5. HOW
THE RESEARCH
IS HELPING
INSURERS
5.1 To put the application of output of
data into context, it is necessary to understand the commercial
and regulatory factors which affect insurers operationally. Like
other businesses, insurers must perform to the satisfaction of
shareholders so must aim to produce returns on investment which
are "equivalent" to those other businesses. However,
the volatility of claims and the need for insurers to be "secure"
has led to insurers being tightly regulated. Because of this,
the amount of business an insurer can write is determined by their
capital base and the ratio of premiums to capital is rather confusingly
called the "Solvency Margin"—though solvency ratio
would be more correct. The Department of Trade and Industry makes
an assessment of each insurer's solvency margin against set criteria
and judgement all applied on a "prudential" basis.
5.2 Individual insurers try to obtain sufficient
premium to cover their potential exposure and to do this they
need to understand the underlying risk. Put simply, the output
of the Halcrow research can be applied to this end by analysing
the areas at risk against the locations and post codes of insured
properties to establish aggregate portfolio exposure. Insurers
can then determine the premium income they need and the level
of premium for different risk locations.
5.3 Insurers usually have to operate with
the support of reinsurers to give them added capacity or to reduce
the financial consequences of a catastrophic loss. These reinsurers
need to be satisfied that the insurers they are backing are not
themselves overexposed and also require the technical evidence
the research provides in order to take on these risks.
5.4 The data analyses from the original
study were, therefore, able to assist the insurers to:
— assess their overall exposure;
— determine the correct premium rates
to charge; and
— provide information to reinsurers
to gain their "capacity" and "catastrophe"
support.
5.5 Only a few years ago, insurers could
buy ample reinsurance protection for major storm or flood damage
at a relatively low cost. Things are very different now. Due partly
to the storms of 1990, which cost insurers £2,400 million,
reinsurance premiums for the biggest UK insurers increased fourfold,
while the amount of protection reduced significantly. Insurers
recovered 60 per cent of their losses from the 1990 storms from
reinsurers, now they would recover only 20 per cent. With concerns
over the potential impacts of climate change, insurers and reinsurers
are now much more aware of the need to manage accumulations of
exposure.
5.7 This has been a major driving force
behind the desire of insurers to harness new technology such as
geographic information systems (GIS) and to use flood and storm
etc data in increasingly advanced catastrophe models.
Macro: Modelling and Estimated Maximum Loss
5.8 In the past, historic claims experience
was a good measure for predicting future risk. Nowadays insurers
recognise that the world is changing too rapidly for them to be
able to rely solely on this method. Insurers need to be more precise,
and one way to do this is to analyse the concept of risk by looking
separately at its component parts: hazard, vulnerability and exposure.
Insurers can then build predictive models and compare them with
historic results.
Hazard
5.9 The hazard is a combination of frequency
and severity. In the case of flood, the probability of flood and
the depth of flood are important, but other factors have to be
considered; how much warning can be given, the velocity of the
water, whether it is freshwater or salt water, the extent of contamination,
and the duration of inundation. All of these have an effect on
the amount of damage. The hazard is largely outside the control
of insurers, and is changing all the time, not just due to climate
change, coastal erosion, sea level rise and tectonic tilt, but
other factors, such as deforestation, loss of flood plains and
urbanisation which all tend to increase the hazard or move it
to new areas. In such circumstances, insurers are very interested
in the standards of sea and river defences and how much protection
they provide, hence the ABI's commissioning of the Halcrow studies.
While hazard is hard to manage, the other sides of the triangle
are perhaps more controllable; there is an analogy here with the
water industry in the South East of England; they are currently
facing up to the problems of projected reductions in precipitation
and possible water shortages, by looking at ways to manage demand
through metering and consumer awareness. Insurers may have to
look at ways to manage this demand side for situations where there
is too much water ie floods.
Vulnerability
5.10 Vulnerability could be seen as a potential
candidate for such "demand management". Modern building
materials such as chipboard and plasterboard are very vulnerable
to flood damage. The same applies to the typical contents of a
home, office or factory, for example the increasing use of high
value and easily damaged electronic equipment.
5.11 In propoerties in very high risk situations,
flood damage can be reduced by designing the building to be less
vulnerable to flood damage and by keeping vulnerable contents
on upper floors. A good example of this is General Accident's
new building in York, which was designed from the outset to be
flood proof.
Exposure
5.12 The location of a property is clearly
crucial, and insurers welcome the efforts of the Environment Agency
to discourage new developments in flood plains. In Scotland, GA
and ABI were consulted by the Scottish Office when they were drawing
up the Planning Policy Guidelines for flood (NPPG 7) and we were
pleased to see them adopt our suggestions that the insurance industry
be more involved in planning decisions in Scotland.
5.13 Insurers and reinsurers are increasingly
aware of the potential accumulations of exposure from properties
in high hazard areas, and new technology like GIS is making it
easier for their assessments to become more precise. Exposure
management is the easiest way to control the risk to an insurer
of suffering catastrophic losses following a major flood, and
insurers are already monitoring their exposure to ensure that
the market shares the risks equally.
