Water Bill

Written evidence submitted by the Adaptation Sub-Committee to the Committee on Climate Change (WB 16)


Improving Flood Re from an adaptation perspective

1. The Adaptation Sub-Committee was established by the 2008 Climate Change Act to provide independent, evidence-based advice to the UK Government and Parliament on preparing for climate change.

2. The proposal from the Association of British Insurers (ABI) to tackle the affordability of property insurance in flood risk areas has the potential to build a much greater awareness of flood risk amongst high risk households and encourage appropriate and cost-effective action to reduce it. Flood Re could unlock new, strategic, long-term approaches to reducing the economic losses from flooding in the UK. This would deliver immediate benefits whilst also building the country’s resilience to the risks posed by climate change [1] . But Flood Re is not currently designed to do this. The consequence is that Flood Re’s costs will be higher than they need to be, at the expense of householders funding the programme through the industry levy.

3. Simple changes to the policy would:

· improve the signalling of risk to households who may otherwise be unaware;

· support, encourage and incentivise cost-effective action to avoid flood losses;

· reduce the short and long-term costs of Flood Re to other policyholders, and;

· improve upon its value for money.

Insurance costs as a signal of risk, and an incentive to act

4. As proposed Flood Re will largely remove any financial incentive for flood risk to be managed amongst householders covered by the scheme. Currently, around a fifth of customers at significant flood risk pay more for their insurance than lower risk households [2] . These price signals alert customers to their heightened risk - encouraging them for example to sign up to flood warnings - whilst also creating the scope for risk mitigation to be rewarded by a reduction in their future insurance bills. Under current proposals for Flood Re any existing price signals will largely be removed. High risk households will pay the same for their insurance no matter how severe their risk, and whether or not they take steps to protect themselves.

5. The ASC’s progress report published in 2012 [3] found that there is considerable scope to cost-effectively reduce flood losses by households fitting property-level measures such as flood gates and air brick covers. It found that the historic pace of fitting such measures would need to increase by a factor of 20 in order to reach and support all the appropriate households by 2035. Flood Re threatens to stall progress in this area when it could accelerate it. A decline in demand could undermine the nascent UK market for such measures.

Achieving a gradual transition

6. Flood Re is intended to be a transitional measure, with the benefits withdrawn during its proposed 20 to 25 year timescale. There are many different ways to do this. The nature of the transition will have significant implications for insurers, and in particular, high risk households. Knowledge of what might happen to their future insurance costs would provide important signals and incentives to households to take action before the benefits are fully withdrawn. At present there are no proposals for how the transition will be achieved in practice, only that there will be no withdrawal of benefits in the initial years [4] . Without a clear framework agreed at the outset, there is the risk that difficult decisions to reduce the benefit of Flood Re to high risk households and insurers will be continually postponed by the government of the day.

The costs of Flood Re to others

7. We currently expect the number of households at significant flood risk to increase over the coming decades. Current investment plans are insufficient to counter the combination of deterioration in existing flood defences, sea level rise, and the more frequent and intense rainfall patterns predicted [5] . This remains the case despite the recent recovery in capital investment and the planned increases with inflation through to 2021. Spending on the maintenance of existing defences has been in decline [6] . Unless transition occurs, we can expect more households to become underwritten by Flood Re over time. This would create a growing burden of costs falling on other insurance bill payers.

Value achieved by Flood Re in comparison to flood mitigation

8. In the long-term, the most sustainable and cost-effective way of achieving affordable flood insurance is to reduce the risk of flooding. Flood Re spreads the risk – it will not reduce it unless it is designed to incentivise people to do so. According to the Environment Agency, each £1 spent on flood defence reduces future damages by an average £8. Each £1 invested in property-level protection typically achieves benefits of £5 or more [7] . Flood Re does not reduce flood losses; it protects some from the costs of flooding at the expense of others.

9. In return for the £180 million levy, Flood Re is set to deliver a £50 million subsidy to risk-reflective prices [8] . The remaining levy is needed to manage the volatility of annual claims upon Flood Re, including through reinsurance. As the £50 million subsidy is paid for by other policyholders the benefit in economic terms is less, and is valued at around £10 million per year (range: £4-17 million) [9] . Overall, including the additional ‘distributional’ or ‘equity’ benefits of Flood Re, the policy achieves 70 pence in benefits per £1 of economic cost. This can be improved if Flood Re becomes instrumental in incentivising additional flood risk reduction.

