Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [139]
Take-Aways from These Experiences
These experiences over the years have expanded my understanding of human behavior with respect to uncertainty and risk. They have also led me to think about ways in which individuals’ and firms’ decision-making processes can be improved. In my view, this can be accomplished by developing a set of guiding principles that serve as focal points for designing programs and policies aimed at enhancing both individual and social welfare.
GUIDING PRINCIPLES FOR MANAGING SOCIETAL RISK PROBLEMS
During the past few years, a group of us at the Wharton Risk Center have developed a set of guiding principles for designing strategies to deal with low-probability, high-consequence events.
Three Principles for Encouraging Investment in Protective Measures
In our recently published book, At War with the Weather (written with our colleagues Neil Doherty, Martin Grace, Robert Klein and Mark Pauly), Erwann Michel-Kerjan and I suggest strategies for reducing losses from natural disasters. 1 Given our interest in utilizing insurance to encourage investment in risk-reducing measures we formulated the following two insurance principles, which address the issue of setting insurance premiums that reflect risks while trying to deal with issues of equity and affordability.
Insurance Principle 1: Premiums should reflect risk. That is, 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. Risk-based premiums should also reflect the cost of capital that insurers need to integrate into their pricing to ensure adequate return to their investors.
Insurance Principle 2: Equity and affordability issues need to be dealt with. In particular, 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.
Note that Insurance Principle 2 applies only to individuals who currently reside in a hazard-prone area. Those who require special treatment could be given some type of voucher, such as an insurance stamp for the explicit purpose of purchasing coverage against the risks from natural disasters. This concept is similar to the food stamp program that assists low-income families in the United States. Others who decide to move to the area in the future should be charged premiums that reflect the risk. Note, too, that providing newcomers with financial assistance from public sources to purchase insurance would encourage development in hazard-prone areas and exacerbate the potential for catastrophic losses from future disasters.
Inducing individuals to invest in risk-reducing measures requires an understanding of their decision processes with respect to making tradeoffs between the costs of taking this action and the expected benefits from reducing future losses should an untoward event occur. We thus include the following behavioral principle:
Myopic Behavior: When designing strategies for encouraging investment in protective measures one needs to recognize that individuals focus on short-term horizons in their decision processes. Indeed, there is considerable empirical evidence suggesting that when individuals and businesses plan for the future, they do not fully weigh the long-term benefits of investing in loss reduction measures. They have even less interest in investing in protective measures when there is only a small chance of reaping financial returns from having taken such action. The up-front costs of these protective measures loom disproportionately high relative to