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The economics of flood insurance
The economics of flood insurance

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2.1 Demand factors: why buy homes in flood plains?

As you’ve seen in Section 1, flooding is at best a miserable and costly affair for the households affected and at worst life-threatening. Therefore, it seems irrational that anyone would opt to live in a flood-risk area, but clearly many UK households do.

Activity 5 Reasons for buying

Timing: Allow 15 minutes for this activity

Think of at least one reason why a household might be living in a flood-risk area. Explain how this might be a rational decision. (A rational decision would be where the household has chosen the option that maximises its well-being or benefit, which in economics is called utility.)

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The decision could be rational if the household knew about the risk and had fully taken on board the cost of making their home flood resilient (for example, using water resistant plaster, siting plug sockets at waist height rather than low down), dealing with flood repairs themselves and/or buying appropriate insurance. To accept these downsides, there would need to be some trade-off against other aspects of living in the area that offset the disadvantages. The offsetting factor might be, for example, the value of being located on flat ground and close to an existing town, perhaps because mobility is limited. An attractive riverside or coastal location might be highly prized. Maybe the home was cheaper than similar properties in other locations, perhaps because the flood risk was reflected in the buying price. Of course, in individual cases, the choice of location might be due to personal factors, such as relatives living nearby.

The decision may also have been rational if, at the time of purchase, there was little or no flood risk and the risk has only arisen since, for example due to the shift towards make-space-for-water policies and/or climate change.

Another potentially rational possibility is that the household knew about the risk, but were confident that, say, the government would put in place adequate flood defences or provide compensation (for example, providing alternative accommodation) if the worst happened. This is an example of moral hazard. It might not be an unreasonable assumption, because housing is such a sensitive social issue. Voters are not keen to be made homeless by flooding and so the government may feel obliged to pick up the welfare bill of supporting those left destitute by floods. However, the household’s decision to live in a flood plain might be less than rational and so a case of bounded rationalityif its confidence in the government were misplaced.

Similarly, the household could have been acting rationally if, although the flood risk did exist and at the time of purchase, the household was unaware of this. This might be because nobody knew about the risk then and knowledge has only now improved due to better flood-risk measurement and mapping or that this particular household did not know of the risk. In either case, there will have been a violation of the information condition for perfect competition. In other words, there is a market failure as a result of imperfect information. (More precisely, this is likely to be a case of asymmetric informationbecause the supplier (builder) presumably knew the risk but the buyer did not.) On the other hand, the household might have had only bounded rationality if they had the information but failed to take it fully into account (for example, over-optimistically assuming that a flood will never happen or the disruption if it did would be minimal).