Natural Catastrophe Insurance: Analysis of a Proposed Combined Federal Flood and Wind Insurance Program
Published: 2008-04-25T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Disputes between policyholders and insurers after the 2005 hurricanes highlight the challenges of determining the cause and extent of damages when properties are subject to both high winds and flooding. Additionally, insurers want to reduce their exposure in high-risk areas, and state wind insurance programs have grown significantly. H.R. 3121, the Flood Insurance Reform and Modernization Act of 2007, would create a combined federal insurance program with coverage for both wind and flood damage. GAO was asked to evaluate this potential program in terms of (1) what would be required to implement it; (2) the steps the Federal Emergency Management Agency (FEMA) would need to take to determine premium rates that reflect all future costs; and (3) how it could affect policyholders, insurance market participants, and the federal government. To address these questions, GAO analyzed state and federal programs, examined studies of coastal wind insurance issues, and interviewed federal and state regulatory officials as well as industry participants and analysts. FEMA and the National Association of Insurance Commissioners generally agreed with GAO's report findings. FEMA emphasized the challenges it would face in addressing several key issues. FEMA also provided technical comments, which were incorporated as appropriate.
section_title: What GAO Found
paragraphs: To implement a combined federal flood and wind insurance program, FEMA would need to complete certain challenging steps. First, FEMA would need to determine wind hazard prevention standards that communities would have to adopt in order to receive coverage. Second, FEMA would need to adapt existing programs to accommodate wind coverage--for example, the Write Your Own program. Third, FEMA would need to create a new rate-setting process, as the process for setting flood insurance rates is different from what is needed for wind coverage. Fourth, promoting the new program in communities would require that FEMA staff raise awareness of the combined program's availability and coordinate enforcement of the new building codes. Finally, FEMA would need to put staff and procedures in place to administer and oversee the new program while it faces current management and oversight challenges with the National Flood Insurance Program (NFIP). Setting premium rates adequate to cover all the expected costs of flood and wind damage would require FEMA to make sophisticated determinations. For example, FEMA would need to determine how the program would pay claims in years with catastrophic losses without borrowing from the Department of the Treasury. H.R. 3121 would require the program to stop renewing or selling new policies if it needed to borrow funds, effectively terminating the program. It is also unclear whether the program could obtain reinsurance to cover such losses, and attempting to fund losses by building up a surplus would potentially require high premium rates and an unknown number of years without large losses, something over which FEMA has no control. Further, FEMA would need to account for the likelihood that participation would be limited and only the highest-risk properties would be insured. These factors would further increase premium rates and make it difficult to set rates adequate to cover future costs. A federal flood and wind insurance program could benefit some policyholders and market participants but would also involve trade-offs. For example, not requiring adjusters to distinguish between flood and wind damage could reduce both delays in reimbursing participants and the potential for litigation. However, borrowing restrictions could also leave property owners without coverage after a catastrophic event. In addition, the proposed coverage limits are relatively low compared with the coverage that is currently available, potentially leaving some properties underinsured. The program could also reduce the exposure of some insurers by insuring high-risk properties that currently have private sector coverage. However, an unknown portion of the exposure currently held by state wind programs--nearly $600 billion in 2007--could be transferred to the federal government. While H.R. 3121 would require premium rates to be adequate to cover any exposure and restrict borrowing by the program, the potential exists for losses to greatly exceed expectations, as happened with Hurricane Katrina in 2005. This could increase FEMA's total debt, which as of December 2007 was about $17.3 billion.

section_title: Letter
paragraphs: Hurricanes can cause extensive wind and flood damage that can be  devastating to property owners. Determining the extent of the damage  caused by each peril can be difficult, leading to disputes between  policyholders and private insurers and delays in payments that property  owners need for living and rebuilding expenses. For example, in the  aftermath of the unprecedented damage as a result of the 2005 hurricanes,  disputes emerged between policyholders and insurers over the extent to  which damages would be covered under a homeowner’s policy when both  high winds and flooding occurred. As of November 2007, some of these  disputes had yet to be resolved.
Such disputes arise because events such as hurricanes are multiperil  events, making determinations of the cause of damage difficult. Private  property-casualty insurance policies may cover wind damage but exclude  flood damage, and in some cases, the presence of flood damage in addition  to wind damage may raise questions about the extent to which wind  damage is covered. Adjusters face several challenges in their efforts to  determine the cause of damages after multiperil events. For example, the  scope of damage following Hurricane Katrina meant that not enough  adjusters were available, that the available adjusters had difficulty  reaching the properties, and that evidence at the damage scenes was often  limited or compromised.
The potential for extensive damages following hurricanes can also mean  that insurance in hurricane prone areas (primarily on the eastern and Gulf  coasts of the United States) may not be widely available and, when it is,  may be unaffordable. In some high-risk areas, insurers have sought to  increase their premium rates and reduce their exposure. To address these  issues, a number of coastal states have created programs to sell wind  insurance in the highest-risk areas within their states. In some states, such  as Florida, Mississippi, and North and South Carolina, participation in  these programs has grown tremendously since 2004, exposing the  programs to potentially large losses.
In response to these and other concerns, the House of Representatives  passed H.R. 3121, the Flood Insurance Reform and Modernization Act of  2007, in September 2007. H.R. 3121 would, among other things, create a  federal program to provide coverage for both wind and flood damage. You  asked us to evaluate this program in light of current deliberations about  the future of the National Flood Insurance Program (NFIP). This report  discusses (1) the resources and processes that the Federal Emergency  Management Agency (FEMA) would need to implement the program; (2)  the steps that FEMA would need to take to determine premium rates that  adequately reflected all expected costs; and (3) the possible effects of the  program on policyholders, insurance market participants, and the federal  government.
