National Flood Insurance Program: FEMA's Management and Oversight of Payments for Insurance Company Services Should Be Improved
Published: 2007-09-05T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Extraordinary recent flood events raise serious questions about the solvency of the National Flood Insurance Program (NFIP), which is administered by the Federal Emergency Management Agency (FEMA). The NFIP is largely implemented by private insurance companies that sell and service policies and adjust claims under the Write Your Own (WYO) Program. This report, prepared under the authority of the Comptroller General, examines (1) how much FEMA paid the WYO companies in recent years for operating costs and how FEMA determined payment amounts; (2) how FEMA's approach to determining operating costs assures that payments are reasonable estimates of companies' expenses; and (3) how FEMA assures that financial and management controls are in place for the WYO program and operate as intended. To do these assessments, GAO interviewed FEMA and insurance officials, and analyzed statutes, regulations, payment data, methodologies, and audits of WYO companies.
section_title: What GAO Found
paragraphs: FEMA's payments to WYO insurance companies for operating costs ranged from more than a third to almost two-thirds of the total premiums paid by policyholders to the NFIP for fiscal years 2004 through 2006. In fiscal years 2005 and 2006, larger payments to WYO insurance companies were the result of settling an unprecedented number and dollar amount of claims for damages resulting from major hurricanes and flood events including Hurricane Katrina. To determine the amount of these payments, FEMA negotiated payment approaches with insurance industry representatives when it established the current WYO program in 1983 based on industry averages for operating expenses for other lines of insurance (such as homeowners, commercial, and fire), past practice, and discussion. The approach FEMA uses to determine operating costs for WYO insurance companies, rooted in policies negotiated and established about 25 years ago, cannot ensure that payments are based on reasonable estimates of actual expenses because actual expenses incurred by the companies for their services to the NFIP are not considered. Although it has authority to do so, FEMA does not collect data on actual WYO flood insurance expenses that could provide a basis for insuring that the WYO payments are based on a reasonable estimate of actual expenses. FEMA officials said that they have not asked WYO insurance companies to provide expense information due to concerns that the approach would increase FEMA's administrative costs and cause a decline in WYO program participation. However, some data on expenses WYO insurance companies allocate to flood insurance are available. FEMA officials said that they cannot use this information due to reporting inconsistencies. Also, there is some precedent in two similar public-private insurance partnerships for collecting actual expense information. FEMA's decision to rely on long-standing practices does not meet federal internal control standards that agencies be held accountable for, among other things, stewardship of government resources. Biennial financial statement audits--FEMA's primary mechanism to provide assurance that it receives complete and accurate financial management information from the WYO insurance companies--were not performed consistently as required by regulation. FEMA regulations require each participating company to arrange and pay for these audits by independent certified public accounting firms. However, many WYO insurance companies did not comply with the schedule in recent years. For example, for fiscal years 2005 and 2006, 5 of 94 participating companies had biennial financial statement audits performed. FEMA officials said they allowed some companies to delay having the audits done because they were in the process of contracting with new subcontractors to perform their financial reporting responsibilities. Nonetheless, without the required biennial audits, FEMA lacks an appropriate internal control mechanism for effective program oversight.

section_title: Letter
paragraphs: The Federal Emergency Management Agency (FEMA), a component of the  Department of Homeland Security (DHS), provides insurance protection  against flood damage to homeowners, businesses, and others, and  assumes the risk for insured flood losses, through the National Flood  Insurance Program (NFIP). The NFIP is largely implemented by private  insurance companies that participate in FEMA’s Write Your Own (WYO)  program. Through the WYO program, insurance companies enter into  agreements with FEMA to sell and service flood insurance policies and  adjust claims after flood losses. As of December 2006, 88 insurance  companies were participating in the WYO program.
While the NFIP, by design, is not actuarially sound because Congress  authorized subsidized insurance rates for some policyholders, the program  was largely successful until recent years in paying its expenses with  premium revenues—the funds paid by policyholders for their annual flood  insurance coverage. As a result, since its inception in 1968, in most years  the NFIP paid for flood losses and operating expenses with policy  premium revenues, rather than tax dollars. However, because the  program’s premium rates have been set to cover losses in an average year  based on program experience that did not include any catastrophic losses,  the program has been unable to build sufficient reserves to meet future  expected flood losses. The series of extraordinary flood events in recent  years—including Hurricane Katrina in August 2005, which inflicted  extensive damage on the Gulf Coast—has raised serious questions about  the financial solvency of the NFIP and highlighted this known program  limitation. Collecting premiums that are based on an average historical  loss year does not enable the NFIP to build sufficient reserves to cover  losses that exceed the historic averages. As of April 2007, FEMA had paid  almost $16 billion in claims for flood damage as a result of Hurricane  Katrina, more than the $14.6 billion it had paid for the cumulative total of  all flood events from 1968 until Hurricane Katrina occurred. After Katrina,  FEMA was unable to cover all of the claims received for flood losses and  had to increase its borrowing authority from the U.S. Treasury from   $1.5 billion to more than $20 billion. In March 2006, we designated the  NFIP as a high-risk program, and Congress has been considering a  number of legislative changes to improve the program’s financial solvency.
Compounding the dramatic increase in the amount paid on flood  insurance claims have been increases in the amounts of money FEMA has  been required to pay for services to WYO insurance companies. This  report, prepared under the authority of the Comptroller General in order  to contribute to the discussion about ways to improve the NFIP’s financial  solvency, addresses the following questions: (1) In recent years, how much  in operating costs did FEMA pay to the WYO insurance companies that sell  and service NFIP policies and adjust claims and how does FEMA  determine the amount of these operating costs? (2) How does FEMA  provide assurance that the approach it uses to determine operating costs  is based on reasonable estimates of WYO insurance companies’ expenses?  and (3) How does FEMA provide assurance that financial and  management controls in place for the WYO program operate as intended  and in accordance with program requirements?
This is one of several reports and testimonies we have completed or have  under way related to the administration and management of the NFIP  since the unprecedented losses from Hurricane Katrina and other major  flood events in 2004 and 2005 illustrated the extent of the federal  government’s exposure to losses in catastrophic flood years. Related work  we recently completed addressed issues including the NFIP’s financing,  oversight and management, implementation of the program in the  aftermath of Hurricanes Katrina and Rita, the inventory of insured  properties that suffer repetitive flood losses, and the status of efforts to  revise and improve the nation’s flood maps. (See the list of related GAO  products on page 52 of this report.) In addition, we have reviews under  way assessing how insurance companies manage losses that may be  covered by both wind and flood insurance, the impact of subsidized  properties on the NFIP, and additional aspects of FEMA’s financial  oversight of WYO insurance companies.
To assess how much FEMA paid to WYO insurance companies in recent  years for operating costs and how FEMA determines the amount of these  operating costs, we interviewed FEMA officials, examined documentation  such as FEMA’s financial subsidy arrangement with the WYO insurance  companies, and analyzed FEMA data on amounts paid to WYO insurance  companies for fiscal years 2004-2006. We examined internal controls  FEMA had in place to ensure the reliability of the data. We determined  that the information was sufficiently reliable for our purposes by  discussing with officials the internal control processes in place, observing  the monthly process used by FEMA’s program contractor to reconcile cost  information submitted by WYO insurance companies, and reviewing audits  of DHS financial statements. We conducted semi-structured interviews  with representatives of a judgmental sample of five WYO insurance  companies and the National Association of Insurance Commissioners  (NAIC) to obtain their perspectives on FEMA’s payment methodologies.  We chose our sample to include representatives of four of the five largest  participating WYO insurance companies in terms of their market share of  NFIP policies in force in 2006 and one mid-sized WYO insurance company.  However, our sample is not a representative sample of all participating  WYO insurance companies, so the views expressed should not be  generalized to the universe of the 88 participating companies.
To determine how FEMA provides assurance that its approach to  determining operating costs for WYO insurance companies results in  reasonable estimates of the companies’ expenses, we reviewed the  statutory and regulatory framework for establishing a schedule of  operating costs and federal internal control standards, and we obtained  the views of FEMA and insurance industry officials on the effectiveness of  the current payment approach and the potential implications of  implementing other payment methodologies. We also assessed how the  approach FEMA currently uses to pay WYO insurance companies for their  services compares to payment methodologies used by two similar public- private insurance arrangements. These are (1) the Federal Crop Insurance  Corporation’s (FCIC) arrangement with private insurers for handling  expenses associated with insuring agricultural crop values; and (2) the  NFIP’s arrangement with its Direct Servicing Agent, a FEMA contractor  that sells and services policies and adjusts claims on about 4 percent of  flood insurance policies that are not, for various reasons, handled through  the WYO program.
