Flood Insurance: Opportunities Exist to Improve Oversight of the WYO Program
Released: 2009-09-21T00:00:00

Letter

Background

Because of the catastrophic nature of flooding and the difficulty of adequately predicting flood risks, private insurance companies have largely been unwilling to underwrite and bear the risk of flood insurance. Under NFIP, the federal government assumes liability for flood insurance losses and sets rates and coverage limitations, among other responsibilities. Since its inception, NFIP, to a large extent, has relied on the private insurance industry to sell and service policies, as Congress envisioned when it authorized the program in 1968. The authorizing legislation provides broad authority for FEMA to work with the private insurance industry, and over time, FEMA has utilized several arrangements with private insurers, including with companies themselves and with a single vendor. Because of customer complaints and stagnant policy growth, in 1983, FEMA established the WYO program. According to FEMA, the goals of the WYO program are to increase the NFIP policy base and the geographic distribution of policies, improve service to NFIP policyholders through the infusion of insurance industry knowledge, and provide the insurance industry with direct operating experience with flood insurance.

In 1986—the first year of the WYO program—48 WYO insurance companies were responsible for about 50 percent of the more than 2 million policies in force. As of September 2008, about 90 WYO insurance companies accounted for 97 percent of the nearly 5.6 million policies in force at that time. Because WYOs are not risk-sharing insurers, they are not paid an explicit profit percentage or amount.

Private insurers become WYOs by entering into an arrangement with FEMA (the Financial Assistance/Subsidy Arrangement) to issue flood policies in their own name. The insurers must have experience in property and casualty insurance lines, be in good standing with state insurance departments, and be capable of adequately selling and servicing flood insurance policies. They must also comply with the provisions of FEMA’s Control Plan, which outlines the companies’ responsibilities for program operations, including underwriting, claims adjustments, cash management, and financial reporting, as well as FEMA’s responsibilities for management and oversight.

WYOs adjust flood claims and settle, pay, and defend all claims arising from the flood policies. Insurance agents from these companies are the main point of contact for most policyholders. Based on information the insurance agents submit, WYOs issue policies, collect premiums, deduct an allowance for commission and operating expenses from the premiums, and remit the balance to NFIP. In most cases, insurance companies hire subcontractors—flood insurance vendors—to conduct some or all of the day-to-day processing and management of flood insurance policies.

When flood losses occur, policyholders report them to their insurance agents, who notify the WYO insurance companies. The WYO companies review the claims and process approved claims for payment. FEMA reimburses the WYO insurance companies from the National Flood Insurance Fund for the amount of the claims plus expenses for adjusting and processing the claims, using rates that FEMA establishes. Claims amounts may be adjusted after the initial settlement is paid if claimants submit documentation showing that some costs were higher than estimated.

FEMA Does Not Systematically Consider WYOs’ Actual Expenses When Setting Payment Rates

FEMA does not systematically consider actual flood insurance expense information when it determines the amount it pays WYOs for selling and servicing flood insurance policies and adjusting claims. Since the inception of the WYO program, FEMA has used proxies to determine the rates at which it pays WYOs. For example, payments for operating expenses are determined annually based on the average industry operating expenses for five lines of property insurance. WYOs’ actual flood insurance expense information has been available since 1997, when the companies began reporting the data to NAIC. However, FEMA has not systematically considered these data when setting its payment rates, and thus does not determine in advance the amounts built into payment rates for estimated expenses and profit. Further, FEMA has not, after the end of each year, compared the WYOs’ actual expenses to payments it makes to the WYOs. Because FEMA does not routinely take WYOs’ actual flood expenses into account when calculating payments and does not analyze actual payments and WYO flood insurance expenses, it does not have the information it needs to determine whether its payments are appropriate and how much profit is included in its payments to WYOs.

