Hurricane Matthew wreaked havoc in Haiti before causing massive damage to parts of the southeastern United States earlier this year. In the Carolinas, flooding damage from the storm was assessed at more than $1 billion. Insurance against a catastrophic event, such as a hurricane or earthquake, often is not purchased by consumers or purchased too late. The most common reason is that homeowners believe the odds are stacked in their favor. Howard Kunreuther, Wharton professor of operations, information and decisions and co-director of the Wharton Risk Management and Decision Processes Center, put together a report that looks at the insurance industry surrounding catastrophic events. He recently appeared on the Knowledge at Wharton show, part of Wharton Business Radio on SiriusXM channel 111 to talk about what can be done to improve coverage and minimize risks.
An edited transcript of the conversation follows.
Knowledge at Wharton: Why do so many homeowners and business owners not purchase insurance against catastrophic events?
Howard Kunreuther: It’s a real challenge. People generally feel that these events are not going to happen to them. That’s a simple answer that seems to really make the whole process very, very difficult. People are living in areas that are hazard prone. They like the area because there are lots of other features that are very positive. They are near the water or they are on a beach and whatnot. They don’t want to think about the event, and it’s a low probability event. Often, they have not experienced it. There’s a tendency to feel [like] ‘I don’t have to protect myself because it’s not going to happen to me.’
Knowledge at Wharton: A lot of people figured Florida’s eastern coast was going to get hit hard by Matthew. It did suffer damage, but not as much as a lot of people thought. North Carolina ended up being the focus, and there was flooding far inland where many people wouldn’t even consider this type of insurance.
Kunreuther: That’s exactly right. One of the real challenges is that there are areas that are affected that are not classified as being high-hazard areas, flood-prone areas. They are not required to buy flood insurance and, in many cases, people have no idea that they could have damage from something like a hurricane. There are also areas like Baton Rouge, Louisiana, that are inland that had a storm surge and heavy rainfall. Pensacola, Florida, had that in 2014, and Baton Rouge had it this past August. Very few people in these areas have flood insurance for two reasons: They didn’t expect it, and they are not required to buy it. If you have a federally insured mortgage and you’re in a high hazard zone, a zone that is classified as a special flood hazard area, you have to buy it. Many people still don’t or it’s not fully enforced. But if you’re not in that area, you don’t have to buy it, and people will think that they’re safe.
Knowledge at Wharton: That’s a state-to-state decision, correct?
Kunreuther: No, that’s a federal decision. That’s the National Flood Insurance Program, which is what markets that policy.
One area that I want to mention right away is the importance of having accurate mapping. The Federal Emergency Management Agency is working on that. I’m on the Technical Mapping Advisory Committee, just for full disclosure, where we’ve been talking about the fact that FEMA is really working hard to get maps that are better designed to let people know what the hazard is, and to communicate the risk in a way that is not the case today.
Knowledge at Wharton: There are coastal areas in Louisiana and Florida where the water level is changing. It could be vastly different in 10 years. Even doing the mapping now, you are doing it knowing that there will be changes within the next decade?
“It’s extremely hard to let people know that the best return on an insurance policy is no return.”
Kunreuther: I think that’s right. The first step is to get the mapping now. Let’s put that on the table and get good maps now. The second step — and it has to come as quickly as one can do that — is to recognize that with climate change and other factors, the maps may change. You want to at least recognize sea level rise as a real issue that has to be considered, that we need to pay attention if you’re going to be designing new homes, to recognize that they will have to meet some of the problems in the future that we don’t have right now.
Knowledge at Wharton: For people who live near water or could be in the path of a storm, is the insurance affordable?
Kunreuther: This is a major question. I am glad you brought it up because in the issues brief that I recently wrote and other work that our Wharton Risk Center has been doing, we raise the issue of affordability right at the outset. There are two principles that I think need to be considered when you’re dealing with insurance to make it acceptable, both in terms of communicating the risk and dealing with the equity and affordability issue. Insurance premiums should reflect risk. If you have a premium that reflects risk and you let everyone know “this is what your insurance premium should be,” you give people information that they otherwise wouldn’t have. And if you subsidize the premium right at the outset and never tell them what a risk-based premium is, they’re never going to know and they’re going to think they’re a lot safer than they actually are. That’s one reason.
The other reason is that if you tell them, “Look, there are things that you can do to reduce your insurance premium and reduce your risk, and that is to make your house safer.” In some cases, you can elevate; in other cases, you can flood-proof. A risk-based premium would go way down if it turns out that you will take those steps. But if that’s all you say and you’re raising the question of affordability, you really are dead in many ways before you get started.
