House of Commons - Managing Flood Risk - Environment, Food and Rural Affairs Committee

Managing Flood Risk - Environment, Food and Rural Affairs Committee Contents

7 Household flood insurance

60. Around 2% of households are considered to be at high risk of flooding; in a free market these properties would incur higher premiums than if they were located in a low flood risk areas to reflect the higher risk of claims for flood damage.[120] Insurance for such homes, as well as for small businesses, is currently provided in line with a 'Statement of Principles' agreed between the Association of British Insurers (ABI) and the Government in July 2008. Under this, insurers agreed to provide until the end of June 2013 flood insurance to the vast majority of households and small businesses in areas of 'significant flood risk' where plans exist to reduce the risk below 'significant' within five years. Properties built from 2009 onwards are not covered by the Statement.

61. The ABI considered that the Statement of Principles was only ever meant to be a temporary "sticking plaster," not appropriate for the long term for the key reasons that customers typically tend to have no choice of insurer, affordability is not safeguarded, and those new to insuring homes have no legacy of commitments under the agreement giving them a "a significant commercial advantage".[121] We raised with Ministers on numerous occasions the urgent need to reach agreement, including in our Draft Water Bill report published in February.[122] The report cited evidence from the Local Government Association that, should the insurance industry's agreement to provide cover to the more than 5 million properties in flood risk areas be withdrawn, there would be a danger of blight, with significant impacts on the housing market and social cohesion.

62. Ministers told us that they were working urgently to find a solution with the insurance industry, but did not wish to conduct negotiations in public.[123] We requested that Defra provide details of the legislative solutions being considered in the Government's response to our Draft Water Bill report. We regret that, in spite of repeated requests from us, the Government only published this on 27 June, promising a further public update at the earliest opportunity.[124] On the same day, Defra launched a public consultation on how the Government intended to move forward. Insurers agreed to continue to meet their commitments under the Statement of Principles until such time as a new model, Flood Re, could begin operating.[125]

63. We welcome the Government's increased funding for flood defences which has enabled the insurance industry to undertake to continue to provide affordable flood insurance under the Statement of Principles regime until new arrangements can be put in place. The Government and insurance industry have had a number of years to consider future arrangements and we regret the delay in announcing a solution. This uncertainty has exacerbated the concerns of householders facing potentially significant rises in insurance premiums. The Government must conclude negotiations urgently on the details of the measures it proposes so as to spell out clearly the arrangements which will apply in the future and end the current uncertainty.

Potential models for flood insurance provision

64. The focus of evidence to us was on two main approaches—'Flood Re' and 'Noah' (modified to 'Flood Mu'). Much media focus has been on the former; a model proposed by the ABI. However, representatives of the insurance and reinsurance industry presented arguments to us on the merits of alternative models, including the Noah/Flood Mu model, and Flood Re Mutual proposed by Richfords Fire and Flood, discussed below. Media reports indicate a high level of disagreement within the sector over the best way forward. and no model garnered universal support from witnesses to this inquiry.[126]

Flood Re

65. The ABI told us that, in the absence of any proposals from Defra, the insurance industry had developed a 'Flood Re' model with economic consultants Oxera. This approach would provide a not-for-profit fund to provide flood insurance to the 1-2% (around 200,000) of properties where, according to the ABI, obtaining insurance on the open market would be "problematic".[127] The Association told us that under Flood Re policies for these properties would be charged at a set price, according to council tax band. It estimated that in a free market premiums for a home in a high risk area would be around £1,400 as opposed to around £750 under Flood Re.[128] Any insurer paying a claim for flood damage to such a property would be compensated from a fund built up from annual contributions from insurance companies based on their level of overall premium income. Companies would fund this contribution from a levy applied to all their household insurance premiums.[129] The ABI told us that this household levy would be around £3 per contents policy and £5 per buildings policy per annum.[130] Under this model, the Government would be required, at least initially, to be the 'insurer of last resort' in the event of an extreme flood event that overwhelmed the capacity of the fund to meet consequent claims. The ABI noted that taxpayer support would be withdrawn once the fund had accumulated sufficient funds to enable it to "handle any likely flood on its own".[131] However, if the Government did not provide such back-stop funding guarantees, the scheme costs would increase from the current annual cross-subsidy value of some £150 million to around £280 million.[132] This would significantly increase the estimated cost per household per year.[133]

