Tag Archives: Kunreuther

Why Fairness Matters in Federal Reforms

As Congress looks at restructuring two national insurance plans — the American Health Care Act of 2017 and the National Flood Insurance Program — legislators must address the issue of fairness. That is the view of Wharton professors Howard Kunreuther and Mark Pauly, who co-wrote the book, “Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry.”

In this opinion piece, they argue that considering the issue of fairness in designing these programs is not merely an exercise to aid the old and needy. Rather, it is also to make legislators think about what policies will make premiums less onerous to people with lower risk so they will not be discouraged about getting coverage.

The U.S. is at a critical moment as Congress is attempting to determine how two insurance programs should be structured to help Americans who need protection from physical and financial risk. Both the reauthorization of the National Flood Insurance Program (NFIP) and the American Health Care Act of 2017 raise questions as to whether affected individuals would be treated more fairly under the new legislation than they currently are.

For us, fairness in the context of new legislation means consideration of the impact that a sudden increase in premiums or unexpected changes in the terms of coverage will have on the well-being of the affected individuals.

See also: Flood Risk: Question Is Where, Not When  

When the National Flood Insurance Program (NFIP) was enacted in 1968, there was a concern that high premiums would significantly reduce property values and that this could become an unfair economic strain. For this reason, the NFIP specified that homeowners living in high-risk areas at the time the law was enacted would be charged a subsidized premium.

The same potential conflict regarding fairness applies to health insurance. Is it fair that those with pre-existing medical conditions or those who unexpectedly acquire high-risk conditions might have to pay much higher health insurance premiums than when they were less at risk?  Yet this is what will happen if private insurers are allowed to charge risk-based premiums and politicians decide to provide limited subsidies to cushion those higher premiums.  However, is it fair to impose high premiums on individuals with low risks to finance such subsidies? And is it fair to offer no reward to those who take steps to improve their health status and thus reduce their future health spending risk?

Elected representatives on both sides of the aisle continually espouse the principle of fairness across a wide range of issues, including trade, tax reform and jobs. If they truly want to extend that allegiance to the principle of fairness, they might wish to consider offering some form of financial assistance to help working class families who become high-risk for floods or to help them buy or continue coverage for health care. The choice of the right amount of support regarded as fair is ultimately a political issue where voters’ perspectives may differ.

There are efficient ways to address the fairness problem for both insurance programs that might gain bipartisan support. With respect to health insurance premiums, it is easy to justify assisting low-income and older people who want to buy coverage. Empirical studies of Medicaid programs suggest that individuals care about other people’s health conditions. Many taxpayers are thus likely to support having the public sector cover part of the cost of health insurance for those whose health might be improved by having insurance.

In the case of flood insurance, those subject to water-related damage should receive information on the cost of insurance that reflects their flood risk. If this risk-based premium exceeds a proportion of their income or housing costs, they could be given an insurance voucher or tax credit so they could afford insurance. A new RAND study recommends that those whose total housing costs — including flood insurance premiums — exceed a certain percentage of their income be provided with financial assistance. This would ensure that taxpayers are not subsidizing high-income individuals.

It is important to encourage property owners in flood prone areas to invest in cost-effective, loss-reduction measures. Homeowners could be offered a long-term home improvement loan, tied to the property, to pay for cost-effective ways to mitigate future losses, such as elevating the house or moving utilities to a higher floor, so that the annual cost of the loan, paid all or in part by vouchers or tax credits, would be less than their savings from the reduced risk-based premium. This proposal is not only fair but also encourages property owners to reduce future losses from inevitable disasters. It also avoids using taxpayer dollars to assist uninsured and unprotected victims from hurricanes and floods who will demand and may receive federal disaster relief.