To complete our work, we analyzed the provisions of H.R. 3121 that were  related to the establishment of a federal flood and wind insurance  program. We discussed the potential implications and effects of these  provisions with officials from FEMA, the NFIP, the National Association of  Insurance Commissioners (NAIC), state insurance regulators, state wind  insurance program operators, insurers, reinsurers, insurance and  reinsurance associations, insurance agent associations, risk-modeling  organizations, actuarial consultants, the American Academy of Actuaries,  and others. We also obtained information on state-sponsored wind  insurance programs in three coastal states and one inland state and talked  with program officials as well as the insurance regulators within those  states. In addition, we reviewed academic and other studies of coastal  wind insurance issues, Congressional Budget Office (CBO) reviews, and  hurricane loss data. Appendix I contains additional information  concerning the scope and methodology of our work. We conducted this  performance audit from September 2007 to April 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 believe that the evidence obtained  provides a reasonable basis for our findings and conclusions based on our  audit objectives.
subsections: section_title: Background
paragraphs: Coastal properties in the United States that lie on the Atlantic Ocean and  the Gulf of Mexico are at risk of both flood and wind damage from  hurricanes. One study put the estimated insured value of coastal property  in states on these coasts at $7.2 trillion as of December 2004, and  populations in these areas are growing. Property owners can obtain  insurance against losses from wind damage through private insurance  markets or, in high-risk coastal areas in some states, through state wind  insurance programs. Flood insurance is generally excluded from such  coverage, but property owners can obtain insurance against losses from  flood damage through NFIP, which was established by the National Flood  Insurance Act of 1968.
As we have reported, insurance coverage gaps and claims uncertainties  can arise when coverage for hurricane damage is divided among multiple  policies because the extent of coverage under each policy depends on the  cause of the damages, as determined through the claims adjustment  process and the policy terms that cover a particular type of damage. This  adjustment process is complicated when a damaged property has been  subjected to a combination of high winds and flooding and evidence at the  damage scene is limited. Other claims concerns can arise on such  properties when the same insurer serves as both the NFIP’s WYO insurer  and the property-casualty (wind) insurer. In such cases, the same company  is responsible for determining damages and losses to itself and to the  NFIP, creating an inherent conflict of interest.
subsections: section_title: H.R. 3121 Would Create a Combined Federal Flood and Wind Insurance Program
paragraphs: H.R. 3121, the Flood Insurance Reform and Modernization Act of 2007, set  an effective date for its proposed flood and wind insurance program of  June 28, 2008. A version of this bill, S. 2284, was introduced in the Senate  in November of 2007, but this version did not include provisions that  would establish a federal flood and wind program. As of March 2008, no  additional action had been taken on S. 2284. In a September 26, 2007,  Statement of Administration Policy regarding H.R. 3121, the Executive  Office of the President stated that the Administration strongly opposes the  expansion of NFIP to include coverage for windstorm damage.
H.R. 3121’s provisions include the following:  In order for individual property owners to be eligible to purchase federal  flood and wind coverage, their communities must have adopted adequate  mitigation measures that the Director of FEMA finds are consistent with  the International Code Council’s building codes for wind mitigation.
The Director of FEMA is expected to carry out studies and investigations  to determine appropriate wind hazard prevention measures, including  laws and regulations relating to land use and zoning; establish criteria  based on this work to encourage adoption of adequate state and local  measures to help reduce wind damage; and work closely with and provide  any technical assistance to state and local governmental agencies to  encourage the application of these criteria and the adoption and  enforcement of these measures.
Property owners who purchase a combined federal flood and wind  insurance policy cannot also purchase an NFIP flood insurance policy.
Federal flood and wind insurance will cover losses only from physical  damage from flood and windstorm (including hurricanes, tornadoes, and  other wind events), but no distinction between flood and wind damage  need be made in order for claims to be paid.
Premium rates are to be based on risk levels and accepted actuarial  principles and will include all operating costs and administrative  expenses.
Residential property owners can obtain up to $500,000 in coverage for  damages to any single-family structure and up to $150,000 in coverage for  damage to contents and any necessary increases in living expenses  incurred when losses from flooding or windstorm make the residence  unfit to live in.
Nonresidential property owners can obtain up to $1,000,000 in coverage  for damages to any single structure and up to $750,000 in coverage for  damage to contents and for losses resulting from an interruption of  business operations caused by damage to, or loss of, the property from  flooding or windstorm; If at any time FEMA borrows funds from the Treasury to pay claims under  the federal flood and wind program, until those funds are repaid the  program may not sell any new policies or renew any existing policies.
section_title: NFIP Is Designed to Offer Federally Backed Flood Insurance but Not to Be Actuarially Sound
paragraphs: Over 20,000 communities across the United States and its territories  participate in the NFIP by adopting and agreeing to enforce state and  community floodplain management regulations to reduce future flood  damage. In exchange, the NFIP makes federally backed flood insurance  available to homeowners and other property owners in these  communities. Homeowners with mortgages from federally regulated  lenders on property in communities identified to be in special high-risk  flood hazard areas are required to purchase flood insurance on their  dwellings. Optional, lower-cost coverage is also available under the NFIP  to protect homes in areas of low to moderate risk. Premium amounts vary  according to the amount of coverage purchased and the location and  characteristics of the property to be insured.
When the NFIP was created, Congress mandated that it was to be  implemented using “workable methods of pooling risks, minimizing costs,  and distributing burdens equitably” among policyholders and taxpayers in  general. The program aims to make reasonably priced coverage available  to those who need it. The NFIP attempts to strike a balance between the  scope of the coverage provided and the premium amounts required to  provide that coverage and, to the extent possible, the program is designed  to pay operating expenses and flood insurance claims with premiums  collected on flood insurance policies rather than tax dollars. However, as  we have reported before, the program, by design, is not actuarially sound  because Congress authorized subsidized insurance rates for some policies  to encourage communities to join the program. As a result, the program  does not collect sufficient premium income to build reserves to meet the  long-term future expected flood losses. FEMA has statutory authority to  borrow funds from the Treasury to keep the NFIP solvent. In 2005,  Hurricanes Katrina, Rita, and Wilma had a far-reaching impact on NFIP’s  financial solvency. Legislation incrementally increased FEMA’s borrowing  authority from a total of $1.5 billion prior to Hurricane Katrina to $20.8  billion by March 2006, and as of December 2007, FEMA’s outstanding debt  to the Treasury was $17.3 billion. As we have reported, it is unlikely that  FEMA can repay a debt of this size and pay future claims in a program that  generates premium income of about $2 billion per year.
