Is it time for a U.S.-style flood insurance program?

Although the National Flood Insurance Program (NFIP) in the United States has its shortcomings, a similar program could benefit Canada if steps were taken to avoid its flaws, suggested an article published in MSA’s Quarterly Outlook Report for Q2 2019.

Some of the flaws include the continuous renewal of flood insurance policies despite repeated claims and no limit to the number of claims that can be made on a property over time, wrote authors Victor Adensanya, Marcos Alvarez and Stewart McIlwraith of Toronto-based rating firm DBRS. Other flaws are underpricing of premiums and that the program is not structured to provide incentives to homeowners or businesses in high-risk locations to relocate, even after their properties have been damaged.

These issues can create a circular effect, where buildings that are affected by flooding are being rebuilt in the same location, only to get damaged again by subsequent flooding. In some cases, claims paid can exceed the value of the building. As well, those who struggle to meet higher premiums would also be less likely to have the resources to relocate.

“To avoid incurring repetitive losses on one property, a Canadian version of the program could be designed to provide a financial incentive to relocate once a property has been damaged and has been confirmed to be in a high-risk area,” the authors wrote in DBRS: High Cost of Flooding in Canada Again in 2019 – It May Be Time for a U.S.-style Flood Insurance Program. “Pricing of the premiums would likely be capped to ensure affordability. Subsidies to participating homeowners could be provided initially, then aggregate pricing could develop over time and be adjusted to make the program self-sustaining.”

Insurance Bureau of Canada released a paper in June putting forward three options for managing flood risk. One option included the creation of a high-risk flood insurance pool, with premiums capped or subsidized to ensure affordability.

There may be a role for the government to subsidize either the insurance fund of the cost of relocating households and businesses or both, the article said. “There does appear to be a need for the government to perform a backstop role, as the U.S. federal government does for the NFIP.”

One of the challenges faced by the Federal Emergency Management Agency, which administers NFIP, is that its goals are conflicting. It is tasked with keeping flood insurance premium rates affordable while ensuring the NFIP remains solvent. “This had led to situations where premium rates may not reflect the total risk of loss, which resulted in insufficient premiums to pay claims in some years.”

For example, the agency borrowed US$17.5 billion to settle claims related to Hurricanes Katrina, Rita and Wilma. “This situation can be avoided in Canada if the rates charged for a Canadian insurance program are enough to cover claims made.”

Between 1978 and 2018, the NFIP has “almost broken even, but has seen significant volatility year by year,” the article said. Cumulatively, it has generated US$63 billion in earned premiums, but paid out US$66.4 billion in claims for an underwriting loss of US$3.4 billion – about 4% of premiums. There have, however, been several years where claims paid significantly exceeded earned premiums.

A national flood insurance program that provided cover for homes currently at risk and helped discourage further development of communities of lands situated on floodplains would help reduce reliance on taxpayer dollars for disaster relief, the authors noted.

By comparison, the Disaster Financial Assistance Arrangements (DFAA) program is completely reliant on taxpayer dollars to fund disaster relief; it has paid out over $5 billion in assistance since 1970. NFIP also features a private-market reinsurance cover, unlike DFAA.

Canada’s national assistance program also does not provide incentives to mitigate flood risk. “One alternative is an NFIP model that is a risk-based approach to flood risk, because individuals have economic incentives to avoid high flood risk zones due to the cost of premiums.”

A program like the NFIP has the potential to reduce taxpayer spending, since it would receive premiums to offset claims. Construction activity on floodplains would also be more controlled because communities would have to establish restrictions on building in flood-prone areas to qualify for participation in the program.

A separate problem is the lack of publicly available information on flood risk in Canada. Households, businesses, farmers and government entities should have this information readily available so they can take steps to protect their homes, operations, buildings and other property, the authors suggested. Such information would improve decisions on where to locate and would be critical for insurance companies and any federal program to appropriately price insurance policies.