Flood Risk in the U.K.: What Does Mr. Market Think? (Part 4 You Ain’t Seen Nothing Yet)

The National Flood Risk Assessment  (NaFRA) of 2008, conducted by the Environment Agency (EA), calculates that 330,000 properties are at ‘significant’ risk (defined as one in 75 years) of fluvial flood in England. The survey is a bit long in the tooth nowadays, and I expect that if they repeated the assessment exercise today, more houses would fall into the ‘significant’ risk category.

In a similar vein, The Association of British Insurers’ (ABI) submission to the U.K. parliament talks of around 200,000 homes (some 1 to 2 percent of the total housing stock) that would now find it difficult to obtain flood insurance if open market conditions solely determined availability (and if they can’t get insurance, they won’t be able to support a mortgage).

For climate change “skeptics” who believe in free markets, the fact that the British insurance industry takes climate change as a given, and has done so for many years, is a difficult fact to face. In a forward to a report called “The Changing Climate for Insurers” back in 2004, The ABI’s then Head of General Insurance John Parker was unequivocal:

Climate change is no longer a marginal issue. We live with its effects every day. And we should prepare ourselves for its full impacts in the years ahead. It is time to bring planning for climate change into the mainstream of business life.

What the ABI is doing through requesting the government to create a new insurance arrangement after the expiry of the Statement of Principles agreement in June 2013 is to “prepare ourselves for (climate change’s) full impacts in the years ahead”. We can hardly say we were not warned.

We can also hardly say that climate change is alarmist nonsense or a socialist plot. The insurance industry is about as close to “red in tooth and claw” capitalism as one could get. And the message from Mr. Market in his insurance industry incarnation is very clear: climate change is coming to a place near you very soon—get used to it.

Yet the ABI has blurred the line between uninsurability and unafordability. Tim Hartford in his Financial Times’ “Undercover Economist” column sets out three hard-to-insure risks. First, genuine unknown unknowns, where the insurer has no idea of the shape of the frequency distribution and severity distribution. Second, the adverse selection situation, where there is an asymmetry of information acting against the insurer: those who know they are bad risks use their effective insider knowledge to seek out and profit from insurance. Finally, insurance that is just expensive. He puts flood insurance into the final category:

Now the third kind of hard-to-insure risk is stuff that’s expensive and happens quite often. I’m trying to buy a house, I’m nearly 40 and so I’m trying to buy insurance for my family in case I die or become too ill to work. This is perfectly possible: it’s just expensive, because it’s not unusual for middle-aged men to get seriously ill. This sounds like a much better description of allegedly uninsurable homes: if there is a one in five chance of a flood, and a flood is going to cost £50,000, don’t expect to pay less than £10,000 a year for flood insurance.

…..but unaffordability is not uninsurability. It’s insurable but expensive.

If these homes actually were uninsurable the government would need to step in and cut some kind of deal with the insurance industry – exactly the kind of deal that has lasted for the past few years and seems about to unravel. But if the problem is unaffordability, trying to solve it by cutting a deal with the insurance industry is just a way of obscuring what is really going on. The real solution is simple and stark: the government needs to decide whether it wants to pay people thousands of pounds a year to live in high-risk areas or not.

And in austerity Britain, no Chancellor of the Exchequer really wants to shoulder these extra payments. Hartford goes on:

If (the government does not want to pay), then people who currently live in flood-risk areas will see the price of their homes collapse…..

……To whatever price would tempt people to live somewhere that was not only prone to distressing and disruptive floods, but was also hugely expensive to insure. Which in extreme cases will be “zero”.

The charity the Joseph Rowntree Foundation in its March 2012 Viewpoint Report entitled “Social Justice and the Future of Flood Insurance” describes Hartford’s preferred approach as ‘individualist, risk-sensitive insurance’ as opposed to their preferred approach called ‘solidaristic, risk-insensitive insurance’.

