Conversations about Risk Rating 2.0
Part I with David Maurstad
May 23, 2022
Earlier this year, the Federal Emergency Management Agency (FEMA) fully implemented the National Flood Insurance Program’s (NFIP) new rating methodology, Risk Rating 2.0: Equity in Action.
Currently, the NFIP insures over $1.3 trillion in assets for nearly five million policyholders in over 22,500 communities, making it the largest single-line insurance program in the country. (For more background on the NFIP, see the Risk Center’s primer or our research page on flood insurance.)
The NFIP’s new rating system updates FEMA’s approach to pricing flood insurance by harnessing improved data and modeling, both of which have dramatically improved since the founding of the NFIP over fifty years ago. This new pricing methodology will reflect the flood risk of a single property, eliminating some of the cross-subsidies that had plagued the earlier approach to pricing based on broad flood map zones. The use of catastrophe models will ensure the new rating methodology can adapt to climate change. Finally, Risk Rating 2.0 will also undo a historically regressive aspect of NFIP pricing that failed to account for the replacement value of homes, perversely charging higher rates to lower-valued homes and lower rates to higher-valued homes.
With all these changes, many stakeholders have been seeking more information on Risk Rating 2.0 and what it means for policyholders and potential policyholders, the fiscal position of the NFIP, and broader implications for flood mapping and how the program prepares for escalating climate-driven flood risk. To answer these questions, the Wharton Risk Center is pleased to share a blog series with a range of experts on the pricing of flood insurance. We are delighted to begin this series with an interview between our Executive Director, Dr. Carolyn Kousky, and the head of the NFIP, David Maurstad.
David Maurstad is highly regarded for his transformative leadership in communicating disaster risk, closing the insurance gap and incentivizing mitigation actions against all hazards. He is deeply committed to using every tool within his authority to reduce disaster suffering in all communities. At the start of 2022, David began a detail serving as the Acting Associate Administrator of FEMA’S Resilience organization. While in this new role, David will continue to direct ongoing efforts to advance the National Flood Insurance Program, reinsurance and reauthorization. David’s expertise in emergency management stems from high-profile roles in the private sector, and local and state government as a former insurance company executive, mayor, state senator, and lieutenant governor in Nebraska.
Thanks for talking with us, Mr. Maurstad. To begin, can you tell us a bit about what motivated FEMA to undertake this overhaul to its pricing strategy?
David Maurstad: After nearly five years of conducting research based on the latest actuarial science, our analysis revealed inequities in the old system that revealed policyholders with lower-value homes paying more than they should and policyholders with higher-value homes paying less than they should. As a federally mandated program responsible for following Congress’ direction, we could not turn away from this information or from our policyholders who have been paying more than they should and unjustly subsidizing other properties.
For years, industry experts, policymakers, and stakeholders, including Congress, the Government Accountability Office, and the Department of Homeland Security Office of the Inspector General have urged the National Flood Insurance Program to make substantial changes to our rating system. We also recognized that the old way of conducting business was not fiscally sustainable to withstand the frequency and intensity of weather events in recent years or the storms we know will strike in the months and years to come due to climate change.
The old methodology and the IT system that supported it was not flexible. So, FEMA undertook Risk Rating 2.0 to address the inequity in as fast a manner as possible. Roughly five years ago, we set out to apply the latest advances in technology to help us communicate a property’s full flood risk and better equip property owners with the information they need to make informed decisions about mitigation actions.
With the implementation of Phase 2 on April 1, 2022, both rate increases and decreases are equitable. This is in line with the Biden Administration’s call to action to assess federal programs for inequities and to immediately address them.
To really appreciate what Risk Rating 2.0: Equity in Action means and how it’s an improvement over the outdated rating methodology, it’s useful to consider where we’re headed in comparison with where we were.
The old methodology used static zones on a flood map and did not account for the full range of variables to determine an individual property’s flood risk. That meant the cost of insurance was misleading. It created a false sense of security for current policyholders and prospective customers.
Those days are behind us. Risk Rating 2.0: Equity in Action is not just a minor improvement, but a transformational leap forward. FEMA now has the capability and tools to address rating disparities by incorporating more flood risk variables, such as multiple flood frequencies. Not just the 1% annual chance event, but multiple flood types from river overflow, storm surge, coastal erosion, heavy rainfall and distance to a water source. It also considers property characteristics such as elevation and the cost to rebuild.
Since the new plan now takes into consideration the cost to rebuild, FEMA is equitably pricing premiums across all policyholders based on the unique flood risk characteristics of their property. This has been an industry standard for years that the NFIP is now adopting. Risk Rating 2.0 builds on years of investment in flood hazard information by incorporating private sector data sets, catastrophe models and evolving actuarial science.
In short, we now have a modern rating system that builds on and expands upon years of scientific developments, actuarial data and environmental analysis.
It is a methodology in which all policyholders pay premiums based on the unique characteristics and risk of their individual property. The skewed risk sharing of the old system is no more.
