National Flood Insurance Program
FEMA's Management and Oversight of Payments for Insurance Company Services Should Be Improved Gao ID: GAO-07-1078 September 5, 2007Extraordinary recent flood events raise serious questions about the solvency of the National Flood Insurance Program (NFIP), which is administered by the Federal Emergency Management Agency (FEMA). The NFIP is largely implemented by private insurance companies that sell and service policies and adjust claims under the Write Your Own (WYO) Program. This report, prepared under the authority of the Comptroller General, examines (1) how much FEMA paid the WYO companies in recent years for operating costs and how FEMA determined payment amounts; (2) how FEMA's approach to determining operating costs assures that payments are reasonable estimates of companies' expenses; and (3) how FEMA assures that financial and management controls are in place for the WYO program and operate as intended. To do these assessments, GAO interviewed FEMA and insurance officials, and analyzed statutes, regulations, payment data, methodologies, and audits of WYO companies.
FEMA's payments to WYO insurance companies for operating costs ranged from more than a third to almost two-thirds of the total premiums paid by policyholders to the NFIP for fiscal years 2004 through 2006. In fiscal years 2005 and 2006, larger payments to WYO insurance companies were the result of settling an unprecedented number and dollar amount of claims for damages resulting from major hurricanes and flood events including Hurricane Katrina. To determine the amount of these payments, FEMA negotiated payment approaches with insurance industry representatives when it established the current WYO program in 1983 based on industry averages for operating expenses for other lines of insurance (such as homeowners, commercial, and fire), past practice, and discussion. The approach FEMA uses to determine operating costs for WYO insurance companies, rooted in policies negotiated and established about 25 years ago, cannot ensure that payments are based on reasonable estimates of actual expenses because actual expenses incurred by the companies for their services to the NFIP are not considered. Although it has authority to do so, FEMA does not collect data on actual WYO flood insurance expenses that could provide a basis for insuring that the WYO payments are based on a reasonable estimate of actual expenses. FEMA officials said that they have not asked WYO insurance companies to provide expense information due to concerns that the approach would increase FEMA's administrative costs and cause a decline in WYO program participation. However, some data on expenses WYO insurance companies allocate to flood insurance are available. FEMA officials said that they cannot use this information due to reporting inconsistencies. Also, there is some precedent in two similar public-private insurance partnerships for collecting actual expense information. FEMA's decision to rely on long-standing practices does not meet federal internal control standards that agencies be held accountable for, among other things, stewardship of government resources. Biennial financial statement audits--FEMA's primary mechanism to provide assurance that it receives complete and accurate financial management information from the WYO insurance companies--were not performed consistently as required by regulation. FEMA regulations require each participating company to arrange and pay for these audits by independent certified public accounting firms. However, many WYO insurance companies did not comply with the schedule in recent years. For example, for fiscal years 2005 and 2006, 5 of 94 participating companies had biennial financial statement audits performed. FEMA officials said they allowed some companies to delay having the audits done because they were in the process of contracting with new subcontractors to perform their financial reporting responsibilities. Nonetheless, without the required biennial audits, FEMA lacks an appropriate internal control mechanism for effective program oversight.
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Director: Team: Phone:GAO-07-1078, National Flood Insurance Program: FEMA's Management and Oversight of Payments for Insurance Company Services Should Be Improved
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Report to Congressional Committees:
United States Government Accountability Office:
GAO:
September 2007:
National Flood Insurance Program:
FEMA's Management and Oversight of Payments for Insurance Company
Services Should Be Improved:
National Flood Insurance Program:
GAO-07-1078:
GAO Highlights:
Highlights of GAO-07-1078, a report to congressional committees.
Why GAO Did This Study:
Extraordinary recent flood events raise serious questions about the
solvency of the National Flood Insurance Program (NFIP), which is
administered by the Federal Emergency Management Agency (FEMA). The
NFIP is largely implemented by private insurance companies that sell
and service policies and adjust claims under the Write Your Own (WYO)
Program. This report, prepared under the authority of the Comptroller
General, examines: (1) how much FEMA paid the WYO companies in recent
years for operating costs and how FEMA determined payment amounts; (2)
how FEMA‘s approach to determining operating costs assures that
payments are reasonable estimates of companies‘ expenses; and (3) how
FEMA assures that financial and management controls are in place for
the WYO program and operate as intended. To do these assessments, GAO
interviewed FEMA and insurance officials, and analyzed statutes,
regulations, payment data, methodologies, and audits of WYO companies.
What GAO Found:
FEMA‘s payments to WYO insurance companies for operating costs ranged
from more than a third to almost two-thirds of the total premiums paid
by policyholders to the NFIP for fiscal years 2004 through 2006. In
fiscal years 2005 and 2006, larger payments to WYO insurance companies
were the result of settling an unprecedented number and dollar amount
of claims for damages resulting from major hurricanes and flood events
including Hurricane Katrina. To determine the amount of these payments,
FEMA negotiated payment approaches with insurance industry
representatives when it established the current WYO program in 1983
based on industry averages for operating expenses for other lines of
insurance (such as homeowners, commercial, and fire), past practice,
and discussion.
The approach FEMA uses to determine operating costs for WYO insurance
companies, rooted in policies negotiated and established about 25 years
ago, cannot ensure that payments are based on reasonable estimates of
actual expenses because actual expenses incurred by the companies for
their services to the NFIP are not considered. Although it has
authority to do so, FEMA does not collect data on actual WYO flood
insurance expenses that could provide a basis for insuring that the WYO
payments are based on a reasonable estimate of actual expenses. FEMA
officials said that they have not asked WYO insurance companies to
provide expense information due to concerns that the approach would
increase FEMA‘s administrative costs and cause a decline in WYO program
participation. However, some data on expenses WYO insurance companies
allocate to flood insurance are available. FEMA officials said that
they cannot use this information due to reporting inconsistencies.
