Risk Analysis and Risk Management in an Uncertain World

Howard Kunreuther (kunreuther@wharton.upenn.edu)

Risk Management and Decision Processes CenterThe Wharton School

University of Pennsylvaniahttp://opim.wharton.upenn.edu/risk

SAMSI WorkshopDuke UniversitySept. 16, 2007

Radisson Hotel RTP, Research Triangle Park, NC

Outline of Talk

Conceptual Framework

Risk Assessment

Risk Perception

Risk Management

Application to Catastrophic RisksNatural Disasters

Role of Insurance and Mitigation Measures

2

A Conceptual Framework for Studying Risk

Statistical Data Building

Scenarios

Risk Perception and Choice

• Public Perceptions• Expert/Layperson Differences• Risk Communication

Risk Assessment& Vulnerability

Analysis

Modelingof Risks

Risk Management Strategies Public Private Partnerships

3

A Conceptual Framework for Studying Risk

Risk Management Strategies:Public Private Partnerships

• Information Provision• Incentives• Regulation• Standards• Compensation• Insurance• Liability

Evaluation of Strategies• Impact on Society• Impact on Interested Parties 4

Questions to Be Addressed for Undertaking Risk Analyses of Health, Safety and Environmental Issues?

• How can one link the tools of risk assessment and our knowledge of risk perception to develop risk management options that are likely to be successful and implemented?

• What is the changing role of the public and private sectors in dealing with these risks?

 • How can we utilize lessons from dealing with past events in

helping to plan for the future?

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Risk Assessment & Vulnerability Analysis

Risk Assessment– Encompasses estimates of both the chances of a specific set of events occurring and their

potential consequences

– Experts differ in their estimates of the risk

– Find your favorite expert to support your position

Vulnerability Analysis– Characterize forms of physical, social, political, economic, cultural, and psychological

harms to which individuals and modern societies are susceptible

– Millions of dollars have already been spent to reduce our vulnerability

Constructing Scenarios – What are the probabilities of specific events?

– What are the potential consequences?

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Using Exceedance Probability (EP) Curves to Depict Risk

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Risk Assessment Questions to Ponder

• What are the chances that New Orleans will have a Category 3 or higher hurricane in the next 10 years and what will be the resulting damage and indirect losses?

• What is the likelihood of a severe nuclear power accident somewhere in the United States and what would be the resulting impacts?

• What are the chances that an airplane will crash into the Sears Tower in the next year and how serious would the consequences be?

• What are the chances that there will be a smallpox epidemic in the United States in the next five years and how many people would be affected?

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Risk Assessment and Vulnerability AnalysisOpen Issues and Questions

How accurately can experts estimate the likelihood and consequences of disasters of hurricanes of different magnitudes and intensities?

Can one characterize the types of uncertainties that currently exist in assessing risk, and suggest ways to improve these estimates in the future?

What are the expected costs and benefits of undertaking specific risk-reducing measures in hurricane-prone areas, and can one rank them on the basis of cost effectiveness?

What are the interdependencies in the system (e.g. infrastructure damage affecting supply of electricity, water, telephone/telecommunications, and other services to residences and businesses)?

How do these interdependencies affect the direct and indirect losses that would result from a future natural disaster?

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Risk Perception and Choice Basic Concepts

Focuses on psychological and emotional factors that have been shown to have an enormous impact on behavior.

• Hazards where individuals have little knowledge and experience are highly dreaded and perceived as being very risky

• Disparity between experts and laypersons (e.g. nuclear power, storing radioactive waste)

• Ignoring public’s perception of risk by scientific community if it differed significantly from their own estimates

Individuals exhibit systematic biases in processing information and making choices• Estimating likelihood of event is influenced by salience• “It cannot happen to me” bias before a disaster• “It will happen to me” bias after a disaster• Framing of information may influence choice

Individuals have difficulties learning due to biases and information processing limitations

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Stigmatization and Social Amplification of Risk

The Alar Case

A bag of Alar plant growth regulant surrounded by

Red Delicious apples

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Stigmatization and Social Amplification of Risk

The Alar Case

• No scientific evidence that Alar was carcinogenic

Were based upon animal studies that were considered suspect because the doses used had been so large as to have been acutely toxic.

No evidence from epidemiological studies showing Alar to be a human carcinogen.

• The reaction by the public to Alar illustrates social amplification of risk.

Media amplified the risk and effectively stigmatized the product.

Millions of consumers stopped buying apples and apple products after CBS news story on “60 Minutes” stated Alar could cause cancer.

Convincing my wife that children from birth to 3 could drink apple juice with Alar

12

Risk Perception:

People Don’t Think Probabilistically

• “It will happen to me” or “ it will not happen to me”

• Other factors influence protective decisions---worry; peace of mind

• Affect and emotion play a key role in decision-making

• Availability bias: likelihood of an event is estimated by the ease with which a person can visualize it.

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Explain this behavior:

• I bought my first set of battery cables only after my car wouldn’t start and it had to be towed. The towing charge was twice as much as the cost of the battery cables.

