Compulsory elementary damage insurance: suitable for German homeowners?

Climate change is predicted to cause more frequent and intense extreme weather events like the floods seen in Germany in summer 2021, which caused nearly 200 deaths and property damage worth billions of euros.

Annual flood damage in the EU is estimated to rise to €20-40bn by 2050, so mitigating the damage through mechanisms such as flood insurance for homeowners is becoming a priority. The Insurance of Climate Risks Forum, part of the Climate Forum series of workshops, was held in Berlin on 22 November 2021 and saw representatives from science, politics, business and civil society discuss how to reform Germany’s elementary damage insurance system.

Freshfields contributors and Dr. Lutz Philip Hecker, economist and co-organiser of the Climate Forum and research assistant at Brandenburg University of Technology Cottbus-Senftenberg, summarise some of the key points below.

Low insurance density for elementary damage insurance against floods

Currently, homeowners in Germany can voluntarily insure themselves against elementary damage with private insurance companies. Insurance companies calculate premiums not only to cover expected loss, but also the costs of administration and the fluctuations in aggregate damage. Thus, insurance premiums are risk-based and depend on the individual risk of natural hazard damage to the residential real estate. However in 2021, the relatively low density of insurance coverage against floods of less than 50% of homeowners compels the state to provide ad hoc aid to uninsured homeowners in the event of disastrous flood and inundation disasters. Such ad hoc state aid is normally not budgeted for by the state and would either increase the state’s debt or reduce the state’s expenditure in other welfare enhancing areas, thus placing itself in “the Samaritan's dilemma”. Homeowners anticipating government bailouts have less incentive to insure themselves against natural hazards. The problem of underinsurance is magnified by the fact that insurers are not obliged to insure every homeowner against elementary damage, leaving homeowners in flood-prone locations frequently unable to find affordable insurance coverage.

The reform proposals aim to break this vicious circle, create more security for homeowners and cut state expenditure by increasing the insurance coverage for homeowners across the country. One of the options is mandatory elementary insurance.

Increasing insurance coverage for elementary damage 

The introduction of compulsory elementary damage (and its alternatives) poses a number of questions for the banking and insurance industries.

Compulsory elementary damage insurance for residential real estate

Compulsory insurance would mean that the law will require every homeowner to insure his or her residential real estate and compel insurance companies to offer insurance for all homeowners.

Complete insurance coverage would reduce political pressure on the state to provide government assistance to uninsured victims of a “flooding disaster”. However, if insurance premiums are risk-based, some homeowners, especially those in high-risk locations, may not be able to afford insurance. To avoid social hardship, the state may, therefore, still need to intervene with financial support.

Alternatively, uniform premiums could be introduced for all residential real estate to keep insurance coverage affordable. However, uniform premiums would reduce incentives for risk minimisation. Additionally, uniform premiums also do not incentivise adaptation to long-term consequences of climate change, for example, by moving away from high-risk locations or not constructing new buildings in high-risk locations.

From a legal perspective, the introduction of compulsory insurance would have to be carefully analysed to determine whether this would violate German constitutional law and EU law. Furthermore, would a compulsory elementary damage insurance compel insurance companies to offer such insurance to all homeowners? How much discretion would insurance companies have in formulating policy conditions, evaluating and promoting insurability as well as determining premiums? Could the insurance policy provide incentives to adapt to the long-term consequences of climate change, such as implementing good building practices for flood-prone areas?

Opt-out "for all"

Since compulsory insurance interferes with the property rights of homeowners, an opt-out "for all" option is discussed as an alternative. In Germany, homeowners’ insurance (Wohngebäudeversicherung) is very widespread, protecting insureds against fire, storm and hail damage, and damage related to drinking water (Leitungswasser), but not against flood damages. The idea of opt-out "for all" is to include an elementary damage insurance in all homeowners’ insurance policies (new and existing). However, affected homeowners would have the right to opt-out from the elementary damage insurance if they sign a legally binding declaration to forego assistance from third parties. Thereby, it is argued that such a conscious declaration would reduce pressure on the state to make payments to the uninsured victims of catastrophic floods.

From a legal point of view, opt-out "for all" is easier in terms of possible legal hurdles, as it gives property owners the option to object to insurance and allows them to bear the risks themselves. However, the option may create the risk of adverse selection as homeowners with a low risk of loss will take advantage of the opt out option. If only homeowners with a high risk of loss remain insured, this could result in a low insurance density, thus leaving the problem of underinsurance against floods unsolved. Another interesting question could be whether property taken as credit protection is considered adequately insured (see Art. 208 (5), Regulation (EU) No. 575/2013) against risk of damage if it is not insured against elementary damage in the light of increasing risk of damage caused by extreme weather events. When would credit institutions influence a homeowner’s decision to “opt-out” if the homeowner mortgages his/her residential real estate? Would the state consider financially supporting an elementary damage insurance system to provide available and affordable premiums for those who cannot opt out because opting out would preempt obtaining a mortgage? Currently, there are two well-known models – the US FEMA National Flood Insurance Programme and the UK government’s flood reinsurance scheme, Flood Re. – that could provide interesting insights into a non-compulsory elementary damage insurance for Germany.

Awareness campaigns

A mild state intervention would be to spread knowledge about flood risks and insurance options for homeowners. More effective and intense communications are hoped to persuade uninsured homeowners to voluntarily purchase elementary damage insurance.

Awareness campaigns by the state certainly increase risk awareness among homeowners. However, past campaigns have done little to increase insurance density in Germany.

Taxpayer-funded disaster fund

Another option is the creation of a taxpayer-funded disaster fund that establishes and effectively communicates pay-out rules to affected homeowners in advance. The fund would replace the current ad hoc state reliefs by increasing transparency and predictability for homeowners. The idea is to clearly separate situations where the state will assist from situations where homeowners must make their own provisions by purchasing insurance.

The establishment of a taxpayer-funded disaster fund makes aid calculable for recipients. However, this measure does not incentivise homeowners to increase their insurance coverage. In addition, it may be difficult for the state to justify bailing out some homeowners at the expense of taxpayers.

What are the German government’s plans?

Discussions during the Climate Forum made it clear that increasing insurance coverage alone is not the sole answer to climate change-related damages, in particular catastrophic flooding. Insurance is only one important element of an overall strategy that includes measures such as building protecting infrastructure, changing construction law or new construction requirements.

Indeed, the coalition agreement of the new German government consisting of SPD (Social Democratic Party), Greens and FDP (Free Democratic Party) does not contain any explicit reform plans relating to elementary damage insurance. In general, it states that the European insurance market is to be strengthened and the stability of insurance to be better ensured, among other things, by taking appropriate account of climate risks. At the same time, the agreement makes explicit reference to the flood catastrophe in summer 2021 and holds out the prospect of developing a precautionary climate adaptation strategy.

A climate law would make it possible for the German federal and state governments to jointly provide sufficient financial resources for climate precautions and adaptations. In addition, communications will be improved by creating uniform federal standards for the assessment of flood and heavy rainfall risks, and the creation and publication of hazard and risk maps. The catalogue of exceptions for the approval of construction projects in designated floodplains is to be reviewed and, if necessary, adapted. The public Credit Bank for Reconstruction (KfW) is to provide financial support to private homeowners for flood and heavy rain prevention. Introduction of compulsory insurance for property owners is not mentioned in the coalition agreement.

Before introducing mandatory insurance, its legality under the German Constitution and EU law and its concrete implications for businesses would have to be clarified.

A viable model for a non-mandatory insurance against flooding needs more research; the devil is usually in the detail. and one conceptual design may not fit all.