Natural Catastrophe Insurance
Analysis of a Proposed Combined Federal Flood and Wind Insurance Program Gao ID: GAO-08-504 April 25, 2008Disputes between policyholders and insurers after the 2005 hurricanes highlight the challenges of determining the cause and extent of damages when properties are subject to both high winds and flooding. Additionally, insurers want to reduce their exposure in high-risk areas, and state wind insurance programs have grown significantly. H.R. 3121, the Flood Insurance Reform and Modernization Act of 2007, would create a combined federal insurance program with coverage for both wind and flood damage. GAO was asked to evaluate this potential program in terms of (1) what would be required to implement it; (2) the steps the Federal Emergency Management Agency (FEMA) would need to take to determine premium rates that reflect all future costs; and (3) how it could affect policyholders, insurance market participants, and the federal government. To address these questions, GAO analyzed state and federal programs, examined studies of coastal wind insurance issues, and interviewed federal and state regulatory officials as well as industry participants and analysts. FEMA and the National Association of Insurance Commissioners generally agreed with GAO's report findings. FEMA emphasized the challenges it would face in addressing several key issues. FEMA also provided technical comments, which were incorporated as appropriate.
To implement a combined federal flood and wind insurance program, FEMA would need to complete certain challenging steps. First, FEMA would need to determine wind hazard prevention standards that communities would have to adopt in order to receive coverage. Second, FEMA would need to adapt existing programs to accommodate wind coverage--for example, the Write Your Own program. Third, FEMA would need to create a new rate-setting process, as the process for setting flood insurance rates is different from what is needed for wind coverage. Fourth, promoting the new program in communities would require that FEMA staff raise awareness of the combined program's availability and coordinate enforcement of the new building codes. Finally, FEMA would need to put staff and procedures in place to administer and oversee the new program while it faces current management and oversight challenges with the National Flood Insurance Program (NFIP). Setting premium rates adequate to cover all the expected costs of flood and wind damage would require FEMA to make sophisticated determinations. For example, FEMA would need to determine how the program would pay claims in years with catastrophic losses without borrowing from the Department of the Treasury. H.R. 3121 would require the program to stop renewing or selling new policies if it needed to borrow funds, effectively terminating the program. It is also unclear whether the program could obtain reinsurance to cover such losses, and attempting to fund losses by building up a surplus would potentially require high premium rates and an unknown number of years without large losses, something over which FEMA has no control. Further, FEMA would need to account for the likelihood that participation would be limited and only the highest-risk properties would be insured. These factors would further increase premium rates and make it difficult to set rates adequate to cover future costs. A federal flood and wind insurance program could benefit some policyholders and market participants but would also involve trade-offs. For example, not requiring adjusters to distinguish between flood and wind damage could reduce both delays in reimbursing participants and the potential for litigation. However, borrowing restrictions could also leave property owners without coverage after a catastrophic event. In addition, the proposed coverage limits are relatively low compared with the coverage that is currently available, potentially leaving some properties underinsured. The program could also reduce the exposure of some insurers by insuring high-risk properties that currently have private sector coverage. However, an unknown portion of the exposure currently held by state wind programs--nearly $600 billion in 2007--could be transferred to the federal government. While H.R. 3121 would require premium rates to be adequate to cover any exposure and restrict borrowing by the program, the potential exists for losses to greatly exceed expectations, as happened with Hurricane Katrina in 2005. This could increase FEMA's total debt, which as of December 2007 was about $17.3 billion.
GAO-08-504, Natural Catastrophe Insurance: Analysis of a Proposed Combined Federal Flood and Wind Insurance Program
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Report to Congressional Requesters:
United States Government Accountability Office:
GAO:
April 2008:
Natural Catastrophe Insurance:
Analysis of a Proposed Combined Federal Flood and Wind Insurance
Program:
GAO-08-504:
GAO Highlights:
Highlights of GAO-08-504, a report to congressional requesters.
Why GAO Did This Study:
Disputes between policyholders and insurers after the 2005 hurricanes
highlight the challenges of determining the cause and extent of damages
when properties are subject to both high winds and flooding.
Additionally, insurers want to reduce their exposure in high-risk
areas, and state wind insurance programs have grown significantly. H.R.
3121, the Flood Insurance Reform and Modernization Act of 2007, would
create a combined federal insurance program with coverage for both wind
and flood damage. GAO was asked to evaluate this potential program in
terms of (1) what would be required to implement it; (2) the steps the
Federal Emergency Management Agency (FEMA) would need to take to
determine premium rates that reflect all future costs; and (3) how it
could affect policyholders, insurance market participants, and the
federal government. To address these questions, GAO analyzed state and
federal programs, examined studies of coastal wind insurance issues,
and interviewed federal and state regulatory officials as well as
industry participants and analysts.
FEMA and the National Association of Insurance Commissioners generally
agreed with GAO‘s report findings. FEMA emphasized the challenges it
would face in addressing several key issues. FEMA also provided
technical comments, which were incorporated as appropriate.
What GAO Found:
To implement a combined federal flood and wind insurance program, FEMA
would need to complete certain challenging steps. First, FEMA would
need to determine wind hazard prevention standards that communities
would have to adopt in order to receive coverage. Second, FEMA would
need to adapt existing programs to accommodate wind coverage”for
example, the Write Your Own program. Third, FEMA would need to create a
new rate-setting process, as the process for setting flood insurance
rates is different from what is needed for wind coverage. Fourth,
promoting the new program in communities would require that FEMA staff
raise awareness of the combined program‘s availability and coordinate
enforcement of the new building codes. Finally, FEMA would need to put
staff and procedures in place to administer and oversee the new program
while it faces current management and oversight challenges with the
National Flood Insurance Program (NFIP).
Setting premium rates adequate to cover all the expected costs of flood
and wind damage would require FEMA to make sophisticated
determinations. For example, FEMA would need to determine how the
program would pay claims in years with catastrophic losses without
borrowing from the Department of the Treasury. H.R. 3121 would require
the program to stop renewing or selling new policies if it needed to
borrow funds, effectively terminating the program. It is also unclear
whether the program could obtain reinsurance to cover such losses, and
attempting to fund losses by building up a surplus would potentially
require high premium rates and an unknown number of years without large
losses, something over which FEMA has no control. Further, FEMA would
need to account for the likelihood that participation would be limited
and only the highest-risk properties would be insured. These factors
would further increase premium rates and make it difficult to set rates
adequate to cover future costs.
A federal flood and wind insurance program could benefit some
policyholders and market participants but would also involve trade-
offs. For example, not requiring adjusters to distinguish between flood
and wind damage could reduce both delays in reimbursing participants
and the potential for litigation. However, borrowing restrictions could
also leave property owners without coverage after a catastrophic event.
In addition, the proposed coverage limits are relatively low compared
with the coverage that is currently available, potentially leaving some
properties underinsured. The program could also reduce the exposure of
some insurers by insuring high-risk properties that currently have
private sector coverage. However, an unknown portion of the exposure
currently held by state wind programs”nearly $600 billion in 2007”could
be transferred to the federal government. While H.R. 3121 would require
premium rates to be adequate to cover any exposure and restrict
borrowing by the program, the potential exists for losses to greatly
exceed expectations, as happened with Hurricane Katrina in 2005. This
could increase FEMA‘s total debt, which as of December 2007 was about
$17.3 billion.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-504]. For more
information, contact Orice Williams at (202) 512-8678 or
williamso@gao.gov.
[End of section]
Contents:
Letter:
Result in Brief:
Background:
Implementing a Combined Federal Flood and Wind Insurance Program Would
Require FEMA to Address Several Management Challenges:
FEMA Would Need to Set Premium Rates for the Flood and Wind Program
Adequate to Cover All Future and Catastrophic Losses without Borrowing:
A Federal Flood and Wind Insurance Program Could Benefit Some but Would
Involve Trade-offs:
Agency Comments and Our Evaluation:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Comments from the Federal Emergency Management Agency:
Appendix III: GAO Contact and Staff Acknowledgments:
Tables:
Table 1. Comparison of Combination of State Wind Program and H.R. 3121
Flood Insurance Policy and State Wind Policy Limits with H.R. 3121
Flood and Wind Policy Limits:
Table 2. Comparison of Selected State Wind Insurance Program Policies
in Force and Exposure from 2004 to Most Recent Available:
Figure:
Figure 1: Geographic Areas That Experience Floods and Hurricanes, 1980-
2005:
Abbreviations:
AAA: American Academy of Actuaries:
AIA: American Insurance Association:
ASFPM: Association of State Flood Plain Managers:
CBO: Congressional Budget Office:
CRSNFIP: Community Rating System:
FEMA: Federal Emergency Management Agency:
NAIC: National Association of Insurance Commissioners:
NFDA: National Flood Determination Association:
NFIP: National Flood Insurance Program:
WYO: Write Your Own:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
April 25, 2008:
The Honorable Barney Frank:
Chairman, Committee on Financial Services:
House of Representatives:
The Honorable Ginny Browne-Waite:
House of Representatives:
Hurricanes can cause extensive wind and flood damage that can be
devastating to property owners. Determining the extent of the damage
caused by each peril can be difficult, leading to disputes between
policyholders and private insurers and delays in payments that property
owners need for living and rebuilding expenses. For example, in the
aftermath of the unprecedented damage as a result of the 2005
hurricanes, disputes emerged between policyholders and insurers over
the extent to which damages would be covered under a homeowner's policy
when both high winds and flooding occurred. As of November 2007, some
of these disputes had yet to be resolved.
Such disputes arise because events such as hurricanes are multi-peril
events, making determinations of the cause of damage difficult. Private
property-casualty insurance policies may cover wind damage but exclude
flood damage, and in some cases, the presence of flood damage in
addition to wind damage may raise questions about the extent to which
wind damage is covered. Adjusters face several challenges in their
efforts to determine the cause of damages after multi-peril events. For
example, the scope of damage following Hurricane Katrina meant that not
enough adjusters were available, that the available adjusters had
difficulty reaching the properties, and that evidence at the damage
scenes was often limited or compromised.
The potential for extensive damages following hurricanes can also mean
that insurance in hurricane prone areas (primarily on the eastern and
Gulf coasts of the United States) may not be widely available and, when
it is, may be unaffordable. In some high-risk areas, insurers have
sought to increase their premium rates and reduce their exposure. To
address these issues, a number of coastal states have created programs
to sell wind insurance in the highest-risk areas within their states.
