oversight

Flood Insurance: Information on Financial Aspects of the National Flood Insurance Program

Published by the Government Accountability Office on 1999-10-27.

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

                   United States General Accounting Office

GAO                Testimony
                   Before the Subcommittee on Housing and Community
                   Opportunity, Committee on Banking and Financial
                   Services, House of Representatives


For Release
on Delivery
Expected at
                   FLOOD INSURANCE
10 a.m. EDT
Wednesday
October 27, 1999
                   Information on Financial
                   Aspects of the National
                   Flood Insurance Program
                   Statement of Stanley J. Czerwinski, Associate Director,
                   Housing and Community Development Issues,
                   Resources, Community, and Economic
                   Development Division




GAOT-RCED-00-23
    Mr. Chairman and Members of the Subcommittee:

    We are here today to discuss the financial condition of the National Flood
    Insurance Program administered by the Federal Emergency Management
    Agency’s (FEMA) Federal Insurance Administration. The program, along
    with low-interest loans provided by the Small Business Administration and
    individual and family grants provided by FEMA, is a major component of the
    federal government’s efforts to provide flood-related disaster assistance.
    Floods have been, and continue to be, the most destructive natural hazard
    in terms of economic loss to the nation, according to FEMA. From fiscal
    years 1986 through 1998 the program paid about $7 billion in insurance
    claims primarily from premiums collected from program policyholders. In
    recent years, claims paid by the program have increased as a result of a
    series of storms, creating a greater drain on the cash reserves of the
    program.

    Prior to the flood insurance program’s inception in 1968, flood insurance
    was generally not available from private insurance companies. The
    National Flood Insurance Act of 1968 (P.L. 90-448) established the
    program to identify flood-prone areas, make flood insurance available to
    property owners living in communities that joined the program, encourage
    floodplain management efforts to mitigate flood hazards, and reduce
    federal expenditures on disaster assistance.

    Our statement today will provide information on the (1) financial results of
    the program’s operations since fiscal year 1993, (2) major factors
    contributing to the financial difficulties faced by the program, and
    (3) actions taken by and plans of the Federal Insurance Administration
    that may affect the program’s financial health. We provided similar
    testimony at a field hearing of the Senate Committee on Banking, Housing,
    and Urban Affairs on August 25, 1999.

    The following summarizes our work:

•   In March 1994, we reported that while sufficient to cover flood losses
    experienced at that time, overall income from the program’s premiums
    was not sufficient to build reserves to meet future expected flood losses.1
    Therefore, we concluded that it was inevitable that losses from claims and
    the program’s expenses would exceed the funds available to the program
    in some years. In this regard, during the 6-year period from fiscal years

    1
     See Flood Insurance: Financial Resources May Not Be Sufficient to Meet Future Expected Losses
    (GAO/RCED-94-80, Mar. 21, 1994).



    Page 1                                                                        GAOT-RCED-00-23
    1993 through 1998, the program experienced losses from floods that were
    greater than the premiums collected from policyholders. Cumulative
    operating losses to the program (program income less program costs)
    totaled about $1.56 billion during the 6-year period. To finance these
    losses, the Federal Insurance Administration has periodically borrowed
    from the U.S. Treasury. According to FEMA, $541 million was owed by the
    program to the U.S. Treasury as of August 31, 1999.
•   Two major factors contribute to the financial difficulties faced by the
    program. First, the program is not actuarially sound because it does not
    collect sufficient premium income to build reserves to meet the long-term
    future expected flood losses.2 Second, the cost of multiple-loss properties
    (two or more losses greater than $1,000 each within a 10-year period) to
    the program is large—about 36 percent of all claims paid historically,
    currently about $200 million annually. The program, by design, is not
    actuarially sound because the Congress authorized subsidized insurance
    rates to be made available for policies covering certain structures to
    encourage communities to join the program. Because about 30 percent of
    the policies were subsidized as of 1998, overall premium income is not
    sufficient to build reserves to meet future expected flood losses. The
    Federal Insurance Administration’s annual target for the program’s overall
    premium income is at least the amount of loss and expenses in an
    historical average loss year, which approximates the average annual loss
    experienced under the program since 1978. Since no catastrophic loss
    years3 have occurred since 1978, collecting premiums that are based on an
    historical average loss year does not enable the program to build sufficient
    reserves to cover a possible catastrophic loss year in the future. Because
    the program does not collect sufficient premium income to build reserves
    to meet the long-term future expected flood losses, including catastrophic
    losses, it is inevitable that losses from claims and the program’s expenses
    will exceed the funds available to the program in some years.
•   The Federal Insurance Administration has studies under way and has
    taken other actions recently that may affect the program’s financial health.
    Among other things, it has studies under way assessing the (1) economic
    effects of eliminating subsidized flood insurance rates for policies
    covering certain structures and (2) program’s underwriting and claims
    processes and controls. The Federal Insurance Administration has also
    developed a strategy to mitigate flood losses (to prevent future losses or



