National Flood Insurance Program (NFIP); Determining the Write- Your-Own Expense Allowance

FEDERAL EMERGENCY MANAGEMENT AGENCY

44 CFR Part 62

RIN 3067-AC92

National Flood Insurance Program (NFIP); Determining the Write-

Your-Own Expense Allowance

AGENCY: Federal Emergency Management Agency (FEMA).

ACTION: Final rule.

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SUMMARY: We (FEMA) are changing our method for establishing the Write-

Your-Own (WYO) expense allowance percentage for years beginning on or

after October 1, 1999. We will use a new formula to derive the expense

ratios in determining the operating portion of the expense allowance.

This formula will use direct, as opposed to net, premium and expense

information for the property/casualty industry and will have the effect

of lowering the expense allowance. However, during arrangement year

1999-2000 only we will set the expense allowance at the mid-point

between the expense allowance calculated using direct as opposed to net

premium and expense information.

EFFECTIVE DATE: This rule is effective on October 1, 1999.

FOR FURTHER INFORMATION CONTACT: Edward T. Pasterick, Federal Emergency

Management Agency, Federal Insurance Administration, 500 C Street SW.,

room 429, Washington, DC 20472, 202-646-3443, (facsimile) 202-646-3445,

or (email) [email protected]. We will post at www.fema.gov/nfip

the text of the 1999-2000 Arrangement by June 1, 1999.

SUPPLEMENTARY INFORMATION: On November 13, 1998, we proposed a rule at

63 FR 63432 that would change the method for establishing the Write

Your Own (WYO) expense allowance percentage for arrangement years

beginning on or after October 1, 1999. We proposed using a new formula

to derive the expense ratios used in determining the operating portion

of the expense allowance. This new formula would use direct, as opposed

to net, premium and expense information for the property and casualty

industry. It would have the effect of lowering the expense allowance to

participating companies.

On Tuesday, February 9, 1999, we held a public meeting to discuss

the proposed rule and other changes to the WYO expense allowance that

were published in an advance notice of proposed rulemaking at 63 FR

63431, November 13, 1998. Nineteen people representing fourteen WYO

companies and vendors attended this meeting. Most of the comments made

at the public meeting duplicated the written comments submitted in

response to the notice of proposed rulemaking. This Supplementary

Information also discusses new comments made at that meeting.

General Comments

Concerns about reduced WYO company compensation. During the comment

period, we received comments from ten WYO companies that opposed

reducing the WYO expense allowance. The companies agreed that it is

reasonable to use direct rather than net

[[Page 27706]]

data in order to establish the expense allowance percentage, but the

overarching concern of the companies was that such a change would

reduce company compensation. In every case where a commenter cited the

differences or complexities of writing flood insurance, the underlying

concern was not that we are creating a further complexity with this

rule but that reducing the expense allowance will reduce profits. None

of the companies, however, provided any data to support the assertion

that their operating costs have increased during the fifteen years of

operation of the WYO program. Nor has the WYO program ever guaranteed

any set profit margin for participating companies.

We want to continue the same basic approach that we have used for

more than 15 years. That is, we will continue to use published

property/casualty industry expense information to derive flood

insurance expense allowances. But we base our new formula on

statistical data that were not available fifteen years ago when we

established the compensation formula, that is, direct versus net

premium.

Direct versus net premium. Our use of direct rather than net

premium more accurately than before reflects the unique nature of the

flood insurance partnership between the Government and industry where

we assume liability for flood losses, and companies do not have to

incur costs for reinsurance. A number of companies that commented on

the proposed change agreed that this is a logical approach. At issue

are the specifics of the formula we use to set compensation for

participating companies.

We believe that continuing to use net rather than direct premium

for the property/casualty industry as basis for compensation would

neglect more refined data now available to us and would also include

components that do not apply to the NFIP. Fifteen years ago, the

Insurance Expense Exhibit for the property and casualty insurers did

not provide direct premium and expense information comparable to what

is available today in Aggregates and Averages. The result was that we

calculated an expense allowance that all found in the early days of the

program to be reasonable and acceptable.

