FIRST PAGE PROOFS. Risk Management in an Era of Global Environmental Change. Howard Kunreuther University of Pennsylvania, Philadelphia, PA, USA

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1 Risk Management in an Era of Global Environmental Change Howard Kunreuther University of Pennsylvania, Philadelphia, PA, USA Society faces large challenges as to how we will deal with the increasing losses from natural, technological and environmental hazards. Residents in hazard prone areas are reluctant to protect themselves before the event occurs. The insurance and reinsurance industry is concerned that they cannot provide protection against these catastrophic risks without exposing themselves to the danger of insolvency or significant loss of surplus. There has also been a concern that these losses in the future will be increasing due to population growth in hazard prone areas and climate change creating more disasters than in the past. This article explores the importance of insurance coupled with other policy instruments, such as regulations and standards, and interested parties (e.g., banks and financial institutions) to encourage loss reduction measures and provide financial protection against these hazards. New advances in information technology and risk assessment coupled with the emergence of new financial instruments for covering large losses provide the ingredients for rethinking the way society deals with catastrophic risks. To encourage investment in cost effective loss reduction measures there is a need for well-enforced building codes as well as financial incentives such as long-term loans tied to an insurance policy. INTRODUCTION There is grave concern, by the property and casualty insurance and reinsurance industry, that they cannot continue along their current path of providing protection against certain risks or taking on additional risks, without exposing themselves to the danger of insolvency or significant loss of surplus, which will threaten the availability of future coverage (Kunreuther and Roth, Sr, 1998). More specifically, since 1989 insurance and reinsurance firms have suffered losses from disasters that have wreaked havoc with their balance sheets. Figure 1 depicts the magnitude of the catastrophic losses experienced by the insurance industry in the United States from 1949 to The drastic change from 1989 to 1999 is obvious. Prior to Hurricane Hugo in 1989 (where insured losses were over $4 billion), the insurance industry had never suffered any loss of over $1 billion from a single disaster. Since that time Hurricane Andrew in 1992 caused over $15 billion in insured losses and the Northridge earthquake in California resulted in over $12 billion in insurance claims Between 1989 and 1999 another 15 disasters exceeded $1 billion in insured losses (Swiss Re, 2000). Commercial development has followed the population s movement to coastal areas, and this has increased the potential economic losses from natural disasters in this part of the country. The purpose of this article is to explore how insurance can be combined with other policy instruments, such as mitigation measures, building codes and well specified standards, to better manage safety and reduce losses from catastrophic risks from technological and natural hazards. In particular, there is a need for a public private partnership for dealing with these challenging issues. The principal focus will be on reducing losses from natural disasters, but the concepts and principles discussed below are relevant for dealing with safety systems for technological hazards. Three recent developments provide the ingredients for rethinking the way society deals with these risks: 1. There has been an emergence of new capital market instruments, such as catastrophe bonds for dealing with losses from mega-disasters. Although the volume of business to date in these instruments is relatively small, they offer promise for protection in the future, both in the developed countries as well as emerging economies (Insurance Services Office, 1999). 2. New advances in information technology (IT) and risk assessment offer an opportunity to estimate the chances and potential losses of future disasters and catastrophic events more accurately than in the past. On the IT side, the development of faster and more powerful computers enables one to examine extremely complex phenomena in ways that were impossible even five years ago. Scientific advances in risk assessment have reduced the uncertainty associated with predicting the chances and consequences of these low probability high consequence (LP HC) events. 3. Mitigation measures promise to reduce losses from natural disasters and catastrophic accidents. In particular, there are many benefits, which have traditionally not been considered as part of standard benefit cost analysis. These benefits may make mitigation extremely attractive to all of the concerned parties. (Heinz Center, 1999; Mileti, 1999) 4. Global mean surface temperature has increased by between about 0.3 and 0.6 C since the late 19th century, a change that is unlikely to be entirely natural in origin and suggests a noticeable human influence. There are uncertainties in key factors, including the magnitude and patterns of long term natural variability. Global sea level has risen by between 10 and 25 cm over the past 100 years and much of the rise may be related to the increase in global mean temperature (Intergovernmental Panel on Climate Change, 1995) In April 2000 the Intergovernmental Panel on Climate Change (IPCC) released the draft of a new report concluding that there has been a discernible

