Affordability of National Flood Insurance Program Premiums: Report 1 (2015)

7

Policy Alternatives for an Affordability Strategy

This chapter begins with the premise that some households will face National Flood Insurance Program premiums that would be unaffordable if they had to pay NFIP risk-based premiums. As a result, some or all of those households might receive financial assistance. Whereas Chapter 6 discussed the full range of decisions that must be made by policymakers in designing assistance programs, this chapter focuses mainly on how assistance will be provided. It reviews three broad policy options for providing assistance:

• Direct financial assistance to policyholders. This could be for mitigation actions that reduce the cost of flood insurance or for the cost of premiums directly. The households would need to meet predefined eligibility and assistance criteria (as discussed in Chapter 6) before assistance is offered.
• Additional NFIP reforms, which could reduce the cost of flood insurance for all policyholders through changes to NFIP structure and requirements.
• Community-based programs.

DIRECT FINANCIAL ASSISTANCE TO POLICYHOLDERS

Assistance policies for individual policyholders can be related to implementing mitigation measures that lower premiums, directly subsidizing the annual cost of flood insurance premiums, or a combination of the two. The specific property owners receiving assistance would be determined by the

defined eligibility criteria and the amount of assistance received may vary among those eligible (see Chapter 6). The direct assistance options are discussed below, recognizing that an affordability program may include several of them simultaneously.

Targeted Mitigation Grants

Even if mitigation could be implemented by policyholders to reduce premiums, the cost of such actions may be a barrier to their adoption. Existing mitigation grant programs, paid for from general federal revenues, might be modified to overcome that barrier. Federal grant programs currently support mitigation (see Box 7-1). Two of them provide funding for

mitigation before a disaster event occurs and two are targeted at areas that have experienced disasters by incorporating mitigation in the post flood rebuilding process. In all programs, states, tribes, or territories apply for the funding and if approved, funds are disbursed to local government or agency sub-applicants for use at individual properties. Reforms to target funds toward securing NFIP premium affordability for cost burdened households may be necessary.

Three ways of reforming mitigation grant programs to address affordability can be identified. First, mitigation projects must pass an engineering feasibility test and show that the benefits in the form of reduced future claims, net of premiums paid, exceed the costs of the mitigation. In 2013, FEMA issued a memorandum, which was based on review of 11,000 previous mitigation investments, that said that elevation or acquisition of structures (buyouts) in a Special Flood Hazard Area that cost less than $175,000 or $276,000, respectively, can be automatically considered to pass the benefit–cost test (memorandum from David Miller, FEMA Associate Administrator, Federal Insurance and Mitigation Directorate, to Regional Mitigation Division Directors and Hazard Mitigation Assistance Branch Chiefs, 2013¹).

With that benefit-cost decision rule, a property owner who is paying pre-FIRM subsidized premiums and making large and frequent claims can receive mitigation assistance without regard to their ability to pay for his or her own mitigation. Once the provisions of BW 2012 and HFIAA 2014 have been fully implemented (the premise of this discussion), premiums will be NFIP risk-based. As a result, the difference between future claims and premium revenues (the benefit) would shrink for all properties. As the benefits of mitigation as currently calculated approach zero, the benefit–cost test would no longer be useful for establishing mitigation funding priorities. The benefit–cost criterion might be replaced with a means tested basis for prioritizing mitigation grant spending.

Second, an administratively simple assistance program would begin with eligibility criteria chosen by FEMA and Congress that can be used to identify a group of households that have pre-FIRM subsidized premiums and would be allowed to retain those premiums (or have premiums frozen at a level consistent with the household’s ability to pay).² These same households then would be given priority for receiving mitigation grant funding as such funding becomes available. In this way, mitigation funds

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¹http://www.fema.gov/media-library-data/1382557637411-c1e5842153d2c957aabc0a09f008564c/PrecalcBenClarific_memo_508withsig.pdf.

²As long as this group of households pays less than NFIP risk-based rates, NFIP revenues for the group could fall below expected claims. Congress could consider continuing the HFIAA 2014 surcharge on all policies to cover this revenue shortfall, or could agree to pay claims made by households in this group from general revenues.

are targeted to those for whom the NFIP risk-based premium creates an affordability challenge. Once mitigation funding is received, a property owner would, consistent with BW 2012, pay NFIP risk-based premiums thereafter, although the owner may still quality for premium assistance (see discussion of vouchers).

