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Mandatory Insurance Against Natural Disasters: Why and How?

The German flood disaster of summer 2002 highlighteda dilemma concerning insurance against damagescaused by natural forces. The area of Dresden was themost visible example. On the one hand, owing to the ris-ing incidence of natural disasters, private insurancecompanies are increasingly withdrawing coverage offloods. On the other, the availability of emergency relieffunded by the state and private donations in case of anatural catastrophe are systematically weakening theincentive for potential private victims to implement pre-ventive measures so as to reduce the risk of damages.And local authorities also believe that the governmentwill cover the cost of repairs and adjust their effortstowards risk prevention. The dilemma is further exacer-bated by the evident overestimation of the extent ofdamages in the immediate aftermath of natural disas-ters, resulting in unnecessary withdrawal of private pur-chasing power and an ad hoc reprogramming of publicinvestment.

These problems could be largely resolved by theintroduction of a general mandatory buildings insuranceagainst natural catastrophes. A practicable natural haz-ard insurance would essentially be based on two princi-ples: first, all the basic natural disasters (windstorms,floods, earthquakes, etc.) would be covered by a singlepolicy. Second, in the case of floods, only 'once-a-cen-tury' damages would be insured. Regularly recurringfloods would not be covered. The state would step in asinsurer of last resort in cases of accumulating damages,but this state intervention would be strictly limited, cov-ering only extreme losses above a certain threshold.

Damage costs of the recent flood disaster in Germany

The German experience of the summer 2002 floods isyet again a case against the common ad hoc solutions tonatural disaster damages.1 Last summer's flood disaster

caused much less damage than initially feared. The gov-ernments of the German states (Länder) affected _ Sax-ony, Thuringia, Brandenburg, Saxony-Anhalt, Mecklen-burg-West Pomerania, Lower Saxony and Schleswig-Holstein _ now estimate the total cost for their Länder at8.5 billion euro; the federal government is liable for fur-ther losses amounting to 700 million euro (cf. table 1).Immediately after the flood, the damages were estimatedat up to 20 billion euro. The federal government, Länderand local authorities provided emergency relief ofalmost 10 billion euro to cover the losses. This sum wasfinanced by postponing the second stage of the taxreform for one year and by reallocating funds from thetransport budget and the EU Structural Fund for Ger-many (cf. table 2). An additional 440 million euro weremade available to the German regions hit by floods bythe EU Solidarity Fund (established in November 2002).If, as many experts expect, the estimated losses arerevised further downwards, the available funds will sig-nificantly exceed requirements.

The insurance companies' balance sheets are in amuch less healthy condition. In fact, the losses to insur-ance companies as a result of last summer's flood disas-ter are much higher than was initially estimated. Thecosts for Allianz Insurance alone _ the company with thehighest outlay related to the floods _ amount to 770 mil-lion euro, as against the figure of 550 million euroannounced at the end of August 2002.

Allianz has been particularly hard hit by the sum-mer floods because the Eastern German home insurancepolicies that Allianz took over during the reunificationprocess also cover flood damages. Allianz recentlyannounced significant increases in premiums of up to50% for existing policies and rising deductibles. Heavyrainfall and dyke break have been added as risk factorsthat could justify denial of coverage in individual cases.Compared with the situation prior to the summer floods,this means that insurance companies would refuse toprovide coverage that was previously consideredunproblematic.

The German Insurance Association (GDV) estimatesthat if these risk factors are included, the share of unin-surable areas would increase from 10% now to between20% and 25%. Insurers are generally adopting a morecautious stance in view of the rising incidence of naturaldisaster damages in Germany. While in 'pre-Dresden'times the calculation of premiums was based on maxi-mum flood-related losses of 2.5 billion euros, the basis ofcalculation is now 10 to 15 billion.2 Before last summer's

1 'Natural disaster damages' are defined as the consequences of natu-ral events. In insurance terms, these are damages sustained followingvolcanic eruptions, earthquakes, land subsidence, landslides, ava-lanches, snow pressure, windstorms, hail, heavy rainfall, floods andstorm tides. Fires caused by lightning are covered by fire insurance,unlike damages sustained due to 'overvoltage'.

2 Gerhard Berz, 'Naturkatastrophen an der Wende zum 21. Jahrhun-dert: Weltweite Trends und Schadenpotentiale.' In: V. Linneweber (ed):'Zukünftige Bedrohungen durch (anthropogene) Naturkatastrophen',Bonn, 2000, p. 14; GDV, personal communication.