In some states, such as Florida, Mississippi, and North and South
Carolina, participation in these programs has grown tremendously since
2004, exposing the programs to potentially large losses.
In response to these and other concerns, the House of Representatives
passed H.R. 3121, the Flood Insurance Reform and Modernization Act of
2007, in September 2007. H.R. 3121 would, among other things, create a
federal program to provide coverage for both wind and flood damage.
[Footnote 1] You asked us to evaluate this program in light of current
deliberations about the future of the National Flood Insurance Program
(NFIP). This report discusses (1) the resources and processes that the
Federal Emergency Management Agency (FEMA) would need to implement the
program; (2) the steps that FEMA would need to take to determine
premium rates that adequately reflected all expected costs; and (3) the
possible effects of the program on policyholders, insurance market
participants, and the federal government.
To complete our work, we analyzed the provisions of H.R. 3121 that were
related to the establishment of a federal flood and wind insurance
program. We discussed the potential implications and effects of these
provisions with officials from FEMA, the NFIP, the National Association
of Insurance Commissioners (NAIC), state insurance regulators, state
wind insurance program operators, insurers, reinsurers, insurance and
reinsurance associations, insurance agent associations, risk-modeling
organizations, actuarial consultants, the American Academy of
Actuaries, and others. We also obtained information on state-sponsored
wind insurance programs in three coastal states and one inland state
and talked with program officials as well as the insurance regulators
within those states. In addition, we reviewed academic and other
studies of coastal wind insurance issues, Congressional Budget Office
(CBO) reviews, and hurricane loss data. Appendix I contains additional
information concerning the scope and methodology of our work. We
conducted this performance audit from September 2007 to April 2008 in
accordance with generally accepted government auditing standards. Those
standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
Result in Brief:
To implement a combined federal flood and wind insurance program, FEMA
would need to complete a number of steps, similar to those undertaken
to establish the NFIP, which would require the agency to address
several challenges. First, FEMA would need to determine appropriate
building codes that communities would be required to adopt in order to
participate in the combined program. Second, FEMA would need to adapt
existing processes under the NFIP flood program to accommodate the
addition of wind coverage. For example, revisions to the Write Your Own
(WYO) program, which uses private insurers to sell and underwrite NFIP
policies, would need to address the conflict of interest inherent in
having these companies sell a federal wind product and their own wind
coverage. Third, FEMA would need to create a rate-setting mechanism and
process for wind insurance that, according to FEMA officials, would
require contractor support. Fourth, promoting the combined program in
communities would require that FEMA staff raise awareness of the
combined program's availability and coordinate enforcement of the new
building codes. Finally, FEMA is facing a $17.3 billion deficit and
attempting to address several management and oversight challenges
associated with the NFIP, and balancing those demands with expanding
current staffing capacity and contractor services to administer,
operate, and monitor and oversee a new program could further strain
FEMA's ability to effectively manage the NFIP.
Setting premium rates that would adequately reflect all expected costs
without borrowing from the U.S. Department of the Treasury (Treasury)
would require FEMA to make a number of sophisticated determinations. To
begin with, FEMA would need to determine what those future costs are
likely to be, including costs in years with catastrophic losses. Such
determinations can be difficult, particularly in the early years of a
program's operations, when little is known about the properties that
might be insured, and can have a significant impact on premium rates.
Once FEMA has determined the expected future costs of the program, it
would need to determine premium rates adequate to cover those costs.
Such determinations could be challenging for several reasons. First,
the rate would need to be sufficient to pay claims in years with such
catastrophic losses without borrowing funds from the Treasury. Under
the proposed legislation, if FEMA ever needed to borrow to pay claims-
-something that could occur in any year given the variability of wind
and flood losses regardless of the rate setting process--the program
would have to stop renewing or selling new policies and thus would
effectively terminate. Private sector insurers generally use
reinsurance--insurance for insurers--to cover potential catastrophic
losses, but it is not clear that reinsurers would be willing to sell
such coverage to a federal program because of the potential for a large
concentration of high-risk properties. The program could attempt to
build a surplus large enough to pay catastrophic losses, but doing so
would require high premium rates compared to the size of expected
claims and an unknown number of years without larger than average
losses, over which FEMA has no control. Second, rate setting would have
to account for two factors: adverse selection, or the likelihood that
the program would insure only the highest-risk properties, and
potentially limited participation because of comparatively low coverage
limits. Both of these factors would necessitate higher premium rates,
which in turn could further limit participation and require even higher
premium rates. This circular process, known as an adverse selection
spiral, could make rate setting very difficult. Finally, although no
distinction between flood and wind damage would be necessary for
property owners to receive payment on claims, such a distinction would
still be necessary for rate-setting purposes.
A federal flood and wind insurance program could benefit some property
owners, state wind insurance programs, and private insurers, but these
potential benefits involve trade-offs. For property owners, the program
could reduce potential delays in claim payments for wind damage by not
requiring adjusters to distinguish between wind and flood damage,
potentially avoiding the wind-related payment delays and disputes that
followed the hurricanes of 2005. In addition, the program could help
ensure that property owners had access to wind coverage in high-risk
areas. However, these benefits could be limited if FEMA needed to
borrow money to pay claims, potentially shutting down the program and
leaving property owners without coverage following a catastrophic
event. In addition, comparatively low policy limits could leave some
property owners underinsured. The program could also allow private
insurers to further reduce their exposure to loss in some high-risk
coastal areas, something that several insurers have been attempting to
do since the 2005 hurricanes. However, this benefit for insurers could
further limit market participation in the provision of catastrophe
insurance.[Footnote 2] These possible benefits also need to be balanced
against the potential for a federal flood and wind program to create an
increased exposure for the federal government. Because of the potential
for the program to insure only the highest-risk properties, this
exposure could be very large. While H.R. 3121 would require premium
rates be determined on an actuarial basis--that is, adequate to cover
expected costs--estimating future losses is challenging and the
potential exists for losses to exceed expectations by a large amount
even if the rates are actuarially based, as happened when losses from
Hurricane Katrina in 2005 were well beyond what was expected by the
NFIP and private sector insurers. If losses for a combined flood and
wind program did exceed the premiums collected by the program, FEMA
would be forced to borrow from the Treasury to pay those losses,
potentially adding to FEMA's total debt, which as of December 2007 was
about $17.3 billion.
We requested comments on a draft of this report from FEMA and NAIC.
FEMA provided written comments that are reprinted in appendix II. NAIC
provided oral comments. FEMA and NAIC generally agreed with our report
findings. Overall, FEMA commended the report and stressed the
challenges it would face in addressing several key issues. Finally FEMA
provided technical comments, which we incorporated as appropriate.
Background:
Coastal properties in the United States that lie on the Atlantic Ocean
and the Gulf of Mexico are at risk of both flood and wind damage from
hurricanes. One study put the estimated insured value of coastal
property in states on these coasts at $7.2 trillion as of December
2004, and populations in these areas are growing.[Footnote 3] Property
owners can obtain insurance against losses from wind damage through
private insurance markets or, in high-risk coastal areas in some
states, through state wind insurance programs. Flood insurance is
generally excluded from such coverage, but property owners can obtain
insurance against losses from flood damage through NFIP, which was
established by the National Flood Insurance Act of 1968.[Footnote 4]
As we have reported, insurance coverage gaps and claims uncertainties
can arise when coverage for hurricane damage is divided among multiple
policies because the extent of coverage under each policy depends on
the cause of the damages, as determined through the claims adjustment
process and the policy terms that cover a particular type of
damage.[Footnote 5] This adjustment process is complicated when a
damaged property has been subjected to a combination of high winds and
flooding and evidence at the damage scene is limited. Other claims
concerns can arise on such properties when the same insurer serves as
both the NFIP's WYO insurer and the property-casualty (wind) insurer.
In such cases, the same company is responsible for determining damages
and losses to itself and to the NFIP, creating an inherent conflict of
interest.
H.R. 3121 Would Create a Combined Federal Flood and Wind Insurance
Program:
H.R. 3121, the Flood Insurance Reform and Modernization Act of 2007,
set an effective date for its proposed flood and wind insurance program
of June 28, 2008. A version of this bill, S. 2284, was introduced in
the Senate in November of 2007, but this version did not include
provisions that would establish a federal flood and wind program. As of
March 2008, no additional action had been taken on S. 2284. In a
September 26, 2007, Statement of Administration Policy regarding H.R.
3121, the Executive Office of the President stated that the
Administration strongly opposes the expansion of NFIP to include
coverage for windstorm damage.
H.R. 3121's provisions include the following:
* In order for individual property owners to be eligible to purchase
federal flood and wind coverage, their communities must have adopted
adequate mitigation measures that the Director of FEMA finds are
consistent with the International Code Council's building codes for
wind mitigation.[Footnote 6]
* The Director of FEMA is expected to carry out studies and
investigations to determine appropriate wind hazard prevention
measures, including laws and regulations relating to land use and
zoning; establish criteria based on this work to encourage adoption of
adequate state and local measures to help reduce wind damage; and work
closely with and provide any technical assistance to state and local
governmental agencies to encourage the application of these criteria
and the adoption and enforcement of these measures.
* Property owners who purchase a combined federal flood and wind
insurance policy cannot also purchase an NFIP flood insurance policy.
* Federal flood and wind insurance will cover losses only from physical
damage from flood and windstorm (including hurricanes, tornadoes, and
other wind events), but no distinction between flood and wind damage
need be made in order for claims to be paid.
* Premium rates are to be based on risk levels and accepted actuarial
principles and will include all operating costs and administrative
expenses.
* Residential property owners can obtain up to $500,000 in coverage for
damages to any single-family structure and up to $150,000 in coverage
for damage to contents and any necessary increases in living expenses
incurred when losses from flooding or windstorm make the residence
unfit to live in.
* Nonresidential property owners can obtain up to $1,000,000 in
coverage for damages to any single structure and up to $750,000 in
coverage for damage to contents and for losses resulting from an
interruption of business operations caused by damage to, or loss of,
the property from flooding or windstorm;
* If at any time FEMA borrows funds from the Treasury to pay claims
under the federal flood and wind program, until those funds are repaid
the program may not sell any new policies or renew any existing
policies.
