Underwater World

A standard insurance policy does not cover flood or water damage that results from rising water. Historically, flood insurance has not been particularly profitable for the insurance industry, and as a result, the industry stopped including flood coverage in standard policies.

The economic law of adverse selection affects the profitability of flood insurance. This means that, because in the past, floods tended to be fairly predictable, property owners who were most likely to be adversely affected by floods purchased the coverage while other property owners did not. Insurance markets typically operate on the principle that large numbers of people purchase coverage but only a small portion of the purchasers make claims, resulting in profitable business.

For example, almost everyone has fire insurance, but few property owners make fire claims. When flood insurance became a special coverage with extra expense, property owners, particularly those outside of flood zones, stopped buying it. As a result, the government became the de facto insurer of flood catastrophes through its disaster relief programs. To manage the problem of a lack of insurance markets to insure these risks and the mounting costs of disaster relief, Congress created the National Flood Insurance Program (NFIP) in 1968.

The NFIP is not simply flood coverage but is intended to be a comprehensive plan to manage flooding on the local level while insuring against flood damage. The NFIP provides flood insurance to property owners only in communities that participate in the program. Participation requires that local communities adopt and enforce local floodplain management ordinances. The local ordinances are aimed at reducing flood risks in 100-year flood zones or special flood hazard areas (SFHAs).

NFIP policies can be purchased directly from the Federal Emergency Management Agency (FEMA) or through the industry marketplace called the WYO (Write Your Own) program. Most NFIP flood policies are purchased through the WYO program. The implementation and administration of the NFIP is largely handled by the insurance industry through this program; the NFIP develops the rates, rules, and regulations, underwrites the risk, and pays claims. The WYO companies market the insurance and adjust losses, which allows participating property and casualty insurance companies to write and service federal flood insurance in their own names. They receive an expense allowance for policies written and claims processed, but the federal government retains responsibility for underwriting losses and adjustment decisions. All WYO companies use the same rates and rules, and they may match their flood business to their normal business practices for other lines of business.

Independent claims professionals who participate in the NFIP’s flood program must be approved and “flood certified.” Certification requires attendance at an annual NFIP claims presentation and submission of the claims professional certification application. WYO company claims professionals are encouraged to “be guided by their particular company’s procedures.” Typically, WYO company claims professionals are assumed to be qualified because they are employed by a WYO company. The NFIP tries to manage the claims resolution process. Claims professionals handling NFIP flood claims do not have the authority to approve or deny a claim. All adjustments are recommendations only and subject to NFIP review and approval.

The NFIP adjustment management review process is particularly relevant to claims in which the claims professional is evaluating coverage under an NFIP flood policy and a standard form property policy, which may be overlapping in some respects. For example, a policyholder might have property coverage with a WYO company and NFIP flood coverage through the same company. The company claims professionals might have to determine if the NFIP policy or the company’s property policy applies. Was the damage caused by flood or wind (not covered by the NFIP policy)? The NFIP policy has various exclusions, such as damage caused by earth movement, landslide, or land subsidence even if caused by a flood. A determination will be made if the property damage was caused by the earth movement (not covered by NFIP) or flood (covered). If the NFIP policy does not provide coverage, the property coverage might.

These adjustment situations have the potential for the appearance of a conflict of interest if the claims professional’s decision benefits his company. The NFIP adjustment management review process assures the evenhanded evaluation of exclusions and coverage. This minimizes the potential for a conflict of interest as a result of a claims professional investigating a loss under two policies with potentially overlapping coverages.

According to the Government Accountability Office (GAO), NFIP currently has approximately 5.3 million flood policies in effect providing over $1.3 trillion in coverage in almost 22,000 communities. As of Jan. 31, 2016, the NFIP had an outstanding debt of $23 billion, borrowed from the U.S. Treasury on a total line of credit of $30.425 billion.

The NFIP’s legal authority expires in 2017. Some expect a fight in Congress regarding its renewal in part because, if it were a business, it would be bankrupt—the premiums simply do not cover claims payments. Some point to the program’s unusual premium structure, the fact that it is a governmental entity with important goals other than making money (such as comprehensive flood control), and the numerous super destructive storms since 2005 and their resulting claims, as reasons for the NFIP’s financial situation.

In response to the NFIP crisis, Congress recently implemented legislation (the Biggert-Waters Flood Insurance Reform Act of 2012 and the Homeowner Insurance Affordability Act of 2014) resulting in premium rate increases, elimination of various subsidies, and remapping, which may result in more property being included in special flood hazard areas (SFHAs), more commonly known as the 100-year flood zone, and more property owners buying insurance. It is questionable whether these measures will be enough to save the program. More legislation can be expected, such as the Flood Insurance Market Parity and Modernization Act (HR 2901), in an effort to exert control over and properly manage the NFIP.