To determine the extent to which FEMA’s financial management controls  for WYO companies provide assurance that payments are proper and in  accordance with program requirements, we documented FEMA’s  regulations and procedures for monitoring and overseeing payments of  expenses to WYO insurance companies for selling and servicing NFIP  policies. We analyzed the schedule and results of biennial financial  statement audits conducted for fiscal years 2001 to 2006. We also  interviewed officials of FEMA and its program contractor. In addition, we  reviewed financial audits of the NFIP done by the DHS Office of Inspector  General (OIG) for fiscal years 2003 to 2006. We performed our work from  June 2006 through July 2007, in accordance with generally accepted  government auditing standards. Additional details on our scope and  methodology are in appendix I.
subsections: section_title: Background
subsections: section_title: Overview of the National Flood Insurance Program
paragraphs: Congress established the NFIP in the National Flood Insurance Act of 1968  to provide policyholders with some insurance coverage for flood damage,  as an alternative to disaster assistance, and to try to reduce the escalating  costs of repairing flood damage. FEMA, within DHS, administers the NFIP  and is responsible for its management and oversight. Floods are the most  common and destructive natural disaster in the United States. In fact,  according to NFIP statistics, 90 percent of all natural disasters in the  United States involve flooding. However, flooding is generally excluded  from homeowner policies that typically cover damage from other losses,  such as wind, fire, and theft. Because of the catastrophic nature of  flooding and the inability to adequately predict flood risks, private  insurance companies have largely been unwilling to underwrite and bear  the risk of flood insurance. Under the NFIP, the federal government  assumes the liability for the insurance coverage and sets rates and  coverage limitations, among other responsibilities. In creating the NFIP,  Congress found that a flood insurance program with “large-scale  participation of the Federal Government and carried out to the maximum  extent practicable by the private insurance industry is feasible and can be  initiated.”
As of May 2007, more than 20,300 communities across the United States  and its territories participated 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 for at least the outstanding mortgage amount. Optional,  lower-cost coverage is also available under the NFIP to protect homes in  areas of low to moderate risk. To insure furniture and other personal  property items against flood damage, homeowners may purchase separate  NFIP personal property coverage. Although premium amounts vary  according to the amount of coverage purchased and the location and  characteristics of the property to be insured, the average yearly premium  for a 1-year policy was $475, as of February 2007.
As shown in figure 1, the NFIP has grown from about 1.5 million policies  in 1978 to about 5.4 million policies in April 2007.
To the extent possible, the NFIP is designed to pay operating expenses  and flood insurance claims with premiums collected on flood insurance  policies rather than by tax dollars. FEMA has statutory authority to  borrow funds from the U.S. Treasury to keep the NFIP solvent in years  when losses are heavy. The NFIP, by design, is not actuarially sound  because Congress authorized subsidized insurance rates to be made  available for policies covering certain structures to encourage  communities to join the program and premiums are based on the average  historical loss year; therefore the NFIP does not build sufficient reserves  to cover losses that exceed the historic averages. The subsidized  properties are generally referred to as Pre-FIRM (Flood Insurance Rate  Map) buildings. The legislative history of the National Flood Insurance Act  recognized that insurance for existing buildings constructed before the  NFIP was established would be extremely expensive because many of  them were flood prone and did not comply with NFIP floodplain  management standards that went into effect after they were built.
Until the last several years, FEMA had been generally successful in paying  flood losses and expenses with premium revenue, exercising its borrowing  authority three times in the last decade when claims payments exceeded  available fund balances. In each instance, FEMA repaid the funds with  interest. Prior to Hurricane Katrina in August 2005, FEMA had also made  substantial progress in repaying the borrowing it had undertaken to pay  losses for the 2004 hurricane season during which Hurricanes Charley,  Ivan, Frances, and Jeanne caused heavy flood damage in Florida and other  East Coast and Gulf Coast states. However, because the program’s  premium rates have been set to cover losses in an average year based on  program experience that did not include any catastrophic losses, the  program has been unable to build sufficient reserves to meet future  expected flood losses.
Hurricanes Katrina, Rita, and Wilma, in 2005, had a far-reaching impact on  the financial solvency of the NFIP. Legislation 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 May 2007, FEMA’s outstanding  debt to the Treasury was $17.5 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 a year. Legislation has  been introduced in Congress to increase FEMA’s borrowing authority to  pay interest on the debt and attention has focused on the extent of the  federal government’s exposure for claims payments in future catastrophic  loss years and ways to improve the program’s financial solvency.
Figure 2 shows the magnitude of the loss payments for Hurricane Katrina  and other flood events in 2005 compared to claims payments over other  years.
In prior work, we have reported that FEMA and the WYO insurance  companies settled the unprecedented number of NFIP claims after  Hurricane Katrina reasonably quickly, reporting that over 95 percent of  Gulf Coast claims for damage from Hurricane Katrina followed closely by  Hurricane Rita were settled in May 2006, about 9 months after the storms.
section_title: History and Goals of the WYO Program
paragraphs: Since its inception, the NFIP has relied to a large extent on the private  insurance industry to sell and service policies, as Congress envisioned  when it authorized the program in 1968. From 1969 through 1977, NFIP  was operated under Part A of the National Flood Insurance Act (the Act),  meaning that private insurers assumed a portion of the risk of financial  loss. In order to implement the program, the Department of Housing and  Urban Development, the agency that administered the NFIP at that time,  entered into an agreement with a consortium of private insurers known as  the National Flood Insurers Association. Under this agreement, the  department reimbursed the association for operating costs, and because  the association was a risk-sharing insurer, it received an additional annual  operating allowance equal to 5 percent of policyholder premiums. In 1977,  in part as a result of disagreements on issues of financial control between  the private insurers and the department, the relationship ended.
Since 1978, NFIP has operated under Part B of the Act, meaning that the  federal government bears the entire risk of loss. Because insurance  companies operating under Part B, such as WYO companies, are not risk- sharing insurers, they are paid only for operating costs. The FEMA  director is to establish a current schedule of operating costs by negotiating  with representatives of the insurance industry. Under the Act, operating  costs include four components: (1) expense reimbursements covering the  direct, actual, and necessary expenses incurred in connection with selling  and servicing flood insurance coverage; (2) reasonable compensation  payable for selling and servicing flood insurance coverage, or  commissions or service fees paid to producers; (3) loss adjustment  expenses; and (4) other direct, actual, and necessary expenses that FEMA  finds are incurred in connection with selling or servicing flood insurance  coverage.
In 1983, FEMA, still operating the NFIP under Part B, established the WYO  program to obtain more industry involvement in the NFIP. 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. Over the years, insurance company participation has grown and  the WYO program has assumed a larger share of the total NFIP policies in  force. During the first year of the WYO arrangement, 48 insurance  companies agreed to participate. In 1986, WYO insurance companies  administered about 50 percent of a little over 2 million policies in force. In  February 2007, WYO insurance companies administered about 96 percent  of the about 5.4 million policies in force at that time.
section_title: Roles of WYO Companies and Other Key Participants in the NFIP
paragraphs: A private insurer becomes a WYO company by entering into an agreement  with FEMA known as the Financial Assistance/Subsidy Arrangement.  Under the arrangement, private insurers agree to issue flood policies in  their own name. In addition, the WYO companies adjust flood claims as  well as settle, pay, and defend all claims arising from the flood policies. To  enter into a WYO arrangement with the NFIP, private insurers must meet  FEMA’s established criteria. Factors FEMA considers in determining  whether companies are accepted into the WYO program include their  experience in property and casualty insurance lines, standing with state  insurance departments, and the ability to meet NFIP reporting  requirements to adequately sell and service flood insurance policies.
Each year, FEMA is required to publish in the Federal Register the terms  for participation in the WYO program, including amounts WYO insurance  companies will be paid for expenses. Companies that agree to participate  in the program sign a financial assistance/subsidy arrangement and are to  comply with the provisions of FEMA’s WYO Financial Control Plan, which  outlines WYO insurance companies’ responsibilities for program  operations including underwriting, claims adjustments, cash management,  and financial reporting, as well as FEMA’s responsibilities for management  and oversight.
