Flood Insurance: Strategies for Increasing Private Sector Involvement
Released: 2014-01-22T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: NFIP has accrued $24 billion in debt, highlighting structural weaknesses in the program and increasing concerns about its burden on taxpayers. As a result, some have suggested shifting exposure to the private sector and eliminating subsidized premium rates, so individual property owners--not taxpayers--would pay for their risk of flood loss. NFIP was created, in part, because private insurers were unwilling to insure against flood damage, but new technologies and a better understanding of flood risks may have increased their willingness to offer flood coverage.

The Biggert-Waters Flood Insurance Reform Act of 2012 moves NFIP toward charging more full-risk rates. It also mandates that GAO conduct a study on increasing private sector involvement in flood insurance. This report addresses (1) the conditions needed for private sector involvement in flood insurance and (2) strategies for increasing private sector involvement. To do this work, GAO reviewed available documentation and hosted a roundtable in August 2013 that included stakeholders from FEMA, the insurance and reinsurance industries, and state insurance regulators, among others. GAO also interviewed other similar stakeholders.

section_title: What GAO Found
paragraphs: According to stakeholders with whom GAO spoke, several conditions must be present to increase private sector involvement in the sale of flood insurance. First, insurers need to be able to accurately assess risk to determine premium rates. For example, stakeholders told GAO that access to National Flood Insurance Program (NFIP) policy and claims data and upcoming improvements in private sector computer modeling could enable them to better assess risk. Second, insurers need to be able to charge premium rates that reflect the full estimated risk of potential flood losses while still allowing the companies to make a profit, as well as be able to decide which applicants they will insure. However, stakeholders said that such rates might seem unaffordable to many homeowners. Third, insurers need sufficient consumer participation to properly manage and diversify their risk, but stakeholders said that many property owners do not buy flood insurance because they may have an inaccurate perception of their risk of flooding.

Stakeholders identified several strategies that could help create conditions that would promote the sale of flood insurance by the private sector. For example,

NFIP charging full-risk rates . Congress could eliminate subsidized rates, charge all policyholders full-risk rates, and appropriate funding for a direct means-based subsidy to some policyholders. Stakeholders said full-risk NFIP rates would encourage private sector participation because they would be much closer to the rates private insurers would need to charge. The explicit subsidy would address affordability concerns, increase transparency, and reduce taxpayer costs depending on the extent and amount of the subsidy. The Biggert-Waters Act eliminates some subsidized rates, but some have proposed delaying these rate increases. Doing so could address affordability concerns, but would also delay addressing NFIP's burden on taxpayers.

NFIP providing residual insurance . The federal government could also encourage private sector involvement by providing coverage for the highest-risk properties that the private sector is unwilling to insure. Providing residual coverage could increase the program's exposure relative to the number of properties it insured, but NFIP would be insuring fewer properties, and charging adequate rates could reduce taxpayer costs.

NFIP as reinsurer . Alternatively, the federal government could serve as a reinsurer, charging a premium for assuming the risk of catastrophic losses. However, the cost of reinsurance premiums would likely be passed on to consumers, with higher rates potentially decreasing consumer participation.

Stakeholders identified other strategies including mandatory coverage requirements to ensure broad participation, NFIP purchasing reinsurance from the private sector rather than borrowing from the U.S. Treasury, and NFIP issuing catastrophe bonds to transfer risk to private investors. As the private sector increases its role in providing flood coverage, the federal government could collaborate with state and local governments to focus on other important roles, including promoting risk awareness among consumers, encouraging mitigation, enforcing building codes, overseeing land use agreements, and streamlining insurance regulations.

section_title: What GAO Recommends
paragraphs: While GAO makes no new recommendations in this report, GAO reiterates its previous suggestion from a June 2011 report ( GAO-11-297 ) that Congress consider eliminating subsidized rates, charge full-risk rates to all policyholders, and appropriate funds for premium assistance to eligible policyholders to address affordability issues.

section_title: Letter
paragraphs: The National Flood Insurance Program (NFIP) is the key component of  the federal government’s efforts to minimize the damage floods cause  and the resulting financial impact and is the only source of insurance  against flood damage for most residents of flood-prone areas. Since  2000, NFIP has experienced several years with catastrophic losses,  primarily from Hurricane Katrina and the other 2005 storms and  Superstorm Sandy in 2012. Since then, the Federal Emergency  Management Agency (FEMA), which administers NFIP, has needed to  borrow money from the U.S. Department of the Treasury (Treasury) to  cover claims in some years. As of September 2013, FEMA owed  Treasury $24 billion—up from $17.8 billion prior to Superstorm Sandy— and had not repaid any principal on its loans since 2010. NFIP is unlikely  to be able to repay this debt in the near future, if ever. Because of its  recurring financial and management challenges, NFIP has been on our  high-risk list since March 2006.

NFIP’s growing debt has highlighted structural weaknesses in the  program and increased concerns about its burden on taxpayers. As a  result, Congress has shown increased interest in reducing the federal  government’s role in flood insurance by transferring its exposure to the  private sector. Flood insurance reform involves the question of who  should be responsible for paying to insure against the flood risk that  arises from living in a particular location—the individual property owners  themselves, taxpayers, or some combination of the two. Unlike private  insurance, which makes individuals responsible for their own risk through  premiums that reflect that risk, NFIP relies in part on taxpayer money.  Historically, NFIP was not designed to be actuarially sound, so premiums  do not cover the program’s costs. The National Flood Insurance Act of  1968 authorized subsidized rates to encourage participation in NFIP,  especially for properties in high-risk locations that were built before Flood  Insurance Rate Maps (FIRM) became available and the level of risk was  clearly understood. Without the subsidies, these properties would have  been charged significantly higher premiums. FEMA estimates that about  1.1 million of 5.5 million NFIP policies—about 20 percent—have  subsidized rates. The discounted premiums encourage property owners  to join the program but do not provide enough revenue to cover potential  losses, and many subsidized policies have had high losses.