NFIP Is Designed to Offer Federally Backed Flood Insurance but Not to
Be Actuarially Sound:
Over 20,000 communities across the United States and its territories
participate 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. Optional,
lower-cost coverage is also available under the NFIP to protect homes
in areas of low to moderate risk. Premium amounts vary according to the
amount of coverage purchased and the location and characteristics of
the property to be insured.
When the NFIP was created, Congress mandated that it was to be
implemented using "workable methods of pooling risks, minimizing costs,
and distributing burdens equitably" among policyholders and taxpayers
in general.[Footnote 7] The program aims to make reasonably priced
coverage available to those who need it.[Footnote 8] The NFIP attempts
to strike a balance between the scope of the coverage provided and the
premium amounts required to provide that coverage and, to the extent
possible, the program is designed to pay operating expenses and flood
insurance claims with premiums collected on flood insurance policies
rather than tax dollars. However, as we have reported before, the
program, by design, is not actuarially sound because Congress
authorized subsidized insurance rates for some policies to encourage
communities to join the program. As a result, the program does not
collect sufficient premium income to build reserves to meet the long-
term future expected flood losses.[Footnote 9] FEMA has statutory
authority to borrow funds from the Treasury to keep the NFIP
solvent.[Footnote 10] In 2005, Hurricanes Katrina, Rita, and Wilma had
a far-reaching impact on NFIP's financial solvency. Legislation
incrementally 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 December 2007, FEMA's outstanding debt to the Treasury was $17.3
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 per year.[Footnote 11]
Implementing a Combined Federal Flood and Wind Insurance Program Would
Require FEMA to Address Several Management Challenges:
To implement a combined federal flood and wind insurance program, FEMA
would need to complete a number of steps, similar to those undertaken
to establish the NFIP, which would require the agency to address
several challenges. First, FEMA would need to undertake studies in
order to determine appropriate building codes that communities would be
required to adopt in order to participate in the combined program.
Second, FEMA would need to adapt existing processes under the NFIP
flood program to accommodate the addition of wind coverage. For
example, FEMA could leverage current processes under the WYO program
and the Direct Service program to perform the administrative functions
of selling and servicing the combined federal flood and wind insurance
policy. Third, to set wind rates, FEMA would have to create a rate-
setting structure, which would require contractor support. Fourth,
promoting the combined federal flood and wind insurance program in
communities would require that FEMA staff raise awareness of the
combined program's availability and coordinate enforcement of the new
building codes. Finally, FEMA is facing a $17.3 billion deficit and
attempting to address several management and oversight challenges
associated with the NFIP, and balancing those demands with expanding
staffing capacity to adjust existing administrative, operational,
monitoring, and oversight processes and establish new ones to
accommodate wind coverage could further strain FEMA's ability to
effectively manage the NFIP.
FEMA Would Need to Determine Appropriate Building Codes:
H.R. 3121 would require FEMA to determine appropriate wind mitigation
measures that communities would be required to adopt in order to
participate in the combined flood and wind program. For several
reasons, this could be a challenging process. First, FEMA would have to
determine how to most effectively integrate a new federal wind
mitigation standard with existing building codes for wind resistance.
As we discussed in a previous report, as of January 2007, the majority
of states had adopted some version of a model building code for
commercial and residential structures.[Footnote 12] However, some local
jurisdictions within states had not adopted a statewide model code and
had modified the codes to reflect local hazards. Standards determined
by FEMA to be appropriate for participation in the combined federal
flood and wind program could conflict with those currently used by some
states and local jurisdictions, and resolving any such differences
could be challenging.
Second, as it did with the NFIP, FEMA would have to address
constitutional issues related to federal regulation of state and local
code enforcement. Further, FEMA would need to establish regulations
similar to those governing the flood program to allow for appeals by
local jurisdictions, a process that could be time intensive. Third, as
we have noted in a previous report, reaching agreement with communities
on appropriate mitigation measures can be challenging, as communities
often resist changes to building standards and zoning regulations
because of the potential impact on economic development.[Footnote 13]
For example, community goals such as housing and promoting economic
development may be higher priorities for the community than formulating
mitigation regulations that may include more rigorous developmental
regulations and building codes. Fourth, according to FEMA officials,
the agency would have to resolve potentially conflicting wind and flood
standards. For example, they told us that flood building standards
require some homes to be raised off the ground, but doing so can
increase a building's susceptibility to wind damage because the
buildings are then at a higher elevation.
FEMA Would Need to Adapt Existing NFIP Processes for Wind Coverage:
While some of the NFIP's current processes could be leveraged to
implement a combined federal flood and wind program, they would need to
be revised, an action that could pose further challenges for FEMA.
According to FEMA officials, both the NFIP's WYO and Direct Service
programs could be used, with some revisions, to sell and underwrite the
combined federal flood and wind insurance policy. The provision within
H.R. 3121 that prevents FEMA from selling new policies or renewing
existing policies if it borrows funds to pay claims would necessitate
that the agency segregate funds collected from premiums under the new
combined program and the flood program to ensure that it has sufficient
funds to cover all future costs without borrowing, especially in
catastrophic loss years. While the NFIP Community Rating System (CRS),
a program that uses insurance premium discounts to incentivize flood
damage mitigation activities by participating communities, could be
adapted for combined federal flood and wind insurance coverage, it
would not be required for the new program to begin operations because
community participation in CRS is voluntary.[Footnote 14]
The WYO Program Could Be Used, but Would Need to Be Expanded:
As part of the WYO program, private property-casualty insurers are
responsible for selling and servicing NFIP policies, including
performing the claims adjustment activities to assess the cause and
extent of damages.[Footnote 15] FEMA is responsible for managing the
program, including establishing and updating NFIP regulations,
analyzing data to 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 ensure
that NFIP is administered properly. These duties under the WYO program
would be amplified with the addition of wind coverage and, according to
FEMA officials, would require FEMA to expand the staffing capacity to
include those with wind peril insurance experience. In addition, FEMA
would need to determine whether existing data systems would be adequate
to manage an increased number of policies and track losses for the new
program.
FEMA could face several challenges in expanding the WYO program. First,
program staff would need to determine how to manage and mitigate the
potential conflict of interest for those companies in the WYO program
that could be selling both their own wind coverage and the combined
federal flood and wind coverage. Current WYO arrangements with the NFIP
prevent WYO insurers from offering flood-only coverage of their own
unless it supplements NFIP coverage limits or is part of a larger
policy in which flooding is one of the several perils covered. H.R.
3121, however, does not appear to prevent companies that might sell a
combined federal flood and wind policy from also selling wind coverage,
which may be part of a homeowners policy. Without this restriction, a
conflict of interest could develop because insurers would have an
incentive to sell the combined federal policy to its highest-risk
customers and their own policies to lower-risk customers. FEMA
officials agreed that this would be an inherent conflict and noted that
it would be difficult to prevent this from occurring without precluding
the WYO insurers from selling their wind policies. Moreover, according
to a WYO insurer with whom we spoke, attempting to eliminate the
conflict by either restricting a WYO insurer from selling its own wind
coverage or requiring it to sell both flood-only and the combined
policy could discourage participation in the WYO program. As noted in a
previous report, private sector WYO program managers have said that
while NFIP has many positive aspects, working with it is complex for
policyholders, agents, and adjusters.[Footnote 16] According to another
WYO insurer we spoke with, adding wind coverage could increase these
complexities.
NFIP's Direct Service Program Could Also Be Used, but Would Need to Be
Expanded:
FEMA officials told us that the agency could also sell and service the
combined flood and wind insurance policies through its Direct Service
program, which is designed for agents who do not have agreements or
contracts with insurance companies that are part of the WYO program.
According to FEMA officials, the Direct Service program of NFIP
currently writes about 3 percent of the more than 5.5 million NFIP
policies sold. Further, as with the WYO program, FEMA may have to
contend with an inherent conflict of interest, and expand staffing
capacity including adding staff with wind peril insurance expertise in
the Direct Service program to administer, monitor, and oversee the sale
of the new product.
The CRS Program, while Not Necessary to Initiate the Program, Would
Also Need to Be Expanded:
H.R. 3121 calls for FEMA to establish comprehensive criteria designed
to encourage communities to participate in wind mitigation activities.
As previously noted, the CRS program would be an important means of
incentivizing wind mitigation activities in communities, but would not
be necessary for the combined federal flood and wind insurance program
to operate. According to FEMA, while the CRS process could be adapted
for wind coverage, the agency would have to assess current practices,
evaluate standards, and devise an appropriate rating system; a
developmental process similar to what occurred for the NFIP. FEMA
officials told us that it took approximately 5 years to develop the
program, during which time extensive evaluation, research, and concept
testing occurred. They estimate that replicating a similar approach for
wind hazard would require at least the same number of years if not
more, recognizing the complexities of current insurance industry
experience associated with the wind peril and the complexities involved
with evaluating current building code practices related to wind and
other wind mitigation techniques.
NFIP Would Need to Establish a New Rate-Setting Structure for Combined
Flood and Wind Premiums:
Establishing a new rate-setting structure for a combined federal flood
and wind insurance program could pose another challenge for FEMA.
According to several insurers and modeling consultants, wind modeling
is the accepted method of determining wind-related premium rates, and
FEMA does not have the necessary in-house wind modeling and actuarial
expertise needed to develop and interpret wind models and translate the
model's output into premium rates.[Footnote 17] They told us that
modeling has several advantages in rate setting over methods that place
greater emphasis on loss data from past catastrophic events, such as
the method used by NFIP to determine flood insurance premium rates. For
example, modeling uses wind speed maps and other data to account for
the probability that properties in a certain geographic area might
experience losses in the future, regardless of whether those properties
have experienced losses in the past. In addition, according to a
modeling expert, wind modeling incorporates mitigation efforts at the
property level because it can estimate the potential reductions in
damage without waiting to see how the efforts actually affect losses
during a storm or other event. While several modeling companies that
are already providing wind modeling to private sector insurers and
state wind insurance programs exist, it is not clear how much such
services would cost FEMA. And while FEMA officials told us that the
agency would have to contract out for wind-modeling services because it
lacks the necessary wind and actuarial expertise, the agency could
benefit from at least some in-house expertise in these areas in order
to oversee the contractors that will provide these services.