Information on direct premiums, however, provides a superior

indicator for computing the expense ratio. Direct premiums written

represent the aggregate amount of recorded, originated premiums--other

than reinsurance--written during a year after deducting all return

premiums. Net premiums written include direct premiums written plus

reinsurance assumed, less reinsurance ceded.

Reinsurance is not, however, a part of the WYO company's flood

business because the Federal Government assumes liability for all

losses. Therefore, the expense allowance should not include reinsurance

in the calculation of the expense ratio. Using net premium has the

effect of including non-applicable reinsurance costs and has had the

effect of providing a WYO company with a level of compensation that is

too high, one that we can no longer justify. This rule appropriately

changes the basis for compensating companies and is adequate to

compensate companies for doing business under the NFIP.

Final Decision on Compensation for Arrangement Year 1999-2000

At the February 9, 1999 public meeting, several companies asked us

not to implement a change in the compensation formula from October 1,

1999 to October 1, 2000 before we study the change in more detail. We

do not believe such a study is necessary. The WYO companies agreed that

using direct as opposed to net data published by A.M. Best is

reasonable. We recognize that any decrease in compensation will require

adjustments by the WYO companies. Therefore, we have decided to provide

a transition phase before the change we proposed on November 13, 1998

becomes effective.

As an accommodation, we will set the WYO expense allowance for FY

2000, which begins on October 1, 1999, at the mid-point between the

expense allowance calculated using direct premium and expense

information and the expense allowance calculated using net premium and

expense information. This will give the companies a one-year adjustment

period before they implement the new method for calculating the expense

allowance.

For the 1999-2000 arrangement year, the midpoint is 31.7 percent,

which compares with the base allowance for the current arrangement year

of 31.6 percent. For FY 2001, beginning October 1, 2000, we will

calculate the WYO expense allowance using direct premium and expense

information.

We are working with the WYO companies to develop new incentives for

rewarding companies' marketing efforts. These incentives will be in

addition to the basic WYO expense allowance described above. We intend

to put these new incentives in place on October 1, 1999.

Specific Comments

During the comment period, a number of Write-Your-Own companies

submitted comments for consideration. We believe that we have addressed

many of the underlying concerns of the commenters in the light of the

accommodation we are making with this final rule. Since these comments

comprise the public record on this rulemaking action, we state our

position on these comments.

No ``Built-In'' Profits

Five companies expressed concerns that the proposed change in the

expense allowance has no ``built-in'' profit margin for flood business

and that companies may not accrue and retain interest on investment

income--a potential source of profit. During the fifteen years of the

WYO program, the expense allowance has never included a specific profit

component in the expense allowance for participating companies. There

is, however, an implicit profit margin because the program draws

insurers whose costs are below the expense allowance. Hence, they earn

a profit.

Also, private WYO participants, appropriately, may not retain

interest on their flood premium income. WYO companies participate in

the program without risk, that is, the Arrangement guarantees

reimbursement for all loss payments. The ability to earn a return on

invested premiums to pay for losses in other lines of insurance is not

a consideration in flood insurance. The proposed change in the expense

allowance does not affect that long-standing and appropriate

restriction.

Commissions

One company believed that company profits decrease as companies

compete for business by offering higher commissions as an incentive to

attract agents. We have always maintained that what a company chooses

to compensate agents is a matter between the company and the agent. We

believe that fifteen percent is a reasonable compensation figure for

agent commissions, which we account for in the expense allowance;

however, if a company chooses to increase its commission as a business

incentive, then that is the company's prerogative.

Reduced Expense Allowance May Reduce the Number of Participants

Five companies expressed concern that a reduction in the expense

allowance will hurt the WYO program-- marginal companies will withdraw

and new companies will balk at joining the program. The result, these

companies

[[Page 27707]]

believe, will be more business on the direct side and less growth in

policies. One of our goals is to encourage insurers to participate and

at the same time to hold the line on program costs which policyholders

and taxpayers bear. But as with any industry, when competition

increases, marginal participants may withdraw and new entrants can

expect less profit. We do not believe that this is necessarily a

negative consequence. We are also confident in our cost data, and we do

not believe that the reduction in the expense allowance will cause

withdrawals from the program by successful companies.

