Weaknesses in the Financial Controls of the National Flood Insurance Program

Published by the Government Accountability Office on 1977-03-21.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                            DOCUMENT RESUK!

OU289 - [&10517251

[Veaknesses in the Financial Controls of the National Flood
Insurance Program]. B-114860; CSD-77-47. March 21, 1977. 9 pp.

Report to Patricia Parris, Secretary, Department of Housing and
Urban Development; by Henry Eschwege, Director, Community and
Economic Development Div.
Issue Area: Accounting and Financial Reporting (100); Automatic
    Data Processing (103);Automatic Data Processing: Using
    Results of ADP Systems (2600).
Contact: Community and Rconomic Development Div.
Budget Function: Miscellaneous: Financial Management and
    Information Systems (1002).
Organization Concerned: rational Flood Insurers Association.
Congressional Relevance: House Committee on Banking, Currency
    and Housing; Senate Committee on Banking, Housing and Urban
Authority. National Flood Insurance Act of 1968 (42 U.S.C. 4011;
    42 U.S.C. 4071). Flood Disaster ProtecticL Act of 1973.
    Government Corporation Control act.

         There are numerous weaknesses in the ability of the
National Flood Insurers Association (NFIA) to generate accurate
financial data on its operations relating to the National F.ood
Insurance Program. Findings/Conclusions: These weaknesses could
adversely affect the Governmentes ability to determine
reasonable amounts payable to NFIA under the program; determine
flood insurance premium rates; prepare financial statements of
the program's condition and results of its operations; and make
management decisions. Both accuracy of financial data and
timeliness of such data ame seriously lacking in the National
Flood Insurance Program. J:ecormendations: Every effort should
be made tc assure that adequate financial control over the flood
insurance program is established as quickly as possible. The
Secretar7 of Housing and Urban Development should: 1) direct the
Federal Insurance Administration (FIA) to review financial
control problems with NFIA with the objective of establishing a
plan that will result in the receipt from NFIA of reliable
financial and statistical data necessary to manage the program;
2) direct the Inspector General to review the plan developed to
make sure such data will meet FIA's needs; and 3) give
consideration to a partial or full assumption by the Government
of necessary functions as permitted under Part B of the National
Flood Insurance Act of 1968. if adequate financial control
cannot be established through arrangements with FIA. (SC)
                                       WASHINGTON, D.C.   20548

      DEVELOPMENT   DIVISION                                  MAR 2 1 1977
                                                              MAR 2 ! 1977

            The Honorable
            The Secretary of Housing and                  .
              Urban Development

            Dear Mrs. Harris:

                 We have reviewed the National Flood Insurers Association's
            (NFIA) financial controls over its operations relating to the
            National Flood Insurance Program. We found numerous weaknesses
            in NFIA's ability to generate accurate financial data.  These
            weaknesses could adversely affect the Government's ability to

                    -- determine reasonable amounts payable to 1NIA, under
                       the program;

                    -- determine flood insurance premium rrtes;

                    -- prepare financial statements of the program's
                       condition and results of its operations; and

                    -- make management decisions.

            The purpose of this letter is to bring these weaknesses to
            your attention so that timely corrective action can be taken.

                 .The National Flood Insurance Program was established
            under authority of the National Flood Insurance Act of 1968
            (42 U.S.C. 4011).   It is a subsidized, Government-sponsored
            program designed to help owners of real or personal property,
            in areas designated as eligible for flood insurance, purchase
            such insurance.   The program is administered by your Federal
            Insurance Administration (FIA).

                 The 1968 act authorized the Secretary of Housing and
            Urban Development to encourage and assist insurance companies
            to form a pool for the purpose of providing the flood insur-
            ance coverage authorized by law. On June 6, 1969, NFIA,


th..-ough its member companies, began providing the authorized
insurance coverage. Membership in NFIA is open to all com-
panies licensed under the laws of any State to write prnperty
insurance. AiIA acts as a liaison between member companies
and FIA, makes ~se public aware of the flood insurance program
through advertising, and conducts educational seminars for
insurance agents. Further, it is responsible for maintaining
accounting and administ.t"ive records of the program's opera-
tions and fo£-reporting on :ts financial condition to the
Administrator, FIA, at least qIarterly. FIA sets policy;
establishes premium rates; desigi.ates areas eligible for
insurance; ar.d reinsures, for a fee, the insurers that sell
flood insurance.                         q>

     The 1.973 Flood Disaster Protection AcL provided for a
mandatory rather than voluntary flood insurance program. FIA
concluded that the impact of this legislation on the program
would be massive.   In March 1974, to avoid operating obstacles
resulting frcm accelerating program growth, the administrator
of FIA ordered the development of a computerized accounting
system for the program's activities. NFIA entered into a
contract with Bradford Computer & Systems, Inc. (Bradford),
for the development and implementation of the computerized
system. The contract became effective in August 1974, but
was terminated in November 1976 because many problems developed
between NFIA and Bradford. Subsequently, NFIA began operating
the system on its own.

