At War with the Weather

At War with the Weather: Managing Large-Scale Risks in a New Era of Catastrophes

Howard C. Kunreuther
Erwann O. Michel-Kerjan
Neil A. Doherty
Martin F. Grace
Robert W. Klein
Mark V. Pauly
Copyright Date: 2009
Published by: MIT Press
Pages: 440
https://www.jstor.org/stable/j.ctt5hhn3h
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  • Book Info
    At War with the Weather
    Book Description:

    The United States and other nations are facing large-scale risks at an accelerating rhythm. In 2005, three major hurricanes--Katrina, Rita, and Wilma--made landfall along the U.S. Gulf Coast within a six-week period. The damage caused by these storms led to insurance reimbursements and federal disaster relief of more than $180 billion--a record sum. Today we are more vulnerable to catastrophic losses because of the increasing concentration of population and activities in high-risk coastal regions of the country. The question is not whether but when, and how frequently, future catastrophes will strike and the extent of damages they will cause. Who should pay the costs associated with catastrophic losses suffered by homeowners in hazard-prone areas? In At War with the Weather, Howard Kunreuther and Erwann Michel-Kerjan with their colleagues deliver a groundbreaking analysis of how we currently mitigate, insure against, and finance recovery from natural disasters in the United States. They offer innovative, long-term solutions for reducing losses and providing financial support for disaster victims that define a coherent strategy to assure sustainable recovery from future large-scale disasters. The amount of data collected and analyzed and innovations proposed make this the most comprehensive book written on these critical issues in the past thirty years.

    eISBN: 978-0-262-25543-1
    Subjects: Business, Economics

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-xii)
  3. Preface
    (pp. xiii-xviii)
    Howard C. Kunreuther and Erwann O. Michel-Kerjan
  4. Acknowledgments
    (pp. xix-xxii)
  5. I CAUSE FOR CONCERN
    • 1 A New Era of Catastrophes
      (pp. 3-24)

      This chapter provides a picture of the increase in catastrophic losses in the United States and the challenges that various stakeholders face in managing the associated risks and costs coming from their different positions and, in some cases, different interests. Gaining an understanding and appreciation of the perspectives and concerns of these stakeholders is critical to developing and evaluating measures that will improve the management of catastrophic risk.

      The economic and insured losses from great natural catastrophes such as hurricanes, earthquakes, and floods worldwide have increased significantly in recent years, as shown in figure 1.1 (each vertical bar represents the...

    • 2 Catastrophe Risk and the Regulation of Property Insurance: A Comparative Analysis across States
      (pp. 25-58)

      The regulation of insurance companies and insurance markets plays a prominent role in the management of catastrophe risk. Each state exercises considerable authority over insurers’ entry and exit, financial condition, rates, products, underwriting, claims settlement, and other activities. Regulatory constraints and mandates in these areas can have significant implications for how property insurance markets function and property owners’ incentives to control their risk exposure. Although there are limits to regulators’ power, there is virtually no aspect of insurance markets and insurance company activities that they cannot attempt to control or at least influence. At the same time, prudent regulators seek...

    • 3 A Market Analysis of Property Insurance against Hurricane Risk
      (pp. 59-82)

      The intense hurricane seasons of 2004 and 2005 caused substantial instability in property insurance markets in coastal states, with the greatest pressure in Florida and the rest of the Southeast.¹ Other coastal states exposed to hurricanes also have experienced some market pressures and changes. The increased risk of hurricanes striking the United States prompted significant changes in these same markets beginning in the early 1990s, but the particularly intense hurricane activity during 2004 and 2005 led to another wave of market adjustments. Both the loss shocks of the 2004 and 2005 storm seasons and the belief that hurricane risk has...

    • 4 Come Rain or Shine: Flood Risk Financing through Public Insurance
      (pp. 83-116)

      The National Flood Insurance Program (NFIP) grew out of a widespread opinion that flood peril was not insurable by private insurance companies.¹ Insurers in the United States claimed that floods could not be insured by the private sector because (1) only particular areas are subject to the risk, so adverse selection would be a problem; (2) the necessary premiums would be so high that no one would be willing to purchase coverage; and (3) flood losses can be catastrophic, that is, enough premiums could not be collected to cover catastrophic events.²

      Congress established the NFIP in 1968, noting that “many...

  6. II UNDERSTANDING THE DEMAND AND SUPPLY OF DISASTER INSURANCE
    • 5 Homeowners’ Decision Making for Purchasing Insurance Coverage
      (pp. 119-128)

      This chapter shows that a normative theory of decision making for purchasing insurance based on expected utility theory does not incorporate descriptive aspects of behavior.¹ We provide an illustrative example as to how a typical homeowner would determine how much insurance (if any) to purchase against losses from a natural disaster by trying to maximize expected utility. While this model does have some predictive power, there are other subtleties to actual decision making that need to be addressed. People do not have access to perfect data, and even if they did, they may process information in somewhat different ways. We...

    • 6 Private Insurers’ Decision Making for Supplying Coverage
      (pp. 129-150)

      In this chapter and the next, we analyze how insurers and reinsurers decide whether to cover a risk and also what premiums to charge. As a result of the recent catastrophes, insurers and reinsurers are reexamining their ability to provide protection against wind damage from hurricanes and are asking whether these events are insurable.

      To understand the concept of insurability, consider a standard policy whereby premiums are paid at the start of a given time period to cover losses during this interval (usually a year). Two conditions must be met before insurance providers are willing to offer coverage against an...

