- Some believe that humanity's spread around the Earth is a story of "follow the water" @KennethPGreen
- Hurricane Rita inflicted more than $11 billion in damages in 2005 @KennethPGreen
- Private insurance markets were failing before the onset of national flood insurance @KennethPGreen
- While flooding is a fact of life, studies show that humans are poor at evaluating the risk of flooding and insuring themselves against potential losses.
- Voluntary, private insurance markets underperform for several reasons: people tend to underestimate flood risks; government flood-control efforts reduce consumer incentives to insure; government insurance regulations hinder private insurer competition; and expectations of post-flood government assistance may increase risk taking.
- Policy options include reforming government assistance to remove perverse incentives, such as expanded development in flood-prone areas; measures that undermine people's inclination to buy insurance, or pay the full cost of risk; and third-party risk subsidization.
- Mandatory insurance may be necessary: some studies suggest that the only way to guarantee that those taking the risks are the ones paying the price, is to mandate the maintenance of fully priced private insurance policies as a pre-condition of property ownership in flood-prone areas.
Some believe that humanity's spread around the Earth is a story of "follow the water." Evidence suggests humans migrated out of Africa along coastlines, branching inland following rivers. And as long as one is near major water bodies, one bears the risk of flooding.
Floods are important both for their life-supporting, and life-threatening potential. On the positive side are the benefits of river flooding, in carrying nutrients downstream from distant headwaters. The flooding of the Nile River was long celebrated for its life-giving nutrients.1 On the negative side, we have an endless litany of damaging floods that have caused lost lives and wealth, and flood-control methods that have often failed spectacularly.
"If risk subsidies can't be entirely abolished, at the very least, subsidized insurance should charge risk-based premiums."
Hurricane Rita, for example, inflicted more than $11 billion in damages in 2005. That was small change compared to Hurricane Katrina, which reached more than $150 billion.2 More recently the news has featured flooding problems of the "Mighty Miss."3 Cost estimates will be long in coming, but are likely to be substantial.
Whether coastal or riparian flooding, humans have long tried to balance the benefits of proximity to water with the attendant risks. For a variety of reasons, such measures have often fallen short. For all the dams, levees, flood walls, insurance programs, assistance programs, and charitable organizations, rivers still flood, and coastlines are still inundated. We also find that people are harmed, killed, dispossessed, and often underinsured or without insurance entirely.
This policy brief will survey how human nature, facilitated by well-intentioned but flawed government policy, leads more people and property into harm's way, undermines insurance markets, and transfers the costs of flood risk to distant taxpayers.
Humans aren't particularly adept at managing risk
As Phil Davies notes in an article published by the Federal Reserve Bank of Minneapolis, people have problems dealing with the kind of risks that floods represent:
Psychological studies have found that the human mind has trouble grasping the true risks of low-probability yet life-changing events, such as hurricanes, volcanic eruptions and terrorist attacks. In an August 2006 paper, Howard Kunreuther and Mark Pauly of the University of Pennsylvania draw upon 30 years of analysis of insurance purchase decisions to argue that most people don't rationally weigh the cost of insurance against the chance, remote but nonetheless real, that a disaster will occur. Instead, people downplay the risks, assuming that they are too low to worry about.
"There's a tendency to really push these things into the background, to say, 'This is a low-probability event that is below my threshold of concern,'" said Kunreuther, an expert in risk management at the University's Wharton School, in a telephone interview. Consequently, many homeowners and businesses don't even consider buying earthquake or terrorism insurance, or regard it as a discretionary expense that can be cut when money gets tight. That mindset shrinks the potential market for disaster insurance, making it more difficult for insurers to spread risks through diversification. Kunreuther and Pauly note that only about 40 percent of residents in the New Orleans area had flood insurance before Katrina hit, even though the federal government heavily subsidized the policies.4
Voluntary private insurance models have problems
Unfortunately, as Mark Brown and Martin Halek point out in a book chapter on risk management, flood risks don't lend themselves well to voluntary, private insurance. They observe that flood risks lack key features of risks that are considered "insurable." Brown and Halek conclude that:
As a result of these limitations, flood risk, like other natural disaster perils, is difficult to insure in the private market. Of course, these same limitations make it difficult for the government to insure it as well. Indeed, the history of the NFIP indicates that demand for flood coverage is not substantial even when it is provided by the government at a rate below the fair market cost of coverage, suggesting that there are limitations on the demand side that might limit a private market even in a world where supply problems did not exist.