Personally, I prefer to call a spade a spade: what we are talking about here is the socialization of risk, or alternatively we could call it the socialization of insurance-related losses. The word ‘solidaristic’ just appears a euphemism to me. But that is not to be judgemental. The right as well as the left appear desperate to keep the word ‘socialization’ hidden in the closet. For example, when the well-heeled Thames Valley occupants of river-front properties write to their local Conservative Party MPs to complain about their treatment at the hands of their insurers, I am sure the letters will contain few passages calling for the socialization of risk. So ‘individualistic, risk-sensitive insurance’ has few natural supporters among home-owners.

The Rowntree Foundation, however, goes on to define three types of fairness: 1) actuarial (espoused by Tim Hartford and Mr. Market), 2) choice-based and 3) social justice.

The choice-based distinction appears a bit of a diversion to me: few people consciously choose to buy a house with the potential for repeated episodes of flooding. Perhaps, as with all things climate change, many people chose not to know by failing to deepen their knowledge of climate change, but this seems an impractical basis on which decide whether any individual property on a flood-prone street gets insurance cover or not. Further, we must always remember the terrifying speed with which climate change has appeared on the horizon as a major social- and economic-policy issue. The Intergovernmental Panel on Climate Change (IPCC) was only created in 1988, and the issue has still not fully made the transition from academia to the general public. So I think few people have knowingly decided to take their chances with climate change when it comes to flood.

So given the foundation’s mandate to support society’s disadvantaged, it is not surprising that social-justice fairness is proposed as the governing philosophy, and ‘solidaristic, risk insensitive’ insurance as the preferred option. Whether the Labour Party will adopt the same approach we do not know. To date the only utterances I  have heard from them on the subject are criticisms of the ruling coalition government for prevarication in reaching an agreement with the ABI. Ironically, a Labour Party victory may be Mr. Angry of Pangbourne on Thames’ best bet to get insurance cover reinstated at a reasonable cost. But even if the Labour Party does adopt the flood-risk socialization principle (or its euphemism-laden equivalent), I still see trouble ahead.

The trouble comes from the degree to which climate change will distort the insurance companies’ frequency and severity probability distributions as we go out beyond a year or two. Unfortunately, data in this area appears sorely lacking. The best data we have comes from Climate Change Risk Assessment (CCRA) published by the Department for Environment and Rural Affairs in January 2012. (Note that the CCRAs will come out in a five-year cycle, so we have no update until 2017.)

The CCRA shows the total number of residential properties subject to ‘significant’ risk of flooding rising from 370,000 today (actually at the time of the last NaFRA in 2008) for England and Wales to 700,000 to 1,160,000 by the 2020s (click for larger image).

Total Properties CCRA Risk jpeg

You can see these numbers graphically here:

Number of Properties at Significant Risk of River or Tidal Flooding jpeg

Accordingly, the estimated annual damage (EAD) will likely rise from £640 million now to £750 million to £1.6 billion (all at current prices) in the 2020s. However, these numbers have a plethora of holes. First they refer to fluvial flooding only. The CCRA is quite clear about this:

These figures cover tidal and river flooding, but not surface water flooding….

….There are estimated to be more properties exposed to the risk of surface water flooding than river and tidal flooding. There is therefore an urgent need to develop projections of future surface water flood risk for the next CCRA.

