Budget Basics: The National Flood Insurance Program

The National Flood Insurance Program (NFIP) is run by the federal government to reduce the impact of flooding on private and public structures. Created in 1968 and housed under the Federal Emergency Management Agency (FEMA), the NFIP provides federally backed flood insurance to property owners, renters, and businesses in participating communities. It also has a larger goal of reducing the risk of flood damage by encouraging floodplain management.

While the NFIP is not a large part of the federal budget (less than 0.1 percent), it is currently running a deficit as its revenues fail to cover its expenditures. Moreover, future climate conditions and the growth of coastal populations could lead to larger liabilities going forward, putting additional stress on the program. Below is an overview of the NFIP and its place within the federal budget.

What Does the NFIP Do?

The NFIP was established in response to a lack of affordable private flood insurance, owing largely to the difficulty of predicting floods and the damage they cause. The NFIP covers up to $250,000 for residential buildings and $500,000 for non-residential buildings damaged by flooding. Coverage for certain commonly owned contents, such as furniture and electronic equipment, is also available for purchase up to $100,000 for residential properties and $500,000 for non-residential. As of September 2019, single-family homes constitute the largest portion of properties covered by the NFIP.

The NFIP calculates coverage levels and premium rates based on the geographic location of a building, the characteristics of its structure (i.e., design, age, contents, and the lowest floor), and other statutory provisions. Currently, over 5 million homes and businesses are covered by the program. Coverage is heavily concentrated in counties in coastal areas where buildings are more vulnerable to flooding.

What Makes the NFIP Different from Private Insurance?

Unlike a traditional insurance program, the NFIP considers more than just the flood risk of a given property for its premium calculation. It also offers certain subsidies to encourage greater participation in the program, as well as to prevent unexpected costs for some homeowners. Most notably, the NFIP provides discounts to two types of properties: pre-Flood Insurance Rate Map (FIRM) properties, which were built before FEMA created the first flood risk map of the community, and “grandfathered” properties, which were FIRM-compliant at the time of construction.

The NFIP also promotes floodplain management through other discounts. Policyholders can make modifications to their buildings — from relocating machinery to elevating the building itself — to reduce their premiums. Community-wide discounts can be obtained through participation in NFIP’s Community Rating System, in which communities are rewarded points for additional efforts to promote and take corrective measures to reduce flood damage to properties.

Most importantly, participation in the NFIP is a community-level decision; in other words, the program offers insurance only to residents that live in communities where the local government has voluntarily adopted floodplain management regulations. However, since 1973, residents that live in Special Flood Hazard Areas (SFHA) and receive federally backed mortgages are required to purchase flood insurance. A 2017 report done by Resources for the Future estimated that the take-up rate was about 50 percent in SFHAs.

How Is the NFIP Financed?

The NFIP depends predominantly on one source of income: premiums paid by policyholders. On the other side of the ledger, in addition to paying insurance claims and servicing policies, the program’s expenditures include non-insurance activities such as floodplain mapping and flood risk mitigation.

Historically, payments on claims and other expenses have exceeded receipts from premiums. Because the NFIP’s claim payments are mandated by law, the NFIP is authorized to borrow money from the U.S. Treasury when premium receipts do not cover its costs. While the NFIP’s shortfalls cannot be attributed to any single incident, the program borrowed significantly in the aftermath of Hurricanes Katrina in 2005 and Sandy in 2012. In 2017, it reached its borrowing cap of $30.5 billion, at which point the Congress canceled $16 billion so that the NFIP could borrow in response to Hurricanes Harvey, Irma, and Maria. Currently, the NFIP has an accumulated debt of $20.5 billion.

A report by the Congressional Budget Office (CBO) suggests that the trend of shortfalls will likely continue into the future. The program is projected to run a deficit of approximately $1.4 billion per year under current conditions, with the expected annual cost of $5.7 billion exceeding the $4.3 billion in expected premiums. That shortfall stems largely from two sources: policies embedded in the NFIP and expected flood damages.

Certain Policies Embedded in the NFIP Reduce Receipts and Increase Costs

As mentioned above, the NFIP offers discounted and grandfathered premium rates to provide affordable coverage and encourage widespread participation. The latest available analysis by CBO estimated that those discounts would constitute approximately 50 percent of the total expected shortfall in 2017; that is, the program was projected to annually receive $0.7 billion less than if it were to charge a fully risk-based rate to all policyholders. Likewise, the Government Accountability Office (GAO) highlighted in its latest report that the NFIP’s fiscal condition has been “high-risk” since 2017 due to premium rates that do not reflect the full risk of flood damage.

Additionally, the voluntary nature of the NFIP results in low coverage. Many properties that are at risk of flooding do not participate in the program, resulting in a potential decrease in program expenditures but also an increased likelihood of the need for federal disaster aid — which ultimately costs more for the government. GAO cites several reasons for why individuals decide not to participate, including the difficulty of comprehending low-probability, high-severity risks and the false sense that non-SFHA zones are safe from flooding. Without closing the insurance gap, the cost of the NFIP will continue to shift from policyholders to taxpayers if the federal government steps in to provide emergency assistance to those without flood insurance.

Finally, debt accumulated by the program incurs annual interest costs. CBO estimated that such interest payments add $0.3 billion to the total one-year cost of the program.

Damages from Floods and Hurricanes Are Expected to Increase

With the frequency of catastrophic hurricanes and their damages expected to grow, the NFIP’s method for calculating premiums will likely exacerbate the program’s shortfalls. The NFIP was originally designed to generate enough revenue for a “historical average loss year,” which is the mean of the annual losses over the life of the program. However, this method of calculating needed revenue underrepresents losses from catastrophic storms. Insurance costs spike and significant deficits accumulate after major hurricanes; according to CBO, nearly three-quarters of the NFIP’s insurance claims over the past 35 years have arisen from hurricane-related storm surges and inland flooding. Although the Biggert-Waters Act addressed the outdated premium-setting methodology by calling for fully risk-based rates, the NFIP has yet to implement the update. In the absence of an effective strategy to generate sufficient revenues for major losses, constraints from the limit on borrowing and increasing interest costs may inhibit the program’s activities in the future.

The Larger Budgetary Implication of Hurricane and Flood Damages

The NFIP is just one component of federal spending related to flood and hurricane damages. During presidentially declared disasters, the federal government will partially compensate for economic losses incurred by both the private and public sectors. A report by CBO in 2019 estimates that, based on current climate conditions, federal government spending in response to hurricane and flood damages will include:

• Providing funds to households and businesses through disaster recovery programs of federal agencies such as FEMA, the Department of Housing and Urban Development, and the Small Business Administration to help repair or replace properties lost in storms. Those programs are expected to cost $4 billion annually.
• Coordinating with state and local governments to provide immediate assistance such as emergency shelters and debris removal, as well as conducting longer-term activities such as repairing public properties. The government is expected to spend $11 billion per year on such activities.

Including $1 billion of administrative costs and the $1.4 billion of subsidies to be paid to the NFIP, the expected federal outlays on hurricane and flood damages is estimated to total $17 billion annually.

Climate conditions are not expected to remain stagnant however. The frequency of hurricanes, rise in sea level, and growth in the coastal population are expected to exacerbate hurricane damage. Whereas in 2016 CBO projected that economic losses from hurricane damage would amount to 0.22 percent of GDP by 2075, its most recent projections show that such losses already represent 0.3 percent of the current GDP.

Conclusion

The NFIP’s projected annual deficits present only a small impact on the federal budget. However, as flooding risks change with the climate and coastal development continues, the NFIP may be liable for potentially significant costs in the future.