Why is it that, in many different situations and perils, people appear to want to relocate toward the risk? What is the role of the private insurance and reinsurance industry in curbing their clients’ risk tropism? Florida showed rapid percentage growth in terms of exposure and number of policyholders If the Great Miami Hurricane of 1926 were to occur again today it would result in insurance losses approaching US$200 billion. Even adjusted for inflation, that is hundreds of times more than the US$100 million damage toll in 1926. Over the past 100 years, the Florida coast has developed exponentially, with wealthy individuals drawn to buying lavish coastal properties — and the accompanying wind and storm-surge risks. Since 2000, the number of people living in coastal areas of Florida increased by 4.2 million, or 27 percent, to 19.8 million in 2015, according to the U.S. Census Bureau. This is an example of unintended “risk tropism,” explains Robert Muir-Wood, chief research officer at RMS. Just as the sunflower is a ‘heliotrope’, turning toward the sun, research has shown how humans have an innate drive to live near water, on a river or at the beach, often at increased risk of flood hazards. “There is a very strong human desire to find the perfect primal location for your house. It is something that is built deeply into the human psyche,” Muir-Wood explains. “People want to live with the sound of the sea, or in the forest ‘close to nature,’ and they are drawn to these locations thinking about all the positives and amenity values, but not really understanding or evaluating the accompanying risk factors. “People will pay a lot to live right next to the ocean,” he adds. “It’s an incredibly powerful force and they will invest in doing that, so the price of land goes up by a factor of two or three times when you get close to the beach.” Even when beachfront properties are wiped out in hurricane catastrophes, far from driving individuals away from a high-risk zone, research shows they simply “build back bigger,” says Muir-Wood. “The disaster can provide the opportunity to start again, and wealthier people move in and take the opportunity to rebuild grander houses. At least the new houses are more likely to be built to code, so maybe the reduction in vulnerability partly offsets the increased exposure at risk.” Risk tropism can also be found with the encroachment of high-value properties into the wildlands of California, leading to a big increase in wildfire insurance losses. Living close to trees can be good for mental health until those same trees bring a conflagration. Insurance losses due to wildfire exceeded US$10 billion in 2017 and have already breached US$12 billion for last year’s Camp, Hill and Woolsey Fires, according to the California Department of Insurance. It is not the number of fires that have increased, but the number of houses consumed by the fires. “Insurance tends to stop working when you have levels of risk above one percent […] People are unprepared to pay for it” Robert Muir-Wood RMS Muir-Wood notes that the footprint of the 2017 Tubbs Fire, with claims reaching to nearly US$10 billion, was very similar to the area burned during the Hanley Fire of 1964. The principal difference in outcome is driven by how much housing has been developed in the path of the fire. “If a fire like that arrives twice in one hundred years to destroy your house, then the amount you are going to have to pay in insurance premium is going to be more than 2 percent of the value per year,” he says. “People will think that’s unjustified and will resist it, but actually insurance tends to stop working when you have levels of risk cost above 1 percent of the property value, meaning, quite simply, that people are unprepared to pay for it.” Risk tropism can also be found in the business sector, in the way that technology companies have clustered in Silicon Valley: a tectonic rift within a fast-moving tectonic plate boundary. The tectonics have created the San Francisco Bay and modulate the climate to bring natural air-conditioning. “Why is it that, around the world, the technology sector has picked locations — including Silicon Valley, Seattle, Japan and Taiwan — that are on plate boundaries and are earthquake prone?” asks Muir-Wood. “There seems to be some ideal mix of mountains and water. The Bay Area is a very attractive environment, which has brought the best students to the universities and has helped companies attract some of the smartest people to come and live and work in Silicon Valley,” he continues. “But one day there will be a magnitude 7+ earthquake in the Bay Area that will bring incredible disruption, that will affect the technology firms themselves.” Insurance and reinsurance companies have an important role to play in informing and dissuading organizations and high net worth individuals from being drawn toward highly exposed locations; they can help by pricing the risk correctly and maintaining underwriting discipline. The difficulty comes when politics and insurance collide. The growth of Fair Access