Third, the post flood Hazard Mitigation Grant Program (HMGP) and the Community Development Block Grant Disaster Recovery (CDBG-DR program; see Box 7-1) could be used for elevating homes or instituting community measures that may alter the FIRM or increase standing in the Community Rating System (CRS; see Chapter 3 and discussion below). Because use of funds for those types of projects is at state and local government applicants’ discretion, these applicants could design programs to direct mitigation assistance to low-income households that face the prospect of paying NFIP risk-based insurance premiums. In fact, a portion of the CDBG funds is directed to benefit primarily low-income or moderate-income households.³ One challenge posed by relying on post flood mitigation grant programs is the delays experienced by state and community officials, as well as households, between submission of a grant application and the awarding of funds. That time delay can be substantial (for example, 18 months or longer), and additional time then is required for state and local government to provide funds to approved homeowners. If homeowners are trying to use funding for a mitigation action that will lower their insurance burden, the NFIP could offer the lower premium as soon as the mitigation project is approved for funding (even if the mitigation has not been implemented).

Mitigation Loans

Mitigation measures can have significant initial costs, but any reductions in annual NFIP premiums will occur later. Ideally, a household may consider a mitigation measure to be cost-effective if the reduction in annual premiums exceeds the initial cost of the mitigation measure. Even if the mitigation is deemed cost effective, mitigation grant funds may not be available and the household may have little access to funds for making the investment. For example,⁴ suppose that a household faces a $4,000 NFIP

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³The Department of Housing and Urban Development notes that this requirement can be met through uses of the funds in which the majority of beneficiaries have low or moderate income or through activities that benefit an area in which over half of the population is of low or moderate income. See https://www.hudexchange.info/cdbg-dr/cdbg-dr-eligibility-requirements.

⁴These suggested calculations suggest deliberative thinking on the part of the household, but (and as pointed out in Chapter 4) homeowners may focus primarily on benefits from investments in the short term, and thus place lower priority on future returns from their mitigation investment.

risk-based premium and could implement low-cost mitigation at a cost of $25,000 and that as a result the annual premium falls from $4,000 to $500 (an annual saving of $3,500). The $25,000 initial cost of mitigation, however, may be prohibitively expensive. Indeed, low-income households are unlikely to have the cash needed to make the investment and may not have access to a mitigation grant. If the household received a 20-year $20,000 loan at an annual interest rate of 3%, the annual loan payments would be $1,680. The NFIP premium would fall to $500 and the total annual cost for managing the household’s flood risk would fall from $4,000 for the NFIP premium to $2,180—$500 for the NFIP premium plus $1,680 for the mitigation loan.⁵ The household may be able to afford the $2,180 annual payment but not the $4,000 annual premium.⁶

Although a loan might appear to make financial sense, a low-income household may not have access to a private commercial loan. Funds might therefore be allocated to a federally backed loan program that is targeted to households that have little access to commercial credit. Also, the attractiveness of a loan depends on the interest rate. Interest rates currently are low and a loan program could offer low rates. If interest rates increase, the program might offer a below-market rate. Interest rate discounts and the need for federal loan guarantees given the possibility of high default rates make this a subsidy program that might be available only to homeowners who meet eligibility and assistance criteria on the basis of the considerations discussed in Chapter 6. ⁷

Vouchers

This committee’s task statement, as derived from BW 2012, identifies “means tested vouchers” for the NFIP as a specific means for providing assistance when NFIP risk-based premiums create a household affordability problem. Generally, a voucher is a certificate issued to an individual to

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⁵The results shown in this illustrative example are specific to the estimates of dollar costs used for making this calculation. Therefore, no general conclusions about the benefits of a loan should be based on this single illustration.

⁶The loan can make the household financially better off each year that it resides in their home. However, the household may not intend to live in the home for the 20 years assumed in the example above. The loan, however, would be a lien on the property and the mitigation would be expected to increase the home’s market value. If the property were sold, the outstanding balance of the loan would be paid off at closing.

⁷For example, the Small Business Administration has a low-interest disaster loan program for households that need funds to repair and rebuild, and it might be authorized to issue such loans. If any new federally backed loan program is to be implemented, it may need to be authorized by Congress and be designed according to tightly specified rules. Guidelines for setting up federally backed loan programs can be found at http://www.whitehouse.gov/sites/default/files/omb/assets/a129/rev_2013/pdf/a-129.pdf.

pay for all or part of a specific good or service. The funds to support a voucher program may come from general revenues. As an alternative, the NFIP may be permitted to impose a surcharge on all policies and use the revenues to provide vouchers to those eligible. Such a surcharge would need to be evaluated against the actuarial principle of minimizing cross subsidies (Chapter 3). In this application, the voucher would be provided to qualifying persons each year when the NFIP premium is due so that the allocated funds could be used to pay a portion of the cost of the premium. Each year, the household would be informed of the cost of the insurance and would apply for a voucher. Funds for offering the voucher would be made available on an annual basis with the amount based on the criteria discussed in Chapter 6.⁸

Ease of administration suggests offering the voucher through existing programs. One approach would allocate funds for the voucher to the Department of Housing and Urban Development through its existing means-tested housing assistance programs. Another possibility is that the NFIP might administer the program by offering a premium discount to those eligible and then transferring an amount equal to the difference between the NFIP risk-based premium and the discount to the NFIP reserve.

