5.4 Taking fairness into account
In the type of CBA carried out by government policymakers, called a ‘social CBA’, economists are concerned about the cost in terms of additional resources, since they could have been used by the economy in alternative ways (in other words, they have an opportunity cost).
Similarly, economists are interested in additional benefits for the economy as a whole. This means that transfer payments from agents in one part of the economy to agents in another (such as taxes used to pay for benefits or, in the case of flood insurance, a subsidy from better-off households to less well-off ones) cancel each other out and so are not in themselves a cost or benefit to the economy as a whole. As the government puts it: ‘Transfers pass purchasing power from one person to another and do not involve the consumption of resources’ (HM Treasury, 2018, p. 40).
Moreover, while the costs and benefits may affect different groups differently, CBA generally aims to identify the option that will maximise net benefit (find the biggest benefit minus cost) overall, rather than for a particular group. So CBA aims to maximise the net benefit generated (the pie), rather than to decide which groups bear the costs (pay for the pie) or enjoy the benefits (get slices of the pie). This may at first seem counter-intuitive or unfair, because the benefits may not fall on those who bear the costs, or might benefit those who need help least. However, the CBA can be modified to take into account the perceived fairness (also called equity) of a policy. One way of doing this is through ‘equity weighting’ (also called distributional weighting).
Under the Flood Re scheme, when an eligible higher-risk household buys home insurance, the household pays less for flood-risk cover part of its home insurance. However, the scheme was designed so that lower-income households receive a bigger subsidy than better-off households.
The scheme needed an easy way for insurers to identify low-income households. Imagine the extra admin and suspicion if people had to declare their income when buying home insurance! The chosen solution with was to use Council Tax bands since they are readily identifiable from postcodes and broadly correlated to income level (with lower-income households tending to live in lower-valued homes which are covered by the lower bands, such as A to D). This is an example of how doing a CBA must often be very pragmatic, using the data available (in this case, Council Tax bands) as a proxy for what the analysts want to measure (in this case, household income).
Table 1 shows how the premium for flood-risk cover was capped at different levels for households in the different Council Tax bands. For example, the maximum the lowest-income households (in Band A) would pay for flood cover would be £210. This would reduce their home insurance premium from an average £1,140 under fully risk-based pricing to £650 under the Flood Re scheme. That’s a reduction of £490; in other words, the average Band A household receives a financial subsidy of £490.
Table 1 Expected impact of Flood Re on home insurance premiums by Council Tax band for households at higher risk of flooding
|Baseline: fully risk-reflective premium for combined buildings and contents insurance||£1,140||£1,165||£1,185||£1,290||£1,430||£1,560||£1,850|
|Flood Re: cap on flood-risk part of the premium||£210||£210||£246||£276||£330||£408||£540|
|Cost of other cover in home insurance plus insurer overheads and profit||£440||£440||£474||£524||£590||£692||£1,010|
|Flood Re scheme: expected premium for combined buildings and contents insurance||£650||£650||£720||£800||£920||£1,100||£1,550|
|Reduction in premium (financial subsidy)||£490||£515||£465||£490||£640||£300|
Activity 10 The financial cross-subsidy
1. Using the data in Table 1, what would the average financial subsidy per household for band E households be?
The answer is £510. This is the difference between the fully risk-based premium (£1,430) and the premium under the Flood Re scheme (£920).
2. Explain why the financial subsidy each eligible household receives would not normally affect the outcome of the CBA.
The financial subsidy is a cross-subsidy from all households who buy home insurance to those households in the table who are at higher risk of flooding. As such, it is a transfer payment from some households to other households. Since it does not involve the use of resources, it is not included in the CBA.