Affordable flood insurance for everyone – but who is going to pay for it?“We support the direction of the NDIR. We like the idea of limiting Government intervention to the small number of high risk properties and have developed a straw man proposal based on the NDIR framework. Good quality, public domain flood risk mapping is the key to an effective solution.”

BackgroundThe National Disaster Insurance Review (NDIR) was set up by the Federal Government in the wake of the devastating floods in January 2011 that affected south-eastern Queensland and other areas.

Unlike most other natural perils, flood is not always covered under a homeowner’s insurance policy and there is significant consumer confusion over what cover they might have. As a result the insurance payout for these most recent floods - while estimated to be in excess of $2.6 billion - will fall well short of the flood damage suffered by homeowners and businesses.

For more information on the fundamental difficulties of insuring for flood, please refer to our earlier flyer http://www.finity.com.au/publication/the-challenge-of-insuring-homes-for-flood/

The NDIR, chaired by former APRA member and insurance executive John Trowbridge, was established to find a solution to the availability and affordability of flood insurance offered by the private market.

The National Disaster Insurance Review (NDIR) has recently released a paper on a proposed way forward for flood insurance. In this newsletter we –>>

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d’finitiveNew answers to an old question. JUNE 2011

[ Flood ]

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Proportion of Dwellings Ranked by Flood Risk (%)

Full Flood Premium

Market Solution with Risk Based Pricing

Government InterventionPremium Relative to Non-Flood Premium (%)

NDIR’S PROPOSED APPROACH

1,000800

400

200

150

100

0

0 97 98 99 100

Note: All numbers are illustrative only

NDIR Proposals so farThe NDIR released its issues paper on the provision of flood insurance at the end of May. The proposed way forward includes two key elements –

1. Market solution and risk-based pricing for the vast majority of homes that have a negligible or modest exposure to flood (referred to as minimal or moderate flood risk)

2. Government intervention in the market for existing properties which have a high flood risk to ensure that flood insurance for these properties is both available and affordable; this intervention will include subsidised premiums for high flood risk properties to ensure that insurance premiums remain affordable.

The following diagram adapted from the NDIR issues paper provides a representation of the proposed approach.

The Issues Paper proposes the establishment of a central vehicle – referred to as the Flood Insurance Pool (or FIP) – to manage the premium subsidies for the high risk properties. The role of the FIP may include some or all of risk assessment, pricing, managing claims and determining the pool funding requirements. The full Issues Paper can be found at: http://www.ndir.gov.au.

In general terms we support the direction of the proposals - particularly the recognition that a market solution for high flood risk properties is not practical. We agree that the focus of the solution should be on these high risk properties rather than the entire market. However, there are many questions still to be addressed and the success of the solution will depend on how those questions are dealt with.

Non-Flood Risk Premium

Aggregate Premium Subsidy

Consumer Flood Premium

Key criteria a flood solution must address

1. Financial responsibility for paying claims and pricing risk must go hand in hand

2. Disputes over what is and what is not covered need to be minimised

3. The solution must recognise and reward mitigation efforts

4. The aim of all stakeholders should be to minimise the level of Government intervention and to reduce this over time

5. The solution should not discourage market entry for insurers

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Understanding the affordability issueBack in 2005 when the insurance industry was making a serious effort to deal with flood insurance, some modelling was undertaken to establish the scale of the problem. Note that this modelling was approximate, did not benefit from the information in the National Flood Information Database (NFID), and has not been updated or validated against recent experience.

The results should, though, be sufficiently reliable to understand the scale of the problem, and are reproduced in the table below.

The first two rows of the table show that there are 6 million properties with sufficiently small flood risk that there should be no affordability problem for consumers and the insurance market is able to provide cover.

The last two rows, representing about 100,000 properties, are the core of the issue – affordability is such a major issue for consumers that private market cover is not viable.

And then there are those in the middle. We were interested to note that the NDIR suggests an affordability threshold of say a 40% premium increase to add flood cover. The 2005 modelling suggests that a threshold at this level might require the flood pool to be extended out to the 1 in 250 year level, rather than being restricted to the 1 in 100 or 1 in 50 year level.