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floods, flood damages were based on an observationperiod of 100 years; 'since Dresden' maximum damagesare calculated on the basis of an observation period of200 to 300 years. The longer the period of observationon which the calculation is based, the higher the poten-tial maximum damages that can be attributed to anevent. In this respect the German insurance market isadopting procedures which have long been commonpractice in the international reinsurance industry.

Do we need mandatory insurance?

The conflicting trends described above reflect a basicdilemma of the current approaches to managing the riskof natural disasters. While _ faced with a rising inci-dence of natural catastrophes _ private insurance com-panies are increasingly withdrawing coverage for dam-ages resulting from disasters such as windstorms andfloods, the ad hoc systems of government emergencyrelief as well as private donations frequently lead toovercompensation of losses and an overestimation of theactual cost of damages. The overestimation results in anunnecessarily large withdrawal of private purchasingpower and government investment funds. This forcesthe government to abruptly revise the programmes onits policy agenda and thus damages the investment cli-mate. Together, these factors affect the credibility ofeconomic policy and have a negative impact on nationalgrowth.

Ad hoc government aid and private donations haveunfavourable effects in other ways, too. They systemati-cally reduce the incentive for those affected by floods toreduce the risk of damage by using protective measuressuch as appropriate building materials and provisionsagainst backwater flooding. There is also too little 'col-lective prevention', as the local authorities continue torely on federal aid.

For these reasons, general mandatory insuranceagainst damages by natural forces has been suggestedfor Germany.3 Insurance of this kind would allow thepolicyholder to calculate the amount of compensationexpected and would also create access to insurance cov-erage in areas that are particularly exposed to risks. Atthe same time, appropriately designed policies wouldprovide an incentive to engage in both collective andindividual prevention because premiums could be low-ered on the basis of the protective measures imple-mented and the choice of less dangerous building loca-tions. Moreover, mandatory insurance would minimisethe negative economic effects resulting from unforeseencontractions of the federal budget. Damages to the pub-lic infrastructure and to the environment, which _

according to preliminary estimates _ account for almosthalf of the total losses incurred in last year's flood disas-ter (cf. figure 1), would, however, be still covered by thestate even if general mandatory insurance were intro-duced.

As a result of its experiences following the last 'once-a-century' flood, the German insurance industry has

Table 1

Damage Costs of the Summer 2002 Floodsin Germanyas at December 2002

Region Damages

Saxony 6 billion euro

Saxony-Anhalt 1 billion euro (direct losses)1 billion euro (indirect losses)

Brandenburg 219 million euro

Lower Saxony 158 million euro

Thuringia 48 million euro

Mecklenburg-West Pomerania 3.4 million euro

Schleswig-Holstein 2.0 million euro

Federal government 700 million euro

Total approx. 9.1 billion euro

Source: www.mdr.de of 11 December 2002

3 Cf. Reimund Schwarze and Gert G. Wagner: 'In the Aftermath ofDresden: New Directions in Flood Insurance', DIW Discussion Paper,Berlin 2003, forthcoming.

Table 2

Emergency Relief and ReconstructionProgrammes for the Flood Damagesof Summer 2002 in Germany

Programme Funds

Emergency relief 500 million euro

'Reconstruction aid' fund3.6 billion euro (federal share)3.5 billion euro (Länder and local authorities)

Transport budget restructuring approx. 1 billion euro

EU Structural Fund for Germany 1.2 billion euro

Total approx. 9.8 billion euro

Source: Federal Ministry of Finance, Monthly Report, September 2002.

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abandoned its previous opposition to mandatory naturalhazard insurance.4 The purpose of this article is to givea significant impact on the discussion on the basis ofnew and more elaborate considerations.

Disaster funds preferable to insurance?

Large-scale natural disasters are regularly followed bycalls for the establishment of disaster funds at nationalor international level. The Eighth Conference of the Par-ties to the United Nations Framework Convention onClimate Change (UNFCCC) in New Delhi saw a furtherreinforcement of such demands.5 At the European level,an EU 'Solidarity Fund' for emergency relief and recon-struction aid was set up in the immediate wake of lastyear's floods in Germany and some of its neighbouringcountries. The fund is endowed with a maximum 1 bil-lion euro per annum. Over 70% of this fund was spent

on emergency relief for the European summer floods (cf.figure 2).

