One War We Shouldn’t Avoid: A New Approach to Reducing the Cost of Future Catastrophes

In 2005, three major hurricanes — Katrina, Rita and Wilma — struck the U.S. Gulf Coast area, causing not just death and destruction, but also leading to insurance payments and federal disaster relief of more than $180 billion. Today, say the authors of a new book titled, At War with the Weather: Managing Large-Scale Risks in a New Era of Catastrophes, the U.S. is even more vulnerable to catastrophic losses because of the increasing concentration of population in high-risk coastal regions. The coming months could bring devastation on a large scale.

Written by Howard Kunreuther and Erwann Michel-Kerjan, with colleagues Neil Doherty, Martin Grace, Robert Klein and Mark Pauly, At War with the Weather analyzes current thinking about catastrophes, risk management and financial recovery, and then proposes new, long-term solutions for reducing loss and providing the necessary financial protection against future disasters. As one of the authors notes, “The question you have to ask yourself before reading the book is: How much are you willing to lose when the next catastrophe strikes?”

Kunreuther, professor of decision sciences and business and public policy, and co-director of Wharton’s Risk Management and Decision Processes Center, and  Michel-Kerjan, the Center’s managing director who also teaches environmental sustainability and value creation in the MBA program, recently talked to Knowledge@Wharton about why they wrote this book and what they hope it accomplishes. An edited version of the transcript follows.

Knowledge@Wharton: Howard and Erwann, thank you so much for joining us today.

Howard Kunreuther: A pleasure to be here.

Knowledge@Wharton: Let me ask you a very basic question. Most of the time when people talk about nature, they talk about living in harmony with nature, but your book is titled, “At War with the Weather.” Why did you choose to emphasize conflict rather than harmony?

Kunreuther: This is a really interesting first question. People like to think that they are in harmony with their environment. And then they get surprised. In many ways we are fighting a series of battles, sometimes in ways that are highly unexpected, and the consequences to them and to society can be extraordinarily large. So we felt this was a war that we should address.

Erwann Michel-Kerjan: Just to complement that, I think living in harmony with nature also means understanding nature, and part of nature is extreme events. Those have been with us for a long time — whether hurricanes, floods, or earthquakes — and as human beings we have to understand that. Now, if knowing that, we decide to live on the coasts where we are highly exposed to the natural extreme events, we have to be ready to pay the price as well.

Knowledge@Wharton: So what was the reason that you wrote this book?

Kunreuther: We have been thinking about these events for many years in the context of our Wharton Risk Center; we are focusing on low-probability, high-consequence events. But I think the principle reason that we wrote this book is that things have changed radically in the last 10 years, and that is the reason why we say “a new era of catastrophes.” When you begin to look at the damage that is caused in these areas, we felt it was important to try to rethink the policies that are in place and try to come up with innovations and new ideas. We felt that it was time to do that.

Knowledge@Wharton: But why is the problem greater now than it used to be? Are there not the same number of hurricanes and earthquakes and tornados that there has always been?

Kunreuther: More people are moving into harm’s way. Climate change is upon us — a combination of these two factors plus a number of others have really made this problem much more severe than it has been in the past.

Michel-Kerjan: What we have tried to do here, too, is to put in one single place — this book — a lot of data (and we can discuss that in a few minutes). It is one thing to say yes, maybe there have been the same number of hurricanes as before and it is another thing to say, yes there are more people, but the real question is how many more people, how much more exposure do we have today? 

Just to give you one figure that we use at the beginning of the book, if you consider all disasters that happened somewhere in the world over the past 40 years — that is a long period of time, 40 years — all countries combined, of the top 25 most costly disasters for the insurance industry, two-thirds of them happened since 2001, and 12 of them here in the United States. That is pretty striking in terms of numbers, so whether you like it or not is not even the issue; the issue is yes, we have already entered this new era of catastrophes — that is point number one. Point number two: Now that we have recognized that, how do we move forward as policy makers, business people, or simply as citizens?

Knowledge@Wharton: What would you say are some of the reasons that this new era of catastrophes is so much more intense than the past, and what kind of innovations are needed to address it?

Michel-Kerjan: It is not only the natural disaster front that this book talks about; in the final chapter we tried to explain that with other types of extreme events. The financial crisis we are in now is a good illustration of that — but things like the swine flu, other types of pandemics and terrorist attacks… we are going to see more and more of these in the next few years.  It is already happening for a few reasons: The first reason is the one that Howard and I mentioned about highly exposed assets. And the second reason is we are living in small village which means that we are more and more globalized — and what happens even 5000 miles away from us will be on our desk tomorrow — and that is new. So, high concentration of assets and people in high-risk areas combined with interdependencies (and Howard can say more about that): You have almost a perfect storm.