section_title: Implementing a Combined Federal Flood and Wind Insurance Program Would Require FEMA to Address Several Management Challenges
paragraphs: To implement a combined federal flood and wind insurance program,  FEMA would need to complete a number of steps, similar to those  undertaken to establish the NFIP, which would require the agency to  address several challenges. First, FEMA would need to undertake studies  in order to determine appropriate building codes that communities would  be required to adopt in order to participate in the combined program.  Second, FEMA would need to adapt existing processes under the NFIP  flood program to accommodate the addition of wind coverage. For  example, FEMA could leverage current processes under the WYO program  and the Direct Service program to perform the administrative functions of  selling and servicing the combined federal flood and wind insurance  policy. Third, to set wind rates, FEMA would have to create a rate-setting  structure, which would require contractor support. Fourth, promoting the  combined federal flood and wind insurance program in communities  would require that FEMA staff raise awareness of the combined program’s  availability and coordinate enforcement of the new building codes. Finally,  FEMA is facing a $17.3 billion deficit and attempting to address several  management and oversight challenges associated with the NFIP, and  balancing those demands with expanding staffing capacity to adjust  existing administrative, operational, monitoring, and oversight processes  and establish new ones to accommodate wind coverage could further  strain FEMA’s ability to effectively manage the NFIP.
subsections: section_title: FEMA Would Need to Determine Appropriate Building Codes
paragraphs: H.R. 3121 would require FEMA to determine appropriate wind mitigation  measures that communities would be required to adopt in order to  participate in the combined flood and wind program. For several reasons,  this could be a challenging process. First, FEMA would have to determine  how to most effectively integrate a new federal wind mitigation standard  with existing building codes for wind resistance. As we discussed in a  previous report, as of January 2007, the majority of states had adopted  some version of a model building code for commercial and residential  structures. However, some local jurisdictions within states had not  adopted a statewide model code and had modified the codes to reflect  local hazards. Standards determined by FEMA to be appropriate for  participation in the combined federal flood and wind program could  conflict with those currently used by some states and local jurisdictions,  and resolving any such differences could be challenging.
Second, as it did with the NFIP, FEMA would have to address  constitutional issues related to federal regulation of state and local code  enforcement. Further, FEMA would need to establish regulations similar  to those governing the flood program to allow for appeals by local  jurisdictions, a process that could be time intensive. Third, as we have  noted in a previous report, reaching agreement with communities on  appropriate mitigation measures can be challenging, as communities often  resist changes to building standards and zoning regulations because of the  potential impact on economic development. For example, community  goals such as housing and promoting economic development may be  higher priorities for the community than formulating mitigation  regulations that may include more rigorous developmental regulations and  building codes. Fourth, according to FEMA officials, the agency would  have to resolve potentially conflicting wind and flood standards. For  example, they told us that flood building standards require some homes to  be raised off the ground, but doing so can increase a building’s  susceptibility to wind damage because the buildings are then at a higher  elevation.
section_title: FEMA Would Need to Adapt Existing NFIP Processes for Wind Coverage
paragraphs: While some of the NFIP’s current processes could be leveraged to  implement a combined federal flood and wind program, they would need  to be revised, an action that could pose further challenges for FEMA.  According to FEMA officials, both the NFIP’s WYO and Direct Service  programs could be used, with some revisions, to sell and underwrite the  combined federal flood and wind insurance policy. The provision within  H.R. 3121 that prevents FEMA from selling new policies or renewing  existing policies if it borrows funds to pay claims would necessitate that  the agency segregate funds collected from premiums under the new  combined program and the flood program to ensure that it has sufficient  funds to cover all future costs without borrowing, especially in  catastrophic loss years. While the NFIP Community Rating System (CRS),  a program that uses insurance premium discounts to incentivize flood  damage mitigation activities by participating communities, could be  adapted for combined federal flood and wind insurance coverage, it would  not be required for the new program to begin operations because  community participation in CRS is voluntary.
subsections: section_title: The WYO Program Could Be Used, but Would Need to Be Expanded
paragraphs: As part of the WYO program, private property-casualty insurers are  responsible for selling and servicing NFIP policies, including performing  the claims adjustment activities to assess the cause and extent of  damages. FEMA is responsible for managing the program, including  establishing and updating NFIP regulations, analyzing data to determine  flood insurance rates, and offering training to insurance agents and  adjusters. In addition, FEMA and its program contractor are responsible  for monitoring and overseeing the quality of the performance of the WYO  insurance companies to ensure that NFIP is administered properly. These  duties under the WYO program would be amplified with the addition of  wind coverage and, according to FEMA officials, would require FEMA to  expand the staffing capacity to include those with wind peril insurance  experience. In addition, FEMA would need to determine whether existing  data systems would be adequate to manage an increased number of  policies and track losses for the new program.
FEMA could face several challenges in expanding the WYO program. First,  program staff would need to determine how to manage and mitigate the  potential conflict of interest for those companies in the WYO program that  could be selling both their own wind coverage and the combined federal  flood and wind coverage. Current WYO arrangements with the NFIP  prevent WYO insurers from offering flood-only coverage of their own  unless it supplements NFIP coverage limits or is part of a larger policy in  which flooding is one of the several perils covered. H.R. 3121, however,  does not appear to prevent companies that might sell a combined federal  flood and wind policy from also selling wind coverage, which may be part  of a homeowners policy. Without this restriction, a conflict of interest  could develop because insurers would have an incentive to sell the  combined federal policy to its highest-risk customers and their own  policies to lower-risk customers. FEMA officials agreed that this would be  an inherent conflict and noted that it would be difficult to prevent this  from occurring without precluding the WYO insurers from selling their  wind policies. Moreover, according to a WYO insurer with whom we  spoke, attempting to eliminate the conflict by either restricting a WYO  insurer from selling its own wind coverage or requiring it to sell both  flood-only and the combined policy could discourage participation in the  WYO program. As noted in a previous report, private sector WYO program  managers have said that while NFIP has many positive aspects, working  with it is complex for policyholders, agents, and adjusters. According to  another WYO insurer we spoke with, adding wind coverage could increase  these complexities.