Selling policies. Insurance agents under contract to one or more WYO  insurance companies are the main point of contact for most policyholders  to purchase an NFIP policy, seek information on coverage, or file a claim.  Based on information the insurance agents submit, the WYO insurance  companies issue policies, collect premiums from policyholders, deduct an  allowance for expenses from the premium, and remit the balance to the  National Flood Insurance Fund. In some 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.
Adjusting claims. Insurance companies work with certified flood  adjusters to settle NFIP claims. When flood losses occur, policyholders  report them to their insurance agent, who notifies the WYO insurance  company. The WYO insurance company assigns a flood adjuster to assess  damages. Flood adjusters may be independent or employed by an  insurance or adjusting company. These adjusters are responsible for  assessing damage, estimating losses, and submitting required reports,  work sheets, and photographs to the WYO insurance company, where the  claim is reviewed and, if approved, processed for payment. WYO insurance  companies are then reimbursed by FEMA from the National Flood  Insurance Fund for the amount of the claims and expenses paid. Claims  amounts may be adjusted after the initial settlement is paid if claimants  submit documentation that some costs were higher than estimated.
FEMA Management and Oversight. About 68 FEMA employees, assisted  by about 170 contractor employees manage and oversee the NFIP and the  National Flood Insurance Fund into which premiums are deposited and  claims and expenses paid. Their management responsibilities include  establishing and updating NFIP regulations, analyzing data to actuarially  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 assure that the NFIP is administered  properly. Figure 3 provides an overview of the WYO companies’ and  others’ participation in the NFIP.
section_title: Payments to WYO Insurance Companies Comprised Up to Almost Two-Thirds of Total Premium Revenue in Recent Years Based on Payment Methodologies Established in 1983
paragraphs: FEMA’s payments to WYO insurance companies for operating costs  ranged from more than a third to almost two-thirds of the total premiums  paid by policyholders to the NFIP for fiscal years 2004 through 2006.  During the 3-year period from fiscal year 2004 through 2006, FEMA’s  payments to WYO insurance companies ranged from $619.2 million to   $1.6 billion in current dollars that were not adjusted for inflation. FEMA  establishes a schedule of operating costs for WYO insurance companies  participating in the NFIP based on industry averages for operating  expenses for other lines of insurance, such as homeowners, commercial  and fire; past practices; and discussions with WYO insurance company  participants and other insurance industry representatives. FEMA  negotiated these payment methodologies with insurance industry  representatives when it established the WYO program in 1983. While  FEMA has periodically adjusted payment amounts since 1983, the  underlying methodologies it uses for determining them have not  significantly changed. FEMA pays WYO companies in two main categories  (1) for selling and servicing insurance policies and (2) adjusting and  processing policyholders’ claims after a flood event occurs. Any portion of  the premium revenues retained by the WYO insurance companies that are  not used to cover expenses may be retained as profit. Because the WYO  insurance companies bear no risk for NFIP losses, the payments they  receive from FEMA are for work incurred in selling and servicing policies  and adjusting claims.
subsections: section_title: Overall Payments to WYO Insurance Companies
paragraphs: As shown in table 1, in the last 3 fiscal years, payments to WYO insurance  companies have consumed from over a third to almost two-thirds of the  total premiums paid by policyholders to the NFIP. In fiscal years 2005 and  2006, payments were larger than for fiscal year 2004 because the WYO  insurance companies received payments in these years for settling the  unprecedented number and amount of claims for damages resulting from  flood events including Hurricanes Charley, Ivan, Frances, and Jeanne in  Florida and other East Coast and Gulf Coast states in 2004 and Hurricanes  Katrina, Rita, Wilma, and other flood events in 2005.
section_title: Selling and Servicing NFIP Policies
paragraphs: WYO insurance companies retain premium revenues for selling and  servicing NFIP policies based on three different calculations: (1) a flat   15 percentage allowance for insurance agent sales commissions; (2) an  average of industry operating expenses for other lines of insurance to  determine the amount for operating expenses associated with processing  and servicing insurance policies, which historically also averages to about  15 percent; and (3) incentive bonuses to WYO companies of up to   2 percent of the premiums generated by selling and servicing flood  insurance policies. Table 2 summarizes the methods FEMA uses to  calculate payments to WYO companies for selling and servicing flood  insurance policies and recent payment amounts.
WYO insurance companies retain a flat fee of 15 percent of premium  revenues for agent commissions. The WYO insurance companies,  however, determine the actual amount of commission they pay to agents.  The amount varies from one WYO insurance company to another and may  be more or less than 15 percent. For example, one WYO insurance  company flood program manager said that agents for his company receive  a commission of 15 percent of the policy amount and may also receive  other incentives during special flood marketing campaigns. Another flood  program manager said that her company’s agents received a commission  that was larger than 15 percent of the policy amount. In the insurance  industry, many independent agents are paid by commission only, whereas  sales workers who are employees of an agency or an insurance carrier  may be paid in one of three ways—salary only, salary plus commission, or  salary plus bonus. In general, commissions are the most common form of  compensation, especially for experienced agents.
The amount of work involved in selling and servicing NFIP policies varies  based on the flood risk of the insured property, according to a  representative of the NAIC. For example, the representative said that NFIP  policy sales for properties located in special flood hazard areas require the  greatest amount of work because of the need to develop information on  the elevation of the property, take photographs, and create other  documentation that is required to determine the premium amount. They  said that policy sales and renewals that require lesser amounts of work  include (1) renewals where information has not changed; (2) sales of  policies on properties that were built before NFIP floodplain management  standards went into effect (because they qualify for subsidized premiums  and do not require extensive documentation to determine flood risk); and  (3) sales of policies for properties that are not located in special flood  hazard areas (because they do not require extensive documentation to  assess flood risk).
subsections: section_title: Selling and Servicing Policies: Operating Expenses
paragraphs: In addition to the 15 percent allowance for agent commissions, WYO  insurance companies retain about 15 percent of the premium revenues for  ongoing operating expenses related to administering the NFIP and  providing services to policyholders. This payment amount is based on an  annual agreement between FEMA and the WYO insurance companies. See  appendix III for the percentage allowances FEMA authorized WYO  insurance companies to retain for operating expenses incurred in selling  and servicing NFIP policies for fiscal years 1984 to 2007. According to the  agreement, the WYO insurance companies may withhold, as operating and  administrative expenses (other than agent commissions), an amount equal  to the average industry expenses ratios for A.M. Best Company’s  Aggregates and Averages for the following five property coverages: Fire,  Allied Lines, Farmowners Multiple Peril, Homeowners Multiple Peril, and  Commercial Multiple Peril (non-liability portion). According to the  agreement, this amount is to be increased by 1 percentage point to  reimburse expenses “beyond regular property/casualty expenses.”
The payment for administrative and operating expenses is intended to  cover a variety of expenses WYO insurance companies incur in servicing  NFIP policies. WYO insurance company managers said examples of  expenses they incurred included fees for services of a vendor or  subcontractor (if one is retained to handle all or part of the flood  insurance business), payment of salaries and expenses for employees with  full or part-time responsibilities for the NFIP work, payment of fees to  independent public accounting firms to conduct biennial audits of  financial systems for the NFIP, and payment of state taxes on the funds  received from the NFIP. Other expenses reported by WYO insurance  companies include costs of marketing NFIP policies, training agents to sell  and service NFIP policies, and creating or modifying computer and  accounting systems to report financial and statistical information required  by the NFIP.
section_title: Selling and Servicing Policies: Bonuses
paragraphs: According to FEMA officials, the agency has used annual bonuses for  WYO insurance companies since 1995 as an incentive to increase the  number of NFIP policies in force. Under the bonus incentive program,  FEMA provides WYO insurance companies with opportunities to earn  additional percentages of premium revenue above the levels established  annually if they increase the number of flood insurance policies they sell  and service. FEMA officials said that they established bonus percentage  amounts through discussions with WYO insurance company officials,  noting that, as of May 2007, the NFIP had experienced 36 continuous  months of policy growth. One official attributed the growth to “a new  American consciousness” of the importance of having flood insurance in  the aftermath of Hurricane Katrina and other major flood events in 2004  and 2005. This growth in policies accounts for the recent parallel growth in  bonuses. Table 3 provides information on how bonuses have been  awarded and distributed. As the table shows, most participating WYO  insurance companies received bonus payments in each of the fiscal years,  and in fiscal year 2006, 67 percent of the companies received the highest  bonus amount of 2 percent of premium revenues.
