At War with the Weather Managing Large-Scale Risks in a New Era of Catastrophes Howard C. Kunreuther Risk Management and Decision Processes Center The Wharton School, University of Pennsylvania Joint research with Erwann Michel-Kerjan NABE Corporate Roundtable August 5, 2010

Summary of Key Points Individuals focus on short-term horizons Want immediate return from their investments Often regard potential disasters as below their threshold of concern Impact of this behavior Failure to take protective measures prior to a disaster Cancel insurance if one doesnt make a claim for a few years Proposed strategy Multi-year insurance and long term loans to encourage adaptation measures Short-term economic incentives to deal with myopia 2

Outline of Talk 1.A New Era of Catastrophe 2.Guiding Principles for Developing Risk Management Strategies 3.Benefits of Adaptation Measures 4.A New Proposal: Long-Term Insurance and Loans 5.Encouraging Adaptation: An Example 6.Summary 3

1. A New Era of Catastrophes A radical change in the scale and rhythm of catastrophes Natural disasters have caused severe insured losses to property in recent years –Hurricane Katrina: $46.3 billion –Hurricane Andrew: $23.2 billion (2005 dollars) –Hurricane Ike: $16 billion Victims complain about receiving substantially less than the actual costs to repair or rebuild their damaged structures Public sector and international organizations (e.g. World Bank) are committed to providing financial assistance to aid the victims of disasters 4

Worldwide Evolution of Catastrophe Insured Losses, (Property and business interruption (BI); in U.S.$ billon indexed to 2007, except 2008 which is current) Sources: Kunreuther and Michel-Kerjan, At War with the Weather (2009) - data from Swiss Re and Insurance Information Institute 5

The 25 Most Costly Catastrophe Insurance Losses, (15 of these since 2001) $ BillionEventVictims (Dead or missing)YearArea of Primary Damage 46.3Hurricane Katrina1, USA, Gulf of Mexico, et al /11 Attacks3, USA 23.7Hurricane Andrew431992USA, Bahamas 19.6Northridge Earthquake611994USA 16.0Hurricane Ike USA, Caribbean, et al. 14.1Hurricane Ivan USA, Caribbean, et al. 13.3Hurricane Wilma352005USA, Gulf of Mexico, et al. 10.7Hurricane Rita342005USA, Gulf of Mexico, et al. 8.8Hurricane Charley242004USA, Caribbean, et al. 8.6Typhoon Mireille511991Japan 7.6Hurricane Hugo711989Puerto Rico, USA, et al. 7.4Winterstorm Daria951990France, UK, et al. 7.2Winterstorm Lothar France, Switzerland, et al. 6.1Winterstorm Kyrill542007Germany, UK, NL, France 5.7Storms and floods221987France, UK, et al. 5.6Hurricane Frances382004USA, Bahamas 5.0Winterstorm Vivian641990Western/Central Europe 5.0Typhoon Bart261999Japan 5.0Hurricane Gustav2008USA, Caribbean, et al. 4.5Hurricane Georges USA, Caribbean 4.2Tropical Storm Allison412001USA 4.2Hurricane Jeanne3, USA, Caribbean, et al. 3.9Typhoon Songda452004Japan, South Korea 3.6Thunderstorms452003USA 3.5Hurricane Floyd701999USA, Bahamas, Columbia 6

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 Changes in climate conditions and/or return to a high hurricane cycle? More intense weather-related events coupled with increased value at risk will cost more, much more. What Will 2010 Bring? 7 Whats Happening? The Question of Attribution 7

Source: Data from AIR Worldwide Corporation Insured Coastal Exposure as a Percentage of Statewide Insured Exposure as of December 2007 (Residential and Commercial Properties) 8

Total Value of Insured Coastal Exposure as of December 2007 (in $ billion; Residential and Commercial Properties) Source: Data from AIR Worldwide Corporation 9

10 AT WAR WITH THE WEATHER A better understanding of how individuals decide whether or not to protect themselves against natural disasters. A set of guiding principles for using insurance to deal more effectively with these events. Key lessons from the financial management of natural disasters to be applied to other global risks such as pandemics, financial crises and terrorism. Ideas for the private sector, and sustainable public policy solutions to protect trillions of dollars of assets and the residents at risk in hazard-prone regions. July MIT Press

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2. Guiding Principles for Developing Risk Management Strategies 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 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. 12

Insurance Vouchers Existing Programs as Models Food Stamp Program Mission: Vouchers to purchase food based on annual income and family size Low Income Home Energy Assistance Program Mission: Assist low-income households in meeting immediate energy needs Universal Service Fund Mission: Provide discounts to low-income individuals in rural areas so rates for telecommunications services are comparable to urban areas 13

Insurance Vouchers Who should subsidize low income residents? General taxpayer – Everyone in society is responsible State government – Source of funding would come from state taxes Insurance policyholders – All homeowners with insurance Residents in coastal areas – Those in hurricane-prone areas 14

$160 billion loss $82 billion saving with Adaptation measures in place 3. Benefits of Adaptation Measures On a 500-Year Event 15

Why Property Owners Do Not Invest in Cost-Effective Adaptation Measures Short Time Horizons (Quick return on investment) High Short-Term Discount Rates (Hyperbolic discounting) Misestimating Probability (Flood will not happen to me) Liquidity and Upfront Costs (We live from payday to payday) Truncated Loss Distribution (Only responsible for small portion of loss due to disaster relief) May Move in 2 or 3 Years (Cant recover costs of adaptation) 16

Proposed strategy Long-term flood insurance contracts through National Flood Insurance Program (NFIP) Long-term home improvement loans for mitigating ones property Insurance and loans are tied to the property, not the individual 4. Encouraging Adaptation Measures through Long-Term Flood Insurance (LTFI)

LTFI Prevents Individuals From Cancelling Their Flood Insurance Policy 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). 18

Tenure of New Flood Insurance Policies in Mississippi New Business Year # New Housing Units8,2977,5398,3459,1839,31644,62115,59914,086 Tenure100% 1 year73%68%65%72%66%73%72% 2 years61%51%52%45%54%62% 3 years47%42%38%37%43% 4 years39%30%32%29% 5 years25%26%27% 6 years20%22% 7 years17% Authors calculation – Data from NFIP/FEMA 19

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% Encouraging Adaptation: An Example 20

Upfront cost of mitigation Expected benefits over time 21

Illustrative Example Cost of partial roof mitigation: $1,500 Expected annual benefit of partial roof mitigation: $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 Rationale for Long-Term Insurance Encouraging Adaptation n with Long-Term Loans 22

7. Summary The Facts: Totally new era of large-scale risks; huge and still growing concentration of value in high-risk areas; indication of more devastating disasters in the future. The Reality: Individuals are myopic and misperceive risks, so they do not adopt cost-effective adaptation measures. Research and policy questions: Is long-term flood insurance coupled with long-term loans tied to the property a good place start for encouraging investment in adaptation measures and aid the recovery process? How do we incorporate climate change in developing insurance as a useful policy tool for encouraging adaptation measures? 23

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