Facing Wildfire Insurance Challenges: Five Lessons from the National Flood Insurance Program

Over the past decade, wildfires have become more frequent and damaging in the western United States, leading to unprecedented financial losses and significant challenges for the insurance market in affected areas, especially in California. Several major insurers have stopped writing policies for new clients in California, at least temporarily. Homeowners in high-risk areas face soaring insurance premiums and increasing insurer-initiated nonrenewals.

In this report, we look at the long experience of insuring flood losses in the United States to find solutions to address the insurability of wildfires. The federal government created the government-backed National Flood Insurance Program (NFIP) in 1968, and since then, the NFIP has provided almost all flood loss coverage. Over time, this single-peril program has faced numerous challenges, including difficulty maintaining widespread participation, financial instability, inadequate pricing with respect to risk, and problems related to flood risk mapping and communication. Floods and wildfires each present insurers with correlated risks that have grown over time as a result of climate change and increasing development in hazardous areas. Because of these similarities, an analysis of the NFIP's experience with insuring flood risk can offer insights for policy directions to address the rising challenges of insuring wildfires.

Lessons from the NFIP

Lesson 1: Most People Do Not Voluntarily Buy Disaster Insurance

Evidence from flood insurance suggests that stand-alone disaster insurance policies have low uptake rates unless mandated. The federal government mandates that owners of homes within Special Flood Hazard Areas (SFHAs), defined based on 100-year floodplains, have flood insurance if they have federally backed mortgages. However, overall take-up of flood insurance is low. This provides a cautionary tale for wildfire insurance. Currently, wildfire insurance is bundled in standard homeowner's insurance policies required by mortgage lenders. If wildfire coverage were to become a stand-alone product or the requirement were to change, there is a risk that take-up will be low, leaving more households exposed to the full financial ramifications of wildfire damages.

Lesson 2: When Insurance Premiums Do Not Reflect Risks, There Will Be Insurer Solvency Problems and Greater Exposure to Risk

Insurance pricing needs to accurately reflect risks, both to support insurer solvency and to send price signals to homeowners about where to live and how much to invest in hazard mitigation. Over time, underpricing of risk by the NFIP has led the program to incur substantial debt to the US Treasury and caused increased development in high-hazard flood areas. Underpricing of wildfire risks in high-hazard areas-resulting from a combination of regulation, climate change, and uncertainty among insurers about the true level of risks-is likely also contributing to current insurability problems. Catastrophe models, which have recently been integrated into the NFIP through Risk Rating 2.0, offer a potential path forward.

Lesson 3: Risk-Based Pricing Will Present Some Affordability Challenges

Risk-based pricing, while necessary for insurer solvency, can result in premiums that are unaffordable for low- and moderate-income households-especially in places facing rapid increases in risk. Means-tested subsidies and public financial backstops are options to address affordability while maintaining insurer solvency. However, there is an inherent tension between addressing affordability concerns and maintaining risk-based price signals. Innovative insurance products like community-based insurance or parametric microinsurance offer potential alternatives, but these approaches have not yet been successfully implemented in the United States.

Lesson 4: Risk Communication Is Essential but Hard to Do Well

Accurate risk communication is critical for informed decisionmaking. Maps of SFHAs, used in the NFIP to delineate where zoning, building code, and insurance requirements apply, often lead to the misconception that outside these zones, risk is minimal. Communicating wildfire risks, which is often done through broad risk categories, may face similar challenges. Recently, FEMA and others have begun to improve access to more graduated, high-resolution flood risk data, and there is some evidence that this information has affected home buyers' search behavior. Evidence from both the flood and fire contexts also suggests that mandatory hazard disclosure can affect buyers' valuations of risky properties, though such rules can face political pushback because of concerns over property values.

Lesson 5: Investments in Risk Mitigation Are Critical but Costly and Difficult

Risk reduction measures lower the cost of insuring disasters and thus provide an important strategy for simultaneously addressing both affordability and solvency concerns. While NFIP premium reductions have incentivized some community-led investments in flood risk reduction, flood adaptation investments are often expensive, and most adaptation investments are heavily dependent on federal funding. More low-cost hazard mitigation options are available for wildfire than for floods, but incentivizing these activities through insurance premium reductions requires coordination across insurers and with fire service professionals and communities. These activities must also be coordinated among homeowners and forest landowners, including the federal government.

Policy Directions

Improving Insurance Availability

To promote insurance availability, premiums should be adequate for covering claims, including those due to catastrophic events. Adopting catastrophe models for wildfire risk assessment, with oversight similar to Florida's approach for regulating use of hurricane catastrophe models, can support risk-based pricing and help maintain insurer solvency. These models can help ensure fair pricing and accurate signaling of risk by minimizing cross-subsidization of policyholders in high-risk areas by those in low-risk areas.

Addressing Affordability

Three options for maintaining affordability are means-tested programs for premium discounts or subsidies, a public financial backstop, and new insurance products tailored to low- and moderate-income community needs, such as community-based insurance and parametric microinsurance. However, along with their effects on affordability, policymakers need to consider effects of such policies on cross-subsidization and incentives for risk mitigation.

Motivating Risk Reduction

Several strategies are available to federal, state, and local policymakers to reduce the three components of risk: exposure, vulnerability, and hazard. Risk communication policies and disclosure laws can help inform household decisionmaking. Local land use policies can help reduce community-level exposure to risk. Building codes can be effective in reducing structural vulnerabilities. Finally, vegetation management-at both the individual and community scales-can help reduce hazard. Policy can play a key role in motivating risk reduction activities and deepening coordination among various stakeholders, including insurers.

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Yanjun (Penny) Liao

Fellow

Yanjun (Penny) Liao is a fellow at Resources for the Future.

Margaret A. Walls

Senior Fellow; Director, Climate Risks and Resilience Program

Margaret Walls is a senior fellow at RFF. Her current research focuses on issues related to resilience and adaptation to extreme events, ecosystem services, and conservation, parks and public lands.

Matthew Wibbenmeyer

Fellow

Matthew Wibbenmeyer is a fellow at RFF. His research seeks to understand climate impacts and climate mitigation policies related to the forest and land sectors, with a special focus on wildfire.

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