However, disaster funds have considerable disad-vantages relative to insurance-based solutions. First ofall, funds do not set any incentive for prevention.Instead they dilute the incentives to reduce risks. Sec-ondly, insurance companies are much better able toabsorb risks than disaster funds, for example by hedg-ing with counter-risks such as the trend in the buildingsector or capital market risks, or by covering indepen-dent single risks with one policy.6 Thirdly, the reinsur-ance system means that risk pooling is automatic atinternational level, whereas in the funds context thismust be thrashed out in lengthy international negotia-tions.

Experiences with international compensation funds –e.g. within the context of EU structural aid or mostrecently the EU Solidarity Fund _ show that in negotia-tions of this kind the countries involved strictly pursuetheir own interests and incur substantial lobbying costsin their efforts to push through their own points of view.

Basic principles of a mandatory natural hazard insurance

Based on experiences to date with supplementary natu-ral hazard insurance in Germany7 and other countries,8

a sufficient regional coverage against natural disasterscan only be guaranteed if contractual freedom is limitedto some extent. With the exception of windstorm andhail insurance, the 'free' market has produced an insur-ance density of less than 10% in the areas exposed tonatural hazards. Mandatory insurance is required if thedisadvantages of the current situation are to be avoided.

This type of insurance should be based on threeprinciples:– It guarantees comprehensive demand for and com-

prehensive supply of insurance coverage.– It promotes prevention of natural disasters on the

part of both private owners affected and the publicauthorities.

– It is open to new domestic and foreign insurancecompanies and permits competition within theindustry.

4 Cf. H. Fromme and S. Clausen: 'Allianz führt neue Flutversicherungein'. Financial Times Deutschland of 17 February 2003. Swiss Reinsur-ance has made similar proposals; cf. H. Fromme: 'Swiss Re schlägtneue Flutdeckung vor'. Financial Times Deutschland of 24 October2002.5 'Negotiation of a Framework Convention on Climate Change.' Docu-ment A/AC237/WG.II/CRP8. B. Müller discusses concrete models: 'AnFCCC Impact Response Instrument as Part of a Balanced Global Cli-mate Change Regime.' IIED Side Event at FCCC SB 16. Bonn, 11 June2002.

Figure 1

Structure of Flood Damages Sustainedin Summer 2002 in Germanyas at December 2002

Source: Estimates of DIW Berlin.

DIW Berlin 2003

Other(waterways, etc.)

9%Business9%

Privatehouseholds

20%

Infrastructure40%

Agricultureand forestry

22%

6 Cf. Neil Doherty, 'Insurance Markets and Climate Change.' GenevaPapers on Risk and Insurance 22, pp. 223-237, 1997.7 Cf. Reimund Schwarze and Gert G. Wagner: 'Flood Catastrophe inGermany _ Beyond Emergency Relief'. Economic Bulletin, vol. 39, no.9, September 2002, pp. 317-320, here p. 318.8 T. von Ungern-Sternberg: 'Gebäudeversicherung in Europa. DieGrenzen des Wettbewerbs.' Bern 2002.

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Comprehensive demand and supply guarantee by pooling risks and mandating an obligation to contract

The limitations on contractual freedom deriving frommandatory insurance can be kept to a minimum if natu-ral hazard coverage is appropriately designed. A stan-dard argument against mandatory flood insurance isthat nonexposed homeowners, e.g. in mountain areas,are forced to purchase insurance that they do not need.This problem of 'missing exposure' can be solved bypooling previously distinct risk events to such an extentthat individual exposure to risk would be almost guar-anteed. If, for example, the risk of flooding and othermore 'local' natural hazards were covered in associationwith the omnipresent risks of windstorm and hail, thenevery building proprietor would be personally at risk ofat least one of these perils. At the same time, by charg-ing exposure-related tariffs the degree of 'cross-subsidis-ation' between the various areas9 would be reduced toan acceptable level. For example, if premiums were cal-culated according to different levels of risk by taking the

flood zones of the electronic Zoning System for Floods(ZÜRS) into consideration, the risk equivalence of thispolicy would clearly increase.

