By Mike Dorf
In the wake of Hurricane Irene, many people who had not previously had cause to think about the question are probably now discovering that their homeowners' insurance does not cover flood damage. My own homeowner's policy is fairly typical. It excludes flood coverage with a boldface capital "NOT" followed by the definition of a flood (taken from the National Flood Insurance Program): "A general and temporary condition of partial or complete inundation of normally dry land areas from overflow of inland or tidal waters or from the unusual and rapid accumulation of surface waters from any source."
That's clear enough and for someone like me, it's pretty safely ignored. After all, I live near the top of a 1200 foot hill, with no bodies of water on higher ground. But language like that is also undoubtedly ignored by thousands of people who, in retrospect, needed flood insurance. Why do homeowner's policies generally exclude flood coverage?
Insurance companies earn fair returns by collecting premiums and paying out for the realization of uncorrelated risks. An insurance company can calculate the likelihood of a lawsuit alleging a slip-and-fall in a typical home and spread the expected payout over the premiums for all similarly situated homes. The more policies the insurance company writes, the more precisely it can match premiums to payouts.
But a flood is a catastrophic event that is correlated among homeowners, meaning that insurance companies often won't have adequate reserves in case of a truly large flood. That's where the federal program comes in. The federal government makes flood insurance available to communities that adopt measures to minimize flood damage. Yet, as this Wall Street Journal article notes, the federal program is under-funded and at risk of being cancelled. The article suggests that if it is cancelled, private insurers will not be able to make money writing flood insurance policies but will be required by state regulators to write them anyway.
That's a puzzle, isn't it? Obviously, insurers will be able to make money if they are permitted to charge premiums that are actuarially sufficient to cover losses. Perhaps the real problem is that the market rate for flood insurance would make it unaffordable for the people who most badly need it. Still, why would state regulators require insurers to write flood insurance policies at below break-even rates? Such a requirement in effect acts as a transfer from people who don't need or want flood insurance to those who do--because an insurer forced to write flood insurance for below break-even rates must subsidize the flood losses from its other insurance lines (including homeowner's insurance without flood coverage) if it is to stay in business. In this regard, state regulation requiring such private insurance would be quite similar to the current federal guarantee, which is a subsidy from taxpayers.
But this simply raises the further question of why people who don't need flood insurance (e.g., "hill people" like myself) should be made to subsidize people who do need it, whether through taxes or through artificially high premiums on other policies. If someone chooses to build an expensive house (or even a modest one) in an area susceptible to floods, but cannot afford to pay the full market premium, why should the rest of us bail him out (almost literally!) after a flood occurs?
There are, of course, circumstances in which either private insurance or public insurance appropriately pays for coverage of harms that could have been avoided through greater prudence. For example, hospitals don't (or at least shouldn't) turn away uninsured or under-insured victims of their own negligence; health insurance covers the cost of treating diseases caused by risky behavior like cigarette smoking; etc. But in these instances we make a collective judgment (with which I wholeheartedly agree) that it would be terribly inhumane to fight moral hazard by letting people die.
To my mind, no such similar principle applies in the flood context. Someone who has lost his home or business because he chose to locate it in a place where he couldn't afford actual-market-price flood insurance has suffered a real loss, but it does not strike me as terribly inhumane to make him bear that loss himself. Why does the law, at least for now, conclude otherwise?
Loss aversion may provide a psychological explanation. To lose one's home (and to a lesser extent, one's business) is experienced as more traumatic than not to obtain a home (or business). Flood insurance thus functions to combat loss aversion--the basic human tendency to treat losses as worse than foregone gains. That's not a policy justification, though, just a hypothesis about causation. We might do better to try to reconceptualize flood losses in a way that requires people to bear the true cost of their risky location decisions. We could and should still make a judgment to provide collectively subsidized aid to assist people rendered homeless by their own risk-taking location decisions, just not the sort of aid that permits them to repeat the exercise.
Finally, I realize that a great many of the people now suffering from flood damage did not make especially risky decisions. But for them, at least, actuarially sound flood insurance ought to be affordable even without a public subsidy. At most, the government might be needed to act as a reinsurer to pool very large risks.