U.S. Taxpayers Need Break From Underwater Flood Insurance

Hurricane Sandy is forcing a re-evaluation of climate change, seawalls and the nation’s power grid.

It should also prompt a re-examination of federal flood insurance. The program gives unneeded subsidies to those with expensive beach properties, skews incentives and repeatedly needs taxpayer bailouts.

Congress established the program three years after 1965’s Hurricane Betsy, which hit New Orleans and was the first storm to inflict more than $1 billion in damage. The aim was to avoid the repeated and enormous costs of providing disaster aid. Private insurers wouldn’t underwrite flood coverage; everyone living in a flood plain is a potential claimant. The government decided it had no choice but to create a market from scratch.

Today, about 90 private companies sell the policies while the Federal Emergency Management Agency manages the $1.27 trillion of insurance in force. Homeowners can insure their properties for up to $350,000, businesses for $1 million. Premiums are lower than they would be based on market prices because of direct subsidies and the government backstop.

Even under the most optimistic scenario, the program charges too little for coverage. One 2010 study found that if there were no unusual weather events, the main cause of major flooding, it would take 100 years for the program to earn its way out of the deficit accumulated from past floods.

Credit Line

Sandy might bring in as many as 300,000 claims. After last year’s Hurricane Irene, a less-violent storm, the average payout was about $30,000. Back-of-the-envelope math suggests a $9 billion hit to the program. And that could be a conservative estimate given Sandy’s force and the high property values in hard-hit New York and New Jersey, where the program underwrites $96 billion of coverage.

Claims of that scope would blow through the program’s $20 billion credit line with the U.S. Treasury, which has already been tapped for almost $18 billion thanks mostly to Hurricane Katrina.

Flood insurance also poses a moral hazard, encouraging people to engage in riskier behavior because they don’t bear all the costs. This has led to an explosion of development in flood-prone areas, particularly the wetlands so vital to protecting coastal areas from lethal storm surges. It’s no surprise that Florida, with its vast coastline, is where more than a third of the 5.6 million flood policies have been sold.

This year, Congress reauthorized the program for five years with the goal of putting it on a sounder financial footing. Coverage of vacation homes and properties with repeated claims will be phased out; rates will increase to help build a reserve fund to absorb losses; and FEMA has been instructed to develop more accurate maps of flood plains.

This was a step in the right direction. But the revisions aren’t enough amid a changing climate that might make big storms (and big flood-insurance claims) more frequent.

The reserve fund the program is supposed to accumulate is pegged at 1 percent of the flood insurance in force. An average hurricane making landfall in Florida could wipe that out. To be effective, the reserve would have to be a good deal bigger.

The government also needs to do a better job of spreading risk. The insurance industry is far more sophisticated than it was 40 years ago and has developed deep markets for reinsurance. Reinsurers basically sell insurance to insurers. This helps protect a company -- or in this case, the flood insurance program -- in the event of catastrophic-loss claims.

Reflecting Risks

Premiums not only need to rise, but also must reflect actual risks. Today, the program offers uniform rates based mainly on flood-plain classification. This method fails to take account of the risk profiles of individual properties.

Perhaps most important, the program hasn’t found a good solution for coping with self-inflicted adverse selection, in this case the requirement that property owners in high-risk locations purchase expensive coverage while those with slightly less risk can get large subsidies or don’t have to buy. This limits the size of the premium pool. One possible answer is for more mortgage lenders to require insurance on properties in lower-risk flood plains as a condition of loan approval.

For the second year in a row, the Northeast was hit by a devastating storm. More are inevitable. Strengthening flood insurance is crucial to those who need it most: the middle-class Americans and small businesses whose lives and livelihoods depend on being close to the water. With the right fixes, the program might avoid more taxpayer bailouts and will be able to stand up to the storm.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.