Can we insure against tsunamis?

Robert J. Shiller, Project Syndicate

Most of the discussion surrounding how to respond to Asia's tsunami disaster has focused on government relief programs and official schemes to implement early warning systems. Little discussion has focused on the promotion of private risk management institutions, notably insurance.

This is unfortunate. Insurance companies provide professional, finely detailed risk management that respects the complexity of the dangers to be hedged and responds creatively to individual needs. Promoting private insurance may seem an indirect response to the tsunami disaster, but it is a rational -- and powerful -- response.

Insurance companies have not penetrated many of the regions that suffered the greatest losses. According to a study by the Insurance Information Institute, expenditures on non-life insurance in 2003 amounted to only 0.83 percent of GDP in Indonesia, 1.19 percent of GDP in Thailand, and 0.62 percent of GDP in India, compared with 5.23 percent of GDP in the United States.

Foreign aid is no substitute for insurance. Charity inspires, reassuring us of our humanity, but it is often capricious. You wouldn't want to rely on it. Indeed, when deciding how much disaster aid to offer, countries often seem to be influenced mainly by their leaders' concerns about how others will view them. Charity responds to attention-grabbing events, often neglecting less sensational disasters.

Insurance, on the other hand, is a reliable and venerable institution, its modern form dating back to the seventeenth century. But insurance and other risk management institutions have been slow to develop, even in advanced countries. In the U.S., most people still do not have flood or earthquake insurance. In California, one of the world's most unstable geological regions, only one in six homeowners buys earthquake insurance.

A fundamental problem is that insurance is not a concept that comes naturally to most people. In fact, as psychologists Daniel Kahneman and Amos Tversky have shown, there is a systematic human tendency to downgrade the perceived probability of low- probability events, so that people go about their lives as if the probability of these events' occurrence is zero. Similarly, humans tend to accept large downside risks in order to avoid small certain losses, such as insurance premiums.

Insurance companies have faced a slow and difficult process in weaning the public from these tendencies. Moreover, designing new risk-management products is not easy. Insurance companies face inherent difficulties in measuring risks, and they must tailor their policies creatively around the human foibles that limit uptake. Insurers must also be attentive to a wide array of possible moral hazards -- perverse incentives to risky behavior -- and to problems of selection bias in attracting clients.

To deal with disasters more effectively, countries must find the will to create an environment in which a much more developed private insurance industry can flourish. In the U.S., the National Flood Insurance Program of 1968 made it mandatory for those financing construction or improvement of structures within Special Flood Hazard Areas to buy flood insurance.

If not made mandatory, insurance must at least be promoted effectively. Otherwise, people will build on flood plains in the belief that their government, or the governments of the world, will feel obligated to bail them out, thereby insuring, in effect, bad risks that should not be taken.

Our international risk-management institutions are steadily improving. Various catastrophe bonds, covering earthquakes and other disasters, and weather derivatives have begun trading on financial markets in recent years. The Kyoto Protocol created a mechanism for trading carbon dioxide emissions, which promises to manage the risks of an even bigger potential disaster: Global warming.

Discussion of early warning systems for tsunamis has focused on government programs. But early warning means more than ocean sensors and satellites; it also implies directing construction away from disaster-prone areas and prodding private businesses to develop effective safety and evacuation procedures.

These are normal activities of insurance companies. Indeed, one of the more striking features of the tsunami disaster was that it caught some of the most glamorous vacation resorts completely unprepared. The lesson is clear: Even high-class businesses are only as professional as the existing institutional infrastructure permits them to be. The ultimate reason for their lack of preparation is that our insurance industry was not covering their tsunami risks, and hence not offering up-to-date disaster-prevention guidance.

The insurance industry can, and should, respond to the tsunami disaster by accepting the moral imperative to take concerted action to expand risk coverage. To the extent that governments are involved, they can promote better risk management through responsive regulation and even subsidization of experiments with new private insurance products.

The writer is Professor of Economics at Yale University, and author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century.