It will be important that the NDIR has access to robust premium estimates in order for the recommendations it makes to be properly costed and economically feasible.

It is also relevant that the majority of the cost of flood risk arises from the relatively small number of properties with high risk (more than 1 in 50 years). In order to keep the overall proposal affordable, it may be sensible to limit the flood cover available to these properties.

APPROXIMATE SCALE OF THE PROBLEM

Approximate number of properties

Estimated flood risk premium as % of non-flood premium

No flood risk 5.8 million Nil

Little flood risk (floods expected to occur less often than 1 in 250 years) 200,000 Up to 30%

Some flood risk (floods expected to occur once every 100 to 250 years) 50,000 30% to 70%

Medium flood risk (floods expected to occur once every 50 to 100 years) 50,000 70% to 150%

High flood risk (floods expected to occur once every 20 to 50 years) 50,000 150% to 400%

Very high flood risk (floods expected to occur more often than 1 in 20 years) 50,000 > 400%

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A ‘straw man’ proposal for the Pool

In order to stimulate thinking about the proposals, we put forward here a ‘straw man1’ - one way that the Pool could be structured and funded – building on the framework proposed in the NDIR paper.

For the purpose of the straw man we assume that there will be a central agency (the ‘Flood Insurance Pool’) that is responsible for flood mapping and risk assessment as well as managing the subsidised flood cover for high risk properties.

FIP assesses the flood risk

The Flood Insurance Pool (FIP) flood maps will identify all ‘high risk’ properties, and if the owners of those properties buy insurance they will be automatically included in the Pool and will automatically get flood cover.

A high risk property owner will pay a defined Flood premium on top of their home premium, specified by the FIP, and retained by the insurer. The FIP will also determine what the full flood risk premium would be for each property – the difference between this amount and the consumer flood premium is a measure of the subsidy. In the event of a flood, the insurer handles claims in the normal way (subject to protocols agreed with the FIP) and benefits from a reinsurance treaty provided by the FIP. The reinsurance is in the form of a variable quota share for flood peril only. The proportion of the claims paid by the insurer is –

CONSUMER FLOOD PREMIUM

FULL FLOOD RISK PREMIUM

This will mean that insurers retain a large share of properties which are just above the FIP high risk threshold, scaling down for the highest risks. The FIP flood maps will have specified the risk level (and hence the policyholder premium and the insurer’s recovery proportion) in advance.

HOW THE VARIABLE QUOTA SHARE WORKS

Risk Level Low Medium High

PREMIUMS AS A % OF SUM INSURED

Full Flood Risk Premium 0.05 0.07 0.10 0.25 1.00 5.00 10.00

Consumer Flood Premium 0.05 0.07 0.07 0.07 0.07 0.07 0.07

PROPORTION OF CLAIMS MET BY:

Insurer 100% 100% 70% 28% 7% 1.4% 0.7%

Pool nil nil 30% 72% 93% 98.6% 99.3%

Advantages of the variable quota share structure

>> Minimum interference in the market mechanisms

>> Insurers keep control of the customer relationship and the claim process

>> Insurers have ‘skin in the game’ and receive a fair premium for the risk they take

>> Funding partly in arrears minimises the economic impost.

1 A ‘straw man’ is a possible solution put forward to aid thinking, not necessarily the best or only solution for a problem

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Funding the Flood Insurance Pool

The ‘straw man’ variable quota share structure describes what the consumer and the insurer pay, but it does not explain how the Pool is funded to meet its share of any flood claims that occur.

We think it makes sense for the FIP to be funded partly in advance and partly in arrears after an event occurs. The ‘in advance’ funding, or regular annual premiums, could come from three sources:

>> A Federal Government premium paid from the National Disaster Management budget (say equal to the total of all consumers’ flood premium)

>> State Government premiums, set based on the degree to which past actions of the State have contributed to the extent of high risk properties, and with future reduction based on mitigation activity

>> A Local Council premium, varying with the number of high risk properties in the Council area, and significantly higher if the flood mapping for the Council area is not up to FIP standards.