66. Flood reinsurance is a key aspect of the model. Reinsurance company, Aon Benfield, which has been working with the ABI on the details of Flood Re, noted that all insurance companies in the UK buy some form of reinsurance protection for their property exposures (risks) which provides "a robust, proven, and well regulated mechanism for transferring risk and protecting insurers' financial positions".[134] The company considered that reinsurance had a key role to play in managing Flood Re's 'survivability' (the ability to meet its obligations) and 'sustainability' (the ability to survive and trade after an event). Reinsurance achieved this through substantially reducing both the probability of failure and the volatility of results. The company's early estimates were that Flood Re's ability to pay out for a single catastrophic event would be some £2 billion, "far in excess" of the scheme's estimated premium income.[135]

67. However, Flood Re has been criticised by some in the insurance and reinsurance industry. Insurance company Marsh Ltd suggested that the model would create perverse incentives for homes in high-risk areas not to manage their flood risk and for developers to build in such areas, prices would rise excessively as tariffs would not be contested, and reinsurance costs would be substantial.[136] The ABI countered that the scheme would not apply to newly built homes and that by improving individual property protection a home could come out of the scheme and find cheaper cover in the 98% of the market which remained a free market.[137]

Noah/Flood Mu

68. An alternative approach, Project Noah, was proposed in April 2012 by the insurance companies Marsh and Guy Carpenter.[138] This aims to provide a pooled risk approach and is predicated on balancing out risk across the country since it was considered unlikely that floods would impact on all areas of the UK at once. Risk would be ceded in some proportion to the reinsurance industry. The model would use detailed flood risk maps to assess premiums and risk. The company described a key advantage of Noah as the fact that the model would require "no taxation, no subsidy, no levies, no legislation, and no additional infrastructure". Further, under Noah, there would be no contingent liability on the Government for flood losses, the relative merits of proposed flood defences could be considered, and householders could reduce premiums by improving their property's resilience to flood.[139] The ABI has criticised the Noah model, stating that it would not ensure affordable cover for customers, would require extensive government support, and was reliant on the international reinsurance market being able to accommodate it. It further added that control over price would sit with one organisation in charge of the Noah pool and that this would lead to the loss of the free market advantages which would, however, continue to apply under Flood Re.[140] Noah was therefore not supported by the ABI's members.[141]

69. Marsh Ltd presented a variation on Noah, 'Flood Mu', during its evidence session with us in March. This proposed a risk-pooling solution, with a pre-set amount of flood claims in a given period being redistributed across all insurers in proportion to the size of their business in household cover. Some risk would stay with the original insurer, the proportion of which had yet to be determined.[142] Insurance companies could obtain reinsurance for their retained risk via the Noah model. The ABI also criticised this variant of Marsh's model, considering that it would not safeguard affordability of premiums or the availability of cover, nor would it incentivise the Government to invest in flood defences.[143]

Flood Re Mutual

70. The Committee received evidence from Richfords Fire and Flood proposing a variation on the Flood Re model; 'Flood Re Mutual' under which a levy on all insurers offering household insurance would be pooled to fund reinsurance and pay out for areas with a greater than 1-in-75 year flood risk.[144] It considered the advantage of this approach would be that the insurer of last resort would be a mutual fund with assets invested for the benefit of its members—the UK public not corporate shareholders. Richfords recommended that legislation be put in place requiring all insurance companies to impose a levy equivalent to the value of 0.03% of the rebuilding cost specified in buildings insurance policies and 0.06% of the sum assured in contents polices".[145] This appears to produce a higher average cost per household than Flood Re. The ABI questioned whether a method similar to that used by Noah, such as the Richfords model, which cedes flood risk into a mutual pool could guarantee to maintain affordable premiums.[146]