FEMA has occasionally modified its methods for determining the amount of expense payments, but only the last of these modifications, made in 2008, has taken into account the amount of actual WYO insurance expenses. In 2001, FEMA increased its payments to WYOs for servicing flood policies by an additional 1 percent of written premiums after some WYOs told FEMA that the payment amounts, based on the proxy used, were not sufficient to cover their operating expenses. FEMA did not take into consideration WYOs’ actual expenses in making these additional payments, which continued each year since 2001 and totaled about $25 million in fiscal year 2007. However, we found that the payments to the six WYOs we reviewed exceeded their actual operating expenses even before these payments were increased by an additional 1 percent of written premiums. FEMA did consider actual flood insurance expenses in 2008 when it changed its method of paying claims processing expenses. Beginning in fiscal year 2008—in response to the significant increase in total payments made to WYO companies in fiscal year 2005 and 2006 following the 2004 and 2005 hurricanes—FEMA changed its method for paying claims processing expenses to take into account actual flood expense data obtained from a selected number of WYO companies. These examples illustrate the benefit of considering actual flood expense data in administering the WYO program.

We recognize that the consistency of WYOs’ reporting to NAIC needs to be improved in order for data on the companies’ expenses to be fully utilized.

For example, we found that, among other things, some companies reported their flood insurance expenses to NAIC after offsetting them with the payments they received from FEMA. We also found that the actual expenses of one of the six companies we reviewed included payments made under service agreements with an affiliated company that may include profit distributions that should not be included in the expense amounts considered when setting payment rates. Nevertheless, we were able to use NAIC flood insurance data, supplemented with information obtained from WYO company officials, to compare the actual flood insurance expenses our six selected companies incurred and the payments they received for calendar years 2005 through 2007. We found that FEMA’s payments exceeded the companies’ actual expenses by $327.1 million, or 16.5 percent of total payments made.

Our results highlight the importance of FEMA’s considering actual flood expense data in administering the WYO program. In accordance with our Standards of Internal Control in the Federal Government, FEMA should ensure that its payment rates to WYOs are appropriate by, for example, comparing payments with actual flood insurance expenses. Further, federal managerial cost accounting standards state that reliable cost information is critical to the proper allocation and stewardship of federal resources and that actual cost information is an important element agency management should consider when setting payment rates.

FEMA Has Not Aligned Its Bonus Structure with Its Long-Term Goals for NFIP

FEMA has not aligned its bonus structure for WYOs with its goals for NFIP, such as increasing penetration in low-risk flood zones, among homeowners without federally-related mortgages in all zones, and in geographic areas with repetitive losses and low penetration rates. Instead, FEMA uses a broad-based distribution formula that awards a bonus of 0.5 percent to 2 percent of the premiums collected if WYOs achieve a 2 percent to 5 percent net growth in policies on an annual basis. This formula primarily rewards companies that are new to NFIP, when it is easiest to increase the percentage of net policies from a small base. Further, we found that most WYOs generally offered flood insurance when requested but did not strategically market the product as a primary insurance line. As a result, any sales increases may in fact result from external factors that are outside the companies’ control, rather than from marketing efforts—factors such as flood events, changes in the housing market, and economic developments. For example, sales of flood insurance tend to rise after flooding events, and FEMA’s Floodsmart media marketing campaign, which also has a goal of increasing flood policies by 5 percent annually, may also impact flood insurance sales. Moreover, FEMA does not review the WYOs’ marketing plans and therefore lacks the information needed to assess the effectiveness of either the WYOs’ efforts to increase participation or the bonus program itself.

The Government Performance and Results Act of 1993 requires agencies to conduct systematic studies to assess how well programs are working. When program results could be influenced by external factors, agencies can use intermediate goals to identify the program’s discrete contribution to a specific result. Although a study funded by FEMA suggested that the agency should focus on increasing market penetration in low-risk flood zones, in targeted geographical areas, and in small, special high-risk flood hazard areas, FEMA has not set targeted market penetration goals beyond its 5 percent goal of increasing policy growth. Having intermediate targeted goals could help expand program participation, and linking such goals directly to the bonus structure could help ensure that NFIP and WYO goals were in line with each other.

FEMA Followed Some but Not All of Its Internal Control Requirements and Procedures

FEMA has explicit financial control requirements and procedures for overseeing the WYO program. FEMA’s Control Plan provides guidance for WYOs that is intended to ensure compliance with the statutory requirements for NFIP and that contains several checks and balances to help ensure that taxpayers’ funds are spent appropriately. The plan has four major components that include requirements for: (1) monthly data and financial reporting, (2) claims reinspections by FEMA’s contractor, (3) various audits by independent CPAs, including required biennial audits, audits for cause, and state insurance department audits, and (4) triennial operation reviews by FEMA staff. FEMA’s Standards Committee is responsible for ensuring that participating companies are complying with the requirements.

