Moral Hazard: How the National Flood Insurance Program Is Limiting Risk Reduction

– Executive Summary –

Moral hazard is a concept that originated in the early insurance industry with broad application in economics, law, and policy debate. Moral hazard is defined as when people do not assume the full risk of an action or decision; people are not inclined to make a fully responsible or moral choice; how the redistribution of risk changes people’s behavior.[1] Many commentators have asserted that government involvement in providing disaster assistance contributes to the rise of a moral hazard, thus limiting the incentive of people to reduce risk.[2] This thesis seeks to explore how federal involvement in providing disaster assistance limits risk reduction and contributes to the rise of a moral hazard through a study of the National Flood Insurance Program (NFIP).

Flooding and flood-related hazards are the most prominent and significant hazards in the United States and account for the highest percentage of major disaster declarations and direct economic losses. The NFIP was created as a mitigation program with the goal of preventing future loss of life and property from the hazard of flooding. The NFIP consists of three main elements that include flood hazard identification and risk assessment, floodplain management, and flood insurance. As provided by Federal Emergency Management Agency (FEMA), “overall, the program reduces the socio-economic impact of disasters by promoting the purchase and retention of general risk insurance, but also of flood insurance, specifically.”[3]

While the NFIP has generally remained fiscally solvent for much of its history, the catastrophic losses associated with the impacts of 2004, 2005, 2008, and 2012 hurricane seasons have generated $24 billion in debt to the U.S. Treasury and revenue is unlikely to cover future catastrophic losses or repay the billions of dollars in debt.[4] Analysis of NFIP program elements that permit repetitive loss and provide flood insurance subsidies underscore policies to limit risk reduction. Furthermore, failures by policymakers to structure the NFIP for catastrophic losses constrains the sustainability of the program.

In participating communities, the NFIP offers structural and content flood insurance coverages, with regulators identifying repetitive losses as a significant concern. FEMA data indicates that from 1978 through 2015, 3.8 percent of policyholders have filed for repetitive losses, accounting for a disproportionate 35.5 percent of flood loss claims and 30.5 percent of claim payments.[5] FEMA estimates that 90 percent of repetitive loss properties receive pre-flood insurance rate map (FIRM) or grandfathered subsidies.[6] Moreover, NFIP policies specifically prevent FEMA from refusing coverage to any policyholder, and FEMA cannot compel property owners to mitigate losses or impose actuarial rates on repetitive loss properties as a penalty.[7]

The majority of flood insurance policies are based on full-risk rates established through FEMA’s annual NFIP actuarial rate review. However, approximately 20 percent of policies are based on pre-FIRM subsidized or grandfathered insurance rates and pay 40 to 45 percent of the full-risk premium needed to fund the long-term expectation of loss.[8] Congress authorized the use of subsidized flood insurance rates to encourage participation and prohibits unfairly penalizing homeowners who built before the government completed the assessment of flood risk.[9] NFIP policies exempt pre-FIRM properties from compliance with floodplain management regulations unless they are substantially damaged or undergo substantial improvement.[10] The continued coverage of repetitive loss properties and the subsidizing of flood insurance policies represents one of the clearest and most obvious indicators of the NFIP limiting risk reduction and contributing to the rise of a moral hazard.

The NFIP is not structured to withstand claims and losses associated with catastrophic flood events; it relies on the borrowing authority with the U.S. Treasury to cover excessive losses.[11] Significant loss events currently average 64 percent of claims and 84 percent of losses for the NFIP. The impact of significant loss events is clearly a threat to the long-term sustainment of the NFIP. Policymakers must address the fiscal challenges facing the program, placing it on a sounder financial framework to allow for improved management of the program when faced with significant loss events. The shortcomings of policymakers in addressing the sustainment of the NFIP presents a parallel argument that there is moral hazard in the current policymaking environment. It can be argued that when policymakers limit the sustainability of the NFIP to historical average losses versus catastrophic losses, they fail to provide for the long-term resilience of the program.

In conclusion, aspects of the NFIP limit risk reduction and contribute to the rise of a moral hazard. Specifically, NFIP policies that support continued coverage of repetitive loss, use of subsidies to desensitize risk, and failure to adjust for catastrophic losses all impact the sustainability and resilience of the program. These findings have important consequences for the broader domain of evaluating the unintended consequences of federal involvement in providing disaster assistance. While there is an imperative for the government to provide assistance in time of crisis, it is important to evaluate the how that assistance may change behavior; policies designed to limit risk may be actually prolong or increase risk.

[1] David Rowell and Luke B. Connelly, “A History of the Term ‘Moral Hazard,’” Journal of Risk and Insurance 79, no. 4 (2012): 1061.

[2] Carolyn Kousky and Leonard Shabman, “The Hazard of the Moral Hazard—Or Not,” Natural Hazards Observer XXXVII, no. 5 (2013): 1.

[3] Federal Emergency Management Agency, “The National Flood Insurance Program,” May 20, 2016,

[4] U.S. Government Accountability Office, Forgone Premiums Cannot Be Measured and FEMA Should Validate and Monitor Data System Changes (GAO-15-111) (Washington DC: U.S. Government Accountability Office, 2014),, 2.

[5] Federal Emergency Management Agency, “Policy & Claim Statistics for Flood Insurance,” June 7, 2016,; Federal Emergency Management Agency Region VI, FEMA NFIP Repetitive Loss Report (Denton, TX: Federal Emergency Management Agency, Region VI, 2016).

[6] Rawle O. King, National Flood Insurance Program: Background, Challenges, and Financial Status (Washington DC: Congressional Research Service, 2011),, 18.

[7] Ibid., 18.

[8] Thomas L. Hayes and D. Andrew Neal, National Flood Insurance Program Actuarial Rate Review: In Support of the Recommended October 1, 2011 Rate and Rule Changes (Washington DC: Federal Emergency Management Agency, 2011),, 9, 34.

[9] Rawle O. King, Federal Flood Insurance: The Repetitive Loss Problem (Washington DC: Congressional Research Service, 2005),, 14.

[10] “Substantial Damages and Substantial Improvements,” YouTube video, posted by Gary Taylor, October 15, 2014, ajNQxa8N5s9G1IJ4gRrsZ&index=3.

[11] Carolyn Kousky and Leonard Shabman, Pricing Flood Insurance: How and Why the NFIP Differs from a Private Insurance Company (Washington DC: Resources for the Future, 2014),, 9.

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