May 132013

Owen Courreges

This past Tuesday, Senator Mary Landrieu proposed an amendment to the Water Resources Development Act that would stop the implementation of National Flood Insurance Program (NFIP) premium increases that Congress imposed last year.  Senator David Vitter is co-sponsoring the amendment.

However, both agree that the NFIP needs to be self-sustaining.  Thus, Louisiana’s Senators are agreed first, that the NFIP should pay for itself, and secondly, that this should not result in massive premium increases that spur voters to kick their keisters out of office.

At first blush, it sounds like Louisiana’s Senators are saying that chocolate should taste good but shouldn’t make you get fat.  That’s not quite the case.

The NFIP was created in 1968 (a banner year for responsible federal policy) to subsidize flood insurance in at-risk areas. Unfortunately, in the 45 years since the NFIP was created, the real estate market has evolved around it.  Expectations have been created.  Values have been established.  Whether it was a wise policy at the outset has become irrelevant.  What matters is that it can’t be changed abruptly without a great deal of upheaval.

Although much of Uptown New Orleans lies on the “sliver-by-the-river,” large swaths remain in flood zones and real-estate values are high.  Substantial premium increases would price some people out of their homes.  For others, it would at least make them cut back on spending, resonating throughout the local economy.

On the other hand, the flood risk of your average home in Uptown isn’t excessively high, and it has been developed for over a hundred years  — long before the NFIP was established.  However, in other parts of the country developments have gradually occurred that wouldn’t have been cost-effective except for federal subsidization of flood insurance.

In economics they call this the problem of “moral hazard,” referring to situations where a person will take risks because somebody else will bear the cost.  Developers, real estate investors, your average homebuyer – they’re interested the brass tacks, in price and profits, not in abstract notions of civic responsibility or in some hypothetical actual value.

This is the reason why politicians are agreed that the gravy train needs to end.  It’s distorting the market and enabling wealthy freeloaders.  At the same time, the NFIP wasn’t created simply because the government enjoys throwing money around (although it does).  In fact, it was created with the best of intentions.  Until the 1950’s, homeowner’s insurance generally covered flood damage.  However, insurance companies shifted flood coverage to a separate rider or policy following major flood events, and later determined that the economics didn’t justify offering it at all.  The government entered in response to what it perceived as an unmet need.

The problem is that if the government hadn’t intervened, the market would have (presumably) eventually adjusted.  Flood insurance rates would have been substantially higher, but those increased premiums would have been reflected in real estate prices and, in turn, in monthly mortgage premiums.  Thus, we’ve been trading low flood insurance rates for higher mortgages.

That’s why Landrieu is right – both to advocate that the NFIP should ideally be self-sustaining, and to argue that these rate increases are wrong.  Homeowners are normally tied into 30-year mortgages, mortgages that were set, in part, on the presumption of the continuation of generous federal subsidies for flood insurance.  Sure, people should not generally rely on the continuation of government policy, but we’re not speaking of individuals here.  We’re talking about entire real estate markets.  We’re talking about a mess the feds need to own.

The NFIP is deep in debt because it is flawed policy based on a flawed model, but the increases proposed last year to correct the error invite too much collateral damage.  Any reforms to the NFIP need to be highly incremental.  Otherwise, places like Uptown New Orleans will be the grist for the mill of reform.

Owen Courrèges, a New Orleans attorney and resident of the Garden District, offers his opinions for on Mondays. He has previously written for the Reason Public Policy Foundation.

  13 Responses to “Owen Courreges: The moral hazard of flood insurance”

  1. A very intelligent analysis. The trouble is insurance companies are shedding coverage for wind damage too. If the government steps in we will be creating another problem. Don’t know the solution.

    • Isabel,

      I don’t know either. Part of the problem may be that with government-subsidized mortgages, a broader group of people are borrowing and subject to insurance requirements. Likewise, the moral hazard problem might be cumulative; many more flood-prone areas may also be more vulnerable to hurricanes, leading to dropping of wind coverage.