Annually issued vouchers could also be used to offset payments for mitigation loans. More specifically, if the property owner were offered a multi-year loan to invest in mitigation, the voucher could cover not only a portion of the resulting risk-based insurance premium, but the loan cost to make the package affordable. A 2014 study proposed using vouchers to cover both mitigation and insurance costs. It was concluded that such a program would probably be financially more attractive to both the property owner and the federal government than a voucher program that covered only the insurance cost, because the mitigation measures would lead to permanent reductions in expected NFIP payouts and hence lower insurance premiums (Kousky and Kunreuther, 2014).

Federal Tax Deductions and Credits

Oher ways to lower household costs of flood insurance premiums or mitigation investments that lowers premiums are through tax deductions and tax credits. A tax deduction reduces how much taxable income an individual must claim on his or her return. An example is the mortgage interest deduction, which allows property owners to deduct annual interest on their home loans from their income. In fact, tax deductions are used to help disaster victims. For example, for presidentially declared disasters, filers can

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⁸Vouchers also could be extended at the discretion of Congress to those who voluntarily buy a policy and the costs borne by the federal government.

deduct some losses not covered by insurance or disaster aid. Eligibility for the deduction is means tested: filers must first subtract $100 and then 10% of their adjusted gross income from their losses (IRS, 2014a).

A tax credit, in contrast, directly reduces the amount of taxes owed. The benefit of a deduction is determined by the filer’s marginal tax rate and by any constraints on the amount that is allowed to be deducted. The reduction in taxable income is also limited to taxpayers who itemize their deductions rather than taking the standard deduction. In 2011, just under 32% of taxpayers itemized their deductions (IRS, 2014b). A credit is independent of the tax bracket but benefits only those who owe taxes unless it is in the form of refundable tax credits, whereby a refund is given if the filer owes less tax than the credit. Two examples are the Earned Income Tax Credit and the First Time Homebuyer Credit. Credits generally provide greater financial assistance in that they lower the actual amount of taxes paid.

Table 7-1 shows deductions or credits that could be given to policyholders on the basis of the amount of premium paid and any other eligibility criteria for determining assistance to address affordability (discussed in Chapter 6).

Some arguments have been raised in favor of and against using the tax code for social policy. On the one hand, the tax code has been criticized for not being transparent, having uncertain effects on behavior, introducing economic distortions, and not appropriately targeting those in need of tax

TABLE 7-1 Effects of Tax Deductions and Credits on Affordability

relief. Some also have contended that it is inappropriate to use the federal tax code to guide social policy. Those favoring use of the tax code maintain the IRS is in a good position to administer income-based policies and that some tax incentives produce better results and are more permanent than outlays (Stead, 2006).

In 2013, a bill entitled the Flood Mitigation Expense Relief Act was introduced. It offered a $5,000 tax credit to taxpayers (individuals or small businesses that had 50 or fewer employees) that undertook qualifying flood mitigation expenses, held an NFIP policy, owned property that faced premium increases, and had an elevation lower than base flood elevation (BFE), or was in a newly mapped high-risk area. Prior to passage of HFIAA 2014, the Flood Mitigation Expense Relief Act of 2013 was introduced. It included a tax credit of up to $7,500 for qualifying flood mitigation expenses for individuals or small businesses that held an NFIP policy (the credit would terminate in 2022). This bill delegated to FEMA the task of defining what flood mitigation expenses would qualify for the credit. To date, neither of these bills has been passed.⁹

Disaster Savings Accounts

Another disaster assistance option is a tax deductible disaster savings account. Pre-tax funds placed in such an account could be used to cover disaster damages, hazard mitigation investments and/or flood insurance premiums. In fact, the Disaster Savings Accounts (DSA) Act of 2014 would allow homeowners to contribute up to $5,000 annually to cover uninsured disaster damages that exceeded $3,000 for a state or federally declared disaster. Funds could also be used to cover investment in a list of mitigation measures specified in their bill. Funds could be contributed pre-tax, and amounts withdrawn for the designated uses would not be taxed.