Kunreuther: I think that we could turn to the financial crisis that occurred after this book went to press to highlight the importance of rethinking this problem and innovations. The financial crisis highlighted our myopia — the fact that we think in very, very short time frames. We are trying to get people to think long-term; we are trying to get people to recognize that these are problems that have to be dealt with today that have long-term consequences. Our feeling is that this book should at least provide the motivation for individuals and policy makers, not only in the United States, but around the world, and as Erwann said, not only for natural hazards, which this book is focusing on, but for other extreme events, including terrorism. So we really have tried to make the point that we need this new thinking of “long-term” because of myopic behavior. We are all very short-run oriented.

Knowledge@Wharton: So who, in your thinking, should pay the cost associated with these catastrophes? I am sure you are thinking of a combination of individuals and insurers and the federal government, but what does your scheme come up with?

Kunreuther: We have raised that question right at the outset — who should pay? We are not necessarily going to provide an answer, because it depends on how society wants to treat this. If we believe we are all responsible, in some sense, for covering the losses of anyone living in an area, then all of us should be paying. If, on the other hand, we feel that it is important for people to take some responsibility and recognize that they are in harm’s way and that there is a price to pay, then one has to somehow take the stand that the people in these areas should pay. We do have two principles that guide this book that relate to your question. One principle is that if we are going to use insurance as a policy tool, then premiums should definitely reflect the risk, so people know whether or not they are in harm’s way and have some indication of what that is. And this also encourages people to invest in risk-reducing measures, because if the premiums reflect risk, people can get a discount [on their insurance premiums]; they can get something back if they take steps to reduce losses, which is not the case today. Erwann may want to say more about some of the challenges we face using a state like Florida as an example.

We also have a second principle, which is that we have to deal with equity and affordability. There are low-income people and others who need special treatment in these high-hazard areas. If the premiums reflect the risk, then those premiums can be extraordinarily high, and some people might not be able to afford them. So our second principle advocates some kind of subsidy to these individuals. But we do not want the subsidies to come through insurance premiums; we feel they should come through something like an insurance stamp, like we have food stamps today for low-income families. That means that the insurance can still reflect the risk. Those two principles guide almost everything we want to do with respect to policy.

Michel-Kerjan: Just to chime in on that, I think that if you take a look, not only at the U.S., but worldwide — it is true in Asia, it is true in Europe — the more devastating the catastrophes have been, the more involvement there has been from the public sector. Historically it has been true in Europe. It is true now in Asia after the earthquake in China last year and it is true here in the U.S. For many, many years, America was seen as the temple of the free market. What we have seen after the attacks of 9/11, after Katrina, and now with the financial crisis, is that more and more, people are asking the state or the federal government to jump in. What we tried to show in the book — again, using a lot of data and a lot of evidence — is that this is not necessary. We can do better if we are creative, if we try to be innovative. We can talk a little bit about the solutions we have in this book. There is definitely a major role for the private sector to continue to play here. The federal government is not necessarily the answer (even if, in many cases, it has been part of the answer).

Kunreuther: We do not want to downplay the public sector. There needs to be a public-private partnership. We may need well-enforced building codes, we may need land-use regulations, we would need a subsidy for the people deserving of special treatment, and one has to figure out where the funds will come from. And we raised these somewhat as questions for everyone to think about. We do not want to say this is the way one has to go. But as Erwann was saying, we can show that the private sector can do a great deal more than it is currently doing if they are permitted to charge premiums that reflect risk, because right now, they are pulling out of some areas. States like Florida are being taken over by public sector insurance companies — the Citizens Property Insurance Corporation, in this case — that are not necessarily charging rates that reflect risk. We have a problem here.

Knowledge@Wharton: Could we talk a little bit about the solutions that you propose in your book? And also, could you think a little bit about the fact that after the financial crisis, the insurance industry has really been destabilized quite a bit. Even a big insurer like AIG collapsed. What is the appetite for innovative solutions in the insurance industry to accept the kind of solutions that you are proposing?

