Protecting against disaster risks: Why insurance and prevention may be complements

W J Wouter Botzen,Erwann Michel-Kerjan,Howard Kunreuther

doi:10.1007/s11166-019-09312-6

Abstract

We examine mechanisms as to why insurance and individual risk reduction activities are complements instead of substitutes. We use data on flood risk reduction activities and flood insurance purchases by surveying more than 1000 homeowners in New York City after they experienced Hurricane Sandy. Insurance is a complement to loss reduction measures undertaken well before the threat of suffering a loss, which is the opposite of a moral hazard effect of insurance coverage. In contrast, insurance acts as a substitute for emergency preparedness measures that can be taken when a loss is imminent, which implies that financial incentives or regulations are needed to encourage insured people to take these measures. We find that mechanisms leading to preferred risk selection are related to past flood damage and a crowding out effect of federal disaster assistance as well as behavioral motivations to reduce risk.

Highlights

Seminal theoretical papers highlight that insurance and risk reducing protective measures are substitutes (Ehrlich and Becker 1972; Arnott and Stiglitz 1988)
If insurance and risk reduction measures are substitutes one would expect that individuals with flood insurance coverage would undertake fewer risk reduction measures than individuals without flood insurance, because Federal Emergency Management Agency (FEMA) does not give premium discounts for policyholders who adopt such measures
The results of simple probit models (Eqs. 1 and 2) of relations with insurance purchases and risk reduction measures are shown in Electronic Supplementary Material (ESM) Table 2

Summary

Introduction

Seminal theoretical papers highlight that insurance and risk reducing protective measures are substitutes (Ehrlich and Becker 1972; Arnott and Stiglitz 1988). Insurance would discourage individuals from investing in loss reduction measures unless they are rewarded with a reduction in their premiums This behavior may lead to moral hazard when individuals take fewer risk-reducing measures after purchasing insurance, and to adverse selection when it is mainly individuals with a high risk who demand insurance but the insurer cannot distinguish between high and low risk individuals. Recent work over the past decade reveals that some insured individuals may view additional measures to limit risk ex ante as complements to insurance and implement more of these measures than the uninsured do, for example, because they are (highly) risk averse This behavior can lead to both insurance purchases and investments in risk reduction; this has been termed advantageous selection (de Meza and Webb 2001) or preferred risk selection (Finkelstein and McGarry 2006). The datasets used in these studies do not allow for examining the exact behavioral mechanisms behind the observed preferred risk selection, though

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