Paying the Price: The Status and Role of Insurance Against Natural Disasters in the United States (1998)

WILLIAM PETAK

NATURAL HAZARD MITIGATION is defined in FEMA's National Mitigation Strategy as "sustained action taken to reduce or eliminate long-term risk to people and their property from hazards and their effects" (FEMA, 1995). Insurance has traditionally served the purpose of reducing the economic impact of individual losses by arranging for the transfer of all or part of the loss to others who share the same risk. Although insurance is not considered a mitigation measure, a carefully designed insurance program can encourage the adoption of loss reduction measures through economic incentives such as premium reductions and lower deductibles.

Mitigating the impacts of natural disasters requires individual or business action and investment to improve a property's ability to withstand the forces of natural disasters. In view of the low frequency of occurrence of catastrophic events, individual homeowners and small business owners tend to be reluctant to allocate scarce resources to mitigation. They understand that the direct benefits from the costs associated with implementing mitigation measures (i.e., return on the investment) are realized only when a

natural hazard event occurs and the property experiences reduced damage. Further, the notion of freedom of choice in deciding where to live or locate a home or business and how to design and construct a building remains a driving political force. The cumulative result of many individuals exercising that freedom of choice has been the concentration of many buildings in areas subject to earthquake, flooding, landslide, liquefaction, and severe winds, as well as the design and construction of buildings unable to withstand these natural forces.

One question that needs to be addressed is whether insurance premiums, deductibles, and the availability of coverage are sufficient incentives to cause property owners to voluntarily adopt cost-effective mitigation measures. Some believe that the free market is unlikely to lead to an efficient level of investment in mitigation (Litan, 1991). To be effective in this environment, the role of the insurance industry in facilitating both the voluntary application of mitigation measures and the implementation by state and local governments of mandated loss reduction measures needs to be more carefully defined.

Existing communities and continuing economic development in hazardous areas pose significant risk of catastrophic losses from natural hazard events. Climatic change may also increase the frequency and severity of natural hazard events with catastrophic potential. Although individuals and businesses generally view insurance as the primary tool for reducing the potentially large economic losses associated with natural hazards, insurance is not structured to substantially reduce the impact of a major disaster on the total economic system.

From an insurance company risk-rating perspective, an individual property loss is an independent event involving a small annual risk of loss. Accumulated losses are therefore relatively small, making it possible to manage claims and collect premiums within a high degree of certainty. An individual property loss based upon the traditional rules of insurance would be categorized as a private problem because it would not require large amounts of public aid and the property could be rebuilt with resources provided under the terms of the insurance contract. These single risks, however, when aggregated through the forces of a natural disaster, change from a collection of private, individual problems to a public, community problem; Kunreuther et al. (1978) have characterized the situation as a shift from a private risk to a social risk.

Specifically, the aggregated impacts in terms of homelessness, unemployment, abandonment of property, cost in public services, and so on, are social and economic costs borne by the greater system, and require direct financial assistance from government. Reducing the risk of damage to buildings that serve these social functions is therefore a direct benefit to the taxpaying public following the occurrence of a catastrophic event.

When a private risk becomes a social or public risk, mitigation through both individual (private) voluntary action and government (public) regulatory action is required. Two fundamental issues to be addressed are:

• What factors or incentives are necessary to motivate private property owners to engage in voluntary mitigation actions to reduce the risks from natural hazards, particularly low-probability, high-consequence events?

• Where does the responsibility for mitigation of risks posed by natural hazards shift from being primarily a set of individual private decisions to a public problem requiring public sector intervention (i.e., what is the threshold at which the government must set the primary standards for mitigation of natural hazard risks)?

To address these issues, we need a greater understanding of the risks posed by hazards for both the public and private sectors, the cost and efficacy of various mitigation alternatives, the perceptions of risks by the various stakeholders, and the fundamental factors required to motivate risk reduction behavior. The capacity of local, state, and federal government to address these issues is important. Because private insurance companies are a principal stakeholder in the process, it is also critical that the insurance industry establish broad-based hazard mitigation objectives and programs to guide their own activities and address the problem.