    • 7 Private Reinsurers’ Decision Making for Supplying Coverage
      (pp. 151-172)

      Reinsurers provide protection to private insurers in much the same way that insurers provide coverage to their policyholders. They offer coverage against the catastrophic portion of a loss for which insurers do not want to be financially responsible. In this type of arrangement, the reinsurer charges a premium to indemnify an insurance company against a layer of the catastrophic losses that the insurer would otherwise be responsible for covering.

      There are two main types of reinsurance:pro rata(coinsurance or quota-share) reinsurance, in which premium and loss are shared on a proportional basis, andexcess of lossreinsurance, for which...

    • 8 Innovative Insurance-Linked Securities for Financing Extreme Events
      (pp. 173-192)

      As discussed in the previous chapter, there was a significant increase in reinsurance prices for catastrophic risks in the United States in the aftermath of the 2005 hurricane season.¹ In particular, the fact that the size of the retrocession market (reinsurance for reinsurers) was dramatically reduced caused greater uncertainty among reinsurers as to whether such coverage would be available to them in the long term.

      These developments provided an impetus for the expansion of alternative risk transfer (ART) instruments that complement traditional insurance and reinsurance. The field of ART grew out of a series of insurance capacity crises in the...

    • 9 A Framework for Linking Supply and Demand of Disaster Insurance
      (pp. 193-202)

      In order to evaluate the effectiveness of current and alternative disaster insurance programs, one needs to understand not only the demand for protection by homeowners and the supply of coverage, but also how the two interact to create a specific market equilibrium. This chapter complements analyses provided in previous chapters and develops a framework at a conceptual level for understanding the interaction of supply and demand prior to a natural disaster as well as after a catastrophe occurs.

      Our intention is to learn whether the insurance market is functioning effectively, given the play of market forces as shaped by existing...

    • 10 A Multistate Empirical Analysis of Homeowners’ Insurance
      (pp. 203-232)

      The basic demand problem for the homeowner is to select the best insurance policy from among the menu of policies offered in the market.¹ Demand arises from the optimal consumer choice of a bundle of product and company attributes, given the personal characteristics of each homeowner and the economic and demographic characteristics of the neighborhood (postal zone) where he or she resides. The theoretical foundation for this demand analysis and the interacting market equilibrium are based on a model of price-quality competition.² In a perfectly competitive market, the differences in what homeowners are willing to pay for various features will...

  7. III PROTECTING HOMEOWNERS AGAINST NATURAL DISASTERS
    • 11 Impact of Insurance Status on Economic Welfare of Homeowners in Hazard-Prone Areas: The Affordability Challenge
      (pp. 233-246)

      In determining the future of insurance as a policy instrument for financing recovery from natural disasters and enhancing the adoption of adequate mitigation measures, we need to have a clearer understanding of what proportion of homeowners in hazard-prone areas currently have homeowners’ insurance. Furthermore, we need to understand why some have (or should have) homeowners’ insurance while others do not. (Homeowners’ insurance usually does not cover losses from flood damage, but covers damage from other perils.) The first portion of this chapter tackles these issues by looking at American Housing Survey data, the primary source of data on housing expenditures...

    • 12 Enhancing the Implementation of Risk Reduction Measures
      (pp. 247-268)

      This chapter discusses the role that risk reduction measures (mitigation) can play in reducing losses from natural disasters and the positive role that insurance could play in encouraging more homeowners to adopt cost-effective protective measures. It also raises a set of challenges for encouraging the adoption of mitigation measures.

      The challenge society faces today is how to promote investments in cost-effective loss reduction mechanisms while at the same time placing the burden of recovery on those who suffer losses from natural disasters.¹ In theory, insurance is one of the most effective policy tools for achieving both objectives, because it rewards...

    • 13 Policy Analysis of Alternative Programs: Comparing the Status Quo with a True Competitive Insurance Market
      (pp. 269-330)

      Who will pay for the losses from future catastrophes? This chapter provides a series of empirical analyses on how residential losses to homeowners due to hurricanes will be shared among the affected stakeholders under different market environments. The stakeholders we consider are uninsured homeowners, insured homeowners, all insurance policyholders, private insurers, private reinsurers, state insurers, and reinsurers, and general taxpayers. We also examine the significant role that mitigation can play in reducing such losses. There are four principal objectives in undertaking these analyses:

      Determine the economic impact of a series of major hurricanes on the key stakeholders under the current...

  8. IV CREATING INNOVATIVE SOLUTIONS
    • 14 Proposed Innovations for Dealing with Catastrophic Risks
      (pp. 333-350)

      Given the significant increase in damage from hurricanes and other natural disasters and the growing population and assets in high-risk areas, we need a new approach for insuring these risks and encouraging individuals who reside in hazard-prone areas to undertake effective mitigation measures. Two principles should guide the development of new programs for reducing future losses and allocating the costs of disasters in an efficient and equitable manner:

      Principle 1: Premiums reflecting risk.Insurance premiums should be based on risk to provide signals to individuals as to the hazards they face and encourage them to engage in cost-effective mitigation measures...

    • 15 Winning the War against the Weather and Other Extreme Events
      (pp. 351-360)

      While the analysis in this book has dealt with one type of catastrophe (weather-related hazards) and one country (the United States), we believe that the framework and analysis in this book applies to a much broader set of extreme events than natural disasters and can also be extended to other countries.

      In the first few years of the twenty-first century, the world has experienced a spate of unprecedented catastrophes that require us to rethink our approach to reduce future losses and deal with these events in a more proactive way. In the United States on September 11, 2001, a superpower...

  9. Abbreviations
    (pp. 361-362)
  10. Glossary
    (pp. 363-368)
  11. Notes
    (pp. 369-382)
  12. References
    (pp. 383-392)
  13. Study Directors and Other Lead Authors
    (pp. 393-396)
  14. Index
    (pp. 397-416)