For the 10 WYOs in our sample, FEMA followed some but not all of the requirements and procedures of the Control Plan and did not systematically track the outcomes of the various audits, inspections, and reviews. Our review of FEMA’s records for these WYOs showed the following: FEMA collected nearly all of the required monthly data submissions.

WYOs from our sample whose claims were selected for reinspections were reinspected according to the Control Plan’s methodology, and evidence of these activities was provided.

Biennial audits and underwriting and claims triennial reviews were also mostly implemented. FEMA officials said that they focused on claims and underwriting reviews because these areas were the most important to determining whether claims reimbursements to WYOs were appropriate.

Other audits, including audits for cause, state insurance department audits, and marketing, litigation, and customer service triennial operation reviews, were rarely or never implemented. FEMA officials said that they no longer performed marketing, litigation, and customer service operations reviews because each of these functions were being reviewed by other means. However, FEMA could not provide us with evidence that these reviews met the Control Plan’s requirements.

In addition, we found that WYO compliance with each component of the Control Plan was the responsibility of multiple units, and FEMA did not maintain a single, comprehensive monitoring system that would allow it to ensure compliance with all components of the plan. That is, FEMA did not centrally store WYO-specific evaluations, inspections, audits, or reviews that were to be performed in accordance with the Control Plan. FEMA officials told us that various staff within FEMA or its contractor was responsible for ensuring that appropriate documentation of oversight efforts were maintained. These officials told us that there was no centralized access, either physical or electronic, to all of the documentation produced in overseeing WYOs under the Control Plan.

Systematically tracking compliance with the Control Plan could ensure that participating WYOs are collecting appropriate premiums and making appropriate claims payments. Since most payments made to WYOs are based on premiums collected and claims paid, adequate enforcement of the Control Plan is important to ensuring that WYOs are being compensated appropriately. Because FEMA does not implement all aspects of the Control Plan, it cannot ensure that the WYOs are fully complying with program requirements.

Alternative WYO Program Administrative Structures Could Be Used to Incorporate Competition into the Payment Process

FEMA’s current relationship with WYOs facilitates insurance companies’ participation in NFIP. But, as previously discussed in this report, this relationship is based on a payment structure that may not reflect the actual expenses these companies incur. We examined three alternative administrative structures that could replace NFIP’s payment arrangement with a competitively awarded contract that could lower costs for selling and servicing flood insurance policies and administering claims: contracting with one or more insurance companies, contracting with a single vendor (similar to the NFIP Direct program), or contracting with multiple vendors and maintaining the WYO network.

Each of these alternatives has advantages and disadvantages in terms of the potential impact on the basic operations of administering flood insurance policies and adjusting claims, as well as on FEMA’s oversight of the program and its contractors. For example, contracting with one or more insurance companies might lower FEMA’s costs for the program through competitive bidding. But most insurance company officials we spoke to said that they did not want to be federal contractors because of the regulations that would apply and emphasized that they had agreed to participate in the WYO program only because it was not based on an explicit federal contract. Further, contracting with a single vendor, as FEMA does under the current NFIP Direct program, might be less expensive but would almost completely eliminate insurance companies’ participation and their network of insurance agents. Experts we spoke with also pointed out that using a contractor to administer the flood program failed in the early 1980s due to the contractor’s lack of experience in administering insurance policies. Finally, contracting with multiple vendors to service flood policies would allow FEMA to keep the WYO network and might make oversight more effective because FEMA would have a contractual relationship with significantly fewer companies. But experts we spoke to said that this structure would encroach on WYOs’ ability to use a subcontractor to administer their flood line. Flood consultants, vendors, and trade groups we spoke to were more receptive to exploring an alternative structure using multiple vendors.