    2
     For the program to be actuarially sound, overall revenues from insurance premiums would need to be
    sufficient to cover expected losses from claims and the program’s expenses.
    3
     Federal Administration officials told us that a catastrophic year is defined as a year resulting in
    $5.5 billion to $6 billion in claims losses, which has a 1 in 1,000 chance of occurring.



    Page 2                                                                               GAOT-RCED-00-23
                     reduce the losses that might otherwise occur from floods) for currently
                     insured multiple-loss properties posing the greatest risk of loss.

                     Before I discuss these issues in greater detail, let me briefly explain the
                     National Flood Insurance Program and other federal disaster assistance
                     related to this program.


                     Over 19,000 communities have joined the flood insurance program. Under
The National Flood   the program, flood insurance rate maps (FIRM) were prepared to identify
Insurance Program    special flood hazard areas. In order for a community to join the program,
and Other            any structures built within a special flood hazard area after the FIRM was
                     completed were required to be built to the program’s building standards
Flood-Related        that are aimed at minimizing flood losses. Special flood hazard areas, also
Assistance           known as the 100-year floodplains, are areas subject to a 1-percent or
                     greater chance of experiencing flooding in a given year. A key component
                     of the program’s building standards, that must be followed by
                     communities participating in the program, is a requirement that the lowest
                     floor of the structure be elevated to or above the base flood level—the
                     elevation at which there is a 1-percent chance of flooding in a given year.

                     To encourage communities to join the program, thereby promoting
                     floodplain management and the widespread purchasing of flood insurance,
                     the Congress authorized the Federal Insurance Administration to make
                     subsidized flood insurance rates available to owners of structures built
                     before a community’s FIRM was prepared. These pre-FIRM structures are
                     generally more flood-prone than later-built structures because they were
                     not built according to the program’s building standards. Owners of
                     post-FIRM structures pay actuarial rates for national flood insurance.
                     Despite subsidized premiums, the average annual premium for a
                     subsidized policy is currently $580 and the average annual premium for an
                     actuarial policy is currently $290. The higher average premium for a
                     subsidized policy reflects the significantly greater riskiness of flood-prone
                     pre-FIRM properties. The $580 average annual premium for a subsidized
                     policy also represents about 38 percent of the true risk premium for these
                     properties.

                     From 1968 until the adoption of the Flood Disaster Protection Act of 1973,
                     the purchase of flood insurance was voluntary. The 1973 act required the
                     mandatory purchase of flood insurance to cover structures in special flood
                     hazard areas of communities participating in the program if (1) any federal
                     loans or grants were used to acquire or build the structures and (2) the



                     Page 3                                                        GAOT-RCED-00-23
                      loans were secured by improved properties and were made by lending
                      institutions regulated by the federal government. The owners of properties
                      with no mortgages or properties with mortgages held by unregulated
                      lenders are not required to buy flood insurance, even if the properties are
                      in special flood hazard areas.

                      The National Flood Insurance Reform Act of 1994 reinforced the objective
                      of using insurance as the preferred mechanism for disaster assistance by
                      (1) expanding mandatory flood insurance purchase requirements and
                      (2) effecting a prohibition on further flood disaster assistance for any
                      property where flood insurance is not maintained, after having been
                      mandated as a condition for receiving disaster assistance. The act requires
                      federal agency lenders and regulators to develop regulations to direct their
                      federally regulated lenders not to make, increase, extend, or renew any
                      loan on applicable property unless flood insurance is purchased. The act
                      also requires borrowers who have received certain disaster assistance and
                      then failed to obtain flood coverage to be barred from receiving future
                      disaster aid.

