Britain’s floods: How do we pay the £14 billion bill?

February 25, 2014

Nikolas Scherer is researcher at the Hertie School of Governance and Visiting Fellow at LSE IDEAS. The opinions expressed are his own.–

In some parts of the United Kingdom, the recent floods are the worst on record. Since December 2013, over 5,800 homes have been flooded in England alone. The cost to the UK economy had been estimated at as much as £14 billion, from damage, lost business and general economic slowdown. Whatever the exact figures, the bill will be immense.

At some point, the government has to consider where to get the money from.

There may be lessons to be learned here from a recent trend in the developing world, which has been to use climate insurance, or more technically speaking, index insurance instruments, to hedge against adverse weather events.

In contrast to traditional insurance, the payout is predetermined and depends ultimately on the realisation of a specific weather event – for example a certain wind-speed measured at a particular weather station for a given period of time – and not on the ex-post assessment of a loss adjuster. Pay-outs can be made very quickly and allow a quick influx of capital on a state’s balance sheet: money with which the government can begin the rebuilding process.

Index insurance instruments are typically enabled through complex public-private partnerships and often backed up by financial market instruments such as catastrophe bonds or weather derivatives. Investors bet on the non-occurrence of a weather event: if they are wrong, the investment is forfeited, but if the weather stays fine such instruments pay above-average dividends.

The Caribbean Risk Insurance Facility (CCRIF) is a prime example of such an arrangement.  Established in 2007, the CCRIF has made eight payouts totalling $32 million to seven Caribbean governments.

The CCRIF seems to work as intended, and has become a model for other highly exposed and vulnerable states. The World Bank currently runs a pilot project with a number of small islands in the South Pacific and is working on a similar arrangement for Africa.

There are drawbacks. Catastrophe insurance is relatively costly in the long run – governments typically pay in the order of 20% more than expected losses, primarily as a result of the cost involved in the insurer retaining enough capital to be able to make the payout. Another problem is ‘underinsurance’: with Hurricane Sandy in 2012, the hurricane was not strong enough to trigger payments to Jamaica, Haiti and the Bahamas.

A more fundamental problem is whether we really want to give capital markets a greater say in ex-post adaption measures. An index insurance arrangement integrates (re-)insurers into disaster management.

The CCRIF, for example, provides more than just cash: it seeks to advise its Caribbean member states on issues such as where to relocate their displaced citizens and rebuild destroyed infrastructure to minimise future risk. This is a reasonable public policy goal, but it may not be the only consideration, and it should not be forgotten that (re-)insurers are basically global investment houses – because they collect and invest premiums in financial market, their business model – and their ability to make payouts – is dependent on global capital flows.

Privatising public disaster management through index insurance arrangements therefore ties the well-being of both the public finances and vulnerable individuals to inherently volatile capital markets. The credit crunch 2008/2009 and the on-going euro crisis should have warned us off relying on financial market actors as ultimate providers of liquidity.

Moreover, insurance only tackles the symptoms of the problem and can lower the incentive to engage in preventative measures.

Despite these problems, index insurance instruments should not be dismissed out of hand. They remain an attractive alternative for short-term liquidity, and enable governments to raise money without making cuts, raising taxes or issuing debt.

What is needed now is clear-headed analysis about the UK’s risk exposure and the benefits and drawbacks of using such instruments compared to the alternatives. That discussion might prompt us to ask the deeper question of what government should do, and where the limits of private service delivery lie.


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