A Changing Climate for Insurance
The densely populated low-lying areas of the Netherlands are protected from flooding by an elaborate system of dykes, dunes and barriers. However, the country has been struggling to maintain these defences at a level appropriate for current flood risk, and rising sea levels and a changing climate will only increase the probability of flooding in the future. Plans are afoot to 'climate proof' the country against future sea-level rise and river floods, but regardless of how much protection is provided, a residual risk of flooding will always remain. When floods have occurred in the past — for example, on the river Rhine in 1993 and 1995 — the Dutch government ended up paying compensation to those affected. Facing the potential for an increasing compensation bill at a time of budget pressures, the Dutch government is exploring the scope for flood insurance; a change that would represent a major shift in policy direction. Writing in Global Environmental Change, Jeroen Aerts and Wouter Botzen show that this option is affordable at the moment, but emphasize that accurate information about changing flood risk is needed to ensure that insurance premiums are accurately priced.
The low-lying part of the Netherlands is divided into 53 'dyke rings' — units of land protected from flooding by an interconnected system of dykes. Since the early 1990s, the Dutch have been developing detailed models for estimating the probability and consequences of flooding in each of these vulnerable areas. Aerts and Botzen used these model results to estimate flood risk in the Netherlands under future climate change scenarios. They also assessed the impacts of house-building, population growth and economic growth on exposure to flooding, allowing them to estimate the potential cost of flood damage over the coming century.
The risk of flooding is likely to increase in the Netherlands as sea level rises. Aerts and Botzen explore whether a private insurance market for flooding could function under these conditions. Their analysis indicates that although private insurance arrangements would be feasible, they would need to be based on short-term contracts, because the uncertainties involved in estimating flood risk several years into the future are so large. Furthermore, the total liability of insurers would need to be capped, with the government agreeing to meet any costs that exceed this cap.
Their results are striking, but by no means surprising. The team analysed multiple flooding scenarios in each dyke ring to estimate how deep flood waters could realistically get. They found that, at present, the cost of the maximum damage that could occur across all 53 dyke rings is about €242 billion. By the 2040s, an estimated 24 cm of sea-level rise and economic growth of 1% per annum would together increase the potential cost to €455 billion. If growth averages 2.2% per annum, the researchers estimate that the damage could hit €630 billion. These projections of increasing flood damage all assume that the country's dykes are not raised after 2015, which is unrealistic in a country like the Netherlands, where planning for climate change is well under way. But the timing and magnitude of dyke-raising is hard to predict decades into the future, so it is reasonable to start by estimating the costs without accounting for adaptation.
The researchers go on to examine how much it might cost householders to insure against flood damage. They do so by supposing that insurance premiums levied equally on householders living in each dyke ring cover the cost of flood damage in the long run, without allowing for profit or administration costs. On average, they find that the price for household flood insurance would not be expensive, at €34 per year, but the estimated insurance premiums vary markedly across the Netherlands, reaching €250 per year in some locations. These insurance premiums could double by the 2040s, with householders in riverine areas — which have a lower standard of flood protection than coastal areas — projected to see the greatest increases. For Dutch householders, who tend to assume they are completely protected against flooding4, the cost may come as a surprise.
As well as analysing how much annual insurance contracts might cost, Aerts and Botzen analysed the potential cost of longer-term insurance contracts that would provide cover for 5, 10 or 15 years. They chose to analyse contracts of this duration because multi-year contracts can help to reduce the transaction costs of annual contracts and can be used to encourage homeowners to take cost-effective measures to reduce the risk of flood damage. However, long-term contracts are difficult to price because of the uncertainties in how flood risks will change in future. Insurers would charge higher prices to allow for this uncertainty. Conventional annual insurance contracts, which insurance companies can modify each year to reflect their latest knowledge about risks and market conditions, are bound to be the cheaper bet.
Although it seems that flood insurance could be provided in the Netherlands at an affordable price, at least for the time being, it is not clear that insurance companies would wish to enter the market, given the potential for catastrophic losses that could occur if the Netherlands were to flood. Aerts and Botzen show that the reserves of an insurance fund could be wiped out by the claims that would occur if an extreme storm surge in the North Sea were to result in widespread flooding. Insurance companies cover themselves for such catastrophes by buying reinsurance (insurance for insurers), which enables the insurer to pass on a proportion of their risk, typically to one or more multinational reinsurance companies. But Aerts and Botzen argue that for a private insurance market to function in the Netherlands, it would need to be underwritten by a government guarantee to cover damages above a pre-specified amount — an arrangement similar to one that exists in France. They estimate that the government might need to agree to cover losses above a threshold somewhere between €1.5 billion and €10 billion. Yet a government stake in any future flood insurance scheme wouldn't necessarily be a bad thing, as it would provide further motivation for the Dutch government to limit the build-up of vulnerability to flooding and to continue to invest in flood protection.
On its own, flood insurance is simply a means of sharing the burden of the cost of occasional flood damage across populations and through time. It is no panacea, and can indeed be an obstacle to climate change adaptation if insurance subsidies provide a disincentive for property owners to reduce their risk. However, when seen as part of a broader risk-management framework, insurance can play a beneficial role in risk communication and incentivizing adaptation. Insurance premiums hit household and business budgets, and so can provide an immediate economic incentive to reduce flood risk, as well as acting as a more potent annual reminder of the risk than public-information campaigns. The flood risk assessment methods adopted by Aerts and Botzen will contribute to these goals by helping to ensure that insurance premiums accurately reflect flood risk in particular locations.
Using insurance to incentivize adaptation will require partnerships between governments and insurers. Constructing relationships that help to achieve long-term risk reduction, whilst also providing affordable insurance cover, is not straightforward. An example of insurance being used as an incentive for risk reduction is in the US, where communities must agree to adopt and enforce floodplain management regulations and ordinances to be eligible for federal flood insurance. Yet even there, the availability of federal insurance has been accused of encouraging new development in high-risk areas.
Perhaps the most important outcome of Aerts and Botzen's study is a clear demonstration of the added uncertainty that climate change brings to the pricing of flood insurance. In a market where insurers can modify the price of insurance contracts annually, their immediate concern is whether they are pricing risk accurately at the moment. Longer-term climate projections are of strategic importance, but the information insurers will be most interested in is whether there are undetected changes taking place right now, in particular in the (low) probability of extreme events, which might mean that the prices they are charging do not properly reflect the risk. With insurers hungry for this type of information, it's not surprising that understanding patterns of variability in extremes and detection of accelerating changes are hot topics for the climate-services industry. Aerts and Botzen's calculations demonstrate just how much accurate climate services could be worth to the insurers of Dutch flood risk.
For a fully-referenced version of this article, please see the original under the following link:
http://www.nature.com/nclimate/journal/v1/n5/full/nclimate1173.html
Printer-friendly version
Send by email