When the private–public partnership within the National Flood Insurance Program (NFIP) dissolved in 1978, the NFIP took on the role of pricing policies and bearing risks. The congressional goals for the NFIP of high takeup rates and reasonable premiums, however, continued to influence the pricing of NFIP policies from that time until the passage of Biggert-Waters 2012 (BW 2012). This chapter describes pre-BW 2012 NFIP pricing policies, and in so doing provides a basis for explaining the BW 2012 reforms and the reasons for congressional interest in premium affordability.1 Because the reforms in BW 2012 were intended to move the NFIP closer to actuarial pricing, this chapter is organized around a discussion of the principles of actuarial pricing.
Actuarial Pricing Principles
Insurance requires individuals to pay premiums that are greater than the expected loss (the product of probability multiplied by the amount of
1The Homeowner Flood Insurance Affordability Act of 2014 (HFIAA 2014) changed some provisions of Biggert-Waters 2012. The committee recognized these changes, but its task called for a focus on changes made by BW 2012. HFIAA 2014 can be considered from that perspective as a pause in implementing some of the BW 2012 reforms until the Federal Emergency Management Agency completes an affordability framework, and an affordability study.
damage). Insurance is a contract that transfers the financial burdens of a generally low-probability—high-consequence event from the buyer (the insured) to another party (the insurer) in return for stable and predictable periodic payments—the premiums. If an event that is covered by the insurance contract occurs, payment by the insurer indemnifies the insured for their loss up to a maximum amount specified in the policy (the policy limit) in a manner consistent with other contractual terms such as the deductible amount and proof of loss. Thus, insurance is a hedging instrument against the financial consequences of a loss, and the value of this hedge to the insured is realized only if there is a covered loss. Insurance does not alter the probabilities of a loss if an event occurs. Rather, insurance transfers the loss to another entity that is willing and able to accept it. Insurance protects the insured financially if losses could not be borne out of current income or borrowing, and it can speed recovery after the event.
Not all risks can be insured, and several authors have identified ideal conditions of insurability (Swiss Re, 2005; Charpentier, 2008; Kousky, 2013). The conditions include the risk’s being uncertain, random, and out of the control of the insured. Individual policyholder risks ideally are independent (not correlated in space or time). In the case of flood risks, those conditions will not hold (Baranoff et al., 2009), as evidenced by the history of private insurance company efforts to offer flood insurance (Moss, 1999). Recognition of that reality was behind the private-public partnership originally envisioned for the NFIP.
The price paid for insurance will include the expected loss, the costs of writing the policy, and processing of claims. It will account for uncertainty and will provide a rate of return to the insurer. In the United States, an important public-sector role, which is executed through state regulation, is to ensure that the insurer uses proper actuarial principles in setting premiums for specific losses covered by a policy. Those principles also are used to structure the explanation of NFIP pricing. In fact, the Federal Emergency Management Agency (FEMA) publishes an annual report called the Actuarial Rate Review that documents NFIP pricing practices (see Box 3-1 for additional discussion of the setting of premiums in the NFIP).
The Casualty Actuarial Society (1988) defines four principles of actuarial rating (NRC, 2013).
- A rating should reflect the expected value of future claims.
- A rating should provide for all costs associated with the provision of the insurance (accepting the transfer of the risk).
- A rating should provide for the costs associated with individual risk transfer (no cross-subsidization among policyholders).
- A rating should be reasonable and not excessive, inadequate, or unfairly discriminatory.
Ratings and Premiums
The premium charged for insurance is product of the rate charged per dollar of coverage and the level of coverage chosen by the insured. For the NFIP, the private sector insurance agent who writes the NFIP policy (also known as a write your own [WYO] agent) uses an NFIP-issued flood insurance manual, issued new each year, to find the price per $100 of coverage. Based on tables provided in the manual, the agent needs to obtain information about the property from the owner (for example, the presence of a basement) and an elevation certificate prepared by a certified surveyor. With an elevation certificate, the agent can locate the property within a zone of the special flood hazard area (SFHA), or identify as outside an SFHA. Then, using the flood insurance rate map (FIRM), the agent can calculate the difference between the lowest floor and the Base Flood Elevation (BFE) on the FIRM. With that difference and other factors, the rate per $100 of coverage for the property can be established. The process includes determining which rating table applies to the property in question.
