Disaster Economics: Risk Taking and Risk Aversion

We've all heard the pleas from people who have lost everything in a disaster. Most of these cries come from those who went into the disaster unprepared, uninsured and, often, very poor. I mean, when was the last news report you saw about some family whose expensive but insured beach house was washed away and who had to pay a deductible in order to rebuild? No, as the late Houston "consumer reported" Marvin Zindler used to say, "It's hell to be poor!"

Well, it's with a little nod to "the poor" that I refer you to these lessons from the Foundation for Teaching Economics on the Economics of Disasters :

This set of lessons looks at a variety of natural disasters – from the Black Death of the Middle Ages to Hurricane Katrina in our too-recent memory, to fears of avian flu pandemics that haunt the future – through the lens of economic analysis. The contexts were chosen to facilitate the teaching of economic reasoning principles not only in economics courses, but also in history and the other social studies disciplines. Each lesson addresses a question that reflects people’s compassionate reaction to news of disaster and develops one or two key tools of economic analysis in answering that question. Case studies of past disasters provide real-world illustrations.

While all the lessons are good starting points for thinking upon such matters, Lesson 3: When Disaster Strikes, What Can Government Do? is particularly interesting:

Costs of government policies sometimes exceed benefits. This may occur because of incentives facing voters, government officials, and government employees, because of actions by special interest groups that can impose costs on the general public, or because social goals other than economic efficiency are being pursued.
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1. The challenge for government in disaster response and relief is determining when it should take a “hands-on” role and become actively involved, and when the goal of recovery is best-served by stepping back in favor of other institutions better suited to the task.

- The rule of rational choice directs decision-makers to choose the alternative with the greatest excess of benefits over costs. This rule applies not only to private decision-makers but also to government decision-makers: Governments should undertake those activities for which the expected benefits outweigh the expected costs.
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Government ineptitude during natural disasters may be good fodder for comedians and radio talk-show hosts, but the pertinent lesson is more about the need to adjust our expectations than the need for “better” government. Throughout the 20th century, we demanded that government take on more and more responsibility for citizens’ well-being with relatively little consideration of whether or not political institutions are inherently capable of meeting the lengthening list of expectations. The tendency to think that big problems – like natural catastrophes – can best be dealt with by big institutions, like government, is understandable. Persisting in that belief in the face of continuing evidence to the contrary is not. If we expect governments to perform functions for which they do not have the necessary knowledge, incentives, and mechanisms, we not only invite disappointment, but risk undermining their ability to perform the vital tasks for which they were created: restoring civil order, maintaining the rule of law, and providing those few public goods necessary for other economic and social institutions to operate.

If you download the "EOD Lesson 3 Outline" from the page, you'll find a nice discussion of the concept of "Other People's Money" in the disaster context in one of the Appendix 1:

All such programs put some people in a position to decide what is good for other people. The effect is to instill in the one group a feeling of almost God-like power; in the other, a feeling of childlike dependence. The capacity of the beneficiaries for independence, for making their own decision, atrophies through disuse. In addition to the waste of money, in addition to the failure to achieve the intended objectives, the end result is to rot the moral fabric that holds a decent society together.

One of the questions we all should be asking is, "Does government intervention make people less risk averse or more?"

For example, we all know that there are government programs that decrease the insurance costs of people who build big beach house on barrier islands. Would these houses get built if the owners had to bear the true cost of paying for their own insurance - if that insurance were even available? North Carolina, for example, has the Coastal Property Insurance Pool:

The Coastal Property Insurance Pool offers commercial, homeowner and dwelling windstorm coverage and homeowner coverage to any person having an insurable interest in property located in the 18 eligible coastal counties of North Carolina. The Coastal Property Insurance Pool also offers commercial fire and dwelling fire in a more limited area defined as the beach area (comprised of North Carolina south and east of the inland waterway, including the area known as the Outer Banks).

The Coastal Property Insurance Pool is defined by the North Carolina General Statutes as the "Market of Last Resort"; therefore, it is highly recommended that property owners attempt to obtain insurance in the standard market. Your Insurance Agent may assist you in placing coverage either in the standard market or in the Coastal Property Insurance Pool.

