Risk Adviser
Overcoming Biases

• Howard Kunreuther
• June 2019
• 

While flood insurance today is underwritten primarily by the National Flood Insurance Program (NFIP), a number of small private insurers now provide this coverage in Florida and other coastal states. Some of these insurers offer flood coverage as part of their standard homeowners coverage. These policies have been shown to be attractive to property owners, and if more widely offered, could lead to greater take-up in flood coverage than we currently have in the United States. In the future, insurers might also want to consider including earthquake protection as part of a standard homeowners policy.

To improve take-up of disaster insurance, it is important to understand why homeowners do not want to purchase insurance. Specifically, when making their choices with respect to uncertain and risky adverse events, individuals tend to be myopic, optimistic and to exhibit inertia.

My colleague Robert Meyer and I propose a behavioral risk audit that addresses these cognitive biases. The following examples, as discussed in our book The Ostrich Paradox: Why We Underprepare for Disasters, show how private insurers could encourage property owners to purchase insurance at risk-based premiums and invest in mitigation measures:

Dealing With Myopia: Homeowners may not want to incur the high upfront costs of making their house safer because they view the expenditure as too high relative to the short-term benefit. But, homeowners could be encouraged to undertake loss reduction measures if they were offered a long-term home improvement loan tied to the mortgage. The mitigation measures would result in a reduction in their insurance premiums due to lower expected claims, and if the mitigation measures are cost-effective, the annual premium reduction should be greater than the annual loan cost.

Dealing With Optimism: Individuals generally aren't concerned about the likelihood of flood-related damage. So, instead of presenting the probability of a flood or hurricane as a 1 in 100 annual chance, present the probability as a greater than 1 in 5 chance of at least one event occurring in the next 25 years. These two probabilities are mathematically the same, but the latter may spur property owners to pay attention.

Dealing With Inertia: Insurers could offer a homeowners policy that includes flood protection, with the opportunity to opt out of this added coverage. There is significant empirical evidence that individuals are likely to maintain the default option where they would not have purchased flood coverage as a separate policy. This strategy also would educate property owners who mistakenly believe they are protected against flood in their current homeowners policy.

For the private market to offer flood insurance, state insurance regulators must allow insurers to charge risk-based premiums and ensure insurers have enough surplus on hand and sufficient reinsurance to avoid insolvency.

The NFIP would continue to play an important role in addressing issues of equity and fairness for households who can't afford risk-based premiums, and provide federal reinsurance against catastrophic losses that aren't protected through private risk-transfer instruments. The NFIP also can assist in reducing future losses by requiring communities to adopt a well-enforced flood plain management strategy as a condition for joining the program.