How and whether those principles apply to the NFIP is the initial focus of this chapter.
The first of the principles states that the insurance premium needs to account for the mathematical expectation of the loss of the property being insured. This expected loss often is referred to as the “pure premium.” In the case of flood insurance, the pure premium would be this expected loss of the insured property. The pure premium is a forward looking estimate of the cost of this loss over the contract period of the policy. The second principle requires the premium to cover all the costs of risk transfer so that the insurance company can be financially sound. The costs that are added to the premium are for administrative and operational costs, amounts to account for possible errors in assessing (underestimating) risk, and the cost of obtaining a reasonable rate of return for investors in the company. The third principle calls for each risk to be priced for itself and for there to be no cross-subsidization among insureds to the extent possible. When necessary, risk classes may be defined and rates set for the broad group if data is not available or administrative costs would be too high to set rates for individual risks; setting rates for classes of insured is common practice. Finally, if rate making follows the first three principles, it should meet the fourth: to be reasonable and not excessive, inadequate, or unfairly discriminatory.
As is clear from those principles, determining when a premium is actuarially sound can be subject to interpretation, and rate setting must be a
compromise between the ideal and what is administratively possible. The Casualty Actuarial Society (1988) notes several practical considerations when setting actuarial rates. These include the need for having homogeneous groupings of risk, the need to consider historical costs and claims over time, the need to be prepared to pay for catastrophic losses (losses to many of the insured at the same time) via reinsurance, and a regulatory environment that may require cross-subsidies. For example, it might be mandated that automobile insurance policies cannot vary on the basis of age, sex, or race, even if these variables have been shown to be predictors of risk; in this case, rates are still considered actuarially sound, but to be within the confines of the law (Witt and Hogan, 1993).
National Flood Insurance Program Policy Types
National Flood Insurance Program Risk-based Premiums
FEMA defines a risk-based premium as one “charged to a group of policies that results in aggregate premiums sufficient to pay anticipated losses and expenses for that group.”2 That definition calls for actuarial principles that the rates reflect expected losses and other costs of risk transfer and that there not be cross-subsidies across the risk groups. To calculate NFIP rates, FEMA models expected losses for groups of structures that are similar in flood risk and key structural aspects, and then adds to the rates to account for various expenses. The same rate is applied to all the policies in a group or class.
More specifically, for Special Flood Hazard Areas (SFHAs; see Appendix E), FEMA sets rates by using a hydrologic model that includes flood events of various probabilities and relates these events to potential damages. The damage estimates for the different flood events used are checked against claim experience and can vary by factors such as type of basement and number of stories (see Box 3-2 for more detail). Outside SFHAs, rates have been based on actuarial and engineering judgments derived from the results of the rate model and historical experience; the cost of developing detailed analysis of frequency-magnitude relationships would be higher than the value of the information for rate setting that would be gained from such analysis (Garcia-Diaz, 2014; Kousky and Shabman, 2014). This is especially the case for events more rare than a 500-year return period (0.2% probability).
Premiums then are adjusted by several factors. First is a loss-adjustment factor, which covers the costs of loss adjusters and special claims investi-
2See https://www.fema.gov/national-flood-insurance-program/definitions. Accessed December 17, 2014.
gations. Second is a deductible offset. Third is an underinsurance factor, which accounts for the fact that many policyholders do not insure to value and therefore lower claims are likely. Finally, an expected-loss ratio adjustment adds to rates to account for agents’ commissions and other expenses. The NFIP classifies the first $60,000 of building coverage for single-family homes and $25,000 of contents coverage as the “basic limit” and charges higher rates for coverage under this amount because losses are likely to be under it; rates for coverage beyond the basic limit are lower (Garcia-Diaz, 2014; Kousky and Shabman, 2014). Basic limits are higher for commercial properties.
FEMA maintains that the NFIP risk-based group is rated in accordance with actuarial principles but points out that other objectives for the program constrain the application of the principles. In its 2011 Rate Review, FEMA noted that the price of insurance should provide financial soundness to the program, be fair by allocating costs in proportion to risk, and allow economic incentives to operate and encourage availability of coverage. Those objectives depart somewhat from those noted by the Casualty Actuarial Society. The Rate Review further notes that “the system of insurance and pricing must further the purposes of the Act,” which includes encouraging floodplain management, encouraging take up through affordable rates and rates that are acceptable to the public (Hayes and Neal, 2011).
