David Lalonde, FCAS, FCIA, MAAA is senior vice president atcatastrophe modeling firm AIR Worldwide.

Flooding is one of the costliest natural disasters in the UnitedStates, causing an average of $5 billion in economic losses everyyear. Following several destructive hurricanes and associated stormsurge events in the 1960s, many insurers ceased coveringresidential flood risk in the U.S. Without the tools to accuratelyquantify and price the risk, insurers have been unable to offerflood insurance at "affordable" rates to the public. As a result,government-sponsored flood insurance comprises the majority of theresidential market.

In 1968, Congress established the National Flood InsuranceProgram (NFIP) to address the shortfall in the availability ofaffordable flood coverage. From its inception, the NFIP has beenmanaged by the Federal Emergency Management Agency (FEMA) andguided by three mandates: provide residential and commercialinsurance coverage for flood damage, improve floodplain management,and develop maps of flood hazard zones.

Under the NFIP, flood insurance that could not be affordablypurchased in the private marketplace is made available to home andbusiness owners in more than 20,000 communities across the country.In exchange, participating communities agree to adopt and enforcemitigation procedures and ordinances that reduce flood risk. Theprogram currently insures about 5.5 million homes (the majority ofwhich are in Texas, Florida, and Louisiana) and generated $3.6billion in premiums in 2012.

The NFIP Business Model

Contrary to required practices in the insurance industry,Congress allowed the NFIP to operate without any surplus to absorbor transfer the risk of severe flood events. Instead, it wasexpected to collect just enough in annual premiums to coveradministrative costs and historical average annual losses. This ledto rates far below actuarially sound levels, even for propertiesthat were not "grandfathered." However, the flaw was concealed, inpart, because the early years of the program largely coincided witha multi-decadal period of relatively inactive hurricane seasons.Then hurricanes Katrina and Rita struck, putting the program $18billion in debt, and the NFIP borrowed the shortfall from the U.S.Treasury. In 2012, Superstorm Sandy made matters worse, and inJanuary 2013, Congress increased the borrowing authority of theNFIP from $20.775 billion to $30.425 billion.

Sandy served to re-emphasize that the program was in need ofsignificant reform. Among the chief grievances are that the FEMAFlood Insurance Rate Maps (FIRM)—used in determining NFIP premiumrates—are outdated in many communities. Perhaps the toughestcriticism is that the same insured and subsidized properties areflooded repeatedly and are rebuilt often in the same location usingNFIP funds. As of 2012, repeat property losses account for just 1%of NFIP's insured properties, but 25% to 30% of claims. Put anotherway, one in 10 policies has a claims history more than the value ofthe property.

After numerous stopgap measures, Congress approved a five-yearextension of the NFIP in 2012, called the Biggert-Waters FloodInsurance Reform Act of 2012. The act overhauled many aspects ofthe program, removing a variety of existing premium subsidies,mandating improved flood mapping, introducing the gradual phase-inof risk-based rates for remapped properties, and increasing theannual cap on rate increases from 10% to 20%. In addition, itallows FEMA to purchase reinsurance cover for catastrophic losses,and requires several reports to Congress on the program'sclaims-paying ability and the feasibility of reinsurance andprivatization.

Opportunities for the Private Market

While the NFIP has been the dominant player in the floodinsurance market, there are long-term opportunities for privateinsurers and gaps to fill. Private insurers may offer superiorperformance in building a surplus, underwriting properties,spreading risk through the reinsurance and capital markets,determining actuarially sound rates, and prioritizing andimplementing coastal mitigation strategies. Furthermore, insurersthat are currently managing flood exposure should be prepared forpartial or full privatization of the NFIP, an idea that hasgarnered increased attention since Sandy. In theory, there isnothing preventing insurers from entering the flood insurancemarket, except the prospect of competing with artificially lowpremiums offered by the government.

In 1983, private insurers began to participate in the Write YourOwn Program (WYO), which allows property/casualty insurancecompanies to write and service policies in their own names, withthe risk fully backed by the NFIP. Participants receive a flatpercentage commission for acquisition and servicing expenses, whilethe NFIP benefits from the regional expertise of insurers inflood-prone areas.

Going forward, increased participation by the private marketwill largely depend on the ability to manage accumulations ofexposure in flood-prone regions and reliably assess flood risk.

Probabilistic Modeling and the Way Ahead

The actuarial approach mandated for NFIP in 1968—dependentsolely on historical claims data—suffers from the same flaws asthose used by private insurers for hurricane and earthquake perilsprior to the widespread adoption of catastrophe modeling. It is nowwell understood in the private sector that historical loss data isinsufficient for ratemaking for catastrophic perils. Properconsideration of the changing landscape of insured properties,advancements in geographic risk classification, and detailed dataon construction practices and materials requires an integratedcatastrophe modeling approach to generate the appropriate inputs tocalculate actuarially sound rates.

While AIR has been modeling coastal storm surge as part of theU.S. hurricane model for more than two decades, AIR will beintroducing a new inland flood model for the U.S. in 2014. Thefully probabilistic flood model captures the complexities inherentin formulating an objective, risk-based understanding of floodrisk. The model features a robust, event-based catalog developedusing advanced weather simulation techniques, and it useshigh-resolution terrain information to estimate flood depths, thecritical factor in estimating damage. The model also accounts forthe possible failure of flood defenses, meaning that unlike in FIRMmaps, AIR considers the area behind levees to be at risk fromflooding. And because roughly 30% of NFIP flood insurance claimscome from properties outside of the 100- year floodplain, AIR hasdeveloped a separate module for off-floodplain loss estimation.Damage and losses can be aggregated, and the model will allow forthe application of a wide variety of policy terms.

After more than 40 years of operation, the NFIP is one of thelongest standing government-run disaster insurance programs in theworld, but its recent financial troubles have exposed fundamentalflaws in its design. Change may be coming to the marketplace forflood insurance. Insurers and other stakeholders should developcenters of excellence in managing flood risk to position themselvesin the new ecosystem. The AIR model is being developed to meet thewide spectrum of flood risk management needs of public and privatesector institutions. It will enable more informed underwriting andpricing decisions, as well as more effective portfolio management,risk financing, and risk management strategies.