section_title: NFIP’s Direct Service Program Could Also Be Used, but Would Need to Be Expanded
paragraphs: FEMA officials told us that the agency could also sell and service the  combined flood and wind insurance policies through its Direct Service  program, which is designed for agents who do not have agreements or  contracts with insurance companies that are part of the WYO program.  According to FEMA officials, the Direct Service program of NFIP currently  writes about 3 percent of the more than 5.5 million NFIP policies sold.  Further, as with the WYO program, FEMA may have to contend with an  inherent conflict of interest, and expand staffing capacity including adding  staff with wind peril insurance expertise in the Direct Service program to  administer, monitor, and oversee the sale of the new product.
section_title: The CRS Program, while Not Necessary to Initiate the Program, Would Also Need to Be Expanded
paragraphs: H.R. 3121 calls for FEMA to establish comprehensive criteria designed to  encourage communities to participate in wind mitigation activities. As  previously noted, the CRS program would be an important means of  incentivizing wind mitigation activities in communities, but would not be  necessary for the combined federal flood and wind insurance program to  operate. According to FEMA, while the CRS process could be adapted for  wind coverage, the agency would have to assess current practices,  evaluate standards, and devise an appropriate rating system; a  developmental process similar to what occurred for the NFIP. FEMA  officials told us that it took approximately 5 years to develop the program,  during which time extensive evaluation, research, and concept testing  occurred. They estimate that replicating a similar approach for wind  hazard would require at least the same number of years if not more,  recognizing the complexities of current insurance industry experience  associated with the wind peril and the complexities involved with  evaluating current building code practices related to wind and other wind  mitigation techniques.
section_title: NFIP Would Need to Establish a New Rate- Setting Structure for Combined Flood and Wind Premiums
paragraphs: Establishing a new rate-setting structure for a combined federal flood and  wind insurance program could pose another challenge for FEMA.  According to several insurers and modeling consultants, wind modeling is  the accepted method of determining wind-related premium rates, and  FEMA does not have the necessary in-house wind modeling and actuarial  expertise needed to develop and interpret wind models and translate the  model’s output into premium rates. They told us that modeling has  several advantages in rate setting over methods that place greater  emphasis on loss data from past catastrophic events, such as the method  used by NFIP to determine flood insurance premium rates. For example,  modeling uses wind speed maps and other data to account for the  probability that properties in a certain geographic area might experience  losses in the future, regardless of whether those properties have  experienced losses in the past. In addition, according to a modeling  expert, wind modeling incorporates mitigation efforts at the property level  because it can estimate the potential reductions in damage without waiting  to see how the efforts actually affect losses during a storm or other event.  While several modeling companies that are already providing wind  modeling to private sector insurers and state wind insurance programs  exist, it is not clear how much such services would cost FEMA. And while  FEMA officials told us that the agency would have to contract out for  wind-modeling services because it lacks the necessary wind and actuarial  expertise, the agency could benefit from at least some in-house expertise  in these areas in order to oversee the contractors that will provide these  services.
FEMA would also need to determine to what extent it might need to use  wind speed maps in its rate determination process. Flood maps are  currently used in the NFIP to identify areas that are at risk of flooding and  thus the areas where property owners would benefit from purchasing  flood insurance. If FEMA determined that wind maps were necessary, it  would then need to determine whether the agency could develop such  maps on its own or whether contracting with wind-modeling experts  would be required, and what the cost of these efforts might be.
section_title: FEMA Would Need to Promote Participation in a Combined Federal Flood and Wind Insurance Program and Coordinate Enforcement
paragraphs: Implementing the combined program would require FEMA to promote  participation among communities and coordinate enforcement, a task that  could be challenging for FEMA for two reasons. First, FEMA would need  to manage community and state eligibility to participate in the program.  The proposal calls for FEMA to work closely with and provide any  necessary technical assistance to state, interstate, and local governmental  agencies, to encourage the adoption of windstorm damage mitigation  measures by local communities and ensure proper enforcement. While  communities themselves are responsible for enforcing windstorm  mitigation measures, FEMA officials told us they would have to coordinate  with existing code groups to provide technical assistance training and  guidance to local officials, and establish a wind mitigation code  enforcement compliance program that would monitor, track, and verify  community compliance with wind mitigation codes. According to an  official at an organization representing flood hazard specialists, some  communities are very good at ensuring compliance, while others are not.  For example, in some larger communities, a city or county may have  experts with vast experience in enforcing building codes and land use  standards, but in other communities, a local clerk or city manager with  little or no experience may be responsible for compliance. According to  FEMA, the effectiveness of mitigation measures is entirely dependent on  enforcement at the local level. Proper enforcement would require that  resources were in place to pay for and train qualified inspectors and  building department staff.
Second, FEMA would need to generate public awareness on the  availability of wind insurance through the NFIP. Efforts to adopt new  mitigation activities and strategies have been constrained by the general  public’s lack of awareness and understanding about the risk from natural  hazards. To address this issue in NFIP, FEMA launched an integrated mass  marketing campaign called FloodSmart to educate the public about the  risks of flooding and to encourage the purchase of flood insurance. As we  have noted in a previous report, according to FEMA officials, in a little  more than 2 years since the contract began, in October 2003, net policy  growth was a little more than 7 percent and policy retention improved  from 88 percent to 91 percent. Educating the public on a new combined  federal flood and wind insurance program and promoting community  participation could demand a similar level of effort by FEMA to encourage  participation.
