Why do property policies typically exclude flood coverage?

Property policies typically exclude flood coverage primarily due to the risk of adverse selection. Adverse selection occurs when there is an imbalance in the type of risks being insured. In the case of flood insurance, individuals who live in flood-prone areas are more likely to seek coverage, as they are aware of the higher risk they face. This can lead insurers to underestimate the overall risk because they might gather a disproportionate amount of high-risk clients, resulting in potential financial losses.

By excluding flood coverage from standard property policies, insurers can avoid the pitfalls of adverse selection. This allows them to maintain a more balanced risk pool by insuring properties with relatively lower risks that do not face the same level of threat from natural disasters like floods. Instead, flood insurance is often offered through specialized programs, such as the National Flood Insurance Program (NFIP), which is designed to evaluate and manage the risks associated with flood coverage more effectively.

Other factors such as the cost of coverage, demand, and the nature of natural disasters play roles in the coverage landscape, but the primary reason for the exclusion of flood coverage in standard policies is the threat of adverse selection.