Risk and Regulation for Extreme Events

Transcription

1 Risk and Regulation for Extreme Events Howard Kunreuther Wharton School University of Pennsylvania Workshop on Verification, Validation, and Uncertainty Quantification in Regulation National Research Council April 23, Total number of declarations Declarations associated with floods

2 A New Era of Catastrophes A radical change in the scale and rhythm of catastrophes Natural disasters have caused large numbers of fatalities and destruction in recent years Honshu Earthquake (March 2011): Over 10,000 fatalities, 17,000 missing; estimated damage $183 billion (3% of Japan s GDP) Sichuan Earthquake (May 2008): 70,000 fatalities and 5 million residents homeless Hurricane Ivan (Grenada, Sept. 2004): $889 million in damage (365% of GNP) Hurricane Katrina (Sept. 2005): $81 billion in damage and 1,836 fatalities Hurricane Sandy (Oct. 2012): $75 billion in damage and 285 fatalities Many victims are uninsured and complain about receiving substantially less than the actual costs to repair or rebuild their damaged structures Challenge: How can we devise regulations coupled with other policy instruments so that those in harm s way will undertake protective measures in advance of a disaster so public sector relief is reduced after the next catastrophe? 2

3 Worldwide Evolution of Catastrophes,

4 Twenty-Five Most Costly Insured Catastrophes Worldwide, (in 2011 prices) (14 in the U.S., 15 since 2001) $ BILLION EVENT VICTIMS (DEAD OR MISSING) YEAR AREA OF PRIMARY DAMAGE 50.1 Hurricane Katrina 1, * USA, Gulf of Mexico /11 Attacks 3, * USA Earthquake and Tsunami 15, Japan 25.6 Hurricane Andrew * USA, Bahamas 21.2 Northridge Earthquake * USA 18.5 Hurricane Ike * USA, Caribbean 15.3 Hurricane Ivan * USA, Caribbean 15.3 Hurricane Wilma * USA, Gulf of Mexico 13.0 Earthquake New Zealand 11.7 Hurricane Rita * USA, Gulf of Mexico, et al Floods, landslides Thailand 9.6 Hurricane Charley * USA, Caribbean, et al. 9.3 Typhoon Mireille Japan 8.2 Maule earthquake (M w : 8.8) Chile 8.2 Hurricane Hugo * Puerto Rico, USA, et al. 8.0 Winter Storm Daria France, UK, et al. 7.8 Winter Storm Lothar France, Switzerland, et al. 7.3 Storms and tornadoes * USA 7.0 Hurricane Irene * USA, Caribbean 6.6 Winter Storm Kyrill Germany, UK, NL, France 6.1 Storms and floods France, UK, et al. 6.1 Hurricane Frances * USA, Bahamas 5.5 Winter Storm Vivian Western/Central Europe 5.5 Typhoon Bart Japan 4.8 Hurricane Georges * USA, Caribbean 4

5 How much insured value (residential and commercial) is located on the coasts from Texas to Maine? 5

6 U.S. Exposure to Natural Catastrophes Insured Exposure on the Coasts (Texas to Maine as of Dec. 2012): $15 trillion 6

7 What s Happening? The Question of Attribution Higher degree of urbanization Huge increase in the value at risk Population of Florida: 2.8 million inhabitants in million in million in million population in 2010 (590% increase since 1950) Cost of Hurricane Andrew in 2004 would have been $120bn Weather patterns and sea level rise Changes in climate conditions and/or return to a high hurricane cycle? Sea level rise will cause more flood damage More intense weather-related events coupled with increased value at risk will cost more, much more. What Will 2013 Bring? 7

8 Framework for Analysis for Dealing with Extreme Events Based on Daniel Kahneman, Thinking, Fast and Slow 8

9 Framework for Analysis for Dealing with Extreme Events (Converting System 1 to System 2 Behavior) System 1 operates automatically and quickly with little or no effort Individuals use simple associations including emotional reactions Highlight importance of recent past experience Basis for systematic judgmental biases and simplified decision rules System 2 allocates attention to effortful and intentional mental activities Individuals undertake trade-offs implicit in benefit-cost analysis Recognizes relevant interconnectedness and need for coordination Focuses on long-term strategies for coping with extreme events 9

10 Biases and Heuristics Triggered by System 1 Behavior Availability Bias Estimating likelihood of a disaster by its salience Threshold Models Failure to take protective measures in advance if perceived likelihood of disaster is below threshold level of concern Imperfect Information Misperceives the likelihood of event occurring and its consequences. Myopic Behavior Focus on short-time horizons in comparing upfront costs of protection with expected benefits from loss reduction 10

