Managing Catastrophic Risks Through Insurance and Mitigation

Insurance is the only policy tool in the analyst’s repertoire that can reward individuals for taking loss reduction measures in advance of a disaster by giving them lower premiums while at the same time providing these same policyholders with compensation should they suffer losses from the insured event. In theory insurers could refuse to provide coverage against certain events unless the prospective policyholder undertook certain protective measures to lower the potential losses from the risk in question. Although this was common practice with respect to fire coverage in the 19 th century, insurers have been reluctant to do deny coverage on these grounds today. This paper examines the impact the role that insurance and other policy tools can play in encouraging property owners to take steps to reduce losses from natural hazards such as earthquakes, floods and hurricanes and the impact that these measures will have on the solvency of insurers Three basic questions will be addressed in this regard: What are the necessary and sufficient conditions for property owners to want to adopt cost-effective risk mitigation measures (RMM)s? What impact will mitigation measures have on the profitability and insolvency of insurers and their willingness to pass the expected reduction in losses to property owners? What is the appropriate role of building codes, third party inspections and enforcement mechanisms in encouraging the adoption of mitigation measures on property? The next section of the paper focuses on the demand side by developing a simple model for determining when property owners should adopt cost-effective measures and provides empirical evidence as to why most individuals do not utilize this model. Section III turns to the supply side and investigates under what conditions insurers will want to promote mitigation through premium reductions. It also explores the linkage between mitigation and insurers’ need for financial protection through reinsurance and/or capital market instruments that have recently been introduced. The importance of building codes as a necessary means of enforcing mitigation in a hazard management program is examined in Section IV. The concluding section proposes a plan of research for evaluating the importance of insurance coupled with mitigation and other policy tools for reducing future disaster losses.

Reflections on U.S. Disaster Insurance Policy for the 21st Century

This paper proposes that we examine the feasibility of including earthquake and water damage as part of a global homeowners policy for dealing with the catastrophic risk problem from natural disasters. By undertaking such an analysis one is forced to address the question as to who should pay for disasters and how can we encourage individuals to undertake protective measures in advance of the event. Two key principles underlying any disaster insurance program is that the rates reflect the risk and that coverage is affordable. For lower income individuals it will be impossible to satisfy the first principle without some type of subsidy from the public sector. There are also a set of questions as to whether the private sector has the ability to cover losses from catastrophic disasters on their own or will need some type of public sector involvement. There are a set of related issues that have to be considered when developing any type of disaster insurance program. These include the ability to assess the risk and the uncertainty of the models, the appropriate role of regulation, balancing the concerns of the different stakeholders concerned with this issue and the types of subsidies and back-up provision that can be offered by the public sector. Finally we need a clear understanding of the political and social landscape as well as how choices are actually made so as to develop a disaster insurance program as part of a hazard management strategy that achieve its desired impacts. The challenges in this regard are quite different today than they were in the 20th century because of the magnitude of losses from these disasters in the past few years.Health and Safety

Reflections on U.S. Disaster Insurance Policy for the 21st Century

The devastation caused by hurricanes during the 2004 and 2005 seasons has been unprecedented and is forcing the insurance industry to reevaluate the role that it can play in dealing with future natural disasters in the United States. As shown in Table 1 the four hurricanes that hit Florida in the fall of 2004 -- Charley, Frances, Ivan and Jeanne---and Hurricanes Katrina and Rita in 2005 comprised half of the top 12 disasters with respect to insured losses between 1970 and 2005. On a related note, 18 of the 20 most costly disasters occurred between 1990 and 2005 and 10 occurred in the 21st Century. This context is totally different than the scale of economic loss the country has suffered from natural disasters and other extreme events in the 20th century. The first section of the paper addresses the first question by outlining two principles on which a disaster insurance program should be based. Section 3 then focuses on the second question by analyzing the insurability of a risk and examining the challenges facing the private sector in providing coverage against natural disasters. Section 4 turns to the third question and delineates the opportunities and challenges of a comprehensive disaster insurance program. Section 5 poses a set of open issues that are currently being addressed by a research project on disaster insurance undertaken by the Wharton Risk Center in conjunction with the Insurance Information Institute and Georgia State University. The concluding section summarizes the key issues associated with providing disaster insurance in the 21st century.