The Biggert-Waters Flood Insurance Reform Act of 2012 (Biggert-Waters  Act) reauthorized NFIP through 2017 and made some significant  changes, such as eliminating the subsidies for certain properties, creating  a reserve fund, and eliminating the grandfathering of properties at old  rates after remapping. These changes are important steps in putting  NFIP on the path toward financial solvency, but a number of policies will  continue to receive subsidized rates. This report addresses one of several  GAO mandates in the Biggert-Waters Act: to assess a broad range of  options, methods, and strategies for privatizing NFIP. The report  discusses (1) conditions needed for private sector involvement in flood  insurance and (2) strategies for increasing such involvement.

To address these objectives, we reviewed NFIP laws, regulations, and  history, FEMA reports, academic studies, our prior work on NFIP, and  other documentation and reports. We also interviewed a variety of  stakeholders and held a roundtable in August 2013 to obtain views on  increasing private sector involvement in flood insurance. Stakeholders  participating in interviews and the roundtable included representatives  from FEMA, the Federal Insurance Office, private insurers, reinsurers,  state residual insurance programs, state insurance regulators, actuaries,  insurance adjusters, insurance agents, a catastrophe modeling firm,  consumer advocates, floodplain managers, mortgage bankers, realtors,  an academic, and other experts.

We conducted this performance audit from March 2013 to January 2014  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: Floods are the most common and destructive natural disaster in the  United States. However, flooding is generally excluded from homeowners  insurance policies, which typically cover damages from other losses, such  as wind, fire, and theft. Because of the catastrophic nature of flooding, the  difficulty of adequately predicting flood risks, and uncertainty surrounding  the possibility of charging actuarially sound premium rates, private  insurance companies have historically been largely unwilling to  underwrite flood insurance. NFIP, which makes federally backed flood  insurance available to residential property owners and businesses, was  intended to reduce the federal government’s escalating costs for repairing  flood damage after disasters. Under NFIP, the federal government  currently assumes the liability for the insurance coverage and sets rates  and coverage limitations, among other responsibilities, while private  insurers sell the policies and administer the claims for a fee determined  by FEMA. NFIP is managed by FEMA’s Federal Insurance and Mitigation  Administration, which is responsible for administering programs that  provide assistance for mitigating future damages from natural hazards.  Some private insurers provide coverage for flood insurance above the  limit of NFIP coverage, generally referred to as excess flood insurance.  Further, NFIP policies do not provide coverage for business interruption  or additional living expenses, which currently are available through some  private insurers.

Community participation in NFIP is voluntary, but communities must join  NFIP and adopt and enforce FEMA-approved building standards and  floodplain management strategies in order for their residents to purchase  flood insurance through the program. Additionally, communities in Special  Flood Hazard Areas (SFHA)—areas subject to a 1 percent or greater  chance of flooding in any given year—must participate in NFIP for  property owners to be eligible for any aid in connection with a flood,  including disaster assistance loans and grants for acquisition or  construction purposes. Participating communities agree to enforce  regulations for land use and new construction in high-risk flood zones and  to adopt and enforce state and community floodplain management  regulations to reduce future flood damage. Participating communities can  receive discounts on flood insurance if they establish floodplain  management programs that go beyond NFIP’s minimum requirements.

FEMA can suspend communities that do not comply with the program,  and communities can withdraw from it by submitting a copy of a  legislative action stating its desire to withdraw from NFIP. As of May  2013, about 22,000 communities voluntarily participated in NFIP.

NFIP has mapped flood risks across the country, assigning flood zone  designations based on risk levels, and these designations are a factor in  determining premium rates. To help reduce or eliminate the long-term risk  of flood damage to buildings and other structures insured by NFIP, FEMA  has used a variety of mitigation efforts, such as elevation, relocation, and  demolition. Despite these efforts, the number of repetitive loss  properties—generally, those that have had two or more flood insurance  claims payments of $1,000 or more over 10 years—has continued to  grow.
subsections: section_title: Subsidized Premium Rates
paragraphs: NFIP policies have what FEMA describes as either subsidized or full-risk  premiums. The type of policy and the subsequent rate a policyholder pays  depend on several property characteristics—for example, whether the  structure was built before or after a community’s FIRM was issued and  the location of the structure in the floodplain. Structures built after a  community’s FIRM was published must meet FEMA building standards,  and the property owner must pay full-risk rates, which reflect FEMA’s  estimates of the actual risk of flooding. Post-FIRM structures are  generally less flood prone than pre-FIRM properties because they have  been built to flood-resistant building codes or mitigation steps have been  taken to reduce flood risks.

Subsidized rates do not reflect the estimated total flood risk and instead  are highly discounted. Even with highly discounted rates, subsidized  premiums are, on average, higher than full-risk premiums because  subsidized pre-FIRM structures generally are more prone to flooding (that  is, riskier) than other structures. In general, pre-FIRM properties were not  constructed according to the program’s building standards or were built  without regard to base flood elevation—the level relative to mean sea  level at which there is an estimated 1 percent or greater chance of  flooding in a given year. For example, the average annual subsidized  premium with October 2011 rates for pre-FIRM subsidized properties was  about $1,224, while the average annual premium for post-FIRM  properties paying full-risk rates was about $492.

section_title: Program History
paragraphs: Flooding disasters of the 1920s and 1930s led to federal involvement in  protecting life and property from flooding, with the passage of the Flood  Control Act of 1936. Generally, the only available financial recourse to  assist flood victims was postdisaster assistance. When flood insurance  was first proposed in the 1950s, it became clear that private insurance  companies could not profitably provide flood coverage at a price that  consumers could afford, primarily because of the catastrophic nature of  flooding and the difficulty of determining accurate rates.

