Appendix 7: Insurability Issues for Flood: A Global View

How Insurance Works

For a risk to be insurable, there are a number of requirements. The Mnemonic "BASIC MUD" sums these up:

B Big enough "book" of business, i.e. a large enough collection of risks for a statistical spread

A Adverse selection minimised through good knowledge of each risk.

S Sustainable over a number of years for various future scenarios so the risks can be spread over time and reserves built up. Because liability claims can take a number of years to settle, it is possible for casualty insurance to be appear to be profitable in the short term, or as long as the account is growing. If it is not priced properly, however, as soon as the account starts to reduce in size, current income is no longer enough to cover increases in costs of old claims.

I Information readily available from reliable sources about hazard, vulnerability, exposure and claims triggers. Legislation under the Aarhus Convention will make such information more easily obtainable in the future as the Convention requires disclosure of environmental information to the public.

C Consistent with existing insurance practices, systems, customs and law.

M Moral and political hazard low and manageable. For example the country must comply fully with the Harare Declaration, which establishes standards for human and property rights and democratic systems.

U Uncertainty about the potential loss.

At least one of the following must be uncertain:

•  Will it occur? (for example, property or casualty insurance)

•  When will it occur? (for example life insurance) - or

•  How much will it cost? (for example "after the event" insurance);

D Demand for insurance must exist (or have potential to be created) and must be effective, i.e. there must be enough customers prepared to pay the price that insurers need to charge for providing sustainable insurance.

Adverse Selection and "Cherrypicking"

Where the customer knows more about his risk than the insurer, or where the insurer, through ignorance, incompetence, regulation, or market forces has failed to recognise the extent of the risk with adequate premium levels, the customer can select against the insurer. With flood insurance, only the customer in the flood risk areas will want to insure for flood, for example.

The corollary of adverse selection is often called 'cherrypicking'. This is where an insurance company decides to only provide insurance for the most profitable, relatively claims free types of risks. Some insurers, for example, will only offer motor insurance to mature drivers with family cars and a good claims record.

While some larger insurers will use the term "cherrypicking" in a derogatory sense, it is a perfectly valid strategy in a free market, especially for smaller insurers trying to build up a profitable account. It is a less viable strategy for the large insurer trying to maintain a large book of business, and in such cases appropriate pricing strategies are not enough, the insurer will need to offer assistance and incentives to policyholders to manage and reduce their risks wherever possible. In particular, for flood and storm hazards, resilient reinstatement is important.

The Vicious Circle

Commodity business such as household and motor insurance is largely price driven and based on statistical analyses. Commercial business such as property or casualty (fire or liability) cover for factories and offices is written on a more individual basis. For either type of business, accurate underwriting is necessary to avoid the vicious circle. The circle works like this:

•  Premiums are too low for the risks insured

•  Losses are incurred

•  Across the board increases in premium are applied.

•  "Good" risks, for example householders who are careful and have a low propensity to claim, or businesses which are well managed, will find cheaper premiums elsewhere, (or will chose not to insure at all) and will cancel their policies.

•  Because the increases have been inadequate for bad risks, more of these will be attracted, or retained, so a higher proportion of the book will be "bad" risks.

•  Losses are incurred

•  Further across the board increases in premium are applied - return to step 4.

The cycle continues until all the good business has gone.

The Virtuous Circle

•  Premiums are too low for the risks insured

•  Losses are incurred

•  Across the board increases in premium are rejected; instead, highly selective rating increases are applied, and risk management advice is given to policyholders to help them reduce their risks.

•  "Good" risks, for example householders who are careful and have a low propensity to claim, or businesses that are well managed, will be encouraged to stay.

•  "Bad" risks will find cheaper premiums elsewhere and will cancel their policies. Alternatively the underwriter will introduce risk management measures and policy conditions to improve the bad risks.

•  A higher proportion of the book will be "good" risks.

•  Profits are made

•  Further very selective increases in premium are applied, together with discounts for good risks, for example a no claims bonus - return to step 4.