Also, there is some precedent in two similar public-private insurance
partnerships for collecting actual expense information. FEMA‘s decision
to rely on long-standing practices does not meet federal internal
control standards that agencies be held accountable for, among other
things, stewardship of government resources.
Biennial financial statement audits”FEMA‘s primary mechanism to provide
assurance that it receives complete and accurate financial management
information from the WYO insurance companies”were not performed
consistently as required by regulation. FEMA regulations require each
participating company to arrange and pay for these audits by
independent certified public accounting firms. However, many WYO
insurance companies did not comply with the schedule in recent years.
For example, for fiscal years 2005 and 2006, 5 of 94 participating
companies had biennial financial statement audits performed. FEMA
officials said they allowed some companies to delay having the audits
done because they were in the process of contracting with new
subcontractors to perform their financial reporting responsibilities.
Nonetheless, without the required biennial audits, FEMA lacks an
appropriate internal control mechanism for effective program oversight.
What GAO Recommends:
GAO recommends that FEMA take steps to ensure that it has a reasonable
estimate of actual expenses WYO companies incur to help determine
payments for services and that financial audits are performed. The
Department of Homeland Security reviewed a draft of this report and
generally agreed with our recommendations.
[hyperlink, www.gao.gov/cgi-bin/getrpt?GAO-07-1078].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact William O. Jenkins, (202)
512-8757 or jenkinswo@gao.gov.
[End of Section]
Contents:
Letter:
Results in Brief:
Background:
Payments to WYO Insurance Companies Comprised Up to Almost Two-Thirds
of Total Premium Revenue in Recent Years Based on Payment Methodologies
Established in 1983:
FEMA's Long-standing Approach for Establishing a Schedule of Operating
Costs Cannot Ensure That WYO Insurance Company Payments Are Based on
Reasonable Estimates of Actual Expenses:
Financial Management Controls Did Not Provide Assurance That Payments
to WYO Insurance Companies Were Proper and in Accordance with Program
Requirements:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Percentage Allowances FEMA Authorized WYO Insurance
Companies to Retain for Operating Expenses Incurred in Selling and
Servicing NFIP Policies (Fiscal Years 1984-2007):
Appendix III: Comments from the Department of Homeland Security:
Appendix IV: GAO Contact and Staff Acknowledgments:
Related GAO Products:
National Flood Insurance Program:
Federal Crop Insurance Corporation:
Tables:
Table 1: Payments to WYO Insurance Companies Received for Services
Rendered to the NFIP (Fiscal Years 2004-2006):
Table 2: Methodology for Calculating Payments to WYO Insurance
Companies for Selling and Servicing NFIP Policies and Actual Payments
Made, Fiscal Years 2004-2006:
Table 3: Incentive Bonus Award Structure and Distribution to WYO
Companies, Fiscal Years 2004-2006:
Table 4: Methodology for Calculating Payments to WYO Insurance
Companies for Adjusting and Processing Claims after a Flood-Loss Event,
and Actual Payments Made, Fiscal Years 2004-2006:
Table 5: Excepts from the Adjuster Fee Schedule:
Figures:
Figure 1: NFIP Policies in Force, 1978-April 2007:
Figure 2: NFIP Payments to Claimants for 2005 Compared to Other Years:
Figure 3: Key Participants in the NFIP WYO Program:
Figure 4: Biennial Financial Statement Audits of WYO Insurance
Companies Completed from Fiscal Years 2001 to 2006:
Abbreviations:
CPA: certified public accountant:
DHS: Department of Homeland Security:
FCIC: Federal Crop Insurance Corporation:
FEMA: Federal Emergency Management Agency:
NAIC: National Association of Insurance Commissioners:
NFIP: National Flood Insurance Program:
OIG: Office of Inspector General:
WYO: Write Your Own:
United States Government Accountability Office:
Washington, DC 20548:
September 5, 2007:
Congressional Requesters:
The Federal Emergency Management Agency (FEMA), a component of the
Department of Homeland Security (DHS), provides insurance protection
against flood damage to homeowners, businesses, and others, and assumes
the risk for insured flood losses, through the National Flood Insurance
Program (NFIP). The NFIP is largely implemented by private insurance
companies that participate in FEMA's Write Your Own (WYO) program.
Through the WYO program, insurance companies enter into agreements with
FEMA to sell and service flood insurance policies and adjust claims
after flood losses. As of December 2006, 88 insurance companies were
participating in the WYO program.
While the NFIP, by design, is not actuarially sound because Congress
authorized subsidized insurance rates for some policyholders, the
program was largely successful until recent years in paying its
expenses with premium revenues--the funds paid by policyholders for
their annual flood insurance coverage. As a result, since its inception
in 1968, in most years the NFIP paid for flood losses and operating
expenses with policy premium revenues, rather than tax dollars.
However, because the program's premium rates have been set to cover
losses in an average year based on program experience that did not
include any catastrophic losses, the program has been unable to build
sufficient reserves to meet future expected flood losses.[Footnote 1]
The series of extraordinary flood events in recent years--including
Hurricane Katrina in August 2005, which inflicted extensive damage on
the Gulf Coast--has raised serious questions about the financial
solvency of the NFIP and highlighted this known program limitation.
Collecting premiums that are based on an average historical loss year
does not enable the NFIP to build sufficient reserves to cover losses
that exceed the historic averages. As of April 2007, FEMA had paid
almost $16 billion in claims for flood damage as a result of Hurricane
Katrina, more than the $14.6 billion it had paid for the cumulative
total of all flood events from 1968 until Hurricane Katrina occurred.
