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Risk-Management Strategies

In developing effective risk-management strategies for reducing losses from natural and unnatural disasters, leaders of public agencies and private and nonprofit organizations will want to appreciate the findings of risk-assessment studies and the factors that influence risk perception and choice. Drawing on that research, we propose six areas for improving risk management:

  1. Risk forecasting. The broadening of disaster losses to include longer-term impacts and indirect costs has made forecasting more complex. Improvement in the precision of these forecasts is critical for both averting disasters and minimizing their impacts. For example, more detailed weather forecasts of the path and severity of a tropical storm can be key to wise evacuation decisions and avoiding unnecessary flight. So, too, would be better data on the systemic risks that little regulated but highly leveraged financial products can invisibly create.
  2. Communicating risk information. Because people generally dismiss low-probability events by assuming that they will not personally experience such events, expanding the time frame over which the likelihood of an extreme event is presented can garner more attention. If a company is considering flood-protection insurance for the 25-year life of a production facility, for example, managers are more likely to take the risk seriously if a 1-in-100-year flood is presented as having a greater than 1-in-5 chance of occurring during a 25-year period rather than a 1-in-100 chance during the coming year.7
  3. Economic incentives. Both positive and negative economic incentives encourage individuals to take protective measures. But here again, the way people process information on the costs and benefits of reducing the risk can play an important role in their decision on whether to adopt the measures.

    What would be the effectiveness, of say, a policy of reducing homeowners' insurance premiums for homeowners who undertake loss-reduction measures along the Mississippi River, or a policy of incentivizing villagers in Bangladesh to avoid migrating into flood-prone areas? Given that people think only about the potential benefits of such measures over the next year or two, not the next decade or two, they may not view these measures as financially attractive if there is a significant up-front cost. Had they considered a longer time period when evaluating the protective measure, the costs may well have been viewed as worthwhile.

    Fines coupled with specific regulations or building standards can also be used to encourage protective measures, but they, too, must be coupled with measures that ensure a high likelihood that negligent individuals will be penalized. If people perceive the probability of detection to be low or the cost of noncompliance as modest, they may conclude that it does not pay to take protective action.

  4. Private-public partnerships. Because the public, private, and nonprofit sectors share in the costs and benefits of preparing for disasters, furthering collaboration among them ahead of time can be vital for building effective leadership and strategies for facing disasters. Public-private partnerships should thus be created before they are needed. Insurance premium reductions should be given to those who invest in risk-reducing measures to reflect the lower losses from a future disaster. Building codes may be desirable when property owners would otherwise not adopt cost-effective mitigation measures because they either misperceive the benefits from them or underestimate the probability of a disaster occurring. This might have been a factor in the widespread loss of life in the Pakistan earthquake, magnitude 7.6, in October 2005, which killed more than 70,000 inhabitants, many buried under poorly constructed schools and homes. So, too, with investment codes: Had there been stronger regulation on derivative products, such as insurance on subprime mortgage securities, investment bankers would have been less likely to contribute to the systemic risks that rocked the world's economy in 2008.
  5. Reinsurance and other financial instruments. The shortage of reinsurance—insurance for insurance companies that allows them to offer greater protection to policyholders than the assets of the insurers would ordinarily permit—following Hurricane Andrew's damage to Florida in 1992 and the Northridge, California, earthquake in 1994, led U.S. financial institutions to market new instruments for providing protection against mega disasters. Known as catastrophe bonds, these were offered at high interest rates to overcome investors' qualms about the likelihood of losing their principal should a major disaster occur. The market for such bonds grew rapidly in the 2000s, with $2.7 billion in new and renewed catastrophe bond issues in 2008.8

    In anticipating exceptionally massive disasters, it may be necessary for the government to provide insurance protection to pay for losses that the private sector is not willing to cover. Florida established the Florida Hurricane Catastrophe Fund following Hurricane Andrew in 1992, for instance, when a number of insurers reported that they could no longer include windstorm damage as part of their standard homeowner coverage. After the Northridge earthquake in 1994, insurers backed off from earthquake coverage, and the state formed the California Earthquake Authority to provide homeowners with earthquake coverage.

