March 7, 2000
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A flawed program facilitates building in hazardous areas

By Gilbert M. Gaul
and Anthony R. Wood

Related material:
* Federal effort let homeowners seize on an unintended opportunity
* In outdated maps, a poor primer on risk
* A taste of the beach
* Graphics and the series so far

Imagine for a moment you are a fresh graduate of the Wharton School. You want to start an insurance company and are seeking financing.

Your business plan:

Locate in one of the most dangerous areas of the country, the storm-swept coastline.

Pick out the riskiest customers you can find - customers likely to file claims again and again - and then give them a discount.

Agree not to cancel policies, no matter how many claims are filed.

Operate without reserves for covering catastrophic losses - a standard industry requirement - in order to keep rates artificially low.

Who would back such a risky venture? No one in the real world of business.

But the federal government does through taxpayer-backed flood insurance. It covers beach houses and investment properties that flood again and again. It has lost huge sums. The program has no reserves to speak of. And, as an emergency backstop, it relies on the U.S. Treasury, borrowing hundreds of millions to bail it out in tough times.

"Even though we have to pay it back with interest, we're still having to borrow money as a company," said James Lee Witt, director of the Federal Emergency Management Agency (FEMA), which operates the flood program.

"If you and I were the president and CEO of that company and had to go to the bank to borrow that money, the bank would eventually get tired of loaning you that money," Witt said.

The flood program, which covers 4.1 million properties nationwide, is different in other ways. It allows private insurance companies to earn commissions for selling federal policies - while incurring no risk. And the government spends millions advertising its insurance, further encouraging development along the vulnerable coast.

In 1968, Congress created the National Flood Insurance Program in an effort to slash disaster costs from floods and curb development in flood-prone areas.

The program's objectives have not been realized, a yearlong investigation, including analysis of thousands of flood claims nationwide, has found.

Disaster costs from floods, hurricanes and coastal storms are increasing, not declining. Risky development continues along many beach towns and back bays, with tens of thousands of houses erected in the floodplain each year. And with more property than ever exposed to nature's fury, and no reserves, the flood insurance program faces potentially catastrophic losses - with no one to bail it out except taxpayers.

Among the findings:

Faulty design. Normally, insurance rates are based on risk. The greater the risk, the more you pay. The flood program gives huge discounts to its riskiest customers - older, flood-prone properties - while charging newer properties full rates. Three of every 10 of the National Flood Insurance Program's properties are still subsidized: 1.2 million properties, resulting in an average annual shortfall of $450 million on those properties.

Insuring vacation homes. Six of every 10 National Flood Insurance Program properties are in beach towns, including vacation homes and investment properties on storm-prone barrier islands. All told, $309 billion in federally backed coastal property is at risk, including $11 billion in New Jersey. Coastal areas account for a growing share of the program's most expensive claims, including seven of the 10 costliest disasters.

Repeat offenders. Some properties flood again and again but still receive discount rates. They represent fewer than 2 percent of all properties with federal flood insurance yet account for nearly one-third of losses - $200 million annually. Congress has blocked attempts to impose surcharges on the owners of these properties or to limit payouts. Now it wants to use tax dollars to put some of those houses on stilts, another subsidy.

Paper savings. FEMA contends that the flood program saves taxpayers $770 million a year in flood damage payments nationwide through its promotion of safer building standards. That is damage the agency calculates would have occurred had builders used older standards. It does not reflect new flood damage resulting from development in floodplains that FEMA is powerless to stop.

Deficit financing. FEMA says the flood insurance program is designed to be self-supporting, meaning premiums cover losses. Yet over its 30-year history, the program has lost at least $1.2 billion, and recently had to borrow more than $1 billion from the U.S. Treasury just to pay claims. As of last year, it owed taxpayers more than $700 million, with interest. This is like a homeowner who borrows money to balance his checkbook and then claims he is operating in the black. "In essence, we're using our borrowing capacity as our reserve," said Edward T. Pasterick, FEMA's chief financial officer.

No reserves. Congress forbids the flood program to charge enough to cover catastrophic losses, which normally would be funded from reserves. That keeps rates low for the riskiest customers. But it leaves the program vulnerable to large losses. Those losses could top $6 billion in a worst-case event, federal officials say. To build adequate reserves, the government would have to double what it collects now, and more than double what it charges its riskiest policyholders.

"I think the initial intention was to discourage development in hazardous areas," said Raymond J. Burby, a University of New Orleans expert in coastal hazards. "That hasn't occurred. In fact, flood insurance has had the opposite effect. Instead of making it more expensive to build in hazardous areas, it has encouraged and subsidized those risks."