Reduced Expense Allowance May Result in Poor Customer and Agent

Service

Two companies believed that the proposed reduction in the expense

allowance could lead to a deterioration of services to policyholders

and agents. We strongly disagree with this position. The expense

allowance accounts for the costs needed to provide and maintain

adequate services to NFIP policyholders and a profit for efficient

companies.

Inherent Differences Between Flood Insurance and Other Lines

Eight companies said that the ``flood product'' is essentially

different from other property/casualty insurance products because of

the complexity in writing flood insurance. The companies claim that

these complexities, for example, identifying risks ineligible for flood

insurance under the Coastal Barrier Resources Act, increase costs.

There are clearly differences between flood insurance and other lines

of property and casualty insurance. Therefore, we believe that the five

lines of property/casualty insurance that we have been using are still

the best proxy for compensating WYO companies. But we also believe that

using direct rather than net premium data will provide WYO companies

with adequate compensation for their costs.

Flood Insurance Rating

Five companies also highlighted the difference in rating

methodology for flood and for other lines of property and casualty

insurance. The companies cited as an example flood maps, which they

called ``antiquated.'' The companies also expressed concern over the

use of ``non-standard'' forms such as the elevation certificate in the

underwriting process. Because of these complexities, several of these

companies have obtained the services of third parties to determine the

flood zone on FEMA's maps for rating flood insurance policies. The

companies expressed concern that these costs are not reimbursable under

the program. While we do not reimburse companies specifically for

outsourcing flood work, the method of determining the expense allowance

by this rule is adequate to cover these costs.

Agent Training and Education

Several companies also expressed concern that agents find the flood

insurance program complicated, which complexity creates a demand for

training. Training of company agents is the primary responsibility of

the company, and the expense allowance accounts for the expenses of a

WYO company to train its agents. Still, we have made a commitment to

help WYO companies with their agent training in the past, and we will

continue to do so in the future. By the end of the current arrangement

year, we will have conducted 150 workshops for insurance agents

interested in selling flood insurance. The workshops are open not only

to independent agents but also the agents of our WYO partners. We plan

to hold the same number of workshops for agents next year as well. We

have also helped participating companies develop training delivery

systems of their own by conducting, upon request, train-the-trainer

sessions on the NFIP for company trainers. To give agents immediate

access to underwriting and rating information about the NFIP, we

provide on our web site (www.fema.gov/nfip):

The flood insurance manual,

Underwriting information,

A list of WYO companies,

Dates and locations of agents workshops, and

Other program information.

Statistical Reporting

Four companies expressed concern that the WYO program requires

monthly statistical reporting whereas other lines of property and

casualty insurance only require statistical reporting on a quarterly

basis. This point is accurate. Most other lines require statistical

reporting on a quarterly basis. Even so, the WYO program has been

requiring statistical reporting on a monthly basis for fifteen years,

and the method of setting the expense allowance under this rule is

adequate to cover reporting costs as well.

Unique Adjuster Skills

Four companies also pointed out that handling flood claims requires

unique adjuster skills with the adjusters certified by the Federal

Government. This is also accurate. Adjusters handling flood claims

under the Write Your Own program have, for fifteen years, needed

special training and certification to adjust flood claims. Reducing the

expense allowance does not affect this aspect of a company's

participation in the WYO program. Training adjusters is a cost

necessary to do business under the flood insurance program, a cost that

we have taken into consideration in setting the expense allowance.

Higher Company Costs

Two companies commented that we used to provide forms, the flood

insurance policy, manuals, and seminars free of charge to WYO

companies. Companies must now cover the nominal costs to produce these

materials and conduct training at their own expense. We recognize that

companies are now paying for some products that were free; however, the

general expense category of the WYO expense allowance compensates

companies for these and other costs of selling and servicing flood

insurance. Providing companies with free materials was for companies a

further enrichment that we can no longer justify.

