Flood Re - Set up to fail?

The controversy surrounding Flood Re shows no sign of disappearing.  Flood re chief executive Brendan McCafferty and newly appointed chairman Mark Hoban have a struggle on their hands if Flood Re is to be the panacea for tackling the effects of climate change in the UK.

It’s not simply a case of increasing the level of Government spending on flood defences, although sadly, expenditure on flood defences between 2011 and 2015 will be nearly £250 million lower than in 2007 to 2011. Insufficient investment will increase the frequency and severity of flooding and exclude more homes from the scheme, leaving us ‘back to the future,’ where a large number of homeowners cannot get flood cover. And don’t forget, businesses are not even included in Flood Re to start with, a major omission.

Even if more money can be found, there are serious concerns about the viability of the entire Flood Re model.

Currently Flood Re’s model is predicated on estimates that between 200,000 and 500,000 properties are at risk of flooding. At 200,000, the portfolio is likely be very high risk, but greater than 500,000 means the levy, currently slated to be £10.30 per policy, will be insufficient to subsidise those homes ceded to the pool.

The pool will need several years of benign weather to build up sufficient reserves, but there is every possibility that attritional weather event losses from the start will prevent the buffer building up and/or drive up the reinsurance costs. Flood Re will be forced to raise the cost of the levy, risking public opinion. The 2007 floods alone cost the economy £3.2bn, and a similar event will wipe out the pool overnight. In New Zealand, the Christchurch earthquake emptied the EQC (Earthquake Commission) reserves after 25 years of building it up, and that won’t ever be replaced. A significant North Sea surge that causes major flooding in London will do the same, no matter how much cash is in the Flood Re pot.  

The Government and the insurance industry must come up with a different answer. First of all, insurers need to pool their flood mapping data, and utilise historical data from weather stations to get a much truer picture of at risk properties. Granular flood risk data will enable insurers to price more accurately for flood, making a market and so shrinking the at-risk pool to significantly poorer performing properties (below 200,000) that are picked up by Flood Re.

Or, if the at risk incidence is higher (say more than 500,000 homes) they will cede more of those properties to Flood Re. A higher number of homes will allow Flood re to optimise the portfolio, improve loss rations and reduce reinsurance costs.

A third way is to use parametric pricing, a form of insurance which uses technology and historic weather data to hedge against rainfall and river level heights that exceed long term averages.  Armed with granular flood risk data, Flood Re could take out a reinsurance-backed contract – potentially over a three-year period - that pays out should rainfall and river levels exceed normal conditions. In this way, the pool is protected from running out of money, and policyholders are further protected against an unpopular increase in the levy.

Many different businesses are already using this form of insurance to protect their balance sheets and put a ceiling on weather-related losses. There is no need to prove a loss, either, because the policy pays out on the basis of rainfall over a pre-agreed level.  If CFOs of major corporations use this form of insurance, there is no reason why the Chancellor of the Exchequer shouldn’t be interested in it too.

The insurance industry and the Government have, to date, focused on traditional types of insurance to resolve a very modern problem. Flood Re is a knee jerk response to the specific issue of climate change, and as it is currently constructed, Flood Re is set up to fail. Parametric pricing is being used more and more around the world to mitigate the devastating effects of climate change. Britain, however, is in danger of missing the opportunity and paying a very large bill as a result.