      Another, more short-term issue may simply be the struggling stock markets. As I understand it, insurance companies generally pay out as much as they take in; they make their money on investments. Thus, when times are lean they raise premiums and try to shed risk.

      I would think that more coinsurance, higher deductibles and the like would be the best solution, but then those are constrained by the insurance requirements of mortgages. It just seems like we’re all in for ever-higher premiums.

      • It is not just “government subsidized” mortgages that require flood insurance, They all do, plus other hazard insurance. The entire insurance industry is founded on compulsory purchases to meet lender requirements or legal requirements, as in the case of automobile liability insurance. Most people would go uninsured for many risks if it were possible.

    • One solution for insurance companies that are dropping wind coverage is to deny them the right to sell auto insurance in Louisiana.

  2. Let’s also acknowledge that the NFI program wouldn’t be in nearly as much trouble if the federal government hadn’t constructed defective floodwalls in the city of New Orleans, walls that homeowners, real estate markets, and mortgage rates assumed were sound, until they weren’t. Hence, the government itself bears some responsibility for the depth of the NFIP’s debt. In addition, residents in coastal areas are experiencing an increased risk of flooding due to climate change, rising sea levels, and increasingly strong and frequent storms, and all users of carbon-producing fuels are responsible for a trend the U.S. president denied until after year 2000. If climate change is a side effect of burning fossil fuels, that cost should rightly be borne by all who burn fuel, not by those most vulnerable to its effects, and society’s failure to assume those costs is no less of a moral hazard, although a more indirect one. Since the “moral hazard” works both ways here, it is a case of “Oh, what a tangled web we weave / When first we practise to deceive!” The mess won’t easily be untangled.

    • KarenNOLA,

      That’s certainly true — the federal government should have been more concerned with the levees given the fact that it was subsidizing flood insurance. It goes to show how inefficiently the government works, how poorly it sometimes responds to incentives.

      I’m more dubious about climate change; although global warming is well-established and at least abetted by greenhouse gas emissions, I’m less confident of the proportion attributable to man-made causes. The important thing is that the federal government long ago adopted the responsibility for flood control, and if rising sea levels are contributing to flood risk and storm activity, then the federal government should upgrade those systems to protect populated areas, whether through better levees or building up the coastline. Federal taxes are high and the costs of many federal programs have been passed on to the states, so state and local governments simply can’t afford to execute these programs themselves.

      • Expecting the federal government to act in its financial best interest is to personify an amalgam. Individual officials act in their best interest by doling favors to voters and donors while attempting to avoid having to charge those voters for the cost of them by deferring it. On the other hand, betting against 97% of the world’s scientists in favor of wishful thinking is precisely the same mechanism.

        • KarenNOLA,

          I’m dubious of the assertion that 97% of the world’s scientists agree broadly on the proportion of global warming caused by man-made sources. There is disagreement on this point. What’s more, predictive models for future warming have proven unreliable — there’s a great deal of uncertainty here.

          But we do agree about government, which is why I normally prefer that it remain small and not take on greater responsibilities in response to each and every perceived crisis. Otherwise, it gets us stuck in these Catch-22 situations where correcting a bad policy can itself be bad policy.

          • The free market, non-governmental solution to this problem would be for lenders to accept the risk that they might not be repaid if the property is lost to a flood. They could protect themselves through higher rates, re-insurance, or tighter lending policies. Lenders prefer to have government subsidized flood insurance as this increases their loan volume and profits. Much of the “private” sector relies on government subsidies in subtle ways.

          • Mr. Courrèges:

            I agree that the flood insurance changes are poorly constructed, that the growth of government needs to be reversed, and that we all need to receive a bit less and contribute a bit more. But it’s hard to simultaneously argue for small government and then in the next breath ask it to preserve one’s own favorite subsidy, so perhaps that bears reflection.

