The Role of Insurance in Promoting Hazard Resistant Communities

1
"The Role of Insurance in Promoting Hazard
Resistant Communities"

• Paul R. Kleindorfer
• Risk Management Decision Processes Center
• The Wharton School
• Presented to the Forum on
• Risk Management and Assessments of Natural
  Hazards
• February 5, 2001

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Outline of Presentation

• Catastrophe Risk Institutions Science
• New Approaches to Risk Assessment
• Mitigation, Building Codes Insurance
• Supply, Demand and Regulation of Catastrophe
  Insurance
• Conclusions

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Framework for Analyzing Catastrophic Risks
Scientists Estimating Probabilities of
Disasters (e.g. USGS, NOAA)
Engineers Estimating Damage from Disasters
Organizations Modeling Distribution of Losses
from Disasters (e.g. AIR, EQE, RMS)
Reinsurance and Insurance Industry
Financial Institutions
Financial Instruments
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Complementary Roles of Mitigation and Insurance
Financial Institutions
Reinsurance and Insurance Industry
Financial Instruments

• Insurance Protection
• Against Losses
• Encourages Mitigation

Property and Lives at Risk ----------------------
Decision Processes of Homeowners
Insurance Requirements

• Inspections
• Enforcing Provisions
• Certification

Joint Mitigation Strategies
Construction Industry and Real Estate Sector
Public Sector Agencies
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Managing Catastrophic Risks A Research Program
and Industry Forum

• Wharton Risk Management and Decision Processes
  Center
• Wharton Financial Institutions Center
• David Cummins
• Neil Doherty
• Patricia Grossi
• Jaideep Hebbar
• Robert Klein
• Paul Kleindorfer
• Howard Kunreuther

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Whartons Cat Risk Project

• Understanding Mitigation and Uncertainty
• (Howard Kunreuther, Paul Kleindorfer)
• Understanding the Supply, Demand and Regulation
  of Catastrophe Insurance
• (Paul Kleindorfer, Robert Klein, Martin Grace)
• Understanding the Capacity of the Insurance
  Industry under Alternative Institutional
  Scenarios involving Cat Risk
• (David Cummins, Neil Doherty)
• Understanding the Nature and Role of New Market
  Instruments for Cat Risk
• (David Cummins, Neil Doherty, David Croson,
  Andreas Richter)

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Earthquake Loss Estimation Process
Step I
Step II
Step III
Step IV
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Common Assumptions of Risk Modelers

• The results generated are in terms of an
  exceedance probability (EP) curve, defined as the
  probability of exceeding a certain loss level on
  an annual basis.
• EP(L) P(Annual Loss gt L)
• 1 - F(L Parameters)
• F(LPARS) C.D.F. of Annual Loss
• Aleatory vs. Epistemic Risk Components

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HAZUS Analysis

• Example Charleston, SC
• Sources 156 events total (background
  characteristic events)
• Magnitude Conversion Boore and Atkinson (1987)
• Attenuation Project 97 relationship (i.e.
  1/2?Frankel et al., 1996 1/2?Toro et al., 1997)
• Soils Mapping Soil class D (stiff soils),
  NEHRP amplification factors (FEMA, 1997), and no
  liquefaction potential
• Inventory HAZUS default database (updated to
  1999 values)
• Vulnerability HAZUS default fragility curves

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Results SB-HAZUS-EP curve
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Mitigation Decisions

• Mitigation at the Individual Homeowner Level
• Mitigation at the Community Level
• Two Key Elements
• Understand the Effects of Mitigation on Risk
• Align and Communicate the Incentives for Adoption

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Understanding the Effects

• Detailed Assessment of Fragility/Vulnerability
  Curves and the Impact on EP Curves
• By Type of Structure, Contents, End Use and
  Location Factors
• Continuing Experimentation Underway (IBHS and
  Insurance Community)
• Insurance Effects, Individual Effects and
  Community Effects

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Individual Effects

• Experimental and Field Studies by H. Kunreuther
  and others show that Individuals are myopic and
  optimistic when it comes to natural hazards It
  wont happen to me!
• Because of externalities in disrupting neighbors
  and commerce, as well as to correct decision
  processes, well enforced building codes are
  essential, but difficult to develop and implement.

