The economics of flood insurance
The economics of flood insurance

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The economics of flood insurance

6 Conclusion

In this short-course you have learned about the management of flood risk with regards to residential properties. You used economic approaches to understand why sellers and buyers might choose to build or buy homes that have a high risk of flooding. You considered how the private market for high-flood-risk homes can suffer from externalities that means the market over-supplies these sorts of properties and imperfect information that means demand is also too high.

You considered private insurance as a key way that the UK has historically managed flood risk. Yet, the UK flood insurance market has undergone a lot of changes and the ‘Gentleman’s Agreement’ that prevented the flood insurance market from charging entirely risk reflective prices began to crumble after 2000. After the Statement of Principles of 2008, it was clear that the market would shift to fully risk-reflective pricing in 2013 if the government chose to do nothing to stop it.

You looked at how the economic technique of the cost–benefit analysis (CBA) was used by the UK government as an aid to weighing up its policy options. While CBA generally focuses on the total costs and benefits to society in terms of real resources, you saw how distributional aspects of a policy can be taken into account using equity weighting, a technique based on the economic theory of diminishing marginal utility.

Despite not being the best option according to the government’s CBA, the final decision of the UK government was to adopt a scheme called Flood Re under which households at higher flood risk pay subsidised premiums for their home insurance. Flood Re is due to run until 2039. It is intended as a 25-year gradual transition to risk-reflective pricing, which will ease the pressures on the insurance market, but not expose high risk households to a sudden rise in their premiums. The ultimate government aim is to foster the free market to provide the socially optimum number of homes in flood-risk areas with prices there reflecting the true risks and costs corrected for the current market failures. There are challenges to achieving this transition, not least of which is that planning authorities, developers and households will not necessarily use the breathing space afforded by Flood Re to adjust their behaviour in the way the government hopes.

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