What do you think are the most important aspects of Risk Rating 2.0 that you would want to make sure people understand?
Maurstead: First, broadly speaking, Risk Rating 2.0 is changing the entire paradigm of flood insurance protection as risks of catastrophic flooding increase because of climate change. With Risk Rating 2.0 in place, FEMA is fulfilling its obligation to set actuarially sound rates and communicate flood risk clearly and more comprehensively than ever before. Risk is exactly what flood insurance pricing should be based on.
Second, Risk Rating 2.0 is designed to adapt to climate change by using the full range of flood risk across a suite of catastrophe models. Because rates are based on the expected claims during the one-year policy period, they should reflect today’s risk. Future rates will be updated to reflect any changes in that risk.
Therefore, Risk Rating 2.0 is built to consider the possibility of events such as Hurricane Ida, which hit the Gulf Coast and then unleashed flooding in the Northeast last September. Such occurrences should not surprise or cause a shock to premium rates.
FEMA’s multi-model approach is like the National Oceanic and Atmospheric Administration’s (NOAA) use of several models to determine potential hurricane tracks and magnitudes. The NFIP licensed three sets of commercial catastrophe models: AIR Worldwide, KatRisk and CoreLogic. Multiple models are useful when predicting uncertain future events and to ensure that FEMA doesn’t oversteer, or understeer, based on one model. Using multiple models will help us stay on top of risk like climate change and model maturity as each model will develop independently on their own timeline.
In addition to the commercial flood models, FEMA developed two additional models based on government data and models. This includes using existing FEMA mapping data and NFIP policy and claims data along with other Federal government data from the U.S. Geological Survey, NOAA and the U.S. Army Corps of Engineers.
FEMA partnered with the U.S. Army Corps of Engineers (USACE) to identify and use credible levee data to reflect the flood risk reduction provided by levees to set insurance rates for Risk Rating 2.0. Readily available levee data was obtained from the National Levee Database, a dynamic database that is continually updated, and Levee Screening Tool, maintained by USACE. All levees identified in the database from March 2020 were considered for Risk Rating 2.0.
Developing and updating maps is time-consuming and resource intensive. Recent events, such as Hurricane Ida, have provided stark reminders that flooding does not only occur along our nation’s rivers and coasts. Intense precipitation, combined with our nation’s changing landscape, provides increased demand for more comprehensive flood hazard information beyond the boundaries of our traditional flooding sources and in both urban and rural areas alike.
Third, Risk Rating 2.0 should help close the flood insurance gap. Climate change is resulting in storms of greater frequency, intensity and unpredictability. That means we can expect more flooding events. However, too few homeowners are insured against this risk. All but 2% of the counties in the country have experienced flooding, but only 4% of homeowners have flood insurance. That’s a huge insurance gap. Ultimately, we want more insured survivors. When households and businesses are insured, they can rebound and rebuild more quickly and resume economic activity. These are essential elements to building disaster resilience in any community.
Also, Risk Rating 2.0 will help close the insurance gap because it is yielding a product policyholders and customers can understand and trust, and that agents can more easily sell. This is what the times demand. We expect to see more policies, not fewer in the years to come.
Fourth, Risk Rating 2.0 stops the trend of continually increasing premiums in a random, haphazard, inequitable fashion. It is critical to understand that if the old methodology remained in place, all premiums would continue to increase for all policyholders, year after year and—for many policyholders—way beyond the full risk rate of their property.
Under Risk Rating 2.0, on the other hand, roughly 90% of all NFIP policyholders will either see a decrease in their premiums or an increase on par with their experience under the old system.
FEMA has added the tagline “Equity in Action” to Risk Rating 2.0. In what ways does this new pricing strategy improve equity in the price people pay for flood insurance?
Maurstad: As the name implies, Risk Rating 2.0: Equity in Action is rooted in fairness as it addresses an inequity in the program that has inadvertently developed over time and is being corrected. Once we learned that two-thirds of older pre-FIRM—Flood Insurance Rate Map—homes have some of the highest rates in the NFIP today, we could not ignore the inequity.
Under the old system, lower-value homes with minimal- to moderate-flood risk were subsidizing higher-value homes with some of the highest flood risk in the country. Over one million policyholders had been paying more than their fair rate. Risk Rating 2.0 dismantles these inequities and reduces their premium.
With Risk Rating 2.0, FEMA is fixing these longstanding inequities in flood insurance pricing and establishing a system that is better equipped for the reality of frequent flooding caused by climate change.
We are now setting rates that are equitable for policyholders from coast-to-coast. We are ensuring rate increases and decreases are fair and based on an individual property’s risk. The result is that, for the first time in the program’s 50-plus-year-history, policyholders are seeing decreases in their premiums. Even for the select policyholders seeing increases under Risk Rating 2.0: Equity in Action, most of these increases are about the same as the increases they would be seeing under the old system.
With Risk Rating 2.0, we are using tools to incorporate flood risk variables, such as multiple flood frequencies beyond the 1% annual chance event, including river overflow, storm surge, coastal erosion, and heavy rainfall. We are looking at a particular property’s characteristics, such as distance to a water source and elevation and using an industry standard to calculate the cost to rebuild.
