3.6 EFFECTIVE FLOOD INSURANCE BEYOND THE FIVE PRINCIPLES OF INSU...
2.3.6 Effective Flood Insurance
Beyond the five principles of insurance developed by Swiss Re, for a flood insurance system to be
considered effective. i.e. be financially viable and economically efficient it must also overcome obstacles
that are specific to the insurance of flood risk. Flood risk, in common with other natural perils, is high
impact and very low probability and, as such, notoriously difficult to insure when compared to other more
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easily assessable property insurances such as fire
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. Botzen & Van Den Bergh (2008) describe four
main challenges.
The first challenge in designing an effective flood insurance system is to combat adverse selection.
This is the effect of a relatively small number of property owners who are at greater risk of flood taking
out flood insurance, or at least higher levels of flood insurance, than those who are less exposed to flood
risk. This would lead to a situation where overall insurance costs are spread over few policyholders and
individual premiums are consequently higher than if the risk community were broader. A situation of
adverse selection can result in a negative spiral of ever-increasing premiums as the risk community
shrinks thereby making it less attractive to join. Cherry-picking is a similar phenomenon but from the
side of the insurance companies (Crichton, 2003). It occurs when insurance companies choose only to
insure low risk customers leaving high-risk customers with fewer options as to where they can purchase
flood insurance. The likelihood, again, is of higher premiums for high risk policyholders since the risk
community they become part of will eventually be biased to those with high exposure. Both situations
are most likely to arise when flood insurance is not mandatory. A situation of adverse selection or
cherry-picking will reduce financial viability because the system will be more volatile if insured risks
are not balanced in the system as a whole or between competing insurance companies.
The second challenge arises from the fact that the probability of large-scale flooding is very low but has
a high and unknown economic impact. Often a lack of historical data of flood frequency and impact
makes it difficult for insurance companies to assess risk and calculate actuarially accurate premiums
that reflect individual risk. At both ends of the spectrum, both overly expensive or too cheap flood risk
premiums will lead to economic inefficiency in two ways. Premiums that are below true risk will mean
homeowners are not financially stimulated to avoid building in higher risk flood zones or taking out their
own flood protection measures. If premiums are too expensive, lower income communities will opt out of
flood insurance all together and can become a financial and social burden if they are unable to recover
quickly after a flood has taken place.
The third challenge stems from the fact that when flooding occurs, many properties in the same region
are likely to be affected at the same time - this is termed correlated risk. Correlated risks are more
difficult to calculate accurately when indirect losses are also included, for example a business charging
for lost working days. Any insurer - public or private - will not find it easy to know beforehand what the
limit of losses might be, using standard underwriting tools. In a worse case scenario, a single storm
could bankrupt any national flood insurance system and leave those who are insured with inadequate
compensation to rebuild what has been lost. Unless the government steps in with direct financial aid or
capital loans to prop up the insurance sector there is a risk that the sector will become insolvent and/or
withdraw future insurance.
The fourth challenge is political and institutional. In many countries the government often steps in to
offer financial compensation after a flood. This is to minimise social welfare and economic losses and is
driven by political pragmatism even if it is not considered an official duty of the state
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. A government is
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Fire insurance, for example, is a typical property insurance that is more commercially attractive service for insurance
companies to sell for two reasons. First, because it compensates a risk that differs from flood in that it is more predictable
and therefore an easier risk to assess. And second, it is a peril for which there is greater public awareness and, therefore,
demand (EP, 2013).
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In the most recent 2013 floods in Germany, despite the fact that private flood insurance is available the German
government has already committed to providing ad hoc financial compensation to flood victims (Guardian, 2013). There is a
strong political motive behind this decision. As in 2002, the floods occurred just ahead of national elections. This has led to