Conclusions

Given the significant risk exposure to the federal government, it is imperative that FEMA carry out its stewardship responsibilities by effectively and efficiently overseeing the WYO program and the more than 90 participating insurance companies. FEMA has taken some steps to address these issues, including taking into consideration the actual expenses of a selected number of WYOs before changing its method for paying claims expenses and preparing a revised draft of its Control Plan, which had not been updated since 1999. Additional opportunities exist for FEMA to improve its oversight of the WYO program and ensure that payments to the participating insurance companies are based on actual company expenses, thereby improving the program’s cost-effectiveness. However, our review demonstrates the following: FEMA sets rates for paying WYOs for their services without knowing how much of its payments actually cover expenses and how much goes toward profit. Specifically, it does not determine in advance the amounts built into the payment rates for estimated expenses and profit; annually analyze the amounts of actual expenses and profit in relation to the estimated amounts used in setting payment rates; or consider the results of the analysis of payments, actual expenses, and profit in evaluating the methods for paying WYOs. Moreover, it does not have a sound basis for its practice of paying WYOs an additional 1 percent of written premiums for operating expenses. As a result, FEMA does not have the information it needs to determine whether its payments to WYOs are reasonable.

FEMA has not tied its bonus structure to the long-term strategic goals for the program. As a result, it cannot be assured that the WYO program is achieving its intended goals in the most cost-effective manner. Moreover, FEMA does not collect the information on the WYOs’ marketing efforts, which is needed to determine whether the companies’ marketing efforts are aimed at helping to promote increased participation among targeted groups and in targeted areas in line with NFIP goals.

FEMA has not consistently implemented all aspects of its current Control Plan and does not systematically track WYOs’ compliance with the plan’s requirements. As a result, FEMA cannot ensure that the WYOs are fully complying with NFIP requirements, including oversight of the various payments that depend on accurate premiums collected and appropriate claims made.

Recommendations for Executive Action

To provide transparency and accountability over the payments FEMA makes to WYOs for expenses and profits, we recommend that the Secretary of Homeland Security direct the Under Secretary of Homeland Security, FEMA, to determine in advance the amounts built into the payment rates for estimated expenses and profit; annually analyze the amounts of actual expenses and profit in relation to the estimated amounts used in setting payment rates; consider the results of the analysis of payments, actual expenses, and profit in evaluating the methods for paying WYOs; and in light of the findings in this report, immediately reassess the practice of paying WYOs an additional 1 percent of written premiums for operating expenses.

To increase the usefulness of the data reported by WYOs to NAIC and to institutionalize FEMA’s use of such data, we recommend that the Secretary of Homeland Security direct the Under Secretary of Homeland Security, FEMA, to take actions to obtain reasonable assurance that NAIC flood insurance expense data can be considered in setting payment rates that are appropriate, including identifying affiliated company profits in reported flood insurance expenses, and develop comprehensive data analysis strategies to annually test the quality of flood insurance data that WYOs report to NAIC.

If FEMA continues to use the WYO bonus program, we recommend that the Secretary of Homeland Security direct the Under Secretary of Homeland Security, FEMA, to improve it by considering the use of more targeted marketing goals that are in line with FEMA’s NFIP goals.

To improve oversight of the WYO program and compliance with program requirements, we recommend that the Secretary of Homeland Security direct the Under Secretary of Homeland Security, FEMA, to consistently follow the Control Plan and ensure that each component is implemented; ensure that any revised Control Plan include oversight of all functions of participating WYOs, including customer service and litigation expenses; and systematically track insurance companies’ compliance with and performance under each component of the Control Plan and ensure centralized access to all the audits, reviews, and data analyses performed for each participating insurance company under the Control Plan.

