Photo: Mark Mulligan, Staff Photographer / Mark Mulligan / Houston Chronicle

The Federal Emergency Management Agency is taking an unprecedented step to expand private involvement in its flood insurance program by offloading risk to investors, a move that could portend long-term increases in premiums for homes in Houston and other flood-prone areas where devastating storms have exposed the extent of the program’s debt and dysfunction.

The agency is soon expected to issue the National Flood Insurance Program’s first-ever catastrophe bond, a means of reinsurance offered by risk-savvy investors willing to bet on the probability of extreme calamities in exchange for above-market returns. The bond could provide as much as $500 million to cover flood claims after tropical storms or massive hurricanes like Harvey and Katrina — if the damage surpasses a high threshold.

For Wall Street, the deal is a long-awaited opportunity to cash in on devastating flooding, a sort of peril that has until recently been deemed too unpredictable even for a market that thrives on risk. Investor interest intensified last August during Harvey, when fund managers around the world watched Houston drown under 51 inches of rainfall and realized that, with sophisticated probability models, flood risk could be the cat bond market’s next frontier.

For the flood insurance program, faced with mounting debt and the threat of fiercer storms feeding on warming oceans, the deal is part of a broader push toward privatization to relieve a balance sheet burdened with some $20 billion in debt. The program, up for congressional reauthorization at the end of the month, has burned through about $42 billion in taxpayer-funded bailouts in the last 25 years, a Chronicle investigation found. Its capacity to borrow from the U.S. Treasury is capped at roughly $30 billion.

David Maurstad, who oversees the flood insurance program in his role as FEMA’s deputy associate administrator for insurance and mitigation, said the cat bond deal will strengthen the flood program’s reinsurance coverage by providing another layer of protection the event of catastrophic loss. The agency purchased traditional reinsurance for the first time in 2017, essentially insuring itself against major flood losses as part of an ongoing plan to shift risk to the private market.

Investors and industry experts anticipate that expansion of private involvement in the program will eventually require FEMA to raise premiums and curtail its ability to subsidize them, particularly for homes built in flood plains ill-suited for safe development. Sooner or later, they say, the agency will have to take in more money in order to purchase reinsurance because the private market charges rates that reflect the cost of risk.

“If you hand reinsurers your losses, your rates have to go up,” said Craig Poulton, CEO of Poulton Associates, one of the country’s largest administrators of private flood insurance. “The cost of reinsurance is dramatically higher than borrowing from the federal government.”

FEMA said earlier this year that its initial reinsurance purchases — small relative to the size of the program — will not directly affect rates for flood insurance. Maurstad added that it’s too soon to say how the agency will pay for additional coverage.

“We don’t know the answer to that right now,” he said. “That’s part of the give-and-take that will have to occur in the discussions with the Administration and Congress in terms of how to support the overall framework of the NFIP.”

Rates are already rising. Average premiums will increase about 8 percent this year in line with legislative mandates, and FEMA is working to improve its risk assessment methods to better align insurance rates with the cost of coverage.

The push toward privatization changes the very essence of the program, established in 1968 as a government-supported means of offering flood insurance when private companies deemed it too risky to do so. Now, advances in catastrophe modeling and new ways to monetize risk have renewed private interest in backing those policies.

Lixin Zeng, CEO of AlphaCat Managers, a Bermuda-based firm that invests in cat bonds and other reinsurance products, said investors have in recent years shown growing interest in taking on flood risk for either FEMA or private insurers, potentially extending their ability to pay claims and write new coverage.

Hurricane Harvey, he added, reinforced that interest by exposing both the costs of catastrophic flood damage and the extent of uninsured losses in the wake of major rainfall or storm surges.

“The private market is prepared to take on flood risk,” he said. “As long as we, the managers, critically analyze and price the risk, investors will have no problem insuring it.”

Cat bonds occupy an obscure corner of the market that developed in the wake of Hurricane Andrew, the 1992 storm that destroyed more than $15 billion in insured property and led to the bankruptcy of 11 insurance companies.

Using complex risk analysis, investors have for years been betting on nature’s whims with bonds that help shield insurers against extreme losses caused by hurricanes, earthquakes, windstorms, cyclones and other phenomena with the potential to inflict billions of dollars in damage.