See also: How to Make Flood Insurance Affordable  

In summary, the proposed flood and health insurance programs should be designed with reasonable premiums for high-risk individuals so they will want to purchase coverage that protects them against catastrophic financial losses. At the same time, one needs to be concerned about not discouraging low-risk individuals from purchasing insurance by imposing the subsidy burden on them alone through premiums much higher than their risk rather than on the general population through a broad-based tax. By considering the issue of fairness as an important criterion in designing these programs, we will have taken a major step in enabling high-risk individuals to have coverage while at the same time maintaining the basic principles of insurance.

Republished with permission from Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

How to Outfox Our Brains About Risk

Ostriches are often characterized as hapless birds that bury their heads in the sand whenever danger approaches. In fact, they are highly astute escape artists. They use their great speed to overcome their inability to fly.

Much in the same way that ostriches are limited in their defensive actions because they cannot fly, we need to recognize that, when making decisions, our biases are part of our cognitive DNA. In the same way that the ostrich has adapted to risk by taking into consideration its physical limitations, we humans, when thinking about risk, need to develop policies that take into consideration our inherent cognitive limitations. We need to learn to be more, not less, like ostriches — hence the paradox — if we are to be better prepared for disasters.

We read about disasters all the time and often see post-disaster coverage about what people should have done in the situation: They should have put up their storm shutters, they should have evacuated, they should have purchased earthquake insurance — and so on. But people tend to disregard these warnings because of six major decision-making biases.

People have a hard time foreseeing future consequences (myopia); are too quick to forget losses from the past (amnesia); are inclined to think losses will occur to others rather than themselves (optimism); are too inclined to prefer inaction over action when faced with risks and maintain the status quo (inertia); fail to base decisions on all of the information that is made available about a risk (simplification); and are overly prone to imitate the behaviors of others who exhibit the same biases (herding).

See also: Need for Lifelong Learning in Insurance  

Their relative importance varies from situation to situation, but if there is one that it is most fundamental, it is excessive optimism. We have a hard time fully anticipating the physical and emotional toll that disasters can impart, and we are too prone to believe that disasters happen to other people in other places in other times.

A second bias that can create serious problems is myopia. There is a tendency for individuals to focus on short time horizons, so they do not undertake protective measures that have long-term benefits, such as not investing in loss reduction measures because of their high upfront costs.

Most modern approaches to risk management start by analyzing the objective likelihood and consequences of risks faced by individuals or communities and then design measures that could mitigate these risks — and hope that people will choose to implement them. For example, people in areas prone to earthquakes might be provided with checklists for how to prepare for such events and urged to buy earthquake insurance. But because people often do not adopt these measures, effective risk management has to proceed in the reverse order, starting with an understanding of why people may not choose to adopt risk-reduction measures and then design approaches that work with, rather than against, our natural biases.

A behavioral risk audit can — and should — be used as a source of guidance, not just for communities, but also for individuals and households. It should foster a discussion between family members as to the biases that we are most prone to have and suggest measures for overcoming them that the household agrees can be implemented.

When unsure how best to prepare for a disaster, we often choose the option that requires the least active mental effort — such as accepting the basic deductible in an insurance policy when one is unsure what is best or deciding to stay at home when uncertain whether to evacuate. Unfortunately, in many cases, accepting these “defaults” can have tragic consequences, such as staying when evacuation is essential.

This propensity to look for easy ways out in decision-making, however, can sometimes be flipped on its head by making safety something one needs to actively opt out of rather than opt into. As an example, one might overcome the hesitancy of people in flood-prone areas to buy flood insurance by providing it automatically with the payment of property taxes each year and allowing people who would actively prefer not to have it to apply for a refund of the premium.

See also: Next Generation of Insurance Services  

The greatest challenge we face is how to embrace cultures of protective action in the long run as a society. The behavioral risk audit offers a tool that can help individuals overcome the psychological biases that often impede preparedness, such as failing to see the future benefits of protective investments and believing that disasters are things that happen to others. Many of the truly long-run risks we face, however — such as those posed by climate change — are even more difficult to deal with as they require collective rather than just individual action.