After Katrina, FEMA was unable to cover all of the claims received for
flood losses and had to increase its borrowing authority from the U.S.
Treasury from $1.5 billion to more than $20 billion. In March 2006, we
designated the NFIP as a high-risk program,[Footnote 2] and Congress
has been considering a number of legislative changes to improve the
program's financial solvency.
Compounding the dramatic increase in the amount paid on flood insurance
claims have been increases in the amounts of money FEMA has been
required to pay for services to WYO insurance companies.[Footnote 3]
This report, prepared under the authority of the Comptroller General in
order to contribute to the discussion about ways to improve the NFIP's
financial solvency, addresses the following questions: (1) In recent
years, how much in operating costs did FEMA pay to the WYO insurance
companies that sell and service NFIP policies and adjust claims and how
does FEMA determine the amount of these operating costs? (2) How does
FEMA provide assurance that the approach it uses to determine operating
costs is based on reasonable estimates of WYO insurance companies'
expenses? and (3) How does FEMA provide assurance that financial and
management controls in place for the WYO program operate as intended
and in accordance with program requirements?
This is one of several reports and testimonies we have completed or
have under way related to the administration and management of the NFIP
since the unprecedented losses from Hurricane Katrina and other major
flood events in 2004 and 2005 illustrated the extent of the federal
government's exposure to losses in catastrophic flood years. Related
work we recently completed addressed issues including the NFIP's
financing, oversight and management, implementation of the program in
the aftermath of Hurricanes Katrina and Rita, the inventory of insured
properties that suffer repetitive flood losses, and the status of
efforts to revise and improve the nation's flood maps. (See the list of
related GAO products on page 52 of this report.) In addition, we have
reviews under way assessing how insurance companies manage losses that
may be covered by both wind and flood insurance, the impact of
subsidized properties on the NFIP, and additional aspects of FEMA's
financial oversight of WYO insurance companies.
To assess how much FEMA paid to WYO insurance companies in recent years
for operating costs and how FEMA determines the amount of these
operating costs, we interviewed FEMA officials, examined documentation
such as FEMA's financial subsidy arrangement with the WYO insurance
companies, and analyzed FEMA data on amounts paid to WYO insurance
companies for fiscal years 2004-2006. We examined internal controls
FEMA had in place to ensure the reliability of the data. We determined
that the information was sufficiently reliable for our purposes by
discussing with officials the internal control processes in place,
observing the monthly process used by FEMA's program contractor to
reconcile cost information submitted by WYO insurance companies, and
reviewing audits of DHS financial statements. We conducted semi-
structured interviews with representatives of a judgmental sample of
five WYO insurance companies and the National Association of Insurance
Commissioners (NAIC)[Footnote 4] to obtain their perspectives on FEMA's
payment methodologies. We chose our sample to include representatives
of four of the five largest participating WYO insurance companies in
terms of their market share of NFIP policies in force in 2006 and one
mid-sized WYO insurance company. However, our sample is not a
representative sample of all participating WYO insurance companies, so
the views expressed should not be generalized to the universe of the 88
participating companies.
To determine how FEMA provides assurance that its approach to
determining operating costs for WYO insurance companies results in
reasonable estimates of the companies' expenses, we reviewed the
statutory and regulatory framework for establishing a schedule of
operating costs and federal internal control standards, and we obtained
the views of FEMA and insurance industry officials on the effectiveness
of the current payment approach and the potential implications of
implementing other payment methodologies. We also assessed how the
approach FEMA currently uses to pay WYO insurance companies for their
services compares to payment methodologies used by two similar public-
private insurance arrangements. These are (1) the Federal Crop
Insurance Corporation's (FCIC) arrangement with private insurers for
handling expenses associated with insuring agricultural crop values;
and (2) the NFIP's arrangement with its Direct Servicing Agent, a FEMA
contractor that sells and services policies and adjusts claims on about
4 percent of flood insurance policies that are not, for various
reasons, handled through the WYO program.
To determine the extent to which FEMA's financial management controls
for WYO companies provide assurance that payments are proper and in
accordance with program requirements, we documented FEMA's regulations
and procedures for monitoring and overseeing payments of expenses to
WYO insurance companies for selling and servicing NFIP policies. We
analyzed the schedule and results of biennial financial statement
audits conducted for fiscal years 2001 to 2006. We also interviewed
officials of FEMA and its program contractor. In addition, we reviewed
financial audits of the NFIP done by the DHS Office of Inspector
General (OIG) for fiscal years 2003 to 2006. We performed our work from
June 2006 through July 2007, in accordance with generally accepted
government auditing standards. Additional details on our scope and
methodology are in appendix I.
Results in Brief:
FEMA's total payments to WYO insurance companies for operating costs
ranged from $619.2 million to $1.6 billion (in current dollars, not
adjusted for inflation) or from more than a third to almost two-thirds
of the total premiums paid by policyholders to the NFIP for fiscal
years 2004 through 2006. In fiscal years 2005 and 2006, payments were
larger than for fiscal year 2004 because the WYO insurance companies
received payments in these years for settling an unprecedented number
and dollar amount of claims for damages resulting from Hurricanes
Charley, Ivan, Frances, and Jeanne in Florida and other East Coast and
Gulf Coast states in 2004 and Hurricanes Katrina, Rita, Wilma, and
other flood events in 2005. To determine the amount of these payments,
FEMA negotiated payment approaches with insurance industry
representatives when it established the current WYO program in 1983
based on industry averages for operating expenses for other lines of
insurance (such as homeowners, commercial, and fire), past practice,
and discussion with WYO insurance company participants and other
insurance industry representatives. While FEMA has periodically
adjusted payment amounts since 1983, the underlying methodologies it
uses to calculate them have not significantly changed. FEMA pays WYO
companies for selling and servicing insurance policies and adjusting
and processing policyholders' claims after a flood event occurs. For
selling and servicing NFIP policies, FEMA pays WYO insurance companies
(1) a flat 15 percent of premiums for agent commissions; (2) a
percentage for operating expenses, which historically also averages
about 15 percent, based on industry averages for other lines of
insurance; and (3) bonuses of up to 2 percent of their total annual
premium revenues for increasing the number of NFIP policies they sell.