FEMA's Witt acknowledged that the flood program was flawed and said he was taking steps to fix it. He said a $200 million plan to elevate the most frequently flooded properties would cut losses.

"We've got to clean this program up. We've got to change the way we're doing things," Witt said.

If he can do that, Witt added, he will turn the flood program over to private insurers. "It should be part of the private market at some point," he said.

Given the monumental risks along America's crowded, storm-swept coasts, Witt may have a hard time finding takers.

Private insurers wary

How did the federal government's disaster relief agency become the insurer of last resort for some of the endangered real estate on America's coasts?

Private insurers wanted no part of flood insurance. It was too risky, they said. Unlike other natural disasters, such as earthquakes and tornadoes, floods are predictable, particularly on the coast, where hurricanes and other storms strike year after year. Thus, only those at risk would buy coverage, resulting in certain losses for insurers.

For decades, Congress struggled with the issue. One of the staunchest supporters was Harrison A. Williams Jr., a Democratic senator from New Jersey, who introduced flood bills in 1962, 1963 and 1965. Williams contended that because insurers could not afford to offer private insurance, the responsibility should fall to the government. In 1964, Sen. Claiborne Pell, a Democrat from Rhode Island, privately wrote Williams in support of his effort, noting that Pell's Newport home could be "a great beneficiary of such a bill."

In 1965, lawmakers expressed concern that flood insurance would reward risky coastal development. Williams responded that he was proposing coverage only for safe development - "not for those who build in unsuitable areas. Gracious. I have seen people build homes literally on stilts, out in the Atlantic Ocean."

Some members of Congress proposed including a buffer strip along the ocean where insurance would not be written. The idea was to discourage risky building. When legislation finally passed in 1968, however, it did not include buffers, setbacks or other protections. Congress agreed to cover property regardless of where it was built - including on stilts in the ocean.

Nor did Congress distinguish between investment properties, vacation homes, and year-round residences. A working farm in North Carolina was treated the same as a vacation home on an eroding barrier island.

This provided a boost to coastal developers, who advertised the availability of cheap, taxpayer-backed flood insurance, and helped pave the way for an unprecedented wave of beachfront construction, putting yet more property in harm's way.

Today, an estimated $2 trillion in property straddles the nation's vulnerable shorelines and back bays, much of it second homes built during decades of below-normal storm activity. Federally backed flood insurance covers more than $300 billion of that property. It insures residences for up to $250,000 and contents for $100,000.

Federal officials contend that coastal development would have occurred without government flood insurance. And they say their efforts to elevate houses and promote stronger building codes encourage safer development.

"If you've got somebody who's going to build a $1.5 million home on the ocean, he's going to build it regardless of whether he gets protection," Witt said.

Still, at least 2.3 million buildings have been constructed in the most flood-prone areas of the country - the very areas where the government says it wants to curb risky development. Those properties have suffered at least $1.5 billion in flood damage since 1978, FEMA records show - losses that virtually no private insurer would have risked covering.

The agency is only now undertaking a detailed review of the 30-year-old program. "There have been a lot of judgments about policy made without knowing with any precision what the effects have been," said Gilbert F. White, one of the nation's leading experts on coastal hazards.

Initially, Congress expected private insurers to share the risks with the government. And for a time, they did. But then, after a dispute in the 1970s, FEMA assumed all of the risk.

Later, insurers did share in one aspect of the program - its revenues. In the 1980s, FEMA created the Write Your Own flood insurance program. Private insurers were allowed to sell government flood insurance and earn commissions, now totaling $165 million annually. Today, private companies sell most of the flood insurance nationally for the government. But they do not share the risks. Policyholders and taxpayers are responsible for those.

Witt said he would like to see that changed. "If we can get this to the point that we feel comfortable . . . then it should be privatized," he said.

'An unholy alliance'

Failing to include buffers was not the only flaw in the National Flood Insurance Act of 1968. While Congress touted the legislation as a way to direct safe development along the coasts and rivers, it avoided the most effective tool for limiting hazardous development: land-use controls.

Congress was powerless to tell communities where they could build. As long as towns met the federal flood program's minimal requirements, they were allowed in. Municipalities could develop their vulnerable shorelines as they chose, earning millions in tax revenues, yet depend on federally backed flood insurance and taxpayer disaster aid to protect them against storms.

Towns and states have adopted widely varying rules. Some, such as North Carolina, have established setbacks for new buildings, while others have not.

"FEMA believes that local government will act as a shining knight," said Rutherford H. Platt, a coastal expert at the University of Massachusetts. "Local government is in an unholy alliance with speculators and banks to develop their tax base, and has a strong interest in promoting shorefront development. It's their economy."