Agency Comments and Our Evaluation

We received written comments on a draft of this report in a letter from the Department of Homeland Security’s Director, Departmental GAO/OIG Liaison Office, which is reproduced in appendix III. FEMA concurred with our recommendations regarding (1) the usefulness of the data that WYOs report to NAIC, (2) the alignment of the bonus structure with long-term NFIP goals, and (3) the oversight of the WYO program. First, the letter noted that FEMA would work with NAIC to improve the quality of the flood expense data that WYOs report and would include the data as an additional item in determining the annual WYO expense allowance. Second, the letter stated that FEMA planned to examine the incentive bonus prior to making arrangements with WYOs for 2010 and 2011. FEMA said that this examination is to include an assessment of the incentive’s effectiveness in increasing policies; the need for such an incentive; and possible alternatives to it, including identifying target markets where penetration is low and providing incentives for increasing policies in those markets only. Third, FEMA concurred with our recommendations regarding WYO program oversight, although it stated that the litigation, marketing, and customer service reviews were no longer included in the revised Control Plan because they were completed in other ways. Given the newness of these changes, this review did not include an assessment of FEMA’s compliance with these alternative methods or their robustness relative to the Control Plan. Finally, the letter stated that FEMA had implemented new processes to improve the monitoring of WYOs’ compliance with the Control Plan and would continue to look for ways to improve oversight in the future. While the letter did not provide details about the new monitoring processes, we are encouraged by these new steps and will be following up on these activities in our ongoing work.

FEMA did not concur with our recommendations on improving the transparency and accountability of payments made to WYOs, specifically our recommendation that FEMA consider WYOs’ actual expenses and profits when setting its payment rates. In its response, FEMA provided its views on issues that it believes impacted our analysis and the conclusions we drew from our work. Also, FEMA discussed why it does not consider actual flood insurance expense information. We disagree with FEMA’s assertion that the issues it raised resulted in our reaching misleading conclusions, and we continue to recommend that when setting payments rates, FEMA should consider actual flood insurance expenses and the profits that result from its payments to WYO companies.

Specifically, FEMA stated that our review was limited to only six companies, which FEMA believes are the low-cost operators for the five other lines of insurance used to determine the WYO expense allowance. FEMA stated that it seems reasonable that these companies would also have some of the lowest flood operating expenses and, therefore, conclude that the results of our analysis can be expected to significantly understate the operating expenses of the WYO companies as a whole. Our analysis of the expenses and profits of these companies, which represented 53 percent of total net premiums written, 71 percent of total claims losses paid, and 59 percent of total expense payments made by the WYO program for fiscal years 2005 to 2007, demonstrates the importance of information that FEMA does not have about actual expenses and profits that it was paying—information that we consider critical for making decisions regarding the proper administration of NFIP.

FEMA stated that we did not perform a review of the stability of the federal flood expenses because the results for other years were not available to us. FEMA also stated that a review of the stability of federal flood expenses would show the inadvisability of reaching any conclusions from just 1 year of data and that basing compensation on a single year of data is always questionable, especially since our analysis, and the adjustments and assumptions we made in conducting our analysis, have not been vetted. However, our analysis showed that variances in profit over the 3 years we reviewed were caused by, among other things, variations in the expenses incurred to adjust and pay claims losses that also fluctuated from year to year. Moreover, we recognize that setting payments based on a single year of data may not be appropriate. Our recommendation that FEMA consider actual flood insurance expenses and profits in setting payment rates would not limit FEMA’s consideration of actual expenses and profits to a single year of data. We anticipate that FEMA would annually perform an analysis of actual expenses and profits for the current year, and then incorporate that result into its analysis of these data covering the number of years that may be appropriate in the view of FEMA management. The results of the longitudinal analysis would be used to evaluate the rates being used and to determine in advance if a change to the rates is needed. Moreover, we agree that time should be allowed for others, such as the WYO companies and NAIC, to weigh in on the methodology for analyzing payments to the WYOs and their actual flood expenses. Importantly, however, any adjustments we made to the flood expenses reported by the WYOs for the purpose of our analysis were the result of information we obtained from and numerous discussions with WYO company officials.

FEMA stated that actual expenses will be as much of a lagging indicator as the current methodology that uses A.M. Best numbers. FEMA also stated that even if actual expense data is considered to be completely reliable, by the time NFIP could use it to lower expense ratios, about 2 to 3 years would have lapsed. FEMA uses the average expenses for five lines of property insurance other than the federal flood line for setting the operating expense payment rate. We recognize that considering WYOs’ actual flood expenses will be a lagging indicator of the costs to service flood insurance policies. However, it will be a better indicator than FEMA’s current methodology precisely because it will not reflect the trend of expenses for other lines of property business. Importantly, data now used to set payment rates based on other lines of business are subject to events and market forces that affect their expense ratios, but which are not relevant to the WYO program. Our recommendation that FEMA use actual flood expenses to set payment rates would differ from its current methodology in one important aspect: actual expenses and not a proxy would be used to set those rates.