FEMA would also need to determine to what extent it might need to use
wind speed maps in its rate determination process. Flood maps are
currently used in the NFIP to identify areas that are at risk of
flooding and thus the areas where property owners would benefit from
purchasing flood insurance. If FEMA determined that wind maps were
necessary, it would then need to determine whether the agency could
develop such maps on its own or whether contracting with wind-modeling
experts would be required, and what the cost of these efforts might be.
FEMA Would Need to Promote Participation in a Combined Federal Flood
and Wind Insurance Program and Coordinate Enforcement:
Implementing the combined program would require FEMA to promote
participation among communities and coordinate enforcement, a task that
could be challenging for FEMA for two reasons. First, FEMA would need
to manage community and state eligibility to participate in the
program. The proposal calls for FEMA to work closely with and provide
any necessary technical assistance to state, interstate, and local
governmental agencies, to encourage the adoption of windstorm damage
mitigation measures by local communities and ensure proper enforcement.
While communities themselves are responsible for enforcing windstorm
mitigation measures, FEMA officials told us they would have to
coordinate with existing code groups to provide technical assistance
training and guidance to local officials, and establish a wind
mitigation code enforcement compliance program that would monitor,
track, and verify community compliance with wind mitigation codes.
According to an official at an organization representing flood hazard
specialists, some communities are very good at ensuring compliance,
while others are not. For example, in some larger communities, a city
or county may have experts with vast experience in enforcing building
codes and land use standards, but in other communities, a local clerk
or city manager with little or no experience may be responsible for
compliance. According to FEMA, the effectiveness of mitigation measures
is entirely dependent on enforcement at the local level. Proper
enforcement would require that resources were in place to pay for and
train qualified inspectors and building department staff.
Second, FEMA would need to generate public awareness on the
availability of wind insurance through the NFIP. Efforts to adopt new
mitigation activities and strategies have been constrained by the
general public's lack of awareness and understanding about the risk
from natural hazards. To address this issue in NFIP, FEMA launched an
integrated mass marketing campaign called FloodSmart to educate the
public about the risks of flooding and to encourage the purchase of
flood insurance. As we have noted in a previous report, according to
FEMA officials, in a little more than 2 years since the contract began,
in October 2003, net policy growth was a little more than 7 percent and
policy retention improved from 88 percent to 91 percent.[Footnote 18]
Educating the public on a new combined federal flood and wind insurance
program and promoting community participation could demand a similar
level of effort by FEMA to encourage participation.
Expanding FEMA to Implement a Combined Federal Flood and Wind Insurance
Program Could Add to Existing NFIP Management Challenges:
Implementing a combined flood and wind insurance program and overseeing
the requisite contractor-supported services could place additional
strain on FEMA, which is already faced with NFIP management and
oversight challenges and a $17.3 billion deficit that it is unlikely to
be able to repay. In March 2006, we placed the NFIP on our high-risk
list because of its fiscal and management challenges.[Footnote 19] In
addition to the agency's current debt owed to the Treasury, FEMA is
challenged with providing effective oversight of contractors. For
example, as previously reported, FEMA faces challenges in providing
effective oversight of the insurance companies and thousands of
insurance agents and claims adjusters that are primarily responsible
for the day-to-day process of selling and servicing flood insurance
policies through the WYO program.[Footnote 20] In FEMA's claims
adjustment oversight, the agency cannot be certain of the quality of
NFIP claims adjustments that allocate damage to flooding in cases
involving damage caused by a combination of wind and flooding.
[Footnote 21] Expanding the WYO program to include combined flood and
wind policies could increase the NFIP's oversight responsibilities as
well as make resolving existing management challenges more difficult.
In addition, FEMA faces ongoing challenges in working with contractors
and state and local partners--all with varying technical capabilities
and resources--in its map modernization efforts, which are designed to
produce accurate digital flood maps.[Footnote 22] Ensuring that map
standards are consistently applied across communities once the maps are
created will also be a challenge. To the extent that FEMA uses wind
speed maps under the combined program, the agency could face challenges
similar to those currently faced by the NFIP's flood-mapping program.
New management challenges created by implementing a combined federal
flood and wind program could make addressing these existing challenges
even more difficult. According to FEMA officials, implementing a new
flood and wind program is a process that would likely take several
years and would require a doubling of current staff levels. Determining
appropriate wind mitigation measures, adapting existing WYO and Direct
Service processes for wind coverage, establishing a new rate-setting
process, promoting community participation, and overseeing the combined
program would all require additional staff and contractor services with
the appropriate wind expertise. While the total cost of adding staff
and hiring contractors with wind expertise is not clear, FEMA's 2007
budget for NFIP salaries and expenses was about $38.2 million.
FEMA Would Need to Set Premium Rates for the Flood and Wind Program
Adequate to Cover All Future and Catastrophic Losses without Borrowing:
Setting premium rates that would adequately reflect all expected costs
without borrowing from the Treasury would require FEMA to make a number
of sophisticated determinations. To begin with, FEMA would need to
determine what those future costs are likely to be, a process that can
be particularly difficult with respect to catastrophic losses. Once
FEMA has determined the expected future costs of the program, it would
need to determine premium rates adequate to cover those costs, a
challenging process in itself for several reasons. First, the rate
would need to be sufficient to pay claims in years with catastrophic
losses without borrowing funds from the Treasury. This determination
could be particularly difficult because it is unclear whether the
program might be able to purchase reinsurance, and because attempting
to build up a sufficient surplus to pay for catastrophic losses would
require high premium rates compared to the size of expected claims and
an unknown number of years without larger than average losses, over
which FEMA has no control. Second, rate setting would have to account
for two factors: adverse selection, or the likelihood that the program
would insure only the highest-risk properties, and potentially limited
participation because of comparatively low coverage limits. Both of
these factors would necessitate higher premium rates, which could make
rate setting very difficult. Finally, although no distinction between
flood and wind damage would be necessary for property owners to receive
payment on claims, such a distinction would still be necessary for rate-
setting purposes.
FEMA Would Need to Determine the Losses the Program Would Be Required
to Pay, Including Losses from Catastrophic Events:
The proposed flood and wind program would be required, by statute, to
charge premium rates that were actuarially sound--that is, that were
adequate to pay all future costs. As a result, in setting rates FEMA
would need to determine how much the program would be required to pay,
including in years with catastrophic losses, and use this amount in
setting rates, as is done by private sector insurers. H.R. 3121 does
not specify how a federal flood and wind program would pay for
catastrophic losses beyond charging an adequate premium rate. According
to insurers and industry consultants we spoke with, making such
determinations can be difficult and involve balancing the ability to
pay extreme losses with the ability to sell policies at prices people
will pay. For example, insurers could charge rates that would allow
them to pay claims on the type of event they would expect to occur only
very rarely, but the resulting rates could be prohibitively expensive.
On the other hand, charging premium rates that would enable an insurer
to pay losses on events of limited severity could allow them to sell
policies at a lower price, but could also result in insufficient funds
to pay losses if a larger loss were to occur. Insurers can come to
different conclusions over the appropriate level of catastrophic losses
on which to base their premium rates. For example, one state regulator
said that some private sector insurers in his state used an event he
believes has about a 0.4 percent chance of occurring in a given year,
but that the state wind insurance program based its rates on events he
believes have about a 1 percent chance of occurring. For comparison,
one consultant we spoke with believed that an event of the severity of
Hurricane Katrina had about a 7 percent chance of occurring in a given
year.
Determining the losses the program might be required to pay, especially
in the event of a catastrophic event, could be especially important for
FEMA. This is because if an event occurs that generates losses beyond
an amount the program is prepared to pay, the program would be forced
to borrow funds to pay those losses, triggering a borrowing restriction
that would force it to stop renewing or selling new policies,
effectively ending the program. On the other hand, premium rates high
enough to pay losses resulting from the most severe catastrophic events
might make the program prohibitively expensive for property owners.
Determining expected losses for the first year of the program would be
complicated by the fact that FEMA would not know what type of
properties would be insured. Private sector insurers set their premium
rates using models that take into account several variables, including
the number of properties to be insured, the risks associated with the
properties' location, and the characteristics of the properties
themselves. This information is used in the wind-modeling process to
create a variety of scenarios that result in losses of differing
severity that can then be used to create possible premium rates.
Existing insurers have established portfolios of polices and can use
data from these portfolios in the modeling process. A new combined
federal flood and wind insurance program, according to wind-modeling
companies we spoke with, would need to develop a hypothetical
portfolio, making assumptions about how many policies it might sell and
where, as well as the characteristics of the properties that might be
insured. Such assumptions can be challenging because the number and
type of properties insured will, in turn, be affected by the price of
coverage.
FEMA Would Need to Determine a Premium Rate That Is Adequate to Pay for
Expected Losses without Borrowing:
Once FEMA determines the severity of catastrophic losses a federal
program would be required to pay, the agency would need to determine a
premium rate that is adequate to pay such losses. This determination
could be particularly difficult with regard to paying catastrophic
losses--something that could occur in any year given the volatility of
wind and flood losses--because of the borrowing restriction in H.R.
3121. Because it would be difficult, if not impossible, to repay any
borrowed funds without the premium income from new or existing
policies, this restriction, if invoked, could end the program. This
would effectively require the program to charge premium rates
sufficient to pay catastrophic losses without borrowing.
Private sector insurers generally ensure their ability to pay
catastrophic losses by purchasing reinsurance, and include the cost of
this coverage in the premium rate they charge. However, reinsurance may
not be an option for FEMA. Some reinsurance industry officials we spoke
with said that the potential for the program to insure a large number
of only high-risk properties could create a risk of high losses that
could make reinsurers reluctant to offer coverage. Another option would
be to charge a premium rate high enough to build up a surplus adequate
to pay for catastrophic losses. However, such a rate would likely be
high, and it would require an unknown number of years of operations
with lower than average losses to build up a sufficient surplus, over
which FEMA has no control. For example, a loss that exceeds the
program's surplus could occur in the early years, or even the first
year, of the program's operations, potentially forcing the program to
borrow funds to pay losses and effectively ending the program.