Acceptable Error and Reject Rates

Two companies expressed concern that maintaining acceptable error

and reject levels is costly. Company systems, they claimed, for

standard property and casualty processing, do not lend themselves to

handling flood business. Therefore, many companies either outsource

this part of their flood business or develop stand-alone systems. This

is accurate. But again outsourcing or operating stand-alone systems is

no different today than it has been for fifteen years since the start

of the WYO program. Outsourcing or developing stand-alone systems is a

cost of doing business under the program, a cost that participating

companies willingly assume when they choose to join the program.

Audits

Two companies expressed concern that the WYO program requires an

independent audit at the expense of the company. First, we always have

required such an independent audit at the company's expense under this

program. It is nothing new. In addition, independent audits of

companies' financial statements are not a unique requirement of the

flood insurance program. Any publicly traded company requires

accountability to its shareholders in the form of financial statements

that are subject to independent audits. Annual statements by insurance

companies to the National Association of Insurance Commissioners are

also subject to an independent audit.

[[Page 27708]]

Program Changes

Four companies expressed concern that frequent program changes

require additional computer programming, new printing and publications,

more training and mailings, as well as more rewriting of policies.

These companies offered no specific data to indicate the relationship

between the program changes and cost increases to implement those

changes. We believe our data, which justify a lower expense allowance,

take into consideration systems and other program changes that

participating companies must make each year.

Reducing Expenses

One company suggested that we should conduct an analysis of ways to

reduce expenses while improving service to policyholders before

proposing to adjust the expense allowance formula. They contended that

our proposal to reduce the expense allowance failed to consider how to

reduce or eliminate operating costs. The responsibility to hold program

costs to a minimum and to provide the highest service exists apart from

the issue of the expense allowance. We agree that we must provide

improved service at reduced costs, but our purpose in proposing the new

expense allowance formula was to take advantage of data that were not

available when we established the current formula. These new industry

expense data support the proposed reduction in the expense allowance

that, we believe, is adequate to cover companies' operating costs.

Alternative Formula

One company proposed an alternative formula for calculating the

expense allowance. They suggested that we only use cost data for

participating WYO companies rather than data for five property

insurance lines and that we replace the fixed 15 percent commission

allowance in the current formula with the ``Commission & Brokerage''

expense published in A.M. Best. Under their proposal, the ``Commission

& Brokerage'', ``Other Acq.'', ``General Exp.'' and ``Taxes'' would be

combined and the expense allowance would be set at the mean of this

amount plus one standard deviation which, would cover the operating

costs of approximately two-thirds of the companies. The commenter

recognized that companies would have to report their expenses

associated with the NFIP and suggested that this be done on a mandatory

separate statement line on the NAIC Insurance Expense Exhibit. This

company also proposed reporting this information annually and updating

the WYO expense allowance every three years.

We have always favored using published average industry expense

ratios for other acquisition, general expenses and taxes because

neither we nor the WYO companies can affect those ratios. A

disadvantage to the alternative approach to the proposed compensation

formula is that it would impose an additional reporting requirement on

the companies and require the NAIC to change the Insurance Expense

Exhibit. We believe that for 15 years the formula for compensating the

companies has been fair and that we should continue to use it in its

current form based on the best available data.

Adverse Impact on Industry Ratios

One company said that the adverse impact on industry ratios and

ratings, as a result of an insurer's decision to join the WYO program,

should be a factor in determining the expense allowance level. We

recognize that companies must report flood insurance activities on

their financial statements that are used to derive industry ratios and

ratings. However, we believe that a company should evaluate the impacts

that reporting flood business will have on their industry ratios and

ratings before deciding to participate in the WYO program. The effect

of reporting this information will vary significantly among the WYO

companies and is not easily measured. We do not believe the impact on

industry ratios and ratings should be a factor in our compensation to

companies, nor should it be a deterrent to companies participating in

the program.

The Expense Allowance and Marketing Incentives

One company said that the expense allowance should recognize the

marketing goals of the program, that is, to increase the policy base of

the program. Part of that recognition, the company claimed, should

include geographic distribution and retention of policyholders. In

general, the marketing guidelines, which we have and will continue to

develop in close coordination with the companies, address the overall

issue of rewarding a company's growth. We have not included incentives

designed to reward companies for selling and retaining policies in

specific areas of the country because we do not have the data or

indicators needed to target areas of the country for flood insurance

marketing. When we have this capability, we will discuss whether and

how to include geographic based marketing incentives in the

compensation scheme with the WYO companies.