section_title: Expanding FEMA to Implement a Combined Federal Flood and Wind Insurance Program Could Add to Existing NFIP Management Challenges
paragraphs: Implementing a combined flood and wind insurance program and  overseeing the requisite contractor-supported services could place  additional strain on FEMA, which is already faced with NFIP management  and oversight challenges and a $17.3 billion deficit that it is unlikely to be  able to repay. In March 2006, we placed the NFIP on our high-risk list  because of its fiscal and management challenges. In addition to the  agency’s current debt owed to the Treasury, FEMA is challenged with  providing effective oversight of contractors. For example, as previously  reported, FEMA faces challenges in providing effective oversight of the  insurance companies and thousands of insurance agents and claims  adjusters that are primarily responsible for the day-to-day process of  selling and servicing flood insurance policies through the WYO program.  In FEMA’s claims adjustment oversight, the agency cannot be certain of  the quality of NFIP claims adjustments that allocate damage to flooding in  cases involving damage caused by a combination of wind and flooding.   Expanding the WYO program to include combined flood and wind policies  could increase the NFIP’s oversight responsibilities as well as make  resolving existing management challenges more difficult. In addition,  FEMA faces ongoing challenges in working with contractors and state and  local partners—all with varying technical capabilities and resources—in  its map modernization efforts, which are designed to produce accurate  digital flood maps. Ensuring that map standards are consistently applied  across communities once the maps are created will also be a challenge. To  the extent that FEMA uses wind speed maps under the combined program,  the agency could face challenges similar to those currently faced by the  NFIP’s flood-mapping program.
New management challenges created by implementing a combined federal  flood and wind program could make addressing these existing challenges  even more difficult. According to FEMA officials, implementing a new  flood and wind program is a process that would likely take several years  and would require a doubling of current staff levels. Determining  appropriate wind mitigation measures, adapting existing WYO and Direct  Service processes for wind coverage, establishing a new rate-setting  process, promoting community participation, and overseeing the  combined program would all require additional staff and contractor  services with the appropriate wind expertise. While the total cost of  adding staff and hiring contractors with wind expertise is not clear,  FEMA’s 2007 budget for NFIP salaries and expenses was about $38.2  million.
section_title: FEMA Would Need to Set Premium Rates for the Flood and Wind Program Adequate to Cover All Future and Catastrophic Losses without Borrowing
paragraphs: Setting premium rates that would adequately reflect all expected costs  without borrowing from the Treasury would require FEMA to make a  number of sophisticated determinations. To begin with, FEMA would need  to determine what those future costs are likely to be, a process that can be  particularly difficult with respect to catastrophic losses. Once FEMA has  determined the expected future costs of the program, it would need to  determine premium rates adequate to cover those costs, a challenging  process in itself for several reasons. First, the rate would need to be  sufficient to pay claims in years with catastrophic losses without  borrowing funds from the Treasury. This determination could be  particularly difficult because it is unclear whether the program might be  able to purchase reinsurance, and because attempting to build up a  sufficient surplus to pay for catastrophic losses would require high  premium rates compared to the size of expected claims and an unknown  number of years without larger than average losses, over which FEMA has  no control. Second, rate setting would have to account for two factors:  adverse selection, or the likelihood that the program would insure only the  highest-risk properties, and potentially limited participation because of  comparatively low coverage limits. Both of these factors would necessitate  higher premium rates, which could make rate setting very difficult. Finally,  although no distinction between flood and wind damage would be  necessary for property owners to receive payment on claims, such a  distinction would still be necessary for rate-setting purposes.
subsections: section_title: FEMA Would Need to Determine the Losses the Program Would Be Required to Pay, Including Losses from Catastrophic Events
paragraphs: The proposed flood and wind program would be required, by statute, to  charge premium rates that were actuarially sound—that is, that were  adequate to pay all future costs. As a result, in setting rates FEMA would  need to determine how much the program would be required to pay,  including in years with catastrophic losses, and use this amount in setting  rates, as is done by private sector insurers. H.R. 3121 does not specify how  a federal flood and wind program would pay for catastrophic losses  beyond charging an adequate premium rate. According to insurers and  industry consultants we spoke with, making such determinations can be  difficult and involve balancing the ability to pay extreme losses with the  ability to sell policies at prices people will pay. For example, insurers  could charge rates that would allow them to pay claims on the type of  event they would expect to occur only very rarely, but the resulting rates  could be prohibitively expensive. On the other hand, charging premium  rates that would enable an insurer to pay losses on events of limited  severity could allow them to sell policies at a lower price, but could also  result in insufficient funds to pay losses if a larger loss were to occur.  Insurers can come to different conclusions over the appropriate level of  catastrophic losses on which to base their premium rates. For example,  one state regulator said that some private sector insurers in his state used  an event he believes has about a 0.4 percent chance of occurring in a given  year, but that the state wind insurance program based its rates on events  he believes have about a 1 percent chance of occurring. For comparison,  one consultant we spoke with believed that an event of the severity of  Hurricane Katrina had about a 7 percent chance of occurring in a given  year.
Determining the losses the program might be required to pay, especially in  the event of a catastrophic event, could be especially important for FEMA.  This is because if an event occurs that generates losses beyond an amount  the program is prepared to pay, the program would be forced to borrow  funds to pay those losses, triggering a borrowing restriction that would  force it to stop renewing or selling new policies, effectively ending the  program. On the other hand, premium rates high enough to pay losses  resulting from the most severe catastrophic events might make the  program prohibitively expensive for property owners.
Determining expected losses for the first year of the program would be  complicated by the fact that FEMA would not know what type of  properties would be insured. Private sector insurers set their premium  rates using models that take into account several variables, including the  number of properties to be insured, the risks associated with the  properties’ location, and the characteristics of the properties themselves.
This information is used in the wind-modeling process to create a variety  of scenarios that result in losses of differing severity that can then be used  to create possible premium rates. Existing insurers have established  portfolios of polices and can use data from these portfolios in the  modeling process. A new combined federal flood and wind insurance  program, according to wind-modeling companies we spoke with, would  need to develop a hypothetical portfolio, making assumptions about how  many policies it might sell and where, as well as the characteristics of the  properties that might be insured. Such assumptions can be challenging  because the number and type of properties insured will, in turn, be  affected by the price of coverage.
section_title: FEMA Would Need to Determine a Premium Rate That Is Adequate to Pay for Expected Losses without Borrowing
paragraphs: Once FEMA determines the severity of catastrophic losses a federal  program would be required to pay, the agency would need to determine a  premium rate that is adequate to pay such losses. This determination could  be particularly difficult with regard to paying catastrophic losses— something that could occur in any year given the volatility of wind and  flood losses—because of the borrowing restriction in H.R. 3121. Because it  would be difficult, if not impossible, to repay any borrowed funds without  the premium income from new or existing policies, this restriction, if  invoked, could end the program. This would effectively require the  program to charge premium rates sufficient to pay catastrophic losses  without borrowing.
