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After the flood

Flood insurance and wetlands restoration are two policies that hold both promise and problems for flood control. Will they be able to handle the next disaster?

November 1, 2001


Douglas Clement Senior Writer

The floods that hit the cities and towns of the Ninth District this past spring may seem a dim, unpleasant memory as winter approaches. But while public attention to flooding tends to recede along with the waters, government flood policy builds over time. The Great Midwest Flood of 1993 helped focus debate around several policy initiatives, including structural flood control (that is, dams and levees) and property buyouts, as discussed in the September fedgazette cover story. Two other programs that have drawn serious attention—flood insurance and wetlands restoration—also offer both potential and predicaments. And some flood experts contend that all these policies will fail unless we recognize that flood disasters are a moving target: Floodplain management must continually evolve simply because humans constantly change their relationship to the rivers and lakes that bring us such joy—and such misery.

Risk miss-management

After devastating floods in the mid-1960s, Congress devised a plan to institutionalize flood insurance, in the hope that it would decrease future disaster relief costs. The National Flood Insurance Program (NFIP), under the Federal Emergency Management Agency's (FEMA) National Insurance Administration, sought to sign up floodplain residents for government-backed insurance policies. It was a simple enough idea: Home- and business-owners would be encouraged to pay annual premiums in return for payouts in times of disaster.

The problem is, NFIP is broken. In fact, it was designed to be that way.

To encourage people to enroll in the program, NFIP subsidized premiums from the start, charging policyholders less than would be required in an actuarially sound insurance program. In other words, policyholders don't have to assume the full risk because taxpayers cover part of it.

Because of these premium subsidies—and with the extensive flooding of the 1990s—NFIP incurred losses totaling $1.56 billion between 1993 and 1998. To finance those losses, NFIP borrowed from the U.S. Treasury. Fortunately, lower payouts in 1999 and 2000 enabled NFIP to repay its debt, according to a July 2001 General Accounting Office (GAO) analysis. But chances are good that NFIP will again be knocking on the Treasury's door, "because it does not collect sufficient premium income to build reserves to meet the long-term future expected flood losses," according to GAO. "The program is not, by design, actuarially sound."

Better but still broken

The subsidy has been reduced since the program's inception in 1968. Eligibility requirements for lower premiums have tightened, and the size of the premium reduction itself has diminished. Still, about 30 percent of policies remain eligible for subsidized rates, and those policyholders pay only 38 percent of the full-risk premiums for their properties.

Decreasing the subsidy, however, had an unwanted side effect. As insurance premiums rose, some policyholders stopped renewing their policies, especially after several years without a flood made another seem unlikely. And since not all banks enforced the requirement—passed in 1973—that mortgage-holders of federally backed mortgages sign up for flood insurance, homeowners and business people had one less reason to pay for it. A 1994 NFIP reform stiffened bank oversight and compliance has improved.

Still, today, just a fraction of floodplain owners actually have flood insurance, though national estimates of that fraction vary widely. A 1993 report said that fewer than 42,000 households of the 803,000 residing in special flood-hazard areas had purchased flood insurance before the 1993 flood—just 5.2 percent. In 1998, NFIP's director, Ed Pasterick, estimated that "the current 4 million NFIP policies represent less than half of those property owners who should carry the coverage." A 1999 National Academy of Sciences report on disasters estimated that about 20 percent of homes exposed to floods are insured against them. A recent FEMA estimate is that 27 percent of all floodplain owners hold flood insurance.

Ninth District numbers

NFIP policy participation is low in Ninth District states. Authorities in Wisconsin say fewer than 14 percent of structures on state floodplains are currently enrolled in NFIP. And they estimate "even lower participation rates in many Mississippi River communities," said Gary Heinrichs of the Wisconsin Department of Natural Resources. "If 13.5 percent is the figure for the state as a whole, in some areas we may have well less than 10 percent of floodplain properties with flood insurance." In Crawford County in southwestern Wisconsin, said Heinrichs, "where there are hundreds and hundreds of structures, I think there's less than 30 flood insurance policies."

Ironically, FEMA's acquisition program could be contributing to the problem. (See the September fedgazette.) "To the extent that floodplain residents begin to presume the availability of buyouts in the event of a flood," wrote NFIP's Pasterick, "the incentive to purchase flood insurance is significantly reduced."

But of course, if program participation does grow, NFIP's financial footing will become still more precarious, since it will have to subsidize a greater number of policy premiums.

Lost and found, lost and found

While many people drop their flood insurance policies or never buy them in the first place, others have used them like home remodeling services. A National Wildlife Federation analysis of NFIP data between 1978 and 1995 found that a small fraction of total policies made multiple damage claims. These policies, dubbed "repetitive-loss properties," represented only 2 percent of insured properties but accounted for 25 percent of loss claims and 40 percent of NFIP payments. In Minnesota, for example, 46 properties made 137 loss claims totaling over $1.6 million. FEMA officials currently report that North Dakota has 192 repetitive-loss properties, Montana 40 and South Dakota 56. Nationally, the cost of claims by multiple-loss properties has totaled over $2 billion, constituting a "major factor contributing to the financial difficulties" of NFIP, according to the GAO.