to Insurance Requirements (FAIR) plans and beach plans, offering more affordable insurance in parts of the U.S. that are highly exposed to wind and quake perils, is one example of how this function is undermined. At its peak, the size of the residual market in hurricane-exposed states was US$885 billion, according to the Insurance Information Institute (III). It has steadily been reduced, partly as a result of the influx of non-traditional capacity from the ILS market and competitive pricing in the general reinsurance market. However, in many cases the markets-of-last-resort remain some of the largest property insurers in coastal states. Between 2005 and 2009 (following Hurricanes Charley, Frances, Ivan and Jeanne in 2004), the plans in Mississippi, Texas and Florida showed rapid percentage growth in terms of exposure and number of policyholders. A factor fueling this growth, according to the III, was the rise in coastal properties. As long as state-backed insurers are willing to subsidize the cost of cover for those choosing to locate in the riskiest locations, private (re)insurance will fail as an effective check on risk tropism, thinks Muir-Wood. “In California there are quite a few properties that have not been able to get standard fire insurance,” he observes. “But there are state or government-backed schemes available, and they are being used by people whose wildfire risk is considered to be too high.”
With many short-term reauthorizations of the National Flood Insurance Program, EXPOSURE considers how the private insurance market can bolster its presence in the U.S. flood arena and overcome some of the challenges it faces. According to Federal Emergency Management Agency (FEMA), as of June 30, 2017, the National Flood Insurance Program (NFIP) had around five million policies in force, representing a total in-force written premium exceeding US$3.5 billion and an overall exposure of about US$1.25 trillion. Florida alone accounts for over a third of those policies, with over 1.7 million in force in the state, representing premiums of just under US$1 billion. However, with the RMS Exposure Source Database estimating approximately 85 million residential properties alone in the U.S., the NFIP only encompasses a small fraction of the overall number of properties exposed to flood, considering floods can occur throughout the country. Factors limiting the reach of the program have been well documented: the restrictive scope of NFIP policies, the fact that mandatory coverage applies only to special flood hazard plains, the challenges involved in securing elevation certificates, the cost and resource demands of conducting on-site inspections, the poor claims performance of the NFIP, and perhaps most significant the refusal by many property owners to recognize the threat posed by flooding. At the time of writing, the NFIP is once again being put to the test as Hurricane Harvey generates catastrophic floods across Texas. As the affected regions battle against these unprecedented conditions, it is highly likely that the resulting major losses will add further impetus to the push for a more substantive private flood insurance market. The Private Market Potential While the private insurance sector shoulders some of the flood coverage, it is a drop in the ocean, with RMS estimating the number of private flood policies to be around 200,000. According to Dan Alpay, line underwriter for flood and household at Hiscox London Market, private insurers represent around US$300 to US$400 million of premium — although he adds that much of this is in “big- ticket policies” where flood has been included as part of an all-risks policy. “In terms of stand-alone flood policies,” he says, “the private market probably only represents about US$100 million in premiums — much of which has been generated in the last few years, with the opening up of the flood market following the introduction of the Biggert-Waters Flood Insurance Reform Act of 2012 and the Homeowner Flood Insurance Affordability Act of 2014.” But it is clear therefore that the U.S. flood market represents one of the largest untapped insurance opportunities in the developed world, with trillions of dollars of property value at risk across the country. “It is extremely rare to have such a huge potential market like this,” says Alpay, “and we are not talking about a risk that the market does not understand. It is U.S. catastrophe business, which is a sector that the private market has extensive experience in. And while most insurers have not provided specific cover for U.S. flood before, they have been providing flood policies in many other countries for many years, so have a clear understanding of the peril characteristics. And I would also say that much of the experience gained on the U.S. wind side is transferable to the flood sector.” Yet while the potential may be colossal, the barriers to entry are also significant. First and foremost, there is the challenge of going head-to-head with the NFIP itself. While there is concerted effort on the part of the