Kunreuther: AIG is one insurance company; a number of others have not had the same problem, and I think we need to at least indicate the insurance industry is not necessarily suffering in quite the way that AIG suffered. I think it is important to also raise the point that AIG did not suffer because of its insurance operations; it suffered because of an entity in London that was doing a variety of things that are not what one thinks of as insurance. I think there are a number of companies that are doing fine. I think the issue we want to raise with respect to solutions — and I think the insurers are open to solutions now — is the question: Does the financial crisis present an opportunity for change, a small window of opportunity to rethink the problem? We see the Obama administration trying to take advantage of that and we would like to take advantage of that with the idea of having a dialogue on new things that can be done with this short window before it closes.

Michel-Kerjan: Bottom line, what is in the book? And more, outside the book? The book is just the tip of the iceberg. We have been working for three years with many people here at Wharton, Georgia State, and many public and private organizations in the U.S. and abroad. So, the book is not just a book; it is really a consensus as a result of three years of work. Fundamentally, if you believe that we are in a new era of catastrophes, you have to ask: Can we continue with the same business models as we had before? And if most of your assumptions are not true anymore, you know that you have to change the business model. And as always, there will be winners and losers. The winners would be the ones who take the leadership on creating new solutions.

Knowledge@Wharton: When you are talking about personal responsibility and the idea of individuals playing more of a role, is it not kind of a tricky situation because you are talking about events that happen rarely, that people forget about very soon. And, you know, once the latest hurricane has gone, they do not want to pay any more for something that probably they think may never happen to them. So isn’t this kind of a hard area to address?

Kunreuther: You hit it on the head. This is exactly why we are focusing on — myopia, just what you said. When the next crisis takes center stage, we forget the previous one. Our recommendation is to think long-term. Let us be very specific: long-term insurance, long-term loans. Right now we are working with and discussing — with a number of different parties — long-term flood insurance. Flood insurance is a national program. Erwann has done a lot of work on some of the challenges with the flood program. We have been thinking about that issue over the years: Why not have a long-term program so that we are able to somehow deal with the situation that we currently are in? Most people cancel their policies after several years. Even when they are required to have coverage, they cancel their flood policies when they have not had a flood recently. What we are suggesting is a long-term insurance policy that is tied to the property, not to the individual, and a long-term loan that encourages people to make their house safer by investing in shutters and in stronger roofs. Then they are going to get a larger premium reduction than the cost of the loan, and they will not have to think in exactly the way that you are posing that question to us. So we are right with you on that.

Michel-Kerjan: Just a quick point on your low-probability aspect. These events used to be low-probability. If you take a look just at what happened here in this country — just this one country for the past five years — what you have seen are crises, one after another every six months — literally every six months. So the question we try to pose in the book — and everybody who has an interest in these issues should read it — if we get together five years from now, are we going to say, well we should have seen that coming. If between 2001 and 2006, we have seen 20 crises, it is very likely that there will be another 20, if not 30, crises between 2009 and 2013 and 2014. And the question now on the table is, how do you prepare for the next crises?

Kunreuther: Let me give one example to highlight what Erwann is saying on low probability: If you just think of the time dimension which we are talking about and if there is one-in-a-hundred chance of a flood occurring next year, many people will think, “Well that is a very small probability; I do not have to think about it.” If, on the other hand, you pose the problem that there is a greater than one-in-five chance of having one or more floods over the next 25 years, the reaction will be very different. And so, framing the problem in such a way — so that what seems to be a low-probability event over a very short time span like a year can be viewed as a relatively high-probability event by stretching the time dimension — can begin to justify the whole set of activities that one might not otherwise take.

Knowledge@Wharton: I might be wrong but I think the only insurance that we are required to buy right now is auto insurance if you want to get car registration.

Kunreuther: Home owners on a mortgage. If you do not have a mortgage, you are not required to have insurance, but if you have a mortgage, a bank will require you to take that coverage. And flood insurance on a mortgage.

Knowledge@Wharton: And flood insurance. But what thought is being given to mandating certain activities — certain activities that will mitigate the risk of these catastrophes?

Kunreuther: We would be very much in favor of a required flood insurance program. If one could begin to get the political dynamics in much the way that auto insurance, as you said, is required, because so many people in these areas do not have it, and then all of the disaster relief is forthcoming for all of us as taxpayers to pay. Some of these people are upset because they may not even know that they are unprotected if they have cancelled the policy. They may forget when the flood comes that they do not have that policy. So we have some sympathy. We do not necessarily advocate required insurance, but we raise that question for people to think about.

Michel-Kerjan: And we showed in the book, just for Hurricane Katrina, that the amount the federal government paid or provided to people was two or three times more than what the insurance industry reimbursed.

Knowledge@Wharton: What was that final figure? 