On a more technical level, a 2008 Government Accountability Office (GAO) report raised concerns that some of the data used in the modeling was outdated or inaccurate. FEMA has been updating FIRMs and making other improvements, but some items, such as probability estimates of floods, had not been updated recently (Kousky and Shabman, 2014). In its response to GAO, FEMA—through the Department of Homeland Security (DHS)—agreed with some of the GAO report. It is perhaps most telling that the DHS letter stated at the outset that “while GAO raises valid concerns, DHS believes that the analysis does not grasp some of the generally accepted principles of insurance and actuarial rate setting” and referred to such matters as the need for grouping and recognizing other program objectives in setting rates (GAO, 2008). FEMA has since been engaged in such activities as improving map accuracy.
Preferred Risk Policies
For policies outside the 100-year and 500-year floodplains, FEMA has two rate classes: X zone rates and preferred risk policy (PRP) rates.3 X zone rates follow a process similar to that for full risk-rated properties in the SFHA as discussed above. PRPs are low rates for structures that are in an
3Appendix E contains details of FEMA’s SFHA classifications.
Estimating Flood-Damage Relationships
In the notation of FEMA, at a given location and for a given structure type the probability of flood water reaching an elevation I, PELVi, is multiplied by the “loss severity” that would occur at the structure if flood waters reached this elevation (that is, damage based on water depth in a given structure). This is referred to as damage by elevation, DELVi, (NRC, 2013). These products are summed over all possible water elevation levels to arrive at an expected loss:
This calculation is for properties that have similar risk-related covariates (flood risk, elevation, zone, etc.), and a common rate is given to all properties in the class nationwide.
FEMA’s process for determining PELV and DELV components in the above expected value calculation is as follows: For PELV at a given location, this collection of probability curves (called PELV curves) is used to describe the probability of water elevation relative to the 1% percent flood stage at that location. These PELV curves yield flood stage probabilities up to the 0.2% event (flood recurrence once in 500 years). To evaluate flood events that have water inundation higher than that specified for the 0.2% flood, the NFIP doubles the 0.2% inundation level and assumes a “catastrophic” flood occurs. Because this “catastrophic” flood has a very low probability, and because there is assumed to be a relatively small incremental increase in damages incurred between the 0.2% inundation level, and double this inundation, it is believed that this approximation will have little effect on the rate that is ultimately determined.
The damage as a function of the flood stage (DELV) is the second component in the expected-value calculation. In a given rating zone, FEMA bases the DELV on historical damage data at different flood stages in the zone, and it varies with structure content and location. When, on the number and variability of claims, the NFIP’s historical damage data is sufficiently credible, the NFIP data is used
X zone (no grandfathering is allowed; see below) and have favorable loss history. Specifically, a property cannot have had any of the following: two claims of more than $1,000 each; three or more claims of any amount; two federal disaster-aid payments of more than $1,000 each; three federal disaster aid payments of any amount for separate occurrences; or, one insurance claim and two federal aid payments of more than $1,000 each.
Exceptions to NFIP Risk Based Policies
Before passage of BW 2012, the NFIP had three main classes of policyholders that were offered coverage at less than their risk-based rates: pre-
to develop the damage estimate. When there is no NFIP historical damage data, damage data from the U.S. Army Corps of Engineers is used. When there is NFIP historical data available, however, or when it is not itself fully credible, the NFIP blends the NFIP damage data with the Corps of Engineers damage data by using credibility formulas to determine the DELV entry. That is consistent with standard casualty actuarial practice in private insurance.
After the expected damage value has been calculated, it must be “loaded” to obtain the rate for the NFIP to use. That is done by using this formula:
where LADJ is a load factor that reflects damage adjustment expenses, and DED is a load factor that can be thought of as adjusting the DELV to account for the deductible amount (because the damage actually paid by the NFIP reflects the deductible amount).
