Addressing Affordability in the National Flood Insurance Program

Following claims payments from Hurricanes Katrina (2005) and Sandy (2012), the National Flood Insurance Program (NFIP) is $24 billion in debt to the U.S. Treasury as of July 2013. One reason for the NFIP’s financial imbalance is that many homeowners historically received premium discounts below risk-based rates. FEMA estimates that about 20 percent of flood insurance policies receive premium discounts of about 40–45 percent.  Risk-based premiums are needed for the NFIP to be financially self-sustaining. Risk-based pricing is also important to emphasize to policyholders the magnitude of the risk that they face, as well as to encourage them to invest in mitigation measures in return for premium reductions.  Yet affordability is an issue for many low- and moderate-income coastal residents.

We propose a program of means-tested vouchers coupled with low-cost loans for investments in loss reduction measures, made affordable by reductions in the NFIP risk-based premiums. A combination voucher and loan program can save homeowners money by lowering their insurance premiums. Homeowners would receive a loan to make their property more resistant to flood damage, which in turn would lower the cost of their flood insurance. This program will also reduce the NFIP’s exposure and improve its financial soundness through risk-based pricing.

The proposed voucher program has three key features. First, it is based on risk-based insurance premiums which are essential for communicating information about flood risk. Second, the vouchers would not only cover a portion of the insurance premium, but also would cover the costs of the loan to reduce future damage to the residence. Third, as a condition for receiving a voucher, a homeowner would have to undertake loss reduction measures that meet current standards.

Raising a house so it is above base flood elevation (BFE) could save thousands, if not tens of thousands, of dollars on annual flood insurance costs. To qualify for the insurance voucher, the homeowner would be required to elevate his house to one foot above BFE and would be given a loan for this purpose. The voucher would cover the combined costs of the annual loan payment and the insurance premium in excess of $2,500.
Consider two property owners — one in an A zone and one in a V zone – that want to reduce future damage from flooding and storm surge caused by hurricanes by elevating their homes. Both purchase an NFIP policy for $250,000 coverage. Assume that each property is three feet below BFE, and that the annual premium for the A zone resident is $4,000, and the annual premium for the V zone resident is $18,550. Further assume that each homeowner is eligible for a flood insurance voucher and has an income of $50,000 a year. Using 5 percent of gross income as our measure, these individuals would be expected to pay $2,500 toward flood insurance. If no loss reduction measures were undertaken, the A zone resident would receive a flood insurance voucher for $1,500, and the V zone resident would receive a voucher for $16,050.

The costs to elevate the houses in our example are estimated to be $25,000 for the A zone property and $55,000 for the V zone property. Both residents receive a 20-year loan at a 3 percent rate to cover these costs. The resulting annual loan payments are $1,680 and $3,660, respectively. Once the homes are elevated, the annual NFIP premiums drop to $520 for the A zone resident and $6,700 for the V zone resident.

After the homes are elevated, no voucher is required for the A zone resident because the coupled loan payment and premium, at $2,200, is less than the $2,500 that the homeowner is required to pay (based on income) for insurance. The annual cost to the homeowner of elevating the house is less than the cost of insurance ($2,500) without mitigation. For the V zone resident, after mitigation, the combined payment for the loan and premium is $10,360; the homeowner pays $2,500 and the federal government pays $7,860.  During the life of the loan, the total annual savings (the difference between the premium with no mitigation and the combined loan and premium after mitigation) are $1,800 for the A zone property and $8,190 for the V zone property.

For any pre-mitigation premium in the A zone greater than $2,200 and in the V zone greater than $10,360, it is less expensive to elevate the property and obtain the lower NFIP premium. The insurance and loan voucher program is also financially attractive for higher costs of elevation and for a range of loan terms.

 

This article appears in the Risk Center’s 2013 newsletter.