Natural Disaster Insurance and the Equity-Efficiency Trade-Off

By Picard, Pierre | Journal of Risk and Insurance, March 2008 | Go to article overview

Natural Disaster Insurance and the Equity-Efficiency Trade-Off


Picard, Pierre, Journal of Risk and Insurance


ABSTRACT

This article investigates the role of private insurance in the prevention and mitigation of natural disasters. We characterize the equity-efficiency tradeoff faced by the policymakers under imperfect information about individual prevention costs. It is shown that a competitive insurance market with actuarial rate making and compensatory tax-subsidy transfers is likely to dominate regulated uniform insurance pricing rules or state-funded assistance schemes. The model illustrates how targeted tax cuts on insurance contracts can improve the incentives to prevention while compensating individuals with high prevention costs. The article highlights the complementarity between individual incentives through tax cuts and collective incentives through grants to the local jurisdictions where risk management plans are enforced.

INTRODUCTION

The last decades have witnessed the worlwide increasing frequency and intensity of weather-related disasters. Windstorms, typhoons, floods, landslides, and heatwaves were more and more frequent and we have experienced an upward trend in economic losses due to weather disasters, and an even stronger increase in insured losses. (1) These events may be the prelude to a still more critical evolution in the future insofar as climate change seems to play a major role in this evolution. (2) Minimizing the social cost of natural disasters should thus be ranked as a top priority in many industrialised countries and considered as an issue of the utmost importance for economic development and poverty reduction.

What can be the contribution of insurance to the management of natural hazards? In addition to risk pooling within a portfolio of insurance policies or risk spreading through reinsurance, cat bonds or other alternative risk transfer mechanisms, the insurance industry can help governments to create the right incentives for the mitigation of natural hazards. First, insurers may help assessing risks and providing information on risk exposure to individuals, corporations, and governments themselves. Insurers can also convey incentives for prevention through price signals. This may be done by charging risk-adjusted insurance premiums for property insurance or business interruption insurance in order to discourage the development of new housing or productive investment in hazard-prone areas or to incite property developers to comply with building codes. Likewise, insurers may offer crop insurance at affordable price for farming practices able to withstand climate instability (e.g., when farmers plant drought-resistant crop varieties).

However, using insurance pricing to mitigate natural disasters is not an easy task. First, individuals may prefer to rely on postdisaster assistance from governments or nongovernment organizations (NGOs) rather than paying an insurance premium to protect themselves against the consequences of natural hazards. (3) Second, property owners may not purchase disaster insurance because they underestimate their true loss probability. (4) Third, lower income consumers have difficulty affording insurance, and of course this obstacle is particularly important in developing countries. Fourth, because of adverse selection the burden may be concentrated on high-risk individuals, which makes it even heavier.

It is nevertheless particularly important to explore this path, since it uses the forces of economic incentives, which often prove to be much more effective and less costly than a command and control approach. Having said that, we face a fundamental problem. On the one hand, insurance may provide incentives by charging actuarial premiums. By doing so, insurers encourage the agents from the private sector to internalize the cost of natural disasters in their cost-benefit analysis--especially in the case of a new investment project. As we will see, insurance pricing may also indirectly incite communities (e.g., municipalities) to take adequate mitigation measures.

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