In 1965 Congress passed the Southeast Hurricane Disaster Relief Act  that provided financial relief for victims of flooding. In addition, the act  mandated a feasibility study of a national flood insurance program, which  helped provide the basis for the National Flood Insurance Act of 1968 that  created NFIP. From 1969 through 1977, the Department of Housing and  Urban Development (HUD), which administered NFIP at the time, had an  agreement with a consortium of private insurers known as the National  Flood Insurers Association. Under this agreement, HUD reimbursed the  association of insurers for operating costs and provided an annual  operating allowance equal to 5 percent of policyholders’ premiums. HUD  ended the partnership in 1978 and converted NFIP to a government- operated program because it could not come to an agreement with the  private insurers on issues such as HUD’s right to approve their operating  budgets and its authority over policy decisions and regulations. HUD also  estimated $15 million in cost savings by ending the partnership. The  insurers wanted to continue the partnership, but the HUD Secretary  decided to use her statutory authority to convert NFIP to a government  program. In 1978, we determined that the partnership had not reached a  last resort status and that the potential for a new agreement existed.

The Flood Disaster Protection Act of 1973 made the purchase of flood  insurance mandatory for owners of properties in special flood hazard  areas that are secured by mortgages from federally regulated lenders and  provided additional incentives for communities to join the program. The  National Flood Insurance Reform Act of 1994—which amended the 1968  act and the 1973 act—strengthened the mandatory purchase  requirements for owners of properties located in SFHAs with mortgages  from federally regulated lenders. The Bunning-Bereuter-Blumenauer  Flood Insurance Reform Act of 2004 authorized a pilot program to  encourage owners of properties that suffer from repeated flood losses to  take steps to reduce the risk of damage, known as mitigation. Owners of  these “severe repetitive loss” properties who refuse an offer to mitigate  the risks face higher premiums.

Finally, in 2012 the Biggert-Waters Act reauthorized the program through  2017 and removed subsidized rates for a number of insured properties,  such as residential properties that are not an individual’s primary  residence, severe repetitive loss properties, business properties, and  properties that had received payments for flood-related damage that  cumulatively equaled or exceeded the property’s fair market value. The  Biggert-Waters Act also included several other provisions, such as the  following.

Rates that fully reflect flood risk for specified properties are to be  phased in over several years—with increases of 25 percent each  year—until the average risk premium rate for these properties equals  the average of the full-risk premium rates for all properties in that risk  classification.

Properties will no longer qualify for subsidies if the policyholder has  deliberately chosen to let the policy lapse and if a prospective insured  refuses to accept any offer of mitigation assistance (including  relocation) following a major disaster.

Properties that did not have NFIP insurance when the act was  enacted and properties purchased after that date will not receive  subsidies. Subsidized properties that are sold will lose their  subsidies.

FEMA must adjust rates to accurately reflect the current risk of  flooding to properties when an area’s flood map is changed. FEMA  is determining how this provision will affect properties that were  grandfathered into lower rates.

In addition, the act allows average premium increases of 20 percent  annually by risk class (the previous cap was 10 percent), establishes  minimum deductibles, requires FEMA to establish a reserve fund, and  requires FEMA to include losses from catastrophic years in determining  premiums that are based on the “average historical loss year,” among  other things. The potential adverse effects on certain property owners of  the premium rate increases arising out of the Biggert-Waters Act and the  possibility of delaying some rate increases have been the subject of  congressional hearings and recent legislative proposals.

section_title: Policy Goals Framework
paragraphs: We previously identified goals for federal involvement in natural  catastrophe insurance programs. These goals can be adapted to help  evaluate strategies for increasing private sector involvement in flood  insurance. The goals include:  charging premium rates that fully reflect estimated risks, encouraging private markets to provide flood insurance, encouraging property owners to buy flood insurance, and limiting costs to taxpayers before and after a flood.

The four-goal framework captures the public policy goals for providing  insurance against natural catastrophes such as flooding. Stakeholders  with whom we spoke generally agreed that these goals were  appropriate.

section_title: Stakeholders Identified Several Conditions That Must Exist to Encourage Private Sector Involvement in Flood Insurance
paragraphs: Stakeholders with whom we spoke or who participated in our roundtable  discussion identified several conditions that would be needed to increase  private sector involvement in flood insurance. First, private insurers would  have to perceive floods as an insurable risk that they could profitably  cover—that is, they would need to be able to estimate both the frequency  and severity of future losses with some accuracy. Second, they would  need the freedom to charge adequate rates and decide which applicants  they would insure. Third, private insurers would need adequate consumer  participation in order to manage and diversify their risk.
subsections: section_title: Private Insurers Must Be Able to Accurately Assess Flood Risk
paragraphs: Private insurers generally cover only what they see as insurable risks  whose frequency and severity they can estimate with some accuracy.  Being able to calculate the average frequency and severity of future  losses enables insurers to set premium rates that are likely to be  sufficient to pay all claims and expenses and yield a profit. For this  reason, homeowners policies do not cover a variety of risks, such as  flooding, which tend to occur unexpectedly and can cause a devastating  amount of damage. NFIP was created in part because the catastrophic  nature of flooding made it difficult for private insurance companies to  develop an actuarial rate structure that could adequately reflect the risks  to flood-prone properties. The program is the only provider of affordable  flood insurance for most U.S. homeowners.

Stakeholders indicated that private insurers would need more information  and more sophisticated modeling to assess flood risk before they could  begin providing flood insurance. Risk modelers with whom we spoke  questioned the reliability of FEMA’s flood risk zones, which in many  areas, such as along coastlines, were determined using a less  sophisticated methodology than what is available today. For example,  one risk modeler said that FEMA’s base flood elevations were likely too  low in many places and that many structures across the country were at  higher flood risk than the flood maps indicated. According to one insurer,  determining flood risk for commercial policyholders involves reviewing  specific information, including FEMA flood maps and satellite imagery, to  determine a structure’s flood zone, proximity to other flood zones, and  elevation. This insurer uses geographical address information to  determine flood risk on a building-by-building basis based on a range of  factors that include the structural elements of a building and its contents.  One risk modeler suggested that FEMA should design flood risk maps for  future building stock and should model both current and future flood  levels; however, the risk modeler said that determining future flood risks  was a challenge and that the industry lacked consensus on the  methodology that should be used.