The manner in which such accounts are most likely to contribute to NFIP affordability, however, may be to use them for covering homeowner expenses below the insurance policy deductible (Lehrer, 2007); this would encourage homeowners to purchase much less expensive coverage with higher deductibles. If a household could save $5,000 or $10,000 over time, it could purchase an NFIP policy that covers only damage above that threshold. As discussed in the section on higher deductibles (below), this would lower the cost of the NFIP premium.

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⁹At the state level, South Carolina adopted a law in 2007 that provided an annual tax credit of up to $1,250 for property owners that pay more than 5% of their income toward flood insurance on the filers’ legal residences. It is not refundable, so it benefits only those that owe taxes. A similar design could be used for a federal program of providing assistance through the tax code for those who are cost burdened by premium payments.

The financial benefit to a household would depend on its marginal tax rate: higher income households would obtain a larger absolute benefit than lower income ones. It also would not help those whose disposable income is insufficient to place funds into such an account. The costs to the federal government would be the foregone tax revenue; these costs could be calculated in a manner similar to that of other tax-preferred accounts, such as those for health care or retirement.

ADDITIONAL NFIP REFORMS

This section discusses actions that have been suggested in legislation or by stakeholders as a means of lowering premiums for all policyholders.¹⁰ They include expanding the variety of mitigation measures, higher deductibles, designating the US Treasury as a reinsurer during catastrophic-loss years, enhancing the write your own (WYO) agent advisory role, reducing loadings for administrative costs, and eliminating mandatory purchase.

Expanding the Variety of Individual Mitigation Measures That Reduce Premiums

If mitigation actions¹¹ lead to lower damages and lower expected claims, they could make NFIP policies less expensive for households that implement them.¹² However, at the household level, there are only a few mitigation actions that might result in lower NFIP premiums. They include elevating a building above BFE, building a replacement structure above BFE on the same footprint, modifying the ground floor with wet floodproofing measures and moving all improvements and habitable areas up to the second floor, and, for nonresidential structures, dry floodproofing.¹³

As discussed in Chapter 3, NFIP premiums are based on the relation of

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¹⁰BW 2012 Section 100232 asks FEMA to report on opportunities for private insurers to participate in the provision of flood insurance, either as primary insurers or as reinsurers. FEMA may include assessments of whether privatization might result in lower rates and premiums.

¹¹The focus in this section is on ways to implement mitigation measures in single-family homes. Implementing these measures for multi-family units may be expensive and so may require community-wide action.

¹²Mitigation also may help reduce future uncompensated flood damages, and increase resilience of both the household and the community.

¹³Dry floodproofing—prohibiting water from entering a structure—below BFE is not allowed for residential buildings, except in communities that have been given an exception from FEMA for basements. It is not allowed in V zones. Wet floodproofing—using water resistant materials—may be allowed for small enclosed areas or if specified requirements are met and a variance is issued. For more details on floodproofing and the requirements under the NFIP, see https://www.fema.gov/national-flood-insurance-program-2/floodproofing.

the first floor to the BFE, so elevating the home can always result in lower premiums. Elevating a structure can be expensive, however, particularly for large slab structures. In fact, HFIAA 2014 requires the NFIP to consider mitigation measures other than elevating homes for reducing property insurance premiums.¹⁴ One possible approach for single family households that may be more affordable than elevating a structure is low-cost retrofitting of structures that experience shallow water flooding. Studies of that topic date back to the 1960s (Sheaffer, 1960; Sheaffer et al., 1967; Laska, 1986; Laska and Wetmore, 1990, 2000; FEMA, 1999). FEMA has developed several handbooks for identifying mitigation measures and describing their implementation (see FEMA, 2007, 2012b, 2013c). The US Army Corps of Engineers has provided guidance on the topic (USACE, 2005), and FEMA recently refined its publication on low-cost retrofitting (FEMA, 2014c). Homes may realize substantial reductions in damages if shallow water flooding is reduced, which in turn could lead to reduced claims. One challenge for FEMA and the NFIP will be to determine whether shallow water flooding is the reason for the modest claims and, if so, to reflect low-cost retrofitting approaches in the rating tables for homes where shallow water flooding is likely.

For a broader set of mitigation measures, including shallow water flooding, to be considered in setting premiums, FEMA would need to develop data and analyses that would link the measures’ expected reduction in losses to insurance premiums. A particular concern about the effectiveness of any such measures is how to ensure needed maintenance once they are implemented and the reliability of human actions to activate them during floods. Implementation rules and requirements would have to be promulgated for eligible flooding conditions, eligible structures, eligible mitigation measures, requirements for implementation, and the actuarial calculation of the reduction in flood insurance premiums that results from different retrofit measures.

