Climate change: will the insurance industry pick up the bill?

On November 8, Pam Webb worked a usual day at Truffle Lodge, her spa business in the Yorkshire village of Fishlake, near the River Don. Floods were expected nearby, but an email from the UK’s Environment Agency told her that Fishlake was safe.

The agency was wrong. At 9.30pm the water started pouring into the business and Ms Webb’s home next door. “It came in the front and back, it came up through the flooring in every single ground floor room,” she says. “It’s heartbreaking seeing your home and business going in such a small amount of time.”

The flood caused tens of thousands of pounds in damage and forced the spa to close for nine weeks. Adding to the trauma, says Ms Webb, flooding had been excluded from her insurance policies about a year earlier, so she has had to pick up the entire cost.

It is a scenario that has played out again across parts of the UK over the past 10 days, with two severe storms hitting the country and adding to the cost associated with climate change. Economic damage worldwide from flooding last year was $82bn, the greatest of any natural peril, according to Aon. Just $13bn of that was insured.

Global warming means that flooding is likely to become more frequent, say natural catastrophe modelling specialists. Warmer air holds more moisture, leading to wetter and more frequent severe storms. Last year Nasa used temperature data gathered from space to reveal that every additional 1°C of ocean surface temperature increases the probability of severe storms by 20 per cent. Meanwhile rising sea levels mean more coastal flooding, with some estimates suggesting that 230m people are at risk from storm surges, a risk amplified by steady migration towards conurbations near coasts and rivers.

Those numbers, combined with the lack of cover, should be an attractive target for a global insurance industry that has abundant capital after low interest rates drew fresh investors into the sector seeking better returns. The risk consultancy Milliman estimates that the US market alone could generate $48bn of annual premium revenue for insurers.

Floods were once considered too irregular to underwrite profitably, but sophisticated catastrophe models — which can more accurately predict where floods might occur — have changed that.

“Reinsurance companies want the risk,” says Nancy Watkins, principal and actuary at Milliman. “They have been the leaders, and have been running around trying to sell [flood reinsurance] for four or five years.”

Yet, managing the increased flooding is going to be very expensive. Insurance systems and government programmes have developed haphazardly, and are ill-suited to deal with the growing risks. This is prompting a rethink over which risks should be held publicly, and which privately.

“The world has got enough insurance capital to protect against flood risk,” says Stephen Hester, chief executive of insurer RSA. “It’s a question of whether society wants people who live on flood plains to pay the right price for the risk, or whether there should be some sort of subsidy.”

In the US the National Flood Insurance Program, the federal scheme that provides the overwhelming majority of US residential coverage, has about 5m policies providing $1.3tn of cover. The numbers look large, but only 15 per cent of US households have any flood coverage at all. During 2017’s Hurricane Harvey that hit Texas and Louisiana, 70 per cent of the estimated $125bn in damage was uninsured.

Flood insurance is mandatory for anyone in the US with a government-backed mortgage — that is, most US homeowners — if the home falls into a designated “special flood hazard area,” defined as being at risk of inundation at least once every 100 years.

But the NFIP, established in 1968, was never designed or capitalised to operate like a private insurer. The idea “was to price the product so more people would have it and it would [then] reduce the disaster costs to the government”, says David Maurstad, chief executive of the NFIP. By design, “the government would make up the difference” in above-average years for flooding.

This arrangement worked until about 20 years ago. Between 1978 and 2003, the NFIP paid out claims of under $500m a year. Since then, the claims have averaged $3.5bn a year. Premiums and fees have been inadequate to cover the payouts. In 2017, the federal government forgave $16bn in NFIP debt. Even so, the scheme owes $20bn to the US Treasury.

That the mandatory coverage areas are too small is only part of the problem, say critics. They also give the impression that flood risk stops at a line on a map. In fact, “flood risk varies continuously both within that 100-year floodplain and beyond”, says Carolyn Kousky, executive director of the Wharton Risk Center. Flood risk is not included in US home insurance policies creating the impression, say flood experts, that the risk is incidental or secondary.

These are not the only distortions. NFIP charges premiums that do not vary with the replacement cost of houses, so expensive houses pay below-market rates. It means taxpayers are effectively providing subsidies for luxury beach houses. “The more expensive your house, the better deal you are getting from the NFIP,” Ms Watkins says.

The NFIP is not permitted to withdraw coverage once it is granted, so pays repeatedly to repair and rebuild thousands of homes in high-risk areas. According to the Pew Charitable Trust, such “severe repetitive loss” properties had cost the NFIP more than $12.5bn as of 2016.