Second, these numbers are based on the 2008 UK Climate Projection, which in turn has a whole range of assumptions, some realistic some not. The most important weakness, to me, is the sea level rise estimate (click for larger image):
UK Sea Level Rise Estimates jpeg
As with the Intergovernmental Panel on Climate Change’s Fourth Assessment Report (AR4), the analysis excludes dynamic ice sheet melt effects (Greenland and the Antarctic). As a result, the next IPCC report is likely to see a substantial hike in the sea level rise estimates as such dynamic impacts are included, and this will worsen the outlook for coastal flooding in the U.K. The next U.K. Climate Projection will almost inevitably show sea level rise estimates going up.
So while it is very difficult to put an exact time and amount, we appear destined to see annual damages from flood exceed £1 billion before too long. Moreover, spikes are soon likely to exceed the £5 billion of damages in 2007 (the insurance bill was the lower figure of £3 billion since not all properties were covered by insurance; moreover, even for those that were covered, the home-owners had to stump up their insurance policy excesses).
Then what part of those £1 billion average losses, or £5 billion plus spikes, will society decide to ‘socialize’? I think the ABI research brief dated January 2011 that I referred to in my previous post on flood risk may give us some tentative answers. According to the ABI numbers, at the time of the survey the average cost of home insurance was £220. Those within the ‘significant risk’ category paid slightly more at £260, but the ABI estimates that the true risk-adjusted payment should have been £690. The £430 is the current socialization of risk—a risk transfer from ‘significant’ flood risk home-owners to non-‘significant’ risk home-owners.
For holders of buildings and contents policies, the ‘significant’ risk homeowners pay £340 against £282 for the average policy nationwide. Among these policy holders, most of the risk is held within the high risk tail; that is, those properties whose risk of flooding is a lot greater than one in 75 and whose depth of flooding is likely to be measured in the tens of centimetres. This can clearly be seen in the ABI table below (click for larger image):
Under-Pricing of Flood Risk jpeg
For this reason, even if we do migrate to a ‘solidaristic, risk insensitive’ flood insurance regime as advocated by the Joseph Rowntree Foundation, I still think it inevitable that the high risk tail will get chopped off as climate change progresses.
Fot this reason, home owners needs to take a long, hard look at their properties before the flood risk chickens come home to roost. First, they need to know whether a property is already in the one-in-75-year risk category including surface water and ground water? The answer to this won’t be found by consulting the Environment Agency’s flood map.
Second, owners need to ask themselves whether their property could migrate into the high end of the one-in-75 category due to climate change? If the home enters the one-in-10 category, then I think flood insurance will ultimately cease to be available whatever new agreement is hashed out between the government and the ABI. And that, in turn, means the property will not be able to act as collateral for a mortgage loan.
Third, if a property does get flooded , how will Mr. Market value it in the future? Stuart Clarke, Principal Engineer of West Berkshire Council, sounded one positive note in his talk at Pangbourne (that I started this series of posts with). According to one study he quoted, the value of properties falls by 12% after a flooding event, but recovers to the market level after 5 years. Unfortunately, a review of the literature by the Adam Smith Research Foundation (which sounds like an ‘Astroturf’ libertarian think tank, but in reality is a legitimate academic outpost of Glasgow University) finds that such backward-looking analysis of how flood impacts on housing values to be all but useless. In short, the ‘bounce back’ house price effect found in the housing economics literature is dying and will soon be dead. I will quote the Abstract:

This paper argues that major gaps exist in the research and policy understanding  of the intersection of flood risk, climate change and housing markets. When extrapolating the research on historical flooding to the effects of future floods – the frequency and severity of which are likely to be affected by global warming – housing economists must be careful to avoid a number of methodological fallacies: (a) The Fallacy of Replication, (b) The Fallacy of Composition, (c) The Fallacy of Linear Scaling, and (d) The Fallacy of Isolated Impacts. We argue that, once these are taken into account, the potential magnitude and complexity of future flood impacts on house prices could be considerably greater than existing research might suggest. A step change is needed in theory and methods if housing economists are to make plausible connections with long-term climate projections.

This all sounds very technical, but in actual fact it isn’t. And I urge anyone of thinks they may possibly be in a-one-75- year ‘significant’ risk, or worse, property to read this report. The ‘Four Fallacies’ deserve a quick exposition at least:

a) The Fallacy of Replication: “Properties that currently experience floods are of type x and not type y. Therefore, properties that experience floods in the future will also be of type x, and not type y.”

