Perilous
Times
Prepare yourself, natural disasters will only get worse
By Erwann Michel-Kerjan, Published: September 15
The world has entered a new era of catastrophes. Economic losses
from hurricanes, earthquakes and resulting tsunamis, floods,
wildfires and other natural disasters increased from $528 billion
(1981-1990) to more than $1.2 trillion over the period 2001-2010.
The 9.0 earthquake and massive tsunami in Japan this past spring
caused hundreds of billions of dollars of direct and indirect
costs. It has affected the Japanese macroeconomic forecast and
resulted in the departure of the then-prime minister. And before
this, massive earthquakes in Haiti, Chile and New Zealand
inflicted record human and financial losses as well.
Despite being the richest country in the world, America is still
highly vulnerable to natural disasters. Two principal
socioeconomic factors directly influence the level of economic
losses due to catastrophic events: exposed population and value at
risk. Florida, for example, has seen its population grow from 2.8
million inhabitants in 1950 to 18.8 million in 2010 (+570%).
Increased population and development means an increased likelihood
of severe economic and insured losses in Florida and other
hurricane-prone regions unless cost-effective mitigation measures
are implemented and the risk properly hedged.
So, when an unexpected earthquake was felt on the East Coast,
followed by Hurricane Irene, those of us who have been tracking
extreme events for years knew what would likely happen.
First, the Administration in Washington would have learned the
lessons from the 2005 Hurricane Katrina debacle. Evacuation would
have to be required and enforced. The president, the heads of FEMA
and DHS, along with local, state and federal officials in charge
of disaster management would have to be on the front line very
early. The presence of true professionals would matter a great
deal. Furthermore, this effort and a well-articulated crisis
management strategy would have to be relayed and clearly explained
by leading media outlets.
That is the way it happened.
Following these steps has saved numerous lives. However, the fact
that Hurricane Irene eventually weakened and hit the Northeast
during a weekend helped tremendously. This could have been much
worse. Evacuating part of New York City on a Wednesday and
Thursday with everybody at work, for instance, would have been
much more complicated.
Second, after the rescue effort, the time would soon come to
evaluate the losses and ask the hard question: Who will pay for
this? While Irene caused significant wind losses in the Carolinas,
a majority of the losses in the Northeast have been flood-related.
A political debate started as to whether victims should receive
federal disaster aid, how much, and how to make this unbudgeted
spending fiscally neutral. Based on past experience, and given
that emotions run high, it will be very hard for elected officials
to deny their fellow citizens relief. As a matter of fact, my
colleague Howard Kunreuther and I showed that over the period
1950-2010, two-thirds of all presidential disaster declarations
had been flood-related. So you can count on disaster relief going
to flood victims this time too.
But the debate about federal relief misses an important fact.
While it has been hard, practically, to restrict construction in
hazard-prone areas along the coast, flood risk can be insured.
Typical homeowners’ insurance covers wind damage, but it excludes
flood losses. Still, homeowners can obtain flood coverage from the
federally run National Flood Insurance Program (NFIP), up to
$350,000 (building and contents) and with a deductible as low as
$500. Many large insurers (yours too, most likely) sell NFIP
policies on behalf of the federal government and assess flood
claims in exchange for government fees.
This program has grown significantly in recent years and provides
insurance to 5.3 million policyholders, rich and poor, across the
country today. The program now covers more than $1.2 trillion in
assets (a 250% increase since 1990, when corrected for inflation).
This is not a small program. Because public insurance is offered
by the Federal government, which does not face additional expenses
(cost of capital, return to shareholders, taxes) that private
insurance companies would, its cost is relatively low — on average
$50 per month.
Wildfires fueled by extremely dry conditions and strong winds
have destroyed hundreds of homes in Oklahoma and Texas.
Still, many people don’t buy flood insurance, and many of those
who purchase it don’t keep it for long. In the Louisiana parishes
affected by Hurricane Katrina in 2005, the percentage of
homeowners with flood insurance ranged from 57.7 percent in St.
Bernard Parish to 7.3 percent in Tangipahoa when the hurricane
hit. Only 40 percent of the residents in Orleans Parish had flood
insurance.
I hope Irene will show a different picture, but I would not bet on
it. We also recently did the first ever study of flood insurance
tenure — the number of years that people keep their flood
insurance policy before letting it lapse. Our analysis of the
entire NFIP portfolio over the period 2001-2009 reveals that, on
average, this tenure is only three years. Many people buy flood
insurance when they buy a new house because the bank requires
flood insurance proof to authorize a federally backed mortgage if
the residence is in a flood plain. But they cancel it fairly soon
after. Then, they suffer a flood and regret not having kept that
coverage longer. And don’t think this behavior is specific to
flood. Ninety-one percent of Californians do not have earthquake
insurance today. The state is virtually bankrupted, so I forecast
that all of us as taxpayers will pay when the Big One hits
California. Consider yourself warned.
What is the solution? Several prime ministers, presidents and
rulers around the world have now put this question of management
and financing extreme events on their agenda. Many more executive
boards are doing it too, trying to figure out how best to act
strategically, protect their firms’ assets and create new products
to hedge catastrophe risk. It’s almost impossible to argue against
this being a matter of national interest — to say nothing of good
governance and competitiveness.
We must limit the amount of new construction in high-risk areas
and make sure people and firms already in those areas have proper
financial coverage to assure they can get back on their feet
quickly after the next catastrophe. This will cut down on taxpayer
expense. Unless we start to get serious about making the country
more resilient to natural disasters, we won’t be prepared for what
the 21st century has in store for us.
Without quite realizing it yet, America is at war against the
weather. Irene and the wildfires in Texas are just the latest
battles. More is soon and sure to follow.
Erwann Michel-Kerjan is an authority on managing and financing
extreme events. He teaches Value Creation in the Wharton School
MBA program and is the Managing Director of the Wharton Risk
Management Center. He is the author of several acclaimed books,
including At War with the Weather (with Howard C. Kunreuther).