After flood losses, FEMA pays WYO insurance companies for adjusting and
processing policyholders' claims according to (1) an adjustment fee
schedule used by the insurance industry for other types of insurance
claims and (2) an allowance of 3.3 percent of each claim settlement
amount to pay for their processing expenses. The WYO insurance
companies collect their operating costs from FEMA based on these
methodologies. Any portion of the premium revenues retained by the WYO
insurance companies that are not used to cover expenses may be retained
as profit.
The approach FEMA uses to determine operating costs for WYO insurance
companies, rooted in policies negotiated and established about 25 years
ago, cannot ensure that payments are based on reasonable estimates of
actual expenses because FEMA does not consider actual expenses incurred
by the companies for their services to the NFIP and does not collect
actual expense data from the WYO insurance companies. For example, the
payment formula FEMA uses to set a payment rate of 3.3 percent of
claims settlement amounts for claims processing expenses, such as
setting up operations in flood-damaged areas, has been in place since
the program's inception. Since it created the program in 1983, FEMA has
had no basis, other than discussion with WYO insurance companies, to
determine whether that payment rate is a reasonable estimate of
expenses incurred. As a result of the unprecedented number and cost of
flood insurance claims after Hurricane Katrina, the amount FEMA paid
WYO insurance companies for claims processing expenses based on this
formula increased more than tenfold from about $30 million in fiscal
year 2004 to about $385 million in fiscal year 2005 not adjusted for
inflation. In response, FEMA officials said they are considering a
possible cap on the amount of payments in this expense category in
future catastrophic loss years. Under the National Flood Insurance Act
of 1968, insurance companies choosing to participate in the WYO program
must keep such records as FEMA prescribes and provide access to these
records for purpose of audit and examination. Although it has the
authority to do so, FEMA does not collect data on actual WYO flood
insurance expenses. FEMA's reluctance to impose additional cost
accounting requirements on WYO insurance companies is based on concerns
that the approach would (1) increase FEMA's cost of administering the
program and (2) result in a decline in the number of insurance
companies that choose to participate in the WYO program. Nonetheless,
there is some precedent in two similar public-private insurance
partnerships for considering actual expense data. The FCIC, which pays
insurance companies a percentage of premium revenue for costs related
to insuring agricultural crop values against financial losses by events
such as droughts and other natural disasters, requires the companies to
submit detailed expense reports in a consistent format. The NFIP Direct
Servicing Agent, a FEMA contractor that sells and services policies and
adjusts claims on about 4 percent of flood insurance policies that are
not, for various reasons, handled through the WYO program, has also
calculated its operating costs. Based on standards for internal control
in the federal government, FEMA is responsible for implementing
controls that serve as the first line of defense in safeguarding
assets, preventing and detecting errors and fraud, and helping to
achieve desired results through effective stewardship of public
resources.[Footnote 5] FEMA has not significantly changed the payment
policies that are the foundation of the WYO program in more than 2
decades, and because FEMA cannot ensure that its approach to
establishing a schedule of operating costs is based on a reasonable
estimate of actual expenses or that the amount paid was reasonable, it
may not have effectively implemented these controls.
Biennial financial statement audits--FEMA's primary management control
mechanism to provide assurance that it receives complete and accurate
financial management information from the WYO insurance companies--were
not performed as required by regulation. FEMA's regulations and WYO
Financial Control Plan require each participating WYO insurance company
to arrange and pay for biennial financial statement audits by
independent certified public accountants (CPA) that evaluate its
financial statements for activities related to the NFIP. The audits are
to be funded by the WYO insurance companies from the payments they
receive from FEMA for selling and servicing policies (about 15 percent
of premium revenue). However, many insurance companies participating in
the WYO program received these payments in full yet did not comply with
the requirement to have biennial audits done during the period from
fiscal year 2001 to 2006. Specifically, for fiscal years 2001 and 2002,
40 of the 98 participating companies had financial audits performed by
independent CPA firms. For fiscal years 2002 to 2003, 37 of the 103
participating companies had financial statement audits performed by CPA
firms. For fiscal years 2003 and 2004, 35 of 107 participating
companies had the financial audits performed; for fiscal years 2005 and
2006, 5 of 94 participating companies had biennial financial statement
audits performed. FEMA officials said that FEMA granted 32 additional
WYO insurance companies extensions to complete the biennial financial
audits for 2005 and 2006 by September 30, 2007. The officials said that
the extensions were allowed because the WYO insurance companies were in
the process of contracting with new vendors or subcontractors to
perform their financial reporting responsibilities and conducting
financial audits would have been particularly costly and difficult.
FEMA did not have a mechanism in place for tracking and reviewing the
results of the biennial financial statement audits that were performed.
FEMA officials were able to provide us with copies of only two biennial
audit reports until the conclusion of our audit when they asked WYO
insurance companies and their subcontractors to send copies of
additional reports that might have been prepared. Without the required
biennial audits, FEMA lacks an appropriate internal control mechanism
for effective program oversight to help ensure that payments made to
WYO insurance companies are proper and in accordance with program
requirements. According to the standards for internal controls within
the federal government, such control mechanisms are important in
agencies like FEMA where large amounts of data are processed; where
audit techniques may be used to identify inefficiencies, waste, or
abuse; and where managers should be able to promptly review and
evaluate audit findings in order to identify opportunities for
improvements.