Open market

71. It should be noted that some parts of the industry consider that an open market in flood insurance could provide an affordable approach for homeowners. The British Insurance Brokers Association (BIBA) told us that, for the 2% of high-risk properties which found it harder to find insurance, the Association's not-for-profit signposting facility would help "suitable cover" from a specialist broker.[147] BIBA stated that its members already found cover for 95% of homes rejected by insurers for flood cover. Under a free market the vast majority of property owners would continue to access flood insurance "in the normal way with insurers providing cover as part of the standard bundle of perils".[148] The Association considered that only some 10,000 properties would present a real problem.[149] BIBA noted that any of the three approaches (Flood Re, Noah, or open market) could be developed to provide a "suitable solution" and recommended that a combination of approaches be discussed. However, for a market solution to work after the Statement of Principles expired it would be necessary for there to be signposting to specialist brokers, more promotion of resilience in properties, a fuller appreciation of the value of flood defence spending, and co-operation between owners, insurers, brokers, Defra, the EA, HM Treasury, reinsurers and local authorities.

Government proposals: Flood Re

72. After we finished taking evidence, on 27 June, the Government launched a six week public consultation on its proposal to adopt the Flood Re model under which up to 500,000 high risk households could benefit by paying "significantly less for their insurance than they might otherwise". The model would also constrain the excesses that could be imposed on households at high flood risk.[150] An insurance pool would be established in which premiums paid by households at low risk subsidised those of households at high risk of flooding. Ministers noted that as the levy would capture the existing cross-subsidy it would not impact customers' bills "in general".[151] The levy would be set at £180 million per annum which notionally equates to around £10.50 per customer per year, set for the first five years.[152] This is an increase on the £8 figure that the ABI cited in evidence to us as the likely cost per customer each year. If the scheme were to have insufficient income to meet outgoings, an additional amount would be charged to each member company. The Memorandum of Understanding between the Government and the insurance industry notes that the flood risk element of premiums paid by households in Flood Re would not exceed £210 for a council tax Band A property, rising to a limit of £540 per annum for a Band G property. However, "genuinely uninsurable" properties would be excluded from the scheme, as would Band H properties and those built after 2009. In addition, the Memorandum commits the Government to long term investment in flood defences and to taking primary responsibility in the event of an extreme flood event, with Flood Re and representatives of the insurance industry, in deciding how any available resources should be distributed to Flood Re customers as part of "wider Government action to respond to such a national emergency". The annual liability collectively to insurers would be capped at the level of claims payable in a 1 in 200 year loss scenario.[153]

73. Flood Re would only operate for a limited time; it would be withdrawn within 20-25 years. Whilst stating that an immediate move to a free market would cause "significant hardship for many households", the Government wished to see a "transition to a free market for flood insurance so that flood risk is accurately reflected in prices and the right incentives are in place to manage the risk of flooding".[154] Ministers stated that "in the long term we need to create a situation where everyone is fully aware of their level of flood risk, and households and communities are rewarded through their future bills for the steps they take to reduce flood risk".[155] However, the consultation does not propose measures to ensure that developers who have built in areas at high flood risk share with householders the future costs of premiums which reflect fully the risk of flooding.

74. The Government acknowledges that Flood Re does not achieve "the level of value for money normally required of Government policies" since the costs of Flood Re, including the necessary reinsurance contract, are expected to be greater than its economic benefits. A Ministerial Direction would be required before implementation can proceed.[156] However, it is not clear how Parliament will scrutinise this Direction, but it must be subject to Parliamentary scrutiny.

75. Provisions are included in the Water Bill to enable direct regulation of the insurance market if Flood Re "does not deliver what we need and insurers are otherwise unable to keep prices at affordable levels".[157] The regulatory fall-back option, the 'Flood Insurance Obligation', would require insurers to cover a set share of high risk properties or face penalties.[158] Such a regulatory framework must be open, transparent and subject to Parliamentary scrutiny.