Private insurers hesitate to compete against a subsidised product. A warren of state regulations makes matters worse. In Louisiana, for example, raising premiums because of an “act of God” — defined as a storm or other natural cause — is forbidden. Several US states ban or limit the use of catastrophe models in setting premiums.

Various attempts to reform the NFIP and bring premiums into line with the risks have met resistance from coastal residents, their representatives in Congress and the real estate industry. The latest effort “Risk Rating 2.0,” would have linked prices and risk more closely. Originally scheduled to take effect this year, it was recently pushed into 2021.

The UK has tried a different model. Flood Re, the UK scheme, forces all home insurance buyers to chip in to subsidise the cost of cover in flood-prone areas. Homeowners pay about £10 per year over their existing premium and, in theory, insurance for people in risky areas becomes more affordable.

Flood Re was set up by the government in 2016. If it runs out of money, the industry has to top it up, but that has not happened yet. “The political desire at the time [it was set up] was for it to be an industry-owned solution,” says Andy Bord, Flood Re’s chief executive.

To discourage new development in flood prone areas, Flood Re does not apply to homes built after 2009.

Flood Re is only supposed to last for 25 years. The intention was that it should act as a catalyst for better flood planning by the government, local authorities and homeowners, so that by 2041 insurance would be more affordable for people in flood-prone areas, even without the subsidy.

There is scepticism in the industry about whether this is achievable. But Mr Bord says, “four out of five people [in flood prone areas] have made a saving of 50 per cent or more on their home insurance”.

China and Australia are among the countries that have asked Flood Re for details about the design of the scheme.

Flood Re has yet to be fully tested. The years since 2016 have been relatively quiet for UK floods, although recent events such as Fishlake may prove a more rigorous test. It has only dealt with 1,100 claims in total since it was set up, Mr Bord told the Financial Times in January, as opposed to initial expectations that it would deal with 2,000 per year.

But they have to avoid complacency, says Mr Bord. “People are taking action, but not fast enough,” he says. “If you haven’t been flooded, you think it can’t happen to you. If you have, you think it won’t happen again.”

Flood experts agree that, in relatively wealthy countries, the price of living near the water must better reflect the risks, to both stop overbuilding and encourage infrastructure investment. Many also believe that private insurance — the free market — offers the best pricing mechanism.

Yet there is a reason that, as Wharton’s Ms Kousky says, “there is almost nowhere in the world with a fully private disaster insurance market.” Floods, she says, “are concentrated and correlated risks . . . you have lots of quiet years and then a really bad year.” This requires insurers to hold lots of capital, and therefore charge high premiums.

In some areas high premiums would bring down the prices of prime real estate. In others, they would force out low-income residents. The political barriers to either are high.

Barry Gilway, chief executive of Citizens, a Florida-based property insurer, uses the example of Florida Keys. “Without subsidisation no homeowner could really afford to live or build in Monroe County due to the extremely high costs of funding the risk. After Hurricane Irma [in 2017] they had to rebuild to new building codes. While absolutely appropriate, that is very expensive. With no affordable housing and extremely high insurance costs, where do all the people in the service industry live?”

A few steps would make the public-private balance easier to achieve. Investment in detailed public flood maps would also help increase risk awareness and improve underwriting. The First Street Foundation, a non-profit group, has begun work on this in the US, but public investment is required. “We need an atlas of flooding,” says Stijn Van Nieuwerburgh, a real estate economist at Columbia University.

Ms Kousky of Wharton recommends a system modelled on the way terrorism is insured in the US: a private market with insurers backstopped by the government. ‘We want to have some amount of risk-based pricing [but] that’s perfectly do-able even with a government backstop at a very high level.”

Following the example of the UK, new buildings could be excluded from subsidy programmes. Alternatively, people could be given help to make their homes more resilient, so that future floods cause less damage and cost less to repair. Flood Re wants to be able to cover victims not just for the costs of repairing damage but also to “build back better”.

“Flood risk management cannot be done by the insurance industry alone,” says Konrad Schoeck, a flooding specialist at reinsurance group Swiss Re. “It needs to be the insurance industry, the government and private homeowners.”

It may be that the suffering caused by flooding is not yet enough to force hard choices. But with waters continuing to rise that is unlikely to remain the case.

“As levels of risk rise, there will be more questions about uninsurability and what you do about it,” says Arno Hilberts, vice-president at risk modelling company RMS. “You will reach a threshold where insurance systems don’t really work.”