stopped writing flood policies (King, 2005). Private flood insurance has been essentially unavailable in the United States for residential property since then (Browne and Halek 2010). The previously described ideal characteristics needed for a risk to be privately insurable are simply, to a large extent, missing in flood risk (Baranoff et al., 2009). According to William Hoyt and Walter Langbein in 1955, floods “are almost the only natural hazard not now insurable by the home—or factory owner, for the simple reason that the experience of private capital with flood insurance has been decidedly unhappy” (Moss, 1999).
The lack of availability of flood insurance did not stop floods from occurring, nor did it stop development in flood-prone areas.20 Such flooding motivated the federal government to provide aid to the victims as a humanitarian action. Over time the post-disaster aid moved increasingly away from being primarily provided by private charities (e.g., the Red Cross provided most of the relief in the 1927 Mississippi River flood) to a more central role for federal assistance (Moss, 1999). Indeed, the federal government has had an ever-increasing role in providing disaster relief after floods, and this increased involvement in after-the-fact emergency aid to disaster victims prompted Congress to investigate creation of a federal flood insurance program that could be considered as a form of preloss financing (Moss, 1999). Whereas private insurers feared the catastrophic and highly correlated nature of flood losses to local insurers, a federal program could spread risk nationwide and could make premiums more affordable by not charging (and reserving) for periodic very large disasters. Moreover, the federal government has the ability to mandate purchase, mitigating the adverse selection problem, and enforce building codes, mitigating some of the moral hazard problems. In 1968, Congress passed the National Flood Insurance Act21 with the goal of creating a preloss (insurance) financing arrangement that would lower post-loss disaster relief, encourage responsible development in floodplain areas, and encourage maintenance of flood control operations (e.g., levees).
Browne and Halek (2010) give a comprehensive review of the developments in the federal flood insurance marketplace since the passage of the 1968 law creating the NFIP. Moreover, the challenges reaching the original legislative goals of the NFIP and the various legislative flood insurance law changes enacted to address the shortcomings are detailed in other sections of this report. It remains true, however, that for the reasons previously stated, the private market for flood insurance is still problematic. Private flood insurance is primarily available to commercial businesses that can demand flood coverage as part of a larger insurance program that includes “all-risk” coverage.22 The NFIP remains the primary source of flood insurance for almost all homeowners and small businesses. However, there are a limited number of private insurance companies that offer flood insurance coverage for homeowners and small businesses as excess protection above the NFIP coverage limitations.
There have been many criticisms of the NFIP based on the perception that it does not operate like a private insurer, and impressions of how it should operate are based on notions of how private insurance operates. For this reason, and to set expectations of what is and is not possible for the NFIP in perspective, it is useful to compare the NFIP operation with those that occur in a private insurance setting. Toward this end, it is important to note that there are several ways in which the NFIP operates and prices risks that differentiate it from how a commercial insurer would price similar flood risks. These are in part due to the governmental nature of the NFIP which has different goals and constraints than private insurers, and these differences are briefly detailed below.
First, and importantly, commercial insurers must manage their capital reserves to ensure that they are able to honor their commitment to claims payable for policies in force at any one moment and to remain solvent for paying future claims. This is especially a challenge for any peril that has a potential for a major loss aggregation, of which flood is one of the greatest challenges. The private insurance industry is heavily regulated to ensure that policyholders can be confident that insurers will be able to honor claims made for the coverage they have purchased.
Commercial insurers also consider the time value of money and discount losses from the time of occurrence (Ti) to the time of premium payment using a discount function, V(Ti) that reflects their cost of capital, per equation (5-1). In the NFIP, the time value of money is not considered, and no adequately large contingency reserve has been set up to pay future claims because FEMA is backed by the U.S. Treasury Department should the premiums
20 Along this line, Moss (1999) quotes a congressional task force (U.S. Congress, 1966) as recognizing this problem when they observed “Floods are an act of God; flood damages result from acts of men.”
21 Public Law 90-448.
22 “All-risk” or “all-peril” policies cover any fiscal loss unless it is specifically excluded in the policy.