Who pays the cost of flooding?

This post was contributed by Dr Diane Horn, Department of Geography, Environment and Development Studies and former visiting scholar at Old Dominion University’s Climate Change and Sea Level Rise Initiative, and Michael McShane, associate professor of finance and co-director of the Emergent Risk Initiative at Old Dominion University. It was originally published by the Pilot.

The U.S. National Flood Insurance Programme is facing rough seas  ahead. The programme is about $26 billion in debt after Hurricane Katrina in 2005 and Sandy in 2012. Worse, a large percentage of US property owners are heavily subsidized and do not pay full, risk-based rates. In addition, flood insurance is required only for certain property owners in high-risk flood zones.

No private insurance scheme would survive in a market where only the high risk buy insurance and do not pay risk-based rates.

The insurance programme has survived for 45 years because it can borrow from the U.S. Treasury when flood payouts are more than the amount paid in by policyholders, paying back the loan with interest in years where there aren’t many floods.

This worked pretty well until the 2005 hurricane season and the massive payouts after Katrina. Since then, much of the programme’s income has gone to cover interest on the debt, with little available to pay the debt down. The situation has resulted in calls for fiscal responsibility and the end of subsidies for all high-risk properties.

In this case, however, the “solution” has caused more problems. The Biggert-Waters Flood Insurance Reform Act of 2012, which aims to phase out these subsidies, has created another set of angry constituents – property owners who are experiencing big increases in their flood insurance premiums.

Bipartisan bills in Congress would delay the move toward risk-based rates. The programme finds itself between a rock and a hard place: those who are calling for fiscal responsibility and the end of the subsidies, and those who are having a hard time affording the new rates.

Ongoing research, part of the Climate Change and Sea Level Rise Initiative at Old Dominion University, is looking at how other countries deal with flood losses in the search for solutions to this dilemma.

Our research started by comparing flood insurance in the United States and the United Kingdom, where flood insurance is completely handled by private insurers. In the U.K., flood insurance is included as part of standard homeowners’ policies. This avoids one of the big problems in the U.S., where even people who live in the floodplain don’t buy flood insurance.

Including flood damage as part of a single policy would solve another U.S. problem: determining whether wind or water caused the property damage. Hurricane Katrina shone a light on this problem. If wind caused the loss, it was covered by the homeowner’s insurance policy. If storm surge caused the loss, the flood insurance programme policy would pay.

However, the use of private insurance in the U.K. doesn’t solve the problem of subsidies. Just like in the U.S., British property owners who live in the floodplain pay a lower rate than they should because flood insurance is subsidized. The difference is that in the U.K., subsidies come from other policyholders; the government doesn’t pay anything toward the cost of flood damage.

The U.K. is moving to a new flood insurance system, however. Under the new scheme, policyholders outside flood-prone areas will pay around $17 per year to make the rates more affordable for the high flood-risk policyholders. Rates will still be high in flood-prone areas but not so high as to be unaffordable, at least not initially. The system is designed to end subsidies in 20-25 years, unlike the U.S., where the national flood insurance subsidies are ending over a five-year period.

In the U.S., some are calling for private insurers to take over the flood insurance programme. However, you would be hard pressed to find a private insurer interested in offering flood insurance. Private insurers could not survive in an insurance market where only those most at risk buy flood insurance; they would need to charge even higher rates for those high flood risk policyholders than the national programme charges. The premium shock would be even worse, and Congress would be under even more pressure to step in and reduce rates.

Floods aren’t going to go away, and whenever a flood occurs, someone has to pay to repair the damage. Even with flood insurance, most policyholders don’t pay a price that reflects their true risk, and most flood insurance policies are subsidized to some extent. The real question is who pays the subsidy.

The U.K. experience shows that leaving everything to the private sector doesn’t work, but the U.S. experience shows that leaving everything to the public sector doesn’t work, either. We need to come up with the right mix of contributions from government, individuals and insurance companies – before the next Katrina or Sandy comes along.

Dr Horn and Dr McShane’s paper Flooding the Market” was published in the November edition of the journal Nature Climate Change.

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What is the point of banning discrimination on grounds of sex in insurance?

This post was contributed by Professor Deborah Mabbett, from Birbeck’s Department of Politics.

On 21 December 2012, a ban on the use of sex as a criterion in pricing insurance came into force throughout the European Union. In a forthcoming article in the journal Regulation and Governance (pre-publication version available now), I have examined how the ban came about and what its significance is.  The ban was originally proposed by the European Commission in 2003, but the Commission was persuaded to drop the proposal. Instead, insurers were required to publish the statistical basis for discriminating between men and women, to show that differences in premiums were justified by differences in risk. This compromise was successfully challenged in the Court of Justice of the EU by the Belgian consumer association, Test-Achats.

At the root of the debate about sex discrimination in insurance was the question of whether discrimination was necessary for the market to function efficiently. Insurers do not use every relevant piece of information when pricing their products. Some information is too expensive to acquire, some is already subject to legal prohibitions (such as information about ethnicity or religion) and some is subject to voluntary restraint (such as genetic information). Furthermore, long-established practices of risk classification become entrenched in insurance. Long use yields long data series that enable insurers to check that their assessment of risk is robust, and consumers get accustomed to conventional discriminatory practices.

What drew the European institutions to disrupt the convention that sex is used in pricing some forms of insurance? One answer is that the Commission was concerned about the rise of defined contribution pensions, where individuals buy an annuity with their accumulated pension savings. Women get smaller annuities than men because they live longer, on average. However, on a straightforward cost-benefit analysis, this did not make a strong case for banning discrimination, as women are likely to pay more now for car insurance. Furthermore, insurers can find other indicators for long life expectancy (such as occupation and family history), and they will find new ways of identifying safer drivers too.

A stronger answer is that discrimination was already prohibited in some states of the EU, so different countries had different rules despite the supposed existence of a single market in insurance. The Court of Justice held that there should be a common rule across Europe. Since non-discrimination is a fundamental right, it held that this should be the basis for regulating the single market.

While insurers resisted this strongly, arguing that it would disrupt the market, their reaction now that the matter is decided is rather muted. On the Today programme on 21 December 2012, the spokeswoman for the Association of British Insurers emphasised that the effects on premiums were unpredictable, that the market remains highly competitive, and that consumers should shop around. The fact is that insurers do not want an extended public debate about discrimination. They prefer the legitimation provided by market competition, which leaves insurers autonomy in determining their pricing strategies, subject to regulatory constraints. Public scrutiny is uncomfortable because it is prone to reveal that insurers’ practices have a weaker technical basis than they like to imply. During the debate on sex discrimination, statistical studies were done which suggested that premium differentials were not always explained by underlying differences in risk, and that some potential alternative predictors were ignored. This should not really surprise us. While insurers have competitive incentives to search for good predictors, they also have marketing reasons to set prices to the advantage or disadvantage of particular groups.

It is tempting to see the ban on sex discrimination as a step towards a more ‘social’ Europe, going beyond the creation of a free trade area and regulating market transactions for social purposes. However, it is not clear what the social purpose really is: the Court of Justice has upheld a principle rather than pursuing a goal. The case highlights that markets are based on conventions which come under scrutiny when they are exposed to cross-national comparison. The ban reconstitutes the European insurance market and adjusts the ‘playing field’ for competition, rather than addressing a social policy problem or promoting equality of outcomes.

(Woman next to car image via Shutterstock.)

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