The total ‘in advance’ funding might be of the order of $50m to $100m per annum, sufficient to fund the operations and research of the FIP and build up a modest fund from which to pay claims.

In the event of a major flood, the FIP fund will not be sufficient to meet all claims (by design). The FIP will have pre-arranged funding to pay claims, similar to the terrorism pool (ARPC), and will then increase the premiums paid over the next few years to repay the funding. The time period over which losses are spread would depend on the size of the event.

Limiting the scope of cover and the subsidy

In order to limit the extent of the subsidy and reduce moral hazard, we suggest there could be limitations on what the FIP should cover, such as:

>> Indemnity cover only, not replacement

>> No cover for fences or outbuildings

>> Minimum excess of say $1,000 (if an insurer wanted to meet this excess they could)

>> Maximum cover of say $500,000 indexed (not overly subsidising the wealthy).

HOW KEY FEATURES OF THE FIP MIGHT COMPARE WITH THE ARPC MODEL

It makes sense for the FIP to be funded partly in arrears after the event occurs. This will prevent the build-up of a large pool of funds and minimise the upfront economic impact on all parties.

ARPC FIP

Peril Act of terrorism as declared by Attorney-general

Flood definition to be agreed. Possibly including flash flood. Possibly landslides and actions of the sea

Scope Commercial property, business interruption, public liability

Residential buildings; possibly contents, strata, small commercial

Form of contract Reinsurance – excess of loss Reinsurance – variable quota share

Claims handled by Property insurer Insurer

Funded from Premiums on insured property Premiums from governments

Financial backing Invested fundsLine of creditRetrocession programGovernment guarantee

Invested fundsLine of creditGovernment guaranteeCould be retrocession in future

Liaises with National Security National Disaster Management

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Flood mapping is critical to the solutionThe existence and availability of good quality flood risk mapping is a critical component of any solution. The risk analysis needs to include vulnerability and damage functions as well as risk of inundation. The laudable efforts of the insurance industry to create such maps (the NFID) were partially successful, and we think it is time for that task to be passed to a new agency such as the FIP.

The existing NFID is a great start, and the new mapping solution should include the following features:

>> Legislative compulsion for state and local governments to share information

>> Open availability to insurers, public, etc based on the geo-coded property address

>> Scientifically developed and agreed standards

>> Defined processes for review and update, especially in respect of new land developments and mitigation projects

>> Governance that includes scientific and stakeholder input but is ultimately controlled by science.

Great care will be required around both public release of data and the use of that data as the quality of mapping comes up to the requisite level.

Determining the High Risk Threshold

In line with our view that mapping is critical, we think the high-risk threshold needs to be set independently of the insurance market (the “engineering solution” described in the Issues Paper).

We can’t see how the “price threshold” (i.e. insurance market solution) could work given that there is no objective measure of premiums by peril at present, and the potential for gaming is too great.

Managing the Flood Insurance PoolWe understand the nervousness that some in the insurance industry feel about government intervention in the market. Nevertheless, it seems clear that the economics of flood risk (essentially the concentration of high risk properties) makes an affordable complete market solution not possible.

The details of government involvement need to be carefully thought through so as to make the solution effective but limit the risk of unintended consequences. The terrorism insurance solution (the ARPC) is a model worthy of examination in this regard, although the issues of terrorism risk and flood risk are not the same. One key difference is that we hope the ARPC will never have to meet a claim, while it is inevitable that the FIP will.

Governance and management of the FIP

The FIP should be charged with provision of information to homeowners, insurers and all levels of Government on flood risk and flood affected properties. Over time the aim would be to:

>> Reduce the flood risk for the existing stock of flood affected properties

>> Increase the high-risk threshold

>> Increase consumer flood premiums and therefore reduce the FIP quota share proportion

>> Reduce any under-insurance of high risk properties

>> Influence the development of new high risk properties, and ensure subsidy is not extended to them.