Local land-use decisions

Those pressures were evident in September 1998 after Hurricane Georges destroyed 41 homes on the western end of Dauphin Island, Ala. It was the fifth hurricane to strike the vulnerable barrier island in two decades.

Two days after the storm, Brad Cox stood only feet from the Gulf of Mexico, surrounded by crumpled houses, twisted wood pilings, and concrete slabs where vacation properties recently had perched. His employer, Boardwalk Realty Inc., manages rental properties that were now perilously close to the water.

"I'm really concerned what you will say about these houses, as close as they are to the water now," Cox told Ron Nybakken, a FEMA official assessing the damage. "You could condemn them or order them moved. I'm really concerned."

Cox needn't have worried. Flood program officials lack the power to condemn houses or order them moved. Those are local decisions. The most the agency can do is require an owner to elevate if rebuilding - and only then if inspectors find that damage has reduced the property's market value by 50 percent.

"Quite frankly, some of those decisions are controversial," said Todd Davison, a FEMA executive in Atlanta, "but FEMA has no authority to deal with land-use issues. That's a local decision."

Several weeks after Cox expressed his fears, state and local officials gave owners approval to rebuild. They did so even though the state's construction control line, beyond which no development is allowed, was now more than 100 feet offshore.

Eighteen months later, many of the 41 owners have rebuilt or are in the process of rebuilding. Some, such as Gail Leacy of Mobile, Ala., relied on flood insurance. Leacy collected about $60,000 to make repairs after an oceanfront house that had been ripped from its pilings slammed into her bayside vacation home.

"It was a combination of homeowners' and flood, mostly flood," she said.

Georges was the third hurricane to damage Leacy's house. Hurricane Elena struck in 1985 while the house was being built. Opal tore a hole in her roof in 1995.

"You get pretty discouraged after a while," Leacy said. "But then you get it all fixed up and go down there, and it's absolutely beautiful."

In all, FEMA approved 278 claims of Dauphin Island property owners worth nearly $4 million after Georges - an average of $14,352 per claim.

Since 1978, owners have filed more than 2,300 claims, totaling $16.9 million, or $7,335 per claim. About 70 percent of the 1,500 island properties are second homes or rentals. The average yearly flood premium is $482.

Even some Dauphin Island officials question whether federally backed flood insurance ought to be available for vacation homes.

"I really don't think the [program] was set up to insure rental property or someone's second income," said Alma Wagner, a council member.

Hawking flood insurance

Though it may seem odd for the federal government to hawk insurance for vacation properties, FEMA is not shy about its marketing efforts. It encourages agents to sell policies to property owners who live outside flood-prone areas.

"Think you'll never be flooded because you don't live near water or live high on a hill! Just listen to the news. Experts report that weather patterns are changing fast, and so are your chances of being flooded," a FEMA advertisement states.

Since 1995, FEMA has targeted millions of Americans with television, radio, and direct-mail advertising, at a cost of $55 million from policy fees.

Tens of thousands of new policies have been sold, pushing the number of Americans with flood insurance to more than 4.1 million.

By selling more flood insurance, especially to less-risky properties, FEMA is better able to cover its losses. The agency says it makes money on all but its subsidized policies. It also stresses that only one of every four houses in floodplains is insured.

The agency has prepared ad slicks and counter cards and established an insurance leads program so that 26,000 private agents can get sales leads by fax or phone. Under its co-op advertising program, companies can save up to 50 percent on costs - but only 25 percent if they include information about private insurance they sell. The flood program even has an award - the Administrator's Cup, which goes annually to the company posting the biggest sales gain.

Subsidized risk

When Congress passed the flood insurance act, it faced a quandary. In order to sign up older houses most likely to be flooded, it had to offer attractive rates. But if it based those rates on standard insurance principles, charging enough to cover losses and build a reserve for catastrophes, premiums would be so high that no one would buy coverage.

Congress solved this dilemma by subsidizing the most vulnerable properties. Their owners would get steep discounts, paying about one-third of their actual risks, while owners of new houses paid full rates. Over time, the riskier properties would be replaced by newer houses, and the program would achieve financial stability. At least that was the idea.

Thirty years later, nearly one-third of all properties are still subsidized. And a 1998 FEMA study estimated that those buildings might not be weeded out of the program until 2050.

"When you've got 30 percent of your properties paying only 38 percent of their full risk, there isn't a lot of room to adjust," FEMA's Pasterick said.

He said the flood program had suffered an average annual shortfall of $450 million by failing to charge subsidized properties rates based on their actual risks. That's $2.25 billion in the last five years that could have gone to build reserves.

