Insurance, risk financing, compensation and tax relief have two main purposes in the management of flood risk. Firstly, and most obviously, the provision of these financial mechanisms can be used by those at risk to offset their financial risk from flooding. Although these financial tools obviously do not prevent flooding, they allow recovery without placing undue financial burdens on those impacted by flood disasters.
Advantages
The advantages of flood insurance are clear. For low frequency but high impact events, the provision of insurance spreads the risk of financial loss, centralizes the holding of disaster reserves, and should therefore be a more efficient method of financing disaster recovery. Because of this, governments are increasingly beginning to examine insurance as a risk management option.
The second major function of disaster insurance, compensation and tax relief schemes is to reduce risk and damage, via the need for risk assessment and encouragement of risk mitigation (Cummins and Mahul 2009; Kunreuther 2002). If risk is correctly priced then the incentive to mitigate risks exists via premium pricing; many insurance contracts also implicitly require the policyholder to undertake reasonable risk reduction and mitigation activities and this obligation can be made more explicit, or mandatory, for coverage to apply. Similarly, compensation can be targeted to resilient reconstruction, whilst tax schemes have the potential to influence many aspects of reconstruction, including the use or set aside of flood-prone land. As disaster relief funds are increasingly overstretched, and tend to divert finance from other important development programs, the main focus of this section is the potential to move towards insurance.
Disadvantages
Highly relevant in the context of flood insurance, adverse selection and moral hazard are two behavioral phenomena which undermine the efficient operation of insurance markets where there may be information asymmetry (i.e., policy holders know more about the risk they face than the insurer does). This leads to the potential for adverse selection. Those people who are poorer risks than the average will tend to insure; the informational problems imply that the risk will not be priced correctly. As an example, flood risk is often assessed on an area basis, such as the average damage per property in a postal or zip code. But within a particular code some properties may be on raised ground whilst others are not. If insurance is not mandatory, then it is the residents on low ground who will buy insurance and their average claim will be higher than the code average. This results in an under pricing of risk and, potentially, claims which cannot be met from reserved premiums. The adverse selection problem is minimized where insurance coverage is high, or where cover is mandatory. Moral hazard exists if there is no reward for risk mitigation behavior built into insurance products. Policy holders will therefore rely on insurance to offset their risk and undertake no self-protection. Policy holders will therefore rely on insurance to offset their risk and undertake no self-protection. This has been observed to be the case in the UK, where there is no effective mechanism for premium adjustment in the domestic market in consequence of self-protection, partly due to competition but also to transaction costs. The action of moral hazard results in increased damage costs and higher premiums for all. The use of excess charges, regulation and policy exclusions could potentially encourage self-protection (Kunreuther 2002) but may be difficult to enforce in a market-based system. Alternatively, awareness raising and education regarding the intangible
Financial Requirements and Cost
The coverage of natural disasters in general, and flooding in particular, varies a great deal across nations. For buildings, there is an estimated coverage of 40 percent of high income country losses, falling to 10 percent in middle income countries and less than five percent in low income countries. The UK is one of the best covered countries with 95 percent coverage; by contrast, Taiwan’s coverage is below one percent. Although, following this, there is a perception that, flood insurance coverage is universally high in developed countries and the converse in developing countries, this is in fact not the case. Swiss Re has estimated, for example, that in the Netherlands flood insurance coverage is typically very low, whereas in Indonesia it may be as high as 20 percent (Gaschen et al. 1998). Purchase of insurance is highly dependent on a number of factors, including its availability and cost, the level of the provision of disaster relief, general risk awareness, and attitudes to collective and individual risk (Lamond and Proverbs 2009).
Barriers to implementation
To qualify for insurance, risks have to be insurable. From an insurance provider’s perspective insurability equates to:
- Risk that is quantifiable
- Risk that is randomly distributed
- A high enough number of policy holders to diversify risk
- Sufficient chargeable premium to cover the expected claims, and transaction costs, whilst remaining affordable to policy holders.
For market-derived insurance, a profit margin is also necessary. In the context of flood risk, particularly in developing countries, the quantifiable aspect of insurability is problematic. Flooding is less predictable in its onset and outcomes than for other natural hazards; the availability and reliability of historic data in developing countries is low. The cost of insurance may also pose a problem for prospective policy holders in lower income countries. Many households already exist below economic subsistence level and have no money to spare for the purpose.
In a mature market with good information and well-priced risk, the spread of risk should be appropriate. Even in the developed world, however, the steps in development of a mature market may involve insurers accepting patterns of risk which are less diverse and therefore have unaffordable premiums.