1. Managing Large-Scale Risks in a New Era of Catastrophes Howard C. Kunreuther kunreuther@wharton.upenn.edu Risk Management and Decision Processes Center The Wharton School, University of Pennsylvania http://opim.wharton.upenn.edu/risk kunreuther@wharton.upenn.edu http://opim.wharton.upenn.edu/risk Plenary Session on Global and Trans-boundary Risks 2 nd World Congress on Risk Guadalajara, Mexico June 9, 2008

2. Outline of Talk 1.Nature of Global Risk Project 2.A Framework for Global and Trans-boundary Risks 3.Cause for Concern: A New Era of Catastrophes 4.Wharton Risk Center Initiative on Large-Scale Risks 5.Guiding Principles for Developing Risk Management Strategies 6. Linking Risk Assessment, Risk Perception and Risk Management An Illustrative Example: Effectiveness of Mitigation 7.Summary

3. 1.Nature of Global Risk Project What are the Key Global Risks (10-yr horizon)? (Sources: Global Risks 2008) Our Definition: Non-business risks that affect business (i.e. not operational, project or financial risk) Can be strategic, exogenous and systemic Are highly interdependent (i.e. do not manifest in isolation and can result in runaway conflation) Characterized by uncertainty, sharp discontinuities, non-linearity (power law distributions) and lack of proportionality Can’t be predicted (but can be managed)

4. How are Global Risks Correlated?

5. 2. A Framework for Global and Trans-boundary Risks Nature of Interdependencies Constructing Scenarios Risk Perception Public Perceptions Expert/Layperson Differences Risk Communication Risk Assessment & Vulnerability Analysis Modeling of Risks Risk Management Strategies

6. A Framework for Global and Trans-boundary Risks (cont.) Risk Management Strategies Information Provision Incentives Regulation Standards Compensation Insurance Liability Evaluation of Strategies Impact on Society Impact on Interested Parties

7. A radical change in the scale and rhythm of catastrophes Natural disasters have caused economic losses to property in recent years –Hurricane Katrina: $65-70 billion (in insured losses) –Hurricane Andrew: $22 billion (2005 dollars) (in insured losses) Large number of lives lost in recent catastrophic disasters -Myanmar Cyclone: Over 200,000 people missing and over 100,000 deaths - Sichuan Province (China) Earthquake—death toll could reach 100,000 Challenges in mitigating damage, loss of lives and providing funds for recovery following large-scale catastrophes 3. Cause for Concern A New Era of Catastrophes

8. 8 4. Wharton Risk Center Initiative on Large-Scale Risks 17 partners – Allstate, AIA, AIG, Guardsmark, Liberty Mutual, Lockheed Martin, Munich Re, NAMIC, PartnerRe, PCIAA, RAA, Renaissance Re, Societe Generale Bank, State Farm, Swiss Re, Travelers, Zurich − Georgia State University, Insurance Information Institute, Risk Management Solutions Collaboration with most state and federal programs: FHCF, Citizens, Texas Wind Pool, NFIP, DHS Focus on disaster markets in 4 states and metropolitan areas: Florida (Miami); Texas (Houston); New York (specific postal zones of NYC); South Carolina (Charleston) Timeline Phase I Report: February 2007 Draft Phase II Report: October 2007 Publication Phase II Report: March 1, 2008

9. Worldwide Evolution of Catastrophe Insured Losses, 1970-2007 (Property and business interruption (BI); in U.S.$ billon indexed to 2007) Sources: Wharton Risk Center (2008) - data from Swiss Re and Insurance Information Institute

10. The 20 Most Costly Catastrophe Insurance Losses, 1970-2007 (10 of them occurred since 2001; 9 of these 10 in the U.S.) U.S. $ Billion (indexed to 2007) Event Victims (Dead or missing) Year Area of Primary Damage 66.3Hurricane Katrina1,8362005 USA, Gulf of Mexico, et al. 35.59/11 Attacks3,0252001 USA 23.7Hurricane Andrew431992 USA, Bahamas 19.6Northridge earthquake611994 USA 14.1Hurricane Ivan1242004 USA, Caribbean, et al. 13.3Hurricane Wilma352005 USA, Gulf of Mexico, et al. 10.7Hurricane Rita342005 USA, Gulf of Mexico, et al. 8.8Hurricane Charley242004 USA, Caribbean, et al. 8.6Typhoon Mireille511991 Japan 7.6Hurricane Hugo711989 Puerto Rico, USA, et al. 7.4Winterstorm Daria951990 France, UK, et al. 7.2Winterstorm Lothar1101999 France, Switzerland, et al. 6.1Winterstorm Kyrill542007 Germany, UK, NL, France, et al. 5.7Storms and floods221987 France, UK, et al. 5.6Hurricane Frances382004 USA, Bahamas 5.0Winterstorm Vivian641990 Western/Central Europe 5.0Typhoon Bart261999 Japan 4.5Hurricane Georges6001998 USA, Caribbean 4.2Tropical Storm Alison412001 USA 4.2Hurricane Jeanne3,0342004 USA, Caribbean, et al. Sources: Wharton Risk Center (2008) - Data from SwissRe and III http://video.google.com/videoplay?docid=619 278176220951495&q=hurricane+katrina&tota l=7291&start=10&num=10&so=0&type=searc h&plindex=7