     The flood insurance program has grown considerably since
its inception.                     =
                By December 31, 19'., an estimated 680,000
policies, representing about $18.6 billion of insurance, were
in force. During calendar year 1975, about $48 million in
premiums was collected and about 23,000 claims were settled
for almost $97 millioin.


     Our review of the financial controls of the National
Flood i..surance Program showed that NFIA has been unable to
generate accurate financial and statistical data. As a
result, it can neither produce its own financial statements
nor supply FIA with the kind of data it needs to make program
decisions, determine subsidy amounts and premium rates, or
produce the financial statements for the program.

                            - 2-

      NFIA's-financial statements at June 0SO,1975, were audited
and certified by Arthur Andersen & Co. The company's repre-
sentatives informed us that the certification was possible
because necessary financial information wiz qenerated by
41) mechanized procedures in place throughout the year at
NF A and (2) manual procedures used and special analyses
provided by NFIA. However, since October 1975, NFIA has been
unable to prepare financial statements on the results of its
operations or to prepare proper billings to the Department of
Housing and Urban Development (HUD) for 'its share of NFIA's
costs and flood losses.   Arthur Anderson & to. concluded,
after a review of the status of NFIA's records as of June 30,
1976, that, if an audit is at all feasible, the scope of the
work would necessarily be so extensive that the cost would
make it Prohibitive.   The audit firm suggested that a
2,.-month ,udit be made at June 30, 19'7, since it believed
that the current problems could be solved by that time.

     The Controller, NFIA, informed us chat NF[A's inability
to prepare financial statements was caused by the failure of
Bradford to properly meet its contractual obligations and
that such failure create& ~ultip]e financial and statistical
problems during the period Bradford was responsible for the
NFIA system, Bradfoid, in a March 1976 letter to NFIA, stated
tiat all significant difficulties in
                                   performance clearlv have
been caused by NFIA's failure to fulfill its own obligations,
by the serious deficiencies in the data made available to
Bradford, and by NFIA's lack of cooperation.

     System development problems bec:ame evident during the
first contract year, and by the lat':er part of 1975, NFIA
became increasingly concerned because of what it considered
to be a lack of progress. In October 1975, NFIA stopped
making payments to Bradford under tne contract.

      FIA was cogni:,ant of the system development problems
since at least January 1975.    However, by February 1976, FIA
considered that the situation had deteriorated to the point
that NFIA no longer wanted to solve the contractual problems
but, rather, wanted to terminate the Bradford contract.     NFIA
concluded that Bradford was in default under the contract and
offered a settlement agreement to Bradford to terminate it.
Bradford, in March 1976, rejected the settlement, choosing
instead to formally arbitrate their differences as provided
f - in the contract. Arbitration began in September 1976.
T'.e arbitrators were dismissed in November 1976, however,
because Bradford and NFIA agreed to terminate the contract.

                             - 3-

     We were informed by the Controller, NFIA, that NFIA has
taken over operation of the Bradford system.  In so doing
they have hired clerical personnel from Bradford and are
utilizing the services of several other Bradford people
during a transitional period. The NFIA Controller informed
us also that NFIA paid aoout $4.3 million of about $5.7 million
billed by Bradford since payment to Bradford was stopped in
October 1975.

Extent of financial control problems

      In November 1975, NFIA engaged Arthur Andersen & Co. to
reviaw th.a system's problems relative to the Bradford con-
tract, In February 1976 Arthur Andersen & Co. reported that
the Bradford system did not meet the criteria established by
FIA and NFIA for accountability of the flood insurance opera-
tions. They cited about 75 deficiencies covering 22 major
system requirements.   Examples o - deficiencies included prob-
lems in the areas of premium calculations, error editing,
processing of agent commissions, pol!cy statistics, policy
servicing, financial statements, policy master files, claims
administration, a~nd system controls.   In 'ebruary i976 Arthur
Andersen & Co. was retained by NFIA to develop support for
potential legal proceedings pursuant to the Bradford contract,
to develcp a Dlan to purify data files and implement effective
file maintenance, and to provide system specifications and
planning. When the parties entered into the arbitration
proceedings, NFIA engaged Arthur Andersen & Co. to assist it
and its attorneys in preparing for the case.