Five ways to improve Flood Re

10. There is the potential to redesign Flood Re to address these weaknesses. The version presented to date is one configuration agreed by the Government and the Association of British Insurers as the basis for further policy development. The final configuration will be subject to Parliamentary approval (which in particular will need to be content with the size of the levy implied by the final design). The European Commission will need to accept the level of State aid involved (the levy will count as State aid to the insurance industry). Flood Re could be improved if the Government were to:

a) Require Flood Re to build awareness of flood risk. Households in areas of significant flood risk are commonly not aware. Flood Re offers the potential, for the first time, for a targeted dialogue with the highest risk households in the country. The Flood Re administrator could be given a role in law to promote awareness and to share the information it will hold on flood risk with householders, the public authorities, and perhaps the general public in the context of house purchasing decisions.

b) Place flood risk reduction at the core of Flood Re’s purpose. Rather than solely pay flood claims, households underwritten by Flood Re could be offered and in certain circumstances be required to fit property-level measures or have flood resilient repairs after a flood event. The benefit to Flood Re’s finances, and therefore the long-term levy requirement, will be substantial as over time Flood Re’s exposure to claims would diminish. Each £1 spent on resilient repairs and other property measures would be expected to reduce the long-term levy requirement by £5 or more [10] . There would also be a business case for Flood Re to contribute towards the costs of community defences, under existing partnership funding [11] rules, in areas where there is a concentration of Flood Re customers. Flood Re is likely to accumulate significant cash reserves, of which a small proportion could be used to manage down the long-term levy requirement through risk reduction activity.

c) Publish a framework for how the transition to a free market will take place. The Government should set out, perhaps in legislation, a framework for how the costs and benefits of Flood Re will be phased out over its proposed 20-25 year timeframe. Without this commitment, important signals to high risk households will be lost, and Flood Re could become a permanent and growing burden on other policyholders.

d) Target the benefits more keenly. Flood Re is set to subsidise the costs of flood insurance for up to 500,000 households. According to the Association of British Insurers only 200,000 of these might otherwise find flood insurance unaffordable or unattainable [12] . The British Insurance Brokers’ Association consider that perhaps 14,000 households would struggle to access flood insurance in a free market, and only if steps are not taken by the householder to address the risk [13] . Targeting the benefits more closely towards those that might genuinely struggle to afford flood insurance, whilst helping them to take measures to reduce their risk, would create stronger incentives for flood risk to be managed and allow the annual levy on other policies to be reduced.

e) Require households and insurers to retain some risk. At the moment Flood Re would meet in full, less a standard excess, the costs of each claim. As a result, the insurer issuing the policy will no longer have a direct interest in limiting the cost of claims. These could spiral and put upwards pressure on the levy. To counter this, Flood Re could pay only (say) 90% of each claim with the insurer issuing the policy meeting the remainder. Doing so would also lead to a small element of risk-reflective pricing for Flood Re’s customers, so that the highest risk households would pay a degree more for their insurance than those only just within Flood Re’s scope [14] . This would retain Flood Re’s focus on delivering affordable insurance for high risk households whilst constraining the levy and preserving appropriate incentives amongst high risk households and insurers.

December 2013

[1] https://www.gov.uk/government/policies/adapting-to-climate-change

[2] Under-pricing of the flood element of home insurance for domestic customers at significant risk, ABI, 2010

[3] http://www.theccc.org.uk/publication/climate-change-is-the-uk-preparing-for-flooding-and-water-scarcity-3rd-progress-report-2012/

[4] Memorandum of Understanding on Flood Re, UK Government/Association of British Insurers, June 2013. Flood Re’s ‘eligibility thresholds’ (price caps) are due to "initially" increase in line with inflation. It is assumed that the thresholds/caps for Flood Re would be reviewed after the first five years of operation, when the levy is due for renewal.

[5] Investing for the future. Flood and Coastal Risk Management in England, a long-term investment strategy, Environment Agency, 2009

[6] Managing Flood Risk, EFRA Select Committee, June 2013

[7] ASC, 2012

[8] Independent review of flood insurance analysis, Prof. Stephen Diacon for Defra, 2013.

[9] Defra, 2013.

[10] Based solely on the typical 5:1 benefit to cost ratio of such measures. If the consequential reduction in reinsurance costs were to be factored in, the benefit to Flood Re’s finances and the levy requirement would be higher still.

[11] http://www.environment-agency.gov.uk/research/planning/134732.aspx

[12] ABI, in oral evidence to the House of Commons Public Bill Committee on the Water Bill, 3 December 2013

[13] BIBA, in oral evidence to the House of Commons Public Bill Committee on the Water Bill, 3 December 2013

[14] For example, if insurers we required to pay 10% of each claim and the ‘true’ risk-based price for the flood component of a policy were £500, the policyholder might be asked to pay an extra £50 on top of the Flood Re price caps (plus any extra insurer mark-up). If desired, Flood Re’s price caps could be reduced to counter-balance this effect, without having to increase the levy.

Prepared 11th December 2013