U.S. government to facilitate a greater private insurer presence in the flood market as part of its reauthorization, the program has presided over the sector for almost 50 years and competing for those policies will be no easy task. “The main problem is changing consumer behavior,” believes Alpay. “How do we get consumers who have been buying policies through the NFIP since 1968 to appreciate the value of a private market product and trust that it will pay out in the event of a loss? While you may be able to offer a product that on paper is much more comprehensive and provides a better deal for the insured, many will still view it as risky given their inherent trust in the government.” For many companies, the aim is not to compete with the program, but rather to source opportunities beyond the flood zones, accessing the potential that exists outside of the mandatory purchase requirements. But to do this, property owners who are currently not located in these zones need to understand that they are actually in an at-risk area and need to consider purchasing flood cover. This can be particularly challenging in locations where homeowners have never experienced a damaging flood event. Another market opportunity lies in providing coverage for large industrial facilities and high-value commercial properties, according to Pete Dailey, vice president of product management at RMS. “Many businesses already purchase NFIP policies,” he explains, “in fact those with federally insured mortgages and locations in high-risk flood zones are required to do so. “However,” he continues, “most businesses with low-to-moderate flood risk are unaware that their business policy excludes flood damage to the building, its contents and losses due to business interruption. Even those with NFIP coverage have a US$500,000 limit and could benefit from an excess policy. Insurers eager to expand their books by offering new product options to the commercial lines will facilitate further expansion of the private market.” Assessing the Flood Level But to be able to effectively target this market, insurers must first be able to ascertain what the flood exposure levels really are. The current FEMA flood mapping database spans 20,000 individual plains. However, much of this data is out of date, reflecting limited resources, which, coupled with a lack of consistency in how areas have been mapped using different contractors, means their risk assessment value is severely limited. While a proposal to use private flood mapping studies instead of FEMA maps is being considered, the basic process of maintaining flood plain data is an immense problem given the scale. With the U.S. exposed to flood in virtually every location, this makes it a high-resolution peril, meaning there is a long list of attributes and inter-dependent dynamic factors influencing what flood risk in a particular area might be. With 100 years of scientific research, the physics of flooding itself is well understood, the issue has been generating the data and creating the model at sufficient resolution to encompass all of the relevant factors from an insurance perspective. In fact, to manage the scope of the data required to release the RMS U.S. Flood Hazard Maps for a small number of return periods required the firm to build a supercomputer, capitalizing on immense Cloud-based technology to store and manage the colossal streams of information effectively. With such data now available, insurers are in a much better position to generate functional underwriting maps – FEMA maps were never drawn up for underwriting purposes. The new hazard maps provide actual gradient and depth of flooding data, to get away from the ‘in’ or ‘out’ discussion, allowing insurers to provide detail, such as if a property is exposed to two to three feet of flooding at a 1-in-100 return period. No Clear Picture Another hindrance to establishing a clear flood picture is the lack of a systematic database of the country’s flood defense network. RMS estimates that the total network encompasses some 100,000 miles of flood defenses; however, FEMA’s levy network accounts for approximately only 10 percent of this. Without the ability to model existing flood defenses accurately, higher frequency, lower risk events are overestimated. To help counter this lack of defense data, RMS developed the capability within its U.S. Inland Flood HD Model to identify the likelihood of such measures being present and, in turn, assess the potential protection levels. Data shortage is also limiting the potential product spectrum. If an insurer is not able to demonstrate to a ratings agency or regulator what the relationship between different sources of flood risk (such as storm surge and river flooding) is for a given portfolio, then it could reduce the range of flood products they can offer. Insurers also need the tools and the data to differentiate the more complicated financial relationships, exclusions and coverage options relative to the nature of the events that could occur. Launching into the Sector In May 2016, Hiscox London