NFIP is a federal program created by the National Flood Insurance Act of 1968 that enables property owners in participating communities to purchase insurance protection against losses from flooding. This program is administered by FEMA. Participation in NFIP is based on an agreement between local communities and the federal government. The federal government makes flood insurance available to any community that adopts and enforces a floodplain management ordinance to reduce future flood risks to new construction in areas known as Special Flood Hazard Areas (SFHA). Property owners located in the SFHA with mortgages from federally regulated lenders are required to purchase and maintain flood insurance policies. In these areas, new construction and substantial improvements must conform to NFIP’s building standards. For example, the lowest floor of a structure must be elevated to or above the base flood elevation (BFE)—the level at which there is a 1 percent chance of flooding in a given year. NFIP offers two types of flood insurance premiums: subsidized and full risk. The National Flood Insurance Act of 1968 requires that NFIP offer subsidized premiums to owners of certain properties. These subsidized rates are not based on flood risk and, according to FEMA, represent only about 35 to 40 percent of the full flood risk. Subsidized properties account for about 25 percent of all NFIP policies, while those with full-risk premiums account for the remaining 75 percent. The type of policy and the subsequent rate a policyholder pays depend on several property characteristics—for example, whether the structure was built after or prior to the development of the community’s Flood Insurance Rate Map (FIRM) and where the structure is located relative to the floodplain. NFIP studies and maps flood risks, assigning flood zone designations based on the risk level for flooding. For our purposes, in this report we generally refer to risk levels as moderate- to low-risk, high-risk, high-risk coastal, and undetermined risk. Potential policyholders can purchase both building and contents flood insurance for residential and commercial properties (table 1). Congress mandated the use of subsidized premiums to encourage communities to join the program and mitigate concerns that charging rates that fully and accurately reflected flood risk would be a burden to some property owners. The Flood Disaster Protection Act of 1973 made the purchase of flood insurance mandatory for the protection of properties within SFHAs that are secured by mortgages from federally regulated lenders, thus expanding the use of subsidized premiums. In addition, NFIP was authorized to begin charging full-risk premiums for all construction built after 1974 or the date of the community’s initial FIRM. According to FEMA, Congress made these changes to encourage further participation in NFIP through low premiums. More recently, legislation has been introduced that would limit NFIP subsidies aimed at improving the financial stability of the program. Pre-FIRM structures generally are more prone to flood damage (that is, riskier) than structures built later because they were not constructed according to the program’s building standards. Owners of post-FIRM structures generally are not eligible to receive subsidized rates. Largely because subsidized properties tend to be riskier than properties insured at full-risk premiums, in 2007, the average annual premium for a subsidized policy was about $869, while the average annual premium for a full-risk policy was about $378. Flood insurance rates are calculated for each flood zone. However, as shown in table 2, flood insurance rates also depend on flood zone. The insurance operations of NFIP differ from those of most private insurers in a number of ways. First, unlike private insurers that can reject applicants with properties whose potential losses would not be offset by premiums, NFIP is required to accept virtually all applications for insurance. Therefore, NFIP is less able to offset the effects of adverse selection—that is, the phenomenon that those who are most likely to purchase insurance are also most likely to experience losses. Adverse selection may lead to a concentration of policyholders in the riskiest areas; the problem is compounded by the fact that those at greatest risk are required to purchase NFIP insurance if they have a mortgage from a federally insured lender. Second, NFIP’s ability to adjust premiums is limited by statute. While most states regulate premium prices, they tend to allow private insurers considerable flexibility in their ability to set prices. Third, NFIP assumes all the risks for the policies it sells. Private insurers typically retain only part of the risk that they accept from policyholders, ceding a portion of the risk to reinsurers. This mechanism is particularly important in the case of insurance for catastrophic events, because the availability of reinsurance allows an insurer to limit the possibility that it will experience losses beyond its ability to pay. Finally, NFIP is not authorized to charge premiums that are sufficient to build the capital that most private insurers have to offset losses or purchase reinsurance in the private global market. For