FEMA officials said that the methodologies they use for paying WYO  companies for selling and servicing flood insurance are fair for both the  government and the insurance industry. The officials noted that because  the methodologies approximate the expenses incurred for insurance  policy sales and servicing on an industrywide basis, they result in fair  compensation for the WYO insurance companies. According to FEMA  officials, many of the traditional operating costs associated with other  lines of insurance are also incurred in selling and servicing flood insurance  for the NFIP (i.e., commissions to agents, staff salaries, taxes, and building  and equipment costs). Moreover, FEMA officials considered the payment  of the same percentage of premium revenue to WYO insurance companies  for more and less time-consuming sales and renewals to be a reasonable  approach because it results in a reasonable overall compensation rate for  the services the companies perform. They said that because the method  for paying companies to sell and service policies has worked well over the  years, FEMA has not deemed it necessary to significantly change its  approach since it was put into place at the inception of the WYO program  in 1983.
Of the five WYO companies we interviewed (including four of the five  largest participating in the NFIP), views on the sufficiency of FEMA’s  payment structure were mixed. Three WYO company officials stated that  the expense percentage was generally sufficient, while two stated that it  was too low. In addition, one NAIC representative we interviewed said  that the methodology was generally fair to the insurance companies and  taxpayers, and another noted that expense allowance percentages are  probably too high for some renewals and too low for new business but  overall work out to a reasonable amount of compensation.
section_title: After Flood Losses, FEMA Pays WYO Insurance Companies for Adjusting Claims and Providing Claims Processing Services
paragraphs: In addition to paying WYO companies for selling and servicing NFIP flood  insurance policies, FEMA also provides payments after a flood loss occurs.  WYO companies are paid both for adjusting claims and for processing  claims and providing certain claims-related services, such as setting up  temporary flood insurance claims processing centers. Table 4 provides  information on the methodologies FEMA uses to calculate these payments  and recent payment amounts.
FEMA pays WYO insurance companies for adjuster fees based on a fee  schedule that FEMA periodically negotiates with WYO insurance company  representatives. Using the fee schedule, FEMA, through the WYO  insurance companies, pays adjuster fees based on the amount of each  claim settled, with higher fees for larger claims settlement amounts. While  some WYO insurance companies use adjusters who are company  employees, other WYO insurance companies hire and pay claims adjusting  firms that employ their own workforces. These adjusting firms may keep a  percentage of the fee for expenses and profit and pay a portion to  independent adjusters they engage. For example, while one adjusting firm  we visited paid independent adjusters 40 percent of the amount on the  adjuster fee schedule, FEMA officials said that independent adjusters  typically received 70 percent of the amount on the adjuster fee schedule.
According to FEMA’s director for NFIP claims, the adjuster fee schedule  system is based on fee schedules used by independent adjusting firms for  claims on other lines of insurance (i.e., homeowners). According to the  director, rates paid on the fee schedule have been adjusted periodically  since 1983 and were last revised in 2004 based on discussions with the  WYO insurance companies and independent adjusting firms. Table 5  shows excerpts from the adjuster fee schedule effective as of May 2007 for  claims with loss dates of September 2004 and later.
After a flood loss, in addition to claims adjustment payments, FEMA pays  WYO insurance companies for processing claims at a rate of 3.3 percent of  the flood insurance property settlement. According to FEMA officials, this  allowance is provided to WYO insurance companies to set up operations  to process claims in flood-damaged areas. For example, WYO insurance  companies may set up disaster recovery centers to organize their claims  processing efforts on behalf of the NFIP and special telephone hotlines to  provide service, and pay travel expenses for employees and salaries of  temporary workers to staff recovery centers. According to FEMA officials,  the rate of payment for these expenses was initially determined by FEMA  based on data on expenses incurred to adjust losses for other lines of  insurance provided by A.M. Best, the insurance industry rating and  information agency. However, during the 1980s, the insurance industry  changed its requirements for reporting expenses incurred for loss  adjustments; therefore, comparison information for other lines of  insurance was no longer available, according to a FEMA official. Since that  time, the official said that FEMA has not changed the claims expense  allowance percentage because of discussions with representatives of the  insurance industry who consider the percentage to be reasonable.
subsections: section_title: Views Mixed on the Sufficiency of Payments for Post-Flood Activities
paragraphs: The views of the five WYO insurance company managers we interviewed  were mixed on whether the 3.3 percent claims adjustment expense  allowance FEMA pays is sufficient in relation to the costs they incur. One  WYO insurance company manager thought the expense percentage was  sufficient. Three WYO company managers said that the expense  percentage was generally reasonable in catastrophic loss years but not in  average loss years, and another WYO insurance company manager said the  expense percentage was reasonable in noncatastrophic loss years but not  in catastrophic loss years when prices charged by adjusters for their  services increase and resources are not as readily available to manage  claims adjustment operations. NAIC representatives said that they were  not able to comment on whether the amount paid was generally  reasonable for the insurance companies and taxpayers because they did  not have data necessary to form an opinion.
A senior FEMA official said that while FEMA has discussed the  reasonableness of the payments for claims processing expenses with  representatives of the WYO insurance companies, FEMA has not, since  1983, assessed the amount of the payments based on either expenses  incurred by the WYO companies for processing of NFIP claims or actual  costs incurred by insurance companies for processing claims on other  lines of insurance. The official said that some consideration was being  given to capping the amount of the claims expense allowance paid in  catastrophic loss years. The official said that a draft proposed rule is being  discussed with WYO insurance company officials and action could be  taken as early as fiscal year 2008.
section_title: FEMA’s Long-standing Approach for Establishing a Schedule of Operating Costs Cannot Ensure That WYO Insurance Company Payments Are Based on Reasonable Estimates of Actual Expenses
paragraphs: FEMA’s methodologies for determining WYO’s operating costs, rooted in  policies established about 25 years ago, cannot provide assurance that  payments are based on reasonable estimates of actual expenses because  actual expenses incurred by the companies for their services to the NFIP  are not considered. It is important that FEMA be able to rely on a  methodologically sound approach for making decisions about NFIP  operating costs, given both the program’s growth and rise in payouts in  recent years. Although FEMA has the authority to collect expenses  information and FEMA officials said that they have considered alternative  methodologies for paying WYO insurance companies, the officials raised  concerns about collecting expense information from WYO insurance  companies. Nevertheless, there is a precedent for doing so since two other  public-private insurance partnerships with similarities to the WYO  program use information on the actual costs incurred by participating  insurance companies as one basis for determining how much to pay for  services.
subsections: section_title: FEMA’s Methodologies Cannot Ensure That the Schedule of Operating Costs Is Based on Reasonable Estimates of Actual Expenses
paragraphs: While the WYO program has operated without interruption since 1983 in  both catastrophic and noncatastrophic flood years, FEMA has not  determined whether payments it makes reasonably reflect the actual  expenses WYO insurance companies have incurred in selling and servicing  NFIP policies and settling claims for flood losses. The methodologies  FEMA currently uses to determine payment amounts for the WYO  insurance companies for services rendered do not meet the federal  internal control standard that agencies be held accountable for, among  other things, stewardship of government resources. For example, as noted  earlier, FEMA allows the WYO insurance companies to retain a percentage  of premium revenue it collects based on average expenses for five  property/casualty lines of insurance; this amount is increased by 1  percentage point to reimburse expenses for the NFIP beyond regular  property/casualty expenses. However, without obtaining and considering  audited data on the actual costs incurred by the WYO companies, FEMA  has no assurance that the additional 1 percentage point—about $20 million  annually programwide—is an accurate reflection of the expenses WYO  companies actually incur beyond regular property/casualty expenses. Nor  can FEMA determine, based on current payment methodologies, how  WYO insurance company costs might have changed over time because its  payment approach is rooted in policies established in 1983, when the WYO  program began. For example, the payment formula FEMA used to set the  3.3 percent payment rate for claims processing expenses incurred by WYO  insurance companies has been in place since the program’s inception, and  FEMA has no basis, other than discussion with WYO insurance company  officials, for determining that the 3.3 percent claims processing payment is  a reasonable estimate of expenses incurred.