Achieving effective collective action requires us not only to address individual biases but embrace a series of guiding principles of societal-level safety, such as demanding that safety and long-run preparedness be a top priority in government planning and insisting that social equity be a consideration in the formation of policies.

6 Reasons We Aren’t Prepared for Disasters

When dawn broke on the morning of Sept. 8, 1900, the people of Galveston, Texas, had no inkling of the disaster that was about to befall them. The thickening clouds and rising surf hinted that a storm was on the way, but few were worried. The local Weather Bureau office, for its part, gave no reason to worry; no urgent warnings were issued, and no calls were made to evacuate. But by late afternoon it became clear that this was no ordinary storm. Hurricane-force winds of more than 100 mph were soon raking the city, driving a massive storm surge that devoured almost everything in its path. Many tried to flee, but it was too late. By the next day, more than 8,000 people were dead, the greatest loss of life from a natural disaster in U.S. history.

Fast-forward to September 2008 when Hurricane Ike threatened the same part of the Texas coast — but this time it was greeted by a well-informed populace. Ike had been under constant surveillance by satellites, aircraft reconnaissance and land-based radar for more than a week, with the media blasting a nonstop cacophony of reports and warnings, urging those in coastal areas to leave. The city of Galveston was also well-prepared: A 17-foot-high seawall that had been constructed after the 1900 storm stood ready to protect the city, and government-flood insurance policies were available to residents who were at risk of property loss. Unlike in 1900, Texas residents really should have had little reason to fear. On their side was a century of advances in meteorology, engineering and economics designed to ensure that Ike would, indeed, pass as a forgettable summer storm.

See also: 5 Techniques for Managing a Disaster  

It didn’t quite work out that way. Warnings were issued, but many in low-lying coastal communities ignored them — even when told that failing to heed the warnings meant they faced death. Galveston’s aging seawall turned out to be vulnerable; it was breached in multiple places, damaging roughly 80% of the homes and businesses in the city. The resort communities to the north on the Bolivar Peninsula, which never saw the need for a seawall, fared even worse, witnessing almost complete destruction. And among the thousands of homeowners who suffered flood losses, only 39% had seen fit to purchase flood insurance. In the end, Ike caused more than $14 billion in property damage and 100 deaths — almost all of it needless.

Why are we underprepared for disasters?

The gap between protective technology and protective action illustrated by the losses in Hurricane Ike is, of course, hardly limited to Galveston or to hurricanes. While our ability to foresee and protect against natural catastrophes has increased dramatically over the course of the past century, it has done little to reduce material losses from such events.

Rather than seeing decreases in damage and fatalities because of the aid of science, we’ve instead seen the worldwide economic cost and impact on people’s lives as hazards increased exponentially through the early 21st century, with five of the 10 costliest natural disasters in history with respect to property damage occurring since 2005. While scientific and technological advances have allowed deaths to decrease on average, horrific calamities still occur, as in the case of the 230,000 people estimated to have lost their lives in the 2004 Indian Ocean earthquake and tsunami; the 87,000 who died in the 2008 Sichuan earthquake in China; the 160,000 who lost their lives in Haiti from an earthquake in 2010; and the 8,000 fatalities that occurred in the 2015 Nepalese earthquake. Even in the U.S., Hurricane Katrina in 2005 caused more than 1,800 fatalities, making it the third-most deadly such storm in U.S. history.

In our book “The Ostrich Paradox,” we explore six reasons that individuals, communities and institutions often under-invest in protection against low-probability, high-consequence events. They are:

  1. Myopia: a tendency to focus on overly short future time horizons when appraising immediate costs and the potential benefits of protective investments;
  2. Amnesia: a tendency to forget too quickly the lessons of past disasters;
  3. Optimism: a tendency to underestimate the likelihood that losses will occur from future hazards;
  4. Inertia: a tendency to maintain the status quo or adopt a default option when there is uncertainty about the potential benefits of investing in alternative protective measures;
  5. Simplification: a tendency to selectively attend to only a subset of the relevant factors to consider when making choices involving risk; and
  6. Herding: a tendency to base choices on the observed actions of others.

