Flood insurance reforms – challenges and road ahead by Sutherland Global Services

Flood Insurance Reforms – Challenges and Road Ahead January 2014

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Need for Flood insurance and National Flood Insurance Program (NFIP) National Flood Insurance Program •

Flooding has been, and continues to be, a serious risk in the US. Since standard homeowners insurance doesn't cover flooding, it's important to have protection from the floods associated with hurricanes, tropical storms, heavy rains and other conditions that impact the US

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Many factors made it uneconomical for private insurers to make flood insurance available to those in need of such protection on reasonable terms and conditions. The flooding risk has been so serious that most insurance companies have specifically excluded flood damage from homeowners insurance

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To address the need, Congress created the National Flood Insurance Program (NFIP) in 1968 to help provide a means for property owners to financially protect themselves. The NFIP offers flood insurance to homeowners, renters, and business owners if their community participates in the NFIP

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The National Flood Insurance Program (NFIP) is administered by the Federal Emergency Management Agency (FEMA), which works closely with nearly 90 private insurance companies to offer flood insurance to property owners and renters. In order to qualify for flood insurance, a community must join the NFIP and agree to enforce sound floodplain management standards

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The NFIP, a federal program, offers flood insurance, which can be purchased through P&C insurance agents. Rates are standardized and do not differ from company to company or agent to agent. These rates depend on many factors, which include the date and type of construction of one’ home, along with the building’s level of risk

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The NFIP does more than make flood insurance available; it also supports local communities in their efforts to reduce the risk and consequences of serious flooding. In order to participate in the NFIP, a community must agree to adopt and enforce sound floodplain management regulations and ordinances. In exchange for these practices, FEMA makes flood insurance available to homeowners, business owners and renters in these communities

Source: FEMA

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National Flood Insurance Program – Challenges and Financial Status Total Payments Made to Policyholders (in Bn)

Total Face Value of Coverage by Calendar Year (in Tn) 1.4 1.2

Coverage

1.0 0.8 0.6 0.4 0.2

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

0.0

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1988

1986

1984

1978

Dollars Paid

Policies

2005-Hurricane Katrina, Rita and Wilma

1982

20 18 16 14 12 10 8 6 4 2 0 1980

1990

Total Policies in Force by Calendar Year (in Mn)

Comments • NFIP currently has more than 5.6 Mn policies-in-force nationwide covering approximately USD1.2 Tn in property assets • For many years, however, the premiums collected have not been sufficient to cover losses. To overcome this situation, Federal Government keeps increasing NFIP’s borrowing authority to allow the agency to continue to pay flood insurance claims • This has resulted in a current debt to the US Treasury of more than USD20 Bn which is expected to grow to USD30 Bn once all hurricane sandy claims are settled by homeowners • FEMA is not likely to be able to repay the debt because of the considerable amount of interest associated with that level of borrowing. Interest payments on the program’s debt to the Treasury are almost USD1 Bn annually

Source: FEMA

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NFIP faces a long-term solvency challenge NFIP solvency and Tax Payers’ Money • •

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NFIP was not established on an actuarially sound basis since it charges less-than actuarial rates for pre-FIRM structures (Buildings constructed after December 31, 1974, or after the publication of a flood insurance rate map) Two-tier rate classification system consisting of actuarial and subsidized rates is used by NFIP – Actuarial flood insurance premiums are calculated based on the various parameters pertaining to the property like location, age and elevation. These rates are based on expected losses derived from flood probability estimates in addition to expected loss adjustments and other operating expenses – On the other hand, subsidized rates are determined by a statutory mandate that requires rates to be affordable, so the individuals are encouraged to participate FEMA’s rate-setting structure is designed to generate premiums at least sufficient to cover losses and loss adjustment expenses relative to the historical average loss year. There is no contingent amount added to premium for profit margins in order to build a surplus The program’s long-term expenses, claim costs, interest and principal debt repayment to the US Treasury can not be covered by annual premiums When losses and expenses exceed premiums, the program is authorized to borrow from the Treasury but must repay the funds with interest NFIP does not build loss reserves for the infrequent but very catastrophic loss years and rates are by statute underpriced to make rates affordable, therefore NFIP faces a long-term solvency challenge. The program does not have a financing mechanism for handling catastrophic losses other than borrowing from the federal Treasury Federal taxpayers ultimately subsidize any financial shortfalls created by the NFIP’s financial structure and its tendency to keep premiums low This essentially means that the poor financial structure at FEMA and exposure to risk as a result of the potential for future catastrophic flooding could impose negative externalities on taxpayers

