Congress agreed with Representative Barney Frank's (D-Mass.) assessment of the National Flood Insurance Program (NFIP) and on September 29, 2008, passed a bill extending the Program through March 6, 2009. The extension was made "necessary" to allow congress time to iron out differences of opinion about the program including: the addition of wind coverage (see "Why Flood Policy Should Not Include Wind Coverage"); and whether or not to forgive NFIP's $18 billion debt.

Radical changes are needed to fix the broken NFIP system. Anything the congress throws together between now and March 6 is a temporary patch. Adding wind coverage to an already actuarially unsound program would doom the American taxpayer to greater rate subsidization; and forgiving the debt would amount to another bailout for bad management (detailed below). Further, trying to force the correct AND non-subsidized rates on current policyholders will result in the classic adverse selection spiral. There must be a call from the insurance industry and the tax-paying public for an end to "business as usual" at the NFIP.

Current NFIP Statistics

The National Flood Insurance Program insures only 0.02 percent, approximately, of the residential and non-residential structures in the United States. Based on year-end 2007 data, the NFIP:
• Insures $1.14 trillion in property;
• Has in force 5.65 million policies; and
• Collects more than $2.85 billion in annual premiums. This generates an average premium of $505 per policy and an average rate of 0.25 per $100 (both too low for the exposure).

According to a 2006 Congressional Research Service study, the NFIP operated at a loss in 19 of the 34 years between 1972 and 2005. During the same period the NFIP borrowed over $4 billion from the Federal government. They repaid most of that amount and, according to outside sources, had the rest of the debt forgiven. That was before 2005's Katrina, Rita and Wilma.

2005 Revealed Problems in the NFIP

INSURED flood losses in 2005 totaled over $17.6 billion. This amount is made up of flood losses from the three previously mentioned hurricanes and another $775 million in non-hurricane-related flood losses. The result is that the NFIP is now $18 billion in debt to…the tax payers.

Actuarially sound rates could have avoided the amassing of this debt. Subsidized rates and apparently high operating costs (exposed below) appear to have contributed to the "excessive" debt. (The debt is "excessive" when comparing NFIP premium, loss and operating expenses against insurance industry norms. These calculations are detailed in the following paragraphs).

"Rate-Gate" (The Combination of Inadequate Flood Rates and High Operating Costs)

In 1990 the average rate for an NFIP Flood Policy was $0.31 per $100; jumping to $0.33 in 1991. During the remainder of the 1990's the average rate remained relatively constant, peaking at $0.34 in 1992, 1994 and for the final time in 1998. The average rate began falling in 1999, dropping 4 percent in one year to $0.32; by 2007 it had plummeted to $0.25, a 34 percent dive in nine years. (As an aside, the average rate dropped to $0.25 in 2006 from $0.26 in 2005, the year following $17.6 billion in flood losses.)

Premium and loss totals for the years 1990 to 2007 show that the NFIP collected $28.3 billion in total premium and paid out $30.2 billion in losses during the period; a difference of less than $2 billion. So why is NFIP's debt to the Federal Government topping out over $18 billion? Even attributing 30 percent to operating cost (which is adequate for most major insurers), the short fall for that time period should still only be a little more than $10 billion. Where is the other $8 billion? The numbers just do not add up.

This seems to indicate that operating costs are much higher than reasonable. Simple math applied to the known data indicates that operating expense is more than 55 percent of income making the NFIP the most inefficient insurer known. Now there is more than rate adequacy in question.

Eli Lehrer, senior fellow at the Competitive Enterprise Institute (CEI) in Washington, DC, says of the unreasonably high costs of the program, "It's pretty obvious that NFIP is mismanaged, I'd put only a little blame on the people in charge. Without any market forces to discipline NFIP's operations, waste was inevitable. The write your own program very likely encourages additional waste by giving private companies the opportunity to get revenue—if not significant profits—without actually taking on any real insurance risk."

The Required, Non-Subsidized Rate

If the NFIP had applied an average rate of $0.34, the highest average rate utilized between 1990 and 2007, every year of the 18-year span, premiums would have totaled $33.4 billion. Subtract 30 percent for operating expenses (again, a reasonable amount) and the NFIP would still have operated at a $6.8 billion LOSS.

Based on historical losses and assuming a "normal" 30 percent operating cost, the NFIP would have required a $0.44 per $100 average rate be applied every year from 1990 through 2007 in order to operate at a "combined ratio" of 100 (or, in other terms, to "break even"). This rate is 76 percent HIGHER than the current rate and nearly 30 percent higher than the highest rate used in any year during this period.

However, even the $0.44 average rate would not have been adequate based on the previous conclusion that the NFIP is highly inefficient. Assuming a 50 percent operating cost (5 percent lower than operating cost calculated above), a $0.62 average rate (two and one-half times higher than the current rate) would have been required in each of the 18 years in order for the NFIP to operate at break even. Based on the above information, the average premium for current policyholders should be $1,251 rather than the $505 being charged.

Rate adequacy is apparently not the only problem. Many charge that the exposures are not correctly identified and thus improperly rated due to the supposed inaccuracy of the current flood insurance rate maps (FIRM's).

Gilbert White chaired the Task Force on Federal Flood Control Policy in 1966. The task force's conclusions, published as House Document 465 in August of that year, were that a move should be made toward a national flood insurance program. But the study contained a stern (and apparently unheeded) warning: "A flood insurance program is a tool that should be used expertly or not at all. Correctly applied, it could promote wise use of flood plains. Incorrectly applied, it could exacerbate the whole problem of flood losses. For the Federal Government to subsidize low premium disaster insurance or provide insurance in which premiums are not proportionate to risk would be to invite economic waste of great magnitude."

Artificially low premiums and potentially inaccurate exposure information combined, as predicted by White, to doom the NFIP to its current well of red ink; and the six-month extension will do little to correct the problem unless a truly innovative program replaces the current scheme. A workable program would likely still require NFIP involvement, but on the fringes rather than on the front line; working behind the insurance industry as opposed to beside it.

An Alternative Plan

It is time to question our government over NFIP's mismanagement and to challenge the status quo. The next two posts will outline an alternative flood insurance plan. It is a radical idea, but it appears that a major overhaul of NFIP is required to assure its future health.