Under the right conditions, having the private market—whether primary insurers, reinsurers, the capital markets or some combination of all three—pitch in to take on additional flood exposure could be a win-win for taxpayers as well as the insurance industry.
The challenge, however, is how a private-public partnership to relieve the burden on the National Flood Insurance Program (NFIP) might be made mutually beneficial, according to a recent report by Deloitte’s Center for Financial Services.
In our last blog, we outlined the opportunities and obstacles facing those interested in taking on more flood risks, as laid out in Deloitte’s report: “The Potential for Flood Insurance Privatization in the U.S.: Could Carriers Keep Their Heads Above Water?”
In this entry, we detail 10 potential ways forward on privatization, many of which are not mutually exclusive, and which in fact might work best in tandem. Each has its own variables in terms of ease of implementation and degree of privatization.
The reinsurance model
The NFIP could spread its risk and limit its maximum exposure in catastrophic years simply by purchasing reinsurance from the private sector. Even if such coverage only extends to a middle-range loss, with the program itself assuming the highest-level losses over and above a pre-determined reinsured layer, the impact of an anomalous loss year would still be alleviated. The advantage here would be to limit NFIP (and taxpayer) exposure.
This option has underlying facilitators in place. The last two reform bills passed by Congress both explicitly provided for the purchase of reinsurance coverage from the private market, while setting the stage for such a step by requiring the development of a protocol through which the NFIP can release to private reinsurers the data necessary for assessment of aggregated and individual flood insurance risks.
However, it’s questionable whether reinsurers would write flood coverage unless the exposures are underwritten according to the actual risk being assumed. This is not the case now, as one-in-five NFIP policies represent subsidized coverage.
The capital market model
The capital markets might offer additional avenues to help spread risks through securitization via the sale of catastrophe bonds to investors.
The spreading of disaster risks via cat bonds is well established in terms of wind and earthquake exposures, and is already being employed to help mitigate some flood exposures. Indeed, New York City’s transit system announced plans to sell cat bonds to hedge against damage from storm surge, following the losses suffered during Superstorm Sandy.
The crop insurance model
With crop insurance, private carriers write a certain level of primary coverage while reinsuring catastrophic levels with the federal government.
The advantage here would be to have the private sector assume responsibility for a specific underlying loss level in any given year, while federal funds are only required to cap the industry’s maximum loss in particularly intense catastrophe years. An additional layer of private-market protection could be added through reinsurers offering excess-of-loss coverage to cap the government’s aggregate exposure and further spread the risk.
However, once again, a big question would be whether primary carriers or reinsurers would be interested without assurances that rates would be allowed to reflect actual risk assumed.
The pooling model
A flood-insurance pool could be set up, similar to the California Earthquake Authority (CEA), where participating insurers could sell flood coverage bundled with standard homeowners insurance. This has the advantage of insurers pooling their resources and paying out claims from that pool, thus diversifying their risks.
Since the CEA does not rely on public funds, it is considered self-sustaining to the extent to which it can pay claims. However, this concept has its share of skeptics, particularly when it comes to the potential take-up rate given the likely cost of coverage for higher-risk properties.
The partial privatization model
Another arrangement could involve private insurers picking up more moderate flood risks, while leaving the NFIP in place as a residual market for those who cannot get coverage otherwise.
However, this “cherry-picking” arrangement could exacerbate the adverse selection issue for NFIP and still leave the program in a precarious financial state even if prices for the policies it writes are based on actual risk assumed. And it’s not clear how many property owners would purchase the coverage if they feel their flood risk is not high, and if they believe they could receive government support in the form of grants or loans in a worst-case scenario.
The bundling model
In the United Kingdom, flood insurance is included with a standard homeowner’s insurance policy and is a mandatory coverage. In turn, the government has pledged to reduce flood exposures through specific infrastructure development. The agreement, which was up for renewal in mid-2013, has been extended until a new “not-for-profit” reinsurer called Flood Re is set up by 2015. Might such a model work in the United States?
Making flood insurance a mandatory purchase would accomplish some key goals. It would assure that everyone has coverage. It would overcome the problem of adverse selection, since everyone would buy insurance, not just those with the highest risk. Plus insurers would have a large enough pool to diversify their exposure. In addition, a large pool of participants will likely help make premium rates reasonably affordable.
Still, there would likely be challenges in implementation of this approach. Homeowner insurers, particularly in regions with windstorm exposures, as well as auto insurers in some states, have often had a difficult time overcoming regulatory rate suppression to address affordability concerns. Without having the flexibility to charge actuarially-determined rates, it might be problematic to generate the necessary premium volume to make flood insurance viable financially for private carriers, even if everyone is mandated to buy it.
In addition, homeowners who do not believe they face a significant flood risk might be up in arms against a mandate to buy coverage they feel they do not need.
The ‘opt-out’ model
Instead of mandating the purchase of flood insurance, one approach might be to require that all property owners be offered flood insurance along with their standard homeowner or business-owner policy, but be allowed to opt-out of that coverage. Regardless of whether the market is further privatized, this option might help bolster participation in flood insurance, similar to how opt-out provisions seemed to boost employee participation in 401(k) retirement plans.
Participation in flood insurance might increase even more under this scenario if a “hammer” was included—that being a notice that anyone who turned down flood insurance would not be eligible for federal disaster assistance if an event occurs. But there is skepticism among industry leaders whether the federal government would be able to overcome political pressure to follow through on such a pledge after a major catastrophe.
The ‘lend a hand’ model
Under this scenario, the federal government and/or individual states with high-risk communities could offer vouchers or other types of financial support to those homeowners who cannot afford to pay risk-based rates for flood insurance or to mitigate their exposure.
That way, insurers would collect risk-based premiums without putting prices beyond the reach of many property owners. Such voucher subsidies could be phased out over time to cushion the blow on policyholders.
The ‘it takes a village’ model
The potential benefits of purchasing flood insurance on a community-rated basis might also be considered. Such an approach would function much like group health insurance, with residents likely paying a lower premium than they would if they bought coverage individually.
By enhancing affordability, more homeowners in flood-prone areas might be motivated to buy a policy, potential flood risks would be more effectively spread out, and local governments would have a strong incentive to take mitigation steps so as to lower community insurance rates.
The ‘stimulate state privatization’ model
Instead of waiting for the federal government to take steps to attract private market participation to write flood insurance, more states could launch efforts to stimulate their own local markets. In Florida, at least two private carriers have stepped forward on their own, suggesting they might be able to offer lower prices than the NFIP. Meanwhile, the Florida legislature is considering legislation to allow private carriers to offer flood coverage via the surplus lines market, while giving consumers the option to buy minimal limits to cover their mortgage, or higher amounts to pay replacement costs.
Adopting any one of the above options, or some combination thereof, might offer a fair chance to the private sector to write flood insurance at a profit, while easing the potential burden on the NFIP and, by extension, on taxpayers.