Catastrophic floods have been damaging homes for as long as people have had permanent dwellings. They can cause devastating losses to homeowners and businesses alike almost anywhere in the U.S., both on and off of established flood plains.

Exacerbating the impact of floods is the fact that flood insurance, the product that should serve as the primary backstop against these types of losses, is not widespread. Outside of dedicated government-funded programs and a limited set of specialty policies, flood coverage is extremely limited, and only a small fraction of those risk-exposed residential and commercial properties have any real source of financial protection.

A Program Destined to Fail

At the time of its founding, the U.S. National Flood Insurance Program (NFIP) had the best intentions of its lawmakers at heart. Flood insurance had once been a covered provision in a typical homeowners policy. However, as a result of a series of damaging floods that took place in the U.S. during the 1950s and ’60s, payouts from flooding consistently exceeded the premiums this coverage generated. The policies had simply proved to be unprofitable, and flood coverage was almost entirely eliminated.

To ease the burden of risk borne by homeowners in flood-exposed regions, the federal government established the NFIP in 1968. Its purpose was to enable homeowners to purchase insurance for flood events directly from the government. Originally intended as a way to lessen the burden on individuals by pooling flood risks nationally while also incentivizing flood risk management, the NFIP has since evolved away from serving its purpose.

Because its aim from the start was to provide affordable coverage for at-risk property owners, the insurance provided by the NFIP has never been subject to actuarially sound rates. Presently, there are more than five million properties covered by the NFIP, and as many as a fifth of them are subject to rates that are less than half the price a private insurer would need to charge. According to a report from the Union of Concerned Scientists, as of November 2012, the NFIP was more than $20 billion in debt, forcing a program once intended to be self-sufficient to look for special subsidies and borrow heavily from the government.

Despite the admirable aims of the legislators who wrote and enacted the NFIP, the goal of providing affordable insurance to home and business owners in some of the most at-risk flood areas has, sadly but inevitably, resulted in a case of significant adverse selection: a small percentage of covered properties are responsible for a disproportionately large amount of the payouts made. Indeed, in some areas, individual properties that have been flooded more than a dozen times continue to receive federal aid after flood events, with no commensurate increase in premiums. Running the program this way has led to a large number of property owners living in flood-exposed regions effectively receiving a government subsidy to continue to do so.

Recent Reforms Pave the Way for Change

These types of “subsidies” for property owners in flood-exposed areas cannot continue if the NFIP is ever to conquer its mounting debt. Lawmakers have long recognized this problem and continue to seek ways to remedy the situation.

The NFIP has undergone many changes and improvements in recent years, starting with the Biggert-Waters Reform Act of 2012. Some of the most notable changes include revising existing rates and updating mapping information, which have changed flood classifications for some policyholders. In an effort to reduce the deficits accrued by the NFIP, this new program required that the rates charged by the NFIP be actuarially sound—resulting in massive rate increases for policyholders in some of the most at-risk locations.

These rate increases provided an opportunity for the insurance industry to step in and provide alternative coverage to that offered by the NFIP. However, in practice, this proposition was fraught with complications. Some state insurance commissioners wanted private insurers to change policy terms to provide added protection, such as different deductibles or additional replacement cost protection. Others wanted to retain NFIP terms entirely.

Furthermore, many banks have not provided clear guidance as to what they deem to be acceptable as flood insurance, and some have been reluctant to accept policy wording that is not identical to the NFIP’s. This uncertainty restricts the ability of the customer to choose private coverage.

Fortunately, insurance companies have several tools at their disposal that were not available historically. In particular:

• FEMA has been updating flood maps and has converted them into an electronic format, making zonal determination easier for an agent.
• Mapping technology has improved, which allows for an alternative (or updated) view of risk, especially in areas that may not have an updated FEMA evaluation.
• Probabilistic flood modeling provides insurance companies with the ability to manage aggregate exposures and evaluate the impact of different financial structures.

These tools enable companies to more accurately assess the inherent flood risk of a particular property. This, in turn, can reveal opportunities for profitable expansion into areas that before had been deemed unacceptable due to the perceived risk of flooding. The coarsely defined flood maps that had previously been used to determine rates made it impossible for insurers to perform intelligent risk selection. Now insurers have the tools necessary to assess risk at a much finer granularity, revealing previously invisible and thus undiscovered opportunities.

To help ease regulatory restrictions, allow more access to this market to third-party insurers and give customers more choice in flood coverage beyond mandated NFIP protection, Rep. Dennis Ross, R-FL, resubmitted the Flood Insurance Market Parity and Modernization Actas a bill to the House on June 25, 2015. (Sen. Dean Heller, R-NV, submitted the sister bill to the Senate.) Key provisions of these bills include the following:

• Banks will be allowed to accept flood policies from insurance companies to satisfy mortgage protection requirements.
• State insurance commissioners would approve policy wordings and rates, as is already done for other insured perils.
• Both admitted and nonadmitted policies would satisfy the flood insurance requirement.
• The required flood insurance purchase would be lowered to the least of three values: the home value, the outstanding mortgage loan balance or the maximum NFIP policy limits available.

How Private Insurance Can Help Fix the Problem

Effectively, these bills would open the door for insurance companies to compete directly with the NFIP and would help guide the approvals of state insurance regulators. With the acceptance of these bills, insurance companies would be able to write standalone policies, have proper endorsements, allow customers to choose from a range of deductibles and provide additional protection above the NFIP. These are all issues that have plagued adjusters for years. While there is no opposition to the bills, due to the full docket in Congress, they are unlikely to make it to the floor for voting without the support of the insurance industry.

One area where these provisions are being given a chance to work is the Florida insurance market. Florida represents about 40 percent of the NFIP’s total market and is composed primarily of property owners located in off-flood-plain regions. To comply with the legal provisions designed to restore the NFIP to solvency, some homeowners there are facing rate increases as large as 80 percent over the rates of their current policies. Among this pool of policyholders, almost all of whom are located in eight coastal counties, the inception-to-loss ratio is a mere 15 percent of the total premiums collected from these policyholders. While this loss ratio is, in part, due to the 10-year “hurricane drought” that is currently affecting the state of Florida, it nonetheless represents a significant opportunity for private insurance companies to step in and profitably offer more affordable coverage than the NFIP while providing even more comprehensive coverage.

While this situation is not the same in every state across the U.S., it provides a representative example of how insurance companies can use new tools and better data to supplement or even replace the coverage provided by the NFIP in many areas without incurring an unacceptable amount of risk. Similar cases can be found throughout the U.S.; it is only a question of when the federal government and the state departments of insurance will recognize that there is room for private insurers to compete with the NFIP in providing flood coverage, thereby reducing the burden placed on taxpayers forced to fund an unprofitable system.

The evolution of flood insurance regulation is opening up new opportunities for the insurance industry to provide coverage for a peril that has been historically avoided. With the increase in NFIP rates and the introduction of robust probabilistic flood modeling tools, the maturation of a private flood insurance market will provide customers with more choice in the protection they purchase for their homes.