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					"The Role of Insurance in Promoting
  Hazard Resistant Communities"
           Paul R. Kleindorfer
Risk Management & Decision Processes Center
           The Wharton School
        Presented to the Forum on
Risk Management and Assessments of Natural
                  Hazards

              February 5, 2001
             PRK: RMA & Nat'l Hazards (2/5/01)
      Outline of Presentation
• Catastrophe Risk: Institutions & Science
• New Approaches to Risk Assessment
• Mitigation, Building Codes & Insurance
• Supply, Demand and Regulation of
  Catastrophe Insurance
• Conclusions

                PRK: RMA & Nat'l Hazards (2/5/01)
Framework for Analyzing Catastrophic Risks

Scientists Estimating
    Probabilities                                     Engineers Estimating
     of Disasters                                          Damage
(e.g. USGS, NOAA)                                       from Disasters


                         Organizations Modeling
                          Distribution of Losses
                              from Disasters
                         (e.g. AIR, EQE, RMS)




 Reinsurance and                                             Financial
Insurance Industry                                          Institutions
                         Financial Instruments


                        PRK: RMA & Nat'l Hazards (2/5/01)
 Complementary Roles of Mitigation and Insurance

        Reinsurance and
       Insurance Industry      Financial Instruments        Financial Institutions



•Insurance Protection
 Against Losses
                                Property and Lives             Insurance Requirements
•Encourages Mitigation
                                       at Risk
                                ----------------------
                                Decision Processes
                                         of
        •Inspections               Homeowners
        •Enforcing Provisions
                                                         Joint Mitigation Strategies
        •Certification

       Construction Industry
               and                                               Public Sector
        Real Estate Sector                                         Agencies



                            PRK: RMA & Nat'l Hazards (2/5/01)
       Managing Catastrophic Risks:
  A Research Program and Industry Forum

Wharton Risk Management and Decision
          Processes Center
 Wharton Financial Institutions Center

               David Cummins
                 Neil Doherty
                Patricia Grossi
               Jaideep Hebbar
                 Robert Klein
               Paul Kleindorfer
              Howard Kunreuther

            PRK: RMA & Nat'l Hazards (2/5/01)
         Wharton’s Cat Risk Project
• Understanding Mitigation and Uncertainty
   – (Howard Kunreuther, Paul Kleindorfer)

• Understanding the Supply, Demand and
  Regulation of Catastrophe Insurance
   – (Paul Kleindorfer, Robert Klein, Martin Grace)

• Understanding the Capacity of the Insurance
  Industry under Alternative Institutional Scenarios
  involving Cat Risk
   – (David Cummins, Neil Doherty)

• Understanding the Nature and Role of New Market
  Instruments for Cat Risk
   – (David Cummins, Neil Doherty, David Croson, Andreas Richter)

                          PRK: RMA & Nat'l Hazards (2/5/01)
Earthquake Loss Estimation Process

        Step I                                 Step II




    Step III


    Step IV



               PRK: RMA & Nat'l Hazards (2/5/01)
 Common Assumptions of Risk Modelers
• The results generated are in terms of an
  exceedance probability (EP) curve, defined as the
  probability of exceeding a certain loss level on an
  annual basis.

     EP(L) = P(Annual Loss > L)
           = 1 - F(L; Parameters)

   F(L;PARS) = C.D.F. of Annual Loss

• Aleatory vs. Epistemic Risk Components
                PRK: RMA & Nat'l Hazards (2/5/01)
               HAZUS Analysis
Example: Charleston, SC
  – Sources: 156 events total (background & characteristic
    events)
  – Magnitude Conversion: Boore and Atkinson (1987)
  – Attenuation: Project 97 relationship (i.e. 1/2Frankel et
    al., 1996 + 1/2Toro et al., 1997)
  – Soils Mapping: Soil class D (“stiff soils”), NEHRP
    amplification factors (FEMA, 1997), and no liquefaction
    potential
  – Inventory: HAZUS default database (updated to 1999
    values)
  – Vulnerability: HAZUS default fragility curves

                  PRK: RMA & Nat'l Hazards (2/5/01)
                            Results: SB-HAZUS-EP curve
                             0.01




                            0.008

                                                                              MEAN (HAZUS)
Probability of Exceedance




                            0.006




                            0.004




                            0.002




                               0
                                    $0      $5,000            $10,000         $15,000        $20,000
                                                        Losses ($ Millions)

                                         PRK: RMA & Nat'l Hazards (2/5/01)
      Mitigation Decisions
• Mitigation at the Individual Homeowner
  Level

• Mitigation at the Community Level

• Two Key Elements
  – Understand the Effects of Mitigation on Risk
  – Align and Communicate the Incentives for
    Adoption

              PRK: RMA & Nat'l Hazards (2/5/01)
     Understanding the Effects
• Detailed Assessment of
  Fragility/Vulnerability Curves and the
  Impact on EP Curves
• By Type of Structure, Contents, End Use
  and Location Factors
• Continuing Experimentation Underway
  (IBHS and Insurance Community)
• Insurance Effects, Individual Effects and
  Community Effects
              PRK: RMA & Nat'l Hazards (2/5/01)
           Individual Effects
• Experimental and Field Studies by H.
  Kunreuther and others show that Individuals
  are “myopic” and optimistic when it comes
  to natural hazards: “It won’t happen to me!”
• Because of externalities in disrupting
  neighbors and commerce, as well as to
  correct decision processes, well enforced
  building codes are essential, but difficult to
  develop and implement.

