that would incorporate a competitive feature. To evaluate the  advantages and disadvantages of the three alternatives to the WYO  program, we discussed the alternatives with staff within GAO; the WYOs in  our sample; FEMA staff; and other stakeholders, such as flood insurance  vendors and consultants.
We conducted this audit from December 2007 to July 2009 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 the evidence we obtained  provides a reasonable basis for our findings and conclusions based on our  audit objectives.
section_title: Appendix III: Comments from the Department of Homeland Security
section_title: Appendix IV: GAO Contacts and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, the following individuals made  key contributions to this report: Andrew E. Finkel (Assistant Director),  Robert Owens (Assistant Director), Grace Haskins (Analyst-in-Charge), H.  Donald Campbell, Emily Chalmers, Tony Eason, Fredrick Evans, Jeffrey  Isaacs, Scott McNulty, Marc Molino, Roberto Pinero, Paul Revesz, and  Carrie Watkins.