Monika Gruber argues that government backstops for flood damage are artificially dulling risk adversity and unfairly distributing the costs of irresponsible construction across taxpayers.

The American-Indians didn't settle in Florida; they knew that hurricanes raged through the region year after year, destroying goods and chattels, and claiming human lives.

The Neanderthals didn't settle in the lowlands along the river Elbe in central Europe; they knew that a river flood could have destructive powers more than sufficient to obliterate their homes. In the course of the centuries, things have changed. People have settled in regions that are exposed to natural perils, and to a certain extent this has evolved with the development of insurance.

Insurance is a producer of security. Anybody who is prepared to pay the price in the form of an adequate premium can reduce a financial risk. But, at the same time, insurance is a catalyst for risk; if one's personal risk is reduced by insurance, one is willing to enter into new risks and thus to compensate for the `lost' risk. Each individual has a personal risk propensity, which cannot be reduced by insurance, a correlation known in the insurance industry as the `moral hazard' or risk compensation effect.

Taking the curve at 50mph

Take ABS, for example. Short stopping distances and full manoeuvrability while braking are the impressive advantages of ABS - the Anti-Blocking System - in automobiles. When the system was first introduced, it was thought that the extra safety it provided would reduce the number of road accidents, and insurers offered lower premiums for cars fitted with ABS. Within a few years, German motor insurers had to take back the premium reductions for ABS because there was no significant difference between ABS and conventional braking systems in the accident statistics. What had happened to the safety reserve ABS gave drivers? The answer was simple: too many drivers had relied on the extra safety and had started taking more risks. The advantages of ABS only take effect if drivers continue to drive as if they had no ABS.

Another example is the Titanic: Captain Smith had two possible routes for crossing the Atlantic. He had a choice between the safer southern route or the faster, but riskier, northern route. Since the Titanic was considered unsinkable, it did not take him long to decide. On 15 April 1912 the Titanic struck an iceberg, 1,513 people died, and Lloyd's of London paid out £1.4m (in 1912 currency) in insurance claims.

What do ABS and the Titanic have in common with flooding?

Anybody who hedges against old risks takes on new risks. Anybody who is insured against river flooding can build a property closer to a river, because they know they will be indemnified for any flood damage suffered. Somebody who builds a property close to the river but does not insure it against flooding has to bear the loss themselves.

Insurance affects risk behaviour. The risk was known long before the Elbe flooded last August. Take, for example, the town of Freital on the Weisseritz. When this tributary of the Elbe burst its banks in August 2002, it was the third occasion this had happened within a few years. Some years before, the military academy in Munich had mapped out the area for an insurance company, identifying the flood zones. What was clearly apparent was that places such as Riesa-Röderau on the Weisseritz are so highly prone to flooding that no insurance cover could be offered at affordable premiums. Nevertheless, the town boasts a shopping mall, the `Buga-Center', that was washed out when the Elbe flooded last summer, with damage levels hitting millions of euros.

If the hazard exposure is so high that no affordable insurance cover can be provided, surely buildings should not be built in these areas; the risk of flooding is simply too high. Outside of this no-go zone, premiums are graduated so that the closer a building is to the river, the higher the insurance premium. This enables the insurance company to charge a premium commensurate with the risk in order to be able to pay its claims, and also helps influence the risk-taking behaviour of the insurance buyer. If the risk and thus the insurance premium is too high, people will look for less risky locations. Economic incentives trigger ecologically appropriate responses.

Government as an insurer

If the government provides funds for reconstruction after a flooding disaster, it disrupts this regulatory mechanism. Why not build on the riverbank if the government is going to help out when the damage is done? Why insure against flooding if you know financial aid will be forthcoming? Damage suffered helps to heighten risk perception and promotes risk management. `Once bitten, twice shy', as the saying goes. But it would appear that nobody wants to learn the lesson from the recent events on the Elbe. The government is taking the bite out of the catastrophe, so why be shy? People carry on building and re-building regardless. The Buga-Center will be renovated to hide the flood damage, while in Dresden a huge congress centre is currently being constructed right on the river front. The state of Saxony has promised government aid for every single business, even those that could be flooded again any time soon.

Providing financial aid for the victims of flooding disasters is laudable, especially from the humanitarian point of view. But the distribution of that aid should send out the right signals. The German Federal Government, for example, would provide funds to help people relocate, but the state authorities are not playing along. The state governments are taking next to no notice of the Federal Government's offer; instead they are dishing out cash straight to the businesses. A further way in which government funds could be expediently used would be to build flood barriers in the form of dykes and dams. This would raise the return period for flood damage from, for example, five years to 80 years, enabling insurance premiums to be reduced accordingly.

The way government financial assistance is being distributed is not going to change society's attitude to risk. The government pays, so there is no need to move out of the exposed areas or to take out insurance against flooding. But this approach cannot work in the long term: if private providence is relegated to the sidelines, government aid will be taken for granted, seen as an entitlement. In the long run, no economy can afford to replace insurance with taxpayers' money.

A further argument against the indiscriminate allocation of financial aid is the fairness aspect: government subsidies are paid for out of the community chest. Taxpayers all over the country are financing the risks taken by individuals. The tragic consequences of the Elbe floods in August 2002 triggered a wave of solidarity and sympathy. People were pleased to help the victims. But sooner or later a change of mentality will set in across Germany, and insurance will come to be seen as an essential part of flood loss management. People will not be willing to finance other people's omissions out of their own taxes indefinitely. Anybody who deliberately takes risks must take their own precautions against them. By now, the risk of flooding along the Elbe must be evident to all, and those who rely on government support to save them from future flooding disasters are being socially irresponsible. The consequence is an unfair redistribution of incomes. Only private provision levels the playing field for all.