Bond Bailout Could Plug Flood Financing Hole

By Lisa Abramowicz, Bloomberg Gadfly | August 29, 2017

The images from Houston, Texas, in the aftermath of Hurricane Harvey are horrific and heartbreaking, with homes fully submerged and residents being rescued by boats and helicopters. And that’s just the physical toll.

Many residents of the fourth-largest U.S. city also face financial devastation, because only a small proportion of homeowners have some sort of flood insurance. Those that do have such coverage purchased it from the U.S. government, which runs a woefully underfunded program that’ll require additional taxpayer money to remain viable. Meanwhile, insurance companies – while also on the hook for Harvey-related damages – face more containable losses. After all, they mostly just cover wind damage rather than destruction from mass floods, which accounted for the bulk of the damage.

It’s already clear that “an abnormally high portion of economic damage caused by flooding will not be covered,” according to an Aon Plc alert to clients cited in a Bloomberg News story. This scenario doesn’t make sense from a human perspective, and lawmakers in Congress are moving on measures to provide emergency funding.

But the shortfall doesn’t make sense from a market perspective either – not when there is ready money willing to backstop this type of risk. Debt investors are clearly interested in buying catastrophe bonds. These securities raise money for covering disasters by offering holders above-market returns to compensate for the risk that severe losses could wipe out principal. Investors bought a record amount of such debt in the three months ended June 30, according to industry trade publication Artemis, and many deals had more potential buyers than bonds to sell.

The National Flood Insurance Program has yet to attempt offloading risk in public bond markets. In fact, it only just started working with insurance companies to offset potential losses, purchasing reinsurance for storm losses above $4 billion earlier this year, according to Bloomberg Intelligence. Theoretically, it would be cheaper for the government to get financed through an open market process. While flood-linked catastrophe bonds wouldn’t be the entire solution, they could be an important tool for filling the funding gap, according to Gary Martucci, an S&P Global credit analyst. Perhaps the reason why the NFIP has been reluctant to approach financial markets is because it doesn’t have a feasible financial model. It doesn’t charge homeowners a big enough premium to offset its risks, and U.S. representatives have been reticent to make the politically unpopular move of forcing coastal residents to pay a realistic amount to insure against floods. If the NFIP were to approach bond investors, they’d have to confront the dollars and cents of their business model and potentially change the program in politically unpopular ways. Even before Hurricane Harvey, the NFIP owed the U.S. Treasury $23 billion, according to an Aug. 24 S&P Global report citing the General Accounting Office. This debt almost exactly corresponds to the amount that the program paid out for Hurricane Katrina and Sandy, signaling it isn’t financially prepared for catastrophes it’s ostensibly protecting against, Bloomberg Intelligence’s Jonathan Adams said.

Rebuilding from floods will only become more costly for taxpayers in the years ahead. Many analysts expect large, unpredictable storms to become more frequent as seas get warmer. For now, there’s an odd disconnect between the market for flood insurance and everything else. As the rest of the U.S. helps Houston rebuild itself, it’s important to find ways to expedite future recoveries. This means that the program will have to be honest about the amount it needs to charge homeowners, and work with investors to determine a reasonable price to pay for protection against catastrophes. This is only going to become more common. It’s irresponsible not to deal with it head on now.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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