When the government has to fix everything once again

Natural catastrophes like Sandy are enough of a peril without the public sector increasing the risk by making the wrong insurance commitments.
A car drives through a flooded residential area at the U.S. coast after hurricane Sandy./ Credits: Reuters
Clement B. Booth is a member of the Board of Management of Allianz SE. Clement B. Booth is a member of the Board of Management of Allianz SE. Natural catastrophes relentlessly carve a trail of destruction through developed areas, claim lives, and strip survivors of their livelihoods. The destruction along the U.S. coast caused by superstorm Sandy is only the most recent example from a long line of devastating events. More than 100 fatalities and initial estimates of economic losses totaling up to 50 billion dollars leave no doubt: the potential damage that natural catastrophes can cause has taken on huge new proportions.

Settlement patterns such as those along the U.S. coastline play a key role in explaining why the damage caused by these natural catastrophes is so immense. More than half of U.S. citizens now live within 50 miles of the coast, in areas that are at increased risk.

Construction work is continuing unabated on coastlines and rivers using construction methods that virtually ignore the increasing risk. Protective measures initiated by the state are few and far between. The public help provided in the aftermath of weather-induced catastrophes is also sending out the wrong signals. It could turn into a nightmare sooner rather than later.
In order to ensure that this does not happen, it is important that insurance can still be obtained in the private sector even in regions at increased risk like these. This includes the use of catastrophe models that capture the momentum of future claims developments.

Insurers rely on these to calculate rates that will be commensurate with the risk in the future too. Insurers will have to pass more of the risk on to the capital market. Catastrophe bonds (or "cat bonds") are one of the main tools used to spread the financial risks of natural catastrophes more widely and, as a result, enable them to still be insured by the private sector.

As a result, governments should not let themselves be drawn into more insurance commitments in high-risk areas. The policies tend to be subsidized, meaning that the premium is not in line with the risk. Usually, the customer does not share in the risk either. If they did, it would make them more cautious.
This results in false allocations that are extremely significant from an economic perspective. Insurance rates that are kept artificially low encourage people to not behave in a risk-adverse manner, and indeed to actually take risks. By way of example, they continue to build, without hesitation, in areas that are threatened by natural catastrophes. Ultimately, they rely on the government; it will foot the bill for any damage that is under-insured.

The public sector and insurers have to find new forms of partnership, especially when it comes to reinsurance cover. This cover should, however, only be offered by the government above a certain loss amount and only if the risk of major losses cannot be distributed in any other manner.

Private reinsurance companies also have to be involved and premiums paid that match the given risks. In this sort of setup, public reinsurance programs would help to ensure that insurance cover can be provided for natural catastrophes without directly interfering with the free market.

When losses are insurable there is no need for costly assistance after natural catastrophes strike. Sandy gave us yet another sad reminder of that.

 (Originally published in Financial Times Deutschland on November 19, 2012)

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