Why Do Few Homeowners Insure Against Natural Catastrophe Losses?

Insurance has been suggested as a policy instrument that can help in managing the rising economic cost of natural catastrophes. Evidence, however, shows that many homeowners do not insure their homes against natural catastrophes and tend to depend on (unreliable) disaster aid. This paper surveys the economics, insurance and psychology literature to explain why few homeowners insure against natural catastrophes. The paper covers the relevant theoretical approaches as well as the available empirical evidence and possible policy measures.

Catastrophes and insurance

This chapter explores the way financial losses associated with catastrophes can be mitigated by insurance. It covers what insurers mean by catastrophe and risk, and how computer modelling techniques have tamed the problem of quantitative estimation of many hitherto intractable extreme risks. Having assessed where these techniques work well, it explains why they can be expected to fall short in describing emerging global catastrophic risks such as threats from biotechnology. The chapter ends with some pointers to new techniques, which offer some promise in assessing such emerging risks. Catastrophic risks annually cause tens of thousands of deaths and tens of billions of dollars worth of losses. The figures available from the insurance industry (see, for instance, the Swiss Re [2007] Sigma report) show that mortality has been fairly consistent, whilst the number of recognized catastrophic events, and even more, the size of financial losses, has increased. The excessive rise in financial losses, and with this the number of recognized ‘catastrophes’, primarily comes from the increase in asset values in areas exposed to natural catastrophe. However, the figures disguise the size of losses affecting those unable to buy insurance and the relative size of losses in developing countries. For instance, Swiss Re estimated that of the estimated $46 billion losses due to catastrophe in 2006, which was a very mild year for catastrophe losses, only some $16 billion was covered by insurance. In 2005, a much heavier year for losses, Swiss Re estimated catastrophe losses at $230 billion, of which $83 billion was insured. Of the $230 billion, Swiss Re estimated that $210 billion was due to natural catastrophes and, of this, some $173 billion was due to the US hurricanes, notably Katrina ($135 billion). The huge damage from the Pakistan earthquake, though, caused relatively low losses in monetary terms (around $5 billion mostly uninsured), reflecting the low asset values in less-developed countries. In capitalist economies, insurance is the principal method of mitigating potential financial loss from external events in capitalist economies. However, in most cases, insurance does not directly mitigate the underlying causes and risks themselves, unlike, say, a flood prevention scheme.