Private sector insurers generally ensure their ability to pay catastrophic  losses by purchasing reinsurance, and include the cost of this coverage in  the premium rate they charge. However, reinsurance may not be an option  for FEMA. Some reinsurance industry officials we spoke with said that the  potential for the program to insure a large number of only high-risk  properties could create a risk of high losses that could make reinsurers  reluctant to offer coverage. Another option would be to charge a premium  rate high enough to build up a surplus adequate to pay for catastrophic  losses. However, such a rate would likely be high, and it would require an  unknown number of years of operations with lower than average losses to  build up a sufficient surplus, over which FEMA has no control. For  example, a loss that exceeds the program’s surplus could occur in the  early years, or even the first year, of the program’s operations, potentially  forcing the program to borrow funds to pay losses and effectively ending  the program.
subsections: section_title: FEMA Would Need to Account for Likely Adverse Selection and Limited Participation
paragraphs: In determining a premium rate for a federal flood and wind program that  was adequate to pay all future costs, FEMA would also need to take into  account the adverse selection—the tendency to insure primarily the  highest risks—and limited participation the program would likely  experience. These factors can make rate setting difficult because they can  both lead to increased premium rates, which can, in turn, lead to further  adverse selection, limited participation, and the need for additional rate  increases.
section_title: A Federal Flood and Wind Program Is Likely to Insure Primarily High-Risk Properties
paragraphs: For several reasons, a federal flood and wind program would probably  insure mostly high-risk properties. First, a policy that combines flood and  wind insurance would likely be of interest only to property owners who  perceived themselves to be at significant risk of both flood and wind  damage. Because consumers tend to underestimate their risk of  catastrophic loss, those property owners who saw the need for a  combined flood and wind policy would likely be those who knew they  faced a high risk of loss. In addition, because the policy would include  coverage for damage from flooding, those buying it would probably  already have flood insurance, which is currently purchased almost  exclusively in high-risk areas where lenders require it.  As shown in figure  1, areas where there have been multiple floods as well as hurricanes and  where consumers are most likely to see a need for both flood and wind  coverage are primarily limited to the eastern and Gulf coasts.
Second, a combined federal flood and wind insurance policy is likely to be of  interest only in areas where state insurance regulators have allowed insurers  to exclude coverage for wind damage from homeowners policies that they  sell. According to several insurance industry officials we spoke with, in order  to help protect consumers, state insurance regulators generally prohibit  insurers from excluding wind damage from homeowners policies. According  to insurers we spoke with, insurers can profitably write homeowners policies  that include wind coverage in most areas. Only in the coastal areas that are at  the highest risk of hurricane damage have insurers asked for and received  permission from state regulators to sell homeowners policies that exclude  wind coverage. Property owners who already have wind coverage through  their homeowners policies—generally those living in areas outside the  highest-risk coastal areas—would generally not be interested in a combined  federal flood and wind insurance policy because they would already have  wind coverage. Once again then, only property owners in high-risk coastal  areas would be the most interested in purchasing a federal policy. A federal  flood and wind insurance program would find itself in the same situation as  state wind insurance programs that generally sell wind coverage only in areas  where insurers are allowed to exclude it from homeowners policies.  According to officials from the state wind programs we spoke with, their  programs generally insure only the highest-risk properties.
section_title: Participation in a Combined Federal Flood and Wind Program Is Likely to Be Limited
paragraphs: For several reasons, participation in a federal flood and wind program  would probably be limited. First, a federal flood and wind insurance policy  would likely cost more than purchasing a combination of flood insurance  through the NFIP and wind insurance through a state wind insurance  program, potentially limiting participation in the program. With respect to  coverage for damages from flooding, while an estimated 24 percent of  NFIP policyholders receive subsidized premium rates—with average  subsidies of up to 60 percent—H.R. 3121 would require the new program  to charge rates adequate to cover all future costs, potentially precluding  any subsidies. As a result, the flood-related portion of a federal flood and  wind policy would cost more than an NFIP flood policy for any property  owners currently receiving subsidized NFIP flood rates. With respect to  the wind portion of the coverage, a number of state wind insurance  programs typically do not charge rates that are adequate to cover all costs,  so a policy from a federal program that did charge adequate rates would  likely cost more than a state wind program policy. Property owners who  are receiving subsidized NFIP rates and relatively low state wind  insurance rates are unlikely to be willing to move to a new program that  would be more expensive.
Second, a federal flood and wind policy would have lower coverage limits  than the flood and wind coverage currently available in high-risk coastal  areas, further limiting participation. Currently, property owners in coastal  areas subject to both flood and wind damage can purchase flood insurance  through the NFIP and, in some areas, wind insurance through a state wind  insurance program. Table 1 compares the policy limits for a federal flood  and wind policy, as proposed in H.R. 3121, with a combination of policy  limits from state wind insurance program and NFIP policies. While the  federal flood and wind policy would cover a maximum of $650,000 in  damage for a residential property, a combination of NFIP and state wind  program policies would provide on average, around $1.7 million in  coverage, or about 166 percent more coverage, depending on the state. For  commercial properties, the federal flood and wind policy would offer up to  $1.75 million in coverage, but combined NFIP and state wind program  policies would offer, on average, almost $4 million or 126 percent more  coverage.