The factor UINS makes a further adjustment to account for the underinsurance amount since not all properties can (or do insure) for the full potential damage that might be incurred at their property in a flood, and this effects the amount that must be paid by the NFIP. The value of the UINS factor is estimated by FEMA via a review of historical insurance claims. Incurred losses constitute a nonlinear function of the actual damage severity; most damages are smaller and relatively few are much larger (that is, the damage distribution is skewed). UINS adjusts the DELV to account for this nonlinearity. In 2012 the value used for LADJ was 1.05 and the value used for DED was 0.98 (FEMA, 2013a). In the denominator of the above expression, the factor EXLOSS accounts for the expected damage ratio and a risk contingency factor that differentiates between the structure’s being or not being in a velocity zone. EXLOSS adjusts the rate to accommodate commissions, acquisition costs, and other costs in such a way that the product of the rate times the expected damage ratio is sufficient to cover the expected damage when damage adjustment expenses and idiosyncratic choices by the purchaser of the deductible and underinsurance amount are accounted for.
FIRM properties; grandfathered properties; and properties in communities that participate in the community rating system (CRS) program. Each will be discussed in turn.4
4In addition, included in the 5.5 million NFIP policyholders are other small groups that receive lower rates: (1) those in a V zone with a structure built before 1981 and before maps that consider wave height were adopted in setting flood insurance rates (roughly 7,500 policyholders); (2) those structures in an AR or A99 SFHA with levees in the course of reconstruction or construction but given rates as though full protection were in place (roughly 25,000 policyholders); and (3) policyholders that participate in a Group Flood Insurance Policy (GFIP) (see Appendix E for explanation of FEMA SFHA designations).
Pre-Flood Insurance Rate Map (FIRM) Subsidized Policies
Pre-FIRM properties are those built before FEMA mapped flood risk in a community (Kousky and Shabman, 2014). The pre-FIRM subsidy rate applied only to basic limits of insurance (for buildings, the first $60,000 of coverage). It was a lower rate than risk-based for that amount of coverage and was not set according to the height of the first floor relative to the base flood elevation (BFE; see List of Terms), as is done for risk-based properties in SFHAs. As a result, no elevation certificate (see List of Terms) was required to be eligible for pre-FIRM subsidized rates. Offering rates below risk-based levels violates actuarial principles.
As was explained in Chapter 2, however, such rates were offered to properties that were built before a community joining the program. Recall that when the NFIP public-private partnership was in place, the federal Treasury made annual payments to reimburse the pool as needed. This was done to compensate the private sector for offering premiums below risk-based prices. With the pool gone, the annual cash payments from the Treasury to the program were not continued. Instead, in the 1980s the decision was made to set pre-FIRM subsidies at a level that allowed the combined revenue from pre-FIRM and NFIP full-risk premiums to cover losses for the historical average loss year (HALY), which was calculated as the mean annual loss over the life of the program (Kousky and Shabman, 2014). That had the effect of replacing the direct Treasury subsidy to pre-FIRM policyholders with a cross-subsidy from all policyholders.
The HALY was based on a program claims experience that consisted of high-loss years and low-loss years, but it did not include any catastrophic-loss years. The program borrowed from the Treasury in high-loss years, and returned the funds in years that had lower claims. As noted previously, however, Hurricane Katrina and other storms for 2005 resulted in unprecedented payments by the NFIP. In fact, the NFIP paid out more claims for 2005 than it had paid over the life of the program to that point (Hayes and Neal, 2011; Kousky and Kunreuther, 2014). The 2005 storms and claims payouts were offered by Congress as a loan to the program, and this sent the program deeply in debt to the Treasury.5 Hurricane Ike in 2008 and Hurricane Sandy in 2012 deepened the debt further.
The debt was so large that paying it back would have led to large rate increases—a step that FEMA did not want to take without explicit support of Congress. In fact, there was congressional instruction that rates were not to increase by more than 10% in any year. Furthermore, the pre-FIRM
5As of December 31, 2010, the program had paid $18.5 billion in losses and loss-adjustment expenses and more than $2.4 billion in interest payments because of storm events in 2005. The program carried $17.75 billion in debt with the US Treasury and has repaid $1.8 billion since 2005.
subsidy rate was required by legislation. Thus, although it violated the actuarial principle that the rate should reflect expected future costs, it was not something that the NFIP was willing to change without consent of Congress (Hayes and Neal, 2011). As a result of that reluctance, subsequent claims paid for those high-loss years were not fully incorporated in defining the Historical Average Loss Year.
