The UK’s planned state-backed flood reinsurance pool, Flood Re, could leave UK insurance companies more exposed than before as the facility relies on the government keeping its promises on flood defenses and could raise exposure to climate change, said S&P.
Rating agency Standard & Poor’s says in a new report that the Flood Re reinsurance facility plans hold hidden risks for the UK’s insurers. These hidden risks could actually result in UK insurers requiring more reinsurance protection, if the government failed to live up to its promises or if climate change hits hard and increases flood risk.
S&P says that flood risk presents the U.K. retail insurance industry with a greater challenge than other types of natural catastrophe risk because of its complex nature, the difficulty of modelling the peril accurately and the potential material impact.
Human intervention, such as the building of flood defenses, but also just continued development of the built environment, can change the flood landscape and threat dramatically. Climate change is the other great unknown, S&P says, which could change the risk posed by flood significantly.
Flood Re, which is due to come into effect in 2015 to provide the UK’s insurers with a source of flood risk reinsurance, may not be the panacea some have hoped for, note S&P.
As part of the Flood Re deal, the UK government agreed to improve and strengthen flood defenses, but if it does not live up to this promise insurers could find themselves over-exposed. The reason for this is that Flood Re prices in flood risk reinsurance for the insurers and enables them to charge households less for the risk, meaning they could find themselves without sufficient protection should the view of risk change due to the government not living up to expectations and strengthening flood defenses to the degree anticipated under Flood Re.
The scheme commits the insurance industry to insure high-risk of flood properties, which means insurers could be left with responsibility for paying claims without the protection afforded by improved flood defenses.
Climate change is also a key factor and should worst case scenarios of accelerated climate change come true then UK insurers could find themselves increasingly at risk of flood, while the Flood Re facility may become inadequate.
Flood Re will expose all U.K. household insurers to flood risk, even those that don’t underwrite high-risk properties. This is because all U.K. household insurers could be liable to pay additional levies to Flood Re, in proportion to their share of the household market. This could occur if the directors of Flood Re consider such levies necessary for the prudent management of its financial and risk position. However, if a company considers that its exposure to flood risk has increased beyond its risk appetite as a result of its exposure through Flood Re, it cannot easily manage it down.
One way of managing that could be buying additional reinsurance protection at a cost from the private market, but on top of Flood Re levies this could become unworkable we’d imagine.
If climate change hits particularly hard, Flood Re’s parameters (that is, its levies and reinsurance premiums) may have to materially change. Its existence may even come under review. At the same time, even if improvements in modeling or advances in understanding of the effects of climate change on floods cause a major revision in the industry’s view of flood risk, any redesigning of Flood Re is likely to take time, during which the industry would remain exposed to high risks.
Also, Flood Re only covers up to a 1 in 200 year flood event and S&P questions what may happen for higher return period, more severe flood events and how insurers would manage. The state may be expected to step in but that is by no means guaranteed.
S&P says that Flood Re will benefit the industry as long as the government makes good its promise on flood defenses and climate change does not hit particularly hard. Neither of those factors are guaranteed and this cannot be making UK insurers feel very comfortable as 2015 approaches.
The potential for Flood Re itself to tap the capital markets (flood catastrophe bond anyone?) or traditional retrocession markets, to offload some risk, thus expanding its ability to perhaps cover more severe flood events and better protecting the insurers, is something that perhaps needs considering.
If the worst happens and climate change hits particularly hard, increasing severe rainfall, causing rising sea and river levels and resulting in more severe and widespread flooding, UK insurers may find themselves desperately in need of more reinsurance protection, which the traditional and alternative markets would need to satisfy.
Putting in place a solution which works for just a few years, until climate change or a lack of defense work forces more amendments, will not be good for the industry as a whole. But perhaps most importantly, UK insurers need to be certain they have sufficient reinsurance protection for every scenario and this might need the private markets help if Flood Re can’t deliver.
The full report is available via the S&P website here.