Yesterday, a big change in the way risk is priced under the U.S. National Flood Insurance Program (NFIP) was announced, with a shift to fully risk-based pricing of flood insurance potentially set to be a driver of more flood risk into private reinsurance and risk markets.
One piece of the legacy puzzle of U.S. flood insurance risk is that the NFIP has dominated the provision of it, resulting in a one-size-fits-all approach to pricing, that means two homes may pay the same rates despite having vastly different levels of exposure to major flood events.
Now, the U.S. Federal Emergency Management Agency (FEMA) has said that it intends to move towards full risk-based pricing of U.S. flood insurance risk, under a program named Risk Rating 2.0 that is set to come into force from late 2020.
FEMA said that premiums for individual properties will now be tied to their actual levels of flood risk, while at the same time the new rating system will also consider peril-specific features, such as extreme deluges in pricing, historically rainfall levels, have not been taken into account.
The shift will more closely align FEMA's NFIP pricing system with how the private insurance and reinsurance market would like to see flood risks rated.
Property or building-specific risk modelling underpins much of the industry's efforts to understand levels of risk and exposure, helping it to derive risk-commensurate pricing for whatever it is seeking to underwrite.
Now, FEMA will leverage data aggregated from private sector sources to help it better price and underwrite flood risk, which is going to result in significant changes for some, but overall a much healthier approach to valuing and pricing the flood risk that U.S. homes and businesses really face.
It's being called one of the biggest changes in the history of the NFIP, as the program shifts towards proper risk rating of the actual flood exposure individual homes face.
At the moment, NFIP flood insurance prices are set according to more of a zoning map-based approach, with position related to a 1-in-100 year flood plain the main driver.
With this shift in pricing, FEMA aligns the NFIP more closely with the growing private flood insurance market and will also ensure that private market participants can now compete on a more level playing field.
The current NFIP pricing system meant that many portfolios of flood insurance policies looked unattractive to the private market, given the broad-brush pricing approach.
By aligning NFIP pricing with the way the private market wants to price, FEMA will move further along its intended path towards derisking and shedding many of its policies that could be picked up by private flood insurance underwriters.
At the same time, the shift to more granular and risk-based pricing will also open up transfer of more of the NFIP's risk to the reinsurance and capital markets in future as well, potentially enabling FEMA to issue more and larger flood catastrophe bonds as well.
FEMA's moves to privatise risk into the reinsurance market have likely helped to drive this latest change.
It would only be by considering pricing of flood risk at the granular, property level that private reinsurance, insurance-linked securities (ILS) and capital market players demand that FEMA will have been able to socialise the benefits of moving to this new approach.
Once the entire NFIP portfolio is rated on a property level basis, the opportunities to transfer more of that risk will expand significantly, while the private market will also be able to offer a true and comparable NFIP alternative.
The move also has benefits in terms of driving home the true risk people face and therefore encouraging resilience measures to reduce risk as well. That should also increase demand for flood insurance protection as well.
Ultimately, the move by FEMA could result in more effective and risk commensurate flood insurance pricing, in a larger, more privatised U.S. flood insurance market, where the NFIP increasingly shifts to being the (well reinsured) insurer of last resort and the private market plays an increasingly significant role.
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