The cycle continues until all the "bad" business has gone, or has been improved.

Case study

Due to a statistical error, one major insurer charged much lower rates than the rest of the market for a particular type of risk. The underwriters were aware that their rates were out of line with the market and did not fully trust the picture being given by the statistics. Therefore, while they continued with the low rates, rather than accept all business coming their way (as some senior managers wanted), they became very selective about which risks they accepted. For years the insurer attracted good risks from other insurers until when the error was finally spotted, it was no longer a problem because the claims experience had improved so much that the low rates were now justified and the book was making a healthy profit.

Moral Hazard

Moral hazard is a very real problem for insurers. For example, there are those who do not disclose all material facts when proposing for insurance, and there are those who understate their sums insured or who exaggerate the amount of a claim. (A public opinion survey commissioned in 2001 by the Royal & Sun Alliance found that in the UK some 60% of people said they would be prepared to exaggerate a claim after a flood.)

The main types of "claims inflation" or fraud encountered after a flood event have been listed in Appendix Three, but are given in more detail below:

•  Bandwagon Effect - Where claimants are tempted to seek higher settlements after talking to other victims, and are jealous of what others obtained, or are unwilling to accept the loss adjuster's figures.

•  Profiteering - Where tradesmen inflate their usual rates due to the high demand, or carry out work which is not strictly necessary. Flood claims are particularly prone to this. For example, tradesmen may replace floors, doors and windows despite the fact that they could have been could be cleaned, dried out and re used. Often these new materials are actually more vulnerable to future flood damage.

•  Sales pressure - Where tradesmen have pressured victims who are desperate for repairs to accept unreasonable estimates or shoddy work, rather than wait.

•  Collusion - Suspicions that there is collusion between the tradesman and claimant to inflate the estimates (e.g. to cover the excess), or between tradesman and tradesman (to "fix" the lowest estimate).

•  Exaggeration - Where claimants have exaggerated the amount of damage or the value of the losses. Again this may be done to cover the excess, and the bigger the excess, the more likely it is that claimants will exaggerate the amount of the damage.

•  Wrong proximate cause - claiming that the cause was an event that is covered, when the real cause is excluded by the policy. For example, there is anecdotal evidence from loss adjusters in Canada that they are often under pressure to show that flood damage was due to sewage backup, which is covered under a household policy, rather than from other types of flood, which are not covered.

•  Missing salvage - Suspicions can be aroused in cases where damaged contents have not been retained for inspection (perhaps they never existed, or were never owned by the claimant).

•  Opportunistic Crime - Looting, mugging, assaults, and malicious damage can increase during the aftermath of a natural disaster.

•  Selective salvage - It is often alleged by insurers that if a policyholder receives warning of a flood, they will not only move valuables out of harm's way, they will also move some property, such as older electronic equipment, into the path of the flood so that the insurer will replace them with new equipment. Unlike the other sources of fraud listed above, however, the author has not been able to find any evidence of this actually happening, and would welcome comments.

Moral hazard is of course a problem irrespective of whether the insurance is provided by a private insurer or by the government. Indeed it may be more of a problem if a government provides it. An extreme example was the floods in Sarno , Italy , in 1998. A leading Mafia expert has told the author that almost all the government compensation, (the equivalent of 150 million Euros) ended up in Mafia hands.

So long as the moral hazard is low and manageable there should not be a problem for private insurance, although it might be a problem for public insurance. In the USA , where there is a federal compensation scheme, private insurers are often sub-contracted to administer claims payments because they have good systems for counteracting fraudulent claims. Similarly, in other countries, most private insurers have sophisticated methods and data for minimising moral hazard.

Certainly there are some countries where the moral or political hazard is so high that insurers would be reluctant to become involved. For example Goma, hit by the recent Nyiragongo volcanic eruption. Would it be wise for an insurer to offer cover for a city which has an economy founded on aid, smuggling, and arms dealing, with no warning or evacuation system in place? Economic and political stability, plus compliance with the Harare Declaration are crucial.

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