Stakeholders anticipated that risk modeling firms would be releasing new  flood models in the next several years, providing the tools that private  insurers would need to evaluate flood risk. Stakeholders also noted that a  private market for flood insurance would likely create a market for  modeling flood risk, attracting many companies to fill that need.  Stakeholders said that if other conditions for private sector involvement in  flood insurance were met, more risk-modeling companies or private  insurers would begin developing models that private insurers could use to  determine risks more accurately. For example, one risk modeler said risk  modelers could determine how different bodies of water, such as two  rivers, would interact and contribute to flood events—information that  FEMA’s flood maps do not include.

Stakeholders said that in addition to advanced computer modeling,  access to NFIP policy and claims data would help private insurers assess  flood risks and determine which properties they might be willing to insure.  However, FEMA officials said the agency would need to address privacy  concerns to provide property-level information to insurers, because the  Privacy Act prohibits the agency from releasing detailed NFIP policy and  claims data. The Privacy Act governs how federal agencies may use the  personal information that individuals supply when obtaining government  services or fulfilling obligations. FEMA officials said that while the  agency could release data in the aggregate, some information could not  be provided in detail. For example, FEMA could provide zip-code level  information to communities but would need to determine how to release  property-level information while protecting the privacy of individuals.

section_title: Private Insurers Would Need Freedom to Charge Adequate Rates and Manage Risk
paragraphs: Stakeholders said that private insurers would also need to be able to  charge adequate rates that would reflect the full estimated risk of flood  loss and allow for profit. In our prior work, one of the public policy goals  we adapted for evaluating options for increasing private sector  involvement in flood insurance was charging premium rates that fully  reflected estimated risks. Actuarially sound rates determined by private  insurers would differ from NFIP rates in that they would be calculated to  account for potential losses, reflect the cost of capital to cover potential  catastrophic losses, and provide a reasonable return for investors. As a  result, these rates would be higher than present NFIP rates for many  properties and could present affordability challenges for consumers. One  stakeholder said higher prices could lead some homeowners to purchase  lower amounts of coverage or choose not to purchase flood insurance at  all. Further, another stakeholder said higher flood insurance rates could  affect property owners’ home value and ability to sell their property. For  example, one stakeholder said that potential buyers might decide not to  purchase a home in a high-risk area after determining the cost of flood  insurance for the property.

Stakeholders said that the political environment could prevent insurers  from setting adequate rates. For example, they expressed concerns that  efforts to increase flood insurance rates would likely face public  resistance or be politically unpopular. Stakeholders said it was  challenging for private insurers to gain enough confidence to enter the  flood insurance market because they feared not being able to charge  actuarially sound rates or obtain a reasonable rate of return. For example,  stakeholders said that state by state approval of flood insurance rates  might impede insurers’ ability to obtain adequate rates. An insurer said  that most state insurance regulators lacked knowledge about flood  policies, but a state regulation official said that most states took a  measured approach to rate regulation, with an eye toward allowing  insurers to earn a reasonable profit. Further, one stakeholder said that  private insurers would need flexibility to account for potential climate  change effects when pricing flood, hurricane, and other risks associated  with sea level rise. Although potential climate change effects would have  a long time horizon, the stakeholder suggested it was an issue to  consider regarding the regulatory environment for private insurers.

In addition, stakeholders said that private insurers would need freedom in  underwriting policies so that they could accept and reject applicants as  necessary to manage their risk portfolios. Insurable risks have certain  characteristics that make providing coverage possible. As well as being  estimable, for example, loss exposure should not be potentially  catastrophic for the insurer. Freedom to manage risk would help  insurers manage potentially catastrophic losses and further encourage  their participation in the flood insurance market. For example, insurers  might determine that they needed to limit the number of policies in a  geographic area because a single flood event could result in losses on  many of those policies at the same time. Stakeholders said incentives  would be needed to encourage insurers to assume greater risk,  particularly in flood-prone areas. One stakeholder said the political  environment could limit insurers’ ability to accept and reject applicants as  necessary to manage their risk exposure. Further, stakeholders said that  different insurance regulations across states could further complicate  insurers’ ability to underwrite flood insurance. One stakeholder said that  insurers would need clarity on the political and regulatory environment  before entering the flood market.

section_title: Adequate Consumer Participation Would Also Be Necessary
paragraphs: Insurers need to be able to manage their risk exposure by having a large,  diverse risk pool with premiums at a level that property owners are willing  and able to pay. Having a large and diversified risk pool would enable  an insurer to better estimate losses based on loss data it collected over  time and to spread the losses over a large number of properties.  Economically feasible premiums would provide an opportunity or  incentive for property owners to obtain coverage. Further, in our prior  work, one of the public policy goals we adapted for evaluating strategies  for increasing private sector involvement in flood insurance was  encouraging broad consumer participation in the flood insurance market.  We previously have found that efforts to encourage broader participation  in NFIP could reduce costs, depending on how they were implemented.  Likewise, a large risk pool could help private insurers manage their  exposure.

Broad consumer participation in the market would also be necessary to  address adverse selection—the phenomenon that occurs when only  those most in need typically purchase insurance, creating a pool of only  the highest-risk properties. In this case, insurers must be confident that  homeowners other than those in the highest-risk areas will obtain flood  insurance, because adverse selection can hamper an insurer’s efforts to  manage its risk. A 2006 study estimated that NFIP participation rates  were as low as 50 percent in SFHAs, where property owners with loans  from federally insured and regulated lenders were required to purchase  flood insurance. The study also found that participation rates outside of  SFHAs were as low as 1 percent. Another study found that homeowners  both within and outside SFHAs who did obtain flood insurance when  purchasing their homes typically kept it for 2 to 4 years before canceling  their policies. Stakeholders said that homeowners were more likely to  purchase flood insurance immediately following a flood event and to drop  it later as their perception of their flood risk decreased.