The market is dominated by private insurance and reinsurance companies that sell the bonds to investors whose principal is kept in escrow for a certain time frame, typically three years. The insurers pay investors a relatively high rate of interest during the life of the bond — unless a specified disaster strikes and exceeds a predefined threshold based on metrics such as storm strength or total insurance claims. In that case, the principal is liquidated in part or in full to pay the insurer.

For investors, it’s a gamble, but one with good odds. A cat bond is carefully structured so that its threshold hews to a narrow set of conditions, making a full payout of the principal relatively improbable.

For insurers, it’s a guaranteed source of cash if the worst comes to pass — but only if the disaster crosses that narrow threshold. When Harvey churned through the Gulf, for example, its central pressure narrowly missed the measurement required to trigger a partial payout of a cat bond issued by the Mexican government to provide coverage for earthquakes and hurricanes.

Days later, an earthquake off the coast of Chiapas proved strong enough to trigger part of that same bond, prompting a $150 million payment from investors.

FEMA decline to comment on the specifics of its cat bond deal, which is expected to close in the coming days.

London-based industry researcher Artemis, drawing on documents provided by insiders, reported that the agency, through German reinsurer Hannover Re, will issue a three-year cat bond investors willing to shoulder flood risk exclusively. That type of deal has never been offered in the market.

Unlike hurricanes, earthquakes and other natural disasters, flood risk has historically been difficult to model because a wide range of factors, from topography to tide patterns, can influence its severity.

The bond will offer two classes of notes, each different levels of risk.

The first set of notes will provide as much as $325 million in coverage when a single hurricane or tropical storm causes between $7.5 billion and $10 billion in flood claims. Risk models say there’s roughly a 6 percent chance investors will lose some money on the deal; in exchange for that bet, they can expect a return just over 11 percent — well above rates for high-yield corporate bonds.

The second set will provide as much as $175 million in coverage when the same sort of event costs the program between $5 billion and $10 billion in claims. That’s a riskier proposition: The estimated chance of loss approaches 10 percent. Returns, though, could top 13 percent.

Dirk Schmelzer, senior portfolio manager for Plenum Investments in Zurich, had a chance to analyze the deal during a presentation held as part of a “road show” for potential investors. Such presentations typically last about an hour and a half, Schmelzer said, but this one lasted twice that long as FEMA representatives explained the deal and fielded questions.

“Market reception has been positive,” Schmelzer said. “Investors so far are quite optimistic that the NFIP will come back and expand the coverage.”

The flood insurance program has for years run at a loss following a succession of storms that cost billions of dollars in claims. A Congressional Budget Office report last year pegged the program’s annual shortfall at $1.4 billion largely because premiums collected in coastal counties — which account for roughly three quarters of its five million policies — fall far short of expected annual costs.

In Harris County, where rampant development has turned wide swaths of the region’s flood plains into subdivisions, that shortfall tops $10 million.

The program first tapped the private market last year when it purchased traditional reinsurance, paying a $150 million premium for just over $1 billion in coverage. That policy paid out in full in the wake of Hurricane Harvey to cover about an eighth of some $8 billion in claims, and the program upped its reinsurance coverage to $1.4 billion this year.

The cat bond will add an additional layer to that protection, providing money to flood claims once the damage is tallied. The deal was initially valued at $275 million, Artemis reported, but investor interest spurred FEMA to increase it to $500 million.

“The market is ready to support much greater transfer of flood risks,” Artemis owner Steve Evans said. “This is really just evidence of the sophistication of that investor base.”

FEMA’s cat bond issuance will follow a banner year for a market that has grown 15 percent to $28 billion since last year’s spate of storms and disasters, according to Chicago-based Elementum Advisors. Hurricanes Harvey, Irma and Maria, combined with earthquakes in Mexico and wildfires in California, caused at least 16 cat bonds to pay about $750 million to insurers last year, the firm reported, the highest annual payout in the history of the market.

Rather than cause a mass sell-off, the disasters invigorated a market that hadn’t been seriously tested since 2012, when Hurricane Sandy caused catastrophic damage in New York and New Jersey. When last year’s storms triggered massive payouts, investors anticipated that rates of return would increase and have since flooded the market with capital.

“The storms last year validated the role that cat bonds can play in providing reinsurance,” said John DeCaro, founding principal and portfolio manager at Elementum. “The market has a strong appetite for new risk.”

katherine.blunt@chron.com

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