In the nearly six months since Hurricane Katrina destroyed half of New Orleans, many storm victims' expectations of help have been dashed, creating a legacy of bitterness. That legacy may be all the more painful when we consider that many homeowners suffered unnecessarily devastating losses because of their lack of insurance or their underinsurance, often owing to the belief that they could not afford the right coverage.
Future catastrophes -- storms, earthquakes, tsunamis, volcano eruptions, forest fires, agricultural or other environmental crises, disease epidemics, or terrorist attacks -- are likely to result in the same kinds of problems. So it is important to consider the causes of underinsurance and whether our insurance institutions are adequate to the risks that we face.
According to a report from the Insurance Information Institute, nearly 70 percent of homeowners' claims in Louisiana were settled by the end of last month, for a total of US$7.5 billion. Sounds good, but there were roughly 200,000 homes that were either severely damaged or destroyed, so the total amounts to less than US$40,000 per home -- far below what was needed.
Indeed, a large share of New Orleans homeowners -- 60 percent in Orleans Parish -- were completely uninsured against floods. Many of those who were insured discovered that clauses in their policies barred them from collecting full benefits.
In some cases, insurance companies argued that houses were damaged by flood, not wind, which their policies cover more generously. That may seem like capricious hair-splitting to people who have suffered a major loss, but such terms are in the insurance contracts that they signed, whether they understood them or not.
Claims disputes have led to many lawsuits, and many of those who have lost their homes have discovered that the only help available to them now is a low-interest loan. Not unreasonably, US President George W. Bush wants government grants to bail out only the approximately 20,000 homeowners who can't be faulted for failing to buy flood insurance, because they lived outside the designated flood plains.
Despite the disappointments, private insurance is still the best way to deal with possible future disasters. Insurance policies that clearly specify the amounts that will be paid and the types of damage that will be covered are far better than the government-administered, after-the-fact bailout that many people seem to have expected.
Adequate private insurance can be boosted in the future through public education, improved insurance institutions, and lower insurance costs. We need to work on all of these agendas, because each must be part of any new plan to deal with the next catastrophe.
The cost of insurance may be the most serious problem. According to estimates by Robert Klein of Georgia State University, homeowners' insurance premiums in Louisiana had already gone up by 70 percent between 1997 and last year. State insurance regulators resist rate increases, but they are ultimately powerless, because insurers can simply take their business elsewhere.
The National Association of Insurance Commissioners (NAIC) proposed last December that each of the US' 50 states should establish a disaster insurance fund to cover a wide range of big calamities. The funds -- modeled after similar funds in France and Spain -- would be designed to cover the biggest, once-in-50-years catastrophes. The federal government would then augment the protection up to the once-in-500-year level
The NAIC'S proposal is now under discussion. If it were fully implemented, which is unlikely, it would constitute a revolution in risk management in the US similar to that of the creation of Social Security in 1934. But preparation for catastrophe does not have to reside exclusively with the government. Mega-disaster risks can be handled with private financial markets, as long as these markets manage to get the full attention and interest of portfolio investors.
Consider catastrophe bonds (or "cat bonds"), which contain clauses that stipulate that the issuer of the bond (the borrower) does not have to repay the money if a specified catastrophe occurs. The bonds can be sold to a worldwide market by insurance companies that incur major risks by writing policies.
If the insurance companies can get a good enough price for such bonds, they can eliminate their exposure to the risk of a major disaster, thereby allowing them to issue policies to homeowners at a lower cost.
Cat bonds have been growing in importance in recent years. According to estimates by Lane Financial, there were US$1.8 billion worth of cat bonds issued in the year April 2004 to March last year. Since Katrina, issuance has accelerated. In the first three post-Katrina months alone (September to December ), US$2.1 billion were issued.
The total value of outstanding cat bonds is small by Katrina standards. But the trend towards increasing sophistication and breadth of our financial markets suggests that we can expect to see much further growth in cat bonds.
Ultimately, even Hurricane Katrina and other disasters of similar magnitude are small by world standards. The total insured property loss of Katrina, US$34.4 billion according to an insurance industry estimate, even if expanded to represent uninsured losses, represents a miniscule fraction of world wealth.
But such disasters represent a much larger share of a single country's wealth. This is why financial theory prescribes spreading risks as evenly as possible around the world, rather than around only one country, as plans for a national catastrophe fund envision. The possibility of managing national risks globally is another example of the advantages of economic globalization and expansion of financial markets.
Robert Shiller is professor of economics at Yale University and director at Macro Securities Research LLC.
Copyright: Project Syndicate
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