Grandfathered properties are ones that were either built in compliance with the local FIRMS in effect at the time of construction, or demonstrated compliance with a FIRM and maintained continuous coverage after FIRM changes are allowed to maintain a lower rate if a new FIRM reclassifies the property into a higher risk zone (Kousky and Shabman, 2014). Zone grandfathering is the most common form of rate grandfathering, and it occurs when a policyholder once was paying a lower rate because of classification as outside the SFHA, but now, because of the new map, is included in the SFHA. Here, the zone-grandfathered policies going from non-SFHA to SFHA do not pay the lower non-SFHA preferred risk policy (PRP) rate but instead pay an average rate, called the X zone standard rate for policies outside SFHAs but without the favorable loss history of the PRPs. Another way in which zone grandfathering occurs is when a new map reclassifies an insured structure from a lower-risk zone to a higher-risk zone. In this case, the grandfathered structure will pay the lower AE zone rate instead of the newer, higher VE zone rate (see Appendix E for more information on distinctions among these flood hazard zones).
Elevation grandfathering occurs when a new map increases the elevation of the mapped 1% flood, but without changing the zone itself. As an illustration, a property that was mapped previously as being 4 feet above the 1% flood elevation but is now, according to the revised map, only 1 foot above it, would still be allowed to use the rate associated with a property 4 feet above the 1% flood elevation.
Although FEMA does not have an estimate of how many properties are paying grandfathered rates, the program tries to recoup lost revenue from the lower rates by charging higher rates for other policies in the SFHA. That is an explicit cross-subsidization between grandfathered properties and all other properties in the SFHA. It is not clear, however, whether the NFIP is increasing other SFHA policy premiums by an amount equal to the discount from NFIP risk-based rates that are being paid by the grandfathered properties.
Community Rating System Discounts
The CRS program rewards policyholders with premium discounts if their communities adopt specified risk mitigation measures. Discounts begin at 5% and reach a maximum of 45% (note, however, that only one U.S. community has reached the highest discount level). These discounts apply to policies in the areas both inside and outside the SFHA, but the premiums discounts differ by area. PRP policies are not given a discount in CRS communities. CRS discounts are accounted for by adjusting all premiums upward so that aggregate revenue to the program is enough to cover expected claims that will continue to occur at properties that have a CRS discount.6 The expected discount for the April 1, 2014 rate changes was 11.8%, which translates to a 13.4% percent load.7 The lower rates introduce explicit cross-subsidies into the program given that the rate reductions granted to communities are not constrained to be equal to the change in claims to the program. Again, these are violations of the third actuarial principle, but this was intended to promote wise flood risk management policies and actions by local governments (another NFIP objective). As with cross-subsidies for grandfathering, it is unclear whether the increased rates for other SFHA properties are enough to offset the lower CRS discounted rates.
One actuarial principle states that a rate should provide for all the costs of risk transfer. That includes all costs of operating the program. NFIP expenses will differ from the private insurance sector, but including whatever the appropriate costs are in the rate is in line with actuarial pricing principles. Most administrative costs to write policies and process claims are captured in the fees paid to Write Your Own (WYO) companies. The NFIP has voluntarily agreed to pay state insurance taxes and these are included in rates. A $20 policy fee is charged to cover the costs of flood insurance studies, floodplain management activities, and some administrative costs of the program (Kousky and Shabman, 2014). A private company also would load rates to earn a reasonable return on investment, something that the NFIP is not required to do as a public program.
The WYO allowance, as a percentage of written premiums, is roughly
6There are some useful community-based actions for which FEMA allows for lower rates, even though they will not necessarily reduce claims from existing properties. For example, publishing flood risk rate maps in a local library may increase general flood risk awareness in the community, but it may not lead directly to reductions in claims by policy holders.
7In the insurance sector, load is a cost that is built into the cost of the premium. In general, it covers the insurer’s operating costs, the chance that the insurer’s losses for that period will be higher than anticipated, and any changes in interest earned from the insurer’s investments.