It is important that FEMA be able to rely on a methodologically sound  approach for making decisions about NFIP operating costs, given both the  program’s growth and rise in payouts. As shown earlier in figure 1,  participation in the NFIP has steadily increased over time from  approximately 2 million to over 5 million policies in force. Annual  premium revenue, which is the basis for calculating payments to WYO  insurance companies for selling and servicing policies, has increased as  well, from $385 million in 1983 to more than $2 billion in 2007. And costs  of claims settlements have trended upward, as the costs of labor and  materials to repair flood-damaged properties have increased, resulting in  larger payment amounts to WYO insurance companies for adjusting  claims. As a result of the unprecedented number and cost of flood  insurance claims after Hurricane Katrina, the amount FEMA paid the WYO  insurance companies based on its formula for claims processing (i.e.,  setting up temporary flood insurance claims processing centers) was  $385.1 million in fiscal year 2005—a more than tenfold increase from the  $30.3 million, not adjusted for inflation, paid for such expenses in fiscal  year 2004.
FEMA officials said that they are in the process of discussing with WYO  insurance company officials a proposed cap on the amount WYO  insurance companies will be paid for claims processing expenses in future  catastrophic loss years that could become effective in fiscal year 2008, as  noted above. FEMA officials also said that they believed the insurance  companies participating in the WYO program generally had lower  expenses than other companies that choose not to participate in the WYO  program. They cited their analysis of 2004 operating expenses, which  compared the expenses for homeowner policies for insurance companies  that participated in the WYO program to companies that did not  participate and found that companies that did not participate in the WYO  program generally reported higher expenses. Nevertheless, because FEMA  does not collect actual data from WYO insurance companies specific to  their flood insurance expenses, it cannot ensure payments are based on  reasonable estimates of actual flood insurance expenses.
FEMA officials said that they have considered methodologies other than  the current approach for paying WYO insurance companies, including  having the companies submit information on their actual expenses for  reimbursement for services rendered to the NFIP. However, they said that  such an approach could create a number of additional challenges that  might have a negative impact on the program. For example, because the  costs of doing business vary from one WYO insurance company to  another, according to the business models they have developed for  carrying out their services to the NFIP and the amount of their flood  insurance business, the NFIP would, in the agency’s view, have to pay  different companies at different levels, which could result in higher FEMA  administrative costs and could also fail to reward WYO insurance  companies with the most efficient operations. The officials also said that  compensation based on actual expenses could also result in inefficient  companies entering the WYO program because there is no incentive for  them to control expenses. In addition, FEMA officials stated that they  would likely have to hire additional staff and provide resources to review  and validate WYO expense data, further increasing program costs.  However, FEMA could choose, for example, to use data on actual  expenses to establish payment rates based on an average of expenses  WYO insurance companies incur, similar to its current approach. Thus,  WYO insurance companies would continue to have an incentive to  perform efficiently.
section_title: FEMA Has Legal Authority to Collect Data on Actual WYO Expenses to Determine If Payments Are Based on Reasonable Estimates of Expenses, but Officials Cited Concerns about Potential Implications
paragraphs: Under the National Flood Insurance Act of 1968, insurance companies  choosing to participate in the WYO program must keep such records as  FEMA prescribes and provide access to these records for purpose of audit  and examination. Although it has authority to do so, FEMA does not  collect data on actual WYO flood insurance expenses that could provide a  basis for ensuring that the WYO schedule of operating costs is based on a  reasonable estimate of expenses. FEMA’s reluctance to impose additional  cost accounting requirements on WYO insurance companies is based on  concerns that the number of companies choosing to participate in the  WYO program would decline if FEMA did so.
The National Flood Insurance Act of 1968 mandated that FEMA negotiate  with representatives of the insurance industry to establish a current  schedule of operating costs. Operating costs include:    expense reimbursements covering the direct, actual, and necessary  expenses incurred in connection with selling and servicing flood  insurance coverage;  reasonable compensation payable for selling and servicing flood  insurance coverage;  loss adjustment expenses; and    other direct, actual, and necessary expenses incurred in connection  with selling or servicing flood insurance coverage.
In addition, the act provides FEMA with broad audit and access authority  to the records of insurance companies choosing to participate in the WYO  program. In particular, WYO insurance companies must “keep such  records as the  Director shall prescribe, including records which  fully disclose the total costs of the program undertaken or the services  being rendered, and such other records as will facilitate an effective  audit.” Any WYO records pertinent to program costs and services  rendered are subject to audit and examination by FEMA (and GAO).  While these provisions provide a legal basis for FEMA to collect cost data  from WYO insurance companies to ensure that the schedule of operating  costs reasonably reflects actual WYO insurance company expenses, FEMA  officials expressed concerns that new cost accounting requirements would  drive insurance companies out of the WYO program.
Under its agreement with participating WYO insurance companies, FEMA  can request that the companies provide “a true and correct copy of the  Company’s Fire and Casualty Annual Statement, and Insurance Expense  Exhibit,” which the companies are required to file with their respective  state insurance authorities. The Insurance Expense Exhibit provides a  statutory allocation of income to lines of business, thereby measuring the  underlying profitability of the insurance operations. According to NAIC  officials, all revenues and expenditures, whether or not they are  associated with particular policies, are allocated to lines of business,  including flood insurance, and various sets of operating returns are  calculated in the Exhibit, so that profitability by line of business may be  measured. They said that WYO companies allocate costs related to their  flood insurance business based on a reporting requirement established by  the NAIC in 1997 and that companies determine their own allocation  methods, which according to NAIC procedures, must be “reasonable.”
FEMA officials said the requirement for insurance companies to provide  information on costs allocated to their flood insurance business was  established at FEMA’s request, and FEMA has reviewed the data annually  since 2004. However, the officials said they could not use the information  to help determine the reasonableness of payments to WYO insurance  companies for the services they perform for the NFIP because the  methods WYO companies use to report their flood insurance-related  expenses in the Insurance Expense Exhibit vary by company. They said  that FEMA has not required that WYO insurance companies report their  flood- related expenses separately because of their reluctance to increase  federal reporting requirements on their WYO partners in the NFIP.
FEMA officials expressed concern that the number of companies that  choose to participate in the WYO program would decline dramatically if  additional cost accounting requirements were established for them. The  officials said that potential impacts of less private-sector participation  include a reduced ability to respond quickly to catastrophic flood events  and more difficulty for policyholders in locating agents to sell and service  NFIP policies. That concern notwithstanding, however, more specific and  relevant information on actual expenses allocated by the WYO insurance  companies to their flood insurance business could help FEMA determine  the reasonableness of its expense estimates if the flood insurance data  already maintained by participating WYO insurance companies were  consistently reported.
Based on the standards for internal control in the federal government,  FEMA is responsible for implementing controls that serve as the first line  of defense in safeguarding assets, preventing and detecting errors and  fraud, and helping to achieve desired results through effective stewardship  of public resources. Moreover, internal controls are integral to ensuring  the reliability of financial reporting and the effectiveness and efficiency of  operations, including the use of resources. FEMA has not significantly  changed the payment policies that are the foundation of the WYO program  in more than 2 decades, and because FEMA cannot ensure that its  approach to establishing a schedule of operating costs is based on a  reasonable estimate of actual expenses, it has not effectively implemented  these internal controls. A review of the WYO insurance companies’  operating costs would be prudent and timely.
section_title: Other Federal Programs Collect Actual Cost Data to Help Determine Payments for Insurance Industry Services
paragraphs: While FEMA has not elected to collect actual cost data from WYO  companies, it has the legal authority to do so, as noted above, and there is  precedent within the federal government for doing so. Two public-private  insurance partnerships similar to the NFIP’s arrangement with WYO  insurance companies collect information on the actual costs incurred by  participating insurance companies as a basis to help determine how much  to pay for services.
The first is the FCIC, which bears the risk for insuring agricultural crop  values under the auspices of the U.S. Department of Agriculture’s Risk  Management Agency. The FCIC protects farmers who participate in the  program against financial losses caused by events such as droughts and  other natural disasters.