Further, they note that private insurance markets were failing before the onset of national flood insurance:
Nor could property owners at risk of flood damage turn to the private sector: private insurance companies tended not to sell flood insurance because the catastrophic nature of flood risk, and the resulting difficulty of developing actuarial rates that reflected the risk, made establishing a sustainable pricing structure difficult. During the 1920s, several dozen fire insurers sold flood insurance, but after severe river flooding in many parts of the country in 1927 and 1928, these insurers withdrew from the market. From the late 1920s until today, flood insurance has not been considered profitable.5
But direct government interventions may make things worse
One reason why predicted damages associated with sea levels and storms are so high, is because of the popularity of such locales for high-density business and upscale residential development. As a result, damages from extreme coastal weather events have been fantastically expensive. The question, however, is why there was so much value that was so badly protected against completely predictable events? Why were levees and sea-walls so under-designed? Why were so many houses and businesses uninsured? As Charles Perrow observes in The Next Catastrophe, "Even in areas known to be hazardous, only about 20 percent of homeowners purchase flood insurance, and less than 50 percent of businesses purchase flood and earthquake insurance in risky areas."6
As researchers at the Wharton Risk Center observe, "Highly subsidized premiums or premiums artificially compressed by regulations, without clear communication on the actual risk facing individuals and businesses, encourage development of hazard-prone areas in ways that are costly to both the individuals who locate there (when the disaster strikes) as well as others who are likely to incur some of the costs of bailing out victims following the next disaster, either at a state level through ex post residual market assessments or through federal taxes in the case of federal relief or tax breaks."7
"Brown and Halek suggest the government could require banks to price the risk of flooding into mortgages. After a flood, outstanding mortgage balances in the flooded area would be considered paid in full."
And as the Cato Institute points out:
Government-provided programs for crop insurance and flood insurance, as well as other interventions in private disaster insurance markets, often are justified as necessary to overcome the failure of private markets to offer adequate and affordable disaster insurance. Defenders of government insurance programs claim that they reduce dependence on ''free'' disaster assistance and promote efficient risk management by property owners and farmers.
But government policies are the cause of, not the cure for, the limited supply and narrow scope of private-sector disaster insurance. Demand for private coverage is low in part because of the availability of disaster assistance, which substitutes for both public and private insurance. Moreover, a government that cannot say no to generous disaster assistance is unlikely to implement an insurance program with strong incentives for risk management.
The subsidized rates and limited underwriting and risk classification of federal government insurance programs aggravate adverse selection, discourage efficient risk management, and crowd out market-based alternatives.
Federal tax policy reduces supply by substantially increasing insurers' costs of holding capital to cover very large but infrequent losses. State governments also intrude on insurance markets by capping rates, mandating supply of particular types of insurance, and creating state pools to provide catastrophe insurance or reinsurance coverage at subsidized rates. By reducing both the supply and demand sides of private insurance protection, government intervention leads to greater reliance on politically controlled disaster assistance and higher costs for taxpayers.8
Perrow makes the case that things are no better at the state level:
State-mandated pools have been established to serve as a market of last resort for those unable to get insurance, but the premiums are low and thus these have the perverse effect of subsidizing those who choose to live in risky areas and imposing excess costs on people living elsewhere. In addition, the private insurers are liable for the net losses of these pools, on a market-share basis. The more insurance they sell, the larger their liability for the uninsured. Naturally, they are inclined to stop writing policies where there may be catastrophic losses (hurricanes in Florida and Earthquakes in California). The Florida and California coastlines are very desirable places to live and their populations have grown rapidly, but these handsome lifestyles are subsidized by residents living in the less desirable inland areas in the state, and, to some limited extent, by everyone in the nation.9
Finally, in Watery Marauders, Eli Lehrer observes that private insurance markets face challenges not only from financial distortion of the insurance market but also from government's physical management of flood waters:
Federal efforts retarded the development of flood insurance by building breakwaters that reduced the value of flood insurance over the life of a typical mortgage, by implicitly encouraging development in frequently flooded areas, and by implicitly preempting the need for private insurance.10
What can be done?
If risk subsidies can't be entirely abolished, at the very least, subsidized insurance should charge risk-based premiums. As Wharton researchers explain, "Insurance premiums (whether public or private coverage) should, to the extent possible, reflect the underlying risk associated with the events against which coverage is bought in order to provide a clear signal to individuals and businesses of the dangers they face when locating in hazard-prone areas and encourage them to engage in cost-effective mitigation measures to reduce their vulnerability to disasters."11 And there are ways to fix the private insurance conundrum.
Brown and Halek offer several options that can fix most (or all) of the problems with private insurance of flood risk. Their first best policy option would be to have the federal government require that all property owners purchase flood insurance in the private market. A second best option would be to raise the rates on NFIP insurance. Alternately, Brown and Halek suggest the government could require banks to price the risk of flooding into mortgages. After a flood, outstanding mortgage balances in the flooded area would be considered paid in full. Lenders would have to price that risk into the interest rate charged for a mortgage, resulting in stiffer challenges for those who would seek to buy property in flood-prone locations.
All of these measures would raise the costs to property owners in risk-prone areas, but would have the salutary effects of more fully pricing risk, creating disincentives to excess risk-taking, moving vulnerable people and property out of harm's way, and reducing the moral hazard created when those who live in safer areas are made to subsidize those who choose riskier environments.
Kenneth P. Green is a Resident Scholar at AEI.