Reform of the National Flood Insurance Program (NFIP): Introducing Long-Term Flood Insurance

Five years ago, the United States was reeling from the destruction caused by Hurricanes Katrina, Rita and Wilma, and by the four other hurricanes that made landfall the year before. These extreme events caused historical human and economic consequences. Developing America's resiliency to the new era of catastrophes we had entered promised to become national priority.

But other crises occurred on U.S. soil, from a pandemic to the financial turmoil. Our focus has also shifted internationally, too, to earthquakes in China, Haiti, Chile, and a volcanic eruption in Iceland. As a result, our attention to weather-related-disasters has faded, putting us in jeopardy when the next hurricane strikes the United States. But in the current economy, can we afford another Katrina-type catastrophe inflicting $150 billion in losses, or even more?

When it happens, it will result into major flooding as well. Who will pay? Flood risk in the U.S. has mainly been covered by the federally-run National Flood Insurance Program (NFIP) since 1968. Your insurer plays the role of financial intermediary, selling flood insurance and managing claims on behalf of the federal government. The NFIP has grown significantly to cover $1.25 trillion in assets today.

On April 16 Congress passed and the President signed H.R. 4851, the "Continuing Extension Act of 2010." This act provides the NFIP with a short-term extension through May 31, once again. "Once again" because in the past two years, the NFIP has been renewed multiple times, but always with very limited changes. The problem is that these renewals merely serve to postpone again and again a much-needed national debate about what this program should do (and not do) in the post Katrina world. What the NFIP needs is not "as is" renewing -- it needs a well-thought reform.

Now that Congress and the Administration are less tied up with health care reform, this is a good time to launch a national commission to debate the future of the NFIP.

I say, renew the NFIP for one year after May 31 and give this commission those 12 months to report to Congress and the White House's Office of Management and Budget on key modifications. Objective: reform the NFIP into a more effective, equitable and sustainable program for years to come. If the NFIP is renewed "as is" for five years, as advanced by a House panel earlier this week, we could be locked in for five more years during which the necessary modifications will not be made.

Issues to look at include better flood-hazard maps and risk communication, revising the insurance contract menu (deductibles and limits), reducing the subsidies to repetitive losses, providing new economic incentives to invest in risk-reduction measures (e.g. elevating the house), and reestablishing the financial balance of the program, to name just a few.

But there is another major challenge. Many people exposed to flood risks do not have sufficient insurance coverage, if any at all. Too often, they purchased flood insurance when they moved into a new house (because their bank required it at mortgage signing), but let their policy lapse after just a few years.

In a recent study undertaken with colleagues at the Wharton Risk Center, we show that about half of the new flood insurance policies issued by the NFIP since 2001 lapsed after only 3 years.

Some individuals move elsewhere, some underestimate the risk or are told they are safe, and others think Uncle Sam will bail them out anyway, so why purchase insurance? (Congress appropriated nearly $88 billion (in 2009 prices) for emergency response and recovery as a result of the 2005 hurricane season; this federal relief was more than the combined total insurance claims paid by private insurers for wind damage, plus the payments by the NFIP for flood damage caused by Katrina.)

What can be done? A simple -- but potentially powerful -- change in the current operation of the NFIP would be to move away from the traditional annual insurance policy.

Wharton colleague Howard Kunreuther and I have proposed that Congress and the Administration, working with FEMA and other interested parties, consider restructuring the NFIP to develop long-term flood insurance. That is, multi-year flood insurance contracts of 5, 10 or even 20 years that would be tied to the property, not to the individual. This would provide stability to individuals and the NFIP alike.

The NFIP could also work with financial institutions that could provide home improvement loans to make insured properties more resilient to future floods and spread the cost of the risk-reduction measure over time. For example, a homeowner with a 10-year flood insurance policy could obtain a 10-year home improvement loan. If the homeowner sold his property before the end of the policy period, then the insurance policy and the loan would automatically be transferred to the new owner at the same rate.

This would help millions of households stay insured for many years and also reduce their own financial exposure to future floods. America would be more resilient to disasters and the need for massive federal relief reduced. This would also create new jobs in the construction industry and could be combined with the current effort made by the Administration to make America more energy efficient.

We have discussed this proposal with many key parties in the past two years and have noticed significant interest. Earlier this month, we took part in a round-table discussion organized by U.S. Senator Roger Wicker in Gulfport, Mississippi (U.S. Representative Gene Taylor was also on the panel). Local residents expressed frustration that the United States has not yet done anything to modernize the NFIP, echoing complaints I've heard across the Union.

Almost five years after Katrina took 1,300 lives and inflicted historical economic losses, the reform of NFIP has not received the attention it deserves. More globally, how the United States will manage and finance the new era of catastrophes we have entered remains unanswered. Let's not wait for the next crisis to react with regret and confusion. We need to begin to pave the way for proactive and bold changes, now.