Like FEMA does for the NFIP, the Risk Management Agency pays  insurance companies a percentage of premium revenue for expense  allowances for services to the FCIC. Unlike the NFIP, however, beginning  in 1994, the FCIC began to require companies to submit detailed expense  reports in a consistent format following standard industry guidelines,  including the NAIC guidelines for allocating expenses among lines of  business. While the FCIC does not use these reports as a direct basis for  reimbursing individual insurance companies, the actual expense  information contained in the reports informs the agency’s methodology for  establishing future reimbursement rates for expenses related to insurance  services. FCIC requires that companies submit documentation of their  expenses and uses this information to determine the appropriate  percentage as a basis for compensation. This documentation is intended to  provide a basis for program oversight to ensure that payments made to  private insurance companies for their expenses in providing insurance  services are reasonable—documentation that is currently lacking in   the NFIP.
One potential advantage that results from FCIC’s direct access to expense  data is that this information may be used to enhance program oversight.  For example, in reviewing actual expense data submitted by the insurance  companies participating in the FCIC in 1997, we found that some expenses  reimbursed by FCIC were excessive. Among the expenses reported were  those associated with profit-sharing bonuses and lobbying. In addition,  even within the expense categories reasonably associated with the sale  and service of crop insurance, we found expenses that appeared excessive  for reimbursement under a taxpayer-supported program, suggesting an  opportunity to further reduce future reimbursement rates. These expenses  included agents’ commissions that exceeded the industry average,  unnecessary travel-related expenses, and questionable entertainment  activities. Currently, comparable oversight activities cannot be performed  on NFIP’s WYO program participants because the data needed for such  analysis have not been obtained.
The second public-private partnership comparable to the NFIP is an entity  that participates in the flood insurance program, but not as a WYO  insurance company. This entity is the NFIP Direct Servicing Agent—a  FEMA contractor that sells, services, and adjusts claims on about   4 percent of flood insurance policies that are not, for various reasons,  handled through the WYO program. FEMA pays the NFIP Direct  Servicing Agent for selling and servicing flood insurance and for adjusting  and processing claims after a flood event through a competitively awarded  contract at a fixed cost. The contractor has calculated its cost to sell and  service policies as well as adjust claims following a non-catastrophic event  based on prior experience as a vendor for several WYO insurance  companies. Based on these calculations, the contractor charges a flat price  per policy that is not based on the premium amount. For example, a flood  insurance policy with a $400 premium would cost the NFIP Direct  Servicing Agent the same to service as a policy with $800 in premiums,  based on a flat fee paid per policy per month. For catastrophic flood  events, such as Hurricane Katrina, the NFIP Direct Servicing Agent  submits receipts to the NFIP and is reimbursed for expenses related to  setting up a catastrophe center and hiring additional staff.
While the approach used to compensate the NFIP Direct Servicing Agent  for its services illustrates that information on actual costs incurred can be  developed by private sector entities participating in the NFIP, FEMA  officials have cautioned that differences in compensation approaches are  based on a different role for the contractor in the NFIP than that of the  WYO insurance companies. While the WYO insurance companies are paid  on a percentage basis to provide incentives for them to increase the  number of NFIP policies they have in force, the NFIP Direct Servicing  Agent does not market the NFIP; rather, it services the specialized group  of policies it is assigned in its contract with FEMA. Nevertheless, the  financial arrangement with the Direct Servicing Agent shows that cost  information can be collected and is useful in determining reasonable  payments.
Although public-private partnerships for federal insurance programs such  as these include considerations of actual expense information and FEMA  has the legal authority to obtain such information from WYO insurance  companies, FEMA’s current methodologies for determining payment  amounts are not based on an assessment of actual expenses the WYO  insurance companies incur and do not require that WYO insurance  companies maintain or report their expenses. As a result, FEMA does not  know whether the payments it makes to the WYO insurance companies  reasonably reflect the expenses they incur in selling and servicing NFIP  policies and establishing operations in flood-damaged areas.
section_title: Financial Management Controls Did Not Provide Assurance That Payments to WYO Insurance Companies Were Proper and in Accordance with Program Requirements
paragraphs: Biennial financial statement audits—FEMA’s primary management control  mechanism to provide assurances that it receives complete and accurate  financial management information from the WYO insurance companies— were not performed on a consistent basis as required by regulation.  FEMA’s regulations and the WYO Financial Control Plan require each  participating WYO insurance company to arrange for biennial financial  audits that assess its financial statements for activities related to the NFIP;  audit costs are covered by the expense allowance received from FEMA for  selling and servicing policies. However, many insurance companies  participating in the WYO program did not comply with the schedule. In  addition, FEMA did not have a mechanism in place for tracking and  reviewing the results of the biennial financial statement audits that were  performed. Because the biennial financial statement audits were not  consistently completed and reviewed, FEMA lacks assurance that it is  making proper payments for the services of the WYO insurance companies  and that financial information is being properly presented.
subsections: section_title: FEMA Regulations and Guidance Require Biennial Financial Audits of WYO Insurance Companies to Assess the Quality of Financial Controls over NFIP-Related Activities
paragraphs: FEMA regulations as implemented through its WYO Financial Control Plan  require each participating WYO insurance company to arrange for biennial  financial audits by independent CPA firms that assess its financial  statements for activities and controls related to the NFIP. The biennial  financial statement audits are intended to provide FEMA with an  independent assessment of the quality of financial controls over activities  related to WYO companies’ participation in the NFIP and the integrity of  the financial data they report. Biennial financial statement audits provide  assurance that WYO insurance companies report complete and accurate  information on their NFIP activities, which are necessary to ensure that  payments made from the NFIP fund for services rendered are proper and  in accordance with program requirements. The third-party financial audits  are intended to reduce or eliminate the need for FEMA to conduct on-site  visits to WYO insurance companies to oversee their financial activities.  The audits provide opinions and report on the fairness of the WYO  insurance companies’ financial statements, the adequacy of internal  controls, and the extent of the WYO insurance companies’ compliance  with applicable laws and regulations. Some WYO insurance companies  conduct in-house financial management operations while others  subcontract with a flood insurance vendor, or subcontractor, to handle  financial reporting requirements and operations. When a vendor is  involved, WYO insurance companies that have contracted with the same  vendor generally hire an independent CPA firm to audit the vendor’s  financial operations and provide an opinion on the quality of the financial  systems for all of the WYO insurance companies that subcontract with   the vendor.
Under FEMA regulation, WYO insurance companies are responsible for  selecting CPA firms to conduct their audits in accordance with generally  accepted auditing standards and generally accepted government auditing  standards issued by the Comptroller General. The audits are to be funded  by the WYO companies from the expense allowance (about 15 percent of  premium revenue) they receive for selling and servicing policies.
FEMA has several other methods for managing and overseeing the quality  of work performed by WYO insurance companies including monthly  reconciliations and manual validation and recalculation of the amounts  retained by the WYO insurance companies, reviews of the operations of  the WYO insurance companies at least once every 3 years, and quality  assurance reinspection of a sample of claims adjusted after each flood  event. Our review of these other methods of management and oversight  determined that they did not provide direct information about the  propriety and accuracy of payments made to the WYO insurance  companies for their NFIP-related activities. In addition, when FEMA has  concerns regarding the propriety of a WYO insurance company’s financial  reporting, the agency may conduct audits “for cause.” However, according  to NFIP officials, FEMA has not conducted any audits for cause during the  7-year period we reviewed.
section_title: Most WYO Insurance Companies Did Not Meet the Biennial Financial Statement Audit Schedule Required by FEMA
paragraphs: As shown in figure 4, for biennial audits done during the period from fiscal  year 2001 to 2006, the majority of participating WYO insurance companies  did not comply with FEMA’s requirement for biennial audits of their  financial operations to be conducted. The officials also said that   34 additional WYO insurance companies were granted extensions by  FEMA to complete their fiscal year 2005-2006 biennial financial statement  audits by September 30, 2007.
Thirty-nine of the 40 biennial financial statement audits that were  completed for fiscal years 2001 to 2002 were the results of a review by one  independent CPA firm at a vendor for the 39 WYO insurance companies.  Similarly, 23 of the 37 biennial financial statement audits completed for  fiscal years 2002 to 2003 and all 35 of the biennial financial statement  audits that were completed for fiscal years 2003 to 2004 were the results of  reviews of two vendors and resulting reports by two independent CPA  firms. In these cases, the CPA firm visited a single flood insurance vendor  or subcontractor with which the audited WYO insurance companies  subcontracted to handle aspects of their NFIP business.