The insurance industry has an established record of supporting the implementation of mitigation measures to reduce risk to property. The industry offered the first model building code for lessening damage from fires, and provided incentives to encourage the adoption and implementation of effective fire hazard mitigation strategies. To emphasize the importance of codes in improving the quality of construction, the National Board of Fire Underwriters stated in their 1949 National Building

Code: "It is recognized that good construction is of the utmost importance in every city and town. The competent enforcement of good building law tends to raise the general standard of construction throughout the country. Building codes must provide reasonable safety to the occupants, must preserve the property itself and must protect adjoining property" (National Fire Underwriters, 1949, emphasis added).

Although this code set the standard for the insurers' participation in hazard mitigation and for future model codes, it did not cover the risks associated with potentially catastrophic natural hazards. In 1980 the insurance industry, believing "that the model code organizations were fulfilling

(A) This parking garage at the Northridge Fashion Center withstood the 1994 Northridge earthquake relatively well. It was a cast-in-place structure; note the spirally confined columns. (B) Another Fashion Center parking garage after the earthquake. Although this garage was not as old as the one shown above, it did not fare as well. The inadequate transfer of inertial forces to the shear walls of this precast post-tensional construction may have contributed to its collapse (USGS, M. Celebi).

the purpose for which the initial code was established," ceased publication of the National Building Code (American Insurance Association and Alliance of American Insurers, 1995, p. 79).

As pointed out in Chapter 1, the catastrophic disaster losses insurance companies have experienced in the last ten years have sensitized the industry to its vulnerability to natural hazards, and have focused attention on the need for better building construction and hazard avoidance. This experience has caused the industry to review the question of the insurability of natural hazard risks (see Chapter 2) and to become proactive in furthering the cause of better mitigation programs.

To many insurance company officials, the lack of sufficient knowledge about the probabilities associated with a specific natural hazard event, and the uncertainties about the effectiveness of various mitigation approaches in achieving property loss reduction make it difficult for insurers to provide financial incentives for mitigation. The current regulatory system, in which some premiums are fixed below the rates that would be consistent with risk, discourages insurers from adding policyholders to their ranks. If the above conditions prevail, insurers would prefer not to add policyholders by offering premium reductions.

To address the problems of insurability and portfolio risk, both the government and insurance companies rely on analyses performed by consultants who employ various hazard and risk assessment models. Catastrophe models for dealing with earthquake and hurricane hazards are winning increasingly widespread acceptance among insurance firms. However, all the interested parties recognize that in order to link mitigation with insurance it is important to develop models with reduced uncertainty, greater reliability, and improved ability to assess the costs and effectiveness of mitigation alternatives. (For more details on this point see Appendix B, Evaluating Models of Risks from Natural Hazards.)

One specific outcome of the loss experience in recent years and resulting concerns for business viability was that in 1990 the insurance industry initiated House of Representatives Bill 4480. This legislative proposal was aimed at reducing the exposure of private insurers to earthquakes and earthquake-caused catastrophes by transferring some of the risk to the federal government and by establishing an earthquake mitigation program.

A Federal Emergency Management Agency study of the feasibility of

incorporating earthquake loss reduction measures into a federal earthquake insurance program concluded that:

1. There are 15 cost-effective, technically feasible earthquake loss reduction measures, chiefly in land use and building practice, that are acceptable for inclusion in a federal earthquake insurance or reinsurance program.

2. Current earthquake risk analysis techniques, in spite of their uncertainties, are acceptable for the evaluation of loss reduction measures and for the determination of both primary earthquake insurance rates and reinsurance prices.

3. There are two primary vehicles for the effective inclusion of the 15 loss reduction measures into a federal earthquake insurance program:

• earthquake ordinances for state and local government adoption and enforcement, and

• a system of risk-based insurance rates that provide financial incentives for the adoption and enforcement of earthquake ordinances.

4. An enhanced federal program of earthquake loss reduction can be justified by the resulting reduction of existing contingent federal liabilities, especially in higher seismic risk zones (FEMA, 1990).