We are recommending that the Secretary of DHS direct the Under
Secretary of Homeland Security, FEMA to take two actions to strengthen
and improve its administration of the NFIP: (1) take steps to ensure
that its approach to establishing a schedule of operating costs is
based on a reasonable estimate of actual expenses by reviewing
appropriate documentation of expenses incurred by WYO insurance
companies; and (2) ensure that biennial financial statement audits of
WYO insurance companies are conducted by independent CPA firms as
required by FEMA regulation, and that FEMA reviews the audits to help
ensure that payments made are proper and in accordance with program
requirements.
In commenting on a draft of this report, DHS generally agreed with our
recommendations to improve financial accountability over payments the
NFIP makes to the WYO insurance companies. However, FEMA said our
presentation in table 1 of payments to WYO insurance companies for all
NFIP services for fiscal years 2004 to 2006 as a percentage of total
premium revenues was "inappropriate and misleading" because it was most
appropriate to compare the costs of adjusting and processing claims to
total losses in a year, not premium revenue. We disagree. We believe it
is appropriate to summarize aggregate expense payment data as a
percentage of premiums collected because the NFIP is designed to pay
for flood losses and operating expenses to the extent possible with
premium revenues rather than tax dollars. FEMA's comments are contained
in appendix III.
Background:
Overview of the National Flood Insurance Program:
Congress established the NFIP in the National Flood Insurance Act of
1968 to provide policyholders with some insurance coverage for flood
damage, as an alternative to disaster assistance, and to try to reduce
the escalating costs of repairing flood damage.[Footnote 6] FEMA,
within DHS, administers the NFIP and is responsible for its management
and oversight. Floods are the most common and destructive natural
disaster in the United States. In fact, according to NFIP statistics,
90 percent of all natural disasters in the United States involve
flooding. However, flooding is generally excluded from homeowner
policies that typically cover damage from other losses, such as wind,
fire, and theft. Because of the catastrophic nature of flooding and the
inability to adequately predict flood risks, private insurance
companies have largely been unwilling to underwrite and bear the risk
of flood insurance. Under the NFIP, the federal government assumes the
liability for the insurance coverage and sets rates and coverage
limitations, among other responsibilities. In creating the NFIP,
Congress found that a flood insurance program with "large-scale
participation of the Federal Government and carried out to the maximum
extent practicable by the private insurance industry is feasible and
can be initiated."[Footnote 7]
As of May 2007, more than 20,300 communities across the United States
and its territories participated in the NFIP by adopting and agreeing
to enforce state and community floodplain management regulations to
reduce future flood damage. In exchange, the NFIP makes federally
backed flood insurance available to homeowners and other property
owners in these communities. Homeowners with mortgages from federally
regulated lenders on property in communities identified to be in
special high-risk flood hazard areas are required to purchase flood
insurance on their dwellings for at least the outstanding mortgage
amount. Optional, lower-cost coverage is also available under the NFIP
to protect homes in areas of low to moderate risk. To insure furniture
and other personal property items against flood damage, homeowners may
purchase separate NFIP personal property coverage. Although premium
amounts vary according to the amount of coverage purchased and the
location and characteristics of the property to be insured, the average
yearly premium for a 1-year policy was $475, as of February 2007.
As shown in figure 1, the NFIP has grown from about 1.5 million
policies in 1978 to about 5.4 million policies in April 2007.
Figure 1: NFIP Policies in Force, 1978-April 2007:
[See PDF for image]
Source: FEMA.
[End of figure]
To the extent possible, the NFIP is designed to pay operating expenses
and flood insurance claims with premiums collected on flood insurance
policies rather than by tax dollars. FEMA has statutory authority to
borrow funds from the U.S. Treasury to keep the NFIP solvent in years
when losses are heavy.[Footnote 8] The NFIP, by design, is not
actuarially sound because Congress authorized subsidized insurance
rates to be made available for policies covering certain structures to
encourage communities to join the program and premiums are based on the
average historical loss year; therefore the NFIP does not build
sufficient reserves to cover losses that exceed the historic averages.
The subsidized properties are generally referred to as Pre-FIRM (Flood
Insurance Rate Map) buildings. The legislative history of the National
Flood Insurance Act recognized that insurance for existing buildings
constructed before the NFIP was established would be extremely
expensive because many of them were flood prone and did not comply with
NFIP floodplain management standards that went into effect after they
were built.
Until the last several years, FEMA had been generally successful in
paying flood losses and expenses with premium revenue, exercising its
borrowing authority three times in the last decade when claims payments
exceeded available fund balances. In each instance, FEMA repaid the
funds with interest. Prior to Hurricane Katrina in August 2005, FEMA
had also made substantial progress in repaying the borrowing it had
undertaken to pay losses for the 2004 hurricane season during which
Hurricanes Charley, Ivan, Frances, and Jeanne caused heavy flood damage
in Florida and other East Coast and Gulf Coast states. However, because
the program's premium rates have been set to cover losses in an average
year based on program experience that did not include any catastrophic
losses, the program has been unable to build sufficient reserves to
meet future expected flood losses.
Hurricanes Katrina, Rita, and Wilma, in 2005, had a far-reaching impact
on the financial solvency of the NFIP. Legislation increased FEMA's
borrowing authority from a total of $1.5 billion prior to Hurricane
Katrina to $20.8 billion by March 2006, and, as of May 2007, FEMA's
outstanding debt to the Treasury was $17.5 billion. As we have
reported, it is unlikely that FEMA can repay a debt of this size and
pay future claims in a program that generates premium income of about
$2 billion a year.[Footnote 9] Legislation has been introduced in
Congress to increase FEMA's borrowing authority to pay interest on the
debt and attention has focused on the extent of the federal
government's exposure for claims payments in future catastrophic loss
years and ways to improve the program's financial solvency.
