Noneconomic Costs of Flood Insurance in a Regulatory Minefield

The Creation of FEMA

FEMA, created by Executive Order of President Jimmy Carter on April 1, 1979, was initially an agency in the Department of Housing and Development but is now housed in the Department of Homeland Security (DHS), a relatively new department created by the Homeland Security Act of 2002. Within DHS are the following other agencies: Citizenship and Immigration Services, Coast Guard, Federal Law Enforcement Training Center (located in Brunswick, Georgia), Intelligence Careers, and Secret Service. ² FEMA's budget is approximately $14 billion. The flood insurance program is often in the red. As a recent example illustrates, the disaster relief bill signed by President Donald Trump on February 9, 2018, forgives $16 billion of debt owed by NFIP to the US Treasury.

Within FEMA, the NFIP falls under the direction of a Federal Insurance Administrator (FIA). The administrator has the responsibility to develop the national flood policy, which is incorporated in FEMA's rules as a federal regulation from which no deviations are allowed. So, FEMA, through the FIA, writes the federal flood insurance policy and is authorized to interpret the language, including the authority to issue official interpretations of the policy. Federal administrative law, under which agencies and departments with rule-making authority are governed, offers wide discretion to an entity in interpreting its own rules.

In short, what is referred to as "flood insurance" is not actually an insurance policy in the conventional sense; instead, it is a federal regulation as part of a federal program under the NFIA. The regulation may be accessed at CFR 44 Section 61.13. ("CFR" means Code of the Federal Register.) FEMA's "flood insurance policy" has not been approved by any state insurance regulator and is not designed to comply with state law provisions governing insurance policies. The "policy" is a federally subsidized program to pay losses caused by a single cause of loss, flooding, and is made available to the public at a below actuarial rates cost. Funding comes from the premiums charged plus contributions from the US Treasury.

I will use conventional insurance terminology in discussing the NFIP because that is how people are conditioned to learn about flood "insurance"; however, part of my argument is that people may easily be misled about the nature of a program that has insurance policies sold by insurance agents appointed by insurance companies employing adjusters using normal insurance terms to describe a federal regulation. Mirage, perhaps, but no matter what one thinks of it, the program is a great example of "things aren't always as they seem." Besides, if the program had been properly named "public assistance" or "welfare," Congress might have scrapped it long ago.

FEMA and WYO Companies: Policyholder Rights at the Claims Stage

The standards to which WYO companies are held by what FEMA calls an "Arrangement," and their major responsibilities, are delineated at "44 CFR 62.23—WYO Companies authorized." Among other things, WYO insurers are fiscal agents of the federal government but are not general agents. Insurance agents who sell flood insurance are not agents of the federal government either, and their sales commissions are set by the FEMA regulations, not by insurers.

The rule says that insurance producers are agents of the insured. Currently, commissions are 15 percent on the first $2,000 of premium and 5 percent on excess of $2,000. WYO companies sell and manage flood policies in much the same manner as regular books of business, the major difference being that ultimately operating costs and claims are paid out of the US Treasury. Insurers get a percentage of the claims paid, a practice that insurers and FEMA personnel argue reduces any incentive for insurers to underpay claims. Should a disputed claim end up in litigation, legal fees, court costs, and related expenses are also paid by FEMA.

To be specific, 44 CFR 62.23 states:

• (d) A WYO Company issuing flood insurance coverage shall arrange for the adjustment, settlement, payment and defense of all claims arising from policies of flood insurance it issues under the Program, based on the terms and conditions of the Standard Flood Insurance Policy.
• (e) In carrying out its functions under this subpart, a WYO Company shall use its own customary standards, staff and independent contractor resources, as it would in its ordinary and necessary conduct of its own business affairs, subject to the Act and regulations prescribed by the Federal Administrator under the Act.

Especially relevant to this discussion, the regulation at 44 CFR 62.23(i)(6) states:

Pursuant to the Arrangement, the responsibility for defending claims will be upon the Write Your Own Company and defense costs will be part of the unallocated or allocated claim expense allowance, depending on whether a staff counsel or an outside attorney handled the defense of the matter.

The Arrangement further provides allocation of liability at 44 CFR 62, App. A, Art. IX:

The parties shall not be liable to each other for damages caused by inadvertent delay, error, or omission made in connection with any transaction under this Arrangement. In the event of such actions, the responsible party must attempt to rectify the error as soon as possible after discovery of the error and act to mitigate any costs incurred due to that error. In the event that steps are not taken to rectify the situation and such action leads to claims against the company, the NFIP, or other related entities, the responsible party shall bear all liability attached to that delay, error, or omission to the extent permissible by law.