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Aligning Economic Incentives

• Financial Institutions and Governments assess
  risks and uncertainties from seismic hazards.
• Financial Institutions build in risks of such
  hazards into mortgages and loans, including the
  mitigation of such risks via insurance.
• The magnitude of the risk payments facing
  property and business owners causes them to
  consider the adoption of cost effective
  mitigation measures. E.g., Reductions in
  Insurance premia and in annual mortgage payments.

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Critical Role of Mitigation in Hazard Management
Findings of the Project

• Importance of mitigation as part of a cat
  management strategy
• Reduces losses in tail of distribution
• Expands insurance industry capacity and reduces
  prices
• Lowers prices of cat bond and reinsurance prices
• Evaluating role of mitigation in model cities
• Reinforcing homes against earthquakes and
  hurricanes
• Evaluating impact of mitigation on insolvency
  probabilities of insurers
• Impact of mitigation on need for reinsurance and
  cat bonds

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Insurance, Risk Analysis and Mitigation

• Insurance Companies drive science-based risk
  quantification
• Insurance Companies have therefore also a strong
  interest in what mitigation can do to affect the
  EP Curve (and Solvency and Capital Requirements
  and Underwriting,)
• Are the effects of mitigation, individual and
  community, visible in insurance pricing??

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Objectives of Supply-Demand Study

• What is the structure and performance of the
  Catastrophe Insurance Market?
• Demand (Structure, Interdependencies)
• Supply (Profits, Risk/Exposures, Distribution)
• What is the nature and impact of regulation of
  this market on
• Pricing (adequacy and precision)
• Financial risk
• What is the current state of the Market? What are
  possible future (sustainable)states of the Market
  under different scenarios?

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The ISO Database Used

• 60 Companies from 20 Insurance Groups Doing
  Business in Florida and New York
• Slightly summarized data based on unit
  transactions for individual policies as reported
  by insurers to ISO.
• 2.6 Million Records covering the period 1995-1998
  (both Homeowners and Dwelling Fire Policies)

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The Data Elements

• Policy Features
• Coverages, Deductibles, Expected Loss Costs,
  Location and Type/Age of Structures
• Company Characteristics
• Size, Marketing System, Financial Strength
• Socio-Demographic Characteristics of ZIP
• Income, Education, of Mortgages

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Decision Processes Underlying SD

• Consumers Maximize Expected Utility
• Choice Among Policy Features
• Insurers Maximize Expected Profit
• Underwriting Standards and Policy Design
• Exposure Management
• Capital Structure and Financial Strategy
• Premium and Price are the Outcomes of Interest

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Premium and Price Equations

• PREMIUM aF bX cZ e
• F Policy Features
• X Company Characteristics
• Z Socio-Demographic Characteristics (ZIP)
• PREMIUM NPV(Losses)
• PRICE -----------------------------------
• NPV(Losses)

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Price and Premium Equation Results Contract
Terms

• Premiums
• Ord/Law
• Replacement Costs
• Wind Prot Credit
• Coverage A Lim
• Wind Deductible
• Fire Deductible
• Cat Losses
• Non Cat Losses
• Frame 0
• Brick
• Protection
• House built after 1960

• Price Mark-Up
• Ord/Law 0
• Replacement Costs
• Wind Prot Credit
• Coverage A Lim
• Wind Deductible
• Fire Deductible
• Cat Losses
• Non Cat Losses
• Frame
• Brick
• Protection
• House built after 1960 0

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Some Thoughts for Discussion

• Risk Assessment Infrastructure, based on sound
  science and engineering, is a key driver of both
  insurance underwriting and marketing.
• This helps to assure alignment of Economic
  Incentives for efficient risk bearing and risk
  transfer methods
• Both individual decisions (structure types,
  locations, etc.) as well as community decisions
  appear to be reflected in private insurers
  premium decisions and in market demand.
• Much more could be done to link individual and
  community decisions on cost-effective mitigation
  to the financial consequences these engender.

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References

• Grace, M., R. W. Klein, and P. R. Kleindorfer,
  Supply and Demand in Catastrophe Insurance
  Markets, NBER Working Paper, February, 2000.
• Kleindorfer, P. R. and H. C. Kunreuther, The
  Complementary Roles of Mitigation and Insurance
  in Managing Catastrophic Risks, Risk Analysis,
  1999.
• For More Information see the Wharton Cat Risk
  Website
• http\\grace.wharton.upenn.edu\risk\