Private Versus Public Insurance for Natural Hazards: Individual Behavior’s Role in Loss Mitigation

Abstract

This chapter explores how insurance markets can be used to manage social exposure to catastrophic risks. Insurers set premiums to reflect underlying risk levels that they calculate using their best actuarial science. This process gives individuals private incentives prospectively to mitigate risks of loss. Private insurers, however, frequently exclude natural hazard losses from coverage, removing the private loss mitigation incentives from the market and leaving individuals without insurance against natural hazards, unless government-provided or – sponsored plans step in. These government programs amount to a species of public insurance against natural hazards. The chapter explores problems inherent in these public programs and finds that private insurance provides a viable alternative. Conventional explanations say that private insurers exclude natural disaster losses, and indeed are incapable of covering these risks, because of the difficulty in insuring highly correlated, high-dollar losses. However, I show as a matter of both theory and practice that these explanations do not fully explain private insurers’ behavior. Instead, I argue that insurers exclude natural disaster losses because of costly market contracting between insurers and policyholders. Information imbalances between policyholders and insurers and coordination failures among insurers lead to an equilibrium where natural hazard coverage is sacrificed for lower premiums. This analysis suggests that a regulatory response focusing on mitigating or compensating for contracting costs could reinvigorate private insurance’s role in managing risk and offer significant benefits. Throughout the chapter I draw from the United States flood insurance program, a 50-year project run by the federal government that has experienced representative degrees of successes and failures, to show the practical implications from this analysis.