H.R. 4480 was not adopted during the 101st Congress. A new draft legislative proposal with a more clearly stated set of mitigation requirements was prepared by the Earthquake Project of the National Committee on Property Insurance and became H.R. 2806 of the 102nd Congress. However, Hurricane Andrew in 1992 focused the attention of many on the significant potential for catastrophic losses from large hurricane events, and the insurance industry worked for the introduction of House of Representatives Bill 1856 which specifically included the hurricane hazard. The Senate was also considering Senate Bill 1350 related to disaster insurance. S. 1350 was intended to increase the availability of disaster insurance and encourage the adoption of hazard mitigation practices, with the objective of reducing the economic consequences of future natural hazard events and the reliance on federal disaster assistance. This bill would establish three interrelated programs: a residential primary insurance program of earthquake and volcano insurance, a reinsurance program for excess losses experienced by the commercial writers of insurance, and a mitigation program with funding to the states from a

surcharge on the primary and reinsurance premiums. H.R. 1856 was similar in its objectives, but it extended the coverage to tsunamis and hurricanes.

All of the legislative initiatives sought to combine insurance, reinsurance, and hazard mitigation into a unified governmental program. Thus, as with the flood insurance program, these initiatives would have transferred to the federal government a significant portion of the responsibility for insuring the natural hazard risks with the greatest catastrophic potential. Each of the initiatives resulted in congressional hearings. It is useful to consider the concerns expressed by government officials when such far-reaching proposals were being considered.

Frank Reilly, then Deputy Federal Insurance Administrator, in his testimony before the House of Representatives concerning H.R. 4480, stated that any proposal for federal earthquake insurance should (1) account for a correction of a market failure, (2) be based upon actuarial fairness, (3) include sufficient hazard mitigation, (3) have federal oversight and control, (4) be deficit neutral, and (5) be based upon legitimate risk sharing with the private sector.

With regard to hazard mitigation, Reilly stated that the proposal must include provisions requiring participating states and communities to adopt appropriate land use and building code policies that would reduce the risk of loss of life and damage to property. Including these provisions would overcome the ''moral hazard" problem of a proposal that shifts a large measure of financial risk to the federal government (Reilly, 1990).

Thomas McCool of the General Accounting Office, after review of S. 1350 and H.R. 1856, stated in testimony before the House of Representatives that (1) setting actuarially sound rates would be a difficult problem because of data and technological limitations, (2) spreading the risk among a large number of policyholders in order to provide affordable rates is difficult to achieve without mandating, (3) making insurance a mandatory purchase as part of federally related mortgages may be ineffective because a significant number of owners do not have federally related mortgages, (4) reinsurance raises many issues about the federal government's exposure to unlimited liability for losses, and (5) many, both in and out of government, recognize that a mega-catastrophe, or a series of smaller disasters in a short time period, could overwhelm the capacity of the industry and result in large payouts by the federal government,

thus giving the federal government a significant interest in reducing both the total losses and the federal share of the losses. A well-designed mitigation program with insurance-based incentives for mitigation would help to reduce the risk (U.S. General Accounting Office, 1995).

McCool also noted that, "given the nature of earthquakes, it is difficult to predict probable losses for a given area of exposure." He went on to state that "broad participation is critical to effective risk-sharing and accurate loss predictions" and "depends upon sharing catastrophe risk among a large number of individuals." However, "from a slightly different perspective, if people living in earthquake-prone areas forgo coverage now, homeowners living in low-risk areas may not believe they need the coverage, regardless of how low the premium" (U.S. General Accounting Office, 1995, pp. 6-7).

It is also interesting to observe that in his testimony, McCool stated that even with a mandatory purchase requirement for insurance in the NFIP and premium subsidies, Federal Insurance Administration (FIA) officials found that "only about 20 percent of those living in flood hazard areas have flood insurance" (U.S. General Accounting Office, 1995, p. 4). Thus, flood insurance with its mandatory floodplain management requirements has had limited success in achieving a greater level of mitigation for those living in hazard-prone zones. It appears that as a result of these concerns, the proposed legislation has met with little interest or support in Congress, although the insurance industry continues to work for its passage.

