The National Flood Insurance Program (NFIP), established in 1968 and housed within the Federal Emergency Management Agency (FEMA), offers insurance policies that are marketed and sold through private insurers, but with the risks borne by the US federal government. In July 2012, Congress passed the Biggert-Waters Flood Insurance Reform Act (Biggert-Waters 2012, or BW 2012), which was designed to initiate several changes within the NFIP. A core principle of the 2012 legislation was to move toward an insurance program with NFIP risk-based premiums that better reflected expected losses from floods at insured properties.1 This entailed eventual removal of discounts from NFIP policies known as “pre-FIRM subsidized” (pre-Flood Insurance Rate Map) and “grandfathered” policies. Paying the claims for such policies contributed in part to the NFIP having to borrow from the US Treasury to pay for claims after Hurricane Katrina and late storms. That debt was also a motivation for provisions in BW 2012 that directed FEMA to consider actions that had the potential to improve the financial foundation for the program through premium increases that would better reflect flood risks.
BW 2012 Section 100236 called for an “affordability study” from FEMA that would include “methods to aid individuals to afford risk-based
1Some of the terms used in this report may be unfamiliar to the reader or may have been used in inconsistent ways in writing and testimony about the NFIP through the years. Terms specific to the NFIP were taken from FEMA to the extent possible, but other terms were developed by the committee to ensure their consistent use throughout the report. A List of Terms is included at the end of this report for the reader’s convenience.
premiums under the National Flood Insurance Program through targeted assistance rather than generally subsidized rates, including means-tested vouchers.” The study was to inform the development of an affordability framework by FEMA to help inform NFIP policy decisions. However, implementation of BW 2012 rate increases was expected to take effect without awaiting the study and the development of an affordability framework, including an assistance program (see Appendix A for full language of BW 2012 Section 100236).
As BW 2012 went into effect, constituents from multiple communities expressed concerns about the elimination of lower rate classes, arguing that it created a financial burden on policyholders. Some concerns reflected the reality that purchase of the more expensive insurance was in some instances mandatory. Other concerns were based on expectations that higher premiums would depress home values, and on the question of whether higher premiums would thwart attainment of a long-standing objective of the NFIP to expand the number of properties covered by flood insurance. In response to these concerns, Congress passed the Homeowner Flood Insurance Affordability Act of 2014 (HFIAA 2014). The 2014 legislation changed the process by which pre-FIRM subsidized premiums for primary residences would be removed and reinstated grandfathering. In addition, Section 9 of HFIAA 2014 once again called on FEMA to report to Congress with a draft affordability framework. Specifically, the legislation stated
the Administrator shall prepare a draft affordability framework that proposes to address, via programmatic and regulatory changes, the issues of affordability of flood insurance sold under the National Flood Insurance Program, including issues identified in the affordability study required under Section 100236 of the Biggert-Waters Flood Insurance Act of 2012.
Section 100236 of BW 2012 mandated that both the aforementioned FEMA affordability study and a study from the National of Academy of Sciences (NAS) to provide input into FEMA’s work. In response, the National Research Council (NRC)2 convened the Committee on the Affordability of National Flood Insurance Program Premiums. The statement of task guiding this NRC committee calls for two reports and explains the content of and distinctions between them:
The first report, due in February 2015, will discuss the underlying definitions and methods for an affordability framework and describe the affordability concept and applications, and program policy options.
2The National Research Council is the working arm of the National Academies. The National Academies is the collective entity that includes the National Academy of Sciences (NAS), the National Academy of Engineering (NAE), the Institute of Medicine (IOM), along with the National Research Council. For more information, see http://nationalacademies.org
The second report, due in September 2015, will propose alternative approaches for a national evaluation of affordability program policy options, based in part on lessons gleaned from a proof-of-concept pilot study to be guided by the NRC committee.
Consistent with its statement of task, Chapter 6 describes alternatives for determining when the premium increases resulting from BW 2012 would make flood insurance unaffordable and describes key design decisions and policy options for creating an assistance program. Chapter 7 discusses policy alternatives that may lower the cost of flood insurance for eligible households. To set the stage for Chapters 6 and 7, Chapter 2 describes the history of the NFIP emphasizing the effects of that history on premium setting prior to BW 2012. Chapter 3 describes the NFIP pricing practices that were in place when BW 2012 was passed and how BW 2012 might increase premiums. Chapter 4 describes the demand for insurance and offers findings about the challenge of increasing the purchase of flood insurance policies, a long-standing objective of Congress for the NFIP. Chapter 5 identifies places in the nation where the effects of BW 2012 may be most pronounced.3
NATIONAL FLOOD INSURANCE PROGRAM HISTORY
Original proposals for a national flood insurance program date back to the 1950s. The original 1968 legislation that established the program, and implementation of the NFIP over the years that led up to passage of BW 2012, reflected an intent to make flood insurance part of a multifaceted national program for flood risk management. That intent, in turn, affected NFIP premium-setting practices that were used prior to BW 2012. The following findings are based on a review of that history.