                      Other forms of flood disaster assistance include Small Business
                      Administration low-interest loans to flood victims who are creditworthy.
                      In addition, a flood victim who cannot obtain a Small Business
                      Administration loan may apply for an individual and family FEMA grant of
                      up to $13,600 or the amount of the loss, whichever is less.


                      While the National Flood Insurance Program’s costs exceeded program
Sustained Losses to   revenues in some years, cumulative program income exceeded program
the Program From      costs by about $90 million during the period October 1, 1968, through
Severe Flooding       September 30, 1992.4 However, since fiscal year 1993, the flood insurance
                      program has generally experienced operating losses because program
                      costs—driven by losses and related expenses—were greater than program
                      income.5 This occurred because losses from flood claims were greater
                      than what could be paid by premium income collected from the program’s
                      policyholders. As seen in Figure 1, during the 6-year period from fiscal
                      years 1993 through 1998, the program incurred operating losses in 5 of



                      4
                      During this period, FEMA received $1.2 billion in appropriations for the flood insurance program.
                      Without this appropriation, a $1.1 billion deficit would have resulted rather than a $90 million surplus.
                      5
                       Program income primarily consists of premium revenues paid by policyholders, but also includes
                      investment, fees, and other revenues. Program costs primarily consist of claims and related expenses,
                      but also include, among other things, operating and interest costs.



                      Page 4                                                                              GAOT-RCED-00-23
                                        these years—the exception was fiscal year 1994, when net income was
                                        about $270 million.


Figure 1: Net Financial Status of the
National Flood Insurance Program            Net dollars in millions
(Annual Income Minus Costs)
                                            400

                                                                          270
                                            200


                                               0
                                                                                                                                    -0.6

                                        -200                                                                          -117


                                        -400


                                        -600                                                            -536
                                                             -602
                                                                                    -576

                                        -800
                                                      1993            1994          1995            1996            1997           1998
                                                                                         Fiscal Year


                                        Source: National Flood Insurance Program Flood Insurance Rate Review.




                                        The program’s annual losses during this period ranged from about
                                        $600,000 in fiscal year 1998 to $602 million in fiscal year 1993. Cumulative
                                        operating losses experienced by the program totaled about $1.56 billion
                                        during the 6-year period, of which about $1.47 billion was outstanding as
                                        of September 30, 1998 (the $1.56 billion loss less the $90 million in
                                        revenues as of September 30, 1992). To finance these losses, the Federal
                                        Insurance Administration borrowed from the U.S. Treasury during the
                                        6-year period.6 According to FEMA, as of August 31, 1999, the debt owed by


                                        6
                                         The Congress authorized the Federal Insurance Administration to borrow up to $1 billion from the
                                        U.S. Treasury if necessary to pay claims losses. Legislation enacted in 1996 provided a 1-year increase
                                        in borrowing authority to $1.5 billion later extended through 1999. However, no appropriations have
                                        been made to the program since fiscal year 1986.



                                        Page 5                                                                             GAOT-RCED-00-23
the program to the U.S. Treasury totaled $541 million.7 Interest expense
incurred by the Federal Insurance Administration on the program’s
borrowings totaled about $115 million during the 3 fiscal years 1996
through 1998.8

While the program has incurred substantial operating losses in recent
years, it should be recognized that the value of the program in reducing
federal expenditures on disaster assistance is not limited to its financial
status. For example, the Federal Insurance Administration estimated that
the program’s standards for new construction are now saving about
$1 billion annually in flood damage avoided. Also, during the 13-year
period from October 1, 1985, through September 30, 1998, the program
paid about $7 billion in insurance claims primarily from policyholder
premiums that otherwise would, to some extent, have increased
taxpayer-funded disaster relief.