Mitigation measures for reduction of risk from natural hazards can be achieved through voluntary action by property owners, or through the enforcement of a set of government regulations, ordinances, and codes.

Ideally, all property owners would take individual responsibility for evaluating their property and making the necessary adjustments to reduce the risks of damage from natural hazards. In order for voluntary action to occur, property owners need to

• understand the risks associated with natural hazards and the mitigation methods that can be employed to reduce risk to the lowest possible level;

• know the cost and effectiveness of the various mitigation methods; and

• have the appropriate financial incentives and the financial means to take mitigation actions.

It is generally accepted that individual or business property owners will act to reduce the risk of loss from natural hazards when they believe that a significant risk exists and that the risk can be mitigated in a cost-effective manner. Individual property owners must be made aware of the risk, the price of insurance and the degree of attractiveness of specific mitigation measures for their property. If property owners have short time horizons or high discount rates, they will be unwilling to invest in loss reduction measures because they do not perceive the expected benefits to be large enough to justify the expenditure. Those with budget constraints will also be reluctant to incur a certain cost today for uncertain future benefits.

When facilities are considered critical to the continuity of a business operation, professional managers may decide to invest in a hazard mitigation program because it makes good business sense to protect the firm's assets (balance sheet) and shareholder investments from the impact of natural hazard risks. This is of particular concern when a business is publicly owned and management is accountable to the broader financial community through public disclosure rules. The fiduciary responsibility and accountability of corporate financial and operations management will help make the decision to invest in a mitigation program more acceptable.

Other than voluntary action, the most frequently considered means of reducing natural hazard risks is the application of building codes and land use policies. The implementation and effectiveness of these measures, however, depends on the "institutional capacity" of the local, state, and federal governments (Mittler, 1993). There are four aspects of a government's institutional capacity that permit assumptions to be made about how it will respond to the need for greater mitigation.

First are the statutes and regulations that specify what actions governments are required to take. These typically denote department and agency responsibilities and resources, both human and fiscal, that may be dedicated to mitigation. Second are statutes and regulations that

specify relationships between the state and its political subdivisions, cities, and counties. Since disasters are local events, mitigation ultimately depends on the capabilities of the affected area (i.e., trained staff, budget, and political will); however, the assistance states provide, and the laws governing this assistance, will partially determine what eventually gets accomplished.

Third are specific land use management plans and goals. These will most likely include community development plans and codes. Fourth are the experiences of the state and local governments in recent related events. An analysis of what the government did before the event, and what lessons were learned from the event, should provide a guide to future actions.

Within the complex federal system of government, many issues must be addressed when considering an insurance and mitigation program. First, within the structure of state and local governments, how is the responsibility for mitigation determined? Is there sufficient knowledge to enact and enforce appropriate codes and standards? Can the pressure of special interests be overcome in order to do the right thing? How can insurance programs for low-probability, high-consequence events be regulated so that companies can make affordable coverage available to consumers without risking insolvency?

What role should the federal government play in developing shared responsibility? Can the federal government provide mitigation incentives? What is its role in the education of stakeholder groups? Does disaster relief work against the purchase of insurance or the adoption of loss reduction strategies?

The insurance industry will play an important part in the implementation of a hazard mitigation program, whether cost-effective measures are ultimately adopted through voluntary, individual action or as a result of government regulation. The institutional capacity of the industry—that is, the knowledge, perceptions, motivation, and economic strength of the participating insurance companies—also figures into the mix.

For insurers and other interested parties such as banks and FEMA, one of the most important issues is to determine what role insurance should and can play in adoption and enforcement of appropriate building

codes and standards as well as land use practices for both new construction and retrofitting.

The Natural Disaster Loss Reduction Committee of the National Committee on Property Insurance (NCPI) sponsored two building code symposia during 1993. These conferences identified 8 themes (see Sidebar 7-1) that should be central to any industry-based hazard mitigation program, and developed 15 objectives for such a program (NCPI, 1993), all of which are summarized below.