Figure 2 shows the magnitude of the loss payments for Hurricane Katrina
and other flood events in 2005 compared to claims payments over other
years.
Figure 2: NFIP Payments to Claimants for 2005 Compared to Other Years:
[See PDF for image]
Source: FEMA.
[End of figure]
In prior work, we have reported that FEMA and the WYO insurance
companies settled the unprecedented number of NFIP claims after
Hurricane Katrina reasonably quickly, reporting that over 95 percent of
Gulf Coast claims for damage from Hurricane Katrina followed closely by
Hurricane Rita were settled in May 2006, about 9 months after the
storms.[Footnote 10]
History and Goals of the WYO Program:
Since its inception, the NFIP has relied to a large extent on the
private insurance industry to sell and service policies, as Congress
envisioned when it authorized the program in 1968. From 1969 through
1977, NFIP was operated under Part A of the National Flood Insurance
Act (the Act), meaning that private insurers assumed a portion of the
risk of financial loss.[Footnote 11] In order to implement the program,
the Department of Housing and Urban Development, the agency that
administered the NFIP at that time, entered into an agreement with a
consortium of private insurers known as the National Flood Insurers
Association. Under this agreement, the department reimbursed the
association for operating costs, and because the association was a risk-
sharing insurer, it received an additional annual operating allowance
equal to 5 percent of policyholder premiums. In 1977, in part as a
result of disagreements on issues of financial control between the
private insurers and the department, the relationship ended.
Since 1978, NFIP has operated under Part B of the Act, meaning that the
federal government bears the entire risk of loss.[Footnote 12] Because
insurance companies operating under Part B, such as WYO companies, are
not risk-sharing insurers, they are paid only for operating costs. The
FEMA director is to establish a current schedule of operating costs by
negotiating with representatives of the insurance industry. Under the
Act, operating costs include four components: (1) expense
reimbursements covering the direct, actual, and necessary expenses
incurred in connection with selling and servicing flood insurance
coverage; (2) reasonable compensation payable for selling and servicing
flood insurance coverage, or commissions or service fees paid to
producers; (3) loss adjustment expenses; and (4) other direct, actual,
and necessary expenses that FEMA finds are incurred in connection with
selling or servicing flood insurance coverage.[Footnote 13]
In 1983, FEMA, still operating the NFIP under Part B, established the
WYO program to obtain more industry involvement in the NFIP. According
to FEMA, the goals of the WYO program are to increase the NFIP policy
base and the geographic distribution of policies, improve service to
NFIP policyholders through the infusion of insurance industry
knowledge, and provide the insurance industry with direct operating
experience with flood insurance. Over the years, insurance company
participation has grown and the WYO program has assumed a larger share
of the total NFIP policies in force. During the first year of the WYO
arrangement, 48 insurance companies agreed to participate. In 1986, WYO
insurance companies administered about 50 percent of a little over 2
million policies in force. In February 2007, WYO insurance companies
administered about 96 percent of the about 5.4 million policies in
force at that time.
Roles of WYO Companies and Other Key Participants in the NFIP:
A private insurer becomes a WYO company by entering into an agreement
with FEMA known as the Financial Assistance/Subsidy Arrangement. Under
the arrangement, private insurers agree to issue flood policies in
their own name. In addition, the WYO companies adjust flood claims as
well as settle, pay, and defend all claims arising from the flood
policies. To enter into a WYO arrangement with the NFIP, private
insurers must meet FEMA's established criteria.[Footnote 14] Factors
FEMA considers in determining whether companies are accepted into the
WYO program include their experience in property and casualty insurance
lines, standing with state insurance departments, and the ability to
meet NFIP reporting requirements to adequately sell and service flood
insurance policies.
Each year, FEMA is required to publish in the Federal Register the
terms for participation in the WYO program, including amounts WYO
insurance companies will be paid for expenses. Companies that agree to
participate in the program sign a financial assistance/subsidy
arrangement and are to comply with the provisions of FEMA's WYO
Financial Control Plan, which outlines WYO insurance companies'
responsibilities for program operations including underwriting, claims
adjustments, cash management, and financial reporting, as well as
FEMA's responsibilities for management and oversight.
Selling policies. Insurance agents under contract to one or more WYO
insurance companies are the main point of contact for most
policyholders to purchase an NFIP policy, seek information on coverage,
or file a claim. Based on information the insurance agents submit, the
WYO insurance companies issue policies, collect premiums from
policyholders, deduct an allowance for expenses from the premium, and
remit the balance to the National Flood Insurance Fund. In some cases,
insurance companies hire subcontractors--flood insurance vendors--to
conduct some or all of the day-to-day processing and management of
flood insurance policies.
Adjusting claims. Insurance companies work with certified flood
adjusters to settle NFIP claims. When flood losses occur, policyholders
report them to their insurance agent, who notifies the WYO insurance
company. The WYO insurance company assigns a flood adjuster to assess
damages. Flood adjusters may be independent or employed by an insurance
or adjusting company. These adjusters are responsible for assessing
damage, estimating losses, and submitting required reports, work
sheets, and photographs to the WYO insurance company, where the claim
is reviewed and, if approved, processed for payment. WYO insurance
companies are then reimbursed by FEMA from the National Flood Insurance
Fund for the amount of the claims and expenses paid. Claims amounts may
be adjusted after the initial settlement is paid if claimants submit
documentation that some costs were higher than estimated.
