Optimal Flood Insurance in a Second-Best World: Fiscal Spillovers, Reclassification Risk and Moral Hazard

Intensifying climate change makes protection against natural disaster risk – either through ex ante insurance or ex post aid – a first-order public policy issue. Flood risk protection in the U.S. traditionally featured ex post aid through FEMA and heavily subsidized insurance through the National Flood Insurance Program (NFIP). In an effort to correct subsidy-induced overbuilding and under-mitigation in flood-prone areas, the NFIP recently moved to actuarially fair insurance premiums. But this change has two unintended consequences: a fiscal spillover onto FEMA disaster aid as insurance coverage declines in flood-prone areas, and household exposure to uninsurable reclassification risk from uncertain climate projections. We develop a model of optimal flood insurance that incorporates the static and dynamic tradeoffs of subsidizing premiums. We then use a variety of identification strategies and data to estimate the five key parameters needed to implement this model. We find that the fiscal spillover and reclassification risk protection benefits significantly outweigh the moral hazard costs, and that the optimal subsidy to flood insurance is 52%, comparable to the level of subsidization before the recent reform.