Horn2020.Flood

Reading: "Private Flood Insurance and the National Flood Insurance Program,” updated December 21, 2021, Congressional Research Service R45242, Summary and pp. 1-21.

Author: Horn, D. and Webel, B.

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Study Tips

Note: This wiki article is called "Horn2020.Flood", but the article below refers to the most recent version, which is 2021. The reason I didn't change the name of the wiki article is that doing so would have required a bunch of other nuisance changes in the database. (I really shouldn't have put the year in the name of the wiki article but I didn't realize this reading was going to be updated again so soon.)

The syllabus has had 3 very different flood insurance readings over the short time span between 2018.Spring and 2019.Fall. That makes it harder to predict likely questions because questions from those older readings may not be relevant. Interestingly, the previous flood reading was also by Horn (Horn & Brown) and the current reading is by Horn & Webel. It is completely different. Still, it might be valuable to review the 1 previous exam question from Horn & Brown version. That wiki article has been archived here.

The 2020 version of the Horn & Webel reading, introduced for the 2021.Fall exam, does not contain any significant differences from the 2019 version.

I think a very likely exam question would be to identify and briefly describe issues & barriers to greater private offering of flood insurance. Then a related question would be how these issues could be addressed. Not that I would ignore everything else, but if you're pressed for time and want to prioritize, I would cover that subsection first. Click here for direct link.

This is an easy reading but it has a lot of memorization.

Estimated Study Time: 1-2 days (not including subsequent review time)

BattleTable

• this reading is new for 2019.Fall, but there has always been some sort of flood reading on the syllabus

Questions held out from Fall 2019 exam: #8. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2019.Spring #8)	NFIP: - reasons for inception	NFIP: - subsidies	NFIP: - participation rates

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In Plain English!

Preliminary

The increase in hurricanes and floods has put a financial strain on the NFIP (National Flood Insurance Program). A longer-term solution is to expand the availability of private flood insurance and that's the topic of this reading. Use the direct link below for a good summary.

Summary (from source text)

Background on NFIP

General Information

Let's cover some basic facts about NFIP and how it operates. The primary reason for the existence of the program is to fill an unmet need in the marketplace. If private insurers charged actuarially sound rates, flood coverage would likely be unaffordable to those in high-risk areas who need it the most.

Question: briefly describe the National Flood Insurance Program

• a federal flood insurance program administered by FEMA (Federal Emergency Management Agency)
• main provider of primary residential flood coverage (versus private flood insurance)
• involves private insurers and all tiers of government
• created in 1968 and participation is (mostly) voluntary  ←shout-out to downthesun! (see here for an exception)

Note that most other P&C risks (fire, accidents,...) are handled by private insurance. A primary reason for the creation of NFIP in 1968 was withdrawal of private flood insurance from the market (although private insurers still write and service policies underwritten by NFIP.) That left federal disaster relief as the only means of recovery for flood victims. Dealing with a disaster only after the disaster has occurred is an inefficient way to structure a program. If people in a high-risk area know they'll receive disaster relief, they may be less likely to take steps to mitigate losses before the flood occurs. (This is a moral hazard.)

The design of NFIP is guided by its policy goals. (Click for a forum post with an slightly different memory trick to the one I've given below. Shout-out to ActuariesAreNerds!)

Question: what are the policy goals of NFIP [Hint: AM&R]

1. Access:

   → provide access to primary insurance (transfers some of the financial risk to the federal government)

2. Mitigate & Reduce:

   → mitigate & reduce flood risk through floodplain management standards

Horn & Webel draw a distinction between policy goals versus objectives. Alice isn't really sure what the difference is, but she advises memorizing their wording. It seems that policy goals are more general, and objectives are more specific.

Question: what are the objectives of NFIP, according to Horn & Webel [Hint: RASH]

Risk-based premiums

Affordability

Sustainability (premiums should cover claims costs & expenses)

High participation rates

Note that for high-risk insureds, the objectives of risk-based premiums and affordability may conflict with each other.

