The National Flood Insurance Program, which began in 1968, is close to 40 years old. It’s reasonable to expect that at least several catastrophic floods will occur in the United States over the next 40 years. The impact of these events on the affected areas, the finances of the government, and the economic health of the country will depend on the risk control and risk financing methods put in place prior to their occurrence.

When the National Flood Insurance Program was enacted, it had three goals. One was to protect policyholders from the devastating financial consequences of flood damage. The second was to protect lenders from potential loan defaults resulting from flood losses. Third, and perhaps most important, was to protect the federal revenue funds of the United States by collecting money from those exposed to flood loss prior to the loss.

The program also serves other important purposes. It facilitates real estate transactions, promoting homeownership, which is a societal goal. It benefits the insurance industry as it relieves public pressure to provide flood insurance coverage. Flood peril presents an important threat to the property and well being of a significant portion of the world’s population. Like earthquake, it has the potential to bring economic catastrophe and death to a broad geographic area. Also similar to earthquake, little coverage against the flood peril is available through the private insurance market.

Flood peril presents an important threat to the property and well being of a significant portion of the world’s population.

A study by the American Insurance Association found several reasons for the apparent failure of the private insurance market. First, losses are a virtual certainty in some areas. Second, flood losses can be catastrophic. Third, consumers are not willing to pay premiums sufficiently high to cover loss exposure. Fourth, insurers are unable to pool insureds with varying degrees of exposure to flood losses because lower risks will not purchase coverage at a pooled rate.

While not mentioned in the American Insurance Association study, an additional factor contributing to market failure may be a charity hazard. Charity hazard is the tendency of an individual at risk not to procure insurance or other risk financing as a result of a reliance on expected charity from others such as friends, family, community, non-profit organizations or a government emergency program. The subsidized flood insurance available through the NFIP was intended to appeal to property owners who did not purchase insurance in the private market. The subsidized insurance is only made available in communities that adopt permanent land-use and control programs.

A colleague of mine, Dr. Robert E. Hoyt of the Terry College of Business at The University of Georgia, and I used data supplied by the National Flood Insurance Program to study what factors influence individuals’ and businesses’ purchase of flood insurance. We found that individuals with greater financial resources are more likely to take advantage of the government’s flood insurance program.
An important question that could be raised is whether or not insurance is the best approach to providing disaster protection to the low-income segment of the population. The low levels of participation in the NFIP and our finding that income matters suggest that perhaps this is not the best approach. Our empirical results indicated that the price of flood insurance, measured as written premiums per $1,000 of flood insurance in force in the state, is negatively correlated with flood insurance purchases. Our analysis suggests that if the government decreased the price it charges for flood insurance, more insurance policies would be sold and the amount of flood insurance in force would increase. However, the demand for additional policies is relatively price inelastic. The number of flood insurance policies sold is positively correlated with flood losses during the prior period. If, as our evidence and that of others indicates, perceptions of the risk of flood loss are an important determinant of insurance purchases, informational materials directed at increasing the public’s awareness of the danger posed by flood peril may be an effective means of increasing the purchase of flood insurance.

Brown chairs the Department of Actuarial Science, Risk Management and Insurance. U.S. News recently ranked its insurance program third in the nation. His complete testimony is posted at U.S. Senate Committee on Banking, Housing, and Urban Affairs Web site.