Table 1. Comparison of Combination of State Wind Program and H.R. 3121 Flood Insurance Policy and State Wind Policy  Limits with H.R. 3121 Flood and Wind Policy Limits  (C) (B)
Combined NFIP  flood and state  wind program  (D) (A-B) (C-D)
section_title: Adverse Selection and Limited Participation Could Lead to Escalating Premium Rates, Making Rate Setting Difficult
paragraphs: Adverse selection and limited participation could, in turn, force FEMA to  raise rates still higher for the projected program, leading to escalating  premiums. This possibility further complicates the rate-setting process. In  general, having only a small pool of very high-risk insureds requires  insurers to charge premium rates at levels above what could be charged if  the risk were spread among a larger pool of insureds of varying risk levels.  As we have discussed, high premium rates can, in turn, further reduce the  number of property owners who are able and willing to pay for coverage  and force insurers to raise rates yet higher. This cycle, referred to as an  adverse selection spiral, can make it very difficult for insurers to find a  premium rate that is adequate to cover losses.
section_title: A Distinction between Flood and Wind Damage Would Still Be Necessary for Determining Premium Rates
paragraphs: Finally, although H.R. 3121 stipulates that a distinction between flood and  wind damage would not be required for a policyholder’s claim to be paid  by a federal flood and wind program, a determination of the cause of  damage would likely still be necessary for rate-setting purposes.  According to several insurance industry officials we spoke with, separate  determinations would be required because data on the losses associated  with each type of damage are used to help determine future rates. For  example, data on wind losses would be used to validate the losses  predicted by wind models. While the officials said that such  determinations would not need to be as accurate as when the distinction  between flood and wind damage would determine under which policy a  claim was covered, they would still need to be made. As a result, FEMA  would need to determine whether and how such a determination might be  made by FEMA staff, or if it would need to establish another process for  doing so.
section_title: A Federal Flood and Wind Insurance Program Could Benefit Some but Would Involve Trade- offs
paragraphs: While a combined federal flood and wind program would entail costs, it  could benefit some property owners and market participants. First,  property owners could benefit from reduced delays in payments and  assured coverage in high-risk areas. In addition, taxpayers in some states  could benefit to the extent that the exposure to loss of state wind  insurance programs is reduced. At the same time, these benefits could be  limited by a borrowing restriction that could terminate the program after a  catastrophic event, and comparatively low coverage limits could leave  some property owners underinsured. Third, private sector insurers could  also benefit if high-risk properties moved to a federal program, reducing  the companies’ risk of loss. But this shift would further limit private sector  participation. Finally, while H.R. 3121 would require premium rates that  were adequate to cover all future costs, actual losses can significantly  exceed even the most carefully calculated loss estimates, as we learned  from the 2005 hurricanes, potentially leaving the federal government with  exposure to new and significant losses.
subsections: section_title: Program Could Expose the Federal Government to an Increased Risk of Loss
paragraphs: Although a combined flood and wind program could provide benefits to  some property owners, states, and insurers, it could expose the federal  government to an increased exposure to loss. While the actual exposure  that a federal flood and wind program might create is unclear, the  likelihood for the program to insure primarily high-risk properties could  create a large exposure to loss. As of 2007, wind programs in eight coastal  states—programs that insure primarily high-risk coastal properties—had a  total loss exposure of nearly $600 billion . While it is unclear how much of  this exposure would be assumed by the federal program, a risk  management consulting firm developed another estimate of potential  wind-related losses that took into account the federal program’s likely  adverse selection.  Assuming that the program experienced just a  moderate amount of adverse selection, and that the program would write  coverage for around 20 percent of the current market for wind coverage,  the firm used wind modeling technology to estimate the potential wind- related losses. The estimates ranged from around $6.5 billion in losses for  the type of catastrophe that has a 10 percent chance of occurring each  year, $11.4 billion for one that has a 5 percent chance of occurring each  year, to around $32.7 billion for the type that has a 1 percent chance of  occurring each year. The same firm that did the modeling for this estimate  considered Hurricane Katrina to be the type of event that has a 6.6 percent  chance of occurring in any year. For purposes of comparison, NFIP flood  losses from Hurricane Katrina alone totaled around $16 billion, and  according to the Insurance Services Office, losses paid by private sector  insurers—most of which were wind-related—totaled around $41 billion.
The potential exposure to the federal government, however, could be  reduced by several factors. First, the program could encourage mitigation  efforts that would reduce damage from wind. As noted earlier in this  report, H.R. 3121 would require communities to adopt mitigation  standards approved by the Director of FEMA and consistent with  International Code Council building codes related to wind mitigation. In  addition, H.R. 3121 would require the Director of FEMA to carry out  studies and investigations to determine appropriate wind hazard  prevention measures. Further, according to FEMA, the CRS structure  could be applied to a federal flood and wind program, reducing premium  rates for communities and property owners that implemented wind  mitigation measures. Such measures could reduce losses due to wind  damage and thus the federal government’s exposure to loss. Second, the  federal government’s exposure is potentially limited to the amount FEMA  is authorized to borrow from the Treasury, which was raised to $20.8  billion in March of 2006. However, if losses were to exceed this limit,  Congress would be faced with raising the amount FEMA could borrow,  thereby increasing the government’s exposure or failing to pay  policyholders up to the full amounts specified in their policies.
While H.R. 3121 would require a federal flood and wind program to charge  premium rates that were adequate to pay all future losses in order not to  create additional liability for the federal government, as we have seen,  estimating future losses is difficult, and losses can exceed expectations.  For example, losses from Hurricane Katrina and other hurricanes were  beyond what NFIP could pay with the premiums it had collected. NFIP  reported unexpended cash of approximately $1 billion following fiscal  year 2004, but as of May 2007 the program had suffered almost $16 billion  in losses from Hurricane Katrina. In addition, officials from several wind- modeling companies told us that the severity of Hurricane Katrina was  well beyond their previous expectations, and rates that they had believed  were actuarially sound turned out to be inadequate. As a result, they have  had to revise their models accordingly. If losses for a combined flood and  wind program did exceed the premiums collected by the program, FEMA  could be forced to borrow from the Treasury to pay those losses. As of  December 2007, FEMA still owed approximately $17.3 billion to the  Treasury, an amount it is unlikely able to repay. In addition, the  requirement in H.R. 3121 to stop renewing or selling new polices until such  losses are repaid could actually increase the cost to the federal  government. This is because the program’s source of revenue, which it  could use to pay back the borrowed funds, would be limited to premiums  paid by those whose policies had not yet come up for renewal. And once  those policies expired, the program would receive no premium income. It  is not clear how any debt remaining outstanding at that time would be  paid, and the costs could fall to the federal government and, ultimately,  taxpayers.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft from FEMA and NAIC. FEMA provided  written comments that are reprinted in appendix II. NAIC orally  commented that they generally agreed with our report findings. FEMA also  generally agreed with our findings and emphasized the challenges it would  face in addressing several key issues. Finally, FEMA provided technical  comments, which we incorporated as appropriate.