5.14 Another way insurers could reduce exposure
is by applying an excess to flood claims. This has the added attraction
of giving an incentive to the household to take precautions when
a flood warning is given, for example by moving property upstairs,
or putting sandbags in front of the door. In many of our scenarios,
however, the depth of flood is so great that the average claims
cost would not be significantly reduced by applying an excess,
and it could be seen as being unfair to those unable through age
or infirmity to be able to move their possessions in time.
Reinsurance Issues
5.15 A major insurer will typically buy
reinsurance protection from over a hundred reinsurance companies
all round the world, so that the risk of a major event is literally
spread throughout the global economy. This is a very efficient
way to reduce the burden on the UK economy from a major storm
or flood, but it does mean an annual cost of many millions of
pounds of premium flowing out of the UK. To minimise this, while
at the same time ensuring there is enough protection against a
disaster, requires sophisticated mathematical calculations and
modelling. A key part of such modelling is something insurers
call "Mean Loss Ratios".
Mean Loss Ratios
5.16 Many insurers have developed sophisticated
mathematical models for assessing the likely costs of different
flood scenarios. This is essential work to enable insurers to
assess just how much a major flood might cost and, from this,
how much reinsurance they need to purchase to protect themselves.
A major insurer could spend as much as £25 million a year
on catastrophe reinsurance, depending on its size and the amount
of risk it retains, so the accuracy of these flood models is very
important, not just to the insurance industry, but to the UK economy;
if insurers buy too much reinsurance, that means too much money
is leaving the country. If insurers buy too little, and there
is a major flood, that means the UK economy is bearing too much
of the cost.
5.17 A central part of any such flood model
is the relationship between the depth of flood and amount of damage
sustained. This is what insurers call the "Mean Loss Ratio".
The Flood Hazard Research Centre at Middlesex University has carried
out very thorough and detailed work for MAFF to determine this
relationship in terms of the cost to UK plc for various flood
scenarios. Unfortunately, its figures, whilst indicative, are
not easily applied to insurance modelling without extensive calibration
to take account of other factors, in particular, "new for
old" claims settlements and other different forms of indemnity
which the insurer may use. In other words, the amount which insurers
actually pay in claims is likely to be considerably more than
the "Middlesex figures" would suggets. Therefore, so
that UK insurers can better assess how much reinsurance to purchase,
General Accident and the Alexander Howden Group are sponsoring
research projects at Dundee University which are designed to produce
a set of flood damage tables based on what floods actually cost
the insurance industry. The "Dundee Mean Loss Ratios"
will be made freely available to UK insurers and to reinsurance
companies, and hopefully will become the industry standard for
flood modelling.
Micro: Underwriting Individual Risks
5.18 At the micro, or individual risk level,
it is possible to address two sides of the risk triangle:
(i) Vulnerability—insurance surveyors
can advise commercial enterprises to store easily damaged goods
on racks or upper floors, or take other precautions, including
local flood defences. In some cases, insurers may call for a hydrologist's
report for a specific site, and make more detailed recommendations;
(ii) Exposure—the main thrust of insurers'
efforts will be on the exposure aspects.
5.19 Exposure management will increasingly
become very important as insurers become more precise in their
analyses of possible flood scenarios and hazardous areas. Managing
that exposure will not be done overnight; no major insurer would
want to cancel all its policies in such areas without very good
reasons. However, where it considers it has more than its share
of policies in a high risk area, it may increasingly be looking
to manage its exposure in such areas by seeking a higher premium.
5.20 Not so long ago, household insurance
was rated at postcode area level. Now it is typically at postcode
sector level and increasingly at full postcode unit level. Many
insurers aim to rate at individual address level, and indeed some
already do so in high hazard areas.
5.21 From a rating point of view, the Halcrow
research was intended primarily to assist with insurers' rating
of commercial risks; these tend to be individually underwritten,
and underwriters are looking not just at premium, but also recommendations
on specific precautions to be taken.
5.22 However, the research has been of great
interest to household insurers, and many of them have been looking
at additional sources of good quality, high resolution data which
can enable them to gain competitive advantage by identifying degrees
of hazard within the high hazard areas identified in the Halcrow
reports. The best source of data of course is from actual flood
events, but it is not always easy to gather. Aerial photography
might be one solution, but for some reason floods are often accompanied
by low cloud cover and stormy conditions, which makes this solution
difficult and dangerous. We are interested in the potential for
using synthetic aperture radar satellite data, especially as the
number of such satellites and therefore the availability of such
data is growing rapidly. Insurers would hope that ultimately it
might be possible to track floods in real time, so as to be able
to monitor the development of the flood and improve the warnings
to those likely to be affected. Not only do warnings reduce the
amount of loss to property, they could potentially save lives.
PART THREE
6. THE
OUTLOOK FOR
INSURANCE COVER
6.1 As explained in Part Two, the information
from the existing and any future research will be applied by the
insurance industry in two basic ways, managing overall portfolio
exposure and in underwriting individual property risks.
6.2 Balancing of exposures is likely to
continue for a number of years, and insurers will increasingly
be using GIS data together with local knowledge to become more
precise in their underwriting.