According to the Deputy Assistant Administrator for Insurance of FEMA’s  Mitigation Division with responsibility for management and oversight of  the NFIP, FEMA did not require all WYO insurance companies to meet the  schedule for completing biennial financial statement audits during the  period we reviewed because some companies were in the process of  contracting with new vendors, or subcontractors, to do their financial  reporting so doing financial audits would have been particularly costly and  difficult. In addition, the Deputy Assistant Administrator said that FEMA  had no indication that the WYO insurance companies that did not have  biennial financial statement audits performed had any financial  management weaknesses. Nonetheless, without having the biennial audits  conducted as required by regulation, FEMA lacks assurance that WYO  insurance companies have financial systems in place to ensure that proper  payments are made and controls are in place for the services of the WYO  insurance companies. This assurance is necessary for FEMA to meet the  internal control standard for federal government agencies that they have  reasonable assurance program objectives are being achieved and  operations are effective and efficient. In addition, according to standards  for internal controls within the federal government, such a control  mechanism is important in agencies like FEMA where large amounts of  data are processed; where audit techniques may be used to identify  inefficiencies, waste, or abuse; and where managers should be able to  promptly review and evaluate audit findings in order to identify  opportunities for improvements.
The Deputy Assistant Administrator also said that FEMA did not seek to  recoup the portion of the allowance paid from the NFIP fund for biennial  financial statement audits from the companies that did not have them  performed. He said that reimbursement was not requested because the  public-private partnership depends upon a level of cooperation without a  constant exchange of dollars.
section_title: Biennial Financial Statement Audits Identified One Company with Material Weaknesses and Some Noncompliance and Internal Control Weaknesses
paragraphs: For the biennial financial statement audits that were completed from fiscal  year 2001 through fiscal year 2006, the independent CPA firms identified  material weaknesses in one instance and they identified some other  internal control weaknesses and instances of noncompliance with  financial reporting requirements. In all but one of the audit reports  completed, the independent CPA firm issued an unqualified opinion that  for the WYO insurance companies it audited, the financial statements  fairly presented, in all material respects, the WYO program assets,  liabilities, and accumulated deficit. The various audit opinions also stated  that the results of operations and cash flows of the companies’  participation in the WYO program for the 2-year periods audited  conformed with generally accepted accounting principles in the United  States.
The audit in which material weaknesses were identified involved one WYO  insurance company during fiscal years 2002 to 2003. The independent CPA  firm that conducted the audit found significant deficiencies in design or  operation of internal controls over financial reporting that could affect the  company’s ability to record, process, summarize, and report financial data.  Actions by the WYO insurance company to resolve the weaknesses  identified were documented and included engaging a new vendor for its  financial management functions. According to the Deputy Assistant  Administrator, as of July 2007, the company did not participate in the   WYO program.
Among the instances in which internal control weaknesses and instances  of noncompliance were identified, a CPA firm noted in its fiscal year 2001  to 2002 audit report that it considered a vendor’s lack of internal control  procedures over its financial reporting to be a significant deficiency that  could adversely affect its ability to record, process, summarize, and report  financial data for the 39 WYO insurance companies with which it had  contracted to perform financial management activities. The audit report  also found that accounting department and executive staff did not have  the appropriate accounting expertise to adequately review and identify  errors in the financial reporting process. The vendor disagreed with the  audit report recommendation that it develop formalized procedures or  controls over financial reporting but indicated that it would evaluate and  document future procedures as necessary. A FEMA official said that  FEMA did not follow up on the audit recommendations because the  vendor went out of business shortly after the audit was completed. An  audit report for fiscal year 2003 to 2004 covering another vendor’s  financial management activities for 35 WYO insurance companies cited  instances of noncompliance such as documentation missing from policy  files and reports from claims adjusters not being filed within specified  time frames. WYO insurance companies agreed to take action to address  the audit recommendations.
section_title: FEMA Did Not Track or Review Financial Statement Audits
paragraphs: FEMA did not have a mechanism in place for tracking and reviewing the  results of the biennial financial statement audits that were performed.  FEMA officials were able to provide us with copies of only two biennial  audit reports until the conclusion of our audit when they asked WYO  insurance companies and their subcontractors to send copies of additional  reports that might have been prepared. Thus, it was apparent that the  results of the financial audits were not considered and used by FEMA to  identify opportunities for program improvements.
section_title: Conclusions
paragraphs: The NFIP was structured more than 25 years ago as a public-private  partnership between the government and private insurance companies  that agree to sell and service flood insurance policies on the government’s  behalf. Over the years, the program has made flood insurance widely  available to consumers, while FEMA and the taxpayers have assumed all  of the financial risks for the program, should premiums be insufficient to  cover claims. In the aftermath of the catastrophic flood events of 2005,  which tested all aspects of the federal government’s response to large- scale natural disasters, FEMA and the WYO insurance companies worked  together to settle an unprecedented number of flood insurance claims  reasonably quickly. Moreover, the partnership has, over time, relieved  FEMA of the need to develop, hire, and train an in-house corps of sales  agents, adjusters, and others to administer flood insurance. However,  while the WYO program has been beneficial, FEMA runs the risk of not  being able to ensure that it is able, as time goes on, to manage and control  the program’s costs. In fiscal year 2006—the catastrophic year that  included payments for claims resulting from Hurricane Katrina—FEMA  paid almost 65 cents of every dollar collected in premiums to the WYO  insurance companies.
Two factors account for the operating cost-related risks FEMA incurs  through the WYO program. First, because FEMA cannot ensure that the  schedule of operating costs it pays to WYO insurance companies is based  on reasonable estimates of their expenses, FEMA does not know whether  the operating costs it pays appropriately reflect the expenses the WYO  insurance companies incur in selling and servicing NFIP policies and  adjusting claims. This is primarily because FEMA has not significantly  changed its methodologies for determining the schedule of operating costs  for WYO insurance companies since 1983, when the current structure was  created. As a result, the underlying methodologies may not take into  account factors that have changed over the life of the program. For  example, costs of claims settlements have trended upward as the costs of  labor and materials to repair flood-damaged properties have increased,  resulting in larger payment amounts to WYO insurance companies for  adjusting claims. Information on costs WYO insurance companies allocate  to their federal flood business has been collected and reported by the  NAIC since 1997 and reviewed by FEMA since 2004. Such information  could be helpful to FEMA officials in determining appropriate payments to  WYO insurance companies for the services they perform for the NFIP;  however, FEMA officials said that they do not use the information to help  determine a schedule of operating expenses because the WYO insurance  companies are inconsistent in the ways they allocate costs to flood  insurance and report the data.
Second, a lack of sufficient oversight of WYO insurance companies’  financial management processes limits FEMA’s ability to ensure that  payments made to the WYO insurance companies participating in the NFIP  were proper and in accordance with program requirements—and ensure  that its operations are effective and efficient. Biennial financial statement  audits were not completed as required by FEMA regulation.
section_title: Recommendations for Executive Action
paragraphs: To improve financial accountability over payments the NFIP makes to the  WYO insurance companies, to strengthen controls over expenditures of  policyholders’ and taxpayers’ dollars, and to provide assurance that  payments made to the WYO insurance companies are proper and in  accordance with program requirements, we are recommending that the  Secretary of Homeland Security direct the Under Secretary of Homeland  Security, FEMA, to take the following two actions:  1.  Ensure that its approach to establishing a schedule of operating costs  is based on a reasonable estimate of actual expenses by taking such  actions as FEMA deems necessary such as working with NAIC to  ensure consistency in the way all WYO insurance companies compile  and report data on expenses allocated to their federal flood business.  2.  Ensure that biennial financial statement audits of WYO insurance  companies are conducted by independent CPA firms as required by  FEMA regulation, and that FEMA reviews the audits to ensure that  payments made are proper and in accordance with program  requirements.
section_title: Agency Comments and Our Evaluation
paragraphs: On August 29, 2007, DHS provided written comments on a draft of this  report dated August 14, 2007. DHS generally agreed with our  recommendations to improve financial accountability over payments the  NFIP makes to the WYO insurance companies. However, DHS said our  presentation in table 1 of payments to WYO insurance companies for all  NFIP services for fiscal years 2004 to 2006 as a percentage of total  premium revenues was “inappropriate and misleading” because it was  most appropriate to compare the costs of adjusting and processing claims  to total losses in a year, not premium revenue. We disagree. We believe it  is appropriate to summarize aggregate expense payment data as a  percentage of premiums collected because, as noted in the report, the  NFIP is designed to pay for flood losses and operating expenses to the  extent possible with premium revenues rather than tax dollars. Our report  also provides detailed information on the types of WYO payments made  each year separately for claims and other costs, including agent  commissions and expenses for selling and servicing policies.
