A Flood Insurance Primer – Why Are So Few Homeowners Insured?

Flood insurance was a hot topic in the wake of Gulf Coast hurricanes Katrina and Rita. The lesson taken away from those disasters from a flood insurance perspective was generally the right one – The Congressionally-mandated flood insurance program does not work. Not nearly enough people buy flood insurance – ironically, far fewer buy mandatory flood insurance than would if the market were allowed to educate the public and convince them to buy it. To understand why so many homeowners even in hurricane prone areas lack flood insurance, it’s necessary to learn a little bit about how flood insurance works in America.

The who and what of federal flood insurance

The Federal Emergency Management Agency (FEMA) designates flood zones based on a number of factors, all boiling down to the chance property in the zone will suffer flood damage. Whether federally subsidized flood insurance will be required (under circumstances described below) depends on the flood zone the property is or will be located in.

The National Flood Insurance Program (NFIP) makes federally subsidized flood insurance available, including where mandatory. (The mechanics of how insurance can be legally “mandated” are covered below.) Because NFIP is a federal government program – and so, someone else’s money, unsullied by a profit motive — flood coverage is incredibly cheap.

Flood zones and what they mean (for insurance purposes)

There are three basic types of flood zones designated by FEMA, subdivided into several more detailed zones.

Moderate to Low Risk areas are designated by flood zones B, C and X.

Generally a less than 1% chance of flooding per year.
Flood insurance is “available” to homeowners in these zones through the NFIP.

High Risk areas are designated by flood zones A, AE, A1-A30, AH, AO, AR and A99.

Generally a greater than 1% chance of flooding per year.
Which generally translates into a 26% chance of flooding over the life of a 30-year mortgage.
Mandatory flood insurance rules apply for mortgages in these zones.

High Risk – Coastal Areas designated by flood zones V, VE and V1-V30.

Generally the same chance of flooding as A (High Risk) zones.
Mandatory flood insurance rules apply for mortgages in these zones.

There is also a Zone D, “undetermined” risk area.

The gulf coast is almost entirely designated High Risk – Coastal Area.

“Mandatory” flood insurance

To understand what “mandatory” means when it comes to flood insurance, it’s useful to step back and consider what Congress is and is not authorized to do under the Constitution.

The federal government cannot constitutionally mandate that people buy flood insurance. It cannot enforce building codes that would restrict the kind of construction authorized in certain flood zones.

What it can do is create a program, like the NFIP, and make it available to communities that pass and enforce flood zone building codes. You may be more familiar with Congress’ threat to withhold highway funds to states that did not set a 55 and then 65 MPH speed limit. Same principle: What Congress cannot constitutionally require, it may accomplish by creating a benefit and threatening to withhold it.

So: Communities become eligible to participate in NFIP by taking steps to ensure new construction and existing structures mitigate flood risk.

NFIP was created in 1968 as a voluntary program. Because of low participation, Congress “mandated” (we’re still getting to what that means) flood insurance in certain areas (now flood zones) in 1973. Participation remained low.

In 1994, Congress enacted flood insurance reform, continuing the “mandatory” nature of flood insurance and establishing new, severe sanctions for nonparticipation, in the form of requiring that homeowners having received relief purchase flood insurance to be eligible for similar help in the future.

You could stop reading here and know a lot about what’s wrong with flood insurance: Congress said that it would only take care of uninsured homeowners’ flood damage once. What this means to most people smart enough to have bought a home is that the federal government will take care of uninsured homeowners’ flood damage once.

Who is subject to the “mandatory” flood insurance law?

Not the homeowner – rather, federally regulated lenders, GSEs and public agencies. These entities are required to ensure that any mortgage secured by structures in a flood hazard area has flood insurance.

If required, flood insurance will be required at the time a loan, including a refi, is made. Generally, notice is given to homeowners that they are required to purchase flood insurance at their expense. If they fail after notice, the lender may purchase it for them and add the cost to the monthly payment if the property is in a flood hazard area.

Life of loan monitoring is not required by law. (This becomes important in a way we will see.)

Lenders face civil money penalties — no more than $100,000 aggregate per year — if (and only if) they engage in a pattern or practice of shirking their flood insurance responsibilities.

Why might a homeowner in a flood-prone area not have insurance?

This is the heart of the matter. Considering the history, politics and division of responsibility for ensuring that flood-prone homeowners have insurance, here is why they don’t:

People think homeowner’s insurance covers floods. It doesn’t.
Their property may not technically be in a flood zone designated by FEMA as requiring insurance, so it’s not mandatory.
They worked through a non-federally regulated mortgage lender, that did not sell their loan to Fannie Mae or Freddie Mac, so it’s not mandatory.
They have no mortgage — it may be paid off or never have been encumbered (the 90-year-old home that’s been in the family for three generations).
Lenders may not comply. A company originating $50 billion in mortgage loans in a quarter might economically view avoiding a possible $100,000 penalty as not worth the cost of rigorous compliance.
Homeowners get the insurance to get through closing, but then let coverage lapse, and they haven’t been “caught” because there is no mandatory life of loan monitoring.
Their community may not participate in the program.
They assume the government will make them whole after losses without their buying insurance. Generally, they’re right.
Flood insurance represents a failure of central planning, and an apt demonstration of it inferiority to the free market. To better ensure that homeowners in hurricane prone areas are insured in greater numbers, Congress should bite the bullet and withhold aid where flood insurance was cheaply available and a choice was made not to purchase it (continuing to help those who lack insurance for reasons beyond their control). It should continue to require flood insurance at loan closing where it has the power to do so, but open the market to private insurance companies and require life-of-loan monitoring if it’s serious about enforcing an insurance requirement. And penalties must be increased – the current one simply is not an economically feasible deterrent.