Gollier’s seminal work (Eeckhoudt et al., 1996; Gollier and Pratt, 1996; Gollier and Schlee, 2006) finds, under fairly general conditions, that a higher level of “background risk” (here, the flood/drought risks) makes individuals less willing to take risks in other domains (e.g. innovation/entrepreneurship). In other words, being exposed to one risk increases an individual’s risk aversion regarding other categories of risk. These results suggest that households consider their vulnerability to natural risks like floods and droughts when making other risk-related decisions in other domains – such as creating a business or migrating to a city.

Empirical work finds that higher levels of background risk are associated with increased risk-aversion in financial decisions (Guiso and Paiella, 2008; Heaton and Lucas, 2000; Lusk and Coble, 2008). More recent literature also finds evidence of risk vulnerability with regards to land reform (Tella et al., 2007), early life financial experiences (Malmendier and Nagel, 2011), stock-market crises (Guiso et al., 2013), and violent trauma (Callen et al., 2014; Voors et al., 2012).

There are two mechanisms through which an increase in the background risk can lead to high risk aversion and lower investment in growth and development.

- The first is perfectly rational: there is a possibility that the two independent risks (one related to disasters, the other to risk-taking in general) materialize together (Gollier and Pratt, 1996). This combined risk – and the non-linearity in the utility function – increases risk aversion because a large income shock changes not just an individual’s location on the utility function, but also the shape of that function (Cassar et al., 2015).

- The second mechanism is behavioral. A shock such as a flood can lead to an overestimation in an individual’s perceived likelihood of future natural shocks occurring. (Cameron and Shah, 2015) find, after a flood in Indonesia, that an individual’s expectations of future flood occurrence is an order of magnitude higher than the true probability. Emotional responses can lead individuals to have greater fear of any negative event, reducing risk-taking (Cassar et al., 2015). Consequences, either real or perceived, from multiple shocks occurring in close proximity or simultaneously can be devastating.

The importance of past events on risk aversion is documented in a number of countries including Indonesia, Bangladesh, Nicaragua and Peru.

**_Indonesia._** East Java, Indonesia has a population of 37 million and is particularly prone to natural disasters – with flood and earthquake posing the largest risks. (Cameron and Shah, 2015) examine whether recent experience of floods and earthquakes impacts the level of background risk and risk-taking within the region. In October 2008, the authors ran a series of experimental games in a random sample of 1,550 individuals across 120 villages, and find that individuals in villages that suffered a flood/earthquake in the past three years exhibit higher levels of risk aversion compared to individuals in villages that did not experience a disaster (41% decrease in probability of making a risky choice in the experiment).

A year later, the authors conduct a survey asking households to report the probability (or likelihood) that a flood and/or earthquake would occur in their village the following year. For floods (but not earthquakes), individuals who experienced an event are significantly more likely to report a higher probability of flood 20