If the natural disasters experienced across the nation in recent years are any indication of what the future holds in terms of weather-related catastrophes, securing residential insurance, even at a premium price during these difficult economic times is an important step for all homeowners. But despite these high prices, claims coverage sometimes comes up short, raising questions as to whether there could be a better pricing model for insurance.
In 2011, natural disasters resulted in $350 billion in insurance reimbursements for homeowners nationwide. Presidents have made nearly 100 disaster declarations since 1953, two-thirds of which were due to hurricanes and floods.
Because of global warming, climate patterns are likely to continue to fluctuate in the coming years causing sea levels to rise even higher, therefore increasing the likelihood of flooding during more intense hurricanes and coastal erosion.
Currently, the majority of homeowners' residential flood insurance is provided by the National Flood Insurance Program, which is set to expire at the end of May. The NFIP, which is run by the Federal Emergency Management Agency, provides insurance to more than 5.6 million households in exchange for $3.3 billion in premiums paid.
However, NFIP does face important challenges such as outdated flood maps. Many residents in flood-prone areas are not insured and the program is currently facing a $17.8 billion deficit due to historical flood claims and accrued interest from hurricanes that took place between 2005 and 2008.
Through NFIP, properties built before flood maps were created are offered at rates subsidized by approximately 25%, while new structures are charged the full-risk premium based on their location in specific flood zones determined by FEMA. Under this pricing strategy, NFIP insurance rates are not necessarily risk-based for a given residence, so prices can be “too high” for some and “too low” for others.
The purpose of NFIP is to collect enough premiums to cover the operating expenses and losses associated with the historic average loss year. But when Hurricanes Katrina, Ike and Irene made landfall in several states causing severe damage to hundreds of thousands of homes, the NFIP was not able to fully fund the amount of claims that came in.
According to a recent study by the Wharton Risk Management and Decision Processes Center in conjunction with CoreLogic called “A Methodological Approach for Pricing Flood Insurance and Evaluating Loss Reduction Measures: Application to Texas,” private insurers could offer lower flood insurance premiums than what is currently being presented by the NFIP.
Jeff Czajkowski, Howard Kunreuther and Erwann Michel-Kerjan authored the study and argue that a new strategy for managing floods can increase personal responsibility, decrease risk and lower government exposure.
“This presents opportunities for private insurers to provide coverage in some of those areas, to complement the NFIP,” said Michel-Kerjan. “There are several practical barriers that would need to be addressed for private insurers to sell such coverage, but if done, this could significantly increase the number of residents with proper coverage, thus reducing the need for government disaster relief.”
The Wharton study focused on two counties in Texas—Galveston and Travis—that total 1.3 million residents and are both in areas prone to flooding. The analysis calculated the “actuarially fair” flood insurance premium, based on the probabilistic risk models, for more than 300,000 residences in Galveston and Travis counties and then compared these rates to those currently being charged by the NFIP.
The study found that in Travis County, NFIP on average seems to undervalue the risk in high-risk zones for flooding, but overprices the risk in moderate and low risk zones compared to the probabilistic model results in these areas. For example, in moderate-risk flood zones, the NFIP's premium rates are nearly twice the rates indicated by the flood model data, while rates in Travis County's low-risk flood zone are on average up to 16 times higher than those indicated by the flood model data.
“Consequently, the NFIP may not be adequately covering itself in the Travis County high-risk zone and could be negatively impacting take-up rates in the moderate and minimal risk zones, potentially fostering adverse selection and fiscal insolvency,” the report said.
Meanwhile, in Galveston County, the NFIP on average may be under pricing the flood risk in certain zones by not properly covering itself against the risk of storm surge.
On the other hand, NFIP premiums are higher on average in a zone than what the model predicts, therefore negatively impacting take-up rates in this specific high-risk coastal area.
Overall, the study finds that premiums that would be charged by private insurance companies might not be higher than those charged by the NFIP, even including administrative costs and cost of capital, therefore helping distressed borrowers who might not currently not have flood insurance through NFIP.
“There might be important opportunities for the private insurance sector to become much more active in selling flood insurance,” the report said. “This could be done in complement to the NFIP if insurers are capable of determining in a granular fashion where residents are overcharged by the NFIP compared to what the insurers could offer. This could increase take-up rates and ensure more individuals are effectively covered against floods.”
“While the NFIP faces challenges that must be addressed, the program continues to provide enormous benefits to millions of Americans,” the authors expressed in the Wharton study. “Nevertheless, we feel it is possible to envision an increased role for private insurers to sell flood insurance as a complement to, and potentially in competition with, the NFIP.”
