Decision Making for Low Probability Events: A Conceptual Framework

Recent empirical evidence from field surveys and controlled laboratory experiments reveal anomalies with respect to decisions by individuals to protect themselves against low probability, high loss events. In particular, behavior is frequently at odds with what would be predicted by standard models of choice which involve benefit-cost comparisons. This paper develops a framework for analyzing decisions for low probability events and discusses their policy implications. The framework highlights the following four interrelated components: (1) Type of information collected by individuals in making their decisions (i.e., accuracy of data on losses, probabilities and protective options); (2) The decision process of individuals (e.g., expected utility maximization, threshold models); (3) Implications of policies on specific groups (e.g., affected individuals. general taxpayers); and (4) Welfare implications (e.g., equity and efficiency considerations). Examples from studies on natural hazards, health and safety problems will be used to illustrate how this framework synthesizes descriptive models of choice with policy prescription. The paper concludes by suggesting directions for future research

Societal Decision Making for Low Probability Events: Descriptive and Prescriptive Aspects

Society has become increasingly concerned with the appropriate procedures for evaluating projects which promise to yield long-run benefits, but also create potentially catastrophe consequences. Recent examples of such problems are the siting of energy facilities such as nuclear power plants or liquefied natural gas (LNG) terminals. This paper has two principal purposes. Utilizing recent theoretical and empirical contributions to the literature on choice under uncertainty, it proposes a descriptive model as to how such decisions are reached in the United States. On the basis of this descriptive model, suggestions are made for improving the process. The paper thus attempts to integrate descriptive and prescriptive components for analyzing these societal problems

Misinformation and Equilibrium in Insurance Markets

This paper focuses on the role of misinformation by firms and consumers with respect to the selling and buying of insurance. For example, the reader may wish to think of automobile insurance when the firms do not know the accident probabilities for each of their customers and insured individuals in turn, may misperceive the probabilities of being involved in an accident. Our point of departure is the model developed by Rothschild-Stiglitz which demonstrated that firms could distinguish between different types of risks by offering a set of policies consisting of a premium per dollar and a stated amount of coverage. We will investigate two types of equilibrium concepts in the spirit of this model: a traditional Nash equilibrium where each firm determines the set of policies it will offer under the assumption that all other firms make no changes in their offerings and a Wilson equilibrium here firms look far enough ahead in the future to evaluate the consequences of a new policy offering on the profitability of current policies. The paper contrasts the Nash and Wilson equilibria for cases where consumers correctly perceive the probability of a loss as well as when they misperceive this probability. We focus attention on the case where there are two risk groups in order to highlight significant differences between Nash and Wilson equilibria through graphical procedures. The final portion of the paper generalizes the results to n risk groups and discusses the welfare implications of consumer misperceptions

Insuring Against International Hazards: Descriptive and Prescriptive Aspects

Today multinational firms face grave uncertainties with respect to their investment strategies in other countries. This paper stresses the importance of integrating the descriptive aspects of this problem with prescriptive recommendations. It does so by raising two broad interrelated questions: (1) How do multinational firms and insurers deal with the problems of international risk in making their decisions on what investments to undertake? (2) What role can analytic approaches, including insurance mechanisms, play in better managing risk and uncertainty in international transactions? These questions are addressed by developing a conceptual framework which emphasizes the importance of problem formulation, institutional arrangements and decision processes as a basis for prescriptive recommendations. The problem is characterized by lack of a detailed statistical data base to estimate probabilities and consequences of different types of political, economic, and social risks. Corporate planners and risk managers who have responsibility for these investment decisions are anxious to avoid uncertainty. Hence, their actions appear to be greatly influenced by past experience and personal contacts. Our prescriptive recommendations are designed to widen the statistical data base by the use of experts and Bayesian analysis as well as to broaden the responsibility for investment decisions within the organization. We also propose a jointly operated private-federal insurance program which maintains features of current government operated systems but has private firms marketing policies and settling claims. The above theoretical concepts are illustrated with a case study of Indonesia's investment evaluation problem pursuant to their decision to provide the United States with liquefied natural gas in the early 1970's. This case study illustrates the political risks of firms investing even in highly developed economies such as the United States

Insuring and Managing Hazardous Risks: From Seveso to Bhopal and Beyond

This executive review describes in brief the International Conference on Transportation, Storage, and Disposal of Hazardous Materials, held at IIASA, and the ensuing Proceedings "Insuring and Managing Hazardous Risks." The Conference brought together representatives of academia, business and government from East and West to discuss the nature of current problems in the area of hazardous materials. An important objective of the Conference was to suggest steps that could be undertaken by industrial firms, the insurance industry, and government agencies to improve the safety and efficiency with which hazardous materials are produced and controlled in industrialized societies

The Risk Analysis Controversy: An Institutional Perspective

Risk analysis has generated considerable controversy in recent years as to its meaning with respect to societal decision making. The papers in this book highlight different aspects of the risk debate. In particular, confidence in expert statements on risk has diminished and there has been an increasing recognition of the difference between analysis of the risk associated with an event and people's preferences/values. These concerns are articulated in the papers and discussions contained here. The volume does not provide answers to the dilemma facing society but rather raises a set of questions which need to be considered

Equilibrium in Insurance Markets with Experience Rating

This paper investigates the properties of equilibrium in insurance markets where insurers can obtain specific and private knowledge of the loss experience of their customers. We examine the case where firms obtain information over time from insurance claims and use these data in a Bayesian fashion to adjust individual premiums to experience. We first consider the case where firms can change their premiums from one period to the next and customers are free to stay or leave as they see fit. We refer to this case as a single period equilibrium. The resulting premium schedule earns monopoly profits even if entry by new firms into the insurance market is perfectly free. We next investigate a myopic multi- period equilibrium, in which firms maximize the present value of the stream of expected profits over the period in which the individual is insured, but individuals select the firm offering the lowest premiums. With free entry, expected profits are zero but premiums are generally too low or too high relative to actuarial values. We also investigate the properties of a full multi- period equilibrium where insurance firms specify premiums in advance for all future periods as a function of the number of claims that a customer has made within a given time span. In this type of equilibrium long-run profits are zero and insurance firms consciously charge actuarially unfair premiums to some of their customers. Although these models are illustrated in an insurance context, they also apply to other situations as well, notably labor markets. The concluding sections briefly explores these extensions and draws out lessons for regulatory policy

Low Probability Events and Determining Acceptable Risk: The Case of Nuclear Regulation

This paper discusses two aspects of the problem of determining and managing risk policies for low probability events. The public choice problem concerns the difficulty of defining acceptable societal risk when there is considerable individual disagreement about acceptable risk. The information processing problem addresses how individuals and organizations perceive and make decisions about low probability, catastrophic events. Both problems, and their interactions, impact on policy design and institutional performance for this class of problems. The paper discusses these impacts and their implications for developing and managing public policies