Horn - Private Flood Insurance and NFIP

Question 1

What was the primary reason for the creating of NFIP?

Answer 1

The primary reason for the creation of NFIP in 1968 was withdrawal of private flood insurance from the market.

That had left federal disaster relief as the only means of recovery for flood victims, which is not an effective system of dealing with risk.

Question 2

What is NFIP?

Answer 2

A federal flood insurance program administered by FEMA (Federal Emergency Management Agency)
and is the main provider of primary residential flood coverage (versus private flood insurance) involves private insurers and all tiers of government

Question 3

What are the policy goals of NFIP?

ARM

Answer 3

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

Social
mitigate & reduce flood risk through floodplain management standards

Parts of Arm: A = Access, R = Reduce, M = Mitigate

Question 4

What is NFIP’s approach to achieving the policy goals?

RASH

Answer 4

• Risk-based premiums
• Affordability
• Sustainability (premiums should cover claims costs & expenses)
• High participation rates

Risk based premiums and affordability are may be in conflict with each other.

Question 5

How is NFIP different than traditional private insurance.

Answer 5

NFIP has social and non-insurance goals

Social
* provides coverage to high-risk customers who can’t find coverage in private market

Non-Insurance
* 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

Question 6

In what scenario Flood Insurance mandatory?

Answer 6

For property owners who are in a Special Flood Hazard Area (SFHA) and whose mortgage is backed by the federal government.

mortgage lender could specifically requires participation (even if outside a SFHA)

Question 7

How does pricing work for NFIP and what are 3 exceptions to that pricing?

Answer 7

Rates should be risk-based (actuarially sound)

3 Exceptions
* 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)

Question 8

What is an important NFIP association?

Answer 8

FEMA = Federal Emergency Management Agency
FIRMs = Flood Insurance Risk Maps
SFHAs = Special Flood Hazard Areas (these are high-risk flood hazard areas)

FEMA makes FIRMs which identify SFHAs

Question 9

How can private insurance companies be involved with flood insurance?

Answer 9

• service policies (marketing, selling, writing, claims management)
• assume full risk as primary insurer
• assume a portion of risk as a reinsurer (sharing risk with FEMA)

Question 10

Describe the 2 specific servicing arrangements available to private companies within the NFIP framework?

Answer 10

Direct Serving Agent (DSA)
* 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. Also, policy terms & premiums are the same through DSA & WYO<- Sweet deal

DSA accounts for around 13% of the NFIP portfolio, so WYO is 87%.

Question 11

How does NFIP use private reinsurance and captial markets?

Answer 11

• 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 12

What are some of the advantages of NFIP using reinsurance or capital markets?

Answer 12

• 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)

Question 13

What are some of the disadvantages of NFIP using reinsurance or capital markets?

Answer 13

• 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

Paying extra money for cost certainty, but may leave insufficient funds for other functions.

Question 14

Why has flood insurance been considered uninsurable?

Ca²p

ie….why NFIP has been necessary

Answer 14

• catastrophic nature of flooding
• 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)
• pricing difficulties (data is highly variable from year to year, unlike auto pricing which has a stable data history)

Question 15

What are the most common types of private flood insurance?

Answer 15

• 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)

Question 16

identify and briefly describe issues & barriers to private flood insurance

Answer 16

• coverage must be “at least as broad” as NFIP coverage (hard to determine)
• continuous coverage requirement (coverage must be continuous to retain NFIP premium subsidies
• 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
• NFIP subsidized rates (a private insurer can’t compete with taxpayer-subsidized rates) and profit margins that private insurers requires
• regulatory uncertainty (private coverage increases state involvement which increases compliance costs since each state may have different regulations)
• 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)
• participation rates (necessary to manage & diversify portfolio, but even where flood insurance is mandatory participation can be low)

Question 17

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

Answer 17

• more choice (higher limits, expanded coverages like business interruption and living expenses, shorter waiting periods before policy becomes effective)
• lower prices (lower-risk, non-subsidized NFIP customers may be charged lower rates by private insurers)
• variable protections (consumer protections for private policies may vary considerably from state to state)
• 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)
• 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)