Approximately $150 million was provided by Congress in 2014 for pre-disaster mitigation (see Box 7-1), but that funding allows for only 2,500 structures to be elevated if a $75,000/house cost estimate is used.¹⁵ As one option for FEMA to consider, a portion of the grant funds could

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¹⁴See Sections 14 and 26 of the act. Section 14 directs FEMA to carry out studies to estimate risk premium rates “based on consideration in part of the flood mitigation activities undertaken on a property, including differences in the risk due to land use measures, floodproofing, flood forecasting, and similar measures.” Section 26 directs FEMA to issue guidelines for alternatives to elevation, to take them into account when calculating rates, and to inform homeowners about how they will affect their rates.

¹⁵The $75,000 figure admittedly may be low. The median building elevation costs of elevations through the FEMA mitigation program (2008—2013) was $166,000 (Ryan Janda, FEMA, personal communication, 2014).

be set aside for lower-cost alternative mitigation, and this would still leave FEMA pre-disaster and post-disaster mitigation funds to pay for elevating homes for which lower-cost alternatives may not be effective. That would allow a predictable source of funds for lower-cost mitigation.

Encouraging Selection of Higher Insurance Deductibles

As a general matter insurance premiums can be lowered if the purchaser chooses a higher deductible. In the case of flood insurance, the NFIP offered deductibles to homeowners that prior to BW 2012 ranged from $500 to $5,000. A 2010 study found that of the more than 1 million flood insurance policies in force in Florida in 2005, almost 80% of policyholders chose the lowest possible building deductible, $500, and around 18% chose the second-lowest deductible available, $1,000 (Kunreuther and Michel-Kerjan, 2009; Michel-Kerjan and Kousky, 2010). BW 2012 increased the minimum deductible and it is now $1,000.¹⁶ Recent data show that 88% of the homeowners who have NFIP risk-based policies maintained the standard $1,000 (that is, the lowest) deductible. Of the pre-FIRM subsidized homeowners, 37% choose a $2,000 deductible, and 42% choose $1,000. Although those data show that people prefer lower deductibles, they also suggest that offering a higher deductible as a default may lead a sizable number to choose to keep that option—a finding consistent with a large number of empirical studies that show that people disproportionally prefer the default option (see Johnson et al., 2012).

In the case of flood insurance, if the standard deductible chosen was $5,000 instead of $1,000, the NFIP risk-based insurance premium for any residential structure in the SFHA would be reduced by 25% (FEMA, 2014b). For example, a household that was paying $4,000 for flood insurance with a $1,000 deductible would pay $3,000 if it took a $5,000 deductible. If a low-income household suffered a loss of $5,000 or less, however, it may have financial difficulty in covering the repair cost if it took the higher deductible. FEMA’s Individual Assistance (IA) program does provide funds for losses incurred but are not covered because of the deductible. Although such households could potentially be assisted, receiving IA funding is not a certainty and in any case would not be received as quickly as payment for an insurance claim.

The choice of the amount of a deductible depends on a calculation that considers the future value of lower premiums against the possibility of bearing the cost of less damaging (and perhaps more frequent) flood events. Even with such a calculation, other considerations might go into that choice. In fact, the literature on this topic suggests that, for whatever

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¹⁶Current deductibles are $1,000, $1,250, $1,500, $2,000, $3,000, $4,000, and $5,000.

reasons, insurance purchasers tend to choose lower deductibles (Cutler and Zeckhauser, 2004; Doherty and Schlesinger, 1983; Kunreuther, Pauly, and McMorrow, 2013; Sydnor, 2010).

For example, a 1983 study found that consumers choose the lowest deductible to be as fully protected as possible if they suffer a large loss (Doherty and Schlesinger, 1983). A “disappearing” deductible provides a rationale for a homeowner to take a larger deductible with a reduction in premium, knowing that the deductible will disappear if the loss is high enough. For illustration, if the flood damage exceeds $50,000 then the deductible disappears. The NFIP might offer a disappearing deductible, and, given that the NFIP claims data show relatively few large losses from floods, the increase in premium caused by offering such a policy would be small relative to the premium for a policy that has a low deductible. Whatever deductible amounts are offered by the NFIP, encouraging the consideration, if not the choice, of higher deductibles is a possible role for the WYO agent (the WYO agents’ role in assisting homeowners is discussed in greater detail later in this chapter).

