Uncertainty surrounding climate change and its influence on increased frequency and severity of extreme weather events raises questions about the funding adequacy of the UK’s government-backed reinsurance scheme Flood Re, according to Fitch Ratings.
Flood Re remains scheduled for launch in April 2016, in what’s an effort from the UK government and global insurers and reinsurers to provide more affordable flood insurance for vulnerable UK residents.
While the new risk brought to the market via Flood Re has seen strong demand, Fitch Ratings has highlighted potential challenges brought about by climate change, and also the continued and possibly increased need for flood defence spending.
“Increasing frequency and severity of storms as a result of climate change could result in Flood Re being inadequately funded,” said Fitch.
Climate change has fast become one of the most pressing issues and debated topics across all industries.
And following pledges from world leaders at the Paris COP21 climate talks in late 2015 to increase the role of insurance to protect the vulnerable against its perils; the risk transfer landscape has often been at the forefront of discussions.
The impacts of climate change remain uncertain, and while some scientific research predicts a rise in the number of events and the severity of these events, just how much of an influence climate change actually has here isn’t clear.
But the general view across the risk transfer industry and also from talks at COP21 and beyond, seemingly points towards a rise in the frequency and severity of natural catastrophe events.
For Flood Re, as highlighted by Fitch, a rise in extreme storms across the UK could mean that the funding of the retrocessional reinsurance scheme might be insufficient, which in turn would likely result in additional industry levies, that would “likely be passed on to policyholders.”
“A study by the Committee on Climate Change estimated that flood defence spending would need to increase by GBP20m a year on top of inflation until 2035 just to keep the number of significant-risk properties steady,” said Fitch.
It’s worth noting here that owing to the broad uncertainty of climate change and its impact on more intense and frequent storms and resulting flooding, the £20 million per year figure could in fact be higher, underlining the need for continued research into climate change and the possible need for further flood defence funding.
It’s also important to note that reinsurers participating in the Flood Re retrocession program will want to be aware of the climate related uncertainty and ensure it has been factored into their modelling and pricing of the reinsurance program.
Fitch stresses that any shortfall in Flood Re capacity owing to higher-than expected flood losses from climate change would most likely see re/insurers cover the additional costs, again noting that this could lead to higher annual premiums for policyholders, something the scheme was designed to mitigate.
In its special report, ‘Flood Re: Temporary Solution for Policyholders,’ Fitch also highlights the need for continued investment in flood defence systems in the UK, citing that Chancellor George Osbourne recently announced additional funding for flood defences in his 2016/2017 budget.
However, “Fitch believes that by making home insurance affordable, Flood Re reduces the financial incentive for policyholders to make flood-resilience improvements to their properties and or the government to invest in flood defences.”
Fitch suggests that by enabling more affordable flood protection, which is the reason for the establishment of Flood Re, policyholders will be less inclined to spend money on flood defence systems to protect their homes, as they will be paying a premium that will repair any damage from flooding.
This could be extremely detrimental to effectiveness and funding adequacy of Flood Re, especially when combined with the potential for greater capitalisation needs in light of any increased frequency and severity of flooding events as a result of climate change.
Should a rise in flooding events occur alongside a reduction in flood defence measurements, Flood Re could find itself in need of greater retrocessional reinsurance, which in turn could create opportunities for capital markets investors to participate in the scheme and access new risk.
As Fitch notes, Flood Re will likely provide more affordable home insurance for households at heightened risk of flooding until it expires in 2039.
However, a failure to continue flood defence resilience practices and the potential influence of climate change could hinder the performance of the retrocessional reinsurance scheme, meaning that without additional capacity from insurers, reinsurers, and possibly the capital markets, policyholders could be paying higher premiums once again.