Deciding what actions fall outside of the Arrangement is the FIA chief counsel's duty. If something is outside the scope of a WYO company's responsibilities under the Arrangement, for example, the WYO company is on its own, and federal funds will not be available to indemnify the WYO company. Thus, under the program Arrangement, some practices fall under federal law ("trigger a federal interest"), others don't. If an action is within the terms and conditions of the Arrangement, only federal law applies.

Article IX of the flood policy makes this point clear:

IX. WHAT LAW GOVERNS

This policy and all disputes arising from the handling of any claim under the policy are governed exclusively by the flood insurance regulations issued by FEMA, the National Flood Insurance Act of 1968, as amended (42 U.S.C. 4001, et seq.) and Federal common law.

This is called federal preemption, meaning that state law remedies are unavailable. This a serious downside for consumers filing claims under the NFIP.

Additionally, there is no choice of venue in the event that an insured is dissatisfied with FEMA's or a WYO insurer's claims handling. "Condition R. Suit Against US" states:

You may not sue us to recover money under this policy unless you have complied with all the requirements of the policy. If you do sue, you must start the suit within 1 year after the date of the written denial of all or part of the claim, and you must file suit in the United States District Court of the district in which the covered property was located at the time of loss. This requirement applies to any claim that you may have under this policy and to any dispute that you may have arising out of the handling of any claim under the policy.

Cause for pause here. Since the "policy" is a federal regulation, principles of utmost good faith and fair dealing, a part of every insurance contract, are inapplicable.

Administratively, then, flood subsidies are treated as rule enforcement wherein the burden of compliance shifts heavily to the recipient of federal funds, sort of like a public welfare program, and a policyholder's legal rights are sharply curtailed by federal preemption of authority. A comparison of what an aggrieved claimant may do under state laws as opposed to federal remedies available under a flood policy illustrates the magnitude of a buyer's sacrifices under the flood policy.

In an insurance policy issued under most state laws, an aggrieved policyholder may seek a variety of remedies against an insurance company that mishandles a claim. In addition to what is commonly known as a remedy for breach of contract, here are examples of other avenues of redress available in a normal insurance transaction when disputes arise over claims. An insured may file a lawsuit based on the following.

• Fraud, either civil or criminal
• Unfair or deceptive acts or practices under either insurance statutes or consumer protection laws
• State or federal Racketeer Influenced and Corrupt Organizations Act claims
• Negligence
• Intentional infliction of emotional distress
• Tortious interference with business relationships
• Bad faith
• Punitive damages for improper conduct

If the suit proves meritorious, a policyholder may recover attorney's fees, actual damages, and punitive damages. In addition, state insurance regulators can conduct their own independent inquiries into an insurer's claims practices through market conduct examinations.

Most states also have a version of the Unfair Claims Settlement Practices Act that may be used as a measure against which an insurer's conduct is weighed. These laws do not apply to flood claims. Indeed, as one court reminded litigants, a policyholder may seek breach of contract remedies to challenge a claim determination, but policyholders "are not entitled to receive compensatory, punitive, or consequential damages, or attorney's fees." ³

To cite other examples, in overruling a North Carolina consumer who won a bad faith case against Allstate Insurance Company under a state consumer protection law, the Fourth Circuit Court of Appeals held that the policyholder's victory was null and void because the "claim under the policy is preempted by federal law." ⁴

In reviewing this North Carolina and other federal court decisions, I am struck by the unnecessary attention given to the source of money, the US Treasury, in justifying preemption in disputed claims. Examples: In Wright v. Allstate Ins. Co., the court opined that permitting state tort laws to be used against WYO insurers would "increase rather than confine the burdens on the federal government and the federal fisc that the NFIA was created to mitigate." ⁵ Further, in Melanson v. United States Forensic, LLC, District Judge Spratt of the Eastern District of New York remarked that "courts have repeatedly emphasized the harmful effect that duplicative flood loss claims would have on the public fisc," citing in agreement the words of another federal court that "state tort suits against WYO companies, which are usually expensive, would undermine the goal of reducing the fiscal pressure on federal flood relief efforts." ⁶

One need not be an expert in claims handling to sense the bias in elevating protection of the federal fisc to such a high level in claims administration. Indeed, in the usual insurer-insured relationship, an insurer that places its economic interests above those of its insured is a prime candidate for a bad faith verdict, even if the company does so without directly admitting it. Additionally, I have read the NFIA with special attention to the reasons Congress cited in passing the Act. Protecting the federal fisc is not among the reasons, even if individual members of Congress may think otherwise. Further, in FEMA's literature, the agency lists the following purposes of the WYO program.

