Risk and Regulation for Extreme Events

Howard Kunreuther

kunreuther@wharton.upenn.edu

Wharton School

University of Pennsylvania

Workshop on

Verification, Validation, and Uncertainty Quantification in Regulation

National Research Council

April 23, 2013

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Total number of declarations

Declarations associated with floods

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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?

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A New Era of Catastrophes

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Worldwide Evolution of Catastrophes, 1980-2012

$ BILLION EVENT VICTIMS (DEAD OR MISSING) YEAR AREA OF PRIMARY DAMAGE

50.1 Hurricane Katrina 1,836 2005 * USA, Gulf of Mexico

38.2 9/11 Attacks 3,025 2001 * USA

35-40 Earthquake and Tsunami 15,840 2011 Japan

25.6 Hurricane Andrew 43 1992 * USA, Bahamas

21.2 Northridge Earthquake 61 1994 * USA

18.5 Hurricane Ike 348 2008 * USA, Caribbean

15.3 Hurricane Ivan 124 2004 * USA, Caribbean

15.3 Hurricane Wilma 35 2005 * USA, Gulf of Mexico

13.0 Earthquake 181 2011 New Zealand

11.7 Hurricane Rita 34 2005 * USA, Gulf of Mexico, et al.

10.0 Floods, landslides 813 2011 Thailand

9.6 Hurricane Charley 24 2004 * USA, Caribbean, et al.

9.3 Typhoon Mireille 51 1991 Japan

8.2 Maule earthquake (Mw: 8.8) 562 2010 Chile

8.2 Hurricane Hugo 71 1989 * Puerto Rico, USA, et al.

8.0 Winter Storm Daria 95 1990 France, UK, et al.

7.8 Winter Storm Lothar 110 1999 France, Switzerland, et al.

7.3 Storms and tornadoes 350 2011 * USA

7.0 Hurricane Irene 55 2011 * USA, Caribbean

6.6 Winter Storm Kyrill 54 2007 Germany, UK, NL, France

6.1 Storms and floods 22 1987 France, UK, et al.

6.1 Hurricane Frances 38 2004 * USA, Bahamas

5.5 Winter Storm Vivian 64 1990 Western/Central Europe

5.5 Typhoon Bart 26 1999 Japan

4.8 Hurricane Georges 600 1998 * USA, Caribbean

Twenty-Five Most Costly Insured Catastrophes Worldwide, 1970–2011 (in 2011 prices)

(14 in the U.S., 15 since 2001)

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How much insured value (residential and

commercial) is located on the coasts from

Texas to Maine?

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Insured Exposure on the Coasts (Texas to Maine as of Dec. 2012):

$15 trillion

U.S. Exposure to Natural Catastrophes

Higher degree of urbanization

Huge increase in the value at risk Population of Florida:

2.8 million inhabitants in 1950 -- 6.8 million in 1970 -- 13 million in 1990

19.3 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

What’s Happening?

The Question of Attribution

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

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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

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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

Rationale for Regulation

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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

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 2012.

Their annual insurance premium will be reduced by $275 (i.e., 1/100

$27,500) if they undertake this investment.

Failure to Invest in Flood Adaptation Measures

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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)

Flood Adaptation

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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).

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Lack of Interest in Protection Against Disasters:

Cancellation of Flood Insurance Even When Required

New Business

Year 2001 2002 2003 2004 2005 2006 2007 2008

Housing Units 841,000 876,000 1,186,000 986,000 849,000 1,299,000 974,000 894,000

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%

Sources: Michel-Kerjan, Lemoynes and Kunreuther (forthcoming) – Data from NFIP/FEMA

Note: our analysis of the American Community Survey reveals that the median length of residence

was about 6 years over this period.

Dynamic Analysis of Flood Insurance Tenure

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)

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Encouraging Long-term Thinking

with Short-term Incentives

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.

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Guiding Principles for Insurance

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 2nd 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

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Modifying the National Flood Insurance Program (NFIP)

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

Proposed Strategy for Flood Insurance

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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)

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Applying the Three Principles to Flood Insurance

Effects of Mitigation on a 500 Year Event

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Savings from Mitigation

Remaining Losses

$160 billion loss

$82 billion saving with

Adaptation measures in place

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Reduction in Losses from Well-Enforced Building Codes

Adaptation

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%

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Encouraging Lowland Family to Invest in Adaptation Measures

Benefits over 30 years

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

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Upfront cost of adaptation

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Expected Benefit-Cost Analysis of Adaptation

(Annual Discount Rate 10%)

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

Rationale for Multi-Year Flood Insurance

Encouraging Adaptation with Multi-Year Loans

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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

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Linking Multi-Year Home Improvement Loans

with Multi-Year Flood Insurance

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

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Future Research

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.

Conclusions

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The Challenges of Linking Flood Insurance

with Adaptation Measures

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

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Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry

http://www.nap.edu/catalog.php?record_id=13457

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

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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?