     NFIA paid Arthur Andersen & Co. over $1 million in fees
and expenses for its services as follows.

     -- Review of Bradford system resulting
        in February 1976 .eport on system
        deficiencies                            $   169,400
     -- Arbitration support                         447,000
     -- File testing                                 60,600
    -- System specifications and planning           351,500


                              - 4 -

     As of January 1977, Arthur Andersen & Co. was assisting
NFIA in the assumption of the Bradford system, evaluation of
system deficiencies, and correction of problems.  Payment for
these services is at the audit firm's standard biting rates,
plus expenses.

     FIA also reviewed problems associated with the contractual
relationship between NFIA and Bradford.  The prim.ary purpose
of its review was to determine whether problems with the sys-
tem were having an adverse impact on policyholders. The
review was also intended to identify particularly annoying
problems so FIA could work with the parties and seek solutions
to them. FIA's report identified numerous problems relating
to poor financial control.

     Our review was conducted to determine whether the controls
over computer operations could be relied upon to make sure that
automated accounting and administrative records contain accu-
rate and reliable information. We did not perform a follow-ur
examination of control deficiencies to determine specific ef-
fects. We did, however, observe control weaknesses that could
directly affect the accuracy and reliability of data reccrd-d
in the automated general ledger and reported in the annual
financial statements.  Because of these control weaknesses,
incorrect information could be entered into accounting records,
and financial statements prepared from these records could be
misleading.  Specifically, our review indicated that controls
over NFIA's automated accour.ting system were not adequate to
make sure that all

     -- cash receipts were deposited in banks and properly
        recorded in the general ledger,

     -- flood insurance information received by NFIA from
        servicing companies was properly entered into the
        financial records, and

     -- flood insurance forms containing incorrect or missing
        information were identified and rejected before final
        computer processing.

     We discussed these control weaknesses with the Controller,
NFIA, on December 9, 1976. He stated that the problems re-
sulted from deficiencies in the computerized accounting system
and that corrections to the system were being made with the aid
of specialists from Arthur Andersen & Co. He stated that cash

                            - 5-

controls have been improved; however, improvement. 'Cere still
being developed to make sure that (1) all    data rect ived from
the various member insurance companies is    ultimatel' recorded
in the accounting records and (2) editing    proceourei' a-e
adequate to identify incorrect or missing    information.
Effects of inadeauate financial controls
     One effect of inadequate financial control is that the
Federal Gcvernment cannot properly calculate subsidy payments
due insurers. Premium rates for flooc insurance are estab-
lished on an actuarial basis and, insofar as practicable,
at a level sufficient to cover the estimated full cost of
insurance claims a'd to help in the accumulation of reserves
to pay anticipated losses. To encourage the purchase of flood
insurance, the Administrator established lower than full-c,,st
ra ss, referred to as chargeable rates. The difference be-
tweer, chargeable rates and full-cost actuarial rates provided
the basls for a Federal Government subsidy. 1/
       The subsidy, referred to as a premium equalization
payment, is made to the insurer after flood losses covered by
chargeable rate policies are paid.    During the 3-year period
ending June 30, 1975, NFIA was paid equalization payments of
about $22 million, S37 million, and $47 million, respectively.
     On June 2, 1976, FIA requested NFIA to submit, for budget
purposes, an estimate of certain financial data including the
equalization payment due NFIA. On June 11, 1976, NFIA sub-
mitted the data requested with the qualification that the
estimates were based on numerous assumptions and projections,
due to the problems with Bradford, and should be used accord-
ingly. The estimates included $41 million (about $62 million
less credits of about $21 million) due NFIA for equalization
payment. Without accurate financial statements and statis-
tical program data, FIA has little assurance that subsidy
payments to NFIA are proper.

1/   Pursuant to an amendment in the Flood Disaster Protection
     Act of 1973, the Secretary changed the formula for deter-
     mining the subsidy payment to one based on actual premiums
     collected and actual losses incurred.