You really have to address the issue of equity and affordability. We feel very strongly about that in our risk center and our work that we are doing. I personally feel, after having interviewed a number of low-income people in Pensacola, that if we don’t deal with that issue, we are doing an injustice at a very broad level. The view that we have taken is that you have to somehow deal with this, but you shouldn’t deal with it with an insurance premium. You should deal with it in other ways. We deal with it in our society today with food stamps and vouchers. What we’re suggesting is to give them a voucher. It’s saying, “If your premium is very high because it’s risk-based now, we’ll help you out. But at the same time, what we would like to have you consider is mitigate and make your house safer. And if you mitigate and make your house safer, the premium is going to go way down.”
Knowledge at Wharton: It would be a philosophy almost like the energy efficiency principles that the government has pushed, such as low-e glass windows, to encourage energy-saving moves within homes.
Kunreuther: A perfect example. That’s exactly the kind of thing that you can do with damage from floods or hurricanes or storms. You could say, “We will help you out with a long-term loan that you would pay back over a period of 10 or 20 years to help you to make your house safer.” The cost of that loan would be lower than the insurance premium reduction, so you will benefit in much the same way that you save on energy.
The analogy is really one that we’ve used and that people understand. You save in energy by making your house energy efficient or by investing in solar or wind, and that’s basically the same idea here.
Knowledge at Wharton: With hurricanes, there is a focus on people who live near the coast. One of the other areas to consider is along a river, such as the Mississippi River, which has gone over its banks a number of times in the last couple of decades.
“It may be $5 billion to map the country, but the payoff for having that money provided now would be so, so important.”
In the Philadelphia area, if you go north on the Delaware River, residents have lifted their homes onto stilts over the last few years. Those are investments that they have had to make on their own. They have not had some sort of financial break for doing it.
Kunreuther: No, these people have done these things without the kind of assistance that we are talking about. If they have a high enough income, they can do it. If they have a low income, they’re not in a position to do that. The first time this really came into play on a national level was after Hurricane Katrina, where you had a whole set of people in Louisiana who felt that they could not live in their homes anymore without doing something to them, and a number of them are now elevated. The challenge that I think we face today is if you can make this thing affordable to people and if you can have some mechanisms to do it, you would have a lot of people doing things that they otherwise couldn’t do. You need some kind of public sector involvement to do that.
Knowledge at Wharton: You mentioned your work with FEMA. Is this something that Congress is aware of? Because it seems this is going to take some action through the government?
Kunreuther: Congress is always aware of it when new legislation comes forward. We have the renewal of the National Flood Insurance Program in September 2017. I think now FEMA is putting a great deal of time and energy into thinking about what the features should be of renewing that program. A number of us are thinking about that and trying to work with FEMA and other groups such as The National Academy of Sciences, which is concerned about these issues through some of its committees. Two top things on the list that we would like to see done, and I think FEMA is concerned about, is the accuracy of the maps because if you don’t have accurate maps, it’s very hard to talk about a risk-based premium. It’s very hard to talk about how much you will save by mitigating. And it’s really hard to talk about how much the affordability problem is going to be there, because if the rates are actually lower than what people are paying now and you may find that out, then they may feel a lot better about their insurance premiums than they currently will do.
Knowledge at Wharton: In the paper, you bring up some ideas that you would like to see implemented. We’ve touched on architecture. One of the interesting ones that you have is public/private partnerships. Go into how that would play out.
Kunreuther: Right now, the National Flood Insurance Program is a public sector program. Almost everyone buys their insurance through NFIP, so you have one insurer. The private sector could easily play a role here if they had risk-based premiums that they could charge and you knew what those premiums would be, but you would still need a program like the NFIP to deal with a lot of the issues on two levels. One is you’d want to make sure that you had the affordability issue dealt with. Insurers can’t do that because they are charging the risk-based premium. So, you need to have some kind of voucher for housing costs, whether it would be through FEMA or the Department of Housing and Urban Development. Someone has to help out the people who are currently living in the area and not ones who are moving in.
The other part where the NFIP or public sector becomes involved is in very, very high losses, catastrophic losses, where the private sector says it can’t provide re-insurance, which is the insurance to the insurers, because it will be too large. There, you’d want to have a back stop. We do that right now with terrorism and other disasters.
Those are the two things. But one priority that I would want to put at the top of the list is that Congress should give the money to have accurate maps. It may be $5 billion to map the country, but the payoff for having that money provided now would be so, so important.
Knowledge at Wharton: If you invest that money, not only does the mapping help you with potential issues of flooding and low-lying areas, but I would think there would be other risk areas where it would be very important data.