- From the inception of the NFIP, and continuing until BW 2012, Congress sought to achieve multiple objectives for the program. The objectives have been to (1) ensure reasonable insurance premiums for all, (2) have NFIP risk-based premiums that would make people aware of and bear the cost of their floodplain location choices, (3) secure widespread community participation in the program and substantial numbers of insurance policy purchases by property owners,
3This report does not attempt to specify programs or actions to promote flood insurance affordability, nor does it advise on how national flood risks might be reduced through insurance or other actions.
and (4) earn premium and fee income that, over time, covers claims paid and program expenses. These objectives, however, are not always compatible, and at times may conflict with one another.
- The premium-setting practices and procedures that were in place before Biggert-Waters 2012 reflected the multiple objectives of the NFIP, and in some cases reflected premium-setting practices that were put in place when the NFIP was created. BW 2012 increased the emphasis on setting NFIP rates that reflected flood risk, and on charging premiums that would cover claims paid and other related expenses.
NATIONAL FLOOD INSURANCE PROGRAM POLICY PRICING AND EFFECTS OF BIGGERT-WATERS 2012
Well-established actuarial principles require that the combination of insurance premiums and other income sources yield revenues that will pay expected future claims and insurance program expenses (costs). These principles also hold that premiums for an individual policy, to the administratively feasible extent, should be based on expected claims plus fees for the policy. Further, the principles hold that there should be no cross-subsidy whereby one group of policyholders has higher premiums so that others will have lower premiums. Finally, premiums should be no higher than necessary to ensure that these principles are met; regulation of private insurers is expected to limit premiums to costs of providing coverage plus a competitive return on invested capital. The NFIP, although not a private company, seeks to employ actuarial principles when setting premiums. However, historical precedent and congressional desire for premiums to be reasonable, constrained application of these principles. BW 2012 sought to remove constraints on the NFIP’s ability to follow actuarial pricing principles.
As a result, BW 2012 had the potential to increase premiums for three types of NFIP policies: NFIP risk-based, grandfathered, and pre-FIRM subsidized. Pre-FIRM subsided policies have premiums that are less than those of NFIP risk-based policies for structures that were in place before a local flood insurance rate map (FIRM) was available. The NFIP realizes foregone revenues, relative to NFIP risk-based premiums, for this type of policy. To accommodate that reality, FEMA had adopted a revenue target whereby all premium income would equal claims paid on the historical average loss year (HALY). BW 2012 phases out this policy type; as a result, FEMA no longer uses the HALY in NFIP premium setting. The increases may be especially important for the 20% of properties that are eligible for pre-FIRM subsidized premiums.
The grandfathered premiums within the NFIP allow a given rating class to continue for a property even if a new FIRM may indicate a higher level
of flood risk. To make up for revenue losses due to grandfathering the NFIP loads (adds a charge) to other policies in its policy base. Grandfathering—and as a result the cross subsidy—was phased out by BW 2012. HFIAA 2014 reinstated grandfathering.
The Community Rating System (CRS) is a FEMA program that encourages communities to adopt a variety of measures to help reduce flood risks. It allows discounted premiums for some properties when the community adopts one or more NFIP-prescribed flood risk management actions. CRS-discounted premiums are cross-subsidized by charges levied on all NFIP policyholders and were unaffected by BW 2012. The findings that follow are based on a review and discussion of NFIP pricing and the effects of BW 2012 and HFIAA 2014.
- Prior to BW 2012, the NFIP goal was to offer reasonable premiums, but at the same time premiums were expected to follow actuarial principles and cover claims and expenses over the long term. As a matter of practice, the historical average loss year (HALY) became a total premium revenue target. Rates were set so that the total revenue from all policies was sufficient to replace the premium revenue loss from offering pre-FIRM subsidized polices.
- After BW 2012, use of HALY is to be replaced by charging all pre-FIRM properties NFIP risk-based rates. The increase in cost of insurance for policyholders as a result of phasing out pre-FIRM subsidized premiums and the resulting premium revenue increases to the program, may be significant, but can be estimated only when additional data is available.
- HFIAA 2014 delayed but did not reverse the BW 2012 requirement to eliminate pre-FIRM subsided rates and to consider changes to NFIP risk-based rate setting practices.
- HFIAA 2014 reinstated grandfathering. Revenue losses caused by offering grandfathered premiums, and by CRS discounted premiums, which continue to be offered, are expected to be offset by increasing premiums for all policies. Whether the revenue earned from these cross-subsidies compensates for the forgone premium income is uncertain. If grandfathering or CRS discounting expands, the result will be that NFIP premiums increasingly violate the actuarial principle that premiums should be related to risk.
A long-standing objective of the NFIP has been to increase purchases of flood insurance policies. The national flood risk management objective of widespread NFIP purchase was one motivation for keeping NFIP premiums
reasonable, with the premise that the level of the premium determines the willingness and ability to purchase flood insurance. However, property owners’ decisions to purchase insurance include other considerations and influences unrelated to price. A review of the economics and behavioral sciences literature identified no single strategy that will increase purchase of NFIP policies.
