U.S. Government Accountability Office Evaluates Potential Barriers to Private Flood Insurance Market

 

Does the current regulatory environment pose barriers to growing the private flood insurance market?  This was the question the U.S. Government Accountability Office (“GAO”) set out to answer in its recent report (GAO-16-611) issued during July 2016 entitled “Potential Barriers Cited to Increased Use of Private Insurance.”

To access the report, click here.

This report describes (1) lender and regulator implementation of provisions on private flood insurance; and (2) views on regulatory, or other, barriers to using private flood insurance to satisfy the mandatory purchase requirement of the Biggert-Waters Flood Insurance Reform Act of 2012 (“Biggert-Waters”). 

Since Biggert-Waters’ enactment, lenders and their regulators have taken some action to implement its provisions on private flood insurance.  Specifically, lenders told the GAO they send notifications to borrowers that encourage borrowers to compare private and National Flood Insurance Program (“NFIP”) policies.  

In responding to the GAO study, lenders that accepted private policies generally said they used Federal Emergency Management Agency (“FEMA”) guidelines and interagency guidance to evaluate private policies. 

Corresponding federal regulators (Federal Reserve System Board of Governors, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, National Credit Union Administration and the Farm Credit Administration) issued interagency Questions and Answers on private insurance in 2009, which cite the FEMA guidelines. 

However, FEMA rescinded its guidelines in 2013, citing a lack of authority to rule on the acceptability of private insurance policies.  Subsequently, federal regulators issued joint proposed Rules to implement Biggert-Waters’ definition of “private flood insurance,” but have not yet finalized them.  Meanwhile, regulators stated that the information provided in the aforementioned 2009 Questions and Answers remains in effect until final Rules implementing the private flood insurance provisions of Biggert-Waters are adopted.

Stakeholders cited a number of challenges as potentially inhibiting the use of private flood insurance to satisfy the mandatory purchase requirement.

Regulatory Uncertainty

Without final regulations implementing Biggert-Waters’ requirement to accept private flood insurance, there was uncertainty among stakeholders about which private policies would satisfy the mandatory purchase requirement.  Many stakeholders, including some lenders, emphasized that lenders needed discretion when evaluating policies and that ensuring policies met Biggert-Waters’ definition would be challenging for lenders, in part due to their lack of insurance expertise.

Recent NFIP Changes

Stakeholders noted that a recent NFIP policy change could discourage consumers’ use of private insurance.  Recently, FEMA stopped allowing policyholders to obtain a refund of their unused NFIP premium if they obtained a non-NFIP policy.  FEMA officials stated that, based on their recent review of NFIP cancellation policies, this practice was not explicitly permitted in the NFIP standard flood insurance policy terms and conditions. 

Due to this change, consumers who wish to obtain private coverage would forfeit any unused portion of their premium if they switched after the NFIP policy’s effective date.  While FEMA’s standard policy terms do not specifically address refunds when a non-NFIP policy is obtained, FEMA could revise the standard policy to allow for such refunds.  The GAO explained that this type of refund would be in line with industry practice to allow refunds of paid premiums when cancelling insurance policies, as well as Congressional interest in transferring some of the federal government’s exposure to flood insurance risk to the private sector.

Market Challenges

Many stakeholders noted that low private sector participation in flood insurance was also due to market challenges, some citing the inability to compete with discounted NFIP rates as a primary barrier-a finding that GAO also reported in previous report (GAO-14-127).

The GAO noted that the NFIP was created, in part, because private insurers historically have been unwilling to insure against flood damage.  Even now, the private flood insurance market remains small.  Biggert-Waters took steps to encourage private-sector participation by requiring regulators to direct lenders to accept private flood insurance to satisfy the mandatory purchase requirement-a federal requirement to purchase flood insurance on certain properties.

According to stakeholders with whom the GAO spoke in creating its report, several conditions must be present to increase private sector involvement in the sale of flood insurance.  First, insurers need to be able to accurately assess risk to determine premium rates.  For example, stakeholders told the GAO that access to the NFIP policy and claims data and upcoming improvements in private sector computer modeling could enable them to better assess risk. 

Second, insurers said they need to be able to charge premium rates that reflect the full estimated risk of potential flood losses while still allowing the companies to make a profit, as well as be able to decide which applicants they will insure.  However, stakeholders said that such rates might seem unaffordable to many homeowners. 

Third, insurers said they need sufficient consumer participation to properly manage and diversify their risk, but stakeholders said that many property owners do not buy flood insurance because they may have an inaccurate perception of their risk of flooding.

Stakeholders identified several strategies that could help create conditions that would promote the sale of flood insurance by the private sector. 

For example:

• NFIP charging full-risk rates.  Congress could eliminate subsidized rates, charge all policyholders full-risk rates, and appropriate funding for a direct means-based subsidy to some policyholders.  Stakeholders said full-risk NFIP rates would encourage private sector participation because they would be much closer to the rates private insurers would need to charge.  The explicit subsidy would address affordability concerns, increase transparency, and reduce taxpayer costs depending on the extent and amount of the subsidy.  The Biggert-Waters Act eliminates some subsidized rates, but some have proposed delaying these rate increases.  Doing so could address affordability concerns, but would also delay addressing NFIP’s burden on taxpayers.

• NFIP providing residual insurance.  The federal government could also encourage private sector involvement by providing coverage for the highest-risk properties that the private sector is unwilling to insure.  Providing residual coverage could increase the program’s exposure relative to the number of properties it insured, but the NFIP would be insuring fewer properties, and charging adequate rates could reduce taxpayer costs.

• NFIP as reinsurer.  Alternatively, the federal government could serve as a reinsurer, charging a premium for assuming the risk of catastrophic losses. However, the cost of reinsurance premiums would likely be passed on to consumers, with higher rates potentially decreasing consumer participation.

Stakeholders identified other strategies, including mandatory coverage requirements to ensure broad participation, the NFIP purchasing reinsurance from the private sector rather than borrowing from the U.S. Treasury, and the NFIP issuing catastrophe bonds to transfer risk to private investors.  

As the private sector increases its role in providing flood coverage, the GAO suggested that the federal government could collaborate with state and local governments to focus on other important roles, including promoting risk awareness among consumers, encouraging mitigation, enforcing building codes, overseeing land use agreements, and streamlining insurance regulations.

In the conclusion of its July report, the GAO recommended that FEMA reconsider allowing policyholders who cancel their NFIP policy to be refunded, on a prorated basis, when obtaining a non-NFIP policy and take any necessary steps to amend the NFIP standard policy to do so.  FEMA agreed with this recommendation.

 

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