Rely on the US Treasury to Help Paying Claims in Catastrophic-Loss Years

Whether the NFIP can raise revenue to pay back the debt, build a reserve that can cover catastrophically high-loss years, and simultaneously promote takeup and keeping premiums at levels that would not require a substantial program of policyholder assistance remains an open question. Revisiting the original 1968 legislation (Chapter 2) that created the NFIP suggests one possible way to reconcile conflicting goals. The 1968 legislation established the US Treasury as a reinsurer for catastrophic-loss years: when total losses in any year exceeded a threshold level, the Treasury would provide the funds needed to honor claims that exceeded the threshold.

The logic at that time was that if the Treasury acted as reinsurer, NFIP risk-based premiums would be kept at reasonable levels to encourage purchase. In the contemporary context, proposing a similar role for the Treasury could be one option within a larger affordability context. It might work as follows. First, Congress could forgive all or a share of the current NFIP debt. Second, Congress could designate the US Treasury as reinsurer for the NFIP, as was the case in the original legislation. Specifically, Congress could explicitly state that when total annual losses in the program exceed some designated threshold (as an illustration, $2 to $6 billion, perhaps on the basis of the average of noncatastrophic historical claims years), the Treasury will provide funds to allow the NFIP to honor all the claims. The funds may be provided through the Disaster Relief Fund, and, if needed, by an emergency supplemental budget. Taken together, those

two actions could result in lower NFIP risk-based premiums, enhance affordability, and in turn lead to less spending for assistance. Congress would incur occasional costs by designating the US Treasury as the source of funds for payment of claims above the defined threshold in high-loss years but would not need to draw on the Treasury each year to provide assistance payments to policyholders who face unaffordable premiums.

Enhance the Write Your Own Agent Advisory Role

The WYO agent has the most direct and most frequent contact with property owners as the owner considers an NFIP purchase decision. There may be opportunities for the agent to play a new and creative role in providing residents in flood-prone areas with information on the risks they face and actions they can take to reduce future losses and make their premiums more affordable. More specifically, agents could provide data on the premium savings associated with investing in specific loss reduction measures (especially as new measures are considered in rating a property’s risk), inform homeowners of mitigation programs, assist in obtaining mitigation loans and choosing the deductible, and so on.

For a WYO agent, providing those services would require additional work, new training, and new technology. FEMA could provide the necessary new training and technologic support. For example, Web-based and automated rating tables might allow a WYO agent to evaluate the effect of a mitigation action on premiums quickly, especially if the number of mitigation actions that affect premiums is increased. The cost of increased time to learn and then consult with clients may have to be compensated. The costs may increase WYO administrative charges, but FEMA may deem such additional costs to be justified. Whether the costs would be recovered through higher premiums is a matter to be determined.

In addition, because WYO agents and their companies are compensated as a percentage of the premium charged (for example, 15% of the premium to the agent), a different compensation structure that is not based on a percentage of the premium may be required.

Reducing National Flood Insurance Premium Administrative Cost Loadings in Premiums

The NFIP pays a portion of premium revenue to the WYO insurance companies to compensate them for writing policies, collecting premiums, and settling, paying, and defending claims. Reducing administrative costs could help lower premiums across the board but determining the effects of this option requires an understanding of the fees paid to WYO companies.

When those are examined, substantial reductions in premiums through lower WYO payments appear unlikely.

WYO companies receive an allowance that is composed of three categories: 15% of written NFIP premiums covers agent commissions; 2.3% of written NFIP premiums goes to voluntary-payment state premium taxes on WYO policies; and 12.5-13.5% of written premiums compensates insurance companies for their expenses. In addition, if WYO companies meet targets to increase the number of policies written, they can receive up to a 2% bonus.

There is little room to adjust commissions. The NFIP has entered into an agreement to pay state premium tax taxes (state insurance departments oversee the WYO companies). Those costs thus seem difficult to reduce. To determine how much insurers receive for expenses, the NFIP calculates a 5-year industry average of multiple property insurance lines and then adds an extra 1% to cover additional expenses for participating in a federal program.

Although the NFIP could potentially collect actual expense data from the approximately 85 WYO companies, the administrative cost of such data collection is nontrivial, and it is unclear how large the savings would be. A 2010 GAO report noted that a survey of six WYO companies found that payments from FEMA were 16.5% higher than actual expenses (GAO, 2010). That would be a reduction in administrative costs but not a very large one, so it is unlikely to address premium affordability issues substantially and, like some other measures discussed herein, would not be targeted specifically at cost-burdened households.

