October 19, 2005 | WebMemo on Regulation
Proposals put forward by the Consumer Mortgage Coalition and by Rep. Gene Taylor would allow the owners of properties damaged or destroyed by Hurricanes Katrina and Rita to join the National Flood Insurance Program (NFIP) retroactively and to receive payments from it-even though they chose to go without insurance at the times of the two storms. NFIP is a part of the Federal Emergency Management Agency (FEMA). These proposals could destroy NFIP. Allowing after-the-fact insurance coverage would undermine the important principle of individual financial responsibility and create a very bad precedent.
Flood damage from Katrina alone is expected to be extremely expensive. According to David Maurstad, Acting Insurance Administrator FEMA, claims due to Katrina and Rita could exceed $22 billion, or about one-and-a-half times the $15 billion NFIP paid out in total claims between the time that it started in 1968 and the end of 2004. Maurstad's estimate is over 11 times the almost $2 billion NFIP paid for flood insurance claims caused by the hurricanes that hit Florida and other areas in 2004.
How NFIP Works
Congress created NFIP to reduce federal disaster aid. It requires homeowners in a flood plain (defined as an area with a one percent chance of flooding each year) to buy insurance that replaces government grants and loans. FEMA estimates that for every $300 in flood insurance claims that are paid, federal disaster aid is reduced by $100.
Currently, NFIP insures approximately $800 billion in structures and contents. It is self-supporting in average years, meaning that its income from premiums usually equals the amount paid in claims and spent on operating expenses. The program takes in about $2 billion in premiums and fees per year and, between 1994 and 2004, paid about $867 million in claims annually. If claims do exceed the income from premiums, NFIP can borrow up to $3.5 billion from the Treasury Department. This line of credit was temporarily increased from $1.5 billion in September 2005 to give the program the ability to handle claims resulting from Katrina and Rita. Further increases are expected so that NFIP can cover all storm-related claims.
Property owners can purchase federal flood insurance policies through most property insurance brokerages. NFIP insures 4.7 million properties located in the 20,000 or so communities that participate in the program. These communities contain about 95 percent of properties in high-risk flood areas. In order to receive a mortgage from a federally insured financial institution, homeowners must buy flood insurance if their property is located in a floodplain. If flood insurance is required and the mortgage lender offers escrow accounts for items such as homeowners insurance or local taxes, then flood insurance must be paid through the escrow account also.
About 40 percent of mortgages, however, are made by unregulated lenders, which do not have to comply with these requirements. This includes a high proportion of mortgages for manufactured housing, which is usually financed by the dealer. Additional millions of structures in flood-prone areas are not covered by flood insurance because the homeowner failed to buy or renew a policy. As well, the law requires flood insurance only where there is a one-percent chance of a flood and assumes that flood control measures such as levies and dykes will protect the properties near them. It also does not require NFIP coverage in low-lying areas where surges are likely following major storms but not otherwise. Significantly, many NFIP policies only cover the remaining balance on a structure's mortgages, not the cost of actually replacing it.
The average homeowner pays $300 a year for about $130,000 of coverage. Homes can be covered for up to $250,000 for the structure and up to $100,000 for contents. Businesses can purchase up to $500,000 in coverage for both the building and its contents. Premiums are based on a number of factors, from the risk of flood in the area to the presence of a basement, the height of the property above expected flood levels, and the community's efforts to control flood damages. Maximum residential coverage costs as little as $320 and as much as $1800 annually, depending on these factors.
About 76 percent of policyholders pay risk-based premiums that include the possibility of a catastrophic loss. However, structures that existed before the community joined NFIP-24 percent of the total-receive flood insurance at subsidized rates that imply a substantially lower risk of flooding than actually exists. GAO estimates that some premiums are only 35 to 40 percent of what they would be without the subsidy. The total value of this subsidy is an estimated $1.3 billion annually.
If a property has two or more claims of over $1,000 each in 10 years, NFIP can offer to move, raise, flood-proof, or even buy the property to the reduce overall cost to the program. At one point, according to NFIP estimates, just one percent of insured properties were responsible for about 25 percent of claims, mainly due to repeated flooding and rebuilding in the same location. According to GAO, structures with repeat losses represented almost a third of all claims paid between 1978 and March 2004. The areas in Alabama and Mississippi affected by Hurricane Katrina include roughly 2,400 structures with repeat losses, while the areas of Louisiana damaged by the storm include roughly 20,000 structures that have had repeat claims.
Hurricane Katrina destroyed hundreds of thousands of homes and damaged far more. According to data compiled by the Insurance Information Institute, Katrina destroyed about 275,000 homes, or 10 times the 27,500 destroyed by the four hurricanes that struck Florida and nearby states in 2004. Much of this damage was caused by flooding and storm surges.
The proportion of homes covered by NFIP in the areas hit by Katrina varied widely. Areas near New Orleans had the highest coverage, at just over 57 percent, but even there more than 40 percent of homes were not covered. The three coastal counties of Mississippi had extremely low participation, with Harrison and Jackson counties at about 10 percent while Hancock reached roughly 23 percent. Though parts of these counties are outside the area where NFIP policies are required, homeowners gambled with their futures when they chose not to buy flood insurance. After Katrina, it became obvious that thousands had lost their bets.