Market launched its FloodPlus product into the U.S. homeowners sector, following the deregulation of the market. Distributed through wholesale brokers in the U.S., the policy is designed to offer higher limits and a wider scope than the NFIP. “We initially based our product on the NFIP policy with slightly greater coverage,” Alpay explains, “but we soon realized that to firmly establish ourselves in the market we had to deliver a policy of sufficient value to encourage consumers to shift from the NFIP to the private market. “As we were building the product and setting the limits,” he continues, “we also looked at how to price it effectively given the lack of granular flood information. We sourced a lot of data from external vendors in addition to proprietary modeling which we developed ourselves, which enabled us to build our own pricing system. What that enabled us to do was to reduce the process time involved in buying and activating a policy from up to 30 days under the NFIP system to a matter of minutes under FloodPlus.” This sort of competitive edge will help incentivize NFIP policyholders to make a switch. “We also conducted extensive market research through our coverholders,” he adds, “speaking to agents operating within the NFIP system to establish what worked and what didn’t, as well as how claims were handled.” “We soon realized that to firmly establish ourselves … we had to deliver a policy of sufficient value to encourage consumers to shift from the NFIP to the private market” Dan Alpay Hiscox London Market Since launch, the product has been amended on three occasions in response to customer demand. “For example, initially the product offered actual cash value on contents in line with the NFIP product,” he adds. “However, after some agent feedback, we got comfortable with the idea of providing replacement cost settlement, and we were able to introduce this as an additional option which has proved successful.” To date, coverholder demand for the product has outstripped supply, he says. “For the process to work efficiently, we have to integrate the FloodPlus system into the coverholder’s document issuance system. So, given the IT integration process involved plus the education regarding the benefits of the product, it can’t be introduced too quickly if it is to be done properly.” Nevertheless, growing recognition of the risk and the need for coverage is encouraging to those seeking entry into this emerging market. A Market in the Making The development of a private U.S. flood insurance market is still in its infancy, but the wave of momentum is building. Lack of relevant data, particularly in relation to loss history, is certainly dampening the private sector’s ability to gain market traction. However, as more data becomes available, modeling capabilities improve, and insurer products gain consumer trust by demonstrating their value in the midst of a flood event, the market’s potential will really begin to flow. “Most private insurers,” concludes Alpay, “are looking at the U.S. flood market as a great opportunity to innovate, to deliver better products than those currently available, and ultimately to give the average consumer more coverage options than they have today, creating an environment better for everyone involved.” The same can be said for the commercial and industrial lines of business where stakeholders are actively searching for cost savings and improved risk management. Climate Complications As the private flood market emerges, so too does the debate over how flood risk will adjust to a changing climate. “The consensus today among climate scientists is that climate change is real and that global temperatures are indeed on the rise,” says Pete Dailey, vice president of product management at RMS. “Since warmer air holds more moisture, the natural conclusion is that flood events will become more common and more severe. Unfortunately, precipitation is not expected to increase uniformly in time or space, making it difficult to predict where flood risk would change in a dramatic way.” Further, there are competing factors that make the picture uncertain. “For example,” he explains, “a warmer environment can lead to reduced winter snowpack, and, in turn, reduced springtime melting. Thus, in regions susceptible to springtime flooding, holding all else constant, warming could potentially lead to reduced flood losses.” For insurers, these complications can make risk selection and portfolio management more complex. “While the financial implications of climate change are uncertain,” he concludes, “insurers and catastrophe modelers will surely benefit from climate change research and byproducts like better flood hazard data, higher resolution modeling and improved analytics being developed by the climate science community.”
