Losses from Hurricane Harvey are projected to be in the billions of dollars, likely making it the costliest natural disaster in U.S. history. Craig Lemoine is a professor at the College of ACES and director of the Financial Planning Program. Lemoine, also a certified financial planner, spoke with News Bureau business and law editor Phil Ciciora about the flood insurance market.
Are floods from natural disasters covered by standard homeowners insurance?
Most homeowners carry a form of homeowners insurance that is “open peril.” It covers all perils unless they are specifically excluded. Flood damage is typically excluded from these types of policies.
Separate flood insurance sold by private insurance companies through the National Flood Insurance Program can provide protection from the peril of flood damage, but coverage is capped at $250,000 for residential homes and $500,000 for businesses. The coverage extends to damage caused by natural or man-made floods, excluding some acts of war or terrorism.
Flood insurance is different because writing policies on flood loss is an unattractive market for private insurers. Floods create massive systematic risk for insurance companies and open the door to balance-sheet destroying losses. Earthquakes, war and volcano damage also are excluded from homeowners policies under the same principle. Flood insurance may be optional or forced upon the homeowner by a housing lender, based on the odds and severity of a home flooding. This risk is determined by flood plain maps and estimates of catastrophic events.
The Consumer Federation of America estimates that only two in 10 Harvey-affected homeowners had flood insurance on their property.
Should the government step in and create a risk pool for natural disasters such as flooding?
The lack of private flood insurance coverage options certainly does create a gap. This gap is filled by the National Flood Insurance Program, which was created in 1968 and was intended to be self-sustaining and mimic auto and homeowners policies: charge premiums, invest reserves, pay claims.
Unfortunately, this program has been quietly spiraling out of control and quickly running out of money. Recent estimates say the program is around $25 billion in debt. Legislatively, it can only borrow another $5.8 billion to pay out claims. Somewhere around 5 million policies are in place, and almost 9 percent of those are in counties within Texas and Louisiana that may have been impacted by Hurricane Harvey.
A flaw with the entire program is that flood plain maps do not reflect climate change or damage from previous storms to infrastructure and coastline. What these outdated maps and assumptions do is paint a false picture of true risk. Without true risk, fewer lenders force homeowners to purchase coverage. And without accurate prediction mechanisms, flood insurance premiums are absurdly low.
Our flood insurance market is a bubble similar to the 2008 mortgage crisis, only with more deadly outcomes: mispriced risks, and homes that don’t have protection when homeowners may think they do.
In sum, our flood insurance model is broken, and it’s only likely to get worse. The National Flood Insurance Program is set to expire Sept. 30. It will be up to Congress to renew or revise the program by that deadline.
What fixes would you like to see to the current system?
A shored-up system would require more sophisticated risk pricing that takes into account climate change, population surges and aging infrastructure. Premiums would have to increase dramatically to a point where we are accurately assessing the risk of living near coastal areas and rivers.
Alternatively, we could compel all homeowners to pay into a risk pool and take advantage of the law of large numbers. Perhaps a combination of both methods.
Whatever the fix is, it must include transparent and accurate assessments of flood risk.
Editor’s note: To contact Craig Lemoine, email craiglem@illinois.edu.