As an example, your well-heeled owner of £2 million Thames side property already knows about flood risk and has defended against it. Further, the property will always retain an amenity value that only a river-front property, with its charming boat house, can provide. The properties 5o metres back are, in effect, subject to ‘virgin risk’; they are sub-prime properties relative to the riverfront prime, and are not set up to absorb the impact of a full-blown flooding event that goes beyond the river front (which will inevitably happen).

b) The Fallacy of Composition: “Significant financial safety nets are viable if a single area is flooded. Therefore, significant financial safety nets will be viable if all areas are flooded.”

This has been a recurrent theme of this entire blog series. We have had a system priced off a long-lasting status quo. And now the ABI says the status quo cannot continue. In the words of The Adam Smith Research Foundation:

Existing major UK floods occurred in a financial environment that ensures prospective buyers of flood-liable properties will be able to obtain both insurance and mortgage finance. It is perhaps not surprising that price effects have so far been negligible and temporary. However, once this regime starts to break down, the price effects of floods could be marked, most notably in those flood- prone neighbourhoods abandoned by insurers and mortgage lenders.

c) The Fallacy of Linear Scaling: “The impact of a flood of severity y, is of magnitude z. Therefore, the impact of a flood twice the severity of y, will be twice the magnitude of z.”

The authors pick out three examples under this heading, but I will just highlight one, since I have a keen interest in the psychology of risk:

Humans have a tendency to underestimate risks that appear distant or global, or which others seem to accept without concern (Kousky & Zeckhauser, 2006). Recent studies indicate that buyers may not have full information about properties due to  high search costs and sellers’ unwillingness to reveal information about dis-amenities such as flood risk (Chivers & Flores, 2002; Lammond, 2009).

Disclosure of flood risk is therefore likely to decrease market value (Troy & Romm, 2004; Pope, 2008). While individuals may underestimate flood risk, this may not be true if floods become frequent and ubiquitous, because flood events raise people’s awareness of potential risk (Bin & Polasky, 2004).

Even in years when a particular dwelling is not flooded, the prevalence of flooding elsewhere, communicated via accounts in news reports and social dialogue, will act as constant reminders of the household’s flood risk. People will not forget because the climate and media will not permit them; and the bounce-back effect will become a thing of the past (Pryce et al., 2011).

d) The Fallacy of Isolated Impacts: “The price of house A is reduced because it is flooded. House B is not flooded and, therefore, its price will not be reduced, irrespective of its proximity to A.”

This is really just common sense. You only need one part of the neighbourhood to be impaired in order to impact on the value of the entire neighbourhood.

The report ends with something that seems obvious to me, but I am amazed by how few have absorbed it:

Unfortunately, the housing economics literature on floods has so far developed largely under the assumption of climatic stability.

This applies to absolutely every single economic, financial and social relationship that has been forged in the modern era. The climate is undergoing a step change away from that of the holocene—under which civilisation was founded, took root and spread—to the human-generated climate of the anthropocene. The chart below, from Bart Verheggen’s blog, shows predicted temperature change set against the background of the temperature of the last 20,000 years (back to the last ice age). Message for flood prone home owners: you ain’t seen nothing yet.

Temperature Anomaly  jpeg

Can we put some numbers on the bad stuff that could happen to the price of flood-prone houses going forward? Well the Adam Smith Research Foundation certainly doesn’t.  I would sum up their paper with these words: “we used to know some stuff about the value of houses after flooding but now we don’t—and what we know we don’t know isn’t good”.

One other thing we do know is that when insurance companies know something they don’t know they will either not insure, or alternatively only insure at vast cost. Personally, when it comes to flood risk, I don’t like the fact that I know I don’t know. So when buying a house, my first reaction on coming across the merest whiff of flood risk in this new era of the anthropocene would be ‘don’t buy’. For an existing owner, the same applies: which means ‘sell’.

Finally, for those who love their houses—even if they are categorised as ‘significant’ risk—and wish to hand them down to their children, my advice would be to get active in lobbying the government to do more to prevent climate change. If you think that climate change doesn’t exist or is not your problem, then  you must understand that Mr. Market disagrees.

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