FEMA stated that our analysis assumes that actual WYO company expenses are stable, which FEMA concludes could yield misleading results. FEMA also stated that during the last 5 years insurance companies have managed to significantly reduce their operating expenses in other lines, and suspects that many of those efficiency gains also made it into companies’ flood insurance operations. Our analysis was not based on any assumptions about the trends in WYO company expenses, in general, or flood expenses, in particular. Rather, we analyzed the actual flood expenses of selected companies over a 3-year period and compared the payments to the companies’ actual flood expenses. As previously indicated, we observed fluctuations from year to year in actual flood expenses—in particular, expenses for adjusting and processing claims. Our recommendation that FEMA consider actual flood expenses and profit when setting payment rates will move FEMA from not knowing (“suspecting”) the trend in actual flood expenses to considering those trends when setting rates, and not continuing to utilize proxies of other lines of business and the trends in those other lines that may not be relevant to the WYO program. Whether actual expenses are stable or otherwise is not relevant.

FEMA stated that while we acknowledge in the body of our report that the years we reviewed—2005 to 2007—included the heaviest loss years in the history of the program and that these years are not indicative of typical years for loss adjustment expenses, we do not carry these caveats forward to our conclusions. FEMA stated that this results in a significant distortion of the expense reimbursement to WYO companies for the loss adjustment expenses. We did consider the unusually high losses in 2005 and 2006 when reaching our conclusion that FEMA sets rates for paying WYOs for their services without knowing how much of its payments cover expenses and how much is for profit. An analysis of actual expenses over time would enable FEMA to identify and correlate trends in actual WYOs’ flood expenses to flood events and related claims losses. In fact, such an analysis could have helped FEMA to determine before the hurricanes of 2004 and 2005 that its method for paying claims processing expenses would result in significant payments in excess of actual expenses in heavy loss years.

FEMA also stated that it addressed the problem that led to outsized WYO compensation by changing how WYOs are paid for claims processing expenses—referred to as Unallocated Loss Adjustment Expenses (ULAE). As support, FEMA cited the fact that WYOs’ compensation for ULAE would have been $29 million less and $267 million less in fiscal years 2005 and 2006, respectively, and would have been $9 million more in 2007. This would have been a combined decrease of $287 million for the 3 years had this new payment schedule been in place then. Further, FEMA said that had the new payment schedule been in place in those years, it is likely that most, if not all, of the $155 million in profit from claims adjusting and processing that we reported for the six companies we reviewed would disappear. Prior to 2008, FEMA paid WYOs 3.3 percent of claim losses incurred for claims processing expenses. Beginning in 2008, FEMA began paying the WYOs 1 percent of net premiums written and 1.5 percent of claim losses incurred for their claims processing expenses. Our analysis showed that for the years 2005 to 2007 FEMA paid the six WYOs in our analysis profits of $327.1 million, including $155.2 million for claims adjusting and processing expenses, without knowing the actual flood expenses of any of these companies. FEMA’s statements that it is not clear how much of its “savings” would have been borne by the six WYOs we reviewed and that FEMA can only speculate as to the effect the change would have on the companies’ profit support our finding that FEMA does not know how much of its payments are for actual flood expenses and how much are for profit. Our point is that FEMA should know how much it is paying for expenses and for profit.

In our judgment, considering actual expenses and profit in setting payment rates would result in a fair and equitable treatment of policyholders and the WYO companies over time, as well as serve to better protect the interests of taxpayers who ultimately bear the risk of losses from the WYO program. In discussing why it does not consider actual flood insurance expenses in setting payment rates, FEMA said that the WYO flood insurance program is based on companies’ applying their normal business practices to NFIP and that these practices are bound to vary from company to company, and that it would be impossible for NFIP to accurately calculate actual expenses for 90 companies. FEMA also said that because of these two factors, and the fact that in the early years of the program actual flood insurance expenses of the companies’ were not available, the decision was made to use information on other lines of insurance business from A. M. Best as a proxy in setting rates for payments to NFIP companies. FEMA also stated that even now, when some WYOs’ flood insurance expense information is available, FEMA is not certain how accurate this information is, and that its management is skeptical that using actual flood insurance expenses, as GAO recommends, would yield lower payment rates than would result from the proxies that the program uses to set payment rates. FEMA further stated that it will work with NAIC to improve the quality of the flood expense data.