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Are there other models besides Automatic Flood Cover or Automatic Flood Cover with Opt Out that could improve availability and affordability?

We are suggesting Automatic Flood Cover for high risk properties as the most effective mechanism to extend insurance cover, reduce disputes and increase certainty for all parties. The straw man solution does not require any particular flood cover model for properties outside the high risk criteria.

Identifying homes with high flood risk

We favour objective criteria which are independent of the insurance market and price as this provides greater certainty and control regarding the size of the FIP.

Risk and premium transfer between insurers and the FIP

In the straw man model the amount of risk transferred from insurers to the FIP is commensurate with the severity of the flood risk – the more severe the flood risk the greater the transferred risk. The risk transfer method is a variable quota share reinsurance. The model does not require premium transfers between insurers and the FIP.

How might the FIP be structured?

Rather like the ARPC.

Role of FIP in flood risk measurement

The FIP should collect, analyse and make available information on flood risk for all properties.

Funding premium subsidies This should be from a combination of Federal, State and Local Government and does not need to be all in advance.

Should the flood insurance model include contents, strata title, caravans, etc?

In principle yes, although mitigation and moral hazard issues are more difficult.

Should the flood insurance arrangement extend to small business?

While a few types of business might need to be excluded, in principle the flood arrangements should extend to property owned or occupied by small to medium businesses.

Should home insurance be compulsory?

No - the problem identified is not with home insurance per se but with affordable flood cover for the small proportion of high flood risk properties.

Extending the scope of cover to landslide and actions of the sea?

Once the mechanics of a flood solution are developed, this can then provide a framework to extend the scope. Action of the sea warrants serious consideration with storm surge as the key issue especially given the likelihood of rising sea levels.

Response to the NDIR questions

We have not tried to respond to all of the questions raised in the NDIR issues paper and this note deliberately considers only residential property insurance. The straw man model does however lead to responses to some of the NDIR questions.

Flood and other natural perils

Individual insurers will need to consider their own position and the challenges for them in participating in any solution. In our view, with industry support and the current focus of Government, there exists a real opportunity to develop a considered approach to covering high flood risk properties. There has never been a better opportunity to deal with the thorny problem of flood insurance.

Contacts

Geoff Atkins geoff.atkins@finity.com.au 02 8252 3337

Colin Brigstock colin.brigstock@finity.com.au 02 8252 3330

Ian Burningham ian.burningham@finity.com.au 02 8252 3415

Steve Curley steve.curley@finity.com.au 02 8252 3326

Ada Lui ada.lui@finity.com.au 02 8252 3409

Pravesh Ponna pravesh.ponna@finity.com.au 02 8252 3357

This article is based on Finity’s current understanding of the NDIR. It does not constitute either actuarial or investment advice. While Finity has taken reasonable care in compiling the information presented, Finity does not warrant that the information is correct.

If you would like any further information, or would like to discuss your specific issues please contact your normal Finity contact, or any of the consultants from our flood team.

Finity has been assisting insurers with a number of natural peril pricing

studies. These include a syndicated study for Home insurance. A similar

study will be commencing shortly for Commercial Fire. We have also been

assisting insurers with their flood rating, including how to deal with the gaps in

the industry flood database NFID. Please contact Tim Andrews on (02) 8252 3385 if you would like

to learn more.

Finity Consulting Pty Limited ABN 89 111 470 270

Australia & New Zealand Insurance Industy Award ‘Service Provider of the Year’ 2006, 2007, 2008. 2009.

Contact the Author

Geoff AtkinsTel + 61 2 8252 3337geoff.atkins@finity.com.auSydney Office

Australia

Sydney

Tel +61 2 8252 3300 Level 7, 155 George St The Rocks, NSW 2000

Melbourne

Tel +61 3 8080 0900 Level 3, 30 Collins Street Melbourne, VIC 3000

New Zealand

Auckland

Tel +64 9 363 2894 Level 27, 188 Quay St Auckland 1010

Wellington

Tel +64 4 460 5213 Level 16, 157 Lambton Quay Wellington 6140

d’finitive[ Flood ]

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