Since NFIP is a government insurance program, it is designed differently from private insurance.

Question: identify ways that NFIP is different from traditional private insurance

social goals: (of NFIP)

   - provides coverage to high-risk customers who would not be able to obtain affordable coverage in the private market

non-insurance goals:

   distribute flood maps (to assist with flood-risk management)

   require land use and building standards for participation in NFIP

   reduce the need for other post-flood disaster aid

   fund rebuilding after a flood (makes it easier for people to recover)

   protect lenders against mortgage defaults due to uninsured losses

Alice-the-Actuary is training Ian-the-Intern in flood management practices, but Ian is already getting bogged down with all these lists to memorize. To help him, Alice related to him this story:

Diego-the-Dutiful runs a farm with his husband and has always taken steps to manage his business risks. His farm is near a river but has historically been subject to a low flood risk. Over the past 15 years however, the frequency and severity of weather events has increased substantially. The nearby river has overflowed 3 times in 10 years, causing significant flood damage to his land and buildings.

Fortunately, Diego has always purchased flood insurance through NFIP, and NFIP helps fund rebuilding after a flood. But NFIP has just distributed updated flood maps to reflect current climate trends. Since he is now officially in a high flood-risk area, NFIP requires him to upgrade his buildings to mitigate damage. If he doesn't do this, he will not qualify for coverage under NFIP.

If Diego follows through and upgrades his buildings to the new standards, it will reduce the need for other post-disaster aid. Unfortunately, not every farmer is as dutiful as Diego, and some farmers, wanting to save money in the short-term, won't upgrade their buildings. That means they can't get flood insurance through NFIP. If they have a mortgage on their buildings and the buildings are destroyed, the lenders will be left high and dry, so to speak. The farmer can't pay back the loan and the collateral is destroyed. The last non-insurance goal of NFIP is to protect lenders against this scenario of mortgage default.

Memory trick: NFIP's social goal of availability & affordability is easy to remember. For the non-insurance goals, just remember the 5 words in brown font:

• distribute – require – reduce – fund – protect

Alternate memory trick: If the one above doesn't work for you, there is another one in this forum post.  ←shout-out to Comadiroma!

Oh no! Yet another memory trick! Now there's no excuse for anyone to get this question wrong!: Same link as above: this forum post.  ←shout-out to anonact!

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A Few Details

Let's now start getting into the details of NFIP. It's helpful to define a couple of abbreviations:

• FIRMs = Flood Insurance Risk Maps
• SFHAs = Special Flood Hazard Areas (these are high-risk flood hazard areas)

Memorize this:

FEMA makes FIRMs FIRMs identify SFHAs

In other words: FEMA. FIRMs. SFHAs. (Bears. Beets. Battlestar Galactica ← joke...see The Office Season 3, Episode 20)

Question: identify situations where purchase of flood insurance is mandatory

• for property owners in a SFHA with a federally backed mortgage
• when a mortgage lender specifically requires participation (even if outside a SFHA)

Note that flood insurance is available through the private market, but to satisfy a lender's requirement, private insurance coverage must be at least as broad as what is available through NFIP.

Question: briefly describe flood insurance pricing & subsidies through NFIP

• rates should be risk-based but Congress has authorized FEMA to admit certain exceptions as follows:

pre-FIRM: properties built or improved before December 31, 1974, or before the first FIRM for their community (whichever is later)

newly mapped: properties mapped to a SFHA on/after April 1, 2015 (if applicant obtains coverage within 12 months of map revision date)

grandfathered: properties originally built in compliance with FIRM (even if they are subsequently mapped into a higher-priced class)

It's a running joke (but not really that funny) that the U.S. Congress is unable to agree on anything. The reauthorization of NFIP is no exception. Several short-term reauthorizations have been enacted but no comprehensive, long-term version. An important goal is to encourage the private market to participate more fully in flood insurance. The various proposed bills, none passed, differ significantly in their approach to this issue.