For the past 60 years, flood insurance has been through a cycle in which coverage was afforded in standard policies. In the 1950s and early 1960s, the coverage became unprofitable, so the industry backed away and the government stepped in with NFIP. Now the NFIP is fast becoming overburdened with debt and, some say, unnecessary bureaucratic requirements. Because of the increased threat of floods, more property owners (and many perhaps outside of the 100-year flood zones) may now appreciate the need for reasonably priced flood insurance creating profitable insurance markets. The industry has come full circle. In addition, with current legislation such as HR 2901, it appears that the government may be inviting more industry participation.

Federal law requires that any property in a high-risk flood zone that is financed by a federally backed mortgage has flood insurance. In the past, NFIP insurance was the only acceptable coverage. HR 2901, which recently passed the House of Representatives, allows private insurance companies to provide “mortgage flood insurance” for the first time. Many see this as a fundamental change in the government’s approach to flood insurance.

The combination of increased NFIP premiums, expanded mandatory coverage required by amended flood insurance rate maps, and the invitation by Congress to the private insurance market to participate may provide the opportunity and incentive for insurers to return to the marketplace. As a result of the insurance industry’s continued involvement in flood coverage through the WYO program, it is well positioned to re-enter the market. There is industry infrastructure in place and expertise in marketing the flood policy product as well as risk analysis and claims expertise, including coverage analysis and flood damage assessment. The greatest challenge will be to develop a comprehensive rating scheme and structure.

The 100-year storm or flood concept also is embedded in many of the NFIP’s comprehensive management policies. For example, a prerequisite to purchasing an NFIP policy is that the policyholder must live in a participating community that has agreed to and has adopted minimum ordinances in the 100-year flood plain area. The idea of the 100-year storm, therefore, has added significance with regard to flood insurance and flood management.

Often, the media will report that a flood or storm is a 100-year event. Many people understand this to mean that the event will happen only once every 100 years and, once it occurs, it will not happen again for another 100 years. This is incorrect. It means that the event has a one percent annual chance of occurring. If it occurs in one year, there is a one percent chance that it will occur the next year. This probability calculation also is referred to as the “return” period or “recurrence interval.”

The severity of any recurring event, such as a weather event, can be described by the frequency or probability with which that event occurs. More severe events are less probable than less severe ones. Larger storms occur less often, so the higher the year, the larger and less frequent the storm (e.g., a 500-year storm is larger and less probable than a 100-year storm). Identifying an event with an annual description, such as 100-year storm, is based upon a complicated statistical and mathematical calculation. The statistics underlying the frequency of these events indicate that, if an event has a one percent chance of occurring in any given year, it has a 1/100 probability. Because of the 1/100 probability, a shorthand reference developed identifying such an event as a 100-year storm, but it is really a storm that has a one percent chance of happening in any given year.

For example, if three inches of rain fall in Philadelphia in 24 hours, the National Weather Service refers to this as a 100-year storm. If 3.94 inches of rain fall in an hour, that is referred to as a 1,000-year storm. The National Weather Service has calculated the precipitation return periods for most parts of the country, and the information is available on its website. These tables are referred to as the Precipitation Frequency Data Server.

A flood’s return period typically is calculated using stream or river flow rates. The government has studied and calculated return periods for flow rates in virtually every river and stream in the country using stream gauges it has installed. They might determine that, if 1,300 cubic feet of water per second flows in a stream, it is a 100-year storm. Typically, the higher the flow rate, the larger the flood. These flow rates can be found in various government publications but particularly in FEMA’s flood insurance studies (FISs) for most communities. This, in turn, has a direct impact on the insurability and rating of a particular property.

The idea of the one percent, or 100-year, flood is important for the insurance industry. In addition to flood insurance studies, FEMA has prepared thousands of flood insurance rate maps (FIRMs) for communities that participate in the NFIP. FIRMs describe, among other things, the locations and boundaries of the one percent or high-risk flood zone (one percent zones have an “A” in the designation, such as Zone A, or a “V,” such as Zone VE). The FIRMs also identify the lower-risk 500-year zones (Zone C or X) and moderate-probability zones (Zone B or X), which are usually between the 100- and 500-year zones. Underwriters are typically interested in knowing whether a property is in a high-risk area (the 100-year zone).

These resources also are essential tools in flood recovery litigation and are part of every case. When bringing a subrogation claim in a flood case, the target typically will assert that the storm or flood was unforeseeable, unpredictable, unpreventable, and an act of God. Therefore, nothing could have been done to prevent the flood.

Often, floods are, at least in part, acts of negligence rather than acts of God. Stream channels may not be properly maintained and will not carry the water that they were designed to carry. Retention pond outlet structures may not have been properly designed, built, or maintained and often fail, inundating downstream properties. Storm drain systems designed in the 19th century may not be maintained and updated so that they can accommodate increased drainage resulting from development and constant changes in the watershed. Flood insurance studies, flood insurance maps, stream flow rates and gauges, and rainfall rates and gauges can all be employed to support subrogation claims.   

Note: This information was compiled by General Star Management Company and is intended to provide background information. It is not intended to be legal advice.