            The idea of “the proportion of global warming caused by man-made sources” is fairly meaningless since it could apply equally to the discrepancy between 10% and 90% or the discrepancy between 10.01% and 10.02%. It’s well documented that CO2 retains heat, and I’ve read that without CO2 in the atmosphere, our planet would be frozen. It’s also documented that CO2 levels recently passed 400 parts per million, estimated to be the highest level on the planet in at least 2 million years. The federal government estimates that burning a gallon of gasoline, when combined with oxygen from the air, produces nearly 20 pounds of CO2, and that the US alone consumes about 134 billion gallons of gasoline, so we are obviously putting enormous amounts of heat-retaining CO2 in the air. So, given all this, isn’t talking about whether that process is responsible for .01% more or less just a mental vehicle for delaying change to the status quo and help one avoid thinking about a problem when one understands that solving that problem would be very unpleasant? Oh, wait a minute: that’s almost exactly the same comment made in my first paragraph, about a different issue altogether.

            I will point four fingers back at myself, as the saying goes. I’m a hypocrite. I drive a car; I rely on air conditioning; I travel in planes. It’s hard to succeed in our culture and not do those things. But I do try to acknowledge that we need to make advances on alternative sources of energy, safe mass transit systems, and high-speed rail or less polluting forms of long-distance travel. I think we need to start there, with each of us owning our part in the problem and looking for solutions, rather than obfuscating about percentage allocations.

          • Karen,

            >> [I]t’s hard to simultaneously argue for small government and then in the next breath ask it to preserve one’s own favorite subsidy[.]<>[G]iven all this, isn’t talking about whether that process is responsible for .01% more or less just a mental vehicle for delaying change to the status quo and help one avoid thinking about a problem when one understands that solving that problem would be very unpleasant?<>I do try to acknowledge that we need to make advances on alternative sources of energy, safe mass transit systems, and high-speed rail or less polluting forms of long-distance travel.<<

            We already spend a great deal researching alternative energy sources, but nothing has really panned out thus far. As for using mass transit, high-speed trains, etc. — everybody thinks those are more environmentally-friendly because of greenhouse gas emissions emitted per person, per trip, but it's really more complicated than that. The infrastructure that supports rail is much more extensive and more than doubles the greenhouse gas emissions of rail transit. It also invites opportunity costs because it is far less cost-effective; if not for rail investment we could spend money on other capital projects that could, perhaps, more effectively reduce greenhouse gas emissions.

            If we don't look at the real scope of the problem and we don't analyze proposed "solutions" dispassionately and non-superficially, we could be meddling with the foundations of our economy without any hope of gain. A lot of people could be hurt for no reason. This is why I'm wary of the popular responses to global warming; there's a mindset that we shouldn't look before we leap, and instead just enact old policy sawhorses of those who would prefer greater government control over our economic lives irrespectively.

          • It’s amazing how easily you can acquiesce to the idea that “we” can’t have an impact and the conclusion that curbing emissions would be much more unpleasant than giving them free rein. And speaking of “so extreme as to be unthinkable”: Do you realize that oysters and shellfish are already dying in hatcheries on the west coast when there are deepwater upwellings? Acidified oceans are also toxic to corals and to fish eggs and larvae. The end result of unchecked emissions will be dead oceans, with marine species confined to aquariums in hope that we can eventually change the pH of the waters. Not to mention droughts, famines, hurricanes, and rising seas. And all this is already in progress. But I agree: it will be a lot of trouble trying to prevent all that. Large costs that economic incentives give one motivation to avoid, and we can’t control our neighbors. You’re completely right about all that. I just hoped for a little spirit of ’76, remember Pearl Harbor, and all the other impossible struggles we as a people have opted for. But I know how the line goes: Americans only do the right thing AFTER they have exhausted all the other possibilities.

  3. Ummmm….
    It’s the Obama Care of property insurance.

    The trick here is to have everyone who has the risk and folks with climate change (sorry you can’t argue that away) that means EVERYONE.

    The more people pay in the less we all have to pay.

Sorry, the comment form is closed at this time.