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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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