In their comments, FEMA officials stressed their concerns over the effect  that the program’s proposed borrowing restriction would have on their  ability to set adequate premium rates.  Specifically, they said that  It would be nearly impossible to set premium rates high enough to  eliminate the possibility of borrowing to pay catastrophic losses.
Purchasing enough reinsurance to pay all catastrophic losses  without borrowing, even if it were possible, would require  premium rates so high as to be unaffordable.
The high variability of combined flood and wind coverage means  that there is always the possibility of catastrophic losses in any  given year regardless of how premiums are designed.
In addition, FEMA officials said that the termination of the program due to  the borrowing restriction would create other difficulties.   They said that  not only could it leave property owners without coverage, but it could also  prevent the program from repaying any borrowed funds.
As stated in our report, the proposed borrowing restrictions would make  rate setting a difficult and challenging process, and could result in high  premium rates.  In addition, we stated that termination of the program due  to the borrowing restriction could potentially leave some property owners  uninsured following a catastrophic event and limit FEMA’s ability to repay  any borrowed funds.  Finally, we acknowledged that the high variability of  flood and wind losses would make setting rates adequate to pay losses  without borrowing even more challenging, and we clarified language in the  report that the risk of catastrophic losses could occur in any year  regardless of how premiums are designed.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Ranking Member of  the Committee on Financial Services, House of Representatives; the  Chairman and Ranking Member of the Committee on Banking, Housing,  and Urban Affairs, U.S. Senate; the Chairman and Ranking Member of the  Committee on Homeland Security and Governmental Affairs, U.S. Senate;  the Chairman and Ranking Member of the Committee on Homeland  Security, House of Representatives; the Secretary of Homeland Security;  the Executive Vice-President of NAIC; and other interested committees  and parties. We will also make copies available to others on request. In  addition, the report will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions about 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 III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objective was to examine the proposed federal flood and wind  insurance program put forth in H.R. 3121, the Flood Insurance Reform and  Modernization Act of 2007, in terms of (1) the program’s potential effects  on policyholders, insurance market participants, and the federal  government; (2) what would be required for Federal Emergency  Management Agency (FEMA) to determine and charge actuarially sound  premium rates; and (3) the steps FEMA would have to take to implement  the program.
To evaluate the program’s potential effects on policyholders, insurance  market participants, and the federal government, we interviewed officials  from the FEMA, the National Flood Insurance Program (NFIP), state  insurance regulators, the National Association of Insurance  Commissioners (NAIC), state wind insurance program operators, primary  insurers, reinsurers,  insurance and reinsurance associations, insurance agent associations, risk- modeling organizations, actuarial consultants, the American Academy of  Actuaries (AAA), the Association of State Flood Plain Managers (ASFPM),  the National Flood Determination Association (NFDA), and others. We  also obtained information on state-sponsored wind insurance programs in  three coastal states and one inland state, and discussed them with  program officials as well as the insurance regulators within those states.  We compared selected wind insurance program policies in force and  exposure data from 2004 to the most recent available in eight states:  Alabama, Florida, Georgia, Louisiana, Mississippi, North Carolina, South  Carolina, and Texas. We also collected and analyzed state wind program  data from these eight states and provisions of H.R. 3121 to compare the  combination of state wind program and H.R. 3121’s flood insurance policy  limits with H.R. 3121’s flood and wind policy limits. To develop our natural  hazard risk maps, we used data from FEMA and the National Oceanic and  Atmospheric Administration (NOAA). We used historical hazard data from  1980 to 2005 as a representation of current hazard risk for flood,  hurricanes, and tornadoes. Finally, to evaluate the federal government’s  exposure, we reviewed an estimate of potential wind-related losses for a  federal program from an actuarial consulting firm.
To examine the challenges FEMA would likely face in determining and  charging a premium rate that would cover all expected costs, we spoke  with FEMA/NFIP officials, state insurance regulators, NAIC, state wind  insurance program operators, primary insurers, reinsurers, insurance and  reinsurance associations, insurance agent associations, risk-modeling  organizations, actuarial consultants, AAA, ASFPM, NFDA, and others. We  also reviewed our previous reports and testimonies, Congressional Budget  Office (CBO) reviews, and academic and other studies of coastal wind  insurance issues. In addition, we reviewed information provided by  professional associations, such as the American Insurance Association,  and congressional testimony by knowledgeable individuals from the  insurance industry, ASFPM, and NFDA.
To examine the challenges FEMA would face in developing and  implementing a federal flood and wind insurance program, we discussed  the issue with FEMA/NFIP officials, state insurance regulators, NAIC, state  wind insurance program operators, primary insurers, reinsurers, insurance  and reinsurance associations, insurance agent associations, risk-modeling  organizations, actuarial consultants, AAA, ASFPM, NFDA, and others. We  also reviewed our previous reports on FEMA’s management and oversight  of NFIP. In addition, we reviewed congressional testimony by  knowledgeable individuals from the insurance industry, ASFPM, and  NFDA.
We conducted our work in Washington, D.C., and via telephone from  October 2006 to April 2007 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 obtained provides a reasonable  basis for our findings and conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Federal Emergency Management Agency
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
paragraphs: Orice M. Williams, (202) 512-8678 or williamso@gao.gov.
section_title: Staff Acknowledgments
paragraphs: In addition to the person named above, Lawrence D. Cluff, Assistant  Director; Farah B. Angersola; Joseph A. Applebaum; Tania L. Calhoun;  Emily R. Chalmers; William R. Chatlos; Thomas J. McCool; Marc W. Molino;  and Patrick A. Ward made key contributions to this report.