Congress is poised to give the Federal Emergency Management Agency the power to shift some of its massive financial risk from flooding to private financial firms that charge expensive fees to absorb liability from extreme natural catastrophes, like Hurricane Katrina.
The move marks a significant transition for the agency's National Flood Insurance Program, which collects enough money annually from 5.6 million policyholders to pay damage claims during standard flood years. But the program, experts say, is less prepared for "black swan" disasters, the rare mega-catastrophes that might happen more frequently as populations rise and, in some cases, as the atmosphere warms.
Both chambers of Congress are including provisions in a five-year extension of the flood program clarifying FEMA's ability to buy reinsurance. These are tailor-made contracts with financial institutions willing to pay billions if a catastrophe inflicts extraordinary damage.
Reinsurance is for entities with outsized risk, like traditional insurance companies that sometimes cede portions of their exposure to reinsurers, in some cases to satisfy regulators that they have enough cash to cover potential claims. But other organizations are increasingly pushing off their risks. They include states, countries and, perhaps soon, the U.S. government.
It is not known if the flood program will purchase reinsurance -- or, if it does, how much of its total risk, amounting to $1.2 trillion, it will seek to cover.
Answering those questions could uncork a storm of challenges for the program. It is unclear if it can afford to buy reinsurance without raising its rates, since about 25 percent of its policies are underpriced and not collecting enough money to cover the risk posed to those homes, let alone enhanced coverage of the private sector.
Congress is helping in that regard. The bills increase the program's ability to collect money from policyholders. The House measure, which the chamber passed this summer, would permit some premiums to rise 20 percent a year, double the current maximum. The Senate bill, approved by the Banking Committee this month, requires program administrators to gradually build up a reserve account with about $10 billion.
Testing the market gradually
But in the short term, reinsurance might be unaffordable, says Carolyn Kousky, an expert on flooding risk with Resources for the Future, an environmental think tank. Unlike private insurers, the program has never raised its premiums to account for major disasters, she said. Without this "catastrophe loading," the program cannot build up reserves to pay claims after an outlier crisis. Those surpluses could also be spent on reinsurance.
"Right now, those discounted policies in the NFIP program prevent the program from building up a catastrophe reserve, or from having any extra capital, which it would need in order to buy the reinsurance," said Kousky, who thinks reinsurance could help manage the program's risk.
Opinions differ on that subject. Some observers believe the flood program collects enough premium revenue now, at about $3.3 billion annually, to buy a small amount of coverage from the private sector. That could be used to establish a process for engaging with reinsurers, while targeting one section of the program that is most exposed to financial losses, supporters say.
"The program has a lot of money coming in," said Frank Nutter, president of the Reinsurance Association of America, who has been working with Congress and FEMA to advance the process. "We're not suggesting you lay off huge amounts of the total program into the reinsurance market. We're suggesting you do a pilot program. We're suggesting maybe certain types of risk."
The legislation requires FEMA to undertake a study -- a claims-paying capacity analysis -- to determine if the program can pay its claims under a variety of scenarios, including in the event of a major catastrophe. The analysis would also determine if the NFIP would benefit by buying reinsurance and how much its rates would need to rise to make a purchase possible.
Nutter sought to answer some of those questions this year. He has met with FEMA officials, who are undertaking a sprawling analysis of their own to guide a reform initiative that might include reinsurance, to discuss how private coverage could be used in the flood program. But the agency has not provided him with the data that is needed for reinsurers to give FEMA a handful of options, Nutter said. FEMA declined to comment.
$3B paid in, none coming out -- so far
Other public insurance programs have been using reinsurance or catastrophe bonds, a similar risk-shifting mechanism, for several years. North Carolina incorporated it into the state's growing hurricane insurance program in 2009 so it could cap fees levied on private insurers after major storms.
This year, the state has a catastrophe bond with $506.8 million in coverage against hurricane losses. That protects just a fraction of its exposure, which more than doubled since 2004 to $69.3 billion, according to the Insurance Information Institute.
Other states with public programs that are perilously exposed to storm loss have paid high prices for reinsurance to avoid potentially devastating losses from hurricanes. They include Alabama, Mississippi, Louisiana, Texas and Hawaii.
So how much do these contracts cost? Each one is different, and the price depends on how likely it is for an area to be struck by a catastrophe and the value of property at risk. But here's one example: The California Earthquake Authority spends $200 million a year on reinsurance covering $3 billion in risk. The cost amounts to about 40 percent of the program's annual revenue from premiums.
Over the last 14 years, the program has spent nearly $3 billion on reinsurance. It has never collected a payment.
Now it wants to move in a different direction. The earthquake authority believes it could lower the cost of its premiums by reducing its purchase of reinsurance. That could attract more customers, thereby protecting more homeowners and increasing its revenue.
"We're focused on reducing expenses to increase access," said Chris Nance, an association spokesman.
But reinsurance would need to be replaced with another way to pay claims after a major earthquake. The association wants the federal government to guarantee its ability to borrow money after an event for that purpose. Program officials say that would provide cheaper interest rates -- and lower premiums for customers.
But that just saddles taxpayers with unforeseen liabilities, says Eli Lehrer, a scholar at the Heartland Institute.
"If you just pretend you're covering it, that doesn't cost you anything," he quipped, saying that borrowing money guaranteed by the government to pay claims is like using "Monopoly money."
Still, the earthquake authority's concern about the price of reinsurance might also a play a role in the flood program's outlook on turning to the private market.
Some observers wonder if the use of private reinsurance will help push rates to a level that people are unwilling to pay.
"And we know what happens there," said retired Adm. James Loy, the former deputy secretary of the Department of Homeland Security, who wants the government to provide reinsurance paid for by policyholders in high-risk states.
Loy is referring to a breakdown in insurance coverage, requiring taxpayers, not policyholders, to provide emergency government funding after a disaster strikes.
But in some states, that expensive reinsurance coverage has paid off, and it has likely avoided an infusion of public funding.
The Texas Windstorm Insurance Association, the state's public hurricane insurer, spent $495 million on reinsurance between 2004 and 2008. Hurricane Ike crashed ashore in 2008, pummeling the Texas coastline and the program's finances.
But it would have been worse without the $1.5 billion the state received from reinsurers.
Like what you see?
We thought you might.
Start a free trial now.