It should also be recognized that losses experienced by the program
annually have gradually declined since fiscal year 1995. Total operating
losses declined from $576 million in fiscal year 1995 to $600,000 in fiscal
1998. This decline was primarily due to three reasons. First, claims and
related expenses declined from $1.1 billion in fiscal year 1995 to
$719 million in fiscal year 1998.9 Second, the number of policyholders
covered by the program increased about 24 percent from 3.3 million
policies in force in fiscal year 1995 to 4.1 million policies in force by fiscal
1998. Accordingly, earned premium revenue on these policies increased
from $814 million to $1.2 billion during the period. Third, according to
Federal Insurance Administration officials, the proportion of generally
more flood-prone pre-FIRM subsidized policies insured by the program has
declined, resulting in a less risky portfolio of policies in force. The
percentage of program policies that are subsidized declines over time as
newer properties join the program and are charged actuarial rates. While
41 percent of the 2.7 million policies in force in fiscal year 1993 were
subsidized, 30 percent of the 4.1 million policies in force in fiscal year 1998
were subsidized, according to a Federal Insurance Administration official.

7
 According to a Federal Insurance Administration official, debt owed by the Federal Insurance
Administration to the U.S. Treasury is not equivalent to the program’s cumulative losses because the
amount of borrowing needed depends on (1) the relative timing of payments on the program’s current
obligations and expected monthly premium receipts and (2) future insurance claims.
8
 Federal Insurance Administration officials noted that beginning in fiscal year 1986, the Congress
required all program and administrative costs to be paid for by the program without a commensurate
rate increase. In 1991, the Congress authorized the Federal Insurance Administration to charge
policyholders a federal policy fee to pay for these costs. Federal Insurance Administration officials
estimate the current value of the resulting loss of funds and investment income to be about
$436 million, making the program more vulnerable to the need for exercising its borrowing authority.
9
 The magnitude of flood damage can vary considerably from year to year.


Page 6                                                                            GAOT-RCED-00-23
                                  Two major factors contribute to the financial difficulties faced by the
Major Factors                     program. First, the program is not actuarially sound because, by design, it
Contributing to the               does not collect sufficient premium income to build reserves to meet
Financial Difficulties            future expected flood losses. Second, the cost to the program of
                                  multiple-loss properties is large—about $200 million annually.
Faced by the Program
The Program Is Not, by            The program is not actuarially sound because about 30 percent of the
Design, Actuarially Sound         4.1 million policies in force are subsidized, according to a Federal
                                  Insurance Administration official. For a single-family pre-FIRM property,
                                  subsidized rates are available for the first $35,000 of coverage, although
                                  any insurance coverage above that amount must be purchased at actuarial
                                  rates. Federal Insurance Administration officials estimated that total
                                  premium income from subsidized policyholders are currently about
                                  $500 million less than they would be if these rates had been actuarially
                                  based and participation had remained the same.

                                  Pre-FIRM structures that are within an identified 100-year floodplain and
                                  are covered by subsidized policies are, on average, not as elevated as the
                                  post-FIRM structures in comparison with the base flood level. Federal
                                  Insurance Administration officials told us that, on average, pre-FIRM
                                  structures not built to the program’s standards are three and a half to four
                                  times more likely to suffer a flood loss. When these structures suffer a
                                  loss, the damage sustained is, on average, about 40 percent greater than
                                  the damage to flooded post-FIRM structures. According to the Federal
                                  Insurance Administration, when these two factors are combined, pre-FIRM
                                  structures suffer, on average, about five times more damage than post-FIRM
                                  structures.

Premium Income Not Sufficient     As an alternative to actuarial soundness, the Federal Insurance
to Build Reserves for Potential   Administration developed a financial goal for the program to collect
Catastrophic Losses               sufficient revenues to at least meet the expected losses and expenses of
                                  the historical average loss year, as well as to cover all non-loss-related
                                  program expenses, such as the program’s administration. However, the
                                  historical average loss year is based only on the experience under the
                                  program since 1978. Since that time, no catastrophic year ($5.5 billion to
                                  $6 billion in claims losses) has occurred, and many years in the 1980s were
                                  characterized by low actual loss levels as compared to the historical
                                  average losses experienced in other years. Therefore, the historical
                                  average loss year involves less losses from claims than the expected
                                  annual claims losses in future years. As a result, collecting premiums to




                                  Page 7                                                      GAOT-RCED-00-23
                                 meet the historical average loss year does not reflect the collections
                                 necessary to build reserves for potential catastrophic years in the future.

