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Managing Large-Scale Risks in a New Era of Catastrophes
Howard C. Kunreuther [email protected]
Risk Management and Decision Processes CenterThe Wharton School, University of Pennsylvania
http://opim.wharton.upenn.edu/risk
Plenary Session on Global and Trans-boundary Risks
2nd World Congress on Risk Guadalajara, Mexico
June 9, 2008
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Outline of Talk
1. Nature of Global Risk Project
2. A Framework for Global and Trans-boundary Risks
3. Cause for Concern: A New Era of Catastrophes
4. Wharton Risk Center Initiative on Large-Scale Risks
5. Guiding Principles for Developing Risk Management Strategies
6. Linking Risk Assessment, Risk Perception and Risk ManagementAn Illustrative Example: Effectiveness of Mitigation
7. Summary
1. Nature of Global Risk Project What are the Key Global Risks (10-yr horizon)?
(Sources: Global Risks 2008)
Our Definition:
• Non-business risks that affect business (i.e. not operational, project or financial risk)
• Can be strategic, exogenous and systemic
• Are highly interdependent(i.e. do not manifest in isolation and can result in runaway conflation)
• Characterized by uncertainty, sharp discontinuities, non-linearity (power law distributions) and lack of proportionality
• Can’t be predicted (but can be managed)
How are Global Risks Correlated?
2. A Framework for Global and Trans-boundary Risks
Nature of Interdependencies
Constructing Scenarios
Risk Perception
• Public Perceptions• Expert/Layperson Differences• Risk Communication
Risk Assessment& Vulnerability
Analysis
Modelingof Risks
Risk Management
Strategies
A Framework for Global and Trans-boundary Risks (cont.)
Risk Management Strategies
• Information Provision• Incentives• Regulation• Standards• Compensation• Insurance• Liability
Evaluation of Strategies• Impact on Society• Impact on Interested Parties
A radical change in the scale and rhythm of catastrophes
Natural disasters have caused economic losses to property in recent years– Hurricane Katrina: $65-70 billion (in insured losses)– Hurricane Andrew: $22 billion (2005 dollars) (in
insured losses)
Large number of lives lost in recent catastrophic disasters - Myanmar Cyclone: Over 200,000 people missing and over
100,000 deaths- Sichuan Province (China) Earthquake—death toll could reach
100,000
Challenges in mitigating damage, loss of lives and providing funds for recovery following
large-scale catastrophes
3. Cause for Concern A New Era of Catastrophes
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4. Wharton Risk Center Initiative on Large-Scale Risks
• 17 partners – Allstate, AIA, AIG, Guardsmark, Liberty Mutual, Lockheed Martin, Munich Re, NAMIC, PartnerRe, PCIAA, RAA, Renaissance Re, Societe Generale Bank, State Farm, Swiss Re, Travelers, Zurich − Georgia State University, Insurance Information Institute, Risk Management Solutions
• Collaboration with most state and federal programs: FHCF, Citizens, Texas Wind Pool,NFIP, DHS
• Focus on disaster markets in 4 states and metropolitan areas:Florida (Miami); Texas (Houston); New York (specific postal zones of NYC); South Carolina (Charleston)
• TimelinePhase I Report: February 2007 Draft Phase II Report: October 2007Publication Phase II Report: March 1, 2008
Worldwide Evolution of Catastrophe Insured Losses, 1970-2007
(Property and business interruption (BI); in U.S.$ billon indexed to 2007)Sources: Wharton Risk Center (2008) - data from Swiss Re and Insurance Information
Institute
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1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Man-made catastrophes Natural catastrophes
9/11/2001 loss (property and BI) 9/11/2001 loss (liability and life)
The 20 Most Costly Catastrophe Insurance Losses, 1970-2007
(10 of them occurred since 2001; 9 of these 10 in the U.S.) U.S.