• Most homeowners in California purchase earthquake insurance only after they experienced a quake. When asked whether the probability of a future event was more likely than before the disaster most people responded, “Less likely”.

• Until seat belt laws were instituted in the United States, most drivers refused to wear them. When asked why they did not, a typical response was, “I won’t have an accident.” This response is consistent with the well-document finding that 90% percent of all drivers feel they are better than the average driver.

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Risk Perception and Choice Open Issues and Questions

• What role do perceived likelihoods and resulting consequences play in how people view a particular risk that they may face, such as a severe hurricane?

• How important are emotional factors such as fear, dread and anxiety in how people perceive these risks and learn over time?

• What role do social networks and social norms play in influencing risk perception, choice and learning with respect to low probability events?

• How can one best communicate information to those at risk from natural disasters so they are aware of what actions they can take prior to and after a disaster?

• What is the role of past experience and the media in influencing risk perception and choice?

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Risk Management Strategies: Basic Concepts

Policy options for reducing losses and aiding recovery process– Economic incentives– Insurance– Well-enforced regulations and standards (e.g. building codes)– Disaster assistance

Relevant roles of public and private sectors in implementing hazard management strategy

Criteria for evaluating alternative strategies– Efficiency---allocating resources to maximize social welfare– Equity---concern with fairness and distribution of resources

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Risk Management Strategies

Using Economic Incentives• Premiums reductions on insurance policies for those who

undertake loss reduction measures.

• Overcoming myopia---long-term loans on property coupled with insurance premium reductions

Risk Communication (Framing Information Makes a Difference)• People are more willing to wear seatbelts if they are told they have

a .33 chance of an accident over a 50-year lifetime of driving rather than a .00001 chance each trip.

• People are more willing to buy insurance if they are told that there is a 1 in 5 chance of a 100 year flood occurring in the next 25 years than a 1 in 100 chance of it occurring next year.

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Risk Management Strategies

Present probabilities using concrete comparisons:

Risk of an automobile accident

People need to see these decisions in the contexts of risks that they understand.

Public Sector Involvement

Well-enforced standards (e.g. building codes)

Federal reinsurance protection

Disaster assistance

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Risk Management Strategies Open Issues and Questions

• What type of economic incentives would encourage property owners to mitigate the risks of a disaster and purchase insurance prior to a disaster?

• How does the prospect of federal aid to victims of a disaster affect protective decisions by individuals prior to a disaster?

• What are the appropriate roles of standards and regulations in reducing losses from large scale disasters and the impact of the event following the disaster?

• What types of financial backstops should be provided by the public sector at the state and federal levels for dealing with catastrophic losses following future disasters?

• How can one link different policy tools such as information provision, economic incentives, insurance, third party inspections, regulations and standards to achieve the desired objectives of a hazard management strategy?

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Katrina – As of Sunday, August 28, 2005

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Katrina’s Path

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Nature of the Problem

A radical change in the scale and rhythm of catastrophes

Natural disasters have caused severe insured losses in recent years– Hurricane Katrina: $40-$55 billion– Hurricane Andrew: $22 billion (2005 dollars)

Victims complain about receiving substantially less than the actual costs to repair or rebuild their damaged structures from Katrina

Federal government is committed to providing liberal disaster assistance to aid the victims of Katrina and rebuild the Gulf Coast 22

Who are the Interested Parties? Insurers provide coverage against damage from disasters and can offer financial incentives to

encourage investment in mitigation measures

Reinsurers and capital markets provide coverage against some of the losses from large-scale disasters

Residents and businesses located in hazard-prone areas subject to large-scale losses from natural disasters.

Federal government (including the President and Congress) provides disaster assistance and operates the National Flood Insurance Program

State governments (including Governors) regulate insurance rates, create State funds and/or insurers (e.g. Citizens) are in charge of developing and enforcing building codes and some land use policies

Local governments (county, city level), are responsible for issuing building permits and other activities related to regional development

Mortgage lenders and related financial institutions can create financial incentives for homeowners and businesses to invest in mitigation measures and to purchase and maintain appropriate insurance coverage.

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Worldwide Evolution of Catastrophe Insured Losses, 1970-2005

(Property and business interruption (BI); in U.S.$ billon indexed to 2005)

Sources: data from Swiss Re and Insurance Information Institute

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

Human-caused catastrophes Natural catastrophes 9/11/2001 attacks

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The 20 Most Costly Catastrophe Insurance Losses, 1970-2005 (18 of them occurred between 1990 and 2005; 10 of them occurred in the last 5 years)

Sources: Wharton Risk Center with data from Swiss Re, Insurance Information Institute and press releases

Rank U.S.$ billion(indexed to 2005)

Event Victims(Dead or missing)

