[Federal Register Volume 64, Number 98 (Friday, May 21, 1999)] [Rules and Regulations] [Pages 27705-27709] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 99-12930] ======================================================================= ----------------------------------------------------------------------- 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. ----------------------------------------------------------------------- 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