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Current Role of Private Insurers in NFIP

Even though NFIP bears most of the risk in providing flood insurance, private insurers have always been involved in one way or another.

Question: identify ways that private insurers can be involved in the flood insurance market

• service policies (marketing, selling, writing, claims management)
• share risk with FEMA  ← DELETED in current version of Horn and Webel source text – it's the same the "reinsurer" bullet point below (shout-out to ZB!)
• assume full risk as primary insurer
• assume a portion of risk as a reinsurer

In terms of the first bullet point above, there are 2 possible arrangements.

Question: describe the 2 specific servicing arrangements available to private companies within the NFIP framework

Direct Servicing Agent (DSA):  ← shout-out to AP!

- private contractor for FEMA

- facilitates purchase of flood insurance directly from NFIP

Write-Your-Own program (WYO):

- private companies directly write and service policies themselves

- the majority of NFIP policies are currently written through WYO

Note that for both types of servicing arrangements, NFIP retains the financial risk. The 116th Congress passed a set of rules regarding reimbursement paid to a WYO but this seems too detailed to be asked on the exam. (If you're interested, the reimbursement rules are explained in the paragraph right before the reinsurance section on page 7 of the source text.)

Also, policy terms & premiums are the same through DSA & WYO. Sweet deal! It works the same way in crop insurance - remember Alice's cousin, Fanny the Farmer? Anyway, DSA accounts for around 13% of the NFIP portfolio. Pop Quiz: What percentage does WYO account for? (Hint: DSA + WYO = 100%. Duh.)

Congress permits FEMA to use private reinsurance and/or capital markets as a risk management tool for NFIP.

Question: briefly describe the NFIP risk management tools of private reinsurance and capital markets

• private reinsurance:

   - purchase from a varied group of reinsurers with each bearing part of the risk

• capital markets:

   - catastrophe bond reinsurance is facilitated by a single company

   - risk is then transferred to capital market investors who purchase the bonds

   - investors pay a certain percentage of the losses from a single, large scale event

Question: describe advantages & disadvantages in using private reinsurance for NFIP

advantages:

   - FEMA knows the cost of (some) of its flood risk up front instead of borrowing from the Treasury after a flood (the cost is just the cost of the reinsurance policy)

   - reinsurance reduces the volatility of losses (this helps manage risk)

disadvantages:

   - expected value of long-term costs is higher because reinsurers must be compensated for assuming risk (in addition to paying out claims)

   - NFIP may have insufficient funds after reinsurance premiums to pay claims it retains

   - NFIP may have insufficient funds after reinsurance premiums to fulfill other goals & objectives like risk mitigation, flood mapping, improving NFIP rating structures

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Private Flood Insurance Outside NFIP: Issues & Barriers

Warning: More bullet point lists ahead. :-(

At the top of this article, we noted that NFIP came into existence in 1968 because private insurers had mostly withdrawn from the flood insurance market. Why? Well, they considered floods to be uninsurable.

Question: why do private insurers consider flood risk to be uninsurable

• catastrophic nature of flooding
• pricing difficulties (data is highly variable from year to year, unlike auto pricing which has a stable data history)
• adverse selection (only high-risk customers would purchase flood coverage)
• affordability (risk-based pricing could lead to unaffordable rates for high-risk customers who need it the most)

The reasons listed above are all kind of obvious. You guys have enough actuarial experience now that you could take an educated guess even if you hadn't specifically memorized the answer. Developing the ability to take educated guesses is part of the skill of doing well in exams, or doing well at work (or life in general.) The reason Alice the Actuary is so awesome is that she's good at forging ahead even when she feels totally lost. :-)

Ok, if private insurers consider flood risk to be uninsurable, why are private flood insurers still in the market? They write only a small portion of the primary residential flood risk, but they do have a niche.