                                 For the program to be actuarially sound, its rate-setting process would
                                 have to consider the monetary risk exposure of the program or the dollar
                                 value of expected flood losses over the long run. Since the magnitude of
                                 flood damage varies considerably from year to year, income from
                                 premiums in many years would exceed actual losses. This circumstance
                                 would enable the program to build reserves toward a possible catastrophic
                                 year in the future.

Increasing Premiums for          As we reported in March 1994, increasing the premiums charged to
Subsidized Policies or           subsidized policyholders (thereby decreasing the subsidy) to improve the
Expanding Participation in the   program’s financial health could have an adverse impact on other federal
Program May Have Adverse         disaster-related relief costs. Increasing subsidized rates would likely cause
Financial Impacts                some policyholders to cancel their flood insurance, and if flooded in the
                                 future, these people might apply for Small Business Administration loans
                                 or FEMA disaster assistance grants.

                                 Because they were built before the program’s building standards became
                                 applicable, pre-FIRM structures are generally not as elevated as post-FIRM
                                 structures, and if their owners were to be charged true actuarial rates,
                                 these rates would be much higher than current subsidized rates.10 For
                                 example, if the subsidy on pre-FIRM structures were eliminated, insurance
                                 rates on currently subsidized policies would need to rise, on average,
                                 approximately a little more than twofold, according to a Federal Insurance
                                 Administration official. This increase would result in an annual average
                                 premium of about $1,300 for these pre-FIRM structures. Significant rate
                                 increases for subsidized policies, including charging actuarial rates, would
                                 likely cause some pre-FIRM property owners to cancel their flood
                                 insurance.11

                                 If owners of pre-FIRM structures, which suffer the greatest flood loss,
                                 canceled their insurance policies, the federal government would likely
                                 face increased costs, as the result of future floods, in the form of


                                 10
                                   Also, Federal Insurance Administration officials told us that making all rates actuarially based would
                                 not make the program actuarially sound. They noted that an initial capitalization would be necessary
                                 to establish some reserves in the event that a catastrophic year were to occur before sufficient
                                 reserves were accumulated from income from premiums.
                                 11
                                   The National Flood Insurance Reform Act of 1994 expanded the mandatory flood insurance purchase
                                 requirement on properties financed with any federal loan or grant or loans made by lending
                                 institutions regulated by the federal government that are located in special flood hazard areas.
                                 However, lenders have not always imposed this requirement.



                                 Page 8                                                                             GAOT-RCED-00-23
                          low-interest loans from the Small Business Administration or grants from
                          FEMA. The effect on total federal disaster assistance costs of phasing out
                          subsidized rates would depend on the number of the program’s current
                          policyholders who would cancel their policies. Thus, it is difficult to
                          estimate if the increased costs of other federal disaster relief programs
                          would be less than, or more than, the cost of the program’s current
                          subsidy.

                          On the other hand, expanding participation in the program by increasing
                          the rate of compliance with the mandatory purchase requirement, or by
                          extending the mandatory purchase requirement to property owners not
                          now covered, will likely increase the number of both subsidized and
                          unsubsidized policies. Although greater participation in the program is
                          likely to reduce the cost of FEMA grants and Small Business Administration
                          loans, the resulting increase in subsidized policyholders will put greater
                          financial stress on the flood insurance program, because the premiums
                          received from subsidized policyholders are not sufficient to meet the
                          future estimated losses on these policies.


Repetitive Flood Losses   Another major factor contributing to the financial difficulties facing the
                          National Flood Insurance Program is repetitive flood losses.12 About 36
                          percent of all program claims historically (currently about $200 million
                          annually) represent repetitive losses even though repetitive-loss structures
                          make up a small percentage of all program policies. About 40,000 buildings
                          currently insured under the program have been flooded on more than one
                          occasion and have received flood insurance claims payments of $1,000 or
                          more for each loss. The cost of these multiple-loss properties over the
                          years to the program has been $2 billion.