Objective 1. Cultural Redefinition of the Purpose of Building Codes. Traditionally, building codes have been designed to assure the basic integrity of structures in order to maintain personal safety. This definition should be enlarged to embrace more comprehensive protection of structures and their contents.

Objective 2. Statewide Codes. Building codes should govern entire states, since statewide codes are easier to comply with, train for, and enforce. They also simplify the work of the design and construction industries, which must deal intensively with their requirements.

Objective 3. Insurer Involvement in Code Development. Insurers should be involved in the process of code development.

Objective 4. A Voluntary Minimum Standard for the Nation. A minimum building code standard should be developed at the national level to serve as a yardstick against which states, counties, and communities could measure their code adoption process.

Objective 5. An Expanded Concept of Prescriptive Codes. The use of prescriptive building codes should be expanded. They should be based on proven performance standards, and should define the construction requirements that must be met in order to achieve a performance level that is specified in the code.

Objective 6. A Two-Tiered Code. A two-tiered code should be developed as an incentive to builders to construct homes exceeding the minimum requirements. The basic code, as it now exists, would be the mandatory minimum standard. An optional, higher-level code would permit builders to note the stronger structural features in their marketing efforts.

(The heavy advertising of safety features for automobiles, despite their higher cost, suggests this approach could be successful.)

Objective 7. A Code Enforcement Grading System. A code enforcement grading system, which relates code adoption and enforcement to a community's rate classification, will promote additional code requirements and enforcement.

Objective 8. Enhanced Plan Review Requirements. Minimum standards for plan review should be established and implemented.

Objective 9. Public Education about the Importance of Building Codes for Public Safety. Education programs should be developed that heighten public awareness of the critical role building code departments play in protecting public safety. Funding and staffing of building code departments should also be upgraded so that the departments can meet the demands placed on them.

Objective 10. Retrofitting. More research is needed on retrofitting of existing structures, including research on the costs and benefits of retrofitting. The public should be educated about the value of cost-effective mitigation devices.

Objective 11. Public Awareness of Natural Hazard Exposure. The public should be educated about how natural hazards can threaten lives and personal safety, the damage they can cause to property, and the financial costs of such damage.

Objective 12. Professional Education and Training. Education programs should also be directed toward professional, technical, and government/regulator audiences, as well as contractors, job supervisors, and laborers.

Objective 13. Expanded Interdisciplinary Communication. Efforts should be made to promote communication between engineering, design, construction, product design, code enforcement, and insurance professionals.

Objective 14. Premium Incentives. Communities and individuals are more likely to endorse new construction building code enhancements and to employ mitigation measures if encouraged to do so by insurance incentives such as lower premiums.

Objective 15. Develop a "Multi-Hazard" Approach. National and local standards mitigation programs that address all potential hazards must be designed.

Kunreuther (1996) suggested a program for integrating mitigation with insurance that parallels the objectives arrived at by the NCPI's building code symposia. Kunreuther's program includes six objectives: (1) institute more stringent building codes on new homes, (2) use seals of approval on structures meeting codes, (3) use insurance to encourage hazard mitigation, (4) develop insurance for all natural hazards, (5) institute government reinsurance, and (6) subsidize low-income families.

Given the above objectives and guidelines, the principal means by which the insurance industry can facilitate mitigation investments can be ordered into the following four general categories:

1. Educate the Public. The purchase of insurance and the implementation of mitigation actions is highly dependent upon an individual's perception of risk. This perception may have more effect on mitigation actions than any financial incentives. A major role for the insurance industry, therefore, is to conduct public awareness programs to enlighten individual property owners about the risks they face and the mitigation actions they can take to reduce their chances of loss. An informed property owner is assumed to be more likely to engage in risk reduction activities.

2. Participate in the Model Code Process. Integrating the interests and needs of the insurance industry with the model code development process and the governmental adoption and enforcement process presents a number of very significant challenges. The industry participated actively in the voluntary building code development process before the 1980s, and it must do so again. At present, even though model building codes contain provisions that can be used to reduce unsafe or dangerous building hazards, they are not generally being used to mitigate the risks to existing structures from natural hazards.