               PRK: RMA & Nat'l Hazards (2/5/01)
   Aligning Economic Incentives
• Financial Institutions and Governments assess
  risks and uncertainties from seismic hazards.
• Financial Institutions build in risks of such
  hazards into mortgages and loans, including
  the mitigation of such risks via insurance.
• The magnitude of the risk payments facing
  property and business owners causes them to
  consider the adoption of cost effective
  mitigation measures. E.g., Reductions in
  Insurance premia and in annual mortgage
  payments.      PRK: RMA & Nat'l Hazards (2/5/01)
Critical Role of Mitigation in Hazard
Management: Findings of the Project
•       Importance of mitigation as part of a cat management
        strategy
    –      Reduces losses in tail of distribution
    –      Expands insurance industry capacity and reduces prices
    –      Lowers prices of cat bond and reinsurance prices

•       Evaluating role of mitigation in model cities
    –      Reinforcing homes against earthquakes and hurricanes
    –      Evaluating impact of mitigation on insolvency probabilities of
           insurers
    –      Impact of mitigation on need for reinsurance and cat bonds



                         PRK: RMA & Nat'l Hazards (2/5/01)
 Insurance, Risk Analysis and Mitigation

• Insurance Companies drive science-based
  risk quantification
• Insurance Companies have therefore also a
  strong interest in what mitigation can do to
  affect the EP Curve (and Solvency and
  Capital Requirements and Underwriting,…)
• Are the effects of mitigation, individual and
  community, visible in insurance pricing??

               PRK: RMA & Nat'l Hazards (2/5/01)
Objectives of Supply-Demand Study
• What is the structure and performance of the
  Catastrophe Insurance Market?
   – Demand (Structure, Interdependencies)
   – Supply (Profits, Risk/Exposures, Distribution)

• What is the nature and impact of regulation of this
  market on:
   – Pricing (adequacy and precision)
   – Financial risk


• What is the current state of the Market? What are
  possible future (sustainable)states of the Market
  under different scenarios?
                  PRK: RMA & Nat'l Hazards (2/5/01)
      The ISO Database Used
• 60 Companies from 20 Insurance
  Groups Doing Business in Florida and
  New York
• Slightly summarized data based on unit
  transactions for individual policies as
  reported by insurers to ISO.
• 2.6 Million Records covering the period
  1995-1998 (both Homeowners and
  Dwelling Fire Policies)
             PRK: RMA & Nat'l Hazards (2/5/01)
         The Data Elements
• Policy Features
  – Coverages, Deductibles, Expected Loss Costs,
    Location and Type/Age of Structures …

• Company Characteristics
  – Size, Marketing System, Financial Strength …

• Socio-Demographic Characteristics of ZIP
  – Income, Education, % of Mortgages …

              PRK: RMA & Nat'l Hazards (2/5/01)
   Decision Processes Underlying S&D
• Consumers:     Maximize Expected Utility
  – Choice Among Policy Features

• Insurers:      Maximize Expected Profit
  – Underwriting Standards and Policy Design
  – Exposure Management
  – Capital Structure and Financial Strategy

• Premium and Price are the Outcomes of Interest

                 PRK: RMA & Nat'l Hazards (2/5/01)
  Premium and Price Equations
• PREMIUM = aF + bX + cZ + e
  – F = Policy Features
  – X = Company Characteristics
  – Z = Socio-Demographic Characteristics (ZIP)

               PREMIUM – NPV(Losses)
• PRICE = -----------------------------------
                            NPV(Losses)

              PRK: RMA & Nat'l Hazards (2/5/01)
Price and Premium Equation
Results: Contract Terms
• Premiums                              • Price Mark-Up
  –   Ord/Law             –                  –   Ord/Law             ≈0
  –   Replacement Costs –                    –   Replacement Costs –
  –   Wind Prot Credit +                     –   Wind Prot Credit +
  –   Coverage A Lim +                       –   Coverage A Lim +
  –   Wind Deductible –                      –   Wind Deductible –
  –   Fire Deductible     +                  –   Fire Deductible     +
  –   Cat Losses          +                  –   Cat Losses          –
  –   Non Cat Losses      +                  –   Non Cat Losses      –
  –   Frame               ≈0                 –   Frame               +
  –   Brick               –                  –   Brick               +
  –   Protection          –                  –   Protection          –
  –   House built after 1960 –               –   House built after 1960 ≈ 0
                      PRK: RMA & Nat'l Hazards (2/5/01)
 Some Thoughts for Discussion
• Risk Assessment Infrastructure, based on sound
  science and engineering, is a key driver of both
  insurance underwriting and marketing.
• This helps to assure alignment of Economic
  Incentives for efficient risk bearing and risk
  transfer methods
• Both individual decisions (structure types,
  locations, etc.) as well as community decisions
  appear to be reflected in private insurers premium
  decisions and in market demand.
• Much more could be done to link individual and
  community decisions on cost-effective mitigation
  to the financial consequences these engender.
                PRK: RMA & Nat'l Hazards (2/5/01)
                    References
Grace, M., R. W. Klein, and P. R. Kleindorfer,
 Supply and Demand in Catastrophe Insurance
 Markets, NBER Working Paper, February, 2000.

Kleindorfer, P. R. and H. C. Kunreuther, The
  Complementary Roles of Mitigation and
  Insurance in Managing Catastrophic Risks, Risk
  Analysis, 1999.

     For More Information see the Wharton Cat Risk Website
               http:\\grace.wharton.upenn.edu\risk\
                   PRK: RMA & Nat'l Hazards (2/5/01)