Kunreuther: I think that’s right. You could say on one level, they’re flood maps. But the whole idea of better mapping and even talking about what it means to have an accurate flood map gives a whole community an idea of what it is that they can do. It isn’t just the individuals. You get a map and all of a sudden the community says, “Maybe we need to do something with levies or dams or sea walls.” Then they would get a benefit from the program by having a lower premium for all of its residents because that’s one of the features of the National Flood Insurance Program. They have a community ratings system and communities will benefit. They will benefit a great deal more if they know what their risk is and they have a good feeling that they can do something to reduce it. And everyone benefits from that.
Knowledge at Wharton: You also mentioned multi-year policies instead of yearly, as they are now. By doing a multi-year plan, you’re locking these people into insurance coverage for a longer period. At some level, you have the known quantity for the insurer, which can lower the cost over time for the people that have to buy the insurance, correct?
Kunreuther: Let me say some positive things about what locking in means. People tend to cancel their insurance even if it is required. Certainly, if it’s voluntary, if they haven’t had a loss for a few years. It’s extremely hard to let people know that the best return on an insurance policy is no return. They should celebrate the fact that they haven’t had a loss. With the multi-year policy, you get people to be protected for more than one year. But you can also tie it in with a loan. They say, “My premium is stable each year for five years,” rather than feeling their policy might be canceled, which could be done by the private sector, or that the premiums may go up.
You have a notion of they’re protected. They also know that they are now thinking about this on a longer term. So, investing in mitigation with a loan is positive.
Knowledge at Wharton: You think that if there is a building code violation or a structural issue with these properties, that the builder should be held liable instead of the property owner.
Kunreuther: It’s a really important point, but really challenging to implement. In some cases, it may be the proof. I will give you the best example we know of. During Hurricane Andrew, which was in 1992 in Florida, they determined that one-third of the damage could have been avoided had the building codes there been enforced. Now, Florida has the best building codes because of that particular disaster, but it took the disaster for them to get that building code in place.
“Florida has not had a major hurricane since 2005, so they have been lucky.”
It’s really hard in this country, although we can push for it, to have that kind of responsibility. We don’t tend to have it. Chile, for example, has a policy that any developer is responsible for any damage to the structure for the next 10 years after it’s built. That immediately would tie in with a building code. If you have that, then the developer would say, “We better make sure that building code is enforced.”
Knowledge at Wharton: You also bring up an interesting idea about auctioning off catastrophic re-insurance contracts from the federal level that would go to insurers to help them with costs.
Kunreuther: This would be an idea that has not been implemented…. But it would tie the whole idea of having federal catastrophes and the protection by the federal government to private re-insurance, so that there really would be a public/private connection in a way that would say, “Let’s begin to see what price people would be willing to pay for catastrophic coverage,” and the auction would be a way to do it. I don’t want to get into the complexities of that. But it would be something that one could begin to think of where the public sector could play a role.
Knowledge at Wharton: How important is it to get the mapping done in the next few years?
Kunreuther: Being on the mapping committee introduced me to this in a way that I hadn’t been before. I’m not an expert on mapping. I’m on the committee from a risk management point of view, and that’s why I was appointed to the committee. But I would say that from a risk management strategy, if you don’t have a good map, you’re losing three things: You can’t communicate to people what the risk is and be confident. You can’t encourage people to mitigate and take steps because they don’t really know what it’s going to benefit accurately. And you can’t deal with the affordability issue because you can’t really know how much you have to pay because you don’t have an accurate estimate in terms of what their risk-based insurance premium is going to be.
Knowledge at Wharton: What is the viewpoint of other countries toward disasters and catastrophic insurance?
Kunreuther: Counties vary greatly in how they deal with it. France has the federal government playing a much more important role in providing protection. They don’t have risk-based premiums, for example. The United Kingdom comes a lot closer to what we would see as a model here in the United States. They have all of the hazards in one policy, so a homeowner’s policy will cover the flood risk and the earthquake risk, which it doesn’t do in this country, as well as tornados and other wind damage, which it does do here.
France has a new flood insurance program that subsidizes people in very high hazard areas who have to pay a high premium. It doesn’t deal with affordability in quite the way that we would like it do. But that is a good example of something that has been done that is much more market-based than we have right now.
Knowledge at Wharton: The United States has had some major storms in the last 15 years. If we know that they’re going to hit here, why aren’t we addressing this on a more important level?
Kunreuther: It’s an important point to end up on because it comes back to where we started. If you don’t have a disaster for a few years, people are going to say, “It’s not going to happen to me.” Florida has not had a major hurricane since 2005, so they have been lucky. They had four in 2004 and another one or two in 2005. But people have forgotten that. The real challenge is to get this on people’s radar screens. If you’re living in your house for 25 years and there’s a one in 100 chance next year of a hurricane or flood, the likelihood of that occurring over a 25-year period is greater than one in 5. If people the understand that, they are likely to pay a lot more attention to the idea instead of tuning out when you just tell them it’s one in 100.