See also: Are You Ready for the Next Disaster?

We need to recognize that, when making decisions, our biases are part of our cognitive DNA. While we may not be able to alter our cognitive wiring, we may be able to improve preparedness by recognizing these specific biases and designing strategies that anticipate them.

Adapted from The Ostrich Paradox: Why We Underprepare for Disasters, by Robert Meyer and Howard Kunreuther, copyright 2017. Reprinted by permission of Wharton Digital Press.

Returning Insurance to Its 19th Century Roots

As we celebrate the Wharton Risk Center’s 30th anniversary, we are at the same time envisioning the future of risk management. In this spirit, I would like to make the case that the insurance industry return to its 19th century roots by requiring those at risk to undertake cost-effective loss-reduction measures as a condition for insurance coverage. Back to the future!

This is the way that factory mutuals operated when they were founded in the mid-1800s, and some insurers still do today when marketing commercial policies. Firms were given an insurance policy only after they were inspected and shown to be safe. Insurance premiums reflected the best estimates of the risk; improvements were rewarded with lower premiums, reflecting the expected reduction in future claims. Firms that did not continue to keep their factories operating safely were warned that their insurance policy would be canceled unless they took corrective action.

Insurance could play a similar role with respect to providing coverage to the residential sector where, today, limited attention is given to encouraging homeowners to invest in loss-reduction measures. Premiums should reflect risk, and risk information should be communicated in a transparent manner so decision makers have accurate signals. Those at risk should also be made aware of the reduction in premiums they could receive.

Public-private partnerships are necessary for dealing with insurance against some extreme events. Low-income individuals residing in hazard-prone areas are likely to demand financial assistance if their premiums are subsidized and the increase in the cost of their insurance raises issues of affordability. Even in situations where insurers are allowed to charge risk-based premiums, they may still feel that some hazards are uninsurable without public-sector involvement if catastrophic losses would cause their surplus to be reduced to an unacceptable level and perhaps lead to insolvency.

The National Flood Insurance Program (NFIP) offers an opportunity to creatively address these issues with regard to flood hazards. The Federal Emergency Management Agency (FEMA)’s technical mapping advisory council has already begun focusing on ways to design flood maps that reflect risk, and several reports by the National Research Council are addressing ways the flood insurance program can be modified in advance of its renewal in 2017. More specifically:

  • Updated flood maps will allow insurers to more accurately assess the hazard. If private insurers can charge risk-based rates, they would have an economic incentive to market flood coverage.
  • The public sector could provide financial assistance to low-income homeowners to address issues of affordability and encourage them to undertake cost-effective measures to reduce their risk. One way to do this is through a means-tested voucher program tied to low-interest loans. Well-enforced building codes and seals of approval would provide an additional rationale for undertaking loss-reduction measures.
  • A multi-year insurance policy tied to the property would prevent policyholders from canceling, as many do today when they have not made a claim for several years. Property owners would be provided with stable annual premiums and would know that they were protected against water damage from floods and hurricanes.
  • Reinsurance and risk-transfer instruments marketed by the private sector could cover a significant portion of the catastrophic losses from future floods. Some type of federal reinsurance would provide insurers with protection against extreme losses.

The broader challenge we face is developing long-term strategies that provide short-term rewards so that change is politically viable. There is a growing interest by policy makers and other stakeholders in ways that insurance can encourage individuals, firms, communities and countries to undertake protective measures.

Insurance has an opportunity to play this role in the residential sector by going back to its basic principles that were adopted almost 200 years ago from the commercial side of the house: encourage or require investments in loss-reduction measures today while providing claims payments should one suffer a severe loss.

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