                          The Federal Insurance Administration has studies under way and has
Actions Under Way to      taken other actions recently that may have an affect on the financial health
Address the Program’s     of the program. The Federal Insurance Administration has studies under
Financial Problems        way assessing the economic effects of eliminating subsidized flood
                          insurance rates for pre-FIRM construction and the program’s underwriting
                          and claims processes and controls. It has also developed a repetitive loss
                          strategy that would target, for mitigation assistance, currently insured
                          multiple-loss properties posing the greatest risk of loss. The Federal
                          Insurance Administration also initiated a “Call for Issues” inviting

                          12
                           A repetitive-loss property is one that has two or more losses greater than $1,000 each within any
                          10-year period.



                          Page 9                                                                            GAOT-RCED-00-23
program stakeholders and the public to make recommendations about
ways to make the program more effective.

In line with requirements of the National Flood Insurance Reform Act of
1994, FEMA awarded a contract to study the economic effects of eliminating
subsidized flood insurance rates for pre-FIRM construction. The study is
aimed at determining, among other things, the (1) number and types of
properties that would be affected by an increase in premium rates,
(2) number of policyholders who would likely cancel their flood insurance
policies if premium rates were increased, and (3) effects of increased
premiums on land values and property taxes. The study has been delivered
to the Federal Insurance Administration which is developing
recommendations based on the study, which will be released by the first of
next year.

The improper underwriting of flood insurance policies and adjustments of
flood insurance losses have an adverse effect on the financial health of the
program. In light of the growth in the number of policyholders and losses
experienced by the program, the Federal Insurance Administration
initiated an evaluation of its underwriting and claims processes and
controls. This study will focus on, among other things, how well the
program’s underwriting and claims requirements are being met and the
nature and adequacy of program controls over these processes. The final
report is expected by the end of the calendar year.

Under its repetitive-loss strategy, the Federal Insurance Administration
intends to target for mitigation the most flood-prone repetitive-loss
properties, such as those that are currently insured and have had four or
more losses. The Federal Insurance Administration is considering a
regulatory change proposing that if a target property is offered mitigation
assistance and the offer is declined, flood insurance for the property will
only be renewed or rewritten at a full-risk premium. Currently, about
$20 million has been authorized to address repetitive losses, and the
Federal Insurance Administration is exploring other options for funding.

Lastly, the Federal Insurance Administration continues to categorize 600
issues suggested by lenders, bankers, individuals, and other stakeholders
in response to its “Call for Issues” to make the program more effective.
Due to the large number of issues, the Federal Insurance Administration
does not expect to report on the issues until the end of the calendar year.




Page 10                                                      GAOT-RCED-00-23
                 In closing Mr. Chairman, the Federal Insurance Administration is helping
                 the nation avoid the costs of flood damage through the premiums it
                 collects from, and the claim payments it makes to, program policyholders
                 as well as the building standards it has promoted for new construction
                 that minimize flood damage. However, in recent years, heavy flooding has
                 produced annual flood insurance losses that exceeded the premiums
                 collected from policyholders. As a result, the program has had to borrow
                 funds from the U.S. Treasury to cover its operating losses. Two major
                 factors underlie these financial difficulties—the program, by design, is not
                 actuarially sound and it experiences repetitive losses. These factors are
                 not easy to overcome because they have been an integral part of the
                 program since its inception, and they are related to the promotion of
                 floodplain management and widespread purchasing of flood insurance.
                 The Federal Insurance Administration has studies under way and has
                 taken other actions that may enhance the financial soundness of the
                 program.

                 Mr. Chairman, this completes our prepared statement. We would be happy
                 to respond to any questions that you or Members of the Subcommittee
                 may have.


                 For future contacts regarding this testimony, please contact Mr. Stanley J.
Contact and      Czerwinski at (202) 512-7631. Mr. Robert S. Procaccini and Mr. R. Tim
Acknowledgment   Baden made key contributions to this testimony.




(385832)         Page 11                                                      GAOT-RCED-00-23
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