Source: FEMA, Center for Climate and Energy Solutions

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Flood Insurance Reform Act of 2012 and its implications Flood Insurance Reform Act of 2012 •

In July 2012, the US Congress passed the Biggert-Waters Flood Insurance Reform Act of 2012 (BW-12) which calls on the Federal Emergency Management Agency (FEMA), and other agencies, to make a number of changes to the way the National Flood Insurance Program (NFIP) is run

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The law requires changes to all major components of the program, including flood insurance, flood hazard mapping, grants, and the management of floodplains. Many of the changes are designed to make the NFIP more financially stable, and ensure that flood insurance rates more accurately reflect the real risk of flooding. The changes will be phased in over time, beginning this year

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Key provisions of the legislation will require the NFIP to raise rates to reflect true flood risk, make the program more financially stable, and change how Flood Insurance Rate Map (FIRM) updates impact policyholders. The changes will mean premium rate increases for some-but not all-policyholders over time

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Over the years, the costs and consequences of flooding have continued to increase. For the NFIP to remain sustainable, its premium structure must reflect the true risks and costs of flooding. This is a primary driver for many of the changes required under the law

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More than 80 percent of policyholders (representing approximately 4.48 million of the 5.6 million policies in force) do not pay subsidized rates. Only a portion of those policies that are currently paying subsidized premiums will see larger premium increases of 25% annually starting this year, until their premiums are full-risk premiums

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Five percent of policyholders – those with subsidized policies for non-primary residences, businesses, and severe repetitive loss properties - will see the 25% annual increases immediately. Subsidies will no longer be offered for policies covering newly purchased properties, lapsed policies, or new policies covering properties for the first time

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The 80% of all NFIP policies that already pay full-risk premiums will not see these large premium increases. Most policyholders will see a new charge on their premiums to cover the Reserve Fund assessment that is mandated by BW-12. Initially, there will be a 5% assessment to all policies except Preferred Risk Policies (PRPs). The Reserve Fund will increase over time and will also be assessed on PRPs at some undetermined future date

Source: FEMA

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Opportunities for private insurers Road Ahead •

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A number of factors, including increased flooding as a result of climate change, are likely to further widen the gap between revenue and risk. Reforms have long been needed to put the NFIP on the path to solvency and to reduce homeowners’ exposure to chronic and catastrophic flooding risk In addition to rate increase, Biggert-Waters Flood Insurance Reform Act allows FEMA to purchase reinsurance cover for catastrophic losses, and requires reporting to Government on the program’s claims-paying ability and the feasibility of reinsurance and privatization NFIP’s financial troubles have exposed fundamental flaws in its design but a major change with reforms is on the way to the marketplace for flood insurance These structural reforms offer long-term opportunities for private insurers. Insurers who are currently managing flood exposure should be prepared for partial or full privatization of the NFIP The biggest entry barrier for private insurers in the form of low premiums offered by the government seem to be reducing with Flood Insurance Reform Act Private insurers have capabilities in underwriting techniques to determining actuarially sound rates and can mitigate risk through reinsurance and capital markets It has been well understood by the private sector that historical loss data for pricing was the major flaw of NFIP and is insufficient for ratemaking for catastrophic losses. It is imperative for private insurers to have an integrated catastrophe modeling approach to generate relevant and appropriate inputs to calculate actuarially sound rates Some companies like HCI have already started offering Flood insurance in Florida and targeting property owners hit by spiking rates under the National Flood Insurance Program The Gainesville-Florida Flood Insurance Agency is also offering policies backed by the surplus lines carrier-Lloyds Private Flood

Source: Property Casualty 360, Tampa Bay Times, Insurance Journal, SGS Research and Analysis

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