• Increase the NFIP's policy base and the geographical distribution of policies
• Improve service to NFIP policyholders through the infusion of insurance industry knowledge
• Provide the insurance industry with direct operating experience with flood insurance

There is no mention of protecting the federal fisc.

The bottom line about insurance claims filed under the NFIP, even if sold by a licensed insurance company, is that no matter how egregious an insurer's conduct may be in the processing of a claim, the only acceptable basis for redress is a breach of contract claim.

Bad Practices in the Sales and Marketing Are Not Preempted

While a policyholder's only right of redress in the claims process falls under federal law, the trend on sales and marketing of the flood program is against preemption. This makes sense for several reasons. FEMA's literature, the policy, and federal courts concentrate upon the claims process, and the Arrangement, as discussed above, limits preemption to claims. Moreover, the agents who sell the flood program act for the buyers, not the federal government. Additionally, the "federal fisc" question ought not bear upon sales and marketing for the simple reason that no federal money is at risk at the precontract phase of purchasing a policy.

Thus, one may sue an agent or WYO insurer for misrepresentation, failure to procure requested coverage, selling higher limits than necessary, and other unfair or deceptive sales practices. For example, In Houck v. State Farm Fire & Cas. Co., 194 F. Supp. 2d 452 (D.S.C. 2002), a South Carolina district court judge ruled that six causes of action (breach of contract, breach of the covenant of good faith and fair dealing, negligence, negligent misrepresentation, fraud, and civil conspiracy) are not preempted by the Arrangement between FEMA and private insurers. ⁷ The case stemmed from the plaintiff's allegation that the agent misrepresented the amount of insurance necessary to cover the risk.

Concluding Observations

First, people may be misled by the labeling of a federal program as "insurance" by frequent use of words common to the insurance business such as "policy" and the WYO program that further encourages citizens to construe a federal rule as an insurance policy. However, in the final analysis, mimicry of insurance does not make it insurance. Indeed, the statute, regulations, and administrative apparatus flowing from the 1968 statute, as amended, constitute a federal government program as much akin to a public assistance undertaking as to insurance.

Second, the regulatory scheme encourages policyholder abuse. With the limited recourse available to program "insureds" to level the playing field among policyholders and WYO companies armed with their cadre of contract workers and lawyers, it is somewhat difficult to determine whether policyholders are beneficiaries or victims.

Third, program advocates may raise questions as to what incentive WYO companies have for shortchanging claimants since they receive a percentage of what is paid in claims, presumably meaning that claim inflation is more likely than deflation. Oh, if that were the full story. Here's why.

Example: 3.3 percent of a $100,000 claim yields $3,300 for an insurer. Remember, however, that ALL costs of claims handling, including lawyers, adjusters, engineers, "thorough investigations," and so on are compensable, meaning that insurers bill FEMA, under the Arrangement. These costs can easily escalate into another $100,000. Just do the math and imagine how good intentions can go awry or, alternatively, how naïve bureaucrats can innocently overlook a systemic problem.

This potential to inflate the claims administrative costs through dragging out claims processing by rejecting proofs of loss, requiring examinations under oath, and using delays are encouraged by the limited means of redress available to policyholders. Limited means of redress plus the incentive to increase earnings by delay are a virtual "get out of jail free card" for any insurer that wishes to exploit its book of flood program participants. ⁸

Fourth, the following three functions are preempted and exclusively fall under federal jurisdiction.

• The authorship of the policy
• The interpretations of the policy
• The claims process

However, any conduct falling outside those parameters according to current law and practice is subject to state law claims. Although I can find no evidence that state regulatory officials have ever intervened on nonpreempted issues, one might presume that preemption imposes no federal barrier to doing so.

Finally, I have not placed an economic value on the losses consumers may suffer due to the limited rights granted them under the NFIP regulatory scheme. My guess is that most insureds, even if they have claimant experience, are unaware of their status. Congress needs to broaden the right of redress under the NFIP, and courts need to base decisions on factors other than federal budgetary numbers. Moreover, the executive and legislative branches of the federal government need to clarify the differences between a federal program and an insurance policy.

I understand the political significance of characterizing the program as insurance, but more candid portrayals of the program might avoid future misunderstandings. A simple warning that "This is not like an insurance policy" or "If we disagree on claims, you may not sue us in state court. If you sue, you may sue for breach of contract in federal district court only" may be the first step.