Bad maps mean bad rates

A mark of the fundamental nature of NFIP's problems is its difficulty in accurately estimating program participation rates. It knows exactly how many policies it's sold, but no one knows the total number of structures in floodplains. Dams and levees change the floodplain, as do new housing developments, businesses, public buildings and infrastructure alterations, but these changes aren't accurately reflected in NFIP risk rates. According to a May 2001 GAO report, about 63 percent of the nation's floodplain maps are at least 10 years old, a problem that seriously undermines credibility when floodplain managers talk to local officials about flood mitigation strategies. More to the point, outdated floodplain maps make accurate risk assessment impossible and blunt attempts to market flood insurance to those who need it. Efforts are under way to update the maps, but their completion will take years.

Without accurate floodplain maps, NFIP also can't set premiums—subsidized or not—that correspond to risk. Therefore, notes Lester Lave, professor of economics and finance at Carnegie Mellon University, they "don't do a very good job of making the insurance actuarially fair. So if you live at the edge of the 100-year floodplain [with a 1-in-100 chance of being flooded in any given year], you basically pay the same insurance rate as somebody who lives in the five-year floodplain." High-risk people, in other words, would pay little more than low-risk people, and the latter—reasonably enough—will be less likely to pay their premiums, a problem economists call "adverse selection."

Regardless, the rates are often too high for many to afford, especially for those without subsidized premiums. Some floodplain residents along the Mississippi "may have a house that's worth $30,000 and the premium per year might be $2,000 or $3,000," observed Heinrichs, "and they're not willing to pay that kind of premium. They'd rather just pay for the flood damages as they occur. It's a real problem."

Why buy?

And indeed, why pay for insurance? Some who don't sign up undoubtedly believe they can rely on the government to bail them out after the next flood. "I'm just amazed at the multiple layers of assistance available," noted Rep. DuWayne Johnsrud of Wisconsin's 96th District, much of which lies along the Mississippi River. "There's flood assistance available through everybody ... there's FEMA, the state, county, Community Action, SBA, it just never ends. They all have their little special flood-help deal. ... Why get the insurance when you've got all those other things? So, government doesn't really discourage you from living there."

While government aid programs are actually far more restrictive than that, the perception that government will come through in times of need has created a situation that economists call "moral hazard"—excessive risk taking in the belief that protection is in place. It's like driving more aggressively because you're convinced your anti-lock brakes and air bags will stop your car and save your life. If floodplain dwellers believe the government will bail them out of disasters, they may be more liable to put themselves in harm's way, less apt to insure themselves against loss and less likely to protect their homes through elevation.

"If people aren't actually protecting themselves because they think the federal government will help them," observed Howard Kunreuther, co-director of the Center for Risk Management at Wharton Business School, then "it's the worst of all worlds," because government protection is not going to come through. Or will it?

Tough love or flexible Feds?

For NFIP to succeed as a risk management tool, it has to be coordinated with zoning regulations that require people to take steps to reduce flood risk—by elevating their structures, for example, or at least not substantially increasing the value of their floodplain properties. But local authorities have usually been reluctant to enforce these requirements, out of fear of losing their tax base and perhaps out of sympathy with residents vis-a-vis regulators.

"There is the 50 percent rule that says you cannot improve your property more than 50 percent of the current assessed value," noted Johnsrud. "But not everybody's watching everything, and all of a sudden you've got a little shack that turns into a three bedroom snazzy home. ... Then someone has to enforce that law. In my area, [it's difficult] to find a jury that will convict you. You just can't get a court in this area that will say, 'Yeah, you're illegal and you're guilty.'"

"The enforcement is not nearly as good as it should be, in terms of building codes and zoning regulation," observed Wharton's Kunreuther. Despite our deepest resolves to stay tough, we all tend to bend rules in times of emergency. It happens to federal legislators as easily as to local juries. "I think it's very, very hard for politicians not to respond to somebody who's in trouble," noted Carnegie Mellon's Lave. "It almost seems mean-spirited for you to say, 'Hey, look you guys, you could have bought the insurance and you didn't.'"

So politicians tend not to say no, and FEMA or the US Department of Agriculture or the Small Business Administration or all three are given another ad hoc appropriation to help people in need. It's a problem known to economists as "time inconsistency"—adopting a firm policy at one point in time, but not carrying through on it.

Even the Federal Reserve is not immune to the problem. In 1997, in response to the floods that afflicted Minnesota, North Dakota and South Dakota, the Federal Reserve Board issued a statement saying that banks it oversees may find it appropriate to "ease credit terms" to help borrowers restore their financial strength, and it considered waiving its appraisal regulation for real estate-related transactions affected by floods.

Numerous steps have been taken to tighten and improve NFIP since its inception—far fewer policies are subsidized than when it began, and policy purchase requirements are better enforced, for example—but it remains a troubled program. As Carnegie Mellon economist Lave observed, "Every time I hear that things are getting better over time, we then have a flood and there's another statement about all the people who aren't insured. ... We thought we had it solved in terms of the legislation but there's no will to enforce."

Kunreuther agreed. "The issue in terms of subsidized policies without the land-use regulations and controls," he said, "makes the problem a challenging one."


Douglas Clement
Senior Writer

Douglas Clement was a managing editor at the Minneapolis Fed, where he wrote about research conducted by economists and other scholars associated with the Minneapolis Fed and interviewed prominent economists.