example, private insurers have a capital surplus that they use to pay expected claims. In contrast, NFIP operates on a cash flow basis, backed by borrowing authority from the U.S. Treasury. As a result, NFIP does not follow all of the traditional accounting practices that private insurers use—for example, NFIP reports using only Generally Accepted Accounting Principles (GAAP ) accounting, which is an ongoing operations accounting basis, while private insurers must report both GAAP and statutory accounting basis. FEMA uses a rate model to generate prices for flood insurance according to flood risk and expected flood damage. However, we found that in some cases these full-risk premiums may not accurately reflect actual risk because of limitations in the data used as inputs for the model and the effects of certain policy decisions. For instance: Some data FEMA used in rate setting are outdated or inaccurate, including data on flood probabilities, damage estimates, and flood maps. FEMA allows some properties that were remapped into riskier flood zones to keep their previous lower rates. FEMA’s rate-setting process does not fully take into account ongoing and planned development, long-term trends in erosion, and effects of global climate change. FEMA sets rates on a nationwide basis, combining and averaging across many geographically diverse areas. Furthermore, our analysis of the difference between claims payments and premiums collected for all 50 states and the District of Columbia suggests that NFIP’s pricing has not accurately reflected differences in flood risk. Collectively, these factors increase the risk that premiums collected on full-risk rates do not accurately reflect the risks of flooding and therefore may not be sufficient to cover future losses. According to FEMA, rates that are based on the probability of a given level of flooding, damage estimates based on that level of flooding, and accepted actuarial principles are considered to be “full risk.” To set rates for flood insurance that accurately reflect risk, information about the differential risk of flooding is key, with greater flood risks resulting in higher rates. Rates also vary depending on how much insurance is purchased. As claims are more likely to be made against the first several thousand dollars of coverage than against much higher levels of coverage (that is, smaller dollar-value losses are generally expected to occur more frequently than larger ones and thus pose a greater risk), rates per $100 of insurance coverage are lower for higher levels of coverage. the Corps for a number of years. While the Corps has revised its model for estimating flood damage, it still makes use of the hydrologic model to estimate flood damage. In the high-risk and high-risk coastal zones, the model combines estimates of the frequency of flooding with estimates of the magnitude of damage caused by flooding, producing “pure premium” costs intended to cover the actual flood losses. FEMA uses such inputs as the elevation of the lowest floor of the building, the type of building, the number of floors, the presence of a basement, claims data, and mapping information to generate the estimates. This pure premium amount is then adjusted to capture certain program costs, compensate for underinsurance by policyholders, and reflect the fact that the program has a deductible. For the moderate- to low-risk and other full-risk premium zones, rates have been developed based on actuarial and engineering judgments, using the rates generated by the model and the historical experience of the high-risk zones as benchmarks. While other entities employing flood models may use more sophisticated computer modeling techniques, the NFIP rate model is based largely on the same principles. In 2000, FEMA completed a feasibility study on using private market reinsurance to cover a portion of its flood risk that required modeling the frequency and size of catastrophic flood events, and determined that the results of the study were not inconsistent with the results of NFIP’s rating structure. For other lines of catastrophe insurance, private insurers rely heavily on computer models of simulated damage over many possible events to price their products. Like NFIP, other federal agencies and private insurers involved in flood modeling also rely on flood maps and data on the likelihood of flooding and damages. According to FEMA, it has contracted for actuarial services with an external consultant to assess the current state of hazard modeling and the possible applicability of those models to NFIP. Questions remain about the age and quality of the underlying data FEMA uses in its model to calculate full-risk premiums. The NFIP model for setting full-risk premium rates relies on flood probability estimates and expected damage data, which rely in part on outdated or potentially inaccurate information, including outdated FIRMs. As discussed more fully below, flood probability estimates have not been updated since the 1970s and 1980s, most FIRMs are out of date despite FEMA’s recent modernization efforts, and the claims data used to calculate full-risk premiums may be inaccurate. As a result, the premium rates set by NFIP may not fully reflect the risk of loss due to flooding.