                              - 6-

     A second effect is chat the amount of the operating
allowance to be retained by NFIA cannot be properly deter-
mined. NFIA may retain as an operating allowance a part of
the operating profit earned in an accounting period in an
amou-t not to exceed 5 percent of the policyholders' pre-
miums applicable to the period.  Operating profit in excess
of 5 percent of the policyholders' premiums is to be paid
to the Administrator and held in the U.S. Treasury for the
payment of future NFIA losses, operating costs, and operating
allowances.  The inability of NFIA to provide accurate
income and expense statements has a direct effect on the
determination of the operating allowance.

     A third effect concerns the setting of premium rates.
Under section 1307 of the National Flood Insurance Act, the
Secretary is required to estimate the premium rates necessary
to nover the estimated full cost of insurance claims.   How-
ever, NFIA does not have its claim payment process under
adequate financial control. Thousands of claims nave been
paid since September 1975, but because claims processing had
not yet been computerized these clai;ns have not been entered
into the finas.,al records. One FIA official informed us
that FIA has not received adequate gl..  on which to deteri:ine
such premium rates.

     A fourth effect concerns FIA's financial statements.
Under the provisions of the Government Corporation Control
Act, FIA is required to prepare annually a statement of
financial condition, an income and expense statement, an
analysis of surplus or deficit, and a statement of sources
and application of funds. FIA cannot prepare accurate finan-
cial statements required by the act because it depends on
reliable financial data from NFIA to reasonably state part
of the financial data in its statements.

     The weaknesses in financial control over the flood
insurance operations discussed in this report could, in our
opinion, result in other serious program deficiencies. Ac-
curate financial statements and statistical reports are
essential to enable management to make proper decisions in
many of their programs and to keep the Congress informed on
program activities. Not only is accuracy of financial data
required, but also timeliness.  Both are seriously lacking
in the National Flood Insurance Program.


                                         is essential to FIA
      Accurate financial data from NFIA
in performing tasks applicable to   the National Flood Insur-
                                      have such data, it cannot
ance Program. Because FIA does not        showing the financial
properly prepare budgets and statementsdetermine premium rates,
condition of the program, accurately  operating allowances
or calculate accurate subsidies and to make proper management
payable to NFIA. Also, the ability
                       without accurate statistical   and finan-
decisions is limited            has existed  for over  a year;
cial reports. This condition               should be made to
therefore, we believe that every effort over the.flood insur-
assure that adequate financial control as possible.
 ance program is established as quickly
      Accordlngly, we recommend that you:
                                                problems with
      -- Direct FIA to review financial control     a plan that
           NF[A with the objective of establishing
                                            NFIA of reliable
           will result in the receipt fromn
                                                    to manage
           financial and statistical data necessary
           the program.
                                                 the plan
      -- Direct the In3pector General to review meet FIA's
         develoPed to make sure such data will
                                            full assumption by
      -- Give consideration to a partial or    as permitted
         the Government of necessary functions
                             National Flood Insurance Act of
         under Part B of the
                         4071), if adequate financial control
         1969 (42 U.S.C.                            with NFIA.
         cannot be established through arrangements
                                                     with BUD
      We discussed our findings and recommendations
                                    General's office. The
 officials of FIA and the Inspector
 official at FIA generally agreed with our findings and recom-
                                     Inspector General's
 mendations, and the official of the     review of FIA plans.
 office concurred with our proposal for
       As you know, section 236 of the Legislative
                                              agency to submit a
  Act of 1970 requires the bead of a Federal                   to
  written statement                   on our recommendations
                    on actions taken Operations and  the  Senate
  the House Committee on Government
                                     not later than 60 days after
  Committee on Governmental Affairs        and Senate Committees
  the date of the report and to the House              for appro-
  on Appropriations with  the agency's first request
                                              date  of  the report.
                                    after the
  priations made more than 60 days

     We are sending copies of this report to the House
Committee on Government Operations, the Senate Committee on
Governmental Affairs, the House and Senate Committees on
Appropriations; the Bzuse Committee on Banking, Currency
and Housing; and the S.nate Committee on Banking, Housing,
and Urban Affairs. Lopies are also being sent to the
Director, Office of Management and Budget.

      We   would be pleased to discuss the matters included
 in this   report with you or your representatives, and we
 request   that you advise us of any corrective action you
·plan to   take.

                                 Sincerely yours,