Reducing the risks of catastrophes.

• Author: Kunreuther, Howard
• Position: Research Summaries

Given the hundreds of billions of dollars in economic losses that catastrophes have caused in the United States since 2001, people often are surprised to learn that Hurricane Hugo, which struck the South Carolina coast in 1989, was the first disaster to inflict more than $1 billion of insured losses. Sixteen years later, Hurricane Katrina cost insurers and reinsurers an estimated $48 billion. (1)

A comparison of economic losses from natural catastrophes alone reveals a large increase over time: $528.3 billion (1981-1990); $1,196.8 billion (1991-2000); and $1,213.5 billion (2001-2010). (See Figure 1.)

There have been many types of extreme events in recent years (for example, the 9/11 terrorist attacks, natural disasters such as Hurricane Katrina, technological accidents such as the BP oil spill, and the financial crisis of 2008), but they all have the following features in common:

* A failure of key decision makers to undertake risk reducing measures in advance of the disaster;

* A lack of availability of insurance to cover some potential catastrophic losses (such as from terrorism). When insurance is available, it generally does not provide financial incentives to encourage investment in risk reducing measures;

* Growing interdependencies and interconnectedness in the world, and our inability to appreciate how weak links can cause systemic failures.

Over the past ten years, much of my research, in collaboration with colleagues, seeks to explain these issues and considers ways to mitigate the losses from future catastrophes.

[FIGURE 1 OMITTED]

Failure of individuals to undertake protective measures

There are two types of measures that those at risk can undertake to reduce the financial consequences of low probability adverse events: investing in loss reduction measures and purchasing insurance. However, there is a key difference between these two protective actions. Insurance normally is purchased on an annual basis with an option to renew for the coming year. Investing in loss-reduction measures involves an upfront cost, such as the outlay to install shutters to prevent losses from hurricanes; the benefits normally accrue over the life of the structure.

Prior to a disaster, many individuals believe that the event is below their threshold level of concern and thus do not invest voluntarily in insurance and protective measures. (2) After a major flood, earthquake, or hurricane, the government may provide at least some financial assistance to aid the recovery of the unprotected victims. Hurricane Katrina provided vivid evidence of this. Many homeowners who suffered water damage from the disaster did not have flood insurance, even though they were eligible to purchase such a policy at a subsidized rate through the National Flood Insurance Program (NFIP). In the Louisiana parishes affected by Katrina, the percentage of homeowners with flood insurance ranged from 57.7 percent in St. Bernard's to 7.3 percent in Tangipahoa. Only 40 percent of the residents in Orleans parish had flood insurance. (3)

Furthermore, homeowners are likely to cancel their flood insurance policies, even if they had been required to purchase a policy as a condition for a federally insured mortgage. A large-scale analysis of the 7.9 million new policies issued by the NFIP over the period January 1, 2000-December 31, 2009 revealed that the median length of time before those flood policies lapse is only three...