# Presentation: 403859

## "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**

- PRK: RMA & Nat'l Hazards (2/5/01)

## Outline of Presentation

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

- PRK: RMA & Nat'l Hazards (2/5/01)

## Framework for Analyzing Catastrophic Risks

- 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

**Framework for Analyzing Catastrophic Risks**

- PRK: RMA & Nat'l Hazards (2/5/01)

## Complementary Roles of Mitigation and Insurance

- Insurance Industry

- Financial Institutions

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

- Construction Industry
- and
- Real Estate Sector

- Public Sector
- Agencies

**Joint Mitigation Strategies**

**Inspections**
**Enforcing Provisions**
**Certification**

**Insurance Requirements**

**Insurance Protection **
** ****Against Losses**
**Encourages Mitigation**

**Financial Instruments**

**Complementary Roles of Mitigation and Insurance**

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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

- PRK: RMA & Nat'l Hazards (2/5/01)

## Wharton’s 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)

- PRK: RMA & Nat'l Hazards (2/5/01)

## Earthquake Loss Estimation Process

**Step I**

**Step III**

**Step II**

**Step IV**

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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 > L) **
**	****	****      ****	****= 1 - F(L; Parameters)**
**F(L;PARS) = C.D.F. of Annual Loss**
**Aleatory vs. Epistemic Risk Components**

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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**

- PRK: RMA & Nat'l Hazards (2/5/01)

## Results: SB-HAZUS-EP curve

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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 won’t 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.

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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.

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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??

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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?

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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)

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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 ...

- PRK: RMA & Nat'l Hazards (2/5/01)

## Decision Processes Underlying S&D

- _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

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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)

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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.

- PRK: RMA & Nat'l Hazards (2/5/01)

## 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\

- PRK: RMA & Nat'l Hazards (2/5/01)