The floodwaters of Superstorm Sandy amounted to a proverbial black swan event whose sudden, shocking appearance made many private insurance firms reach for their shotguns.
Defenses against the unlikely swan -- a metaphor for a disastrous event believed to be possible but highly improbable -- include socking away cash reserves, in the billions, to pay off claims made by policyholders.
If that taps out, there is another defense. Costly reinsurance, which is purchased more often than it's used, can cover damage claims that threaten to make a firm go bankrupt. This is similar to hiring an escort ship to refill your fuel tanks at sea after they surprisingly go dry. It's a backup that's rarely needed, but that's the point, experts say. You can't know when a big disaster will strike, just that it might sometime.
While these are common tools in the insurance industry, they are absent in the federal government's National Flood Insurance Program. After operating for nearly 40 years without encountering a black swan, it got hit with its second in seven years when Superstorm Sandy drained the funding it derives from 5.6 million policyholders nationwide.
Critics, and even some supporters, contend that the program often charges rates that are too low for today's mounting catastrophes, a result of technical challenges, like outdated flood maps, and political interference to suppress premiums. That makes it difficult to build up reserves, or to buy reinsurance.
The result was witnessed 10 days ago, when Congress authorized the program to borrow $9.7 billion from the Treasury to pay claims. That means the program is close to $27 billion in debt to taxpayers, after adding its losses from Hurricane Katrina in 2005, its first encounter with a black swan.
"It's a perfect storm of factors," David Conrad, a water specialist who has followed the flood program for years, said of its rising debt.
Encountering riskier business
The program is operating in an era of climbing disaster losses -- driven by the presence of more homes in riskier areas, harder surfaces that accelerate runoff, rising oceans and stormier conditions, many experts say. But as all that is happening, many of the program's protocols remain the same.
The program clings to a 1 percent chance of annual flooding to determine where hazards will occur, even as critics contend that the risks have intensified since the program's inception in 1968, from changes in development and climate.
"There is mounting evidence that the effects of changing climate and rising sea levels is having an effect which broadly means that unless we increase standards ... and even consider some strategic retreat from the increased risk areas, we can only expect the program to become weaker and weaker financially," Conrad explained.
So what does the future hold for a program that carries $1.2 trillion in exposure to loss but raises only about $3.5 billion annually from policyholders, many of whom are undercharged and living in areas that are increasingly prone to flood? And how can it cope with the future challenges of climate change, which the Federal Emergency Management Agency estimates will expand the volume of floodplains by up to 45 percent nationally by 2080?
There is broad optimism that the program would improve with the help of higher rates, tougher standards, fewer high-risk properties and stronger incentives for more durable homebuilding. But that optimism is largely born from the lack of an alternative. The flood program was created to fill an absence of private coverage for one of the most prevalent and damaging disasters in the world.
No large group of private insurers has stepped up to take on that widespread risk, but there may be other ways for the private sector to become involved. The program is exploring how it might use reinsurance to cover some of its risks. That would require higher premiums, because the price of reinsurance can be costly and it fluctuates wildly. But it could also protect taxpayers from shouldering rising damages.
"[If] you want to play with the big guys, that comes at a price," said Erwann Michel-Kerjan, managing director of the Wharton Risk Management and Decision Processes Center. "Reinsurance is typically a very volatile market after a large disaster. If there is a big earthquake, tsunami [or] nuclear explosion in Japan, the price of reinsurance increases everywhere around the world."
Blame Congress, not the flood program
Still, he said, reinsurance is an important tool that could offset some of the program's public cost. It should also be combined with higher premiums to account for the true risks of living along the shore, and doubling the number of policyholders to increase revenue and to spread the risk of floods across geographic and time horizons.
But even if those big changes are successfully implemented, Michel-Kerjan believes the public should prepare for future costs.
"Does that mean you and I as taxpayers would never have to bail out the NFIP? No," he said. "One day, a catastrophe could go bigger than that [reinsurance] level."
And it probably would.
But others say the program was never meant to cover black swans. Congress is supposed to forgive the debt from major disasters, said David Maurstad, who ran the program under President George W. Bush. The fact that lawmakers failed to forgive the debt from Katrina, now around $17 billion, before Sandy struck gives the program a sense of failure that it doesn't deserve, he thinks.
"The program is designed to take care of the average historical loss year," Maurstad added, noting that losses rarely exceed the program's revenue of about $3 billion. "It wasn't designed to have a reserve enough to take care of a catastrophic year."
The blame is really Congress', Maurstad said. For years, lawmakers imposed "un-insurancelike" provisions on the program, like requiring discounts for homeowners in risky locations and demanding "artificially low" premiums to please constituents. Those factors foretold big losses, he said.
Other federal policies also contributed to the program's debt, like the failure to maintain New Orleans' levees, which resulted in the bulk of flooding damage during Katrina.
"Ten billion [dollars] of that Katrina loss has been attributed to the federal government's own ineptness in the failure of the levees," Maurstad said. "That's the other irony of all of this."
Looking back for future floods
Others, though, believe the program is doing more damage than good. John Echeverria, a professor who specializes in land-use policies at the Vermont Law School, said the program is dramatically increasing the nation's exposure to risk by facilitating overdevelopment in floodplains. He calls it a "maladaptive" climate change policy because he believes it pushes people toward coastlines being made more dangerous by climate change.
"I think the federal government gets so little in terms of responsible coastal land-use regulation from the flood insurance program that I'm with the libertarians who are in favor of getting rid of the flood insurance program," Echeverria said.
"The private market will come back in. It will provide limited coverage to those people with the means to run those kinds of risk. But it will create a proper incentive structure that will cause people to leave fragile areas. That's the optimal policy solution. The flood insurance program's been a failure."
But he acknowledges there are significant challenges to extinguishing the program. In the short term, it would likely increase the amount of disaster aid shouldered by taxpayers, which also sends a signal that it's safe to build near the beach. And apart from the likely economic toll on the housing market, ending the flood program would also leave 5.6 million families living in risky areas without insurance.
Congress is slowly addressing the program's problems. Last summer, it authorized FEMA to increase rates by 25 percent per year on second homes, businesses and some repetitively flooded properties. It also requires the agency to consider sea level rise and current scientific findings related to hurricanes in its hazard maps for the first time.
The legislation will increase rates on about 400,000 homes whose owners have enjoyed subsidized rates while living in the riskiest areas. That's an improvement, but it still leaves about 800,000 primary residences with suppressed premiums, said Conrad, the water specialist. And the program continues to use historical flooding data, rather than future predictions by computer models that show more substantial future risks.
"We are still approaching flooding in hindsight, and not even well there," Conrad said.