In exchange for processing claims, WYO companies receive reimbursement according to established formulas and additional reimbursement for any special handling expenses, such as litigation costs or engineering studies. Paying WYO companies according to the size of claims led to extraordinary payments to WYO companies in 2004 and 2005. In response, in 2008, FEMA used actual expense data to modify how it handles payments, considering actual costs incurred by the companies (GAO, 2009). Questions of administrative costs of the NFIP are still under review, but the costs to pay WYO companies may be modest in light of the time and cost involved.

Eliminating the Mandatory Purchase Requirement

Households that have mortgages from federally backed or regulated lenders and that are in a mapped SFHA are required to purchase flood insurance policies. Households that have received disaster assistance also

may be required to have flood insurance policies.¹⁷ One way to eliminate the financial burden of NFIP premiums is to eliminate this requirement. If purchase were voluntary, those who could not afford the NFIP risk-based premiums would not have to incur the expense.

If the past is a guide, it is likely that takeup rates for policies could drop substantially if homeowners were not required to purchase them. The NFIP adopted the mandatory purchase in 1972 because 4 years after the NFIP was established in 1968, fewer than 200,000 flood insurance policies were in force nationwide (Pasterick, 1998). In addition, findings in the present report’s Chapter 4 suggest that many households may not voluntarily purchase disaster insurance, even if they would not be cost burdened by it.

As a result, households would need to rely more upon their own resources for post-flood recovery. Households could potentially receive federal aid, although such aid is usually modest, uncertain, and delayed (see Kousky and Shabman, 2012). In addition, the presence of uninsured properties may reduce the resilience of a community in event of a flood disaster. For all these reasons (as noted in Chapter 2), increased takeup rates always have been a goal of Congress for the NFIP. As long as high takeup rates remain a program objective, the additional objective of making premiums affordable, even if there is a subsidy to some, is likely to be a more successful option than making all purchases voluntary.

COMMUNITY-BASED PROGRAMS

This section discusses an affordability strategy that depends on community-based measures of flood risk reduction. Flood hazards and flood insurance premiums can be reduced by a variety of measures, including the limiting of development in floodways, development of stormwater retention practices, construction of wetlands and other green infrastructure for water retention and enhanced drainage, and construction of levees, floodwalls, or dunes to control flood hazards (FEMA, 2013d). Flood risk management projects have been instituted across the nation in partnership with the US Army Corps of Engineers, but state and local funding alone can be used for such projects. Some community-level mitigation measures can lead to lower NFIP premiums through modifications to FIRMs or through the Community Rating System (CRS), discussed below.

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¹⁷At times, federal disaster assistance may help victims with these costs. For example, many recipients of HUD assistance have low incomes and HUD grant funds can sometimes help to maintain flood insurance for these individuals (Tobin and Calfee, 2005). Similarly, state and local governments have at times used federal disaster aid dollars, such as FEMA Other Needs Assistance, to help cover the costs of flood insurance policies for recipients of the aid.

Community Mitigation Programs

HFIAA 2014 requires FEMA to recognize the effectiveness of communitywide and area-wide mitigation activities when setting insurance premium rates (Section 14) and to maintain updated maps for the communities that reflect mitigation actions (Section 27). Community-based efforts aim to direct resources to measures that may benefit clusters of structures, even multiple neighborhoods, while dispersing mitigation knowledge more broadly among community officials and residents.¹⁸ A recent pilot project funded by FEMA and implemented by the Natural Hazard Mitigation Association engaged 10 communities that were actively involved in mitigation. The project, the Resilient Neighbors Network, emphasizes partnerships and recognition and rewards to motivate communities and regulatory and economic alignment (see Hayes, 2012). Many communities are working with FEMA to learn the best ways to promote and incentivize local risk reduction efforts and collaboration among communities. This effort demonstrates a commitment by FEMA to encourage self-initiated efforts in conjunction with their more prescribed CRS approach.

The Community Rating System

The CRS offers premium reductions for “community floodplain management activities that exceed the minimum NFIP requirements” to “reduce flood damage to insurable property, strengthen and support the insurance aspects of the NFIP and encourage a comprehensive approach to floodplain management” (FEMA, 2015). A community that has cost burdened households may take actions to increase flood hazard preparedness, which may result in reduced premiums, by participating in the CRS. For example, representatives of CRS communities in Louisiana have increased their CRS engagement since passage of BW 2012 by forming regional collaborative groups that meet regularly to share best practices for undertaking specified measures, especially ways to improve risk communication (personal communication, Monica Ferris, University of New Orleans, 2014). The regional groups have also transformed their CRS involvement into a community engagement approach. If this multi-community collaboration results in actions that earn additional points in the CRS program, more households may benefit from lower premiums. Some studies have found that CRS participation in various measures—such as open space protection, high elevation

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¹⁸Community-based efforts also may help prepare for flood-related losses that are due to climate change impacts such as sea level rise and increased precipitation and increased severity of tropical storms. These challenges can be brought to the attention of communities through such community-based efforts as those described in this section, especially given the role of communities in land use regulations for floodplains and building codes.

requirements, and small flood control projects—has reduced flood claims and property damage (Brody et al., 2007; Michel-Kerjan and Kousky, 2010; Brody and Highfield, 2013).