2 2 RESPONDING TO GLOBAL ENVIRONMENTAL CHANGE $ billions Figure 1 Insured catastrophe losses ( ) (in 1999 dollars). (Source: Insurance Services Office) human influence on global climate. If those words hold up under further expert and governmental review, they would be the strongest official pronouncement yet that human-induced warming is real (Kerr, 2000). FRAMEWORK FOR ANALYZING CATASTROPHIC RISKS: THE CASE OF NATURAL DISASTERS To analyze the impact of catastrophic risks on society it is important to consider the following elements: Population and Property at Risk One way to characterize who is at risk is to construct a community or region consisting of homes, businesses and other properties, which are subject to future disasters. One needs to know the design of each structure, whether specific mitigation measures are in place or could be utilized, and the property s location in relation to the hazard (e.g., distance from an earthquake fault line or proximity to the coast in a hurricane-prone area) as well as other risk-related factors. There has been a large influx of residents and businesses into hazard prone areas in recent years. By the year 2010 the population in regions of the Southeast Atlantic Coast of the United States, having annual hurricane probabilities of 10% or more, is projected to increase by 23% from 64 to 73 million people compared with 14% for the entire United States (Mills et al., 2000). The reasons often given for moving to these areas is because they are seen as desirable places to live. This may be true in many developed countries. In emerging economies, such as Bangladesh, people are forced to live in these high-risk areas because there is no other place for them to go (Etkin, 1999). Risk Assessment and Potential Damage The potential damage to a community is determined by estimating the probability that disasters of specific magnitudes will occur and specifying the resulting losses to structures in harm s way. Relatively sophisticated models of catastrophic losses have been developed in recent years to model these distributions (Dong et al., 1996). There is still considerable uncertainty as to what impact climate change will have on future disasters and their magnitudes. For example, with respect to hurricanes Pielke and Landsea (1997) found no trend in damages when the data were corrected for inflation, population influx to these areas and changes in wealth. On the other hand, climate models suggest there is likely to be an increase in flooding events due to more precipitation and greater atmospheric absolute humidity (White and Etkin, 1997). Key Stakeholders There are a number of interested parties concerned with natural disaster damage. Government agencies such as the Federal Emergency Management Agency (FEMA) in the United States, have stressed the importance of building codes and enforcement of regulations to reduce losses from natural disasters. The primary insurance companies provide protection to residential and commercial sectors for losses such as those caused by fires (including those resulting from earthquakes) and wind damage from tornadoes and hurricanes. In the United States this coverage is offered through the standard homeowners policies normally required as a

3 RISK MANAGEMENT IN AN ERA OF GLOBAL ENVIRONMENTAL CHANGE 3 condition for a mortgage, and through commercial multi peril policies. The types of policies offered and the nature of the requirements vary from country to country. Reinsurers relate to insurers in the same manner that insurers do to property owners. They provide protection to primary insurers by insuring a portion of their claims in exchange for a premium. For all but the largest insurance companies, reinsurance is a prerequisite to offering insurance against natural disasters when there is a potential for catastrophic losses. As pointed out above, the capital markets have recently provided private insurers access to funds in the form of catastrophe bonds. The insurer borrows from investors or an institution at higher than normal interest rates to cover extreme losses from hurricanes and earthquakes that exceed a trigger amount. If this amount is exceeded, then the interest on the bond, the principal, or both, are forgiven. For more details on these catastrophe bonds and other financing and hedging instruments see Doherty (1997). A number of other interested parties play key roles in the design and enforcement off insurance and damage mitigation requirement. They include financial institutions, through specific conditions for obtaining a mortgage; the construction industry, by designing safer structures; state and local governments, through ordinances and building codes; and the real estate sector through provision of information on hazards to potential buyers and owners. Decision Processes An understanding of the decision processes of the property owner and insurer provides guidance for developing a set of strategies for reducing losses from future natural hazards. If residents in hazard prone areas are reluctant to voluntarily adopt mitigation measures that are cost effective, then this provides a rationale for developing and enforcing building codes. The involvement of municipalities, contractors, third party inspectors and other key stakeholders is essential if this measure is to work. Similarly if insurers are willing to give premium discounts for adopting mitigation measures, then there is an opportunity for banks and financial institutions to partner with the insurers to develop a financially attractive mitigation loan/insurance package. Policy Implications One question that needs to be addressed in developing strategies for managing catastrophic risks is the appropriate roles of the private and public sectors, in financing the cost of large-scale disasters. To the extent that private insurance markets provide protection against catastrophe risk, policymakers must decide how these markets should be regulated. They must also determine the role of regulations (e.g., restricting developments through land-use restrictions) and standards (e.g., well-enforced building codes) and the extent to which private choice and incentives will guide hazard mitigation efforts. Within the realm of public choice, decisions also must be made with respect to the delegation of authority among the different levels of government and its agencies. In evaluating these options, policymakers must consider how various governmental actions affect the behavior of firms and individuals in responding to catastrophe risk. WHY IS THERE LIMITED INTEREST IN MITIGATION? The decision on whether to adopt risk mitigation measures (RMMs) to reduce losses from catastrophic accidents or natural disasters can be framed in a very straightforward manner. There is an up front cost of the mitigation measure which will either reduce the probability of the accident or disaster occurring and/or the magnitude of the loss should the event take place. The benefits of the mitigation measure will be reaped for the length of time that the property is in place. In reality there are several reasons why a firm or individual will decide not to invest in such measures. Some individuals may perceive the probability of a disaster causing damage to their property as being sufficiently low that the investment in the protective measure will not be justified. Individuals may have relatively short time horizons over which they want to recoup their investment. Even if the expected life of the house is 25 or 30 years, the person may only look at the potential benefits from the mitigation measure over the next 3 to 5 years. If people have budget constraints then they will be averse to investing in the up front costs associated with protective measures simply because they feel they cannot afford these measures. It is not unusual for one to hear the phrase We live from payday to payday when asked why a household has not invested in protective measures. Individuals may have little interest in investing in protective measures if they believe that they will be financially responsible for only a small portion of their losses should a disaster occur. For example, if residents anticipate liberal disaster relief from the government should they suffer damage, they would have less reason to invest in an RMM. The empirical data on studies of mitigation adoption in hazard prone areas of the United States suggest that individuals are not willing to invest in RMMs despite the rather large damage that either they and/or their friends and neighbors suffered from recent disasters. For example, after Hurricane Andrew in Florida in 1992 most residents in hurricane prone areas appear not to have made cost effective improvements to existing dwellings, that could reduce amount of damage from another storm at relatively low cost. A July 1994 telephone survey of 1241 residents in six hurricane prone areas along the Atlantic and Gulf Coasts

4 4 RESPONDING TO GLOBAL ENVIRONMENTAL CHANGE revealed that 62% indicated that they had, not installed hurricane shutters, used laminated glass in windows, installed roof bracing, and/or made sure that side walls were bolted to the foundation either before or after Hurricane Andrew (Insurance Institute for Property Loss Reduction, 1995). Measures, such as strapping a water heater with simple plumbers tape, can normally be undertaken by property owners at a cost of under $5 in materials and one hour of their own time (Levenson, 1992). This RMM can reduce damage by preventing the heater from toppling during an earthquake, creating gas leaks and causing a fire. Yet these and other mitigation investments are not being adopted by residents in earthquake prone areas in the United States. A 1989 survey of 3500 homeowners in four California counties subject to the hazard reported that only between 5 and 9% of the respondents reported adopting any loss reduction measures (Palm et al., 1990). This behavior suggests that individuals do not believe that investing in the RMM will increase their residence s property value, or that they have either short time horizons and/or severe budget constraints, which either reduce their perceived net benefits from RMMs or simply prevent them from making the investment (Kunreuther, 1996). Turning to the relationship between insurance and mitigation some interesting findings emerge from recent surveys undertaken by Risa Palm and her colleagues. Palm and Carroll (1998) report that those who had adopted mitigation measures were also more likely to buy earthquake insurance than those who had not taken these loss reduction measures. This raises the interesting question as to whether certain types of individuals and managers want protection for reasons that have less to do with their perception of the risk than their intrinsic worries and concerns. IMPROVING THE ESTIMATES OF THE RISK In setting rates for catastrophic risks insurers have traditionally looked backwards by relying on historical data to estimate future risks. Such procedures are likely to work well only, if there is a large database of past experience, which forms the basis for extrapolation into the future. LP HC events generally have a relatively small historical database. In fact, many technological and environmental risks are associated with new processes, so that past performance data are lacking. One thus has to rely on scientific modeling and epidemiological data to estimate these risks. Fortunately there is considerable scientific work undertaken in the areas of natural, technological and environmental hazards to provide estimates of the probabilities and consequences of events of different magnitudes. A discussion of recent advances in seismology and earthquake engineering can be found in Federal Emergency Management Agency (1994) and Office of Technology Assessment (1995). Regarding technological hazards, the Wharton Risk Management and Decision Processes Center is now compiling a very