FEMA Would Need to Account for Likely Adverse Selection and Limited
Participation:
In determining a premium rate for a federal flood and wind program that
was adequate to pay all future costs, FEMA would also need to take into
account the adverse selection--the tendency to insure primarily the
highest risks--and limited participation the program would likely
experience. These factors can make rate setting difficult because they
can both lead to increased premium rates, which can, in turn, lead to
further adverse selection, limited participation, and the need for
additional rate increases.
A Federal Flood and Wind Program Is Likely to Insure Primarily High-
Risk Properties:
For several reasons, a federal flood and wind program would probably
insure mostly high-risk properties. First, a policy that combines flood
and wind insurance would likely be of interest only to property owners
who perceived themselves to be at significant risk of both flood and
wind damage. Because consumers tend to underestimate their risk of
catastrophic loss, those property owners who saw the need for a
combined flood and wind policy would likely be those who knew they
faced a high risk of loss. In addition, because the policy would
include coverage for damage from flooding, those buying it would
probably already have flood insurance, which is currently purchased
almost exclusively in high-risk areas where lenders require it.
[Footnote 23] As shown in figure 1, areas where there have been
multiple floods as well as hurricanes and where consumers are most
likely to see a need for both flood and wind coverage are primarily
limited to the eastern and Gulf coasts.
Figure 1: Geographic Areas That Experience Floods and Hurricanes, 1980-
2005:
[See PDF for image]
This figure is a map of the United States depicting geographic areas
that experienced floods and hurricanes, 1980-2005. The areas noted fall
into one of the following categories:
6 to 10 floods and 2 to 4 hurricanes;
6 to 10 floods and 5 or more hurricanes;
More than 10 flood and 2 to 4 hurricanes;
More than 10 flood and 5 or more hurricanes.
The vast majority of areas so indicated are along the Gulf Coast and
the Atlantic Coastline.
Source: GAO analysis of FEMA data.
[End of figure]
Second, a combined federal flood and wind insurance policy is likely to
be of interest only in areas where state insurance regulators have
allowed insurers to exclude coverage for wind damage from homeowners
policies that they sell. According to several insurance industry
officials we spoke with, in order to help protect consumers, state
insurance regulators generally prohibit insurers from excluding wind
damage from homeowners policies. According to insurers we spoke with,
insurers can profitably write homeowners policies that include wind
coverage in most areas. Only in the coastal areas that are at the
highest risk of hurricane damage have insurers asked for and received
permission from state regulators to sell homeowners policies that
exclude wind coverage. Property owners who already have wind coverage
through their homeowners policies--generally those living in areas
outside the highest-risk coastal areas--would generally not be
interested in a combined federal flood and wind insurance policy
because they would already have wind coverage. Once again then, only
property owners in high-risk coastal areas would be the most interested
in purchasing a federal policy. A federal flood and wind insurance
program would find itself in the same situation as state wind insurance
programs that generally sell wind coverage only in areas where insurers
are allowed to exclude it from homeowners policies. According to
officials from the state wind programs we spoke with, their programs
generally insure only the highest-risk properties.
Participation in a Combined Federal Flood and Wind Program Is Likely to
Be Limited:
For several reasons, participation in a federal flood and wind program
would probably be limited. First, a federal flood and wind insurance
policy would likely cost more than purchasing a combination of flood
insurance through the NFIP and wind insurance through a state wind
insurance program, potentially limiting participation in the program.
With respect to coverage for damages from flooding, while an estimated
24 percent of NFIP policyholders receive subsidized premium rates--with
average subsidies of up to 60 percent--H.R. 3121 would require the new
program to charge rates adequate to cover all future costs, potentially
precluding any subsidies. As a result, the flood-related portion of a
federal flood and wind policy would cost more than an NFIP flood policy
for any property owners currently receiving subsidized NFIP flood
rates. With respect to the wind portion of the coverage, a number of
state wind insurance programs typically do not charge rates that are
adequate to cover all costs, so a policy from a federal program that
did charge adequate rates would likely cost more than a state wind
program policy.[Footnote 24] Property owners who are receiving
subsidized NFIP rates and relatively low state wind insurance rates are
unlikely to be willing to move to a new program that would be more
expensive.
Second, a federal flood and wind policy would have lower coverage
limits than the flood and wind coverage currently available in high-
risk coastal areas, further limiting participation. Currently, property
owners in coastal areas subject to both flood and wind damage can
purchase flood insurance through the NFIP and, in some areas, wind
insurance through a state wind insurance program. Table 1 compares the
policy limits for a federal flood and wind policy, as proposed in H.R.
3121, with a combination of policy limits from state wind insurance
program and NFIP policies. While the federal flood and wind policy
would cover a maximum of $650,000 in damage for a residential property,
a combination of NFIP and state wind program policies would provide on
average, around $1.7 million in coverage, or about 166 percent more
coverage, depending on the state. For commercial properties, the
federal flood and wind policy would offer up to $1.75 million in
coverage, but combined NFIP and state wind program policies would
offer, on average, almost $4 million or 126 percent more coverage.
Table 1: Comparison of Combination of State Wind Program and H.R. 3121
Flood Insurance Policy and State Wind Policy Limits with H.R. 3121
Flood and Wind Policy Limits:
State: Alabama;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $970,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $320,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $2,340,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $590,000.
State: Florida;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $1,470,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $820,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $2,340,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $590,000.
State: Georgia;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $2,470,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $1,820,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $3,340,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $1,590,000.
State: Louisiana;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $1,220,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $570,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $8,340,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $6,590,000.
State: Mississippi;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $1,720,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $1,070,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $2,340,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $590,000.
State: North Carolina;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $1,970,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $1,320,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $4,640,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $2,890,000.
State: South Carolina;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $1,770,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $1,120,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $3,840,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $2,090,000.
State: Texas;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $2,240,000;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $1,590,000;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $4,456,000;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $2,706,000.
State: Average;
Residential: (A) Combined NFIP flood and state wind program policy
limits: $1,728,750;
Residential: (B): Federal flood and wind program coverage limit:
$650,000;
Residential: (A-B): Difference: $1,078,750;
Commercial: (C): Combined NFIP flood and state wind program policy
limits: $3,954,500;
Commercial: (D): Federal flood and wind program coverage limit:
$1,750,000;
Commercial: (C-D): Difference: $2,204,500.
Source: GAO analysis of state wind program data and H.R. 3121.
Note: H.R. 3121 proposes increased coverage amounts for NFIP flood
policies, which we use in this analysis. Residential coverage is for a
single dwelling and includes coverage for property damage, damaged
contents, and living expenses. Commercial coverage is for a single
building and includes coverage for property damage and business
interruption expenses.
[End of table]
Adverse Selection and Limited Participation Could Lead to Escalating
Premium Rates, Making Rate Setting Difficult:
Adverse selection and limited participation could, in turn, force FEMA
to raise rates still higher for the projected program, leading to
escalating premiums. This possibility further complicates the rate-
setting process. In general, having only a small pool of very high-risk
insureds requires insurers to charge premium rates at levels above what
could be charged if the risk were spread among a larger pool of
insureds of varying risk levels. As we have discussed, high premium
rates can, in turn, further reduce the number of property owners who
are able and willing to pay for coverage and force insurers to raise
rates yet higher. This cycle, referred to as an adverse selection
spiral, can make it very difficult for insurers to find a premium rate
that is adequate to cover losses.
A Distinction between Flood and Wind Damage Would Still Be Necessary
for Determining Premium Rates:
Finally, although H.R. 3121 stipulates that a distinction between flood
and wind damage would not be required for a policyholder's claim to be
paid by a federal flood and wind program, a determination of the cause
of damage would likely still be necessary for rate-setting purposes.
According to several insurance industry officials we spoke with,
separate determinations would be required because data on the losses
associated with each type of damage are used to help determine future
rates. For example, data on wind losses would be used to validate the
losses predicted by wind models. While the officials said that such
determinations would not need to be as accurate as when the distinction
between flood and wind damage would determine under which policy a
claim was covered, they would still need to be made. As a result, FEMA
would need to determine whether and how such a determination might be
made by FEMA staff, or if it would need to establish another process
for doing so.
A Federal Flood and Wind Insurance Program Could Benefit Some but Would
Involve Trade-offs:
While a combined federal flood and wind program would entail costs, it
could benefit some property owners and market participants. First,
property owners could benefit from reduced delays in payments and
assured coverage in high-risk areas. In addition, taxpayers in some
states could benefit to the extent that the exposure to loss of state
wind insurance programs is reduced. At the same time, these benefits
could be limited by a borrowing restriction that could terminate the
program after a catastrophic event, and comparatively low coverage
limits could leave some property owners underinsured. Third, private
sector insurers could also benefit if high-risk properties moved to a
federal program, reducing the companies' risk of loss. But this shift
would further limit private sector participation. Finally, while H.R.
3121 would require premium rates that were adequate to cover all future
costs, actual losses can significantly exceed even the most carefully
calculated loss estimates, as we learned from the 2005 hurricanes,
potentially leaving the federal government with exposure to new and
significant losses.
A Combined Federal Flood and Wind Program Could Reduce Costs to
Property Owners and Some State Taxpayers but Could Leave Some Owners
Uninsured or Underinsured:
The proposed federal wind and flood insurance program could help
resolve claims more quickly and ensure continued coverage for property
owners and could reduce costs to taxpayers in states with wind
insurance programs. Specifically, a federal program that covered both
wind and flood damage could limit the need to determine the extent of
the damage caused by each peril when paying claims, effectively
reducing potential delays in payment of wind claims to policyholders
for rebuilding and other expenses. As we have seen, currently wind and
flood coverage are generally available only under separate policies,
with flood damage covered by the NFIP and wind damage generally covered
under either a private market homeowners policy or a state wind
insurance program policy. Because determining whether damages were
caused by flood or wind also determines which entity is responsible for
paying the claims, disputes can arise over the cause of the damage. As
we saw after the hurricanes of 2005, such determinations can be a
challenge because, for example, more adjusters were needed than were
available, adjusters had difficulty reaching properties, and evidence
at the damage scenes was often limited or compromised.[Footnote 25]
Some disputes over the cause of damages following the hurricanes of
2005 have taken several years to resolve, with consumers waiting months
to receive payment on wind claims made shortly following those events.
