Economic and insured losses against natural disasters, technological accidents, and terrorism have risen every decade since the 1980s, says Munich Re. The international insurer estimates that economic losses from natural catastrophes hit $1.6 trillion in the 2001 to 2011 period. The Japan earthquake of 2011 alone caused an economic loss of $210 billion (along with insured losses of $35 billion to $40 billion).
Why? The escalating costs of disaster are more about flaws in human behavior and risk management than bad luck, say two business-school professors in a recently released paper, “Managing Catastrophic Risk.” Howard C. Kunreuther of the Wharton School for Risk Management and Geoffrey M. Heal, a finance and economics professor at Columbia Business School, say the overarching reason for the high costs of catastrophe is that companies and individuals are “locating in harm’s way while not taking appropriate protective measures.” In particular, they are failing to guard against low-probability, high-consequence events.
In a purely rational world, the authors assume, the decision to protect against an event would involve examining whether the upfront cost of investment is less than the expected benefits, discounted for the factor of time. But neither individuals nor organizations tend to do this. Probability of occurrence may not be assessed at all, for one. And, as Kunreuther and Heal explore in the paper, there are behavioral biases that lead decision-makers not to spend money on insuring against catastrophic risk.
The following are some reasons Kunreuther and Heal say people and organizations don’t invest to protect against low-probability, high-consequence events:
Budgeting based on experience rather than analysis. A company or person may have limited capital on hand to pay the upfront cost of insurance or some other protection, so a cost-benefit analysis may be pointless. Even companies and people with large-enough budgets may eschew the analysis if they have “separate mental accounts for different expenditures,” says the authors. For example, a business owner might say, “We only have $5,000 to spend on insurance,” ignoring how much it would really take to mitigate the consequences of a catastrophic event.
Underweighting the future. Events far into the future are disproportionately discounted relative to immediate ones, say Kunreuther and Heal. So a person will place a lot of weight on the immediate consideration (the upfront cost of insurance) but “instinctively undervalue” the expected benefits of reducing potential losses at a point in the future.
Procrastination. Before Hurricane Katrina hit New Orleans in 2005, emergency planners and the mayor’s office were fully aware of the risks the city faced, say the paper’s authors. But faced with the “inherent ambiguity about just what these investments should be and why they should be undertaken,” they opted to defer the choice to invest. “The tendency to shy away from undertaking investments that abstractly seem worthwhile is exacerbated if individuals have the ability to postpone investments — something that is almost always the case with respect to protection,” say the authors.
Underestimation of risk. Evidence shows that individuals and businesses often do not seek out information on the probabilities of an event when making their decisions, according to Kunreuther and Heal. For example, when other researchers have asked consumers to justify their decisions about purchasing warranties for a product that may need repair, the consumers rarely used probability as a rationale. Some risks are just disregarded when the likelihood of them happening is small enough. Even insurance firms can fall prey to this, say Kunreuther and Heal, pointing to the failure of underwriters to incorporate terrorism risk into commercial insurance policies after the first World Trade Center attack in 1993.
Interdependencies. A nation or company’s choice to protect against a catastrophic risk is affected by the behavior of the peers and neighbors that it is linked to in some way. “Incentives to invest in risk management will be compromised if [the individual company or country] can be damaged by the failure of [its] peers to follow suit,” the authors say.
Kunreuther and Heal describe a hypothetical situation in which a group of small, adjacent countries each have nuclear power plants, and a meltdown in any one plant will lead to “massive radioactive contamination in all of [the countries].” In this case, “the presence of another country that has not invested in reactor safeguards reduces the incentive to protect one’s own reactor because a meltdown elsewhere can damage a country as much as a meltdown at home.”
Because of all these behavioral biases, misperceptions of risk, and factors related to interdependency, the current mode of protecting against catastrophic risks is inadequate, say the authors. “Reliance on pure private-market solutions that depend solely on individual initiatives may fail in this environment.”
Like private-market insurance, centralized industry regulations have definite limitations, especially when the enforcement agency is understaffed. For example, small chemicals firms, say the authors, have little financial incentive to follow regulatory procedures if they estimate that the likelihood of a government inspection is small, they know the fine will be low, or both. “If you know the chances of a meter being checked are very small and the fine is relatively inexpensive, you might think twice before parting with your quarters,” they say.
The authors say industry and government need to work together and move beyond private-market solutions to guard against catastrophic risks. Some of the public-private partnerships Kunreuther and Heal recommend are short-term economic incentives to reward firms for taking the appropriate protection measures; insurance coverage that combines a first layer of private insurance with government liability when the losses exceed a certain cap; and, to address interdependencies, coordination among companies through a trade association or other body, as well as sharing of best practices to ensure members follow rules and regulations.