comprehensive database on the impact of large-scale catastrophic accidents on health and safety risks (Kleindorfer et al., 1997). With respect to environmental risks to health, such as groundwater contamination, databases have been assembled which open up opportunities for providing insurance protection on risks that recently had previously been considered uninsurable by firms in the industry (Freeman and Kunreuther, 1997). As we better understand the effects that climate change is likely to have on the frequency and magnitude of natural hazards, then these impacts need to be incorporated in future risk estimates (see Mills et al., 2000 for the current perspective of the US Insurance Industry on climate change). Today there are a growing number of catastrophe models that have been utilized to generate data on the likelihood and expected damage to different communities or regions from disasters of different magnitudes or intensity. Each model uses different assumptions, different methodologies, different data and different parameters in generating their results. Hence, there is need for a better understanding as to why these models differ and for attempts to reconcile these differences in a more scientific manner than has been done up until now (see Insurance Services Office, 1996). BROADENING PROTECTION AGAINST CATASTROPHIC LOSSES New sources of capital from the private and public sectors could provide insurers with funds against losses from catastrophic events, which would alleviate insurers concerns that the next major disaster might leave them insolvent. Recently investment banks and brokerage firms have shown considerable interest in developing new financial instruments for protecting against catastrophic risks. Their objective is to find ways to make investors comfortable trading new insurance linked secured instruments covering catastrophic exposures, just like the securities of any other asset class. In other words, catastrophe exposures would be treated as a new asset class (Insurance Services Office, 1999). A description of the recent trends in this market can be found in Lane and Beckwith (2000). Turning to the role of the public sector, Lewis and Murdoch (1996) developed a proposal that the federal government offer catastrophe reinsurance contracts, which would be auctioned annually. Another option is for the government to provide reinsurance protection against catastrophic losses. Private insurers would build up the fund by being assessed premium charges in the same manner that a private reinsurance company would levy a fee for excess loss coverage or other protection.

5 RISK MANAGEMENT IN AN ERA OF GLOBAL ENVIRONMENTAL CHANGE 5 POLICY IMPLICATIONS: NEED FOR A PUBLIC PRIVATE PARTNERSHIP The key to a successful hazard management program is to design ways for reducing losses, while providing protection should a disaster occur. The empirical data suggest that there is a need for new public private partnerships to address this problem. Today most property owners have limited interest in investing in loss reduction measures. Insurers have little reason to encourage mitigation in hazard prone areas since they feel that the rates they are allowed to charge are inadequate. Hence they want to charge the same premiums with and without mitigation and hope that some policyholders will decide not to renew their insurance policy (Kunreuther and Roth, 1998). Three types of public private partnership programs are proposed that can reduce losses from future disasters based on our understanding of the decision processes of the relevant interested parties. In order to successfully implement these programs there needs to be a better understanding of the nature of the risks associated with natural hazards. Importance of Building Codes Building codes mandate that property owners adopt mitigation measures. Such codes may be desirable, when property owners would otherwise not adopt cost effective RMMs because they either misperceive the benefits from adopting the RMM and/or underestimate the probability of a disaster occurring. Cohen and Noll (1981) provide an additional rationale for building codes. When a building collapses it may create externalities in the form of economic dislocations and other social costs that are beyond the economic loss suffered by the owners. These may not be taken into account when the owners evaluate the importance of adopting a specific mitigation measure. For example, if a building topples off its foundation after an earthquake, it could break a pipeline and cause a major fire that would damage other homes not affected by the earthquake in the first place. In other words, there may be an additional annual expected benefit from mitigation over and above the reduction in losses to the specific structure adopting this RMM. One way to encourage the adoption of cost effective mitigation measures is for banks and financial institutions to provide a seal of approval to each structure that meets or exceeds building code standards. Upon receipt of that certificate, there would be a set of incentives provided by banks (e.g., lower mortgage rates) as well as insurers (e.g., lower premiums). The success of such a program requires the support of the building industry and a cadre of qualified inspectors to provide accurate information as to whether existing codes and standards are being met. Insurers may want to limit coverage only to those structures that are given a certificate of disaster resistance. For more details on ways to make communities disaster-resistant see Central US Earthquake Consortium (1997). Premium Reductions Linked with Long-term Loans Premium reductions for undertaking loss prevention actions can be an important first step in encouraging property owners to adopt these measures. The basic rule in this case is a simple one: if the premium reduction is less