Flood Insurance
After Katrina, many New Orleans residents whose homes were destroyed by flood damage had no flood insurance and thus lost their largest asset. They had no flood insurance because it simply wasn't available. Why not?
My guess is that it's a form of the adverse selection problem. Insurance companies usually offer insurance to a large number of people whose likelihood of sustaining a particular kind of loss is small and not necessarily concurrent. So, for example, car insurance companies sell insurance to a large number of drivers, each one of whom has a small probability of getting in an accident. Moreover, there's no reason to believe that all drivers will have an accident on the same day (forcing the insurance company to make an enormous payout). Small fluctuations in claim payouts don't bother large, risk-neutral insurance companies. The insurance company can then charge an appropriate premium by calculating the average number of accidents that will occur each day/month/year. (The government helps out car insurance companies--perhaps unintentionally--by requiring all drivers to buy car insurance so that the insurance companies aren't stuck insuring only the worst drivers.)
But insurance companies have little incentive to offer flood insurance to people who live in places like New Orleans, 45% of which is below sea level, where if a flood happens, everyone is affected. Insurance companies may be risk neutral over small fluctuations in claims, but not over extreme fluctuations: they can't pay out claims to everyone simultaneously. So they just don't offer flood insurance.
Adverse selection is a market failure that even neoclassical economists recognize. It seems to me that one way to solve this problem is to provide it publicly. Another way is to require everyone to purchase flood insurance (and probably require insurance companies to have a certain percentage of customers who live in a flood plain)--that way, people who live in low-risk areas subsidize those who live in high-risk areas.
Of course, we probably don't want to subsidize flood insurance too much; after all, we don't want to give people incentives to live in areas likely to be plagued by natural disasters. (We wouldn't want to subsidize homebuilding on the slope of a volcano, would we?)
On the other hand, incentive arguments like this one are arguments about efficiency; they assume a level of equality (or perhaps fairness is a more apt word) among individuals subject to those incentives. So, for example, getting rid of welfare might encourage more people to go to work, but we keep welfare because we believe that not everyone has an equal opportunity to get a job. In other words, efficiency ain't all. So if we believe that residents of New Orleans don't have perfect flexibility to live anywhere in the country, we might be less concerned about the incentives they face.
Thoughts?
My guess is that it's a form of the adverse selection problem. Insurance companies usually offer insurance to a large number of people whose likelihood of sustaining a particular kind of loss is small and not necessarily concurrent. So, for example, car insurance companies sell insurance to a large number of drivers, each one of whom has a small probability of getting in an accident. Moreover, there's no reason to believe that all drivers will have an accident on the same day (forcing the insurance company to make an enormous payout). Small fluctuations in claim payouts don't bother large, risk-neutral insurance companies. The insurance company can then charge an appropriate premium by calculating the average number of accidents that will occur each day/month/year. (The government helps out car insurance companies--perhaps unintentionally--by requiring all drivers to buy car insurance so that the insurance companies aren't stuck insuring only the worst drivers.)
But insurance companies have little incentive to offer flood insurance to people who live in places like New Orleans, 45% of which is below sea level, where if a flood happens, everyone is affected. Insurance companies may be risk neutral over small fluctuations in claims, but not over extreme fluctuations: they can't pay out claims to everyone simultaneously. So they just don't offer flood insurance.
Adverse selection is a market failure that even neoclassical economists recognize. It seems to me that one way to solve this problem is to provide it publicly. Another way is to require everyone to purchase flood insurance (and probably require insurance companies to have a certain percentage of customers who live in a flood plain)--that way, people who live in low-risk areas subsidize those who live in high-risk areas.
Of course, we probably don't want to subsidize flood insurance too much; after all, we don't want to give people incentives to live in areas likely to be plagued by natural disasters. (We wouldn't want to subsidize homebuilding on the slope of a volcano, would we?)
On the other hand, incentive arguments like this one are arguments about efficiency; they assume a level of equality (or perhaps fairness is a more apt word) among individuals subject to those incentives. So, for example, getting rid of welfare might encourage more people to go to work, but we keep welfare because we believe that not everyone has an equal opportunity to get a job. In other words, efficiency ain't all. So if we believe that residents of New Orleans don't have perfect flexibility to live anywhere in the country, we might be less concerned about the incentives they face.
Thoughts?
posted by Garrett at 4:05 PM
1 Comments:
There's actually a fairly simple solution to this problem. The company selling flood insurance buys its own insurance from other companies. In the event of a flood, it has to pay out a large amount, but it also collects a smaller amount from 10-20 other companies. If the amonut is still to big for even the smaller players, then they too could buy insurance.
The two problems for this solution are first, you need enough insurance companies to be able to spread around the risk; and second, ye ol' collective action problem. I have to sell all of Bayou La Batre flood insurance before I can start buying up my own insurance.
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