I have a small cabin at the base of the Blue Ridge Mountains in Greene County, Virginia. In 1995, a 500-year flood hit Greene and Madison Counties in which vast quantities of rock and tree-laden debris scoured the mountains as water cascaded down newly created gullies. My cabin survived although debris opened a gully where my septic field had been. Since the government so kindly offered me taxpayer subsidized flood insurance, I thought it churlish of me not to buy some. My cabin is not in a flood plain, so the premium is quite reasonable.
Flood insurance in the United States is essentially offered only by the National Flood Insurance Program (NFIP). The program still owes the federal treasury nearly $18 billion from the 2005 Hurricane Katrina disasters. The San Francisco Chronicle reports that the House voted 406-22 to renew the program for another five years. Forty years ago, the Feds often paid victims for flood damage, so the program was established in an attempt to get people to pay their own way by buying insurance. Ah, but the unintended consequences of government meddling in markets soon appeared—more people chose to build in harm's way on flood plains and coasts. In 2006, the Freeman reported:
A 1997 Idaho Statesman report on a Boise river flood concluded that the NFIP "has backfired—bringing more people into harm's way" and has made risky development "look not only possible, but attractive." Doug Hardman, Boise-Ada County emergency services coordinator, observed that subsidized flood insurance "did exactly the opposite of what it was designed to do. It has encouraged people to move there and encouraged developers to develop there." The NFIP amounts to a type of anti-environmental socialism. Scott Faber of American Rivers, a conservation organization, observed, "Prior to the 1960s, you didn't have much development in flood-prone areas because you couldn't find any insurer crazy enough to underwrite it. But the federal government came along and said it is okay—we are going to make it financially possible for you to live in a flood plain. The effect of this has been much more dramatic in coastal areas, where we have seen a huge boom in coastal development in the last 30 years."
The primary effect of federal flood insurance is that far more property is now damaged by floods than would have occurred if the insurance had not made it possible to build in flood-prone areas.The Long Island Regional Planning Board in 1989 complained that federal flood insurance "in effect encourages a cycle of repeated flood losses and policy claims." And, especially in places like Long Island, the program underwrites the vacation homes of the wealthy.
How to unravel this situation? Frankly, I generally believe that if you live by government subsidy, then you should die by its withdrawal. However, the free market Competitive Enterprise Institute offered some reform proposals [PDF] in 2008 which featured (1) land buyouts for propeties in the most flood-prone areas, perhaps converting them to public parks; (2) some policies would likely have value in private insurance markets, so sell them off; and (3) and phase out NFIP entirely by offering one time tax credits or grants to cover the declines in property value that terminating flood insurance might cause insured property owners.
Flood insurance is another example of government failure. After a government wind insurance scheme failed in 2008 when hurricanes struck the Texas coast, I explained:
The fact that insurance companies refused to insure property located on storm-wracked coasts is not an instance of market failure. A market failure supposedly occurs when the price of goods and services do not reflect the true costs of producing and consuming those goods and services. That's clearly not what happened here. The market is practially shouting at people, "Don't build something you can't afford to lose where hurricanes periodically crash ashore."
Instead the state "insurance" scheme is an example of government failure which occurs when a government intervention causes a more inefficient allocation of goods and resources than would occur without that intervention. In this case, it's the government that's telling people that it's OK to build in dangerous areas and then not charging them enough for the "insurance."
As background, you might want to read John Stossel's excellent 2004 Reason article about his flood insurance adventures concerning his Long Island beach house, Confessions of a Welfare Queen.