Disaster Risk, Moral Hazard, and Public Policy

Abstract

Natural disasters pose a significant and rapidly growing burden to society, causing over a million deaths and worldwide economic losses in the trillions of dollars in the last twenty years. Concerned over the extent to which their populations are exposed to disaster risk, policymakers in disaster-prone countries strive to increase the penetration of disaster insurance from its relatively low current level and wish to arrest the increasing share of public liability for private losses arising from rising public expenditures on disaster recovery. Although evidence regarding disaster risk and insurance suggests that individuals respond to their economic incentives when deciding on the degree to which to expose their property and other to risk from a recurrent disaster, potential inefficiencies in private insurance markets can distort these individual incentives and result in underinsurance and excessive exposure. Current research into whether such apparent market inefficiencies are primarily attributed to the behavior of private market participants or to the adverse incentives arising from current programs of disaster aid, regulation and other public policies is of fundamental importance to attaining these policy objectives. This article critically assesses the current state of mainstream economic and political research into disasters, public policy, and household behavior toward disaster risk. Findings of the most important and influential empirical and theoretical studies over the last 30 years are described, as well as limits on the robustness and interpretation of these findings arising from the characteristics of economic data on disasters and potential bias in measuring the determinants of disaster insurance coverage. Also discussed are both theoretical and empirical evidence that moral hazard on the part of households, insurance firms, and elected officials results in misallocations of private coverage; and it is demonstrated that, exactly contrary to the objectives of public policy, current programs of disaster aid in the presence of moral hazard create incentives for households to minimize, rather than maximize, market coverage of their exposure to disaster risk. The conclusion presents and proves a proposition, original to this article, that any compensatory public aid program is necessarily a source of economic inefficiency and, conditional on net losses, decreases economic welfare.