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The economics of flood insurance
The economics of flood insurance

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5.1 Problems with affordable flood insurance

Section 1.3 noted that that UK flooding in the year 2000 created a turning point for the insurance market. Up to then, there had been a ‘Gentlemen’s Agreement’ whereby insurers who were members of the Association of British Insurers (ABI) agreed to provide affordable private flood insurance for all, provided the government invested in flood defences. This meant lower-risk households cross-subsidising the cost of flood insurance for those at higher risk.

However, the Agreement created what has been called ‘systemic moral hazard’ (Huber, 2004). Since affordable flood insurance premiums understated the true cost of high flood risks, there were perverse incentives for: households to ignore flood risk in their decisions about where to buy and making their homes more flood-resilient; and for developers to build on flood plains. The first decade of the new millennium brought matters to a head because a number of factors collided:

  • The cost of flood claims was escalating and set to get worse because of climate change.
  • New insurers were coming into the market who were not bound by the Gentlemen’s Agreement and so could cherry pick low-risk homes, exacerbating adverse selection for ABI members.
  • The government started to favour ‘make space for water’ approaches to flood management which included allowing flood plains to flood.
  • Despite central government starting to advise against building on flood plains, local authorities were still approving such developments and unlikely to stop given general pressure for the economy to provide more homes.
  • Advances in flood-risk estimation and mapping were making it increasingly feasible for insurers to solve their problems by switching to risk-based pricing for flood insurance.

As a result of all these factors, the Gentlemen’s Agreement collapsed.

Between 2000 and 2013, there was a series of temporary agreements (Statements of Principles) between government and the ABI, but with the insurers no longer guaranteeing to provide flood cover for all or at affordable prices. By 2013, there were numerous news stories of households being charged thousands of pounds for home insurance and facing huge policy excesses or being unable to get cover at all. This had a knock-on effect with lenders unwilling to grant mortgages on flood-risk homes and thus existing owners within flood-risk areas being unable to sell their properties. The last Statement of Principles (ABI, 2008) was due to expire in 2013 and, if nothing took its place, full-blown risk-based pricing for flood insurance looked set to take off.

Activity 9 Winners and losers

Timing: Allow 5 minutes for this activity

Who would have been the winners and losers from risk-based pricing for flood insurance in 2013?

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You may have thought of other groups, but here are the main ones:

  • Winners: households at low flood risk whose insurance premiums would no longer subsidise high-risk households; ABI insurers who would no longer be at a competitive disadvantage to newer insurers not party to any agreement to offer affordable insurance; the economy as a whole since resources would be allocated more efficiently.
  • Losers: households at high flood risk who would pay more for insurance or, if unaffordable, have to go without; uninsured households affected by flooding; homeowners in high-risk areas unable to sell their homes; local communities where uninsurable and unsaleable homes could undermine local living standards and the local economy.