Risk Analysis and Risk Management in an Uncertain World

The tragic attacks of September 11 th and the recent bioterrorist threats have raised a set of issues regarding how we deal with events where there is considerable ambiguity and uncertainty on the likelihood of their occurrence and their potential consequences. This paper discusses how one can link the tools of risk assessment and our knowledge of risk perception to develop risk management options for dealing with extreme events. In particular it suggests ways that the expertise of members from the Society for Risk Analysis can apply their talents to the risks associated with terrorism and discusses the changing roles of the public and private sectors in dealing with extreme events.

Coping with Stigma: Challenges & Opportunities

This paper discusses several strategies for preventing technological stigma from causing unwarranted bias in public decision making

Self-protection and insurance with interdependencies

We study optimal investment in self-protection of insured individuals when they face interdependencies in the form of potential contamination from others. If individuals cannot coordinate their actions, then the positive externality of investing in self-protection implies that, in equilibrium, individuals underinvest in self-protection. Limiting insurance coverage through deductibles or selling “at-fault” insurance can partially internalize this externality and thereby improve individual and social welfare. JEL Classification: C72, D62, D8

Social Reinforcement: Cascades, Entrapment and Tipping

There are many social situations in which the actions of different agents reinforce each other. These include network effects and the threshold models used by sociologists (Granovetter, Watts) as well as Leibenstein's "bandwagon effects." We model such situations as a game with increasing differences, and show that tipping of equilibria as discussed by Schelling, cascading and Dixit's results on clubs with entrapment are natural consequences of this mutual reinforcement. If there are several equilibria, one of which Pareto dominates, then we show that the inefficient equilibria can be tipped to the efficient one, a result of interest in the context of coordination problems.

Interdependent Security: The Case of Identical Agents

Do firms have adequate incentives to invest in anti-terrorism mechanisms? This paper develops a framework for addressing this issue when the security choices by one agent affect the risks faced by others. We utilize the airline security problem to illustrate how the incentive by one airline to invest in baggage checking is affected by the decisions made by others. Specifically if an airline believes that others will not invest in security systems it has much less economic incentive to do so on its own. Private sector mechanisms such as insurance and liability will not necessarily lead to an efficient outcome. To induce adoption of security measures one must turn to regulation, taxation or institutional coordinating mechanisms such as industry associations. We compare the airline security example with problems having a similar structure (i.e., computer security and fire protection) as well as those with different structures (i.e., theft protection and vaccinations). The paper concludes with suggestions for future research.

Retroactive Liability and Future Risk: The Optimal Regulation of Underground Storage Tanks

The optimal design of environmental liability policy focuses on two primary policy issues: the cleanup of existing sources of pollution and the definition and enforcement of policies to promote prospectively efficient environmental risk reduction. Through the analysis of a policy toward a pervasive environmental risk--leaking underground storage tanks--we analyze the effectiveness of an existing policy governing retroactive and prospective liability issues and suggest ways in which that policy can be improved. While we find some theoretical support for the public financing of UST cleanups, we also find the current system to be flawed in its implementation. In general, the paper argues that public financing of past pollution cleanup costs can lead to greater future risk deterrence by allowing firms to more fully internalize the costs of future environmental risks. However, if it is practically or politically impossible to limit public financing to retroactive liabilities alone, the deterrent effect of such a system is vastly reduced.

Supermodularity and Tipping

We model tipping as a game-theoretic phenomenon and investigate the connection between supermodular games, tipping of equilibria and cascading, and apply the results to issues that arise in the context of homeland security and computer security. We show that tipping and cascading can occur in supermodular games and that "increasing differences"is a sufficient condition for tipping. Supermodularity and tipping of equilibria are closely related. We relate our results to Schelling%u2019s early work on tipping.