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The economics of flood insurance
The economics of flood insurance

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4.2 Compensation through insurance

In Video 2, the last option mentioned by Matt Georges on the spectrum of options for dealing with the problems faced by people living in homes on flood plain is the option of compensating people through insurance if the worst were to happen.

Private insurance is a way of transferring the financial risk of particular events occurring so they are borne by the insurer rather than the bearer of the underlying risk. For a charge (premium) usually paid at regular intervals, the purchaser (policyholder) can have peace of mind, knowing that if the worst were to happen, they could make a claim and receive a sum of money (the payout). However, it is common for the insurance contract to require the policyholder to still bear part of the financial risk themselves in the form of an excess.

Theoretically, there are two ways in which insurance can be provided: on a mutual basis or on a commercial basis. However, in practice, contemporary insurance involves elements of both. Mutual insurance works through risk pooling, which means the risk of suffering a loss is pooled and spread across a large number of people who collectively cover the cost, all paying the same or similar premiums. There is a cross-subsidy from those in the pool who pay the premiums, but do not claim compensation, to those who do claim. However, all benefit from the peace of mind of knowing that if the adverse event did occur, their losses would be covered.

Historically, commercial insurance began with brokers agreeing to cover losses of cargo on trading voyages due to uncontrollable events (theft, weather events, disasters etc.). Rather than the mutual system, in which a pool of cargo ships bearing similar risks might have pooled similar premiums to cover losses, commercial insurers made estimations of the individual risks involved in a voyage and decide on an appropriate premium for the insurance requested. This relied on using data garnered from many previous voyages as the basis for estimating the risk posed by a particular voyage. An appropriate premium could then be charged to reflect the likelihood of having to pay out for losses, with more risky ventures attracting higher premiums than those deemed to be safer. This approach is called risk-based pricing. In this system, there is little or no cross-subsidy between policyholders: each pays according to the risk they represent.

In practice, commercial insurers today use a mix of risk-based pricing and risk pooling to offer private commercial insurance. This involves risk segmentation by which consumers are divided into ever smaller groups with each group paying different premiums according to the risk of their claiming. The ability to segment risks in this way relies on good sources of data. As data improves and becomes more granular (allowing for finer and finer detail about smaller and smaller groups), it becomes increasingly possible to tailor premiums to ever smaller segments and even to individual policyholders.

Another possible type of insurance would be social insurance, in which the premiums would effectively be paid as taxation and the necessary pay outs, in case of a negative event, covered through help from the government welfare system, such as cash benefits for disrupted livelihoods, state-organised housing for those temporarily displaced, and so on.

In the case of household flooding, the UK has a well-established private insurance market, with cover for flood risks bundled into their buildings and contents insurance.

Homebuyers who have a mortgage are expected to have buildings insurance as a requirement of their loan in order to protect the value of the home the mortgage is secured against. Homeowners without a mortgage have an interest in taking up buildings’ insurance because of the potentially disastrous consequences of damage to, or total loss of the home, due to perils such as fire and subsidence, not just flooding. Households in rented accommodation do not themselves buy buildings cover – this is the responsibility of their landlord who may, nevertheless pass the cost on in the rent charged – but may take out contents insurance which will include flood cover for their possessions.