Homeowners that do not purchase flood insurance, including many  residing in SFHAs, make that decision for a number of reasons that would  have to be addressed in order to make private flood insurance possible.  Stakeholders said that affordability was one of the key challenges to  providing flood insurance. In addition, stakeholders said that affordability  could be a particularly difficult issue for low- and moderate-income  homeowners, as evidenced by complaints surrounding rate increases  under the Biggert-Waters Act. Further, stakeholders said that not all  homeowners would be able to afford flood insurance at rates that private  insurers would consider adequate for reflecting the full estimated risk of  flood loss and allowing for profit.

Based on our analysis of stakeholder views and other information, many  property owners may also have an inaccurate perception of their risk of  flooding and thus do not buy flood insurance. For example, a 2012 study  suggested that some property owners believe that only properties in  SFHAs are in a flood zone and that properties located outside of SFHAs  are not at risk of flooding. Stakeholders said that it was difficult to  convince homeowners to pay for coverage for an unlikely event, despite  the potential for severe damage. The former definition of SFHAs as a  “100-year” flood zone has contributed in part to this misperception, given  the long time horizon, so that some property owners have assumed that  after experiencing a flood loss, their properties would be free from  flooding for the next 100 years. And one stakeholder indicated that  many consumers mistakenly assumed that their homeowners insurance  policies included flood coverage. In addition, a banking association with  whom we spoke said that some lending institutions did not see flood risk  as a threat to their safety and soundness and therefore often did not  require flood coverage at mortgage origination, potentially contributing  further to homeowners’ misperception of flood risk.

Finally, stakeholders suggested that many consumers did not obtain flood  insurance because they assumed they would receive federal or state  disaster assistance after a flood event. However, federal disaster  assistance to individuals is limited. Disaster assistance is administered  through several federal programs and is generally made available only  after the President issues a disaster declaration, but homeowners  seeking such assistance must first seek assistance from their flood  insurance policy. Further, while one federal grant program is available— the Individuals and Households Program—federal disaster assistance to  individuals and businesses for the repair or replacement of structures  consists primarily of federal loan programs. These include loans from the  U.S. Small Business Administration that are available to all first-time  applicants but to repeat applicants only if they have flood insurance.  Homeowners can apply for up to $200,000 in home and property disaster  loans for the repair or replacement of a primary residence to its  predisaster condition. Business disaster loans of up to $2 million are the  primary form of federal assistance for the repair and rebuilding of  nonfarm, private sector disaster losses. One stakeholder said many  homeowners without flood insurance would not qualify for individual  assistance or loans from the U.S. Small Business Administration and that  homeowners might not have options—other than filing for bankruptcy—to  recover financially from a flood event. We previously reported that while  the federal government has provided significant financial assistance after  major disasters, the federal role is primarily to assist state and local  governments, which have the central role in recovery efforts.

Based on our analysis, all of these issues would need to be addressed to  create the conditions that would encourage private insurers to consider  providing flood insurance. Addressing them would be a complex task and  would require difficult trade-offs. For example, raising rates beyond what  FEMA currently charges could create significant hardship and put at risk  the homes of those who could not afford flood insurance. Further, it could  be a challenge to encourage property owners to purchase flood  insurance, particularly when many of them do not believe they are  exposed to the risk of flooding.

section_title: Several Strategies Could Encourage Private Sector Involvement, but a Governmental Role Would Likely Be Required
paragraphs: Stakeholders with whom we spoke or who participated in our roundtable  discussion identified several strategies that could be used to help transfer  some of the responsibility of providing flood insurance from the federal  government to the private sector. These strategies, or certain aspects of  them, could be used jointly to promote the conditions that stakeholders  said would be necessary for private sector involvement—the ability to  assess risk, the freedom to charge adequate rates and manage risk, and  adequate consumer participation. These strategies serve only as broad  potential frameworks, and because of the complexity of providing flood  insurance, the success of any reform effort would also depend on how it  is structured and implemented. Further, stakeholders said that any  strategy will likely require certain roles for federal, state, and local  government entities.
subsections: section_title: Several Strategies Could Help Create Conditions for Private Sector Involvement
paragraphs: One strategy stakeholders identified, which we have also mentioned in  previous reports, would be for Congress to eliminate subsidized rates,  charge full-risk rates to all policyholders, and appropriate funding for a  direct means-based subsidy to some policyholders. A second strategy  that stakeholders identified would be for the federal government to  provide only residual insurance, serving as the insurer of last resort for  properties that the private sector is unwilling to insure. Alternatively, a  third strategy would be for the federal government to serve as a reinsurer  and charge private insurers a premium for the federal government to  assume risk for losses that exceed a predetermined amount. In addition  to these strategies, stakeholders proposed others, including mandatory  coverage, reinsurance for NFIP, and catastrophe bonds.
subsections: section_title: Full-Risk Rates with Targeted Subsidies
paragraphs: Stakeholders proposed eliminating all subsidized rates and charging all  policyholders rates that reflected the full estimated risk of flooding, with  Congress providing a direct means-based subsidy to some  policyholders. Stakeholders generally agreed that any subsidies should  be explicit and provided directly to the policyholder instead of hidden in a  discounted premium rate, partly because such hidden subsidies conceal  a property’s actual flood risk and encourage development in high-risk  areas. While the premium levels may be sufficient to cover claims in  years with lower losses, the subsidies result in insufficient premium  revenue over the long term to cover years with higher losses. As a result,  the cost of subsidies is disguised from taxpayers and evident only in  FEMA’s need to borrow from Treasury. Making the subsidies explicit  would require Congress to appropriate funds for them, increasing  transparency by showing the exact annual cost of the subsidies. Such  subsidies could require determining eligibility requirements—for example,  a means test—as well as the amount of subsidies. We suggested that  Congress consider this approach in a previous report and this strategy  continues to be an option that could offer benefits to the program and  could be implemented independent of any increase in private sector  involvement in flood insurance.