15% agent commissions, 2.3% voluntary payment of state premium taxes, and 12.5-13.5% company expenses. The company-expense percentage is based on a 5-year industry average of the expense ratio for multiple property insurance lines and an additional 1% for costs of a federal program. Companies also receive compensation for processing claims, which varies with the size of the claim. WYO companies get a bonus for expanding the policy base of the NFIP (up to 2% of written premiums). In 2008, FEMA used actual expense data to modify the way it handles payments for claims processing because of very large payments to WYO companies in 2004 and 2005 (GAO, 2009; Kousky and Shabman, 2014).
Through a number of specific provisions, BW 2012 directed FEMA to change the premiums it was charging to reflect more fully the risks for all classes of policyholders. In effect, they applied actuarial pricing principles more fully.
Remove Pre-Flood Insurance Rate Map Subsidized Rates
To be consistent with actuarial principles, FEMA was to replace pre-FIRM subsidized rates with NFIP risk-based rates. The replacement would occur more quickly for some properties than for others, but eventually all would pay NFIP risk-based rates. For some properties, effective on July 1, 2012, pre-FIRM subsidized premiums were to be increased at up to 25% per year, and this would continue until the NFIP risk-based rate was achieved. Properties affected by that increase included non-primary residences (such as second homes), severe repetitive loss (SRL) properties,8 business properties, and homes that after BW 2012 implementation had substantial damage or improvements (of over 30% of the market value of the property). Properties that were primary residences and had pre-FIRM subsidies would be allowed to keep those subsidies until flood insurance was allowed to lapse, the property was sold, the primary residence property sustained substantial flood damage amounting to 50% or more of the property value; or the property was substantially improved.
8Biggert-Waters 2012 provided a definition of severe repetitive loss properties as those properties which have “incurred flood-related damage (i) for which 4 or more separate claims payments have been made under flood insurance coverage under this title, with the amount of each claim exceeding $5,000, and with the cumulative amount of such claims payments exceeding $20,000; or (ii) for which at least 2 separate claims payments have been made under such coverage, with the cumulative amount of such claims exceeding the value of the insured structure.”
To implement these changes, beginning with policy renewals in October 2013, elevation certificates were required for all pre-FIRM policies whose subsidies were removed to allow the application of the NFIP risk-based rating tables. Because the rating table used for calculating pre-FIRM subsidized premiums did not rely on elevation data and because elevation certificates result in landowner expenses, there was little incentive for landowners to have such a certificate. The result was that in the absence of elevation data, it was not possible for FEMA to make an accurate estimate of premium increases for individual policyholders or for the effect on total revenue to the program if NFIP risk-based rates replaced pre-FIRM subsidized rates. One approximation of the effect on total revenues developed by FEMA concluded that increasing the premium for subsidized policyholders while leaving the remaining policyholders unchanged would cause the aggregate premium for the entire NFIP to increase. That assessment, however, is based on data from a limited study that today is over fifteen years old. Recent efforts to make such estimates have been hampered by this lack of data (GAO, 2014).
To be consistent with actuarial principles, BW 2012 called for the replacing of grandfathered rates with NFIP risk-based rates. The effect of that provision on total program revenues or on individual policies cannot now be estimated. In any year, calculating the effect on any individual premium would require knowing the zone that the policy is currently rated for, the zone it was in before the map change, and any changes in base flood elevation between the two maps. The change in premium could then be calculated for the given coverage. In some cases, the premium might increase. In other cases, households might realize a premium cost saving if they bought a policy based on the new map if the newer map classified them in a lower risk zone. As a result, the effect of eliminating grandfathering on total premium revenues would be difficult to estimate, especially when it is recognized that if grandfathering were eliminated, the current NFIP practice of adding a charge to all other policies to cross-subsidize grandfathering would cease and that revenue source would be lost.
National Flood Insurance Program Risk-Based Rates
To be consistent with actuarial principles, sections of BW 2012 directed FEMA to review the basis on which it was setting NFIP risk-based rates, with specific attention to ensuring that catastrophic-loss years would be fully incorporated into the NFIP calculation of the HALY. The HALY concept, however, was developed to accommodate the premium revenue loss
caused by offering pre-FIRM subsidized rates. With that rate class no longer available under BW 2012, the HALY concept would not be used by FEMA for setting premiums each year. Nonetheless, the BW 2012 language reflects a concern that NFIP income from premiums would fall short of claims paid and expenses over time. The act therefore requested a report to Congress on the feasibility of purchasing private-sector reinsurance and on the effect of such purchase on premiums and the financial condition of the NFIP. Further reflecting a concern about the ability to pay claims, the act directs the NFIP to build a reserve fund equal to 1% of the sum of potential exposure of all outstanding policies. Finally, with respect to the financial condition of the NFIP, BW 2012 requested a report on what would be required to repay the debt within 10 years. It is currently not possible to estimate accurately how much those provisions would increase NFIP risk-based rates (and in turn premium income), but it is possible to conclude that the combined effects of all provisions would substantially increase NFIP risk-based rates across the board.
