Peter Jones: Financial disaster waiting to happen

The cost of floods in York is yet to be counted but it will be covered by insurance this time round at least. Picture: AFP/Getty Images

Instead of just praying for and pitying those unfortunate folk afflicted by the near-biblical floods swamping northern England, you should know that you are already paying money to help them recover just as they would pay if you and your property was to be similarly deluged. But can we rely on this happening in the future?

I am talking about the insurance industry. Capitalism can be criticised for many things, but insurance is surely one of its great inventions. It makes what could be a financially terminal event – flooding, for example, which destroys a business or a home beyond the capacity of the owner to rebuild – something that can be recovered from.

It is a great example of how private enterprise can be of massive social benefit. By paying a few hundred pounds a year, we can be assured that if a torrent rages through our house, we will not have to pay what could be a bill of a few hundred thousand pounds to dry, repair and replace house and lost possessions.

This is classic pooling of resources to transfer a risk and make it bearable if it turns into a horrible reality. In essence, the insurance business is about taking the premiums we pay, investing them to earn a return, thus yielding both profits and the money to be paid out when a potential risk turns into an actual disaster.

This requires assessing risks. Could that pleasant river chuckling past those houses swell into a roaring monster and engulf them? The insurance company could find from records that in the last 200 years, floods have only reached part way up the gardens, so the risk of home inundation is low.

And that’s where there clearly is a problem. The past is no longer a reasonable guide to the future. The 1-in-200-year event seems to be now much more frequent. The word “unprecedented” is being applied to much of northern England’s current floods, meaning that they have never happened before and were therefore a risk that could not have been quantified.

The cause of this – climate change – is now accepted by all but a few head-in-the-sand types. Climate change means the earth’s atmosphere is getting warmer. Warm air holds more moisture than cold air. Therefore the type of intense heavy downpour which used to be experienced only in the tropics is now becoming more common in our temperate clime.

Flood-inducing monsoons are only one aspect of how climate change is affecting us. Our usually moderate weather cycles are becoming more extreme. Heatwaves and droughts, and the fires associated with them, blizzards and hailstorms and the damage they cause, hurricanes and tornados and the buildings they wreck, will also become much more frequent. That also means the payouts insurance companies have to make are certain to become more frequent and probably larger. But will they be able to make these payments without either bankrupting themselves or jacking up the premiums by so much as to make them unaffordable to people on modest means?

Britain’s government and financial authorities have been examining this. Those who have the misfortune to live in a house prone to flooding probably have heard of a scheme called Flood Re designed to allow them to continue to get reasonably-priced insurance for a property (provided it was built before 2009) where otherwise it might be prohibitively expensive or simply not available.

This New Year also sees the introduction of a regulatory regime called Solvency II, established by the EU. This requires that European-based insurance companies should have enough resources to pay out inside a year all claims that might arise from risks that may materialise once every 200 years.

Oh, really? Cumbrians, as they mop out houses from the third 1-in-200-year flood to have hit them in the last two months may feel that is a very bad joke. Indeed, reading through a report, published by the Bank of England in September, on how the insurance industry might be equipped to deal with the financial implications of climate change and you get the distinct feeling that we are only scratching the surface of a very, very, big problem.

Like banking, insurance is a globally interconnected industry. Events in one corner of the world can have knock-on effects in other corners. For example, the report mentions severe 2011 floods in Thailand, estimated to have caused $45 billion (£30bn) worth of damage and claims of $12bn.

The flooding was unexpectedly bad. It forced over 10,000 factories of consumer electronics, textiles and automotive products to close, disrupting not just the Thai economy, but also the global supply chain of businesses such as Sony, Nikon and Honda. Many of these firms lodged contingent business interruption claims with their insurers and reinsurers, with $2.2bn of the cost being met by Lloyd’s of London.

Events like these are happening more often. The report includes an assessment by Munich Re, a big reinsurer (a broker that transfers risks and premiums from insurers who don’t want them to insurers who do), that weather events triggering major payouts have tripled in the last 30 years, while insurance company losses from these events have quadrupled, now averaging about $140bn a year.

That’s not the only risk faced by insurers. Remember they invest their premiums to earn a return. But what if these investments also get clobbered by severe weather events? Will they not only have to make big payouts from their Solvency II capital, but also face a severe shrinking of the value of that capital?

If you think all this has a horrible familiarity, you are right. It sounds just like the inter-connectedness of the financial system based on those sub-prime mortgage payments which went dreadfully wrong in 2008, causing a global financial crisis.

The bank’s report is not exactly reassuring that the same thing won’t happen with insurance describing, for example, insurers as “reasonably well-equipped” to deal with rare events necessitating big payouts.

I fear this equipment may turn out to be as effective as a line of hastily assembled sandbags. Meantime, I suggest you make checking your insurance policies and whether premium payments are up to date one of your Hogmanay resolutions.