Wednesday, April 2, 2014

Why US disaster losses are so expensive...er, cheap??


Sometimes when people lament the financial cost of disasters in the US, I am struck by what seems to me a bargain deal.  There are individual people in this country that have an estimated net worth equivalent to the cost of many of our disasters.  

For example, Hurricane Katrina cost somewhere over $100 billion.  To be sure, this is a lot of money, but this amount includes the destruction of a good portion of a large metropolitan US port city, New Orleans, and destruction in several other cities and states.  That we can obliterate parts of cities in a nation worth $16 trillion and end up with a bill of around $100 billion of which private industry pays a good portion of- this sounds like a basement bargain deal to me. 




The above image helps explain why our nation's disaster losses can get so big and at the same time can also be pretty cheap all things considered.  

The image is from FEMA's National Flood Insurance Program (NFIP) 2013 budget justification.  Despite the title (though more on that in a bit), the image helps explain why flood loss in the US can be so expensive though perhaps cheap in the long run.

"Risk" has many dimensions social, economic and political.  But for the purposes of insurance, "risk" is a measurable uncertainty estimated by analysis of the frequency and severity of a given type of loss event.  Frequent losses of relatively small severity, such as auto accidents are ideal for insurance.  Insurance has greater difficulty managing infrequent and very large losses.    

Throughout history the US has invested heavily in flood control measures such as damns, levees, zoning, etc.  As a result, more of the nation's land became productive- people could build homes, develop business and otherwise conduct economic activity in areas that without flood protection would too frequently experience flooding to make it worthwhile investing in the land.  

However, while investments helped reduce the frequency of flooding it increased the severity of flood events when they occurred.  This phenomena is often called the "levee effect" with credit to the legendary natural hazards expert Gilbert White

As a result, perhaps all of US flood risk is now tail risk- infrequent, large loss. This is the type of loss, as indicated by the graph, that we use the NFIP to manage.  

Managing this type of risk with insurance is clumsy because by conventional insurance practices, it is very expensive.  Using a public insurance program like the NFIP helps us manage the cost of coverage and pay losses over time.  But this also means that the NFIP is not conventional insurance it's a residual market.

There is a general belief that in the long run, the US economy is better off experiencing infrequent large losses than frequent smaller losses because in between large losses the nation prospers through use of the otherwise hazardous land.  In recent years though, there is some speculation that the flood losses have become so big that, in fact, we lose more than we gain.

Deciding which conclusion is true will tell us if our process of flood management works to "buy down" losses as the graph's title suggests.  But does it really matter?  

The nation is fortunate to have a vast network of rivers, coastline and estuaries and a climate that provides abundant rain in most places.  This also means though that few of us don't face some sort of flood risk.  It is hard to imagine large cities and populations up and moving elsewhere so that we can remove flood infrastructure and try to go back to frequent small loss events. It is equally difficult to imagine revolutionary mitigation to homes while the public still feels that they are struggling to keep up with the cost of living. 

Expecting maintenance of flood infrastructure and perhaps some improvements here, perhaps US flood loss is as cheap as we can expect.    

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