    In providing coverage against large-scale catastrophes, it is important that premiums closely reflect risk. Equity and affordability considerations may justify some type of subsidy for those deserving special treatment, such as low-income residents. This subsidy should not be in the form of artificially low premiums, but should preferably take the form of a grant from the public sector. For example, if a risk-based flood insurance premium of $2,000 is considered to be unaffordable to a household in a high hazard area, the family could be provided an insurance voucher to buy a policy in much the way that food stamps are provided to those in need of household staples. If the family reduces its risks by investing in a mitigation measure such as elevating its house, it receives a premium discount.

  6. Resiliency and sustainability. The resilience of a community after a disaster and its sustainability over the long run have important ramifications for estimating the extent of hazard damage and developing risk management policies. Resilience refers to the ability of a business, household, or community to cushion potential losses through inherent or explicit adaptive behavior in the aftermath of a disaster and through a learning process in anticipation of a future one. Businesses may have alternative power generators in place, households may ration their water supply, and communities may open shelters for those forced to evacuate their homes.9

    Resilience also includes the ability to use price signals, such as premium discounts for investing in mitigation measures, to encourage appropriate actions before and after a disaster. And it entails the ability of community, company, and other leaders to remain focused on recovery even as they may be at risk or personally suffering in the immediate aftermath of a disaster. In the wake of Hurricane Katrina, for example, the president and senior administrators of Tulane University in New Orleans were marooned on campus for four days without food, water, power, or regular contact with the outside world. Despite their severe personal circumstances, they plunged into the arduous work of staff rescue and university restoration. After "being stranded for four days," recalled the president, Scott S. Cowen, "I realized that I could either focus on the darkness, or I could try to see beyond it and focus on the light. I chose the latter." In reflecting on the experience and its personal hardships, he said, it "has taught us as an institution to stay focused on our mission and goals even in the face of financial and physical crisis. It has taught us the responsibility that comes with our role as the largest employer in our home city—a responsibility to help rebuild our city and heal its people."10

    Advanced economies are becoming increasingly interlinked and dependent on sophisticated, vulnerable systems—especially infrastructural services such as highways, electric supply, and the Internet—for which substitution is difficult and thus resilience more critical. When the west coast of Japan was hit by a minor earthquake in July 2007, a supplier of auto piston rings was forced to close, and because Japanese auto making was built on a just-in-time inventory system, the supplier's closing forced Toyota and Honda to suspend production.11 Researchers have a role to play here in identifying ways to improve resilience in a more interdependent and interconnected world, such as the establishment of information clearinghouses for suppliers without customers and for customers without suppliers.

    Sustainability refers to the long-run viability and self-sufficiency of the community in the face of hazard threats. The more general definition of the term emanates from economic development and stipulates that decisions taken today should not diminish productive capacity—broadly defined to include natural resources and the environment of a community—in the future. In the case of natural hazards, sustainability implies that land-use decisions made today—such as forest management or strip mining—should not place the community in greater jeopardy in the future or make it more dependent on external assistance to survive. Sustainability emphasizes the importance of integrating mitigation measures into overall economic development policy and eliminating practices that increase a community's exposure to hazards.12

    Many developing countries are especially vulnerable to disasters because of low-quality structures, poor land use, inadequate emergency response, environmental degradation, and limited funds. Climate change may especially increase the likelihood of disasters in these areas, such as flooding in low-lying Bangladesh. Developing countries often lack the infrastructure and institutions that developed countries take for granted in formulating risk management strategies. And in areas where poverty is extreme, the indirect effects of disaster may include a surge in endemic disease, widespread starvation, and human-rights violations. In the wake of the Mozambique flooding in 2000, for instance, families irretrievably lost birth certificates, marriage documents, and land titles because few personal records had been backed up or computerized.

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