11 Rationale for Regulation Faulty information --- Underestimate probability before an event and overestimate it afterwards Myopia --- Short-term horizons regarding investment in protective measures Faulty decision rules --- Likelihood is below my threshold level of concern Interdependencies and negative externalities --- Failure to protect oneself causes losses to others Poorly constructed roof on unprotected home destroying well-protected neighboring home during a hurricane Unstrapped water heater falling down after an earthquake causing a fire that spreads to other homes 11

12 Failure to Invest in Flood Adaptation Measures The Lowland family resides on the shores of the Mississippi River and is considering whether to invest $1,500 in flood proofing their house so it is less susceptible to water damage. Hydrologists have estimated that the chances of a severe flood affecting their home is 1/100, and that if it occurs, the savings from flood proofing will be $27,500. Their home is required to have flood insurance. Rates in the future will reflect risk as specified in the National Flood Insurance Act of 2012 signed by the President in July Their annual insurance premium will be reduced by $275 (i.e., 1/100 $27,500) if they undertake this investment. 12

13 Flood Adaptation Responses by the Lowland family triggered by System 1 behavior: Imperfect information: Lowland family misperceives flood risk thinking that it is 1/1000 rather than 1/100 Threshold model: Flood risk is below their level of concern Myopic behavior: Failure to consider long-term benefits of flood protection since they plan to move in 3 years Cancellation of flood insurance: Consider it to be a poor investment since they have paid premiums for five years without suffering any damage and hence not making a claim Many banks do not enforce flood insurance requirement Many states do not enforce building codes: 1/3 of the damage from Hurricane Andrew (1992) could have been avoided had Florida enforced its building codes. Today, Florida has well-enforced codes (Learning from Andrew---System 1 behavior) 13

14 Lack of Interest in Protection Against Disasters: Cancellation of Flood Insurance Even When Required Many homeowners cancel their flood policy if they have not experienced a flood for several years. Reason: Flood insurance was not a good investment. Data: Of 1,549 victims of a flood in August 1998 in northern Vermont, FEMA found 84% of residents in SFHAs did not have flood insurance, 45% of whom were required to purchase it (Tobin and Calfee, 2005). 14

15 Dynamic Analysis of Flood Insurance Tenure New Business Year Housing Units 841, ,000 1,186, , ,000 1,299, , ,000 1 year 73% 67% 77% 78% 76% 73% 74% 73% 2 years 49% 52% 65% 65% 63% 59% 58% 3 years 39% 44% 57% 55% 53% 48% 4 years 33% 38% 50% 48% 44% 5 years 29% 33% 44% 38% 6 years 25% 30% 33% 7 years 22% 26% 8 years 20% Note: our analysis of the American Community Survey reveals that the median length of residence was about 6 years over this period. Sources: Michel-Kerjan, Lemoynes and Kunreuther (forthcoming) Data from NFIP/FEMA

16 Encouraging Long-term Thinking with Short-term Incentives We may need regulations and well-enforced standards in order to develop long-term strategies for encouraging investment in mitigation and adaptation measures. (System 2 behavior) At the same time, we need financial incentives to address problems of myopia. (System 1 behavior) 16

17 Guiding Principles for Insurance Principle 1: Premiums reflecting risk Insurance premiums should be based on risk in order to provide signals to individuals as to the hazards they face and to encourage them to engage in cost-effective adaptation measures to reduce their vulnerability to catastrophes. Risk-based premiums should also reflect the cost of capital that insurers need to integrate into their pricing to assure adequate return to their investors. Principle 2: Dealing with equity and affordability issues Any special treatment given to homeowners currently residing in hazard-prone areas (e.g., low-income uninsured or inadequately insured homeowners) should come from general public funding and not through insurance premium subsidies. Principle 3: Multi-year insurance To overcome myopia and encourage investment in preventive or protective measures, insurers should design multi-year contracts with premiums reflecting risk. Insurance vouchers should deal with issues of equity and affordability. 17

18 Modifying the National Flood Insurance Program (NFIP) 1968: Congress authorized the NFIP Subsidized rates for property currently in flood-prone areas Actuarially-based rates for new property Well-enforced building codes and land-use regulations July 2012: Congress renewed the NFIP for 5 years Risk-based premiums for 2 nd homes and those with repetitive flooding Authorized studies by the Federal Emergency Management Agency and the National Academy of Sciences to examine ways to examine feasibility of means-tested insurance vouchers 18