Pooling of risk would further decrease the need to'cross-subsidise' by increasing the efficiency of risk cov-erage. Pooling low frequency events (such as 'once acentury' floods) with high frequency events (such as hailstorms) is a common way of extending the 'limits ofinsurability'. It has been applied in many fields, as in thecase of car insurance, where insurance against hail isincluded in standard coverage even if the car is usedonly in areas where hailstorms seldom occur.10

It could be possible that a tied policy of natural haz-ards and windstorm insurance would render mandatoryinsurance unnecessary. Because of its wide consumeracceptance, comprehensive windstorm insurance wouldautomatically trigger coverage against damages byother natural forces in a compound natural hazard pol-icy.

This policy structure would be supplemented byhigh risk-based deductibles in extremely exposed areasthat are regularly hit by floods. Risk-based deductiblesmake sense especially from an individual point of view,for in the case of very frequent events self-insurance, i.e.the accumulation of personal reserves, would be cheaperfor the insured party than purchasing coverage. In thelatter case policyholders would also have to pay theadministrative costs of the insurance company in addi-tion to the expected damages. In highly exposed areas,therefore, deductibles should be calculated such thatonly rare, large-scale events that cannot be self-insuredare covered by insurance.

An obligation to contract would ensure that insur-ance companies cannot 'cherry pick'. There are wide-spread fears that competition in areas with different lev-els of risk exposure would induce insurers to cover onlythe least-exposed objects and not the buildings at highrisks.11 Even if this likelihood is slim under the pro-posed system of pooled risks and risk differentiated pre-miums, only an obligation on the insurers to contractcan guarantee the desired comprehensive supply. Thiscould be achieved within a framework of mandatoryreinsurance for direct insurers that stipulated an obliga-tion to contract to any customer.

9 Some degree of cross-subsidisation is practically impossible to avoid.Cf. 'Katastrophendeckung: Kapazität nur aus Quersubventionierung?Aus einer sigma-Studie der Schweizer Rück.' Versicherungswirtschaft18/1995, p. 1276; similarily Swiss Re, Natural catastrophes and manmade disasters 2000: Fewer insured losses despite huge floods, sigma2/2001, p. 11.

Figure 2

EU Solidarity Fund for Natural Disasters,by Countryas at November 2002

DIW Berlin 2003

Remainingfunds

272 million euro

Floodsin Germany

444 million euro

Floods in Austria134 million euro

Floods inCzech Republic129 million euro

Floods in France21 million euro

Source: www.europa.eu.int.

10 Christophe Courbage and Patrick M. Liedtke (2002), 'On insurabil-ity, its limits and extensions.' http://www.nottingham.ac.uk/business/cris/ukec/2002paper7.pdf11 Jill Insley, 'The pool that's vital to flood-risk homes', The Observer,September 29, 2002; Dwight M. Jaffee and Thomas Russell, 'Behavio-ral Models of Insurance: The Case of the California EarthquakeAuthority', National Bureau of Economic Research Papers, 2000.http://faculty.haas.berkeley.edu/jaffee/Papers/NBER00.PDF

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State intervention only for mega damages

The insurance-based solution will not suffice withoutstate participation. Especially in the case of accumulat-ing damages the state must step in as the insurer of lastresort. The state's involvement should, however, bestrictly limited to covering very large damages whichare above a certain threshold.

It is important that the primary insurers' and rein-surers' coverage be closely dovetailed with the states'coverage of excess losses. The new insurance againstterrorism risks ('Extremus'), which was established afterSeptember 11 in Germany, is an example of such a stag-gered system of private and public coverage. Extremusinsures against damage to property and losses that aredue to the interruption of business operations that occuras a consequence of terrorist attacks and exceed 25 mil-lion euro. The insurance industry provides a primaryinsurance and reinsurance capacity totalling 3 billioneuro to this end. If the damages caused by an eventshould exceed this sum, then the state guarantees anadditional capacity of up to 10 billion euro to cover theexcess losses.12

In Germany, according to preliminary estimates ofthe insurers association (GDV), a primary insurance andreinsurance capacity of up to 6 billion euro could be gen-erated on annual aggregate13 for natural disaster dam-ages, so that the federal government and the states(Länder) would only be liable for losses exceeding thissum. Given that insured private and business losses typ-ically amount to less than half of economic losses, thestate would thus only have to intervene when faced withextreme events where total damages amount to wellover 12 billion euro.