A combined federal flood and wind insurance program could also help
ensure the availability of wind coverage for property owners in high-
risk coastal areas where some insurers have sought to reduce their
exposure. According to several state insurance regulators and wind
insurance program officials we spoke with, insurers in their states
have been seeking to reduce their exposure in high-risk coastal areas
by writing fewer policies there, and their state wind programs have
generally picked up the policies no longer written by the private
market. We obtained data about eight state wind insurance programs and
found that these programs have grown substantially since 2004 (table
2). For example, between 2004 and 2007 the number of policies written
by the Florida Citizens Property Insurance Corporation (Florida
Citizens) grew about 47 percent to around 1.3 million, and the
program's total exposure increased approximately 110 percent to around
$434 billion. Over approximately the same period, the number of
policies written by the Texas Windstorm Insurance Association increased
by about 92 percent to almost 200,000 and the program's total exposure
grew around 158 percent to around $54 billion. While state insurance
programs appear to be providing wind coverage for those who cannot or
do not obtain such coverage in the private market, a combined federal
flood and wind insurance program could help further ensure the
continued availability of wind coverage in areas that private sector
insurers are leaving.
Table 2: Table 2. Comparison of Selected State Wind Insurance Program
Policies in Force and Exposure from 2004 to Most Recent Available
(Dollars in billions):
State plan: Alabama Insurance Underwriting Association;
2004: Policies in force: 2,909;
2004: Exposure: $0.3;
Most Recent Publicly Available: Policies in force: 8,649;
Most Recent Publicly Available: Exposure: $1.5;
Change (percentage increase): Policies in force: 5,740; (197%);
Change (percentage increase): Exposure: $1.2; (347%).
State plan: Florida Citizens Property Insurance Corporation;
2004: Policies in force: 873,996;
2004: Exposure: 206.7;
Most Recent Publicly Available: Policies in force: 1,288,522;
Most Recent Publicly Available: Exposure: 434.3;
Change (percentage increase): Policies in force: 414,526; (47%);
Change (percentage increase): Exposure: 227.6; (110%).
State plan: Georgia Underwriting Association;
2004: Policies in force: 28,501;
2004: Exposure: 2.8;
Most Recent Publicly Available: Policies in force: 26,445;
Most Recent Publicly Available: Exposure: 4.4;
Change (percentage increase): Policies in force: -2,056; (-7.2%);
Change (percentage increase): Exposure: 1.6; (59%).
State plan: Louisiana Citizens Property Insurance Corporation;
2004: Policies in force: 135,457;
2004: Exposure: 14.3;
Most Recent Publicly Available: Policies in force: 129,203;
Most Recent Publicly Available: Exposure: 21.1;
Change (percentage increase): Policies in force: -6,254; (-4.6%);
Change (percentage increase): Exposure: 6.9; (48%).
State plan: Mississippi Windstorm Underwriting Association;
2004: Policies in force: 14,796;
2004: Exposure: 1.6;
Most Recent Publicly Available: Policies in force: 30,962;
Most Recent Publicly Available: Exposure: 5.4;
Change (percentage increase): Policies in force: 16,166; (109%);
Change (percentage increase): Exposure: 3.7; (229%).
State plan: North Carolina Insurance Underwriting Association;
2004: Policies in force: 94,612;
2004: Exposure: 31.6;
Most Recent Publicly Available: Policies in force: 148,411;
Most Recent Publicly Available: Exposure: 60.8;
Change (percentage increase): Policies in force: 53,799; (57%);
Change (percentage increase): Exposure: 29.2; (92%).
State plan: South Carolina Wind and Hail Underwriting Association;
2004: Policies in force: 20,519;
2004: Exposure: 6.0;
Most Recent Publicly Available: Policies in force: 35,403;
Most Recent Publicly Available: Exposure: 14.5;
Change (percentage increase): Policies in force: 14,884; (73%);
Change (percentage increase): Exposure: 8.5; (141%).
State plan: Texas Windstorm Insurance Association;
2004: Policies in force: 103,503;
2004: Exposure: 20.8;
Most Recent Publicly Available: Policies in force: 199,085;
Most Recent Publicly Available: Exposure: 53.7;
Change (percentage increase): Policies in force: 95,582; (92%);
Change (percentage increase): Exposure: 32.9; (158%).
State plan: Total;
2004: Policies in force: 1,274,293;
2004: Exposure: $284.1;
Most Recent Publicly Available: Policies in force: 1,866,680;
Most Recent Publicly Available: Exposure: $595.7;
Change (percentage increase): Policies in force: 592,387 (46%);
Change (percentage increase): Exposure: $311.6 (109%).
Source: GAO analysis of state wind insurance program public financial
statements.
Note: Some states offer coverage for perils other than wind, including
hail, fire, and broader homeowners coverage. However, policy limits are
not based on the type of damage, so the exposure from wind damage is
equal to the policy limit, regardless of whether the policy includes
other types of coverage. Date of latest information publicly available
as of February 2008: Alabama--September 2007, Florida--April 2007,
Georgia--September 2007, Louisiana--March 2007, Mississippi--December
2006, North Carolina--June 2007, South Carolina--July 2007, Texas--
August 2007.
[End of table]
Further, to the extent that the federal program insures properties that
were previously insured through state wind programs, it could also
reduce costs that some state residents pay to support the state wind
programs. Some state wind insurance programs provide that if premiums
are inadequate to cover the programs losses, the program can assess
insurers operating within the state to make up the difference. For
example, in 2005 the state of Florida assessed insurers a total of $163
million to fund the deficit in its state wind insurance program
(Florida Citizens), while the state of Mississippi assessed insurers
$525 million to cover losses incurred by its wind program. Some states
also use other methods to pay wind insurance program deficits, but
ultimately taxpayers also cover those costs. For example, Florida
Citizens also issued bonds totaling almost $5 billion and arranged for
a $1 billion line of credit to cover losses following the 2005
hurricane season, and the state of Louisiana issued bonds for
approximately $978 billion. States generally allow insurers to pass
along the costs of these assessments to their policyholders, so the
costs of such assessments and financing arrangements are primarily born
by insurers and insureds within those states. To the extent that a
federal program could reduce losses to state wind insurance programs,
it could reduce the costs to insurers and policyholders.
These benefits could, however, be limited by the provision within H.R.
3121 that prevents FEMA from selling new or renewing existing policies
if it borrows funds to pay claims. As noted earlier in this report,
FEMA could find it difficult to determine premium rates adequate to
cover expected losses, especially catastrophic losses. If the program
is unable to pay losses in any year, it could trigger the program's
borrowing restriction and effectively end the program. Ending the
program, especially following a catastrophic event, could leave
property owners without insurance coverage, which in many cases is
required by mortgage lenders, and with no means of buying such coverage
quickly. Several insurance industry and state regulatory officials said
that if a federal flood and wind insurance program were implemented, it
could displace state wind insurance programs and private sector
coverage in high-risk coastal areas. If it did, and then was
effectively terminated because of the borrowing restriction, property
owners might find themselves unable to quickly purchase new coverage
because state wind programs and private markets would not be prepared
to quickly offer such coverage, if at all. The situation would be
particularly difficult for property owners whose homes or buildings had
been destroyed. In this scenario, property owners could find themselves
without the appropriate insurance coverage, in violation of their
agreements with lenders.
Further, the relatively low coverage limits under a federal flood and
wind policy could leave some property owners without adequate
insurance. As we have seen, property owners in coastal areas subject to
both flood and wind damage can purchase flood insurance through the
NFIP and, in some areas, wind insurance through a state wind insurance
program. In table 1, we compared the policy limits for a federal flood
and wind policy, as proposed in H.R. 3121, with a combination of policy
limits from state wind insurance programs and the increased NFIP policy
limits proposed in H.R. 3121. As shown, the federal flood and wind
policy would provide less coverage than that provided by a combination
of NFIP and state wind program policies for both residential and
commercial properties. As a result, the comparatively lower policy
limits proposed for the federal flood and wind policy could leave some
property owners with significant exposure to losses.
In addition, the proposed federal flood and wind policy would cover
fewer perils than the combination of an NFIP flood policy and a state
wind insurance program policy, possibly creating gaps in coverage for
some property owners. For example, while flood and wind damages would
be covered under the proposed federal policy, all of the state wind
insurance programs we reviewed also covered hail damage, and several
insured against additional perils, such as fire. As a result, property
owners who purchased a combined federal policy as a replacement for
NFIP and state wind program coverage might no longer be insured for
certain perils or might have to purchase additional coverage in the
private market to eliminate any coverage gaps. The prospect of reduced
coverage or purchasing additional policies could make a federal flood
and wind policy less appealing to property owners.
Finally, the comparatively lower coverage limits and limited number of
perils covered could result in some property owners purchasing a
federal flood and wind policy as well as other coverage. In instances
where a property owner purchased additional wind coverage through a
private sector or state wind program policy, allocating damages between
a federal flood and wind policy and the additional policy would require
a determination of total wind damage. This determination would, in
turn, require a distinction between flood and wind damage, potentially
undercutting one of the primary goals of a federal flood and wind
program. And to avoid confusion or disputes over how losses would be
allocated among several policies, FEMA would need to reach agreement
with other insurers, in advance, as to how losses would be apportioned
across the separate insurance policies. For example, they would need to
agree on whether one policy would pay before another, or whether losses
would be divided up among policies and in what proportion.
Some Insurers Could Benefit from Reduced Exposure in High-Risk Areas:
Some insurers could benefit from a federal flood and wind program if
the program insured properties in high-risk areas that were previously
covered by private sector insurers. Several state insurance officials
told us that insurers in their states had been seeking to reduce their
exposure in high-risk coastal areas by writing fewer policies there. To
the extent that a federal program insured properties currently insured
by private sector insurers, those insurers would be less exposed to
losses from those high-risk properties. However, the extent to which
the federal program might insure properties currently insured by
private sector insurers would in large part be determined by the
premium rate for a federal program. If the federal policy were less
expensive than private coverage, property owners would be more likely
to move to the new program.
While a federal flood and wind program would not need to include
several costs that private insurers must generally include when
determining a premium rate adequate to cover all future costs--such as
the cost of capital or taxes--it is not clear that premium rates for a
federal program would be lower than those charged by insurers.[Footnote
26] We have noted that federal flood and wind insurance is most likely
to be appealing to property owners in only the high-risk coastal areas
where private sector insurers are trying to reduce their exposure.
