Ratemaking territories and adverse selection for flood insurance

Flood insurance is key to increase resilience but remains challenging to price for actuaries. Despite recent advances in high-resolution flood risk modeling, there are serious obstacles to implementing perfect risk differentiation at the homeowner's level. Creating more homogeneous ratemaking territories or groupings is one obvious solution but they need to be designed with care to avoid introducing significant adverse selection. Adverse selection may occur in insurance whenever the pricing structure is such that it attracts too many homeowners with underpriced policies affecting in turn the viability of the product. In this paper we create ratemaking territories (contiguous or not) for flood insurance based upon clustering techniques (forcing contiguity or not) and compare their risk differentiation capabilities with postal/zip codes, geopolitical territories or floodplain boundaries. We investigate adverse selection by setting up markets made of rational homeowners seeking for flood insurance among two competing sellers using different ratemaking territories. Based upon public data from Calgary (Canada), we find that postal/zip codes and the annual flood probability do not sufficiently capture flood risk, leading to significant adverse selection. When an unsophisticated seller uses geopolitical boundaries, it attracts homeowners with expected losses 2-5 times larger than its competitors yielding a loss ratio that is twice as large. The paper thus highlights the significance of adverse selection when selling flood insurance, with implications in actuarial science, climate risk management and public policy.