According to Maurizio Savina and Adrian Mark, flood risk experts at RMS, as much as 80 percent of 1-in-200 year European flood losses that impact the (re)insurance industry result from Pan-European events. Understanding the “spatial correlation” of countries more prone to simultaneous flooding is, therefore, essential in managing accumulations and identifying opportunities to diversify the risk in a portfolio. In June 2016, the severe floods that affected several European countries are expected to generate claims of up to $1.6 billion for the French market and around $1.4 billion for Germany. This follows Germany’s record year for flood losses in 2013, and a year when total economic losses for flood reached $16.5 billion across central and eastern Europe, of which $4.1 billion was insured. Those flood events demonstrate how multiple river systems can be affected, impacting more than one country, and lasting for several days or even weeks depending on regional meteo-hydrological conditions. The underlying driver of such broad flooding is often just a single weather system that produces heavy precipitation over multiple countries. “SOME NEIGHBORING COUNTRIES SHARING COMMON RIVER BASINS ARE MORE LIKELY TO BE IMPACTED AT THE SAME TIME BY A MAJOR FLOOD.” In fact, a quarter of major European flood events impact more than one country. And floods simultaneously affecting at least three European countries account for more than 90 percent of tail risk across Europe. These facts underscore the importance of understanding the correlation and diversification of risk across both basins and countries in order to accurately estimate portfolio accumulations and capital requirements. Figure 1. Spatial correlation of flood risk between London and other locations in Europe. (Source: RMS Europe Flood HD Models.) To further emphasize the point, RMS estimates that approximately 20 percent of the 1-in-200 year losses arising from portfolios in Germany and the Czech Republic are from events that impact both countries at the same time. This is a statistically significant level of spatial correlation, and a consideration for (re)insurers when managing their international portfolios. Compared to Germany and the Czech Republic, for other territories spatial correlation can be significantly lower, offering (re)insurers opportunities to diversify their flood risk. Figure 1 shows the spatial correlation of flood risk between London and all other parts of Europe. The red territories are highly correlated with London and thus more likely to be hit by common events, with yellow-to-green areas not correlated with London and southern England. By using this information a (re)insurer with a portfolio concentrated in southern England could strategically target expansion into central or eastern Europe in order to grow its portfolio while minimizing accumulations of correlated risk. Closing the Protection Gap The gap between economic losses and insured loss for flood events is a global issue. Each new major flood event further stresses the need for greater insurance penetration around the world. Europe is not immune from the issue. In markets where flood insurance is not bundled into standard insurance policies, such as in Germany, adoption of flood cover is relatively low in comparison to markets like France, Spain and the U.K. While uptake increased marginally in the aftermath of the 2013 floods, there remains a significant opportunity to close the protection gap and improve the country’s flood resilience – with models playing a key role. “A BIGGER GAP BETWEEN ECONOMIC AND INSURED LOSSES FROM THE JUNE 2016 FLOODS IS EXPECTED IN GERMANY THAN IN FRANCE DUE TO LOWER LEVELS OF FLOOD INSURANCE PENETRATION.” The success of “nat cat” schemes in these markets is one mechanism with which the industry can assist governments to close the protection gap. The U.K.’s Flood Re initiative is one example of a public-private approach whose aim is to ensure residential properties at a high risk of flood have access to affordable insurance, while lobbying for increased physical resilience through continued investment in flood defenses and mitigation measures. Catastrophe modeling is essential to the future success of such schemes and to increasing Europe’s flood resilience more generally. Risk transfer and risk mitigation require high-precision modeling across Europe to better understand the impact of Pan-European flooding. But these tools can also be used to understand the importance of investment in flood defenses and inform planning guidelines in flood-prone areas. Managing Flood Accumulations RMS Europe Inland Flood High Definition (HD) Models were developed to help the insurance industry and policymakers better evaluate the potential impact of Europe’s flood events through an improved understanding of risk accumulations, ensuring a major event does not have a disproportionate impact on a (re)insurer’s portfolio. These models simulate hydrology continuously in space and time to reproduce both temporal and spatial correlation of flood risk and offer the largest single Europe-wide event set available on the market, covering 18 river basins and 8,289 catchments over 13 countries. Maurizio Savina is a senior product manager for the RMS Europe flood models. Adrian Mark is senior product manager for RMS flood maps and data.