Question: what are the most common types of private flood insurance

• commercial coverage
• secondary coverage (excess coverage above NFIP maximums, coverage for business interruption,...)
• lender-placed coverage (that's when a bank forces a borrower to obtain coverage to protect the bank's loan)

The next several pages within the source reading cover 7 issues & barriers regarding private flood insurance. There are too many details here and this is a good example of where you have to use judgement: What do you think is likely to be asked on the exam? You should definitely be able to list 3 or 4 of these barriers along with a brief description. I'd also recommend reading through these sections in the source text. That should take 10-15 minutes, even if you take a few notes. As I've mentioned before, you really can't read all 2,500 pages on the syllabus but every now and then it's good to look at the source text. It fleshes out your knowledge versus the highly summarized version in the wiki.

Question: identify and briefly describe issues & barriers to private flood insurance (tubaguy came up with a mnemomic for the issues. thx tubaguy!)

1. coverage must be "at least as broad" as NFIP coverage (might be hard to determine since policy forms can be written differently)
2. continuous coverage requirement (coverage must be continuous to retain NFIP premium subsidies, and a customer switching to private insurance may constitute a lapse in coverage)
3. non-compete clause (a private insurer who sells NFIP policies as a WYO carrier may not offer private coverage that competes with NFIP) ← removed, although possibly not permanently
4. NFIP subsidized rates (a private insurer can't compete with taxpayer-subsidized rates)
5. regulatory uncertainty (private coverage increases state involvement which increases compliance costs since each state may have different regulations)
6. accurate assessment of flood risk (private insurers don't have credible data, but due to the 1974 Privacy Act FEMA can't release NFIP data)
7. participation rates (necessary to manage & diversify portfolio, but even where flood insurance is mandatory participation can be low)

Adverse Selection Concerns: It is projected that the elimination of the non-compete clause will create adverse selection. Lower-risk insureds will tend to switch to private flood insurance while the higher-risk, NFIP-subsidized insureds will stay with NFIP.

I think "issues & barriers" is a very likely exam question. A related question is how can these issues could be addressed.

Question: briefly describe how these issues & barriers to private flood insurance could be addressed

1. replace "at least as broad" with "comply with state regulations" (that's easier for state regulators to determine)
2. pass a federal law stating that private flood insurance counts when assessing whether coverage has been continuous
3. eliminate the non-compete clause (or give WYOs temporary authority to sell certain types of flood insurance) ← this has essentially been done
4. reform NFIP rate structure so that prices match what a private insurer would charge ← this is the purpose of FEMA's redesigned risk-rating system: Risk Rating 2.0
5. don't change anything - state level authority may be better in the long-term because it encourages state-specific solutions
6. remove personally identifiable information from NFIP data then make data public (or release only aggregate data)
7. expand mandatory purchase requirement (require all SFHA properties to buy flood insurance, not just those with a federally-backed mortgage)

I couldn't think of any good memory tricks for the lists in this section. If you can think any, let me know, otherwise you'll have to use brute force. But let me emphasize that I think asking for issues & barriers and how they can be addressed is a very likely exam question.

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Potential Effects of Increased Private Sector Involvement

In the last section we discussed issues & barriers to greater private offerings of flood insurance. In this section we look at the ripple effects of greater private offerings. You know the old saying, "Be careful what you wish for."

Question: identify and briefly describe potential effects of increased private sector involvement in flood insurance

1. more choice (higher limits, expanded coverages like business interruption and living expenses, shorter waiting periods before policy becomes effective)
2. lower prices (lower-risk, non-subsidized NFIP customers may be charged lower rates by private insurers)
3. variable protections (consumer protections for private policies are enforced at the state level and may vary considerably from state to state)
4. adverse selection (private companies may cherry-pick profitable, low-risk policies from NFIP, leaving NFIP with underpriced high-risk policies and weakening its future ability to pay claims)
5. impaired flood mapping & floodplain management (NFIP pays for flood mapping and floodplain management with policy fees so a significant decrease in NFIP policies could weaken NFIP's ability to perform these functions)

If you didn't figure it out, Alice color-coded these effects: green means good, red means bad!

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Conclusion

The source text has a very nice conclusion that wraps everything up. You can read it using the link below.

Conclusion (from source text)

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