Prevention via deductiblesand on-site analyses

In the interests of fostering prevention, premiumsshould depend on the extent of provision undertaken byowners of a building. For private buildings this could beeasily achieved if deductibles were to rise in accordancewith the exposure to risk. Failure to implement provi-sions would thus be penalised more harshly in regionswhere natural phenomena are a frequent occurrencethan in regions where these events are rare. However, inhigh-risk zones it is efficient to cover regular damages

by self-insurance and to buy insurance coverage onlyfor exceptional losses.

For industrial buildings, more complex methods ofon-site risk analysis would be required because in thisarea the technical preventive measures depend on thetype of enterprise in question and because industrialplants are often spread out over several zones of riskexposure. However, there has already been substantialexperience with differentiated, risk-based premiums forindustrial fire and environmental liability insurance.14

In industry, mandatory insurance would not necessarilybe desirable, because these are basically enterprise risks.Voluntary insurance seems sufficient in this case.

Openness to competition

A 'cleverly' designed regulated insurance system of thiskind could also be open to new domestic or foreigninsurers, as long as they were subject to the same obli-gation to contract and mandatory reinsurance as thedomestic suppliers. Insurers for buildings would eachretain an agreed share of the losses (e.g. 30%) them-selves, and pass on the larger share to a reinsurer poolwith obligatory membership at fixed premiums. Thecompetition at primary insurer level would thus bereduced and there would be no incentive to pick 'good'clients. Competition, even a regulated one, on an openmarket would be beneficial to the efforts to broaden theEuropean common market for services and would con-form to European law. It is also possible that the insur-ance model would develop dynamically in an open mar-ket. Experience with industrial environmental liabilityinsurance in Germany has shown, for example, that byopening up the competition between suppliers to foreigninsurers, the 'limits of insurability' can be greatlyextended.

Conclusion

The system of general natural hazard insurance forbuildings proposed here (based on linking risk-baseddeductibles in high-risk zones and obligatory reinsur-ance for primary insurers with state participation andan accompanying obligation to contract) is summarisedgraphically in figure 3. In particular, the deductible for

12 Cf. R. Lansch: 'Assekuranz gründet Terrorversicherung'. Han-delsblatt of 3 September 2002.13 The annual aggregate measures the total maximum coverage whichis available for a limited number of events _ in general, two per year.

14 Reimund Schwarze, 'Environmental Liability and Accident Preven-tion: Preliminary Experiences in Germany.' European Environment.The Journal of European Environmental Policy, Nov/Dec 2001, pp.314-323.

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homeowner's insurance increases sharply in high-riskzone 3 because there is no sense in insuring 'periodicflood damages'. Self-insurance is simply the cheaperoption where floods are a regularly recurring event.

Mandatory natural hazard insurance can be effi-ciently implemented in a competitive insurance system,but state participation is essential. State involvementshould, however, be strictly limited to covering 'megadamages'. The insurance industry, in addition to pri-mary insurer capacity, would provide a reinsurancecapacity in the form of a pool of primary insurers andreinsurers with obligatory membership for all compa-nies. Only when the primary insurance and reinsurancecapacity is exceeded on annual aggregate would thestate provide additional capacity to cover the shortfall.

In Germany, according to preliminary estimates, adirect insurance and reinsurance capacity of up to 6 bil-

lion euro could be generated to cover natural disasterdamages, so that the federal government and Germanstates (Länder) would only have to intervene whereinsured losses exceeded this sum. The floods of summer2002 showed that an additional government capacity ofup to 10 billion euro should suffice to cover evenextreme flood damages. Insured private and businesslosses are typically much lower than for the economy asa whole losses. Since the state guarantee would onlyapply to private and business losses, the federal govern-ment, Länder and local authorities would thus only haveto share a coverage in exceptional cases. This, for exam-ple, would not have been the case for the summer floodsof 2002 in Germany.

Reimund Schwarze and Gert G. Wagner

Figure 3

Structure of Mandatory Natural Hazard

Mandatory insurance,multi-risk policy

Voluntary insurance

Residental buildings Businesses/industry

Risk zone 1

Risk zone 2

Risk zone 3

On-site risk analysis

DeductiblesDamages Deductibles

Primary insurerPrimary insurer

Mandatory reinsurance, obligation to contract

Mega damagesReinsurance pool ('NatCat')

State coverage (6 to 10 billion euros)

DIW Berlin 2003