Year Area of primary damage

1 45 Hurricane Katrina 1,326 2005 USA, Gulf of Mexico et al

2 35 9/11 Attacks 3,025 2001 USA

3 22.3 Hurricane Andrew 43 1992 USA, Bahamas

4 18.5 Northridge Quake 61 1994 USA

5 11.7 Hurricane Ivan 124 2004 USA, Caribbean et al

6 10.3 Hurricane Wilma 35 2005 USA, Gulf of Mexico et al

7 8.3 Hurricane Charley 24 2004 USA, Caribbean et all

8 8.1 Typhoon Mireille 51 1991 Japan

9 6.9 Winterstorm Daria 95 1990 France, UK et al

10 6.8 Winterstorm Lothar 110 1999 France, Switzerland et al

11 6.6 Hurricane Hugo 71 1989 Puerto Rico, USA et al

12 5.2 Hurricane Frances 38 2004 USA, Bahamas

13 5.2 Storms and floods 22 1987 France, UK et al

14 5.0 Hurricane Rita 34 2005 USA, Gulf of Mexico et al

15 4.8 Winterstorm Vivian 64 1990 Western/Central Europe

16 4.7 Typhoon Bart 26 1999 Japan

17 4.2 Hurricane Georges 600 1998 USA, Caribbean

18 4.1 Hurricane Jeanne 3,034 2004 USA, Caribbean et al

19 3.7 Typhon Songda 45 2004 Japan, South Korea

20 3.5 Tropical Storm Alison 41 2001 USA 25

What’s Happening? The Question of Attribution

Higher degree of urbanization

Huge increase in the value at risk Population of Florida - 2.8 million inhabitants in 1950 - 6.8 million in 1970 - 13 million in

1990 - 19.3 million population in 2010 (590% increase since 1950) (U.S. Bureau

of the Census) - A direct hit on Miami by Hurricane Andrew that would have cost $60bn

in 1992 and $120bn in damage in 2004 because the market value has doubled and is still increasing

Weather patterns - Among the top 19 natural disasters that occurred in the past 35 years,

more than 80% were weather-related events - Changes in climate conditions and/or return to a high hurricane cycle?

Direct consequences- More intense weather-related events coupled with increased value at risk cost more,

much more

What will 2007 Bring?

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Insured Coastal Exposure as a % of Statewide Insured Exposure in 2004

63.1%60.9%

57.9%54.2%

37.9%33.6%33.2%

28.0%25.6%25.6%

23.3%13.5%

12.0%11.4%

8.9%5.9%

79.3%

0% 10% 20% 30% 40% 50% 60% 70% 80%

Source: AIR Worldwide

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Total Value of Insured Coastal Exposure in 2004 (in $billion)

$1,937bn $1,902bn

$506bn $663bn

$740bn

$405bn $209bn

$149bn $130bn $117bn $105bn

$76bn $73bn

$46bn $46bn $45bn $44bn

0 250 500 750 1,000 1,250 1,500 1,750 2,000 2,250

Source: AIR Worldwide

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What is at Stake and Goals of Study

What is at stake?– Affordability of living in risky areas – Who ultimately bears the costs and receives the

benefits of such decisions

Develop a strategy document to help inform the current policy debate – Role that the private and public sectors can play in

reducing future disaster losses– Financing the recovery process through insurance and

other means.

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Two Principles Guiding Study

Principle 1: Risk-based Premiums Insurance premiums should be based on risk to provide signals to individuals as to the hazards they face and to encourage them to engage in cost-effective mitigation measures to reduce their vulnerability to catastrophes.

Principle 2: Dealing with Equity and Affordability Issues Any special treatment given to lower income residents in hazard-prone areas who cannot afford the cost of living in those locations should come from general public funding and not through insurance premium subsidies.

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Phase II of Project: 2007 Examine and evaluate alternative programs for providing

protection against financial losses and reducing risks from natural catastrophes

Program 1: Maintaining Status Quo Program 2: Involvement of the Public SectorProgram 3: Free Market

Develop a set of case studies based on different states or metropolitan areas/regions to examine how well alternative insurance programs perform in encouraging mitigation and providing funds for recovery.

FloridaNew YorkSouth CarolinaTexas 31

Summary

The Facts: Totally new era of “large-scale risks”; huge and still growing concentration of value in high risk areas; indication of more devastating disasters in the future

The Reality: Major issues at stake for insurance and mitigation programs that require us to link risk assessment with risk perception and risk management

Research and policy questions: What are the options for risk sharing among different interested parties following catastrophes?What economic incentives can encourage investment in mitigation?

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Questions for DiscussionShould all property owners be required to have protection against

catastrophic losses? – Mandatory insurance coverage– Tax on all property based on actuarial risk

What role should regulation play?– Challenges in states permitting risk-based insurance rates– Reexamination of accounting standards for capital market instruments

What are the liability issues?– Paying for water damage even though homeowners insurance doesn’t

cover it – Lawsuits filed in Mississippi and Louisiana following Katrina claiming that

homeowners policies should provide protection against water damage

What type of special treatment should be given lower income families residing in hazard-prone areas?– Types of subsidies that should be given to this group– Determining proportion of homes eligible for special treatment 33