FEMA Management and Oversight. About 68 FEMA employees, assisted by
about 170 contractor employees manage and oversee the NFIP and the
National Flood Insurance Fund into which premiums are deposited and
claims and expenses paid. Their management responsibilities include
establishing and updating NFIP regulations, analyzing data to
actuarially determine flood insurance rates, and offering training to
insurance agents and adjusters. In addition, FEMA and its program
contractor are responsible for monitoring and overseeing the quality of
the performance of the WYO insurance companies to assure that the NFIP
is administered properly. Figure 3 provides an overview of the WYO
companies' and others' participation in the NFIP.
Figure 3: Key Participants in the NFIP WYO Program:
[See PDF for image]
Source: GAO analysis of FEMA data, clipart (Art Explosion).
[End of figure]
Payments to WYO Insurance Companies Comprised Up to Almost Two-Thirds
of Total Premium Revenue in Recent Years Based on Payment Methodologies
Established in 1983:
FEMA's payments to WYO insurance companies for operating costs ranged
from more than a third to almost two-thirds of the total premiums paid
by policyholders to the NFIP for fiscal years 2004 through 2006. During
the 3-year period from fiscal year 2004 through 2006, FEMA's payments
to WYO insurance companies ranged from $619.2 million to $1.6 billion
in current dollars that were not adjusted for inflation. FEMA
establishes a schedule of operating costs for WYO insurance companies
participating in the NFIP based on industry averages for operating
expenses for other lines of insurance, such as homeowners, commercial
and fire; past practices; and discussions with WYO insurance company
participants and other insurance industry representatives. FEMA
negotiated these payment methodologies with insurance industry
representatives when it established the WYO program in 1983. While FEMA
has periodically adjusted payment amounts since 1983, the underlying
methodologies it uses for determining them have not significantly
changed. FEMA pays WYO companies in two main categories (1) for selling
and servicing insurance policies and (2) adjusting and processing
policyholders' claims after a flood event occurs. Any portion of the
premium revenues retained by the WYO insurance companies that are not
used to cover expenses may be retained as profit. Because the WYO
insurance companies bear no risk for NFIP losses, the payments they
receive from FEMA are for work incurred in selling and servicing
policies and adjusting claims.
Overall Payments to WYO Insurance Companies:
As shown in table 1, in the last 3 fiscal years, payments to WYO
insurance companies have consumed from over a third to almost two-
thirds of the total premiums paid by policyholders to the NFIP. In
fiscal years 2005 and 2006, payments were larger than for fiscal year
2004 because the WYO insurance companies received payments in these
years for settling the unprecedented number and amount of claims for
damages resulting from flood events including Hurricanes Charley, Ivan,
Frances, and Jeanne in Florida and other East Coast and Gulf Coast
states in 2004 and Hurricanes Katrina, Rita, Wilma, and other flood
events in 2005.
Table 1: Payments to WYO Insurance Companies Received for Services
Rendered to the NFIP (Fiscal Years 2004-2006):
Dollars in millions.
Fiscal year: 2004;
Premium revenue received by the NFIP Fund: $1,772.8;
Payments to WYO insurance companies for services rendered: $619.2;
Percent of premium revenue paid for WYO insurance company services:
34.9.
Fiscal year: 2005;
Premium revenue received by the NFIP Fund: 1,943.6;
Payments to WYO insurance companies for services rendered: 984.5;
Percent of premium revenue paid for WYO insurance company services:
50.7.
Fiscal year: 2006;
Premium revenue received by the NFIP Fund: 2,439.9;
Payments to WYO insurance companies for services rendered: 1,583.5;
Percent of premium revenue paid for WYO insurance company services:
64.9.
Source: GAO analysis of FEMA data.
Note: Dollars are not adjusted for inflation.
[End of table]
Selling and Servicing NFIP Policies:
WYO insurance companies retain premium revenues for selling and
servicing NFIP policies based on three different calculations: (1) a
flat 15 percentage allowance for insurance agent sales commissions; (2)
an average of industry operating expenses for other lines of insurance
to determine the amount for operating expenses associated with
processing and servicing insurance policies, which historically also
averages to about 15 percent; and (3) incentive bonuses to WYO
companies of up to 2 percent of the premiums generated by selling and
servicing flood insurance policies. Table 2 summarizes the methods FEMA
uses to calculate payments to WYO companies for selling and servicing
flood insurance policies and recent payment amounts.
Table 2: Methodology for Calculating Payments to WYO Insurance
Companies for Selling and Servicing NFIP Policies and Actual Payments
Made, Fiscal Years 2004-2006:
Dollars in millions.
Type of payment calculation [A]: (1) Insurance agent sales commissions;
Calculation methodology: Percentage amount established in the annual
financial assistance/subsidy arrangement between FEMA and participating
insurance companies;
Calculation result (actual or estimated): 15% of premium revenue
retained;
Actual payments: FY04: $524.9;
Actual payments: FY05: $634.6;
Actual payments: FY06: $687.3.
Type of payment calculation [A]: (2) Operating expenses[B];
Calculation methodology: Based on a 5-year rolling average of direct
operating costs as reported by the industry for other types of property
and casualty insurance;
Calculation result (actual or estimated): About 15% percent of premium
revenue retained.
Actual payments: FY04: $524.9;
Acual payments: FY05: $634.6;
Actual payments: FY06: $687.3.
Type of payment calculation [A]: (3) Incentive bonus;
Calculation methodology: Awarded to companies that achieve 2 to 5
percent or more growth in the number of NFIP policies they have in
force;
Calculation result (actual or estimated): 0.5% -2% of premium revenue
retained;
Actual payments: FY04: 31.6;
Actual payments: FY05: 21.4;
Actual payments: FY06: 44.5.
