Should Uncle Sam Subsidize Living in Paradise?

I try to spend at least part of every year on the beach. Now that I live in the southwest, my go-to beach vacation spot tends to be in southern California. But while I was living in Florida in the 1980s, Key West was one of my favorites.

One night, when I was sitting in Sloppy Joe’s bar (a favorite watering hole of Hemingway when he lived in Key West), I met “Melanie,” a local resident. At the time, she was about 60 years old.

Melanie told me about a nearly-forgotten hurricane that overwhelmed Florida in 1935 when she was a girl. The “Labor Day hurricane” was the most intense storm to ever hit the US. With sustained winds of 185 mph, it drove a 20-foot storm surge over the low-lying islands. (The highest point on Key West is only 18 feet.)

Melanie survived the storm because her parents fitted her with a life preserver and chained her to an iron post. As the storm rushed in, the life preserver kept her afloat while the chain prevented her from being washed away.

Her parents weren’t as lucky. They perished in the storm, along with more than 400 others. As well, Melanie’s home and everything her family owned was washed out to sea.

“Thank goodness,” she concluded, “we now at least have flood insurance.”

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Yes we do. And it’s all courtesy of the American taxpayer.

The National Flood Insurance Program (NFIP) Melanie praised came into existence in 1968 after most commercial insurance companies pulled out of the market following record-breaking claims from Hurricane Betsy. The handful of companies that stayed charged such high premiums that few homeowners in flood-prone areas could afford coverage.

To deal with what critics of insurance companies called a market failure, Congress decided that the federal government would be the flood insurer of last resort. The NFIP gave property owners the ability to purchase taxpayer-subsidized flood insurance. Currently, you can buy total coverage up to $350,000 – $250,000 for the home itself and $100,000 for personal possessions. About five million Americans now have NFIP-subsidized policies. To keep costs under control, Congress passed a series of amendments to encourage policyholders to build more flood-resistant homes and give states incentives to not build in flood zones.

Unfortunately, it hasn’t worked. In 2014, Congress reversed many of its previous reforms because owners in flood-prone areas complained coverage was no longer affordable. Meanwhile, development on floodplains has exploded, especially in coastal areas. Now, after paying out nearly $25 billion to policyholders in the wake of Hurricanes Katrina and Sandy, the NFIP is broke.

While Congress provided temporary funding to help deal with cleanup efforts from Hurricanes Harvey and Irma earlier this month, without further congressional action, it won’t nearly be enough.

At least 25% – over 1.2 million – of all NFIP-covered properties were flooded by either Harvey or Irma. If the average claim is settled for $100,000, that’s $120 billion American taxpayers will have to pony up. And that’s just for 2017.

Is there a better way? Yes, there is: stop giving people incentives to build in flood-prone areas. Permanently.

These incentives are an example of a phenomenon that economists call moral hazard. It occurs when someone takes larger risks because he can transfer that risk to someone else. The NFIP creates a moral hazard because it shifts the risk of building on flood-prone land from homeowners to taxpayers.

It turns out that over the last 40 years, 3.8% of NFIP policyholders are responsible for 35.5% of flood loss claims and 30.5% of claim payments. One home in Mississippi has flooded 34 times, with a total of $633,000 in claims. Amazingly, the owner of this property can’t be denied coverage, nor can the premium be raised to a risk-based rate.

Harvey and Irma promise to spur Congress to once again debate the future of the NFIP. And to that end, I have a suggestion: abolish the program, once and for all.

I realize this proposal may be viewed as unfair to millions of Americans living in flood-prone regions. Without the NFIP, they might not be able to obtain insurance coverage at all, or they’ll have to pay very high premiums.

Sorry about that. But if you want to build your dream home in a floodplain, don’t ask me for a subsidy. And without a subsidy, don’t be surprised if your flood insurance premium is high. You might not be able to get coverage at all.

Is that a market failure? Not at all. Some places are so prone to natural disasters that no insurance carrier could anticipate making a profit if it issued coverage. The market failure is actually a market signal announcing “move on” or “build at your own risk.”

Once development in flood-prone areas is no longer taxpayer-subsidized, it will dramatically slow and perhaps even reverse itself. Ultimately, terminating the NFIP will reduce property losses and put fewer lives at risk.

Unfortunately, Congress is unlikely to end the NFIP or even institute meaningful reforms. One reason is that the (often wealthy) owners of coastal real estate – shockingly – enjoy living in paradise. They’ll lobby their congressional representatives to keep flood insurance premiums “affordable.” And they’ll probably get their way.

Taxpayers, reach for your wallets. Rinse and repeat.

Reprinted with permission from