$ Billion(indexed to 2007)
EventVictims
(Dead or missing)
Year Area of Primary Damage
66.3 Hurricane Katrina 1,836 2005 USA, Gulf of Mexico, et al.
35.5 9/11 Attacks 3,025 2001 USA
23.7 Hurricane Andrew 43 1992 USA, Bahamas
19.6 Northridge earthquake 61 1994 USA
14.1 Hurricane Ivan 124 2004 USA, Caribbean, et al.
13.3 Hurricane Wilma 35 2005 USA, Gulf of Mexico, et al.
10.7 Hurricane Rita 34 2005 USA, Gulf of Mexico, et al.
8.8 Hurricane Charley 24 2004 USA, Caribbean, et al.
8.6 Typhoon Mireille 51 1991 Japan
7.6 Hurricane Hugo 71 1989 Puerto Rico, USA, et al.
7.4 Winterstorm Daria 95 1990 France, UK, et al.
7.2 Winterstorm Lothar 110 1999 France, Switzerland, et al.
6.1 Winterstorm Kyrill 54 2007 Germany, UK, NL, France, et al.
5.7 Storms and floods 22 1987 France, UK, et al.
5.6 Hurricane Frances 38 2004 USA, Bahamas
5.0 Winterstorm Vivian 64 1990 Western/Central Europe
5.0 Typhoon Bart 26 1999 Japan
4.5 Hurricane Georges 600 1998 USA, Caribbean
4.2 Tropical Storm Alison 41 2001 USA
4.2 Hurricane Jeanne 3,034 2004 USA, Caribbean, et al.
Sources: Wharton Risk Center (2008) - Data from SwissRe and IIIhttp://video.google.com/videoplay?docid=619278176220951495&q=hurricane+katrina&total=7291&start=10&num=10&so=0&type=search&plindex=7
What Is at Stake and Goal of the Study
What is at stake?• Affordability of living in risky areas • Who ultimately bears the costs and receives the
benefits of such decisions
Research challenge • Need to better understand the impact of state
insurance regulations on the dynamics of the market• Need quantitative measurements of these effects
Goal: Develop a strategy document to help inform the current policy debate • Role that the private and public sectors can play in
reducing future disaster losses• Enhancing the recovery process due to better
financial coverage through insurance and other means
Higher degree of urbanization
Huge increase in the value at riskPopulation of Florida 2.8 million inhabitants in 1950 - 6.8 million in 1970 - 13
million in 1990 19.3 million population in 2010 (590% increase since 1950)
Cost of Hurricane Andrew in 2004 would have been $120bn
Weather patternsChanges in climate conditions and/or return to a high hurricane cycle?
More intense weather-related events coupled with increased value at risk will cost more, much more.
What Will 2008 Bring? 12
What’s Happening? The Question of Attribution
Insured Coastal Exposure as a % of Statewide Insured Exposure in
2004
63.1%60.9%
57.9%54.2%
37.9%33.6%33.2%
28.0%25.6%25.6%
23.3%13.5%
12.0%11.4%
8.9%5.9%
79.3%
0% 10% 20% 30% 40% 50% 60% 70% 80%Source: Data from AIR Worldwide
Source: Data from AIR Worldwide
Total Value of Insured Coastal Exposure in 2004
$1,937bn $1,902bn
$506bn $663bn
$740bn
$405bn $209bn
$149bn $130bn $117bn $105bn
$76bn $73bn
$46bn $46bn $45bn $44bn
0 250 500 750 1,000 1,250 1,500 1,750 2,000 2,250
5. Guiding Principles for Developing Risk Management Strategies
Importance of assessing risks and characterizing uncertainties surround these estimates.
Recognition of interdependencies associated with risks and the dynamic uncertainties associated with these interdependencies.
Understanding behavioral biases and heuristics utilized by decision makers, such as misperceptions of probability, myopia and the disaster won’t happen to me.
Risk management strategies should be based on assessments of the risk, recognize interdependencies and address behavioral biases and heuristics used by decision makers.