We agree that business practices will vary among the participating companies and we agree with FEMA’s statement that actual flood insurance expenses of WYOs were not readily available 25 years ago, when the program started. However, the National Association of Insurance Commissioners (NAIC) began requiring that companies report financial information on their federal flood insurance business in 1997. Therefore, continuing to use other lines of business as proxies for setting WYO program payment rates is no longer necessary. Moreover, continuing with the same practice without assessing the reasonableness of the payments made to WYOs by comparing those payments to the WYOs’ actual expenses does not provide sufficient justification or accountability for hundreds of million of dollars in federal program expenses.

We are encouraged by FEMA’s statement that, in the future, it will consider actual flood insurance expenses WYOs report to NAIC as an additional item when determining the annual WYO expense allowance, which is intended to cover the companies’ operating, marketing, and administrative expenses. While this is a positive step, given the changes in the program and available information, we continue to recommend that FEMA consider all categories of expenses when setting payment rates, including payments for commissions, claims adjusting, and other claims- related expenses. Consideration of all categories of actual flood insurance expenses reported by WYOs in setting payment rates for these expenses, as well as the profits that the program pays to the companies for their participation in NFIP, is necessary for FEMA to know whether its payments to the WYOs are reasonable.

As agreed with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution of this report until 30 days from the report date. At that time, we will provide copies to the Chairman of the Senate Committee on Banking, Housing, and Urban Affairs; the Chairman and Ranking Member of the Senate Committee on Homeland Security and Governmental Affairs; the Chairman and Ranking Member of the House Committee on Financial Services; the Chairman and Ranking Member of the House Committee on Homeland Security; and other interested committees. We are also sending a copy of this report to the Secretary of Homeland Security and other interested parties. In addition, the report will be available at no charge on our Web site at http://www.gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report.

If you or your staff has any questions about this report, please contact Orice Williams Brown at (202) 512-8678 or willamso@gao.gov, or Jeanette M. Franzel at (202) 512-2600 or franzelj@gao.gov. GAO staff who made major contributions to this report are listed in appendix IV.

Appendix I: Briefing Slides

Opportunities Exist to Improve Oversight of the

We provided a draft of this presentation to FEMA for its

review and they agreed with the content.

Appendix II: Scope and Methodology

WYO Expenses

To assess FEMA’s practice of determining the amounts it pays to WYO insurance companies for their services without considering the companies’ actual expenses, we compared the payments FEMA made to six WYO companies to the companies’ actual flood insurance expenses. Insurance companies report flood insurance expense data in annual statements that are submitted to NAIC, which also include expenses for the companies’ other property and casualty lines of business. The six WYOs we selected wrote flood insurance policies whose premiums totaled approximately 53 percent of the total WYO program premiums in fiscal year 2007. Our sample is not a representative sample of all WYOs, so the results of our analysis cannot be generalized to the universe of WYOs.

We reviewed NAIC and FEMA flood financial information to assess the reliability of the information for our purposes. Because FEMA’s payments to WYOs are determined by applying various proxies to premiums written or claim losses, we identified differences between the written premiums and claim losses that the companies reported to FEMA and NAIC. We obtained from WYO company officials explanations of these differences and determined that they would not significantly impact the companies’ flood expenses. Further, to review the payments and expenses for the six companies selected, we converted FEMA’s fiscal year WYO payment data to calendar year amounts for comparison to calendar year actual expenses reported to NAIC; recalculated the expense payments reported by the six WYOs to FEMA on a test basis, using the written premium and claim losses incurred amounts the WYOs reported to FEMA and FEMA’s payment rates, all without exception; and interviewed officials of the WYOs regarding their flood operations, accounting for and assignment of expenses to the flood line, and reporting of flood line data to NAIC.