- The original NFIP legislation expected NFIP premiums to be priced at reasonable levels to promote voluntary purchase of NFIP policies. Empirical studies have found that premium prices may affect takeup rates although the size of that effect is small. The effect of the availability of disaster aid on insurance purchase decisions is uncertain.
- Studies have found that people may use intuitive thinking, as opposed to systematic consideration of the cost of premiums in relation to expected claim payments, when choosing to forego insurance or to cancel an existing policy.
- The combination of acknowledgement of intuitive thinking and the limited effects of premiums on insurance purchase decisions suggests that lower premiums alone will not increase takeup rates substantially.
- Keeping NFIP premiums at reasonable levels can be part of any strategy to maintain compliance with mandatory purchase requirements and increase voluntary takeup rates. A multipart strategy to motivating purchase of NFIP policies can be designed using insights from the behavioral sciences literature.
NATIONAL FLOOD INSURANCE PROGRAM POLICIES: LOCATIONS OF POTENTIAL AFFORDABILITY CHALLENGES
The NFIP policy database can be used to describe the locations of policies and areas of concentration. Knowing the location of all policies, pre-FIRM subsidized policies, and grandfathered policies could aid in formulating alternative strategies to provide assistance to households that find NFIP risk-based premiums to be affordable. Likewise, knowing the location of policies can provide insight into places where takeup rates are low.
- About 60% of the approximately 5.5 million NFIP polices are in three states: Florida, Texas, and Louisiana. The rest are distributed widely throughout the nation. Any effects of BW 2012 therefore will be more concentrated in some places, but will appear throughout the nation.
- Available estimates of takeup rates suggest that they are low, especially outside Special Flood Hazard Areas. Meeting the long-standing
goal of high takeup rates for flood insurance would therefore require a large increase in purchases.
- The extent and location of premium increases that might result from elimination of grandfathering can be determined by further analysis of the policy data, but cannot be estimated now.
- Slightly more than 1 million NFIP policyholders—or 19% of all policyholders—are paying pre-FIRM subsidized rates and will potentially see rate increases if the provisions of BW 2012 remain in effect. Pre-FIRM subsidized policies are found throughout the nation, but there are areas of concentration.
DECISIONS WHEN DESIGNING ASSISTANCE PROGRAMS TO ENHANCE AFFORDABILITY
Both BW 2012 and HFIAA 2014 reflect concerns that NFIP risk-based premiums may be unaffordable for some households. FEMA is directed to review that possibility and suggest policy actions that would make premiums affordable for households that are financially burdened by the cost of flood insurance. If a premium is deemed unaffordable, the household paying that premium might receive assistance. The assistance may offset part of the cost of the premium, may be for mitigation actions that would reduce the risk and in turn the premium, or may be some combination of the two.
HFIAA 2014 suggests that premiums are unaffordable if the premium exceeds 1% of the insurance coverage. Other measures of affordability can be defined by relating household income to the cost of housing or simply be based on when a household income is below a specified level. Whatever measure used, it will be only one consideration in the design of an assistance program. The form and amount of assistance provided, if any, will need to be determined.
- There are no objective definitions of affordability. Although the concept is substantially subjective, the choice of a definition can be informed by research evidence and experience in administering means tested programs that, for example, provide housing and other assistance.
- There are many ways to measure the cost burden of flood insurance on property owners and renters. Policymakers have to select which measure(s) will be used in the NFIP for targeting assistance to enhance flood insurance affordability. This decision is not amenable solely to technical analysis.
- To design a program that provides assistance in making flood insurance more affordable to NFIP policyholders, policymakers face several choices, including who will receive assistance, what type of
assistance will be provided, how assistance will be provided, how much assistance will be provided, who will pay for assistance, and how an assistance program will be administered.
- The decisions that must be made in designing an affordability assistance program entail tradeoffs that will have to be resolved by policymakers.
OPTIONS FOR DELIVERING ASSISTANCE TO ENHANCE FLOOD INSURANCE AFFORDABILITY
With passage of BW 2012, Congress asked FEMA to increase rates but at the same time to suggest ways to make premiums affordable through direct assistance programs that are based on ability to pay and means testing. Vouchers in particular were called out for attention. In addition to assistance with paying premiums, means tested assistance can support mitigation that would reduce expected claims and premiums. Proposals for policies that might reduce the burden of premium payments or that might direct mitigation assistance toward households that qualify for assistance have been presented in legislation, in congressional testimony, and in professional literature. The committee reviewed the proposals and concluded the following:
- 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.
Choosing among affordability policy options, alone or in combination, requires an evaluation of their effects not only on premiums for households for which NFIP risk-based premiums create a cost burden but on NFIP net revenues, expenditures from federal general revenues, and takeup rates. This committee’s second report, to be published later in 2015, will suggest analytical protocols that FEMA might use to evaluate affordability policy options.