Stakeholders said that removing the hidden subsidies and charging full- risk rates to all policyholders has a number of advantages. For example,  demonstrating the political will to charge full-risk rates within NFIP could  signal to private insurers a greater likelihood of being allowed the freedom  to charge adequate rates in a private flood insurance market, thus  encouraging their potential participation. However, stakeholders  expressed concerns over discussions of proposals to delay rate  increases, specifically those authorized by the Biggert-Waters Act.  These stakeholders said that such delays would increase private insurers’  skepticism about the feasibility of participating in a private flood insurance  market. Although raising rates could create affordability concerns for  some, delaying the increases could reduce the chances of increasing  private sector involvement in flood insurance, leaving taxpayers to  continue paying for flood claims through future borrowing from Treasury.

Based on our analysis, providing means-tested subsidies to some  property owners would allow Congress to address affordability concerns  associated with premium rate increases. Currently, subsidies are  available regardless of a property owner’s ability to afford a full-risk  premium. Means testing the subsidies would ensure that only those who  could not afford full-risk rates would receive assistance and should  increase the amount in premiums NFIP collects to cover losses.  Collecting more in premiums by providing subsidies to fewer  policyholders would reduce taxpayer costs, one of the goals for reforming  catastrophe insurance. Finally, charging full-risk rates to all policyholders  would demonstrate a property’s actual flood risk to property owners,  discourage further development in high-risk areas, and encourage  property owners to invest in mitigation to lower their exposure to flood risk  as well as their premium rate. However, while means-tested subsidies  could make premium rates more affordable, they could also decrease a  property owner’s incentive to mitigate.

Stakeholders raised other concerns about increases in flood insurance  premium rates. One stakeholder noted that rate increases could lower a  home’s market value because the cost of owning the home would rise.  Further, stakeholders said that some communities with a high risk of  flooding could become economically unviable if premium rate increases  made flood insurance unaffordable for too many residents. For example,  stakeholders as well as participants in congressional hearings have said  that rate increases in some high-risk areas could make it unaffordable for  many homeowners within a community to stay in their homes, which  could lead to declining property values for homes and businesses.  Premium rate increases could also cause some property owners to  cancel their coverage or opt not to purchase it, particularly those who  were not already mandated to purchase flood insurance. Reduced  participation could negate some of the benefits of providing the targeted  subsidies. Means-based subsidies could soften some of these potential  effects, but any solution will need to consider whether other steps would  be necessary to limit adverse effects on particular communities.

Finally, the Biggert-Waters Act eliminates the transfer of subsidies when  homes are sold and the renewal of subsidized policies if a policyholder  deliberately chooses to allow flood coverage to lapse. We previously have  reported that the continuing implementation of the act is expected to  decrease the number of subsidized policies. As the number of  subsidized policies falls, NFIP’s premium shortfall will decrease, helping  its financial condition. Means-based subsidies could provide greater up- front savings by limiting the number of policyholders that would be eligible  for the subsidies. However, there could be a point when the cost of  continued means-based subsidies could exceed the level of subsidies  that will otherwise exist as homes are sold or coverage lapses. Some  stakeholders suggested that targeted subsidies should be temporary to  help address this concern.

section_title: Government as Residual Insurer
paragraphs: According to stakeholders, another strategy for increasing the private  sector’s role in flood insurance is to have the federal government serve as  the insurer of last resort. This strategy would give private insurers the  opportunity to provide flood insurance to most property owners who  desire it, and the federal government would offer coverage only to the  highest-risk properties that private insurers were unwilling to underwrite.  Stakeholders said that particularly in the early years, private insurers  might be conservative regarding the properties they were willing to insure,  but many might be willing to insure more properties as they grew  comfortable with underwriting flood coverage. Some states have similarly  structured residual insurance programs for other perils that could provide  insight and offer lessons in structuring such a program for flood  insurance. For example, representatives from state residual insurance  programs with whom we spoke said their programs charged rates that are  higher than what would be available in the private market to ensure they  remain insurers of last resort and discourage property owners from using  it as an alternative to private sector coverage.

This strategy could help create the conditions we identified earlier in this  report for increasing private sector involvement. To address private sector  concerns about being able to accurately set rates, FEMA could grant  private insurers access to historical claims data. However, as noted  earlier FEMA would need to ensure that any disclosure complies with the  Privacy Act. Further, the premium rates for residual coverage should be  above what private market rates would be for comparable coverage to  discourage property owners from using it as an alternative to private  coverage.

Because this strategy would transfer many of NFIP’s policies to the  private sector, NFIP’s total exposure would likely decrease. To the extent  that the residual policies sold by NFIP were priced at full-risk rates, long- term taxpayer costs could be reduced. However, while full-risk rates  would reduce taxpayer costs in the long-term, the average cost and  volatility of the program’s remaining policies would increase, because  NFIP would be left with the highest-risk policies. Further, because these  residual policies would have the highest risk, they would require high  premium rates to cover their full risk of loss, potentially reducing  consumer participation. Combining this option with means-based  subsidies could help address affordability concerns and maintain  consumer participation.

section_title: Government as Reinsurer
paragraphs: According to stakeholders, a third strategy for increasing private sector  involvement in flood insurance would be for the federal government to  provide reinsurance to private insurers. Specifically, the federal  government could provide a backstop for private insurers by agreeing to  pay the difference when total claims exceeded a certain amount within a  specified period. To fund reinsurance claims for catastrophic losses, the  federal government could collect premiums from private insurers. Some  stakeholders said that the private reinsurance industry might be able to  provide some reinsurance to private insurers, reducing the federal  government’s potential role in reinsurance. However, other stakeholders  expressed concerns that private reinsurers might raise premium rates or  cancel coverage after a catastrophic loss year, creating uncertainty for  private insurers that could affect their willingness to enter the flood  insurance market.