To assist in comparing actual expenses to the expense payments, we adjusted the WYOs’ reported flood expenses in cases where, for example, companies offset their expenses incurred with the payments they received from FEMA. We found that the data the six companies submitted to NAIC and FEMA were, as adjusted by us, sufficiently reliable for our purposes.

For the purposes of this audit, we considered profits to be to the difference between the amounts paid to the WYO companies and the companies’ actual flood expenses on a pretax basis. In determining profits, we excluded miscellaneous other companywide income and expenses.

We did not audit the financial data the six WYOs submitted to FEMA, NAIC, or to us. However, the federal flood financial information the companies submitted to NAIC was included in financial statements prepared in accordance with statutory accounting principles that were audited by independent certified public accounting firms, which expressed unqualified opinions for those years covered by our review. We compared amounts in the audited financial statements for calendar year 2005 to 2007 to amounts the companies reported in their annual statements for earned premiums, losses incurred, and underwriting and loss adjustment expenses incurred for all lines of property and casualty insurance. The differences we identified did not significantly impact our analysis. Further, the federal flood financial information the companies submitted to FEMA was included in biennial financial statements prepared in accordance with generally accepted accounting principles that were also audited by independent certified public accounting firms who expressed unqualified opinions. We reviewed the audited biennial financial statements for four of the six companies that had submitted separately audited statements to FEMA. The differences we identified did not significantly impact our analysis.

Marketing and Bonuses

To evaluate the extent to which bonus payments to WYOs for increasing the number of flood policies they sell were based on WYOs’ actual marketing efforts, we discussed the bonus payment methodology with FEMA staff, WYOs, and other stakeholders and reviewed documents relating to the methodology used to make the bonus payments. We analyzed the bonus payments and evaluated the extent to which they could be attributed to the marketing efforts of WYOs or to other external factors, such as flood events and economic conditions. To determine whether the existing bonus formula benefited WYOs with fewer policies and years in NFIP, we compared those WYOs by size and year in the program to those receiving top bonuses.

For the 10 WYOs that we selected to interview, we identified those that had submitted marketing plans or undergone a marketing operations review. We also asked whether the bonus was a major factor in their marketing efforts and whether they considered flood insurance to be a primary insurance line.

Program Oversight

To evaluate FEMA’s compliance with the Control Plan, we discussed procedures with appropriate FEMA staff, requested and reviewed all the documents that were required under the plan, and discussed these requirements with the WYOs and other stakeholders. To address FEMA’s oversight of the WYOs, we selected a sample of 10 WYOs that administered over 50 percent of the flood insurance policies written for the year 2007. Our sample included companies that covered the spectrum of WYOs—for instance, they differed in size based on premiums written, losses incurred, and overall rank in market share and included companies that did and did not use a vendor.

We used a data collection instrument to review the required documents for the 10 WYOs selected for our review. Our data collection instrument included the four major components of FEMA’s Control Plan: (1) monthly data and financial reporting ; (2) claims reinspections performed by FEMA’s contractor.; (3) various audits by independent CPAs, including required biennial audits, audits for cause, and state insurance department audits; and (4) triennial operation reviews performed by FEMA staff. We used the 1999 Control Plan that was being used at the time of our review NFIP has a draft plan that it began developing in 2007.

Alternative Administrative Structures

In consultation with congressional staffers, we identified three possible alternatives that would incorporate a competitive feature. To evaluate the advantages and disadvantages of the three alternatives to the WYO program, we discussed the alternatives with staff within GAO; the WYOs in our sample; FEMA staff; and other stakeholders, such as flood insurance vendors and consultants.

We conducted this audit from December 2007 to July 2009 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe the evidence we obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix III: Comments from the Department of Homeland Security

Appendix IV: GAO Contacts and Staff Acknowledgments

Staff Acknowledgments

In addition to the contacts named above, the following individuals made key contributions to this report: Andrew E. Finkel (Assistant Director), Robert Owens (Assistant Director), Grace Haskins (Analyst-in-Charge), H. Donald Campbell, Emily Chalmers, Tony Eason, Fredrick Evans, Jeffrey Isaacs, Scott McNulty, Marc Molino, Roberto Pinero, Paul Revesz, and Carrie Watkins.