On Mandatory Disaster Insurance

December 27, 2009

In the current state of national and state policy, it is expected that whenever
a natural disaster occurs, the government will step in to alleviate the massive
losses borne by property owners and rms. In most cases, aid doled out to
make up for the dierence between the actual damage and the however much
the property was insured for. Unfortunately, it is becoming increasingly com-
mon for property owners to insure for less than the total value of their holdings,
if at all. This choice to shy away from insurance as a method for alleviating will
be unnecessarily costly for taxpayers in the long run, and imposes a horrendous
opportunity cost due to the loss of eciency. It is because of this that the
mandating of comprehensive disaster insurance is a viable approach to tackling
the waste of the state and federal funds. This mandate, although not without
its own intrinsic drawbacks, will `weed out' one of the many sources of ine-
ciency that the state suers from and is of course trying to cut back upon. It
must be said from the start that I support such a policy as outlined by Howard
Kunreuther and Mark Pauly in the their paper entitled Rules Rather Than Dis-
cretion: Lessons from Hurricane Katrina, but only conditionally. The plan as
outlined is feasible, but there must be concessions and changes made to t the
unique needs and qualities of the State of Illinois and its inhabitants. The basis
of the Kunreuther and Pauly's proposal lies in two assumptions. Firstly, that
private insurance is empirically superior to public assistance, including the cost,
the amount of payout, the rapidity of action and sheer eciency (Kunreuther
and Pauly, 11). The authors feel that public assistance from either branch of
government will be slow, unfocused and subject to political inuences (11). The
second assumption made is that the vast majority of homeowners simply cannot
make a rational assessment of the risks they face and construct a method of deal
with the said risk (8). While this idea is anathema to the writings of other policy
analysts, such as Thomas Schelling, who wrote that all actors, rich or poor, know
how to maximize the utility of their money better than any outside actor can
dictate (Schelling, 14), Kunreuther and Pauly provide a comprehensive argu-
ment for why that is not the case in this specic instance. Their reasoning boils
down to  families only choose to pay to reduce their risk if their perceived prob-
ability of a [catastrophic event] is greater than their threshold level of concern
(Kunreuther and Pauly, 12), or concisely, families only pay for security when
they feel there is an actual threat, regardless of what is factual. Examples of this
theory, along with other anecdotes of homeowner ineptness dot the pair's paper,

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but idea what they are aiming to convey for is that Joe Sixpack has no real grasp
on the principles of basic probability (14) or economics (13). In order to combat
the ineciencies incurred by these assumptions, Kunreuther and Pauly suggest
imposing a mandatory comprehensive disaster insurance for all homeowners.
Reasons, they claim, for supporting such a policy include: [1]widespread imple-
mentation, even with subsidies to insurance companies from the government,
will be cheaper than public assistance (18), [2] a larger pool of diverse insurees
lowers the risk borne by insurance rm, allowing for lower premiums (19), and
nally [3] reduces ambiguity and confusion on the part of the insuree (20). As
with any policy, there will be disadvantages, some more signicant than others.
Since the subjects of this policy are American homeowners, the mostly glaring
issue with the proposed policy is the restriction of freedom, and how that may
be received by citizens both within and without Illinois. For sure, the reaction
of the public to such a restrictive policy will color the enthusiasm with which
politicians and lawmakers champion the measure. Another troublesome issue
with the pair's proposal is the lack of an eective punishment for those choos-
ing not to follow the mandate. The authors themselves say that  large scale
losses from disasters are a driving force with respect to the actual provision of
government relief  (11). At this time, it should so be stated that I dispute, or
at the very least disagree with Kunreuther's claim that  decision makers do not
report that they anticipate receiving any federal aid following a disaster (10).
With the prevalence of news media more than thirty years after that study was
done, one can be nearly sure that the layperson knows that the government will
always come to the rescue, albeit with some delay. Directly tied with my last
point is the looming issue of the cost of a haphazard implementation of the plan.
As outlined above, the plan lacks any means of enforcement and the government
will be prompted to bailout abstainers. It is very possible that cost of bailing
added to the cost of implementing the initiative could very well be greater than
the cost in the initial state. Again, just as with every policy, there advantages,
both intended and unintentional. As it would be a waste of time and space, the
benets/advantages mentioned before will not be reiterated here. Perhaps the
most monetarily signicant advantage lies in that this mandate would provide
an incentive for insurance companies to enter the market [Recall that the much
larger pool generated by the mandate will lower the variance of the risk that
the insurance rm is exposed to (20)]. With insurance rms being attracted to
the market for comprehensive disaster insurance, competition will surely ensue,
and with that, lower rate. These rates will be much closer to an actuarially
fair rate than there would be otherwise. Lower prices from competition means
that the government would have to subsidize the insurance companies less in
order to drive rates down. However, in actuality, the insurance market lends
itself to oligopolies, due to the massive economies of scale required to vary risk
enough to make the industry protable for the rm. The rate will be higher
than if the rms engaged in perfect competition, but lower than if there was
a single rm. Because of this, eciency is gained due to competition. After a
careful analysis, I can say that I recommend the initiative, although with nu-
merous conditions. I feel that there can only be success if the following two

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actions can be taken. Firstly, the State should strive for 100 percent participa-
tion by whatever means they have at their disposal. Whether they be carrots or
sticks, that is not for me to recommend, nor does it matter, as long as the goal
is reached. The perils of insucient participation were outlined above, but is
should be reiterated that a failure to include an amount of homeowners beyond
the threshold of feasibility will result in a situation worse and more inecient
than the status quo. I feel it is necessary that I make explicit my desire for
the state to develop a method of punishment for non-participation. Secondly,
competition among insurance rms should be fostered as much as possible. The
greater the amount of rms participating in the market, the closer to the fair
rate the actual rate will be. The primary question that I feel servants of the
State must ask themselves before undertaking this initiative is: are you willing
to expend the amount of political capital necessary in order to push through
what will most likely be a very unpopular idea? If not, then the servants of the
State should just move on the next idea aimed at increasing eciency. Before
ending this brief, I feel it necessary to comment on the unique situation that
the State of Illinois currently enjoys. The State's geographic location spares
the state from many of the extremes that currently plague regions to the north,
south, west, and southwest, including but not limited to `tornado season', fre-
quent ice and snow storms, drought, and other events. Because of this, I ask
the state to perform a cost-benet analysis in order to consider the possibility
that this venture might not be protable. In practice, I do not believe that this
will have a substantial eect, as the insurance premiums will reect the realistic
risk, but it should be done anyway for thoroughness' sake.

References
[1] Kunreuther, Howard and Mark Pauly.  Rules Rather Than
Discretion: Lessons from Hurricane Katrina. NBER Work-
ing Paper Series. National Bureau of Economic Research. 2006.
<http://www.nber.org/papers/w12503>.

[2] Schelling, Thomas. Choice and Consequence. Cambridge: Harvard Univer-

sity Press, 1984.