The Federal Emergency Management Agency (FEMA) does not have the information it needs to determine whether its payments to Write Your Own (WYO) insurance carriers are reasonable according to a July 2009, report from the Government Accountability Office (GAO). On average, WYO's retain 30 to 40 percent of the flood insurance premiums they collect as reimbursement and payment for services rendered to FEMA to cover the cost of managing the flood policies these carriers write. The GAO says this is excessive when compared against actual expenses.

At the request of the Committee on Banking, Housing and Urban Affairs and its ranking member, Sen. Richard C. Shelby (R - Ala.), the GAO undertook a 19-month study of FEMA. Between December 2007 and June 2009, the GAO studied FEMA's WYO program to: 1) assess FEMA's methods of determining the amounts it pays WYO's for selling and servicing flood insurance and adjusting claims; 2) examine how FEMA evaluates the effectiveness of its WYO bonus incentive structure to determine whether bonus payments reflect actual flood insurance marketing efforts; 3) evaluate the extent and effectiveness of FEMA's oversight of WYO carriers; and 4) evaluate the relative advantages and disadvantages of three alternatives to the current program.

Determining Payment to WYO's

Ninety-seven percent of in-force NFIP flood policies are managed by the 87 WYO carriers currently listed on FEMA's Website. From a premium standpoint, these WYO's control approximately 89 percent of the total flood insurance premium collected (based on 2007 data, the last year for which information is provided on FEMA's Website). FEMA paid WYO's $868.5 million in 2007 for managing these policies representing 30.3 percent of total NFIP flood premiums written ($2.85 billion) and 34.3 percent of the $2.535 billion in premiums managed by WYO's.

In its report to Senator Shelby, the GAO states that "FEMA does not systematically consider actual flood insurance expense information when it determines the amount it pays WYO's for selling and servicing flood insurance policies and adjusting claims." In fact, payment to WYO carriers is calculated based on proxy information (the cost to manage other lines of insurance) rather than the actual cost of managing the flood program.

At the time the WYO program was introduced (1983) there was no credible method for estimating the carrier's cost of managing the program. To set the reimbursement rate, FEMA chose to base the flood program costs on the cost to manage five long-established property lines of coverage: fire, allied lines, farmowners' multi-peril, homeowners' multi-peril and the non-liability part of commercial multi-peril. Not until 2008 did FEMA apply actual cost when considering reimbursement rate, but such consideration was limited to claims processing expense; nothing has been done to alter the selling and servicing fee calculation method.

FEMA did not begin to require WYO carriers to report the actual costs for managing NFIP flood policies to the National Association of Insurance Commissioners (NAIC) until 1997. However, FEMA has chosen not to use this data when setting reimbursement rates because, as the GAO points out in its findings, the financial data submitted by the WYO's is suspect as there is currently no clear guidelines or rules regarding how and what cost information is to be provided.

Commission expense, operating expense, incentive bonuses, claims adjustment expenses, claims processing expenses and additional adjusting expenses are used to calculate the amount a WYO carrier gets paid. Each has its own method of calculation:

• Commission expenses are a flat 15 percent of written premium;
• Operating expenses fluctuate annually based on the average costs of the proxy lines of coverage (listed above);
• Incentive bonus amounts are based on policy growth. WYO's growing 2 percent receive a 0.5 percent bonus and carriers increasing their book by 5 percent or more can earn as much as an additional 2 percent of the annual written premium (the maximum available);
• Claim adjustment expenses depend on the size of the claim. Individual losses below $50,000 earn the carrier a flat rate ranging between $60 and $1,250; fees for claims over $50,000 are based on a percentage of the loss amount beginning at 3 percent and going down to 2.1 percent when losses reach $250,000 or more. The greater the amount of claims paid, the more the WYO earns;
• Claims processing fees are 3.3 percent of losses incurred (again, the higher the claims amount, the more earned in fees); and
• Additional adjusting expense is based on actual costs to pay for litigation, engineers and appraisers.

Only the commission expense and the additional adjusting expense have any relationship to the actual cost of managing the flood program. None of the remaining four, which constitute the greatest total cost to FEMA, have any correlation to the program's cost to the WYO's.

To highlight its point, the GAO studied and reported on six of the largest WYO carriers. During the three policy years beginning 2005 and ending 2007, FEMA paid these carriers $327.1 million more than their actual expenses. This translates to a 16.5 percent overpayment.

Six GAO recommendations resulted from part one of the study:

1. Determine in advance the amounts built into the payment rates for estimated expenses and profit;
2. Annually analyze the amounts of actual expenses and profit in relation to the estimated amounts used in setting payment rates;
3. Consider the results of the analysis of payments, actual expenses and profit in evaluating the methods for paying WYO's;
4. Immediately reassess the decision to pay WYO's an additional 1 percent of written premiums for operating expenses;
5. Take actions to obtain reasonable assurance that NAIC flood insurance expense data can be considered in setting payment rates that are appropriate; and
6. Develop comprehensive data analysis strategies to annually test the quality of flood insurance data that WYO companies report to NAIC.

