Many folks believe the government should provide insurance against natural disasters. Congress recently voted to extend the National Flood Insurance Program for another four years. The NFIP was established in 1968 to provided “affordable” insurance to people living in the most flood-prone areas. (In the West, federal flood insurance has primarily taken the form of taxpayer-financed dams on the region’s major rivers.) Last year, federal agencies spent over $1.3 billion suppressing almost 86,000 fires, which burnt nearly 5 million acres. When there is a fire on the residential/forest interface, the Forest Service concentrates on saving the homes built there -- essentially providing those homeowners with taxpayer-subsidized fire insurance. But such government intervention promotes unnecessarily risky behavior.

Here’s an economic truism: Underpriced goods will be overutilized. If water is free, you’ll leave the hose running while you wash your car. But rising prices lead consumers to reduce consumption and look for substitutes.

The insurance industry is a competitive industry. Insurance companies have strong incentives to evaluate risks carefully and set their policy rates accordingly to protect their assets. Thus, prices for insurance are pretty accurate indicators of risks. The National Flood Insurance Program, and federal disaster insurance and assistance in general, distort this connection.

According to Nebraska Representative Doug Bereuter’s office, the national average for premiums under the National Flood Insurance Program was about 38 percent of the true risk rate. Such underpricing of insurance misleads buyers, creating the illusion of lower risks. As a result, more folks move into flood-prone areas than would if higher, market rates for insurance prevailed.

Not only does the NFIP encourage development in flood-prone areas through reduced insurance premiums, it also pays for the inevitable losses. Since 1978, it has paid out an average of $475 million per year. And, as the New York Times recently reported, “about 30 percent of the total claims go to property owners who hold 1 percent of the...policies issued.”

When insurance is artificially cheap and the government is paying for losses or protection, both property owners and insurers have less incentive to avoid or reduce future damages. But the higher insurance rates a free market would produce in response to greater risks would lead many to think twice about avoiding those risks. If insurance rates in a flood zone are “excessively” high, people respond by not moving or building there, unless they have flood-proof structures.

Of course, such federal largesse comes with strings attached. As the Federal Emergency Management Agency explains on its web site: “Nearly 20,000 communities across the United States and its territories participate in the NFIP by adopting and enforcing floodplain management ordinances to reduce future flood damage. In exchange, the NFIP makes Federally backed flood insurance available to homeowners, renters, and business owners in these communities.”

Since the NFIP has destroyed the signals sent by competitive insurance prices, the government must now add regulations to try to correct the outcome produced by subsidies. Essentially, the government creates its own customers for regulation -- and thus a reason to expand its power -- by encouraging development in high-risk areas. Likewise, it perpetuates the demand for federal disaster assistance.

Such programs inevitably lead to abuse. The New York Times reported an example of a $114,000 home that had received more than $800,000 in flood insurance claims over 18 years -- another opportunity for more legislation and regulation. As Congressman Bereuter noted: “Congress is finally acting to stop the very expensive treading through the water of repetitive loss after repetitive loss.” Such lax (lack of?) vigilance is rarely found in competitive markets. But since government bureaucracies spend other people’s money, they have little, if any, incentive to be careful or thrifty. In fact, most agencies are rewarded for spending more money, so such fraudulent claims might actually be “good for business.”

Is it just for taxpayers to subsidize the risk taking of others? Should we really be paying people to live in disaster-prone areas? For that’s exactly what such policies amount to.

Government programs produce unintended consequences that lead to calls for further government interference. Much of this could be avoided by forgoing the initial intervention. Insurance markets are sophisticated processors and conveyors of information. Meddling with them is risky business.