6.3 To date insurers have been very responsible
in the use of the output from the research. Rates have and may
continue to increase in selected locations because of risks being
assessed for flood cover on a geograpic basis. Some insurers may
also decide they are overexposed in certain areas and either not
accept new business or, possibly, not renew. However, as rates
stabilise at realistic levels there should not be significant
problems in finding cover. The approach being taken by insurers
is entirely consistent with higher theft insurance rates being
charged in high crime areas or higher rates for areas with a demonstrably
worse subsidence risk. It also recognises the conflicting demands
of consumers many of who want to pay only the premium that is
commensurate with the risk they bring. The skill will be to contain
increases by the continued development of sensible flood defence
strategy and strict control of development in flood prone areas
and to uphold a balanced approach to risk pricing.
6.4 Some potential weaknesses have, of course,
been identified regarding defences in general. However, the way
in which the research has helped insurers more accurately to quantify
the real risk of coastal flooding and the positive action being
taken by EA should allay any significant fears that coastal and
estuarine or Thames flooding represents an uninsurable risk.
6.5 The single event study shows that the
exposure to storm scenarios, although substantial, is less than
originally feared, so capacity problems with flood risks in the
market overall should be avoided.
6.6 This generally positive outlook should
continue provided flood defence strategy and development controls
are developed effectively. Insurers recognise the invaluable work,
finance and co-ordination already employed by EA and MAFF. However,
more needs to be done if insurers are to continue in the longer
term to provide cover with any confidence that shareholders' interests
are adequately protected. Consumers and businesses also need confidence
that their own "investment" in potentially affected
local communities is protected adequately. Otherwise, there is
the possibility of "blight" developing significantly
in defended coastal areas.
6.7 Inevitably, the research which has been
carried out gives rise to the question of availability and affordability
of insurance. While these are not issues at present, we need to
be aware that they could become problems in the future. This is
particularly the case for:
— new development in flood plains,
undertaken against the advice of the Environment Agency and without
adequate defence provision;
— properties in areas where the residents
have refused to have flood defence work carried out for aesthetic
or other reasons;
— properties purchased cheaply because
of a history of regular flooding.
6.8 This then poses the question whether
insurers should provide cover in such cases, at the expense of
their other customers? Arguably, the unrealistic continued provision
of cover could seriously compound the problem. It would be far
better to control development now and increase general public
awareness of the threat and difficult realities before a withdrawal
of cover presents serious and less manageable economic consequences
in the longer term.
6.9 So far insurers are extremely encouraged
by the discussion and co-operation with EA and MAFF in relation
to coastal flood research. There has also been some dialogue with
the Scottish Office and the Scottish Environment Protection Agency.
This demonstrates that the commercial and political problems can
be overcome to the benefit of all. It is a process that the insurance
industry is committed to, so that the risk of coastal flooding
is reduced to an acceptable level.
PART FOUR
7. ACTION
NEEDED
7.1 It would be wrong to assume that in
an insurance context all is now well in relation to coastal flood
defence. The progress made is very encouraging but "too little
too late" is a saying that must be avoided in future.
7.2 From an insurers' point of view there
must be even more liaison and co-operation between interested
parties. This should not be limited to national organisations:
liaison with local communities and their elected representatives
and insurer involvement in local Flood Defence Committees should
also be considered, so that they understand the issues facing
insurers. The more informed we are the better placed we will be
to make sensible decisions on flood defence.
7.3 The issue in March 1997 of the Environment
Agency policy document "Policy and Practice for the Protection
of Flood Plains" is an extremely positive development. It
focuses attention on the important issues of river and coastal
flood plain development. Although it does not represent a change
in flood defence policy, the consolidation of existing custom
and practice is a valuable intitiative. Insurers also welcome
the recent legislation in Scotland which requires local authorities
to review the flood risks in their areas and in particular to
ensure that culverts and storm drains are adequately maintained.
7.4 Insurers recognise the interests which
flood defence strategy has to balance. The policy statement should
be used as the catalyst in improving planning controls and implementation
of remedial schemes.
7.5 There appears also to be considerable
scope for achieving consistency and improving the co-ordination
between the mainly autonomous Environment Agency regions. To establish
a sensible overarching national strategy and make it effective
demands very close liaison and discussion between regions albeit
within target standards for the defences which are their responsibility.
7.6 Consideration should also be given to
the commerical constraints of the insurance industry and their
duties to their shareholders. Insurers should not be expected
automatically to provide cover where regular flooding occurs,
where remedial schemes have been refused at local level or where
development has taken place without due regard to adequate defence
provision and hence insurance implications. If effective planning
controls were to be introduced, the likelihood is that problems
over insurance availability and affordability would be reduced
to a minimum.
7.7 The launch of the new EA warning system
is a positive development which has the wholehearted support of
insurers.
8. CONCLUSION
8.1 The insurance industry will continue
working with EA, MAFF and others but it will be essential in future
not to rely exclusively on insurers to continue providing cover.
Rather, efforts should be made to reduce exposures to a manageable
level leaving insurers as a sensible long-stop which helps to
make flood defence manageable in economic terms.
26 June 1998