Effectiveness of the Incentive Bonus

FEMA has as its goal a 5 percent net policy increase every year. Part of this goal is to increase policy count among what are, historically, under-represented insureds:

• Insureds in "low-risk" flood zones (B, C and X);
• Home owners without federally-related mortgages in all flood zones; and
• Insureds in geographic areas with repetitive losses.

According to a 2006 Rand Corporation study (as quoted in the GAO report), only 50 percent of homeowners in special flood hazard areas (SFHA's) and less than 1 percent outside of SFHA's carry flood coverage. To accomplish the goals of growth and increased participation, FEMA offers an incentive bonus for carriers that increase their total written premium. Ostensibly, the bonus is intended to award carriers for their increased marketing efforts as supposedly evidenced by growth.

What the GAO found is that the only WYO carriers that seem to benefit from this incentive program are those with small flood books (5 percent of a $1 million book is far less than 5 percent of a $14 million book). Nearly across the board the largest WYO carriers did not qualify for the maximum incentive (2 percent of written premium) in the most recent years.

Additionally, the GAO discovered from its conversations with various WYO carriers that policy growth was most often by chance or the result of major flood events or other catastrophes (i.e. Hurricane Katrina). WYO carriers, as a group, did not report undertaking any special marketing efforts; in fact, only one carrier ever even submitted a marketing plan â€" and that was for just one year. Even the marketing efforts undertaken by FEMA only had a minor affect on policy growth.

As a result of this finding, the GAO recommended that to improve the incentive program (should FEMA desire to even continue it), FEMA should consider using more targeted marketing bonus goals rather than basing payout solely on growth.

The Effectiveness of FEMA's Oversight of WYO's

"FEMA has explicit financial control requirements and procedures for overseeing the WYO program.... The plan has four major components that include requirements for: 1) monthly data and financial reporting; 2) claims reinspections by FEMA's contractor; 3) various audits by independent CPA's, including required biennial audits, audits for cause and state insurance department audits; and 4) triennial operation reviews by FEMA staff."

Ten (of the 87 listed) WYO's were sampled by the GAO to judge how consistently and thoroughly FEMA followed these guidelines. The WYO's sampled managed more than 50 percent of total $2.854 billion in flood insurance premiums written in 2007.

The GAO's reported findings were somewhat less than stellar. FEMA, according to the report:

• Collected and reviewed approximately 90 percent of the required monthly financial reports;
• Reinspected only 243 of the 1,539 claims eligible for reinspection (nearly 16 percent);
• Collected some but not all of the required biennial audits. FEMA did not have a complete set of audits from any of the sampled carriers during the studied years; and
• Conducted nearly all of the required triennial operational underwriting and claims reviews; but conducted almost none of the required marketing, customer service and litigation reviews.

FEMA provided explanations for some of the shortcomings reported by the GAO regarding the biennial audits and triennial operational reviews.

• Biennial audits. FEMA officials reported that some of the sampled carriers were exempted from the reporting requirement following the 2005 hurricane season due to an overwhelming number of hurricane claims. The GAO did note that beginning in fiscal year 2006, FEMA consistently collected the required audits from the 10 carriers.
• Triennial operational reviews. FEMA reported that operational reviews focused on underwriting and claims because those areas are the most important in determining if appropriate premiums are being charged and claims appropriately paid. Litigation data is collected to ensure correct payments, but operational reviews are not conducted. State departments of insurance are depended upon to report any deficiencies in customer service; and FEMA no longer does marketing program reviews because of the bonus program. A draft control plan has been written and submitted showing these changes to the original program.

To correct these deficiencies in the implementation of the control plan, the GAO made three observations and accompanying recommendations:

1. Because FEMA does not implement all aspects of the control plan, it cannot ensure that the WYO's are fully complying with the program requirements. To improve oversight, FEMA should consistently follow the control plan;
2. Compliance with the control plan ensures that participating WYO's are being compensated appropriately. FEMA must ensure that any revised control plan includes oversight of all functions of participating WYO's to include customer service and litigation; and
3. FEMA does not systematically track and centrally store all required evaluations, inspections, audits or reviews. This lack of centralization should be corrected to ensure timely and easy access for management and staff to all audits, reviews, inspections and data analysis.

Alternatives to the Current WYO Program

Three alternatives to the current WYO program were offered by the GAO:

• Alternative Plan 1: FEMA contracts with one or more insurance companies;
• Alternative Plan 2: FEMA contracts with one vendor; and
• Alternative Plan 3: FEMA contracts with multiple vendors and maintains the WYO network.

The advantages and disadvantages of each plan proposed by the GAO are found on page 70 of 83 of the full report linked in the final paragraph.

No alternative is perfect and no change in the current program will occur quickly. These are but recommendations for congressional and FEMA consideration.

The Report

Findings and opinions published by the GAO as highlighted above are not very favorable to FEMA. A copy of the full report can be found on the GAO website.