University of Liverpool researchers from the Institute for Financial and Actuarial Mathematics explain how embracing a new approach to flood risk management across socio-economic environments can help to address the impacts of climate change and reduce global inequality.
The global impact of flooding
According to the United Nations Office for Disaster Risk Reduction (UNISDR), climate-related disasters accounted for 91% of all recorded disasters between 1998 and 2017. Floods are responsible for 43% of these events, making them the most frequent climate-related disaster worldwide. Aside from their destructive effects on the environment, the devastating human impact that floods have on populations around the world cannot be understated.
The UNISDR estimates that flooding between 1998 and 2017 affected over two billion people globally with associated economic losses of $656 billion USD. Although the absolute value of economic losses resulting from floods are often greatest in high- and upper-middle-income countries, the reality is that low- and lower-middle-income countries face the greatest economic threat from flooding when losses are considered relative to GDP.
Climate change is widely accepted as a key driver behind the global increase in flood risk but the exact relationship between the two is not currently fully understood, as flood risk is also highly dependent on socio-economic factors. Community exposure and vulnerability to extreme flooding is continually rising due to the acceleration of population growth, wealth and urban development in risk-prone areas which are experiencing fast-paced economic improvements. Addressing the threat of flood risk on the global scale is therefore crucial for sustaining future economic development worldwide.
Flood insurance and risk pooling
Mitigating the threat that flooding poses to communities, flood insurance facilitates the transfer of risks associated with extreme flood events away from those who would be affected. Insurance coverage can range from full coverage (all those affected by floods have insurance cover) in countries where participation is mandatory, to coverage of less than 10% of the population, with some flood insurance not actively taken when offered.
Flood insurance is provided by schemes with varying levels of public and private involvement. Around the world, the demand for traditional flood insurance and the coverage offered by insurance schemes is generally low, with the most vulnerable countries often reliant upon governmental and international aid. Catastrophe risks – such as those linked to floods – are naturally diversifiable when considering a large geographical area.
The nature of the risk, be it a flood, an earthquake, or a pandemic, and the time of its occurrence largely depends on geographical location. The likelihood of all risks occurring at the same time and of the same magnitude is extremely low, therefore when addressing a group of such risks together rather than considering each individual risk, the overall risk is ‘diversified’. Insurance risk pooling exploits this principle, facilitating the management of unpredictable risks through participation in a risk pool.
Regular contributions by members of the pool, which covers any loss in the event of a claim, form the basis of the risk pooling structure. Flood risk pooling systems greatly benefit exposed communities – funding flows improve and disaster costs are spread throughout the pool.
This eliminates the need for governments to reallocate their budgets in response to a crisis and increases the efficiency of disaster relief. Successful examples of existing multi-country risk pools include the Caribbean Catastrophe Risk Insurance Facility, the Pacific Catastrophe Risk Insurance Pilot and the African Risk Capacity.
Flood risk management across socio-economic environments
Recognising the importance of flood risk management, our new research paper ‘On Flood Risk Management Across Socio-economic Environments’ (DOI: 10.26360/2020_4) published in Revista Anales del Instituto de Actuarios Españoles, discusses the risk pooling methodology at both the continental and global levels.
By analysing 120 years of global catastrophic event data taken from the Emergency Events Database, we were able to observe the historical annual flood economic losses for each country (as a percentage of GDP) and group countries into a number of risk pools, both globally and per continent.
We then determined how to cluster groups of countries by event frequency, followed by their Value at Risk (VaR) – a measure which represents the potential financial loss each country could experience.
Our risk pooling methodology groups countries in a way that minimises the total financial risk across a region.
We analysed the appropriateness of this strategy for each allocation by comparing the shared VaR of a pooled risk group with the sum of the non-pooled VaRs of individual countries within that group.
While in most instances the group VaR is the lower measure, indicating a positive risk-pooling effect, risk exposure may also increase as a result of the pooling.
Although certain group members (countries) would fare better through the management of their own risk, at the continental level flood risk pooling considerably reduces the VaR of all continents worldwide despite any higher risk exposure at the country level.
Our analysis leads us to advocate risk pooling via joint insurance products between countries or regions, sharing the risks associated with floods in a ‘give-and-take’ manner.
Equal partnerships are at the heart of this concept, enabling a widespread immediate response to a disaster and therefore minimising the implications for communities exposed to flooding.
As researchers, we are passionately championing this cooperative risk management solution to flooding.
When used in conjunction with innovative insurance strategies such as parametric insurance and microinsurance, this risk pooling approach would allow vulnerable communities in lower-income countries to be better financially shielded from the devastating aftermath of natural disasters such as flooding.