Before this CPIP plan, there was a potentially huge state liability (see here), which was addressed in part. See here. The new plan still leaves inland property owners subsidizing beach front property insurance - but to a much lesser extent:

Before the new law, North Carolina's plan required property insurers to help play claims in the event that the plan's coffers couldn't cover the costs of a huge storm. But there was no mechanism to allow insurers to pass the costs to customers. The unlimited liability drove one major insurer out in 2008, and officials feared others would follow.

Now, if the plan's coffers are emptied by a big storm, the plan would first call on the insurance industry to contribute as much as $1 billion. If that still isn't enough, policyholders from across the state would face surcharges on their property-coverage bills of as much as 10%.

As you might gather, not everyone is happy with this level of unknown risk. On the other hand, tourism, especially people renting beach houses for vacations on the coast is a big part of the NC economy - which is why the law encourages beach house building. It might seem fair, however, to add a tax to each beach rentals that would go into a fund helping to cover disaster costs before tagging the other homeowners in the state.

If you are poor and have little? Does that make you more likely to take on more risk to protect what you have? Is there an explanation in this question for people who refuse to evacuate from the potential impact area of a hurricane so that they can defend their few possessions from pre or post storm looters? One paper discusses this briefly here at p 5:

As to the impact of natural disasters on risk attitudes, Cameron and Shah (2012) conduct incentivized risk game experiments in Indonesia and find that people who recently lived though natural disasters such as floods or earthquakes exhibit higher risk aversion than living in otherwise like villages. They also interestingly show that the impact persists for many years, particularly if the disaster was severe. However, part of the documented effect is driven by income losses.

The Cameron and Shah paper can be found here. An interesting effect on Katrina evacuees shows that initially they may be more willing to take risks. See abstract of Risk loving after the storm: A Bayesian-Network study of Hurricane Katrina evacuees:

We investigate risk preferences of a sample of hurricane Katrina evacuees shortly after they were evacuated and transported to Houston, and another sample from the same population taken a year later. We also consider a third sample of resident Houstonians with demographics similar to the Katrina evacuees. Conventional statistical methods fail to explain a strong risk-loving bias in the first Katrina-evacuees sample. We utilize Bayesian Networks to investigate all relevant conditional distributions for gamble choices, demographic variables, and responses to psychometric questionnaires. We uncover surprising results: Contrary to prior experimental evidence, we find that women in our sample were significantly more risk loving in the first Katrina sample and only mildly more risk averse in the other two samples. We find that gamble choices are best predicted by positive-emotion variables. We therefore explain the risk-loving choices of the first Katrina-evacuees sample by the detected primacy of negative-emotion variables in that sample and explain the latter by traumatic and heightened-stress experiences shortly after the hurricane.

Of course, part of the problem lies in defining what "risk aversion" is.

Can sheltering in place in the face of storm representing x% chance of harm actually be more risk averse than leaving knowing that there is much higher possibility that all your possessions will be stolen in your absence? What is the impact of having insurance in such a case? Do those insured find it easier to evacuate?

My hypothesis is that it that these "risk taking" decisions are highly economic in nature and that if governments are wondering why there is resistance in some areas to "mandatory" evacuations, much more thinking and research needs to be done along these lines.

I think Maslow's hierarchy of needs" comes into play - a disaster drops us all into the lower levels dealing with physiological needs and those safety needs:

Safety and Security needs include:

- Personal security
- Financial security
- Health and well-being
- Safety net against accidents/illness and their adverse impacts

There's a reason why Red Cross shelters offer security, lots of snacks and food, health providers and people on watch throughout the night.

But that "financial security" part? Not so much.

I remember, after one tornado,  meeting a woman whose rented house had a tree fallen right down its middle, rendering it unfit for human occupancy. She was staying, however, because she had just bought a big screen television which she knew would disappear if she removed to a shelter. Given her evident poverty level, that television represented a substantial financial asset to her - one she was unwilling to put at risk.

Economics.

In making up your disaster plan, it is important you know what you might assume greater risks to avoid losing and figure out a way to deal with that ahead of time.