Stakeholders said that the risk of insolvency in the event of catastrophic  flood losses might make some private insurers hesitant to enter the flood  insurance market and that providing reinsurance could help address  these concerns and encourage their participation. If the federal  government collected adequate reinsurance premiums, this strategy  could also reduce costs to taxpayers, one of the goals for reforming  natural catastrophe insurance, because most of the flood risk would be  transferred to the private sector. However, the costs of these reinsurance  premiums would likely be passed onto the policyholder, and the resulting  higher rates could reduce consumer participation. Once again, means- based subsidies could help soften these rate increases and maintain  consumer participation.

section_title: Other Strategies
paragraphs: Stakeholders identified several other strategies that could help encourage  private sector involvement in flood insurance.

Mandatory coverage. In particular, some stakeholders said that a federal  mandate could help achieve the level of consumer participation  necessary to make the private sector comfortable with providing flood  insurance coverage. For example, some stakeholders said that the  federal government could mandate that homeowners insurance policies  include flood coverage or that all homeowners purchase flood  insurance. Either mandate could increase the number of homeowners  purchasing flood insurance, something that could help private insurers  diversify and manage the risk of their flood insurance portfolio and  address concerns about adverse selection. However, the stakeholders  were also concerned that private companies might oppose a mandate  that homeowners policies include flood coverage, potentially raising legal  issues. Further, stakeholders said that some property owners— particularly those who perceived their flood risk to be low—might also  resist being required to purchase flood insurance. Finally, as we have  reported the federal government has faced challenges with enforcing the  current mandatory purchase requirement for flood insurance, which  applies to properties in high-risk areas with federally regulated  mortgages. If the federal government faces similar challenges with  additional mandates, it might not realize the intended benefits of  increased consumer participation.

Reinsure NFIP. Other stakeholders discussed NFIP purchasing  reinsurance from the private sector to cover exposure to catastrophic  losses rather than relying on borrowing from Treasury. While doing so  would increase private sector involvement in flood insurance, the federal  government would still play an active role in flood insurance, because  NFIP would still serve as the main provider of primary flood insurance  coverage. However, the federal government’s exposure to catastrophic  losses could be reduced. On the other hand, stakeholders noted that  private companies might cancel reinsurance after a catastrophic loss  year, leading to uncertainty as to the degree to which the federal  government’s exposure would be mitigated. Further, stakeholders said  that NFIP may need to collect additional premiums on its existing policies  to pay for the reinsurance. However, given that NFIP’s current premium  levels are insufficient, NFIP may be unable to pay for this additional  expense.

Catastrophe bonds. Stakeholders said that as an alternative to  reinsurance, NFIP might be able to limit its exposure to large losses by  transferring risk to capital markets through insurance-linked securities  such as catastrophe bonds. For example, NFIP could issue interest- bearing bonds to investors willing to bear the risk of losing some of their  investment if flood claims exceeded a predetermined amount. Like  reinsurance, catastrophe bonds could help NFIP manage its risk  exposure, but again it would need to be able to collect adequate  premiums to cover any necessary payments of principal or interest. We  have previously reported that state insurance entities, as well as private  sector insurers, have used catastrophe bonds to manage their risk.

section_title: A Governmental Role Would Remain Even in a Private Flood Insurance Market
paragraphs: Stakeholders with whom we spoke or who participated in our roundtable  discussion said that no matter which strategies Congress might choose  for increasing private sector involvement in flood insurance, the federal  government would likely still have some role. For example, some  strategies include transforming the federal government’s role from  primary provider of flood insurance to a residual insurer or a reinsurer. As  the private sector increases its role in providing flood coverage, various  government entities could collaborate on other important roles. In  particular, stakeholders said that it would continue to be important for  federal, state, and local governments to encourage mitigation through  direct funding or other less costly strategies and to promote risk  awareness among consumers. Stakeholders said that government  entities want to reduce property owners’ current and future exposure to  flood risk and increase the resiliency of their structures. Stakeholders also  said that with private flood insurance, both the insurance company and  the policyholder would have some incentive to mitigate, the insurer to  reduce its risk exposure and the policyholder to lower the premium rate.  More generally, stakeholders also said that various government entities  should continue developing and enforcing building codes and land use  agreements in order to reduce the flood risk of current structures and  prevent future development in high-risk areas. Stakeholders also said that  the federal government should ensure consistent insurance standards  and regulations across states, in part through streamlined state  regulations or federal oversight, to allow insurers to charge adequate  rates.

section_title: Concluding Observations
paragraphs: While a number of conditions are important to attract private sector  participation in the flood insurance market, key among them is the ability  to charge rates that fully reflect the estimated risk of flooding. The  Biggert-Waters Act includes a number of provisions that begin moving  NFIP toward full-risk rates for some properties, a critical first step.  Delaying or repealing rate increases in the Biggert-Waters Act may  address affordability concerns but would likely continue to increase  NFIP’s long-term burden on taxpayers. Further, it may reinforce private  insurers’ skepticism that they would ever be permitted to charge adequate  rates and make their participation unlikely in the foreseeable future. As  debates over the private sector’s role continue, one step to address the  burden on low- and moderate-income policyholders could be taken  immediately. As we have suggested previously, Congress could eliminate  subsidized rates, charge full-risk rates to all policyholders, and  appropriate funds for a direct means-based subsidy to eligible  policyholders. The movement to full-risk rates would encourage private  sector participation, and the explicit subsidy would address affordability  concerns, raise awareness of the risks associated with living in harm’s  way, and decrease costs to taxpayers, depending on the extent and  amount of the subsidy.

section_title: Agency Comments
paragraphs: We provided a draft of this report to the Federal Emergency Management  Agency (FEMA) and the Federal Insurance Office for their review and  comment. FEMA provided technical comments, which we have  incorporated into the report.

