The National Flood Insurance Program: Factors Affecting Actuarial Soundness

November 4, 2009

In 2005, the National Flood Insurance Program (NFIP), administered by the Federal Emergency Management Agency (FEMA), experienced an unprecedented volume of claims resulting from hurricanes Katrina, Rita, and Wilma. Total payments on those claims were greater than the total for all of the programs previous years combined and led the NFIP to borrow about $17 billion from the Treasury. The 2005 losses highlighted a number of factual and policy questionsdiscussed in a CBO paper released todayabout the NFIPs financial health, including the actuarial soundness of the premium rates charged on policies that are not explicitly subsidized and the cost of paying claims for properties that have suffered multiple flood losses.

As of July 31, 2009, the NFIP had 5.6 million policies, with a total insured value of $1.2 trillion and total premiums of $3.1 billion. For most of those policies, about 80 percent, FEMA charges full-risk premium rates, which it considers to be actuarially sound (that is, sufficient to cover the expected value of flood claims and administrative costs). About 20 percent of the premium rates are explicitly subsidized under current law; those explicit subsidies give the NFIP a built-in actuarial deficit of about $1.3 billion per year, by CBOs estimate. Those policies mainly cover older structures in areas at high risk of flooding.

Are FEMAs full-risk premium rates actuarially sound?

Historically, the NFIPs full-risk premiums have been too low to cover the flood claims and administrative costs of the policies insured at those rates. Between 1978 and 2004, premiums for such policies totaled $10.2 billion in nominal dollars, while claims and expenses totaled $10.7 billion. The result was a loss of $0.5 billion over that period on policies with full-risk rates. Taking into account the large losses of 2005, income was about half of costs over the 1978-2006 periodtotal premiums were $12.6 billion while claims and expenses were $24.2 billion.

Previous experience does not necessarily imply that current premium rates are too low, however, because rates have risen over time and because the frequency of future catastrophic years like 2005 is highly uncertain. In part because of that uncertainty, CBO does not have enough information about the current distribution of flood risks to calculate whether the present full-risk premiums are actuarially adequate.

Further, analyzing the methods that FEMA uses to set the full-risk rates also does not provide definitive answers. Some aspects of those methods tend to contribute to an actuarial surplusthe primary one being the additional 10 percent that FEMA includes in the rates in high-risk areas (20 percent in high-risk coastal areas) as a safety margin for uncertainty. Other aspects of the agencys rate-setting methods tend to contribute to an actuarial deficit. FEMA is not reviewing its flood maps every five years as required by law, and some older maps do not reflect significant changes in local conditions, such as coastal erosion, which can increase the probability of flooding. In addition, evidence suggests that climate change has increased the risk of flooding from rivers and perhaps also from coastal storms, making FEMAs models of flood frequencies out of date. Those issues may warrant attention regardless of the overall adequacy of the programs full-risk rates.

To what extent are the NFIPs losses attributable to properties that have experienced multiple floods?

Currently insured repetitive-loss properties (RLPs)defined by FEMA as those that have been the subject of at least two flood-claims payments of more than $1,000 apiece in any 10-year periodaccount for 2 percent of current policies and 3 percent of current premiums but about 12 percent of total claims since 1978. Including formerly insured RLPs, such properties accounted for almost one-quarter of claims payments since 1978. About 23,000 RLPs nationwide have been the subject of at least four claims payments while insured, and 10,000 of those have prompted six or more payments. FEMAs approach to reducing the cost of repetitive-loss properties focuses more on measures to mitigate the worst flood riskssuch as elevating, relocating, flood-proofing, or demolishing propertiesthan on charging higher premiums for flood insurance. More than half of the policies covering RLPs in high-risk areas have subsidized rates.

This paper was prepared by Perry Beider of CBOs Microeconomic Studies Division.