Joining the CRS requires a community application. Requirements were modified in 2013, and some of these modifications of which were considered by some communities to be burdensome. For example, smaller communities with little GIS technical capability have difficulty in producing the detailed maps that FEMA requires to earn points for some activities (for example, improving a community’s drainage capacity). The modest premium reduction achieved for the prescribed CRS actions and the small number of communities that have attained substantial rate improvements do not suggest that this program, given the costs of application, will contribute greatly to the affordability of flood insurance. A recent increase in interest in the CRS by many communities, however, suggests that they believe that the CRS will help to lower premiums, and that they may be willing to incur the CRS application costs.

Community Insurance Policies

Various reforms to the NFIP have been considered over the years. One is community-level insurance policies. A community insurance option would enable communities to purchase a group flood insurance policy on behalf of all properties that are at risk of flooding. The community would pay a single premium for the group policy and then recover the costs of the policy through special assessments levied on covered properties, most likely as an adjunct to the property tax. A FEMA report that evaluated NFIP reform options that were based on assessments by expert panels concluded that a community insurance option would substantially reduce exposure to flood hazards but that administrative challenges and political feasibility would need to be addressed (FEMA, 2011). Under HFIAA 2014, FEMA has been directed by Congress to examine and report on a community insurance option.

Community insurance would increase takeup rates by automatically insuring all members of a participating community. That could exacerbate, instead of lessen, affordability problems by forcing all members of a community to pay flood insurance premiums. That said, risk-based premiums could be coupled to premium reductions when communities or individuals engage in flood risk management activities that lead to higher adoption of flood mitigation measures. If the reduction in premiums incentivized greater adoption of hazard mitigation at a community level, such as encouraging communities to move up through the CRS program discussed in the previous section, it would translate into lower insurance costs for all residents—but again the reduction in premiums may not be sufficient

to address affordability issues. Community insurance could shift the issue of affordability to the local level and let each community address it in the way that it sees fit; this could be achieved through cross-subsidizations in the assessments of premiums or by using other community funds to offset high premiums for low-income and moderate-income households. And, of course, community insurance could be combined with other programs discussed in this section.

SUMMARY

BW 2012, Section 100236, as well as HFIAA 2014, focus on affordability of insurance rates motivate the development of affordability policy options. Chapter 6 discussed the array of decisions that must be made by policymakers, and this chapter has focused on options for assisting individual policyholders or entire communities. Although the options are discussed separately, a subset of them could be implemented simultaneously. The options can be combined in different ways; for example, mitigation loans may be reserved for low-cost mitigation actions. Options may have conditions attached to them; for example, eligibility for a voucher for assistance in paying a premium may include a requirement to implement mitigation actions.

• The NFIP can strive for risk-based premiums while addressing affordability by implementing a combination of policy measures, including means tested mitigation grants, mitigation loans, vouchers, and encouragement of higher premium deductibles.
• Reforms to mitigation grant programs can be implemented so that means testing, as a replacement for the current benefit-cost test, is the basis for setting priorities for mitigation grant spending.
• A mitigation loan can make it financially attractive and feasible for low-income residents to invest in mitigation measures without having to rely on mitigation grants.
• Vouchers are an administratively simple way to direct payments to cost burdened policyholders for use in paying premiums or for offsetting mitigation costs.
• The few mitigation measures that result in lower NFIP premiums tend to be expensive, such as elevating homes. As a result of BW 2012, FEMA will consider whether lower-cost mitigation of structures will result in lower premiums. Determining the effect of lower-cost mitigation on NFIP risk-based rates will require additional analyses.
• If Congress authorized supplements from the Treasury to be used for making NFIP claim payments in catastrophic-loss years, this could

• allow lower NFIP risk-based premiums and, in turn, less spending for assistance.

• Some policies that have been advanced to lower NFIP risk-based premiums for cost burdened households either will not have that effect, or may not be easily accessed by cost burdened policyholders. These include reducing administrative fees, disaster savings accounts, and income tax credits and deductions.
• Community measures can lower insurance premiums through mitigation actions that benefit clusters of structures and through the CRS. These might be particularly important in mitigation related to multi-family properties.

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