We are sending copies of this report to the appropriate congressional  committees, FEMA, and the Federal Insurance Office. In addition, the  report is available at no charge on the GAO website at  http://www.gao.gov.

If you have any questions about this report, please contact me at (202)  512-8678 or cackleya@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 key contributions to this report are  listed in appendix II.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The Biggert-Waters Flood Insurance Reform Act of 2012 (Biggert-Waters  Act) mandated that GAO conduct a number of studies, including this  study on assessing a broad range of options, methods, and strategies for  privatizing the National Flood Insurance Program (NFIP). This report  discusses (1) conditions needed for private sector involvement in flood  insurance and (2) strategies for increasing it.

To both identify conditions needed for private sector involvement in flood  insurance and evaluate the benefits and challenges of strategies for  increasing private sector involvement, we reviewed the laws, regulations,  and history of NFIP, Federal Emergency Management Agency (FEMA)  reports, academic studies, our prior work on NFIP, and other  documentation and reports. We also held a roundtable in August 2013  composed of a variety of stakeholders to obtain their views on these  issues. The 14 stakeholders participating in the roundtable included  FEMA officials; state insurance regulators; a catastrophe modeling firm;  an academic; and individuals representing associations of private  insurers, reinsurers, actuaries, consumers, and floodplain managers. We  supplemented information obtained through the roundtable with  interviews with stakeholders representing the groups listed above as well  as Federal Insurance Office officials; state residual insurance programs;  and groups representing insurance adjusters, insurance agents, realtors,  and mortgage bankers. We selected a diverse group of stakeholders for  the roundtable and interviews based on type of organization, role, and  membership. In addition, we identified some stakeholders based on work  conducted from a prior report, and suggestions from other stakeholders.  The roundtable discussion focused on four broad themes that included: a policy goals framework for evaluating options for increasing private  sector involvement in flood insurance, barriers to private sector involvement that would need to be options for private sector involvement and associated benefits and  challenges, and  the governmental role that would remain in a private flood insurance  market.

We identified four public policy goals to evaluate options for changing the  federal role in natural catastrophe insurance in a prior report. These  goals are generally consistent with the evaluation criteria the stakeholders  discussed. Roundtable participants and other stakeholders generally  agreed that these goals were applicable for evaluating options for  increasing private sector involvement in flood insurance.

We conducted this performance audit from March 2013 to January 2014  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: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Patrick Ward (Assistant Director);  Emily Chalmers; Heather Chartier; William Chatlos; Christopher Forys;  Patricia Moye; and Carrie Watkins made key contributions to this report.


Question-summary annotations: questions: question: What did stakeholders explain to GAO regarding private sector involvement in flood insurance sales?
answer: According to stakeholders with whom GAO spoke, several conditions must be present to increase private sector involvement in the sale of flood insurance.
child_questions: question: What is the first condition?
answer: First, insurers need to be able to accurately assess risk to determine premium rates. For example, stakeholders told GAO that access to National Flood Insurance Program (NFIP) policy and claims data and upcoming improvements in private sector computer modeling could enable them to better assess risk.

question: What is the second condition?
answer: Second, insurers need to be able to charge premium rates that reflect the full estimated risk of potential flood losses while still allowing the companies to make a profit, as well as be able to decide which applicants they will insure. However, stakeholders said that such rates might seem unaffordable to many homeowners.

question: What is the third condition?
answer: Third, insurers need sufficient consumer participation to properly manage and diversify their risk, but stakeholders said that many property owners do not buy flood insurance because they may have an inaccurate perception of their risk of flooding.

questions: question: How could Congress create a direct means-based subsidy for some policyholders?
answer: Congress could eliminate subsidized rates, charge all policyholders full-risk rates, and appropriate funding for a direct means-based subsidy to some policyholders.
child_questions: question: How might this subsidy be beneficial, according to stakeholders?
answer: Stakeholders said full-risk NFIP rates would encourage private sector participation because they would be much closer to the rates private insurers would need to charge. The explicit subsidy would address affordability concerns, increase transparency, and reduce taxpayer costs depending on the extent and amount of the subsidy.

question: How might delaying the Biggert-Waters Act help?
answer: The Biggert-Waters Act eliminates some subsidized rates, but some have proposed delaying these rate increases. Doing so could address affordability concerns, but would also delay addressing NFIP's burden on taxpayers.

questions: question: What has NFIP's debt accrual highlighted?
answer: NFIP has accrued $24 billion in debt, highlighting structural weaknesses in the program and increasing concerns about its burden on taxpayers.
child_questions: question: What has this resulted in?
answer: As a result, some have suggested shifting exposure to the private sector and eliminating subsidized premium rates, so individual property owners--not taxpayers--would pay for their risk of flood loss.

question: Why was NFIP created?
answer: NFIP was created, in part, because private insurers were unwilling to insure against flood damage, but new technologies and a better understanding of flood risks may have increased their willingness to offer flood coverage.

questions: question: What does the Biggert-Waters Flood Insurance Reform Act mandate?
answer: The Biggert-Waters Flood Insurance Reform Act of 2012 moves NFIP toward charging more full-risk rates. It also mandates that GAO conduct a study on increasing private sector involvement in flood insurance.

question: What does this report address?
answer: This report addresses (1) the conditions needed for private sector involvement in flood insurance and (2) strategies for increasing private sector involvement.
child_questions: question: How did GAO collect data for this report?
answer: To do this work, GAO reviewed available documentation and hosted a roundtable in August 2013 that included stakeholders from FEMA, the insurance and reinsurance industries, and state insurance regulators, among others. GAO also interviewed other similar stakeholders.