Catastrophe Economics: The National Flood Insurance Program

From the article: Michel-Kerjan, Erwann O.. 2010. "Catastrophe Economics: The National Flood Insurance Program." Journal of Economic Perspectives, 24(4): 165–86. Here

[This paper presents] an overview of the 40 years of operation of the National Flood Insurance Program, starting with how and why it was created and how it has evolved to now cover $1.23 trillion in assets.

In summary, the National Flood Insurance Program has grown significantly since its inception in 1968 to cover $1.23 trillion of insured assets in 2010.

Corrected for inflation, it appears that the program has continuously been running a deficit. At the end of 2004, the NFIP was facing a $1.5 billion cumulative deficit since its inception in 1968 (in 2008 prices).

Main question:

Who will pay for the economic consequences of future catastrophes and how best to organize this payment?

Important points:

Hurricane Katrina remains the most financially costly natural disaster in the history of insurance worldwide.

After that catastrophe [hurricane Betsy in Louisiana], and given the lack of interest by private insurance markets in offering flood coverage, the U.S. government established a new program in 1968— the National Flood Insurance Program (NFIP)—to make flood insurance widely available.

The NFIP provides insurance up to a maximum limit for residential property damage, now set at $250,000 for building coverage and $100,000 on contents coverage.

Ninety private insurance companies write flood policies, as well as process, settle, pay, and defend all claims arising from the flood policies, while the NFIP retains responsibility for underwriting these losses [itallics added].

[f]ederally-regulated mortgage lenders must require flood insurance for the purchase of property acquired or developed in Special Flood Hazard Areas (SFHAs).

Inflation-corrected data show that the average quantity of insurance per policy almost doubled over 30 years, from $114,000 in 1978 to $217,000 in 2009.

The state of Florida, which represented less than 6 percent of the U.S. population in 2010, had nearly 40 percent of the total number of flfl ood policies issued by the National Flood Insurance Program as of March 31, 2010.

More than two-thirds of NFIP policies are located in just five coastal states: Florida (2,141,076), Texas (681,425), Louisiana (483,593), California (276,915), and New Jersey (229,461).

The nationwide average annual premium per policy is $572.

[o]n average, insurance cost in 2010 was lower in Florida and Texas ($2.05 and $2.09) and more expensive in Louisiana ($3.00) and New Jersey ($3.70).

Homeowners are charged a relatively low price (on average less than $50 per month to cover $217,000); that continues to be true even in flood-prone states such as Louisiana, Florida, and Texas, which suffered major flood losses due to the 2004, 2005, and 2008 hurricane seasons.

Hurricane Katrina alone generated $16.1 billion in flood insurance payments. Between 2005 and 2008, the program had to borrow a total of $19.3 billion from the U.S. Treasury (King, 2009).

In some sense, the debt accumulated after the 2005 losses just confirms what was known since the inception of the National Flood Insurance Program: it is designed to be financially self-supporting, or close to it, most of the time, but cannot handle extreme financial catastrophes by itself (Wetmore, Bernstein, Conrad, DiVincenti, Larson, Plasencia, and Riggs, 2006).

[s]ome states have been paying many times more than the claim payments they’ve received over the past three decades while others paid several times less than they received, raises questions concerning the adequacy of the maps and associated premiums that are charged.

[f]or many, keeping the veil of ignorance (and thus being treated as a low risk) might seem the more attractive option.

Ways to improve the program:

Challenge 1: prove the Accuracy of the Flood Risk Maps

Challenge 2: Increase Insurance Penetration

A key finding is that on average, flood insurance policies lapse after only two to four years. Surprisingly, this result is robust whether or not the policyholders live in Special Flood Hazard Areas, where flood insurance is required for those with federally-backed mortgages.

Challenge 4: Reducing Repetitive Losses, the Number of Subsidized Properties, and Operating Expenses

Challenge 5: Strengthen Financial Sustainability in the Face of Catastrophes

Indeed, houses that experience multiple floods account for a very small percentage of the policies but for a large portion of all claims paid.

Many residents living in hazard-prone areas not only lack interest in purchasing natural hazard insurance and keeping it, they also rarely undertake voluntary lossprevention measures to protect their property. A 1974 survey of more than 1,000 California homeowners in earthquake-prone areas revealed that only 12 percent of the respondents had adopted any protective measures (Kunreuther et al., 1978). Fifteen years later, there was little change despite the increased public awareness of the earthquake hazard.

If flood insurance policyholders can benefit from an annual reduction on their flood insurance that is greater than the annual loan payment for the home improvement project, this could be a win–win situation for everyone: the homeowners are better protected and pay less by investing in risk reduction measures; the bank would have more secure mortgages; and the general public will have less of its taxes going to disaster relief.

Challenge 3: Encourage Investment in Risk Reduction Measures

But if one wants the finances of the program to be balanced, even after a Katrina-sized catastrophe, then the cost of flfl ood insurance for NFIP policyholders must increase signififi cantly.

In the United Kingdom, flood insurance is provided exclusively by private insurers and is usually included in homeowners’ insurance policies (Clark, 1998). Germany and France have similar models, but not the Netherlands.