Hurricanes, Flooded Homes, and Moral Hazard

By Bruce Yandle of Mercatus.

"With heavy rainfall having brought severe flooding to Maryland and other areas along the Atlantic and Gulf Coasts and the 2018 hurricane season just getting underway, it’s a good time to remember that the United States suffers from more than just weather patterns. In some situations, our flood insurance system encourages people to live where the risk is greatest. The worst part of it? We know better.

Of those hurricanes that eventually make landfall, according to Yale University economist Robert Mendelsohn, only some 4 percent actually hit the United States.

How could that be? What is it about us that causes disproportionate damage in our otherwise-prosperous corner of the world? And why hasn’t our government fixed an obvious problem?

Put in insurance economics jargon, the problem is called “moral hazard.” This is a situation where the solution to a hazard can make the problem worse. Fire insurance provides an easy illustration: If insurance companies wrote policies covering 100 percent of losses from fire, there would be a significant incentive for some people to buy a policy today and set fire to their home tomorrow.

Through centuries of experience, fire insurance companies have learned to require policy owners to bear part of the risk. Policies now commonly cover around 80 percent, and homeowners co-insure. Unfortunately, Uncle Sam has only partially taken this lesson to heart when trying to help homeowners in flood-prone areas.

Federal law requires anyone purchasing a home in a designated flood area using financing from a federally insured and regulated lender to buy flood plain insurance through the Federal Emergency Management Agency (FEMA). Instead of charging insurance premiums that cover the expected cost of floods, FEMA offers partly subsidized insurance; the government discount can be huge. Moral hazard knocks at the door. In 2015, there were 5.1 million policies in force.

FEMA now produces maps for about 60 percent of the country showing the degree to which a particular parcel of land may lie in a flood-threatened location. Generally speaking, the higher the risk, the higher the insurance premium. But the longer a particular homeowner has had floodplain insurance, the lower the premium. Newly sold insurance reflects full cost, but polices that are grandfathered in do not.

To illustrate, consider a $250,000 home with no basement, located in a flood plain and insured before FEMA developed its new full-cost insurance for the area in question. (The latter applies to roughly 12 percent of all insured property.) The annual flood insurance premium in 2014 for this home was $2,644. For an identical property insured after FEMA developed full-cost pricing, the policy cost can be as high as $10,263.

Understandably, homeowners who hold highly subsidized insurance do all they can to keep it. That can mean avoiding selling a property or choosing to rebuild in the same place even after suffering severe damage from a storm. In short, it means some people have a strong incentive to continue to live in flood-prone areas.

To make matters worse, FEMA’s insurance program fails to bring enough revenue to cover costs. The agency must borrow from the U.S. Treasury, which currently owes $25 billion for past flood insurance deficits.

Of course, Congress knows about all this. In 2012, it passed legislation requiring FEMA to move toward full-cost pricing and phase out all subsidized insurance plans. Everything went along well until the next hurricane season. In 2014, Congress backed away from full-cost pricing and the requirement that grandfathered coverage not be renewed. Special interest pleading won out, and citizens living on higher ground paid up. Moral hazard lived to play another day.

Now’s the time for Congress to hit the line, once again, and require FEMA to fix the flood plain insurance problem — this time for good."