The National Flood Insurance Program


   The National Flood Insurance Program (NFIP) was established in 1968 to make flood insurance more widely available to homeowners and businesses, to encourage local communities to prepare better for flood hazards, and to reduce reliance on direct Federal disaster relief following floods. The NFIP currently provides flood insurance for 5.3 million policyholders nationwide, many of whom might not be able to obtain coverage without the program. Residential and commercial property owners in some 20,000 participating communities are eligible to purchase flood insurance policies under the program. Homeowners with mortgages issued by federally regulated lenders on property in communities identified to be in flood hazard areas are required to purchase flood insurance on their dwellings. Property owners can purchase policies either directly from the Federal Government or, more commonly, through local insurance companies who sell NFIP policies under their own name but pass their risk on to the Government. Whether policies are sold directly by the Federal Government or by insurance companies, the NFIP receives premium payments for the policies and bears all financial risks associated with the insurance they provide. The program is administered by the Federal Emergency Management Agency (FEMA).

   FEMA relies on Flood Insurance Rate Maps (FIRMs) when underwriting flood insurance. These maps identify areas within a community that have at least a 1-percent chance per year of being inundated by high water. These areas are called 100-year floodplains. Federal flood insurance is only made available in local communities that agree to adopt zoning ordinances, building codes, and other planning measures designed to reduce future damage caused by floods. For example, communities must require that new buildings be elevated above the level that flood waters are expected to reach on average once per 100 years. According to FEMA, buildings that meet its floodplain management standards suffer 80 percent less damage from floods each year than those that do not. Not all structures insured under the NFIP meet these standards, however; structures completed prior to a community's decision to participate in the program or prior to the publication of a community's FIRM are eligible for insurance under the program even if they do not meet FEMA standards.

   The NFIP charges different premiums for different properties. A structure built or substantially renovated after 1974 or after a community's FIRM was completed (whichever is later) is charged an actuarially fair annual premium equal to an estimate of expected annual claims under the property's flood insurance policy. Policyholders who pay actuarially fair premiums year after year should, in the long run, end up paying premiums that are just sufficient to cover their claims on average. About one-quarter of NFIP policies cover properties built prior to 1974 or prior to the publication of a community's FIRM. By law, these "pre-FIRM" properties are charged subsidized premiums. Pre-FIRM properties are much less likely to comply with modern flood risk mitigation standards since most were built before such standards were widely applied. Because of their higher risk, pre-FIRM properties are assessed higher premiums on average than newer properties, but even these higher premiums are not adequate to cover expected losses. On average, premiums for pre-FIRM properties represent only about 40 percent of those properties actuarially fair rates.

   Not surprisingly, the NFIP pricing scheme has led to serious adverse selection and moral hazard problems. On the one hand, FEMA estimates that one-half to two-thirds of structures in floodplains do not carry flood insurance. On the other hand, some exceptionally high-risk properties continue to receive NFIP coverage at subsidized rates even though they have been damaged by floods multiple times since entering the program. Some 50,644 properties insured by the NFIP as of September 30, 2004 had incurred flood damage resulting in claims of at least $1,000 more than once during a 10-year period. While these properties only represented about 1 percent of all structures then insured under the program, repetitive-loss properties have historically accounted for 38 percent of all program claims payments. Amendments to the Flood Insurance Act passed in 2004 authorized a pilot program to remove some of the most severe repetitive-loss properties from the NFIP insurance roll by allowing FEMA to fund work to elevate or relocate some of them or, in extreme cases, to purchase and demolish them.

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