Affordability of Premiums after Biggert-Waters 2012
Chapter 2 explained that from the beginning of the NFIP and through the passage of BW 2012, Congress and FEMA sought to maintain premiums at “reasonable” levels. The practical effect was to justify limits on what factors were considered in setting NFIP risk-based rates and to justify pre-FIRM subsidized rates, and grandfathering. BW 2012 implicitly rejected that historical attention to reasonableness when setting rates: all rates were to be changed, and as a result increased, to better reflect actuarial principles. BW 2012 acknowledged a concern about the affordability of premiums when it called for an affordability report and study in Section 100236 (Appendix A). The report would allow FEMA to propose programs of assistance for policyholders whose income or wealth was such as to make it difficult to pay increased premiums. Note that affordable premiums and reasonable premiums are defined differently. Affordability was defined in relation to each policyholder’s ability to pay after consideration of his or her income and wealth.
It is worth noting that the premium increasing provisions of BW 2012 were to go into effect on passage of the bill—before any assistance program was studied, let alone put into place. As implementation of BW 2012 began, the resulting premium increases became a focus of intense political and public attention. In particular, Congress received testimony and letters arguing that the proposed rate changes for the pre-FIRM subsidized structures and grandfathered policies would result in premiums that were unaffordable for many persons who had mandatory purchase requirements, and could cause economic disruption in communities around the nation. In
response, Congress passed the Homeowner Flood Insurance Affordability Act of 2014 (HFIAA 2014).
HFIAA 2014 eliminated the triggers that would have led to the immediate and full loss of pre-FIRM subsidized rates when a property was sold or a new policy purchased. For primary residences, HFIAA 2014 replaced the premium increases that would occur at the time of sale or when a policy lapsed with an increase that would begin immediately and was to be 5-15% annually within a single risk class, but no more than 18% annually. This increase would be imposed annually until the premium reached its NFIP risk-based rate. Non-primary residence increases were not affected by HFIAA 2014; as required by BW 2012, annual premium increases of up to 25% would take place until premiums reached their full-risk rate. If a property was sold, the increase took place at the time of sale. The result was still that pre-FIRM subsidized premiums eventually will be gone, as was the case with BW 2012.
HFIAA 2014 reinstated the policy of grandfathering of properties. As noted earlier, some premiums will increase as maps change, and others may decrease. Because the NFIP is likely to continue cross-subsidizing, the effect on NFIP revenues will be muted. The long-term effect of grandfathering, however, will be that increasing numbers of policies violate the actuarial principle that rates should reflect risk. The NFIP is increasingly adding a cost to non-grandfathered premiums to account for the revenue lost (cross-subsidy), so it is causing those premiums to be more expensive (less affordable) and is decoupling those properties’ premiums from their risk. It is not possible to say how big a problem this is or will become without a more complete analysis than is possible with the existing NFIP database.
HFIAA 2014 called for a report on an affordability framework for the NFIP that further stressed the BW 2012 request for an evaluation of programs that could provide aid to persons who were burdened by the cost of flood insurance. HFIAA 2014 was clear that any assistance should be offered in consideration of a policyholder’s income or wealth; Section 9 called for “targeted assistance to flood insurance policy holders based on their financial ability to continue to participate in the National Flood Insurance Program.”
Restrictions that prevented the NFIP program from strictly following actuarial principles before passage of BW 2012 were aimed at achieving the NFIP goal of reasonably priced premiums. The rising NFIP debt stimulated congressional reform legislation that focused in part on whether NFIP premium setting practices were applying actuarial principles. BW 2012 acknowledged and HFIAA 2014 reemphasized a concern about whether
changes called for by BW 2012 would cause premiums to be unaffordable for many policyholders.
- 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.
This page intentionally left blank.