"It's the subsidies that are killing the program," said H. Joseph Coughlin, flood program specialist.

Since 1995, the flood program has had to borrow $1 billion from the Treasury to pay bills associated with hurricanes and Midwest floods.

From time to time, FEMA has proposed adding surcharges and placing restrictions on subsidized properties. Each time, Congress refused, contending it was "inconsistent" with the program's intent.

In 1994, a congressional panel asked FEMA to study the effect of raising rates for subsidized properties. The agency hired an accounting firm, which delivered a report in early 1999. A year later, the report is still being studied. FEMA declined to make the report available.

One fear is that charging actuarial rates would drive high-risk properties from the flood program. Some of those properties' owners would then turn to FEMA for disaster aid after storms. And that would push disaster costs even higher as FEMA faces pressures to cut spending.

To flood and flood again

Properties that benefit from subsidized rates account for a disproportionate share of houses damaged time and again.

FEMA calls these "repetitive-loss properties." They are buildings with at least two claims exceeding $1,000 in a 10-year period. Since 1978, owners of more than 75,000 such properties have filed $2.8 billion in claims.

That means just 2 percent of National Flood Insurance Program properties nationwide account for nearly one-third of the program's $8.6 billion in claims. About 96 percent of the 35,000 repetitive-loss properties still in the program enjoy subsidized rates.

Historically, those properties tended to be located along rivers and levees. That trend began to shift in the 1990s, as hurricanes and coastal storms took their toll on states that had undergone unprecedented development. Florida, New Jersey and North Carolina now rank among the top losers.

Vulnerable Jersey Shore

The problem is particularly acute along the Jersey Shore.

Half of all flood claims in the state's four coastal counties, totaling $131 million, involve buildings with two or more losses. Those 3,887 properties account for nearly one-third of the $403 million in flood claims statewide.

Sixteen beach towns in New Jersey rank among the top 200 communities nationwide with multiple losses. Homeowners in those towns have made 7,831 claims, totaling $88.2 million since 1978, an average claim of $11,262.

Ocean City accounts for $11.2 million of those losses, ranking 18th nationally.

"It's all part of living on an island where the elevation doesn't exceed 11 feet anywhere," said Kit Wright, Ocean City environmental officer. "If we get a storm with a full moon, we're in trouble."

The city is taking steps to lessen flood damage, elevating a dozen buildings, paid for with federal tax dollars. But even as some buildings are removed, others are added. Wright recently got an updated list of repetitive-loss properties from FEMA. "There must be 100 new sheets in there," she said with a sigh.

'The right to relief'

FEMA is spending millions to raise private properties. Some of the resorts that benefit are among the richest beach towns in America, including Malibu, Calif., and Westport, Conn.

Since 1994, Westport has received $776,000 to elevate 19 flood-prone houses along Long Island Sound. Recently, FEMA awarded it $500,000 to waterproof private homes, study ways to reduce downtown flooding, and raffle off a Hurricane Home Makeover to a lucky resident.

The town of expansive Cape Cods and sprawling mansions has one of the highest median household incomes in America - $90,518 in 1996, or three times the national average. Houses sell for an average $660,000. In all, the town's property is worth $6.6 billion.

Westport's tax rate - 1 percent of the value of a home - is among the lowest in the nation. So why did it need federal help?

"Citizens in the U.S., irrespective of their ability to pay, have the right to relief," said Diane Goss Farrell, Westport's top elected official. "The fact that Westport is a wealthy community is less important than the fact it is a coastal community."

State officials, not FEMA, decide which houses are elevated.

"It's pure fantasy to think that these towns are going to raise their own taxes to pay when federal money is available," said Douglas Glowacki, a Connecticut planning official.

Now, Congress and FEMA want to up the ante. Last summer, lawmakers proposed spending $200 million more to elevate flood-prone buildings. Owners who agree to elevate would have 75 percent of the cost paid by taxpayers. Those who refuse would be charged actuarial rates.

Federal officials say elevating the houses would cut flood losses. "It makes good sense to do this," FEMA's Witt said.

But owners of many coastal properties have already elevated on their own, and flood losses keep rising, doubling in the 1990s to more than $5 billion.

Nor is elevation a sure way to prevent damage. As coastlines erode and sea levels rise, homes that appear safe today will become vulnerable in a generation or two, coastal experts say.

"We're already finding that some of the building setbacks we established in North Carolina were not nearly enough," said Courtney Hackney, member of a state board overseeing coastal development. "Elevating isn't going to save you if the ocean is at your doorstep."

Gilbert M. Gaul's e-mail address is; Anthony R. Wood's is

Inquirer researcher Frank Donahue contributed to this series.

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