76. Ministers concede that Flood Re constitutes a "novel approach," with many details still to be worked through with the industry, including the relationship between Flood Re and Parliament. Flood Re, rather than Ministers, would be directly accountable to Parliament for its operations, with Ministers remaining accountable for overall flood insurance policy. The Government proposes introducing a "bespoke scrutiny, administrative and regulatory arrangement" for Flood Re since this would avoid the scheme's funding being considered tax and therefore public expenditure.[159] However, the Government states that these arrangements "offer Parliament less control and less insight into Flood Re's operations" than if the scheme were treated as part of the public sector. Flood Re would also be likely to be classed as State Aid and would need European Commission approval.[160]

77. It is clear that no single approach has the backing of the entire insurance and reinsurance industry. There are advantages and disadvantages to each approach but the fundamental choice to be made is whether or not some flood insurance customers should be subsidised through an increase in premiums paid by all households. The ABI noted that it was a decision for "us as a society to make about our willingness for the 98% to effectively pay something towards the costs of the 2%".[161] The Government has proposed that ultimately the free market should provide flood cover in order that risk is accurately reflected in the premiums charged so as to prompt the right decisions on the location and resilience of homes to flooding. It has, however, recognised that to move immediately to such a free market would cause some people "significant hardship".[162] The Government estimates that some 500,000 households would benefit from a subsidy system, while the insurance industry told us that some 200,000 of the UK's 26 million households could face increases in premiums without it. However, according to insurance brokers only 10,000 households posed a significant problem. Nevertheless, the threat of increased premiums exacerbates the fears of those living in flood-prone areas about the impact not only on their ability to pay the annual insurance costs but also on the value of their homes and the potential blighting of whole communities.

78. The ABI conceded that evidence was "patchy" on whether or not those living outside high flood risk areas would be willing to pay a levy to support those living in such areas".[163] However, the current Statement of Principles already provides an element of cross-subsidy, albeit hidden within the insurance system.

79. We were not persuaded that the open market would be able at present to offer affordable insurance to all households. We welcome the Government's recognition that, whilst premiums should in time reflect a property's risk of flooding, this transition should only take place over a long timescale. A solution must be found to ensure that insurance is available for those homes built in areas at high risk of flood which would be unable to obtain insurance.

80. We endorse in principle the agreement between the Government and the insurance industry to introduce a levy-funded insurance pool for households at high risk of flooding which will keep premiums affordable for all. Flood Re will make transparent the current implicit cross-subsidy under the Statement of Principles so that householders are fully aware of the contribution they are making. This approach will provide stability for communities and certainty for householders in future.

81. However, the Government's announcement raises many questions about the operation of Flood Re, in particular how the scheme will be accountable to Ministers and Parliament, and how taxpayers' interests will be protected in the event of an extreme flood event requiring funding beyond the capacity of the scheme. It is unclear who will bear the costs from such a 1 in 200 year flood event.

82. We are also concerned that the approach does not achieve the value for money normally required of Government policies. Furthermore, it is not clear how assurances will be enforced to limit the amount of levy to be paid by all householders and maintain premiums at affordable levels for those in the scheme. The regulatory regime must be fully transparent and open to Parliamentary scrutiny.

83. Ministers concede that they must publish further details on these issues. These must be provided urgently so that Parliament can scrutinise fully both the Flood Re scheme proposals and the measures in the Water Bill.

120 Q 168 Back

121 Ev 71 Back

122 Environment, Food and Rural Affairs Committee, Sixth Report of Session 2012-13, Draft Water Bill, HC 674 Back

123 Q 374 Back

124 HM Government, Government response to the EFRA Committee's pre-legislative scrutiny of the draft Water Bill, June 2013, Cm 8643 Back

125 Defra, Securing the future availability and affordability of home insurance in areas of flood risk, June 2013 Back

126 For example "Free Market looms for flood insurance", POST online, 27 March 2013 Back

127 Q 168 Back

128 Ev 72 Back

129 As above Back

130 Q179 Back

131 "Flood insurance talks at critical juncture", ADA Gazette, Winter 2012 Back