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Flood insurance – who needs it?

Hurricane Harvey is a tragedy. One college friend of mine lost his house completely, and another the roof, floors, and drywall. Both are wonderful men, Texas Tech graduates. The thought on my mind tonight is flood insurance. I hope they both had policies in force, but am afraid to ask.

Most homeowners carry a form of Homeowners Insurance (HO-3 and HO-5) that is “open peril.” It covers all perils unless they are specifically excluded. Sadly, flood damage is excluded from these types of policies. Flood insurance can provide protection from the peril of flood damage. The coverage extends to damage caused my natural or manmade floods, excluding some acts of war or terrorism.

Flood insurance is unique because writing policies on flood loss is an unattractive market for private insurers. Floods create massive systematic risk for insurance companies and open the door to balance- sheet-destroying losses. Earthquakes, war, and volcano damage are also excluded from homeowners’ policies under the same principle. Flood insurance may be optional or forced by a housing lender, based on the odds and severity of your home flooding. This risk is determined by flood plain maps and estimates of catastrophic events. Coverage is capped at $250,000 for residential homes and $500,000 for businesses. Tragically, the Consumer Federation of America estimates only 2 in 10 Harvey-affected homeowners had flood insurance on their property.

The lack of private coverage options creates a gap. This gap is filled by the National Flood Insurance Program. The program was created in 1968. It was intended to be self-sustaining and mimic the mechanics of auto and homeowners policies: charge premiums, invest reserves, and pay claims. Unfortunately, this program has been quietly spiraling out of control. The national flood insurance program is quickly running out of money. An article on Quartz has the national flood insurance program $25 billion (with a B) in debt. Legislatively, it can only borrow another $5.8 billion to pay out claims. Somewhere around 5 million policies are in place and almost 9 percent of those are in counties within Texas and Louisiana that may be impacted from this storm.

A flaw with the entire program is that flood plain maps do not reflect climate change or damage from previous storms to infrastructure and coastline. These outdated maps and assumptions paint a false picture of true risk. Without true risk, fewer lenders force coverage and without accurate predication mechanisms, flood insurance premiums are absurdly low. Our flood insurance market is a bubble similar to the 2008 mortgage crisis, only with more deadly outcomes. Mispriced risks and homes that don’t have protection when homeowners may think they do. Our flood insurance model is broken.

A shored-up system will require more sophisticated risk pricing that takes into account climate change, population surges, and aging infrastructure. Premiums should increase dramatically, to a point where we are accurately assessing living near coastal areas and rivers. Alternatively, we could force all homeowners to pay into the pool and take advantage of the law of large numbers. Perhaps a combination of both methods.

Whatever the fix is, it must include lenders mandating coverage. I can’t even get my mind around the idea of evacuating everything I own in a boat with my family, and that decades of my life just washed away. And as a lender, how is that conversation going to happen compassionately? Call up the borrower who just lost everything and demand immediate default payment of their mortgage?

Bottom line: Talk with your insurance companies and state insurance bodies. If you are a financial planner, use your knowledge to educate all of your clients about flood insurance.



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