Source: GAO analysis of FEMA data.
Note: Dollars are not adjusted for inflation. In addition to these
major categories of payments related to selling and servicing policies
that WYO insurance companies receive for services to the NFIP, FEMA
officials noted two other smaller categories of payments that are
available. First, WYO insurance companies may receive special
allocations if they need to hire engineers to do studies necessary to
underwrite policies or adjust claims. Total payments are about $2
million a year. Second, in future years, FEMA has proposed to pay WYO
insurance companies ¼ of 1 percent in additional premium revenues for
expenses they incur to comply with provisions of the Flood Insurance
Reform Act of 2004. The proposal is currently under review by DHS. If
approved, it could be effective in fiscal year 2008. The 2004 Act
mandated that NFIP policyholders receive additional informational
materials explaining their coverage, which resulted in additional
expenses to the WYO insurance companies for postage and mailings, among
other items. Total payments on premium revenues of $2 billion would be
about $5 million.
[A] FEMA did not provide payment information for insurance agent sales
commissions and operating expenses as separate line items.
[B] Includes state premium tax, which FEMA officials said averages 2
percent of written premiums.
[End of table]
Selling and Servicing Policies: Agent Commissions:
WYO insurance companies retain a flat fee of 15 percent of premium
revenues for agent commissions. The WYO insurance companies, however,
determine the actual amount of commission they pay to agents. The
amount varies from one WYO insurance company to another and may be more
or less than 15 percent. For example, one WYO insurance company flood
program manager said that agents for his company receive a commission
of 15 percent of the policy amount and may also receive other
incentives during special flood marketing campaigns. Another flood
program manager said that her company's agents received a commission
that was larger than 15 percent of the policy amount. In the insurance
industry, many independent agents are paid by commission only, whereas
sales workers who are employees of an agency or an insurance carrier
may be paid in one of three ways--salary only, salary plus commission,
or salary plus bonus. In general, commissions are the most common form
of compensation, especially for experienced agents.[Footnote 15]
The amount of work involved in selling and servicing NFIP policies
varies based on the flood risk of the insured property, according to a
representative of the NAIC. For example, the representative said that
NFIP policy sales for properties located in special flood hazard areas
require the greatest amount of work because of the need to develop
information on the elevation of the property, take photographs, and
create other documentation that is required to determine the premium
amount. They said that policy sales and renewals that require lesser
amounts of work include (1) renewals where information has not changed;
(2) sales of policies on properties that were built before NFIP
floodplain management standards went into effect (because they qualify
for subsidized premiums and do not require extensive documentation to
determine flood risk); and (3) sales of policies for properties that
are not located in special flood hazard areas (because they do not
require extensive documentation to assess flood risk).
Selling and Servicing Policies: Operating Expenses:
In addition to the 15 percent allowance for agent commissions, WYO
insurance companies retain about 15 percent of the premium revenues for
ongoing operating expenses related to administering the NFIP and
providing services to policyholders. This payment amount is based on an
annual agreement between FEMA and the WYO insurance companies. See
appendix III for the percentage allowances FEMA authorized WYO
insurance companies to retain for operating expenses incurred in
selling and servicing NFIP policies for fiscal years 1984 to 2007.
According to the agreement, the WYO insurance companies may withhold,
as operating and administrative expenses (other than agent
commissions), an amount equal to the average industry expenses ratios
for A.M. Best Company's Aggregates and Averages for the following five
property coverages: Fire, Allied Lines, Farmowners Multiple Peril,
Homeowners Multiple Peril, and Commercial Multiple Peril (non-liability
portion).[Footnote 16] According to the agreement, this amount is to be
increased by 1 percentage point to reimburse expenses "beyond regular
property/casualty expenses."[Footnote 17]
The payment for administrative and operating expenses is intended to
cover a variety of expenses WYO insurance companies incur in servicing
NFIP policies. WYO insurance company managers said examples of expenses
they incurred included fees for services of a vendor or subcontractor
(if one is retained to handle all or part of the flood insurance
business), payment of salaries and expenses for employees with full or
part-time responsibilities for the NFIP work, payment of fees to
independent public accounting firms to conduct biennial audits of
financial systems for the NFIP, and payment of state taxes on the funds
received from the NFIP. Other expenses reported by WYO insurance
companies include costs of marketing NFIP policies, training agents to
sell and service NFIP policies, and creating or modifying computer and
accounting systems to report financial and statistical information
required by the NFIP.
Selling and Servicing Policies: Bonuses:
According to FEMA officials, the agency has used annual bonuses for WYO
insurance companies since 1995[Footnote 18] as an incentive to increase
the number of NFIP policies in force. Under the bonus incentive
program, FEMA provides WYO insurance companies with opportunities to
earn additional percentages of premium revenue above the levels
established annually if they increase the number of flood insurance
policies they sell and service. FEMA officials said that they
established bonus percentage amounts through discussions with WYO
insurance company officials, noting that, as of May 2007, the NFIP had
experienced 36 continuous months of policy growth.[Footnote 19] One
official attributed the growth to "a new American consciousness" of the
importance of having flood insurance in the aftermath of Hurricane
Katrina and other major flood events in 2004 and 2005. This growth in
policies accounts for the recent parallel growth in bonuses. Table 3
provides information on how bonuses have been awarded and distributed.
As the table shows, most participating WYO insurance companies received
bonus payments in each of the fiscal years, and in fiscal year 2006, 67
percent of the companies received the highest bonus amount of 2 percent
of premium revenues.
Table 3: Incentive Bonus Award Structure and Distribution to WYO
Companies, Fiscal Years 2004-2006:
Policy growth level (%):