Use of Data Published by A. M. Best

Three companies commented that since 1994 we have not based the

expense allowance solely on data published in A. M. Best's Aggregates

and Averages. As an incentive for companies to increase the number of

flood insurance policies, we set the expense allowance below the amount

indicated by Best's data, and companies had the chance to earn

additional expense allowance. The companies noted that they believed

this was not a true bonus but a penalty if a company did not meet the

marketing goal.

Granted, since 1994, we have not based the expense allowance

strictly on Best's data. We did this because Best's was simply too high

as a basis for company compensation. Beginning in arrangement year

1994-1995, we determined that the exact amount that a company may

retain would be the extent to which the company met its marketing goal

for the arrangement year and this amount could exceed the calculated

amount. For arrangement year 1996-1997, a company could withhold 32.6

percent of written premium. If a company failed to meet its marketing

goal, the percent of retained expense allowance decreased in proportion

to the unmet goal but would not fall below 30.6 percent. If a company

met its marketing goal, it would retain the entire 32.6 percent. If a

company exceeded the goal, the exact amount of compensation depended on

the extent to which the company exceeded its marketing goal, and the

size of the company's flood business in relation to the total number of

WYO policies. We are discussing alternative marketing incentives with

the companies and plan to address this and other concerns in the next

arrangement year.

Company Investments in Flood Business

Four companies commented that they had made investments to simplify

writing flood insurance, which they believed they could recover based

on the current expense allowance. The companies claimed that a reduced

expense allowance would jeopardize this recovery. We have always

encouraged company investments in their flood insurance business, and

we believe that the expense allowance, which this rule implements, is

adequate to cover start-up costs and other operational improvements.

Such investments, when made wisely, result in improvements in

productivity that

[[Page 27709]]

reduce the cost of doing business for a company and ultimately increase

its profits.

Summary

We believe that basing the amount of compensation for companies

participating in the WYO program on a formula using direct rather net

premium simply takes advantage of statistical data unavailable fifteen

years ago when we first established the compensation formula. This also

better reflects the nature of the liability for companies because

companies do not have to pay for reinsurance for their flood business

since the Federal Government assumes the liability for flood losses. We

believe however in the light of both the written comments and the

comments we heard at the February 9, 1999 public hearing that a one-

year transition will serve the interests of the program better. This

transition will give the NFIP's industry partners time to adjust to the

change in how we calculate the level of compensation for participating

in the WYO program. This rule reflects that decision and adjusts the

effective date of the arrangement to coincide with the start of

Arrangement Year 1999-2000.

National Environmental Policy Act

This rule is categorically excluded from the requirements of 44 CFR

Part 10, Environmental Consideration. We have not prepared an

environmental assessment.

Executive Order 12866, Regulatory Planning and Review

This rule is not a significant regulatory action within the meaning

of sec. 2(f) of E.O. 12866 of September 30, 1993, 58 FR 51735, and the

Office of Management and Budget has not reviewed it. Nevertheless, this

rule adheres to the regulatory principles set forth in E.O. 12866.

Paperwork Reduction Act

This rule does not contain a collection of information and is

therefore not subject to the provisions of the Paperwork Reduction Act.

Executive Order 12612, Federalism

This rule involves no policies that have federalism implications

under Executive Order 12612, Federalism, dated October 26, 1987.

Executive Order 12778, Civil Justice Reform

This rule meets the applicable standards of section 2(b)(2) of

Executive Order 12778.

