The powerful storm surge produced by Hurricane Sandy has added momentum to the federal government’s efforts to farm out a portion of the risk now borne by the National Flood Insurance Program (NFIP), and their appears to be a strong appetite in the private market.

In late January, the Government Accountability Office (GAO) published a 30-page report exploring what conditions would prompt “stakeholders” to buy into flood risk and the possible structure for such transactions.

“The big question is how the pricing would actually work in the private market compared to the current market,” said Brian Schneider, a senior director at Fitch Ratings. “There’s not a lot of flood risk out there now in the asset-backed securities or traditional reinsurance markets. So it’s uncertain what the true cost will be to policy holders.”

The NFIP, created in 1968, provides subsidized flood insurance policies to residents in flood-prone areas, but the premiums on these policies don’t reflect the actual risk of property loss. To plug the funding gap, the Federal Emergency Management Agency (FEMA), which manages the program, has borrowed $24 billion from the U.S. Treasury as of September 2013, and not paid back any principal on its loans since 2010. Before Hurricane Sandy, it had borrowed a total of $17.8 billion. That’s a significant taxpayer burden, but the only option for homeowners, since private insurance policies typically exclude flooding, even though it is the most common and destructive natural disaster in the U.S.

The Biggert-Waters Flood Insurance Reform Act of 2012 eliminated some subsidies and took other measures to improve the NFIP’s solvency, although legislation on Capitol Hill seeks to reverse some provisions, at least temporarily.

The Biggert-Waters Act also tasked FEMA with exploring ways to farm out flood risk to the private market. The GAO report identifies catastrophe bonds as a possible strategy. “NFIP could issue interest-bearing bonds to investors willing to bear the risk of losing some of their investment if flood claims exceeded a predetermined amount,” the report states, adding that, the NFIP “would need to be able to collect adequate premiums to cover any necessary payments of principal or interest.”

Other strategies described in the GAO report include charging policy holders rates that reflect the actual risk and then providing a means-based subsidy; insuring only the properties with the highest risk; and the government acting as a reinsurer, paying the difference when total claims on private policies exceed a certain amount.

The New York Metropolitan Transportation Authority issued the first storm surge deal last July, after Hurricane Sandy flooded several subway tunnels. As a result of strong demand, it was upsized  by 60%, to $200 million, and its 4.5% rate was under the original price range.

Risk Management Solutions was the risk modeling agent on the deal. It launched the first stand-alone storm surge model, separate from its hurricane model, a year before Hurricane Sandy. Managing director Peter Nakada said several other storm surge deals are in the pipeline and likely to come to market this year. He said that RMS’s model closely predicted the Sandy-related flooding that occurred.

Nakada said likely issuers include infrastructure-related businesses as well as private businesses that are particularly vulnerable to flooding. For example, a number of hospitals have lost MRI equipment that was stored in basements during recent hurricanes.

Insuring thousands of individual properties from flood damage is a different matter. State insurance agencies such as Florida Citizens and Louisiana Citizens Property Insurance have successfully leveraged demand for hurricane risk, especially from capital markets investors, to lower both their cat bond and reinsurance rates.
Rates on these kinds of wind-related deals have fall dramatically over the last few years, as institutional demand for catastrophe risk has ramped up. That dynamic is likely to continue across insurance-linked securities based on different perils and could enable flood policy premiums to drop to more acceptable levels.

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