The Consumer Mortgage Coalition Plan
A Consumer Mortgage Coalition (CMC) proposal would allow any property owner whose property was damaged in the two storms to retroactively join NFIP and to receive payments from it. CMC is a trade association representing some of the largest residential mortgage lenders. Because fewer than half of damaged or destroyed structures were part of NFIP when Katrina hit, the CMC proposal could be very expensive. Owners of well over 100,000 additional structures in New Orleans, the Gulf coast, and other areas would become eligible for payments. Already, Congress has more than doubled the flood insurance program's line of credit, and adopting CMC's proposal would require even more borrowing, which NFIP would find difficult to repay once premiums revert to prior levels. NFIP now faces up to $22 billion in storm-related claims, and the CMC proposal could double that.
More significantly, a large proportion of that additional money would go to the owners of vacation homes and rental properties. This is especially true in coastal resort communities. While these structures do need to be rebuilt or repaired, vacation homes especially should have a much lower priority than owner-occupied dwellings. The CMC plan also suffers from the same weaknesses as Rep. Taylor's plan, discussed below.
Rep. Gene Taylor's H.R. 3922
Rep. Gene Taylor's "Hurricanes Katrina and Rita Flood Insurance Buy-In Act" (H.R. 3922) appears to be more limited and reasonable than CMC's proposal, but it is still ill-advised. This bill, cosponsored by 33 Members of the House, would allow the owners of properties damaged by flooding caused by either storm to join NFIP retroactively if they had insurance against wind damage before the storms hit and their properties were not located in a recognized flood plain where flood insurance is usually required. Those able to join could purchase coverage for up to the maximum $250,000 flood insurance or the amount of wind damage coverage in force at the time of the storm, whichever is lower. Owners of properties not meeting these requirements would be ineligible to join NFIP retroactively.
To receive flood insurance coverage, property owners would have to pay 105 percent of the premium level that NFIP would have required over the previous 10 years. However, they would not have to actually pay any money, as these premiums would be deducted from whatever settlement they receive. Thus, if the premium to cover a structure would have been $1,800 per year and it qualified for $250,000 in coverage, NFIP would subtract roughly $19,000 in prior-year premiums from the total payout, resulting in a maximum payout of $231,000. Congress would appropriate the money to cover these claims, rather than require NFIP to use its line of credit with the Treasury.
Property owners receiving this retroactive coverage would have to agree to maintain flood insurance coverage in the future for any structures located on the property, and this requirement would extend to future owners, as well. Both current and future owners would have to accept NFIP offers resulting from any repetitive claims.
On its face, the Taylor bill appears to be a reasonable effort to deal with a significant problem: flooded homes and businesses that were actually outside of an area where flood insurance was required. However, the bill has many flaws. First, the Taylor bill radically changes NFIP from an owner-financed program into a conduit for federal grants. Because the damages paid to homes newly covered under it are paid through federal appropriations rather than premiums, they are not really insurance claims. Rather, they are direct bailouts of owners and lenders and should be treated as such-including under federal tax laws. Disguising these payments as flood insurance claims is not fair to taxpayers or to the thousands who were part of NFIP and paid their premiums before disaster struck.
Additionally, the Taylor bill would cover all properties regardless of their owners' income. Vacation homes should be treated differently than owner-occupied homes and businesses. At a time when thousands of lower-income workers are forced to live in trailer communities or to relocate, upper-income owners of beachfront properties should be very low on the list of those receiving aid. Instead of direct federal grants, upper-income workers should receive loans, at most.
Finally, there is the question of whether it is the federal government's responsibility to replace every home that the two storms damaged. While no one would deny needed assistance to those who lost all, the federal government should not be responsible for all the storms' damage. Rather, when an individual owner cannot finance rebuilding a flooded structure, perhaps using low-cost loans, state and local governments should shoulder a significant portion of the cost through state and local housing authorities and bond programs. Using state and local money to rebuild strongly reduces the chance that a federal entity will direct a community to rebuild to bureaucrats' specifications rather than the community's desires. With federal money comes federal strings that may not meet local priorities.
Raising Premiums To Meet Risk
Even if proposals to allow retroactive coverage are rejected, NFIP still needs to make changes that better reflect the risks that it insures against. Flood insurance premiums are often too low and should be increased to levels that accurately reflect the risk that a property will be damaged. This should be accomplished by eliminating the premium subsidy for older structures. In addition, NFIP insurance should be required in areas outside of the floodplain that would still be hit by a major storm surge. Finally, if vacation homes are to be covered at all, their owners should pay significantly higher premiums than those charged for owner-occupied homes.
Especially in coastal areas, artificially low flood insurance premiums are a subsidy and encourage people to live where natural disasters are likely to occur. While people should be allowed to live where they please, they should also bear the risk that their choice may subject them to storms, floods, tornados, and other natural disasters.
No one would deny needed assistance to the victims of Katrina and Rita. However, short-sighted quick fixes can have lasting implications. Changing NFIP into a conduit for federal grants will be a precedent that will be cited when lesser disasters strike. Congress should not hide its intentions under the guise of insurance payments to uninsured structures.
David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.