Third, NFIP assumes  all the risks for the policies it sells. FEMA sets rates on a nationwide basis, combining and averaging across  many geographically diverse areas. Collectively, these factors increase the risk that premiums collected on  full-risk rates do not accurately reflect the risks of flooding and therefore  may not be sufficient to cover future losses. FEMA’s Rate-Setting Process Uses a Model That Is Based on Flood Risk and Expected Flood Damage

According to FEMA, rates that are based on the probability of a given level  of flooding, damage estimates based on that level of flooding, and  accepted actuarial principles are considered to be “full risk.” To set rates  for flood insurance that accurately reflect risk, information about the  differential risk of flooding is key, with greater flood risks resulting in  higher rates. the Corps for a number of years. They have  not been revisited or updated since that time. FEMA Does Not Track the Number or Location of Remapped Grandfathered Properties That Pay Less than Full-Risk Premiums

FEMA made a policy decision to grandfather into the program certain  properties, that is, it allowed properties that have been remapped into  riskier flood zones to keep their previous lower rates. As  a result of the growth in the program, the rate classes may not accurately  reflect the actual flood risk to individual properties and averaging may no  longer accurately reflect differences in rates within zones. FEMA’s Process for Setting Subsidized Rates May Further Compromise the Ongoing Financial Stability of the Program

FEMA’s rate-setting process for subsidized properties, which depends in  part on the accuracy of the full-risk rates, has evolved over time. Currently, to determine subsidized rates, FEMA first subtracts the total  amount that it expects to collect on full-risk rate premiums from the  average historical loss year target—the minimum amount of premiums the  program needs to collect to cover at least average annual losses based on  historical loss data. The amount remaining from this calculation is the  aggregate target amount of subsidized premiums that the program needs  to collect. Then to set individual subsidized rates, FEMA officials consider  their knowledge of flood risks, previous rate increases for various areas,  and statutory limits on rate increases. Currently, the annual amount that  NFIP collects in both full-risk and subsidized premiums is not enough to  cover its operating costs, claim losses, and principal and interest payments  to the Department of the Treasury. NFIP’s Current Rate- Setting Processes Result in Premiums That Are Not Sufficient to Cover Current Debt and Future Claims

The processes and policies that FEMA uses to set both full-risk and  subsidized premium rates have contributed to NFIP’s inability to generate  enough in premiums to cover the program’s operating costs, claims losses,  and debt to the Treasury. The  2005 hurricanes, especially Katrina, left the program with debt of more  than $17.4 billion as of June 2008. First, potentially outdated and inaccurate data about  flood probabilities, damage claims, and flood maps are increasing the risk  that full-risk premiums do not reflect actual risk of flooding. Finally, FEMA’s rate-setting process for subsidized properties depends in  part on the accuracy of full-risk rates, raising concerns about how these  rates are calculated as well. The resulting subsidized premiums continue  to be a financial strain on NFIP and contribute to its ongoing financial  instability. However, any efforts to improve the  accuracy of the premiums charged by the program will help reduce the  financial risk to which the federal government and, ultimately, taxpayers  are exposed from the flood insurance program. Second, FEMA said that the report does not accurately present the status  of its map modernization efforts and their impact on premium rates. Appendix I: Scope and Methodology

To assess the Federal Emergency Management Agency’s (FEMA) rate- setting process and determine whether it produces rates that accurately  reflect the risk of flooding for properties that do not receive subsidies, we  reviewed and analyzed FEMA’s model for evaluating potential flood  damage to properties as well as the methods used for assessing risk and  setting premium rates for policyholders.
Why GAO Did This Study

Questions about the financial status of the National Flood Insurance Program (NFIP) have increased since the 2005 hurricanes, which left the program with an unprecedented $17.4 billion deficit--a debt that resulted in GAO placing NFIP on its high-risk list in March 2006. Among the concerns are the subsidized rates NFIP must provide for about 25 percent of the policies, mostly for older buildings in high-risk flood zones. And although fully risk-based rates are supposed to reflect actual flood risk, concerns have been raised that they do not. This report evaluates (1) the Federal Emergency Management Agency's (FEMA) process for setting full-risk rates to determine whether it produces rates that accurately reflect the risk of flooding and (2) the process that FEMA uses to set subsidized rates and their effect on the financial condition of NFIP. To do this work, GAO evaluated the NFIP rate model, examined data from FEMA, surveyed relevant literature, and interviewed other relevant agencies and risk-modeling firms.

What GAO Found

FEMA's method for setting its full-risk rates may not ensure that the rates accurately reflect the actual risk of flood damage. The NFIP model combines estimated flood risk with expected flood damage, but a number of factors may affect the accuracy of the rates the model generates. First, some data inputs are outdated or inaccurate. FEMA relies on flood probabilities from the 1980s and damage estimates that do not fully reflect recent NFIP damage experience. Moreover, while FEMA has made updating its flood maps a priority, most of the maps used in rate setting have not yet been updated. Second, FEMA does not require all properties remapped into higher-risk areas to pay rates based on the new designation. This policy, known as grandfathering, erodes NFIP's ability to charge rates that reflect the risk of flooding. The policy is intended to increase participation, but FEMA does not track the number of grandfathered properties and cannot determine their financial impact on the program. Third, FEMA uses a nationwide rating system that combines flood zones across many geographic areas, so individual policies do not always reflect topographical features that affect flood risk. In fact, some patterns in historical claims and premium data suggest that NFIP's full-risk rates may not always reflect actual flood risk. Collectively, these factors increase the risk that premiums collected on full-risk policies may be insufficient to cover future losses, adding to concerns about NFIP's financial stability. FEMA's rate-setting process for subsidized properties depends in part on the accuracy of the full-risk rates, raising concerns about how these rates are calculated as well. To set subsidized rates, FEMA first subtracts the total amount it expects to collect in full-risk premiums from the average historical loss year--that is, the minimum (target) amount that the program needs to collect from all premiums to cover at least average annual losses, as determined by historical data. The remainder becomes the aggregate target amount the program must collect in subsidized premiums. To set individual subsidized rates, FEMA officials then consider their knowledge of flood risk, previous rate increases for various locations, and statutory limits on increases. The resulting subsidized premiums continue to be a financial strain on the NFIP and contribute to its ongoing financial instability. Evidence suggests that flooding is likely to become more severe in the future, resulting in increased risk exposure, the potential for more catastrophic losses, and ongoing financial instability for the program. Currently, the annual amount that NFIP collects in both full-risk and subsidized premiums is not enough to cover its operating costs, claim losses, and principal and interest payments to the Department of the Treasury, thereby exposing the federal government and ultimately taxpayers to ever-greater financial risks, especially in years of catastrophic flooding.