According to several insurance industry officials we spoke with,
insurers are willing to write wind coverage in these areas if they can
charge premiums that cover their expected costs. While NAIC takes issue
with the claim, some insurance industry officials said that state
insurance regulators had denied premium rate increases necessary to
cover expected losses. To the extent that private sector insurers are
not charging premium rates for wind insurance that are adequate to
cover future costs in high-risk coastal areas, the rates for a federal
program that is charging such rates could be higher.
Further, while a federal flood and wind program would likely insure
primarily high-risk properties, private sector insurers currently sell
policies that include wind coverage in all geographic areas, including
medium-and low-risk areas. Such diversification allows insurers to
spread out the risks associated with catastrophic losses on high-risk
properties over a larger group of policyholders, possibly allowing
private sector insurers to charge lower premium rates on the highest-
risk properties as compared to rates for a federal flood and wind
program that does not experience such diversification. Further, private
sector insurers can generally supplement premium income with investment
income on funds that they hold, but a federal flood and wind program
would probably not have such an opportunity. Finally, competition among
private sector insurers can encourage insurers to operate more
efficiently and hence more profitably. A combined federal flood and
wind program would not be subject to such competition, and thus might
not operate as efficiently as private sector insurers.
While reducing private insurers' exposure to loss in high-risk areas
would benefit these insurers, it is not clear that the public in
general would benefit. In a previous report, we identified several
public policy goals that could be used to examine the advantages and
disadvantages of a federal role in the provision of catastrophe
insurance.[Footnote 27] One of these goals was to encourage private
markets to provide natural catastrophe reinsurance, thus reducing the
potential costs to taxpayers. A federal wind and flood program that
insured property owners who had previously had private insurance would
not further that goal. To the extent that the federal program displaced
coverage currently provided by the private market, it could actually
shift more of the risk of loss to taxpayers.
Program Could Expose the Federal Government to an Increased Risk of
Loss:
Although a combined flood and wind program could provide benefits to
some property owners, states, and insurers, it could expose the federal
government to an increased exposure to loss. While the actual exposure
that a federal flood and wind program might create is unclear, the
likelihood for the program to insure primarily high-risk properties
could create a large exposure to loss. As of 2007, wind programs in
eight coastal states--programs that insure primarily high-risk coastal
properties--had a total loss exposure of nearly $600 billion . While it
is unclear how much of this exposure would be assumed by the federal
program, a risk management consulting firm developed another estimate
of potential wind-related losses that took into account the federal
program's likely adverse selection. [Footnote 28] Assuming that the
program experienced just a moderate amount of adverse selection, and
that the program would write coverage for around 20 percent of the
current market for wind coverage, the firm used wind modeling
technology to estimate the potential wind-related losses. The estimates
ranged from around $6.5 billion in losses for the type of catastrophe
that has a 10 percent chance of occurring each year, $11.4 billion for
one that has a 5 percent chance of occurring each year, to around $32.7
billion for the type that has a 1 percent chance of occurring each
year. The same firm that did the modeling for this estimate considered
Hurricane Katrina to be the type of event that has a 6.6 percent chance
of occurring in any year. For purposes of comparison, NFIP flood losses
from Hurricane Katrina alone totaled around $16 billion, and according
to the Insurance Services Office, losses paid by private sector
insurers--most of which were wind-related--totaled around $41 billion.
[Footnote 29]
The potential exposure to the federal government, however, could be
reduced by several factors. First, the program could encourage
mitigation efforts that would reduce damage from wind. As noted earlier
in this report, H.R. 3121 would require communities to adopt mitigation
standards approved by the Director of FEMA and consistent with
International Code Council building codes related to wind mitigation.
In addition, H.R. 3121 would require the Director of FEMA to carry out
studies and investigations to determine appropriate wind hazard
prevention measures. Further, according to FEMA, the CRS structure
could be applied to a federal flood and wind program, reducing premium
rates for communities and property owners that implemented wind
mitigation measures. Such measures could reduce losses due to wind
damage and thus the federal government's exposure to loss. Second, the
federal government's exposure is potentially limited to the amount FEMA
is authorized to borrow from the Treasury, which was raised to $20.8
billion in March of 2006. However, if losses were to exceed this limit,
Congress would be faced with raising the amount FEMA could borrow,
thereby increasing the government's exposure or failing to pay
policyholders up to the full amounts specified in their policies.
While H.R. 3121 would require a federal flood and wind program to
charge premium rates that were adequate to pay all future losses in
order not to create additional liability for the federal government, as
we have seen, estimating future losses is difficult, and losses can
exceed expectations. For example, losses from Hurricane Katrina and
other hurricanes were beyond what NFIP could pay with the premiums it
had collected. NFIP reported unexpended cash of approximately $1
billion following fiscal year 2004, but as of May 2007 the program had
suffered almost $16 billion in losses from Hurricane Katrina. In
addition, officials from several wind-modeling companies told us that
the severity of Hurricane Katrina was well beyond their previous
expectations, and rates that they had believed were actuarially sound
turned out to be inadequate. As a result, they have had to revise their
models accordingly. If losses for a combined flood and wind program did
exceed the premiums collected by the program, FEMA could be forced to
borrow from the Treasury to pay those losses. As of December 2007, FEMA
still owed approximately $17.3 billion to the Treasury, an amount it is
unlikely able to repay. In addition, the requirement in H.R. 3121 to
stop renewing or selling new polices until such losses are repaid could
actually increase the cost to the federal government. This is because
the program's source of revenue, which it could use to pay back the
borrowed funds, would be limited to premiums paid by those whose
policies had not yet come up for renewal. And once those policies
expired, the program would receive no premium income. It is not clear
how any debt remaining outstanding at that time would be paid, and the
costs could fall to the federal government and, ultimately, taxpayers.
Agency Comments and Our Evaluation:
We requested comments on a draft from FEMA and NAIC. FEMA provided
written comments that are reprinted in appendix II. NAIC orally
commented that they generally agreed with our report findings. FEMA
also generally agreed with our findings and emphasized the challenges
it would face in addressing several key issues. Finally, FEMA provided
technical comments, which we incorporated as appropriate.
In their comments, FEMA officials stressed their concerns over the
effect that the program's proposed borrowing restriction would have on
their ability to set adequate premium rates. Specifically, they said
that:
* It would be nearly impossible to set premium rates high enough to
eliminate the possibility of borrowing to pay catastrophic losses.
* Purchasing enough reinsurance to pay all catastrophic losses without
borrowing, even if it were possible, would require premium rates so
high as to be unaffordable.
* The high variability of combined flood and wind coverage means that
there is always the possibility of catastrophic losses in any given
year regardless of how premiums are designed.
In addition, FEMA officials said that the termination of the program
due to the borrowing restriction would create other difficulties. They
said that not only could it leave property owners without coverage, but
it could also prevent the program from repaying any borrowed funds.
As stated in our report, the proposed borrowing restrictions would make
rate setting a difficult and challenging process, and could result in
high premium rates. In addition, we stated that termination of the
program due to the borrowing restriction could potentially leave some
property owners uninsured following a catastrophic event and limit
FEMA's ability to repay any borrowed funds. Finally, we acknowledged
that the high variability of flood and wind losses would make setting
rates adequate to pay losses without borrowing even more challenging,
and we clarified language in the report that the risk of catastrophic
losses could occur in any year regardless of how premiums are designed.
As agreed with your offices, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from the report date. At that time, we will send copies to the Ranking
Member of the Committee on Financial Services, House of
Representatives; the Chairman and Ranking Member of the Committee on
Banking, Housing, and Urban Affairs, U.S. Senate; the Chairman and
Ranking Member of the Committee on Homeland Security and Governmental
Affairs, U.S. Senate; the Chairman and Ranking Member of the Committee
on Homeland Security, House of Representatives; the Secretary of
Homeland Security; the Executive Vice-President of NAIC; and other
interested committees and parties. We will also make copies available
to others on request. In addition, the report will be available at no
charge on the GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions about this report, please
contact me at (202) 512-8678 or williamso@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major contributions
to this report are listed in appendix III.
Signed by:
Orice M. Williams:
Director:
Financial Markets and Community Investment:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
Our objective was to examine the proposed federal flood and wind
insurance program put forth in H.R. 3121, the Flood Insurance Reform
and Modernization Act of 2007, in terms of (1) the program's potential
effects on policyholders, insurance market participants, and the
federal government; (2) what would be required for Federal Emergency
Management Agency (FEMA) to determine and charge actuarially sound
premium rates; and (3) the steps FEMA would have to take to implement
the program.
To evaluate the program's potential effects on policyholders, insurance
market participants, and the federal government, we interviewed
officials from the FEMA, the National Flood Insurance Program (NFIP),
state insurance regulators, the National Association of Insurance
Commissioners (NAIC), state wind insurance program operators, primary
insurers, reinsurers, insurance and reinsurance associations, insurance
agent associations, risk-modeling organizations, actuarial consultants,
the American Academy of Actuaries (AAA), the Association of State Flood
Plain Managers (ASFPM), the National Flood Determination Association
(NFDA), and others. We also obtained information on state-sponsored
wind insurance programs in three coastal states and one inland state,
and discussed them with program officials as well as the insurance
regulators within those states. We compared selected wind insurance
program policies in force and exposure data from 2004 to the most
recent available in eight states: Alabama, Florida, Georgia, Louisiana,
Mississippi, North Carolina, South Carolina, and Texas. We also
collected and analyzed state wind program data from these eight states
and provisions of H.R. 3121 to compare the combination of state wind
program and H.R. 3121's flood insurance policy limits with H.R. 3121's
flood and wind policy limits. To develop our natural hazard risk maps,
we used data from FEMA and the National Oceanic and Atmospheric
Administration (NOAA). We used historical hazard data from 1980 to 2005
as a representation of current hazard risk for flood, hurricanes, and
tornadoes. Finally, to evaluate the federal government's exposure, we
reviewed an estimate of potential wind-related losses for a federal
program from an actuarial consulting firm.