11. What Is at Stake and Goal of the Study What is at stake? Affordability of living in risky areas Who ultimately bears the costs and receives the benefits of such decisions Research challenge Need to better understand the impact of state insurance regulations on the dynamics of the market Need quantitative measurements of these effects Goal: 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 Enhancing the recovery process due to better financial coverage through insurance and other means

12. 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) Cost of Hurricane Andrew in 2004 would have been $120bn Weather patterns Changes in climate conditions and/or return to a high hurricane cycle? More intense weather-related events coupled with increased value at risk will cost more, much more. What Will 2008 Bring? 12 What’s Happening? The Question of Attribution

13. Insured Coastal Exposure as a % of Statewide Insured Exposure in 2004 Source: Data from AIR Worldwide

14. Total Value of Insured Coastal Exposure in 2004

15. 5. Guiding Principles for Developing Risk Management Strategies Importance of assessing risks and characterizing uncertainties surround these estimates. Recognition of interdependencies associated with risks and the dynamic uncertainties associated with these interdependencies. Understanding behavioral biases and heuristics utilized by decision makers, such as misperceptions of probability, myopia and the disaster won’t happen to me. Risk management strategies should be based on assessments of the risk, recognize interdependencies and address behavioral biases and heuristics used by decision makers.

16. Guiding Principles for Developing Alternative Insurance Programs Principle 1: Premiums Reflecting Risk Insurance premiums should be based on risk in order 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 Any special treatment given to homeowners currently residing in hazard-prone areas (e.g., low-income uninsured or inadequately insured homeowners) should come from general public funding and not through insurance premium subsidies.

17. Data Needs Based on These Principles Characteristics of households in hazard-prone areas Socio-economic status Insurance status Nature of structure and mitigation measures in place Characteristics of risk Likelihood of hazards of different magnitudes Consequences of specific hazards under different conditions (e.g. structure mitigated or note mitigated)

18. 6. Linking Risk Assessment, Risk Perception and Risk Management An Illustrative Example: Effectiveness of Mitigation Enforced building codes are effective. Many homeowners do not voluntarily invest in cost- effective mitigation. Coordinating between the public and private sectors is critical to significantly increase adoption of mitigation measures. 18

19. Risk Assessment: Impact of Mitigation Illustration with a 100-Year Event 0 10 20 30 40 50 60 70 80 90 FLNYSCTX State Losses (Billions) Savings from Mitigation Remaining Losses 19

20. $160 billion loss $82 billion saving with mitigation in place Risk Assessment: Effects of Mitigation On a 500-Year Event 20

21. Characteristic of Mitigation Upfront cost/long-term benefits Cost of Mitigation – $1,500 Nature of Disaster –1/100 chance of disaster –Reduction in loss ($27,500) Expected Annual Benefits: $275 (1/100 * $27,500) Annual Discount rate of 10% 21 Motivating Mitigation Example

22. Upfront cost of mitigation Expected benefits over time 22 Benefit-Cost Analysis of Mitigation

23. Behavioral –Myopia (hyperbolic discounting; NIMTOF) –Misperception of risk 1/1000 chance rather than 1/100 chance of hurricane $10,000 reduction in loss rather than $27,500 –Expectation of disaster relief Institutional Realities –Budget constraints – can’t afford $1,500 investment –Insurer may not give me discount next year or cancel policy –Move in 2-3 years. Value of house doesn’t appreciate by investment in mitigation so can’t recoup cost of mitigation 23 Risk Perception Why Individuals do not Adopt Mitigation Measures

24. Proposed strategy Long-term insurance contracts Long-term home improvement loans Rationale Mitigation measure is attached to property rather than to homeowner Overcomes behavioral biases and institutional realities 24 Risk Management Strategies Creating Innovative Solutions

25. Illustrative Example Cost of partial roof mitigation: $1,500 Expected annual benefit of partial roof mitigation: $275 (1/1000 * $27,500) Annual payments from 20 year $1,500 loan at 10% annual interest rate: $145 Reduction in annual insurance payment: $275 Reduction in annual payments due to mitigation: $275-$145= $130 Linking Long-Term Loans with Long-Term Insurance

26. 26 Everyone is a Winner: Homeowner: Lower total annual payments Insurer: Reduction in catastrophe losses and lower reinsurance cost Financial institution: More secure investment due to lower losses from disaster General taxpayer: Less disaster assistance Linking Long-Term Loans with Long-Term Insurance

27. 7. Summary The Facts: Totally new era of large-scale risks; growing concentration of value in high-risk areas that portend more devastating disasters in the future. Data Needs Need better data for linking risk assessment, risk perception and risk management strategies Research questions: How can we develop strategies for reducing our vulnerability to future natural disasters? What types of private-public partnerships are required to increase resiliency of residences, businesses and communities following a large-scale disaster?