Perverse Incentives for Flood Insurance Harm Taxpayers

The National Flood Insurance Program (NFIP) chronically subsidizes the flood insurance premiums for high risk homeowners, offering them premiums that are lower than the predictable payouts. These subsidized homeowners live in areas proven to be flood-prone. Their dwellings are repeatedly insured, then flooded, and then re-built with NFIP money. Since the re-build costs are much higher than the premiums, the insurance program sets up a perverse incentive for homeowners to behave irrationally. The result is that NFIP runs at a loss.

So far the NFIP has accumulated $23 billion in losses. The insurance program refuses to adjust premiums upward to levels consistent with expected costs, thereby conscripting taxpayers to carry an ever bigger burden. If these deficits are not paid by taxpayers annually, they accumulate into a shameful mountain of debt that taxpayers are expected to pay in the future. The mismanagement causing this mountain of debt is clear, but why elected officials allow it to continue is unclear. Congress vacillates between bills that order NFIP to price rationally and bills that subsidize premiums for owners of properties in high flood risk areas.

When there is only one insurer and especially only a government insurer, it takes discipline to set rates (premiums) in accordance with level of risk. A monopoly provider backed by taxpayers’ deep pockets is insulated from a need to avoid subsidies and losses. Elected officials lack the self-control needed to demand rational flood insurance pricing, they’d rather have the few extra votes that come from appearing compassionate.

In a market of competing insurers, market interactions will push prices to a level that covers costs and allows a thin profit. If allowed, the market would produce dynamic adjustments in individual prices as companies try to improve their market share and avoid overall losses – all while contending with flood events through good years and bad years.

Under law authorizing the NFIP, consumers had been denied the advantage of a competitive marketplace for flood insurance. A bill called the Flood Insurance Market Parity and Modernization Act has been introduced and may correct one of the problems inherent in the NFIP. The new bill, which is a good for consumers, allows private insurers to offer flood insurance and allows each state to dictate what is “acceptable.”

Unfortunately, the glaring flaw in NFIP’s pricing behavior remains in place and will need to be addressed in the future. NFIP can still price insurance at rates below expected cost, and this will continue to accumulate annual deficits. When NFIP prices below cost, it drives away private insurance companies. They cannot compete against an entity lawfully allowed to pickpocket taxpayers to cover its losses. If a private insurance company competes for flood insurance in places where the NFIP has priced above cost, the NFIP’s margin will be reduced and its overall deficit will increase. The key to a rational decision means ending the NFIP’s irrational pricing altogether.

The bill, allowing private insurers to compete, is very helpful and consumer friendly, but not completely sufficient since it does not require the NFIP to move to complete risk-based pricing. Resolving NFIP’s irrational pricing is key to ending the perverse incentive to build in flood prone places and halting perverse incentives is the best way to stop growth in a deficit that taxpayers must shoulder.  Eventually, it may take to bills to get this right.

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