To examine the challenges FEMA would likely face in determining and
charging a premium rate that would cover all expected costs, we spoke
with FEMA/NFIP officials, state insurance regulators, NAIC, state wind
insurance program operators, primary insurers, reinsurers, insurance
and reinsurance associations, insurance agent associations, risk-
modeling organizations, actuarial consultants, AAA, ASFPM, NFDA, and
others. We also reviewed our previous reports and testimonies,
Congressional Budget Office (CBO) reviews, and academic and other
studies of coastal wind insurance issues. In addition, we reviewed
information provided by professional associations, such as the American
Insurance Association, and congressional testimony by knowledgeable
individuals from the insurance industry, ASFPM, and NFDA.
To examine the challenges FEMA would face in developing and
implementing a federal flood and wind insurance program, we discussed
the issue with FEMA/NFIP officials, state insurance regulators, NAIC,
state wind insurance program operators, primary insurers, reinsurers,
insurance and reinsurance associations, insurance agent associations,
risk-modeling organizations, actuarial consultants, AAA, ASFPM, NFDA,
and others. We also reviewed our previous reports on FEMA's management
and oversight of NFIP. In addition, we reviewed congressional testimony
by knowledgeable individuals from the insurance industry, ASFPM, and
NFDA.
We conducted our work in Washington, D.C., and via telephone from
October 2006 to April 2007 in accordance with generally accepted
government auditing standards. Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide
a reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.
[End of section]
Appendix II: Comments from the Federal Emergency Management Agency:
U.S. Department of Homeland Security:
FEMA:
[hyperlink, http://www.fema.gov]:
500 C Street, SW:
Washington, DC 20472:
April 15, 2008
Orice M. Williams:
Director:
Financial Markets and Community Investments:
United States Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
RE: GAO Draft Report, Natural Catastrophe Insurance: Analysis of a
Proposed Combined Flood and Wind Insurance Program (GAO-08-504):
Dear Ms. Williams:
Thank you for providing the Department of Homeland Security, Federal
Emergency Management Agency (FEMA), the opportunity to review and
comment on the GAO draft report, Natural Catastrophe Insurance:
Analysis of a Proposed Combined Flood and Wind Insurance Program.
FEMA has completed its review and commends the GAO for writing an
excellent and well researched report that clearly lays out the issues
and challenges in designing and implementing the combined federal flood
and wind insurance program contemplated in H.R.3121. However, we would
like to make the following comments which primarily concern the
emphasis placed on several key issues:
* The draft report states in numerous places the conundrum regarding
the H.R.3121 requirement that the Federal Multi-peril Program would
essentially have to terminate if it ever had to borrow from the
Department of Treasury. As noted in the report there are serious
problems with that requirement, as follows:
(1) setting rates would be next to impossible if the premiums had to be
set high enough to eliminate the possibility of borrowing;
(2) terminating the program abruptly would leave policyholders in the
lurch without coverage; and;
(3) when the program was forced to terminate, the loan could never be
paid back because the premium revenues would stop.
FEMA recommends that these points be stated comprehensively in the
beginning of the report and be given more emphasis. For example, item
#3 listed above, is a key point but it is not referenced until at the
end of the report.
* The draft report states in numerous places that setting the premium
rates would be "difficult." It also states numerous reasons why setting
the rates is difficult. However, the statements do not adequately
convey the magnitude of the problem. As noted above, the H.R.3121
requirement to terminate the program, if and when borrowing would be
required, makes the setting of adequate premium rates nearly
impossible. There are only three ways that to preclude the possibility
of borrowing, none of which would be practical:
(1) Purchase comprehensive reinsurance so that the catastrophic risks
are assumed by the reinsurers. The draft report documents the problems
with a reinsurance approach. Even if the Program could purchase such
comprehensive reinsurance, the size of the premiums required to support
it would make the Program unaffordable to homeowners;
(2) Establish such high premium rates that all conceivable catastrophic
risks would be covered even if large loss events occurred early in the
Program. Again, the magnitude of those rates would mean that few could
afford to purchase the insurance; or;
(3) Incorporate sufficient restrictions and exclusions in the coverage
to protect the Program against catastrophic losses. However, that
approach would negate one of the goals of the Program which is to
provide security to homeowners located in high risk areas.
* The report contains a statement that could easily be misinterpreted.
On Page 4/42, it states:
"Under the proposed legislation, if FEMA set premium rates too low and
needed to borrow to pay claims, the program would have to stop renewing
or selling new policies, and thus would effectively terminate."
Comment: As written, this statement implies there is some level of
premium rates that would assure borrowing would never be needed.
However, that implication is erroneous because there is almost no level
of premiums that could give this type of assurance. For example, if in
the first year of its existence the Program is impacted by a
catastrophic event, borrowing would be unavoidable. Therefore, the
report should clearly indicate that the combination of wind and flood
coverage is a highly volatile and risky line of insurance and that
there is always the probability of catastrophic losses occurring in any
given year regardless of how the premiums are designed. FEMA recommends
that the following sentences replace the text above:
"Under the proposed legislation, if FEMA needed to borrow to pay
insurance claims, the Program would have to stop both renewing in force
policies and selling new policies, and thus would effectively
terminate. Realistically, because possible losses under the combination
of wind & flood coverage are so highly variable from year to year,
there is little chance of designing a program with premiums adequate
enough to preclude the chance of borrowing."
If you need additional information, please contact me by telephone at
202-646-2780.
Sincerely,
Signed by:
David I. Maurstad:
Assistant Administrator:
Mitigation Directorate:
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice M. Williams, (202) 512-8678 or williamso@gao.gov.
Staff Acknowledgments:
In addition to the person named above, Lawrence D. Cluff, Assistant
Director; Farah B. Angersola; Joseph A. Applebaum; Tania L. Calhoun;
Emily R. Chalmers; William R. Chatlos; Thomas J. McCool; Marc W.
Molino; and Patrick A. Ward made key contributions to this report.
[End of section]
Footnotes:
[1] H.R. 3121 uses the term "multi-peril coverage," which it defines as
covering losses from physical damage resulting only from flooding or
windstorm. For purposes of this report we will use the term "flood and
wind coverage" to more specifically indicate the nature of the coverage
provided.
[2] GAO, Natural Disasters: Public Policy Options for Changing the
Federal Role in Natural Catastrophe Insurance, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-08-7] (Washington, D.C.:
Nov. 26, 2007).
[3] Karen M. Clark, "The Coastline at Risk: Estimated Insured Value of
Coastal Properties," AIR Worldwide Corporation (Boston, Massachusetts:
Sept. 2005).
[4] The National Flood Insurance Act of 1968, as amended, is codified
at 42 U.S.C. §§ 4001 et seq.
[5] GAO, National Flood Insurance Program: Greater Transparency and
Oversight of Wind and Flood Damage Determinations are Needed, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-08-28] (Washington, D.C.:
Dec. 28, 2007).
[6] The International Code Council is a membership association
dedicated to building safety and fire prevention. It develops the codes
used to construct residential and commercial buildings, including homes
and schools.
[7] National Flood Insurance Act of 1968, Pub.L No. 90-448, § 1302 (d),
82 Stat. 476, 572 (1968), codified at 42 U.S.C. § 4001(d).
[8] Id, at Section 1302(a)(4), codified at 42 U.S.C. § 4001(a)(4).
[9] GAO, Flood Insurance: Information on the Financial Condition of the
National Flood Insurance Program, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-01-992T] (Washington, D.C.: July
19, 2001).
[10] See 42 U.S.C. § 4016.
[11] See GAO, Federal Emergency Management Agency: Challenges for the
National Flood Insurance Program, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-06-335T] (Washington, D.C.: Jan.
25, 2006).
[12] GAO, Natural Hazard Mitigation: Various Mitigation Efforts Exist,
but Federal Efforts Do Not Provide a Comprehensive Strategic Framework,
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-403]
(Washington, D.C.: Aug. 22, 2007).
[13] [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-403].
[14] The CRS is a voluntary incentive program that recognizes and
encourages community floodplain management activities that exceed the
minimum NFIP requirements, and as a result, flood insurance premium
rates are discounted to reflect the reduced flood risk resulting from
the community actions.
[15] NFIP contracts with private insurers to sell and administer flood
insurance policies through the WYO arrangement, allowing the insurers
to write flood policies backed by the federal government.
[16] GAO, NFIP: Oversight of Policy Issuance and Claims, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-532T] (Washington, D.C.
Apr. 14, 2005)
[17] According to insurance market participants, many, if not all,
insurance companies and state authorities currently use computer
programs offered by several modeling firms to estimate the financial
consequences of various natural catastrophe scenarios and manage their
financial exposures. To generate the loss estimates, the computer
programs use large databases that catalog the past incidence and
severity of natural catastrophes as well as proprietary insurance
company data on policies written in particular states or areas. Using
the estimates provided by these computer programs, insurers can attempt
to manage their exposures in particular high-risk areas. GAO,
Catastrophe Risk: U.S. and European Approaches to Insure Natural
Catastrophe and Insurance Risks, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-199] (Washington, D.C.: Feb. 28,
2005).
[18] GAO, Federal Emergency Management Agency: Challenges for the
National Flood Insurance Program, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-06-335T] (Washington, D.C.: Jan.
25, 2006).
[19] GAO, GAO's High-Risk Program, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-06-497T] (Washington, D.C.: Mar.
15, 2006).
[20] GAO, Federal Emergency Management Agency: Ongoing Challenges
Facing the National Flood Insurance Program, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-08-118T] (Washington,
D.C.: Oct. 2, 2007).
[21] [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-28].
[22] [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-118T].
[23] In areas known as Special Flood Hazard Areas, federally insured or
regulated lenders require borrowers to purchase flood insurance because
of the risk of flood damage.
[24] Officials from several state wind insurance programs said that
they have not been allowed by state insurance regulators to charge
rates sufficient to pay expected future losses, as evidenced by denials
of rate increases and assessments on private market insurers to help
pay state wind program losses.
[25] [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-28].
[26] The cost of capital is the return required by investors to
compensate them for putting their money at risk by investing in a
company.
[27] [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-7].
[28] Tillinghast, Towers, Perrin, "Analysis of H.R. 920, 'Multiple
Peril Insurance Act of 2007'" (Washington, D.C.: July 2007). H.R. 920
proposed a federal multi-peril insurance program and was essentially
incorporated into H.R. 3121. We did not verify the methodology or
results of this analysis.
[29] The Insurance Services Office is a provider of data and analytics
for the risk management industry.
[End of section]
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