Michel-Kerjan: You’re talking somewhere between $140 billion to $160 billion. I know it seems small compared to the financial crisis now; if you do not put a trillion dollars on the table, you know you are nobody. [Laugh] But you are talking about a lot of money, especially compared to what some of these disasters used to cost 20 years ago. Then you were talking about $500 million, $1 billion, even in 2008 prices. Now you are talking about single events inflicting as much loss as what five or 10 years worldwide used to inflict 20 years ago. That is radically different and it is not going to get better.

Kunreuther: And before Hurricane Hugo, which was in South Carolina in 1989, there was not a single disaster in the United States or the world that cost the insurance industry a billion dollars; not a single disaster. Hurricane Hugo was the first disaster that did. In the spirit of what Erwann has just said, then came Hurricane Andrew and you are talking about losses of $20 billion. And then came Hurricane Katrina and you are talking about losses — just insured losses — in the $40 billion to $50 billion range. So we are really talking about a change because of the tremendous growth in these areas and more devastating disasters.

Knowledge@Wharton: If you look beyond the U.S. — and you referred earlier to the politics of the situation — how do you see the role of governments in international catastrophes? For example, if you take the tsunami that hit Asia and hundreds of thousands of very poor people in parts of Sri Lanka whose lives were devastated — what kind of solutions should be put in place for people like that?

Michel-Kerjan: That is a big debate, especially if you relate that to the notion of changing climate and the fact that many poor countries — and mostly the poor countries — will be affected by the consequences. Two things; the tsunami happened within 10 seconds. That is a very different type of catastrophe than hurricanes you can see coming two or three days before. With hurricanes, you have the time technically to evacuate people from the zone. With an earthquake or tsunami, you do not have that time. That is why the international community did a lot in terms of early warning after the December 2004 tsunami you were referring to, trying to create enough technology so we can help poor countries have some of these warnings.

We have been working over the past few years with many international organizations, including the United Nations, the World Bank, the World Economic Forum and the OECD [Organisation for Economic Co-operation and Development] in Paris. These disaster issues are, today, among the top priorities of most of these international organizations — very different than 20 or 30 years ago, not only on the casualty side but also obviously on the economic side. These countries will not have the freedom or capacity to develop themselves because every other week or every other year, they are hit by a new catastrophe: They are really trapped in what we call a poverty trap.

Kunreuther: Just to build on what Erwann said, we just finished a study for the World Bank on the question of what is the role of mitigation. Mitigation is defined as adaptation: How can we do a better job of designing better structures in areas. We looked at places like Jakarta and St. Lucia to try to understand a little bit more what the problem is. I think there are two things that we were struck with. First is that the number of fatalities in the developing world is much greater than fatalities in this country, and so we have to think about loss of life as an important part. The second piece is that developing countries do not have the institutions that exist to provide the kind of protection that we have in our country. For example, insurance is generally absent in most of these areas. There are exceptions; Turkey has set up a new insurance program after the earthquake of 1999, and there are other countries that are thinking of micro insurance, and India has a number of programs.

So what we see essentially is: How do you begin to build up new institutions and think about the roles that international organizations could play? Could the World Bank, for example, play a creative role? What can be done to reduce the loss of life? Turkey is an example. There is a forecast chance of 40% to 60% that a devastating earthquake will destroy Istanbul in the next 20 years. That is well-documented by seismologists. We have to do something today. Turkey does not quite know how to deal with it. This is a global problem and we have to try to address it.

Knowledge@Wharton: Just to wrap this up, in your wildest dreams what do you hope this book will accomplish?

Kunreuther: Wildest dreams — that people will actually agree that we have a war with the weather. That war may be with ourselves and we have to deal with this. And that we have to re-orient our thinking and really take more responsibility today because we tend to put this in the background and say, “it is not going to happen to me.” 

Michel-Kerjan: Well, just to chime in on that, and just to come back to your original question on harmony, I think what we have tried to do here is to help the reader. There are many books out there, so why another book on disasters? As our publisher told us, it might be the largest study done in the past 30 years on these issues, nothing less. So that is point number one; trying to help the readers, as top decision makers or citizens. And step two will be obviously to change the world a little bit so we can be living in harmony with our environment. I am just concerned that we not wait too long to react or at least not wait for the next major series of hurricanes to say, oh yes, the authors were right a few years back. So let us try to act now — now that we have a time horizon to do things — rather than waiting for the next hurricane to strike. 

And fundamentally, the question you have to ask yourself as someone listening to this podcast is: How much am I willing to lose when the next catastrophe strikes?

Knowledge@Wharton: Thank you both for joining us.

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