   Consider the 1994 Uniform Building Code (UBC), which contains an appendix on the abatement of dangerous buildings, giving discretionary authority to local officials. With the exception of a few cases pertaining to the retrofitting of buildings deemed hazardous when subject to earthquakes, little is being done with respect to existing structures. Through the model code process the insurance industry can make its case regarding the need for better codes to reduce property losses from natural hazards. Insurers

and reinsurers have as much at stake in the outcome of these processes as do home builder associations, real estate interests, material suppliers, and local government code officials. After improvement of the model codes, the insurance industry can actively encourage communities to adopt and enforce them.

3. Provide Financial Incentives. The most frequently suggested financial incentives are insurance premium reductions, changes in the amount of the deductible, and changes in coinsurance schedules, which reflect the changes in the risk resulting from the implementation of a mitigation program. In the case of premium reductions, individuals will compare the reduction in premium offered with the estimated cost of mitigation action, and decide whether the mitigation measure is beneficial based on a perception of the reduction in risk from its adoption.

   Deductibles and coinsurance involve risk sharing and are designed to encourage the property owner to take actions to protect against small losses; this benefits the insurance company by reducing the expense of dealing with small claims. Thus, a decision to mitigate may not be made solely on an individual's economic rationality. In general, it is assumed that the greater the premium reduction, the more likely it is that the property owner will decide to take mitigation actions; however, the high front-end capital cost associated with mitigation may weaken the financial incentive of a premium reduction spread over many years.

4. Limit Availability of Insurance. Property owners will most likely be encouraged to implement mitigation measures if obtaining insurance depends on verification that the property to be insured has been built to an acceptable standard, or retrofitted to reduce the risk of property damage. In addition to existing buildings, all proposed new buildings would need to be designed and built to certain specified codes or performance standards before insurance would be made available. The Federal Insurance Administration has demonstrated the power of conditional availability as an incentive by making flood insurance under the National Flood Insurance Program (NFIP) dependent upon the participating community's adoption and enforcement of floodplain management regulations. Given sufficient market penetration, making the availability of financing and insurance for buildings dependent on their meeting certain high mitigation standards should help motivate builders to build to a higher standard and owners to retrofit existing property.

The public increasingly looks to insurance as the mechanism to compensate for losses resulting from many types of risk-taking behavior. Insurance is, however, never an acceptable alternative to loss prevention. In the case of natural hazard risks, it is difficult for most individuals to comprehend the significance of these low-probability, high-consequence risks in their individual lives. The result is inadequate mitigation of natural hazard risks and insufficient insurance coverage. There are no easy explanations, and no easy solutions to the problem of mitigating and insuring against natural hazards. There is, however, an increasing recognition by those in the insurance sector, the model code organizations, and the government that a program must be developed that will address these important issues.

Within the free market perspective, what is needed are changes in the regulatory environment, more imagination by insurers, and incentives for individual businesses and property owners to reduce their own risks. This requires a major change in the way people view disaster insurance and loss reduction measures. Individuals will need to take more responsibility for their risk-taking behavior. Property protection, and thereby the maintenance of community economic viability, needs to be a primary focus of building codes and land use regulations.

Insurers cannot assume that the existence of codes assures the preservation of property and thus need to advocate their importance (Cheshire, 1990). For example, state insurance regulators can restrict the sale of natural hazard insurance to properties built to the standards contained in certain building codes; or as in the case of the National Flood Insurance Program, Congress can require local communities to adopt floodplain regulations in order to qualify for flood coverage. The federal government can, when it determines that there has been a market failure, enter the market and provide an insurance-based mitigation program for all natural hazards.

In summary, there is significant potential for linking insurance to the adoption of mitigation measures that reduce damages to existing buildings and limit the amount of new development in hazardous areas. Making the linkage is very important if individuals, businesses, and government are to benefit from reduced losses.