All of this is based on actuarial science and principles, allowing us to communicate flood risk more comprehensively and accurately than ever before.
Many stakeholders have been wondering how Risk Rating 2.0 interacts with other aspects of the program. We know Risk Rating 2.0 does not change the mandatory purchase requirement. Does it alter the premium reductions communities can get by participating in the Community Rating System?
Maurstad: RR 2.0 Equity in Action is transformational, but it is not changing every aspect of the program. The use of Flood Insurance Rate Maps for mandatory purchase and floodplain management remains unchanged and premium discounts for Pre-FIRM subsidized and newly mapped properties will continue. Also, policyholders will still be able to transfer their rate discount to a new owner by assigning their flood insurance policy when property ownership changes.
Under Risk Rating 2.0, communities will continue to earn rate discounts of 5% – 45% based on their Community Rating System classification. However, since Risk Rating 2.0 doesn’t use flood zones to determine flood risk, the discount will be uniformly applied to all policies throughout the participating community, regardless of whether the structure is inside or outside of the Special Flood Hazard Area. This means more policyholders in participating communities will receive the discount.
The Community Rating System is a great example of how Risk Rating 2.0 is designed to preserve aspects of the NFIP that incentivize people to purchase flood insurance and complement flood mitigation activities.
Right now, the pricing in the program is a bit opaque. Has FEMA thought about an online tool whereby anyone could look up the cost of flood insurance for a property? That could potentially go a long way to improving the communication of flood risk—particularly for prospective home buyers.
Maurstad: FEMA is focused on working with the insurance companies and agents that administer the program to ensure we effectively transition our 4.8 million policyholders into the pricing methodology. The success of Risk Rating 2.0 depends on data that is not only accurate but accessible. That is the idea behind the Rating Engine we developed. This will enable agents to quote flood policies more easily which will significantly increase and improve the customer experience.
FEMA is beginning to explore the possibility of an online tool. We are working with floodplain managers to understand what requirements they would have for such a tool to assist in their conversations with property owners. However, it is too early to commit to a time horizon for designing, building, and implementing this tool.
In the meantime, FEMA is committed to increasing communication for all our stakeholders. One example is a Discount Explanation Guide, which explains various discounts in Risk Rating 2.0, including first floor height, machinery and equipment and flood vents. This discount guide gives the percentage discounts so policyholders can understand how they can lower their insurance premiums.
As we designed and built Risk Rating 2.0 from the ground up, we were looking to streamline the inputs needed from an agent and/or customer to get a policy quote. As we refine the new system, we will continue to create and enhance tools to assist agents, policy holders and other stakeholders.
FEMA released a report on affordability of flood insurance several years ago. Does the NFIP still support this type of additional pricing reform?
Maurstad: There is no getting around the fact that families in high-risk areas will continue to struggle to afford the cost of insuring their properties. Affordability was an issue under the old system and will continue to be a concern with the implementation of Risk Rating 2.0. But Risk Rating 2.0 did not create the affordability challenge.
We were pleased that the FY22 President’s Budget included a FEMA legislative proposal, which would establish a targeted means-tested assistance program, offering low- and moderate-income NFIP policyholders a graduated risk premium discount benefit.
Ultimately, FEMA cannot fix the affordability challenge at the programmatic level. It is up to Congress to address affordability, and we are committed to working with them to find solutions. Making flood insurance more affordable so that more Americans are covered is one of the principles that should guide policymakers on long-term NFIP reauthorization.
Is there anything else you’d like to share?
Maurstad: The new methodology is a landmark achievement and better communicates risk and prices insurance accordingly and more equitably. But more than that, as you pointed out in a commentary in The Hill last year, Risk Rating 2.0 is a critical step in preparing the NFIP for the realities of climate change.
The realities include rising numbers of extreme weather events and more flooding. The implementation of Risk Rating 2.0 is just one example of how FEMA is leading a whole-of-community effort to make the nation more resilient and reduce disaster suffering.
We know that insurance coupled with mitigation is the first line of defense against flooding. Individuals and communities recover more quickly when they are insured. Mitigation helps spare them from the ravages of flooding and insurance assists in recovery when their property is damaged.
Climate change is constantly reminding us that the standards that might have served us well in the past might not serve us well in the future. With Risk Rating 2.0, we have built an entirely new system from the ground up. We have made great progress but there are sure to be challenges ahead. As we move forward, we will continue to be transparent in our efforts and welcome the insights, expertise, and views from the full array of stakeholders on how to refine Risk Rating 2.0 and make it work even better. This will ensure we have a program that is equitable and sustainable for years to come.
FEMA is focused on doing what it can to close the insurance gap in this country. We need more insured survivors and less disaster suffering. I believe that we’re headed in the right direction.
To learn more about Risk Rating 2.0 implementation, I invite you to visit www.fema.gov/nfiptransformation.