DHS concurred with our recommendation to work with NAIC to improve  the consistency in the way WYO insurance companies compile and report  this data so that it is useful as an estimate of the WYO companies’ actual  expenses for selling and servicing flood insurance policies. As progress is  made, it will be incumbent upon FEMA to determine whether the data  already collected on flood insurance program expenses are reliable and  sufficiently comprehensive for FEMA to make a reasonable estimate of  WYO insurance companies’ actual expenses. DHS also concurred with our  recommendation that financial statement audits be conducted and the  results reviewed.
We are sending copies of this report to the Secretary of the Department of  Homeland Security, the Administrator of the Federal Emergency  Management Agency, selected congressional committees, and other  interested parties. In addition, the report will be available at no charge on  the GAO Web site at http://www.gao.gov. Please contact William Jenkins at  (202) 512-8757 or jenkinswo@gao.gov if you or your staff have any  questions concerning this report. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix IV.
section_title: Appendix I: Scope and Methodology
paragraphs: To assess how much the Federal Emergency Management Agency (FEMA)  paid in recent years to the Write Your Own (WYO) insurance companies  that sell and service NFIP policies and adjust claims and how FEMA  determines the amount of these operating costs, we analyzed data on  amounts paid to WYO insurance companies for fiscal years 2004-2006. We  also interviewed FEMA officials on how FEMA set the payment levels and  how the agency reviews the methodologies in place to determine that they  remain appropriate over time, and we examined available documentation  on FEMA’s payment methodologies. The data we examined included the  amounts FEMA paid to WYO companies for selling and servicing policies,  for growth incentive bonuses, and for expenses related to adjusting flood  claims and paying flood claims adjusters. We discussed with FEMA  officials the internal control processes in place and observed the monthly  process used by FEMA’s program contractor to reconcile cost information  submitted by WYO insurance companies. We also reviewed audits of  Department of Homeland Security (DHS) financial statements prepared  for the DHS Office of Inspector General. We determined that the  information was sufficiently reliable for our purposes. We conducted semi- structured interviews with representatives of a judgmental sample of five  WYO insurance companies and National Association of Insurance  Commission (NAIC) officials to obtain their perspective on FEMA’s  payment methodologies. Our sample included representatives of four of  the five largest participating WYO insurance companies in terms of their  market share of NFIP policies in force in 2006 and one mid-sized WYO  insurance company. Our sample is not a representative sample of all  participating WYO insurance companies, so the views expressed should  not be generalized to the universe of the 88 participating companies.
To determine how the approach FEMA uses to establish a schedule of  operating costs provides assurance that it is based on reasonable  estimates of WYO insurance companies’ expenses for the services  rendered, we reviewed the statutory and regulatory framework for  establishing a schedule of operating costs and obtained the views of FEMA  and insurance industry officials on the effectiveness of the current  payment approach and the potential implications of implementing other  payment methodologies. We also assessed how the approach FEMA  currently uses to pay WYO insurance companies for their services  compares to payment methodologies used by two similar public-private  insurance arrangements. To compare other public-private insurance  partnerships, we first identified the universe of similar arrangements with  which to compare the NFIP. We reviewed literature including prior GAO  reports on federal government insurance programs. We determined and  confirmed with NFIP officials that the only other federal insurance  program with similar public-private partnership arrangements was the  Federal Crop Insurance Corporation (FCIC), an insurance program that  protects participating farmers against the financial losses caused by events  such as droughts, floods, hurricanes, and other natural disasters. In  addition, we determined that FEMA’s contract with the NFIP Direct  Servicing Agent, the contractor that administers four percent of NFIP  policies on behalf of FEMA, used methods for calculating and paying for  activities to sell and service policies and adjust claims that should be  included in our scope. We then interviewed officials and reviewed contract  and budget information on these two arrangements. Our analysis was  designed to compare and contrast the arrangements to the NFIP’s WYO  program. We did not make determinations on which programs had the  best practices because information was not available on the expenses  incurred by WYO insurance companies for their services to the NFIP. Our  review was limited to the structure of the financial arrangements between  the federal government and the FCIC and NFIP Direct Servicing Agent to  compensate the private entities for selling and servicing government  insurance policies and adjusting claims. We did not assess the overall  performance of the FCIC and the NFIP Direct Servicing Agent.
To determine the extent to which FEMA’s financial management controls  for WYO companies provide assurance that payments are proper and in  accordance with program requirements, we reviewed FEMA’s regulations  and procedures for monitoring and overseeing payments of expenses to  WYO insurance companies for selling and servicing NFIP policies. We  analyzed the schedule and results of biennial financial audits conducted  for fiscal years 2001 to 2006. In addition, we reviewed financial audits of  the NFIP done by the DHS Office of Inspector General for fiscal years 2003  to 2006. In addition to biennial financial audits, we also reviewed other  FEMA oversight mechanisms. We analyzed the results of 15 operational  reviews and follow-up visits FEMA performed at WYO insurance  companies from 2001 through February 2005, and we reviewed a  statistically valid sample of quality assurance reinspections of claims  adjustments for Hurricanes Katrina and Rita, and we determined that  these oversight mechanisms did not provide direct information about the  propriety and accuracy of payments made to the WYO insurance  companies for their NFIP-related activities. We performed our work from  June 2006 through July 2007, in accordance with generally accepted  government auditing standards.
section_title: Appendix II: Percentage Allowances FEMA Authorized WYO Insurance Companies to Retain for Operating Expenses Incurred in Selling and Servicing NFIP Policies (Fiscal Years 1984–2007)
paragraphs: Appendix II: Percentage  Allowances FEMA Authorized  WYO Insurance Companies to  Retain for Operating Expenses  Incurred in Selling and  Servicing NFIP Policies (Fiscal  Years 1984–2007)
section_title: Appendix III: Comments from the Department of Homeland Security
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contact named above, Christopher Keisling, Assistant  Director; Amy Bernstein; Christine Davis; Dewi Djunaidy;   Wilfred Holloway; Tracey King; Deborah Knorr; and Jesus Ramoz made  significant contributions to this report.
section_title: Related GAO Products
paragraphs: National Flood Insurance Program: New Processes Aided Hurricane  Katrina Claims Handling, but FEMA’s Oversight Should Be Improved.  GAO-07-169. Washington, D.C.: December 15, 2006.
GAO’s High-Risk Program. GAO-06-497T. Washington, D.C.: March 15,  2006.
Federal Emergency Management Agency: Challenges for the National  Flood Insurance Program. GAO-06-335T. Washington, D.C.: January 25,  2006.
Federal Emergency Management Agency: Improvements Needed to  Enhance Oversight and Management of the National Flood Insurance  Program. GAO-06-119. Washington, D.C.: October 18, 2005.
Flood Insurance: Challenges Facing the National Flood Insurance  Program. GAO-03-606T. Washington, D.C.: April 1, 2003.
Major Management Challenges and Program Risks: Federal Emergency  Management Agency. GAO-03-113. Washington, D.C.: January 1, 2003.
Flood Insurance: Extent of Noncompliance with Purchase Requirements  Is Unknown. GAO-02-396. Washington, D.C.: June 21, 2002.
Flood Insurance: Information on the Financial Condition of the  National Flood Insurance Program. GAO-01-992T. Washington, D.C.:   July 19, 2001.
Flood Insurance: Emerging Opportunity to Better Measure Certain  Results of the National Flood Insurance Program. GAO-01-736T.  Washington, D.C.: May 15, 2001.
Flood Insurance: Private Companies’ Participation in the Write Your  Own Program. RCED-87-108. Washington, D.C.: May 29, 1987.
subsections: section_title: Federal Crop Insurance Corporation
paragraphs: Crop Insurance: Opportunities Exist to Reduce Government Costs for  Private-Sector Delivery. RCED-97-70. Washington, D.C.: April 17, 1997.
Crop Insurance: Participation in and Costs Associated with the Federal  Program. RCED-88-171BR. Washington, D.C.: July 6, 1988.