Policy options for managing flood insurance

In much of the developed world, private sector insurance plays an important but often underappreciated rolein the management of natural disasters. Insurance works by spreading individual and independent risks across all policyholders. This notion succeeds for uncorrelated risks such as theft and motor accidents, but is problematic where risks are highly correlated in space and time, as in the case of natural hazards. Insurers transfer much of this risk to international reinsurers who are guided by the principle that natural catastrophes in different parts of the world are uncorrelated. Global diversification allows reinsurers to confer to direct insurers the same assurance that insurers offer their policyholders. This paper outlines these principles and poses questions as to how agovernment might respond when insurers assess some risks as uninsurable. It considers a range of policy options including some that seek to avoid situations where interference by governments in the marketplace has proved unhelpful. A key paradigm is that insurance premiums should reflect actual risk in order to encourage homeowners, planners and government decision makers to reduce risks. While our focus is riverine flood risk, the principles can be generalized to a wide range of natural hazards.