scientific research and improve technology.'<sup>4</sup> It could also ensure the dissemination of results to the agencies in charge of national emergency management.

**Explanation** 2: **Prices of catastrophe** insurance **are** "high" **and quantities of risk transfer are "low" because** insurers **do not discriminate** by zone of risk **or the implementation** of **risk-reduction measures, which amplifies adverse** selection **and moral hazard.**

Even though conditions of housing stock and investment in mitigation differ among clients, insurance companies do not systematically discriminate by either zone of risk or implementation of risk-reduction measures. Catastrophic risk insurers in the Caribbean region do not systematically discriminate between areas that are considered high risk for natural catastrophes and those areas where risks are lower. In Jamaica, for example, there is no differentiation in the rates charged for insuring against earthquake in the coastal regions of Kingston, where the risk is greater, and Montego Bay in the interior, where the risk is lower. Theoretically, the Dominican Republic is divided into five risk zones but there is no rate discrimination among them. In addition, insurers do not provide rate credits or premium abatements for risk-reduction features that reduce the extent of catastrophic damages. In fact, local insurers have been consistently averse to offering discriminatory pricing to consumers for catastrophic risks, even in instances where steps have been taken to reduce the size of probable losses. It is estimated that an expenditure of I percent of property value on vulnerability reduction measures can reduce the estimated maximum loss from a category 3 hurricane by at least 30 percent. Anchoring walls into well-dug foundations, reinforcing wall segments with pillars, fusing walls into roof supports and fixing roof sheeting into roof supports provide effective resistance to high winds. In Barbados and Trinidad and Tobago steps are being taken toward rate discrimination by offering concession rates to structurally sound buildings; however, current policyholders do not as yet benefit from such preferential treatment.

The absence of price discrimination by risk zones and the presence of risk-reduction measures lead invariably to adverse selection and moral hazard which, in turn, lower the quantity of risk transfers.'<sup>5</sup> Adverse selection refers to the fact that individuals who live in high-risk areas are likely to buy more insurance than those in low-risk areas. This practice increases the insurers' exposure to risk, reduces the supply of catastrophic transfer and, ultimately, leads to higher prices. Moral hazard refers to the fact that once insured, individuals are not likely to engage in risk-reduction activities that would reduce the negative effects of potential natural disasters. Moral hazard leads to high premiums which further depress risk transfers.

Moral hazard can be reduced through deductibles or supply of insurance cover conditioned upon the adoption of mitigation techniques. Adverse selection can be alleviated by the implementation of compulsory insurance schemes and premium differentiation by level of risk. However, the origins of these market failures are likely to lie in the low provision of risk identification and forecasting (Explanation 1) and the deficient land-use regulation and building codes (Explanation 4). Indeed, it is reasonable to expect that once these more fundamental causes are resolved, catastrophe insurance and reinsurance companies will offer contracts that will mitigate moral hazard and adverse selection, as they do in more developed economies.

> 4 World Bank, 2002(b), p. vii makes identical recommendations.

**15** In fact adverse selection may lead to a complete disappearance of the market for catastrophe insurance (Akerlof, 1970).

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