Congressional Review of Agency Rulemaking

We have sent this final rule to the Congress and to the General

Accounting Office under the Congressional Review of Agency Rulemaking

Act, Pub. L. 104-121. The rule is not a ``major rule'' within the

meaning of that Act. It is an administrative action in support of

normal day-to-day activities. It does not result in nor is it likely to

result in an annual effect on the economy of $100,000,000 or more; it

will not result in a major increase in costs or prices for consumers,

individual industries, Federal, State, or local government agencies, or

geographic regions; and it will not have ``significant adverse

effects'' on competition, employment, investment, productivity,

innovation, or on the ability of United States-based enterprises to

compete with foreign-based enterprises. This final rule is exempt (1)

from the requirements of the Regulatory Flexibility Act, and (2) from

the Paperwork Reduction Act. The rule is not an unfunded Federal

mandate within the meaning of the Unfunded Mandates Reform Act of 1995,

Pub. L. 104-4. It does not meet the $100,000,000 threshold of that Act,

and any enforceable duties are imposed as a condition of Federal

assistance or a duty arising from participation in a voluntary Federal

program.

List of Subjects in 44 CFR Part 62

Claims, Flood insurance.

Accordingly, we amend 44 CFR part 62, Appendix A, as follows:

PART 62--SALE OF INSURANCE AND ADJUSTMENT OF CLAIMS

1. The authority citation for part 62 continues to read as follows:

Authority: 42 U.S.C. 4001 et seq.; Reorganization Plan No. 3 of

1978; 43 FR 41943, 3 CFR, 1978 Comp., p. 329; E.O. 12127 of Mar. 31,

1979, 44 FR 19367, 3 CFR, 1979 Comp., p. 376.

2. We revise the Effective Date of Appendix A to part 62 to read as

follows:

Appendix A to Part 62--Federal Emergency Management Agency, Federal

Insurance Administration, Financial Assistance/Subsidy Arrangement

* * * * *

Effective Date: October 1, 1999.

* * * * *

3. We revise the Article III.B of Appendix A to part 62, to read as

follows:

* * * * *

Article III--Loss Costs, Expenses, Expense Reimbursement, and Premium

Refunds

* * * * *

B. The Company may withhold as operating and administrative

expenses, other than agents' or brokers' commissions, an amount from

the Company's written premium on the policies covered by this

Arrangement in reimbursement of all of the Company's marketing,

operating and administrative expenses, except for allocated and

unallocated loss adjustment expenses described in C. of this

article. This amount will equal the sum of the average of industry

expense ratios for ``Other Acq.'', ``Gen. Exp.'' and ``Taxes''

calculated by aggregating premiums and expense amounts for each of

five property coverages using direct, as opposed to net, premium and

expense information to derive weighted average expense ratios. For

this purpose, we (the Federal Insurance Administration) will use

data for the property/casualty industry published, as of March 15 of

the prior Arrangement year, in Part III of the Insurance Expense

Exhibit in A.M. Best Company's Aggregates and Averages for the

following five property coverages: Fire, Allied Lines, Farmowners

Multiple Peril, Homeowners Multiple Peril, and Commercial Multiple

Peril (non-liability portion). During the first year of this

change--arrangement year 1999-2000--which begins October 1, 1999,

the expense allowance is set at the mid-point between the expense

allowance calculated using direct premium and the expense allowance

calculated using net premium.

The Company may retain 15 percent of the Company's written

premium on the policies covered by this Arrangement as the

commission allowance to meet commissions or salaries of their

insurance agents, brokers, or other entities producing qualified

flood insurance applications and other related expenses.

The amount of expense allowance retained by the company may

increase a maximum of 2 percent, depending on the extent to which

the company meets the marketing goals for the Arrangement year

contained in marketing guidelines established pursuant to Article

II.G. We will pay the company the amount of any increase after the

end of the Arrangement year.

The Company, with the consent of the Administrator as to terms

and costs, may use the services of a national rating organization,

licensed under state law, to help us undertake and carry out such

studies and investigations on a community or individual risk basis,

and to determine equitable and accurate estimates of flood insurance

risk premium rates as authorized under the National Flood Insurance

Act of 1968, as amended. We will reimburse the Company for the

charges or fees for such services under the provisions of the WYO

Accounting Procedures Manual.

* * * * *

Dated: May 20, 1999.

Jo Ann Howard,

Federal Insurance Administrator.

[FR Doc. 99-12930 Filed 5-20-99; 8:45 am]

BILLING CODE 6718-03-P