Managing Catastrophic Risks Through Insurance and Mitigation
Franklin Allen and Douglas Gale, August 1998

Introduction: Insurance is the only policy tool in the analyst’s repertoire that can reward individuals for taking loss reduction measures in advance of a disaster by giving them lower premiums while at the same time providing these same policyholders with compensation should they suffer losses from the insured event. In theory insurers could refuse to provide coverage against certain events unless the prospective policyholder undertook certain protective measures to lower the potential osses from the risk in question. Although this was common practice with respect to fire coverage in the 19 th century, insurers have been reluctant to do deny coverage on these grounds today.

This paper examines the impact the role that insurance and other policy tools can play in encouraging property owners to take steps to reduce losses from natural hazards such as earthquakes, floods and hurricanes and the impact that these measures will have on the solvency of insurers Three basic questions will be addressed in this regard:

1. What are the necessary and sufficient conditions for property owners to want to adopt cost-effective risk mitigation measures (RMM)s?
   
2. What impact will mitigation measures have on the profitability and insolvency of insurers and their willingness to pass the expected reduction in losses to property owners?
   
3. What is the appropriate role of building codes, third party inspections and enforcement mechanisms in encouraging the adoption of mitigation measures on property?
   

The next section of the paper focuses on the demand side by developing a simple model for determining when property owners should adopt cost-effective measures and provides empirical evidence as to why most individuals do not utilize this model. Section III turns to the supply side and investigates under what conditions insurers will want to promote mitigation through premium reductions. It also explores the linkage between mitigation and insurers’ need for financial protection through reinsurance and/or capital market instruments that have recently been introduced. The importance of building codes as a necessary means of enforcing mitigation in a hazard management program is examined in Section IV. The concluding section proposes a plan of research for evaluating the importance of insurance coupled with mitigation and other policy tools for reducing future disaster losses.

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