19 Proposed Strategy for Flood Insurance Multi-year flood insurance contracts through the National Flood Insurance Program (NFIP) (5 year policies with rates reviewed for another 5 years.) Home improvement loans for reducing property losses Well-enforced building codes and land-use regulations Required insurance and loans tied to the property, not the homeowner

20 Applying the Three Principles to Flood Insurance Rates would reflect risk (Principle 1 ) (FEMA is in the process of updating flood maps) Insurance vouchers for those needing special treatment (Principle 2) (Only for those currently residing in flood-prone areas) Homeowners know that their premiums are stable over time (Principle 3) 20

21 Losses (Billions) Reduction in Losses Effects from of Mitigation Well-Enforced on a 500 Year Event Building Codes 180 $160 billion loss $82 billion saving with Adaptation measures in place Savings from Adaptation Mitigation Remaining Losses FL NY SC TX State 21

22 Encouraging Lowland Family to Invest in Adaptation Measures Characteristic of Adaptation Measures: Upfront cost/long-term benefits Cost of Adaptation Measure: $1,500 to strengthen roof of house Nature of Disaster: 1/100 chance of disaster Reduction in loss ($27,500) Expected Annual Benefits: $275 (1/100 * $27,500) Annual Discount Rate of 10% 22

23 Expected Benefit-Cost Analysis of Adaptation (Annual Discount Rate 10%) Benefits over 30 years $3,000 $2,500 $2,000 $1,500 Upfront cost of adaptation $1,000 $500 $

24 Rationale for Multi-Year Flood Insurance Encouraging Adaptation with Multi-Year Loans Illustrative Example Cost of partial roof adaptation: $1,500 Expected annual benefit of partial roof adaptation: $275 (1/100 * $27,500) Annual payments from 20 year $1,500 loan at 10% annual interest rate: $145 Reduction in annual insurance payment: $275 Reduction in annual payments due to adaptation: $275-$145= $130 24

25 Linking Multi-Year Home Improvement Loans with Multi-Year Flood Insurance Everyone is a Winner: Homeowner: Lower total annual payments Insurer: Reduction in catastrophe losses and lower reinsurance costs Financial institution: More secure investment due to lower losses from disaster General taxpayer: Less disaster assistance 25

26 Future Research Determine costs of adaptation measures so one can undertake a meaningful benefit-cost analysis under different annual discount rates and time horizons. How to bring together key interested parties together to ensure that: Interdependencies and externalities are considered in evaluating these measures Property is inspected to confirm that building codes and adaptation measures are implemented Insurance premiums are readjusted at regular intervals (e.g., 5 years) to reflect new risk estimates due to climate change and other factors 26

27 Conclusions Insurance can play an important role in providing protection against serious risks. It can provide a signal as to the hazardousness of an area It can encourage adaptation through premium reductions It can provide financial assistance following a loss Regulations are required so that people are insured and loss reduction measures are implemented. Hurricane Sandy provides an opportunity to reevaluate the role that regulations can play in reducing future losses from catastrophic disasters. 27

28 The Challenges of Linking Flood Insurance with Adaptation Measures 28

29 Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry Part I: Contrasting Ideal and Real Worlds of Insurance Chapter One: Purposes of this Book Chapter Two: An Introduction to Insurance in Practice and Theory Chapter Three: Anomalies and Rumors of Anomalies Chapter Four: Behavior Consistent with Benchmark Models Part II: Understanding Consumer and Insurer Behavior Chapter Five: Real World Complications Chapter Six: Why People Do or Do Not Demand Insurance Chapter Seven: Demand Anomalies Chapter Eight: Descriptive Models of Insurance Supply Chapter Nine: Anomalies on the Supply Side Part III: The Future of Insurance Chapter Ten: Design Principles for Insurance Chapter Eleven: Strategies for Dealing with Insurance-Related Anomalies Chapter Twelve: Innovations in Insurance Markets through Multi-Year Contracts Chapter Thirteen: Publicly-Provided Social Insurance Chapter Fourteen: A Framework for Prescriptive Recommendations 29

30 Disaster Resilience: A National Imperative The National Research Council National Academies of Science 30

31 Questions for Discussion How does one accurately assess the risks of future flooding? What are the challenges in enforcing regulations? Required insurance Building codes Land use regulations (e.g., relocating residents following Hurricane Sandy) How feasible is it to tie insurance to property? What role can third party inspections play in enforcing regulations? What types of incentives will get people to voluntarily move to less hazardous areas? 31