Flood Insurance for Dummies

By Sebastian Mallaby
Monday, October 9, 2006

We all love stories about evil corporations that hijack public policy, riddling it with tax loopholes and earmarks. But sometimes corporations are the ones that formulate enlightened policy -- and then get hijacked by government.

When it comes to climate change, for example, the insurance industry has things figured out. The big companies retain their own climate scientists to help them predict hurricanes. They develop sophisticated models to price the risk correctly. They come up with clever ways to pay for future disasters, floating "catastrophe bonds" on the capital markets and mobilizing hedge fund capital in funky contingency funds.

This sophistication has the potential to help everyone. By pricing the risk of beachfront homes accurately, insurers could encourage developers to build elsewhere, reducing the cost of future hurricanes -- which tend to end up in the laps of taxpayers. To the extent that people want beach houses anyway, insurers could give them discounts for adopting safety features such as hurricane shutters.

Such price signals work well in some foreign markets. As Emma Duncan explained recently in the Economist, some people are moving out of flood-prone areas of Grand Bahama while others are building houses there on stilts. Price signals also work, at least to some extent, in the U.S. market for commercial property. In Florida, commercial property accounts for half of all the coastal real estate; but because insurers' price signals have driven companies to build safely, commercial property accounts for only about a quarter of Florida's hurricane insurance claims.

But the insurers' sophisticated climate models have no impact -- indeed, are not allowed to have impact -- on the price incentives facing owners of private homes. State insurance regulators, many of whom are elected, refuse to let insurers charge a fair premium for risky buildings; in Florida, private insurers have responded by refusing to underwrite coastal homes. In their place, an insurer set up by Florida's government sells underpriced coverage. Inevitably, its losses are made good by taxpayers: Thus are workers in Orlando obliged to subsidize millionaires in beachfront homes.

It's ironic that Gov. Jeb Bush, who aspires to marketize Florida's public school system, should have stupidly socialized hurricane insurance. But his mugging of the private sector pales next to his brother's neo-Soviet tolerance of central planning. The federal flood insurance program should have been the first thing that President Bush reformed after Hurricane Katrina. But he has sat on his hands.

The federal flood insurance program uses taxpayers' money to subsidize houses that are prone to flooding: It is, in two senses, the quintessential slush fund. The program's most extreme subsidies go to old properties that were grandfathered into the system; these pay only 38 percent of the actuarily fair insurance premium. That might sound bad enough, but it isn't the worst feature. David Conrad of the National Wildlife Federation has shown that, when these old properties get flooded, the feds often pay to rebuild them -- in the same way and in the same place.

The program is supposed to discourage building in areas that flood more than once per decade. But in 1995 there were almost 75,000 insured properties that had flooded at least twice in 10 years. Far from discouraging this sort of building, the program appears to encourage it: Ten years on, the feds now insure 134,000 two-floods-per-decade homes. Over the past decade, these houses have generated insurance claims worth $5.7 billion while paying less than $1 billion back in premiums.

The story goes on, like a joint production from Monty Python and Franz Kafka. Houses are supposed to be insured if they are built in an area that floods at least once every hundred years. But the maps used to determine flood risk tend to be old, so some exposed homeowners pay zero premiums and then get bailed out by the feds anyway. Property built by state and local government is not insured either. But when the waters come, a deluge of federal cash reliably follows.

The insurance industry, which has billions of dollars on the table, cannot afford this sort of nonsense. It is focused on understanding climate patterns and devising rational responses. But government central planners are blind to the usefulness of price signals. So thousands of Americans build dream houses by the waters, oblivious to the risks and costs -- to themselves and to the rest of us.


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