than the savings in expected claim payments due to mitigation, it is a desirable action for the insurer to promote. If homeowners are reluctant to incur the up front cost of mitigation due to budget constraints, then one way to make this measure financially attractive to the property owner is for the bank to provide funds for mitigation through a home improvement loan, with a payback period identical to the life of the mortgage. The cost of the loan will then be less than the reduction in insurance premiums if the mitigation measure is a cost effective one with respect to reducing property damage (Kunreuther, 1997). Many poorly constructed homes are owned by lowincome families, who cannot afford the costs of mitigation measures on their existing structure or the costs of reconstruction should their house suffer damage from a natural disaster. Equity considerations argue for providing this group with low interest loans and grants for the purpose of adopting cost effective RRMs or for them to relocate to a safer area. Since low-income victims are likely to receive federal assistance after a disaster, subsidizing these mitigation measures can also be justified on efficiency grounds. Lower Deductibles Tied to Mitigation An alternative way to encourage consumers to adopt mitigation measures is to change the nature of their insurance coverage rather than reducing the premium. More specifically, the insurer could offer a lower deductible to those who adopt mitigation at the same or lower price than if they had decided not to invest in the RMM. Such a program is likely to be very attractive given the empirical and experimental evidence that suggests that consumers appear to dislike deductibles even though they offer considerable savings in premiums (Johnson et al., 1993). CONCLUSIONS AND SUGGESTIONS FOR FUTURE RESEARCH This article makes the case for a new approach for dealing with catastrophic accidents and disasters that takes advantage of recent developments in IT and the emergence of new financial instruments to deal with non-diversifiable risks. These two major changes open up opportunities for residents and firms to undertake cost effective loss protection

6 6 RESPONDING TO GLOBAL ENVIRONMENTAL CHANGE measures while at the same time providing a financial cushion to insurers concerned with catastrophic losses that will lead to insolvency. A strategy for undertaking research in this area suggests analyzing the impact of disaster or accidents of different magnitudes on a set of structures, industrial plants or their equipment. In order to determine expected losses and the maximum probable losses arising from worst case scenarios, it may be necessary to undertake long-term simulations. For example, one could examine the impacts of earthquakes or hurricanes of different magnitudes and intensities on the losses to a community or region over a year period. In the process one could determine expected losses based on the probabilistic scenarios for each of these disasters as well as the maximum credible loss during this period based on a worst case scenario. By constructing large, medium and small representative insurers with specific balance sheets, types of insurance portfolios, premium structures and a wide range of potential financial instruments, one could examine the impact of different disasters and accidents on the insurer s profitability, solvency and performance through a simulation. Examples of the application such an approach to a model city in California facing an earthquake risk and one in Florida facing a hurricane risk can be found in Kleindorfer and Kunreuther (1999a,b). There is considerable uncertainty in estimating the probability of disasters of different magnitudes occurring and the magnitude of the resulting losses. Future studies could examine how one can incorporate these uncertainties in an analysis as to which mitigation measures are cost effective and how to price new financial instruments. Will mitigation reduce the uncertainty of future losses, so that these new financial instruments could be more easily marketed to investors? This is a very exciting time for key stakeholders in the public and private sectors to explore new opportunities for dealing with catastrophic risks. If insurance can be used as a catalyst to bring other interested parties and new financial instruments to the table, it will have served an important purpose in helping both the industry and society deal with the critical issue of reducing future losses, and providing protection against natural, technological and environmental disasters. ACKNOWLEDGMENTS Support from NSF Grant #CMS to the Wharton Risk Management and Decision Processes Center at the University of Pennsylvania is gratefully acknowledged. Portions of this paper incorporate material from Kunreuther (2000). Kunreuther is the Cecilia Yen Koo Professor of Decision Sciences and Public Policy, Department of Operations and Information Management, The Wharton School, University of Pennsylvania. REFERENCES Central US Earthquake Consortium (CUSEC) (1997) Disaster Resistant Communities, CUSEC, Memphis, TN. Cohen, L, and Noll, R (1981) The Economics of Building Codes to Resist Seismic Structures, Public Policy, Winter Doherty, N (1997) Financial innovation for financing and hedging catastrophe risk, presented at the Fifth Alexander Howden Conference on Disaster Insurance, Gold Coast, Australia. Dong, W, Shah, H, and Wong, F (1996) A Rational Approach to Pricing of Catastrophe Insurance, J. Risk Uncertainty, 12, Etkin, D (1999) Risk Transference and Related Trends: Driving Forces Towards more Mega-disasters, Environ. Hazards, 1, Federal Emergency Management Agency (1994) Assessment of the State-of -the Art Earthquake Loss Estimation, National Institution of Building Sciences, Washington, DC. 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