Guiding Principles for Developing Alternative Insurance Programs
Principle 1: Premiums Reflecting Risk Insurance premiums should be based on risk in order to provide signals to individuals as to the hazards they face, and to encourage them to engage in cost-effective mitigation measures to reduce their vulnerability to catastrophes.
Principle 2: Dealing with Equity and Affordability Any special treatment given to homeowners currently residing in hazard-prone areas (e.g., low-income uninsured or inadequately insured homeowners) should come from general public funding and not through insurance premium subsidies.
Data Needs Based on These Principles
Characteristics of households in hazard-prone areasSocio-economic status
Insurance status
Nature of structure and mitigation measures in place
Characteristics of riskLikelihood of hazards of different magnitudes
Consequences of specific hazards under different conditions (e.g. structure mitigated or note mitigated)
6. Linking Risk Assessment, Risk Perception
and Risk ManagementAn Illustrative Example: Effectiveness of
MitigationEnforced building codes are effective.
Many homeowners do not voluntarily invest in cost-effective mitigation.
Coordinating between the public and private sectors is critical to significantly increase adoption of mitigation measures.
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Risk Assessment: Impact of Mitigation Illustration with a 100-Year Event
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FL NY SC TX
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Savings from Mitigation
Remaining Losses
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Effects of Mitigation on a 500 Year Event
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$160 billion loss
$82 billion saving with$82 billion saving withmitigation in placemitigation in place
Risk Assessment: Effects of Mitigation On a 500-Year Event
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Characteristic of Mitigation Upfront cost/long-term benefits
Cost of Mitigation – $1,500
Nature of Disaster– 1/100 chance of disaster – Reduction in loss ($27,500)
Expected Annual Benefits: $275 (1/100 * $27,500)
Annual Discount rate of 10%21
Motivating Mitigation Example
Benefits over 30 years
$0
$500
$1,000
$1,500
$2,000
$2,500
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1 2 3 4 5 8 10 15 20 25 30
Upfront cost of mitigation
Expected benefits over time
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Behavioral– Myopia (hyperbolic discounting; NIMTOF)
– Misperception of risk
1/1000 chance rather than 1/100 chance of hurricane
$10,000 reduction in loss rather than $27,500
– Expectation of disaster relief
Institutional Realities– Budget constraints – can’t afford $1,500 investment
– Insurer may not give me discount next year or cancel policy
– Move in 2-3 years. Value of house doesn’t appreciate by investment in mitigation so can’t recoup cost of mitigation
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Risk PerceptionWhy Individuals do not Adopt Mitigation
Measures
Proposed strategy Long-term insurance contractsLong-term home improvement loans
Rationale Mitigation measure is attached to property
rather than to homeowner
Overcomes behavioral biases and institutional realities
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Risk Management StrategiesCreating Innovative Solutions
Illustrative Example Cost of partial roof mitigation: $1,500
Expected annual benefit of partial roof mitigation: $275 (1/1000 * $27,500)
Annual payments from 20 year $1,500 loan at 10% annual interest rate: $145
Reduction in annual insurance payment: $275
Reduction in annual payments due to mitigation: $275-$145= $130
Linking Long-Term Loans with Long-Term Insurance
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Everyone is a Winner:
Homeowner: Lower total annual payments
Insurer: Reduction in catastrophe losses
and lower reinsurance cost
Financial institution: More secure investment due to
lower losses from disaster
General taxpayer: Less disaster assistance
Linking Long-Term Loans with Long-Term Insurance
7. SummaryThe Facts:
Totally new era of large-scale risks; growing concentration of value in high-risk areas that portend more devastating disasters in the future.
Data Needs Need better data for linking risk assessment,
risk perception and risk management strategies
Research questions: How can we develop strategies for reducing our vulnerability to future natural disasters?
What types of private-public partnerships are required to increase resiliency of residences, businesses and communities following a large-scale disaster?
