Climate Change and the Future of Risk

The risk models that policymakers, insurers and communities rely on to predict the nature and frequency of weather-related disasters are becoming less reliable as climate change advances.  A Wharton School climate risk expert examines how we might adequately, and equitably, prepare for future disasters.

In 2012 Hurricane Sandy caused over $70 billion in damage along the U.S. Atlantic coast, leaving communities in desperate financial condition and pushing the National Flood Insurance Program, already financially stretched by a decade of severe weather-related claims, deeper into debt. In addition, coastal cities like Miami and Norfolk, Virginia now experience regular nuisance flooding, demanding huge investments in protective infrastructure to fend off rising seas.

How will the U.S. pay for infrastructure needed to minimize the impact of future disasters even as population grows in increasingly flood-prone areas?

Howard Kunreuther, Co-Director of the Risk Management and Decision Processes Center at the Wharton School at the University of Pennsylvania, discusses the challenge of balancing support for communities at risk for natural disaster with the economic and political challenges to doing so. He also highlights how human psychology can make it hard for people to grasp the likelihood of future disasters, and the role this has played in pushing the national flood insurance program to the brink of insolvency.

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Andy Stone: Good day and welcome to the Energy Policy Now Podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone. Severe weather events have become increasingly common in recent years with grave human costs and extensive damage to infrastructure. In 2012, Hurricane Sandy caused more than $70 billion worth of damage along the Atlantic coast. Coastal cities like Miami and Norfolk, Virginia now floods with predictable regularity and extended droughts of fanned fires in damaging agriculture and the West.

Today’s podcast explores the increasing uncertainty that global warming brings to the task of identifying, understanding, and preparing for natural disasters that may happen years into the future. We’ll look at how the insurance industry is grappling with a future that looks less predictably like the past, the choices policymakers face when preparing for natural disasters, and the related challenge of motivating people to protect themselves from future risk.

Our guest is Howard Kunreuther, Co-Director of the Wharton School’s Risk Management and Decision Processes Center, and an expert on the management of low probability, high consequence events related to technological and natural hazards. He is also the James G. Dinan Professor of Operations Information and Decisions at the Wharton School at the University of Pennsylvania. Howard, welcome to the podcast. 

Howard Kunreuther: Good to be with you, Andy. 

Stone: Howard is a Fellow of the American Association for the Advancement of Science and a Distinguished Fellow of the Society for Risk Analysis. He has served on the Intergovernmental Panel on Climate Change.

He is also co-author of a new book with Robert Meyer on why we under prepare for disasters. The book’s title is ‘The Ostrich Paradox’. So Howard, risk that’s often in the future and very remote is something that can be very difficult to get one’s mind around. Can you describe the specific types of risk your work is focused on? 

Kunreuther: Well, Andy, we actually started, my late colleague Paul Kleindorfer and myself, started a Wharton Risk Management and Decision Process Center 30 years ago now. And from the outset we were focusing on how we deal with low probability high consequence events. And when I say we, I mean individuals, organizations, government at the state local and federal level and globally, climate change, obviously being a topic we’ll discuss today.

And we’ve been focusing on that from the very beginning. We had the word decision processes in the title of the center, and it’s still there, because we’re interested in how these various institutions and individuals make decisions and then stressing ways that we can try to improve them when we’re dealing with extreme events. 

Stone: Now you’ve been dealing with extreme events and risk for several decades. How has the view of risk evolved over time?

Kunreuther: Well, I think the big change we’ve seen is that people are now paying attention to the fact that individuals and organizations and the country do not do a very good job of dealing with them. We’ve had more of these disasters in recent years, we’re in a new era of catastrophes. They are now center stage on a framework of organizations, decisions, making and people are now concerned. As you indicated with Hurricane Sandy, the consequences of floods and hurricanes on their own livelihood and on their own property.

Stone: So looking at risk, are you specifically looking at those major risks related to disasters, such as a Hurricane Sandy, that type of thing?

Kunreuther: We’re looking at those risks, that’s really taken a more center stage in recent years. We’re also looking at chemical accidents, at terrorism, at any low probability event that could be caused by natural forces or that could be person made.

Stone: Now much of your work is with the insurance industry. What questions specifically are you trying to answer for insurers, for government, for others?

Kunreuther: I think our big question that we’re trying to answer is why we don’t take steps before a disaster to prepare for them. As you mentioned, the book that Bob Myer and I wrote, he’s my co-director of the Risk Center just recently, on why we under prepare for disasters highlights the fact that there are just a set of biases that individuals, anyone, has in making these decisions and our interest is in understanding them. And then trying to figure out ways that we can do a better job.

And the insurance industry is a critical player in all of this because they are ones who would provide financial protection when individuals may suffer from a disaster. But they also will encourage individuals and firms to actually take measures by reducing premiums if they mitigate. So they have a dual role to play here and they can be tied in with a lot of other policy tools, which we can talk about.

Stone: Well, I want to jump to that issue right away. I mean, you’ve applied cognitive psychology and behavioral economics to understand why we don’t tend to prepare for disasters. People live in a flood zone. They know a flood is going to happen at some point, but they don’t buy insurance. Why is that?

Kunreuther: Well, I think there’s several reasons, Andy, as to why they don’t do it. The first is it’s not going to happen to me. It’s going to happen to someone else. I really don’t want to think about this. This is beyond, below my threshold level of concern. I’ve got a lot of other things to worry about and thinking about a flood, isn’t a very pleasant thought. Anyway, I’m living in an area where I’m enjoying the beach, I’m enjoying a whole set of amenities. The idea of thinking about the consequences of a hurricane is not something I prefer to think about. And we haven’t had one in a few years. And so why should I worry about that?

 And so that’s one aspect. And the second is myopia, you know, I can’t afford to take steps to make my house safer. Insurance is one step but I could elevate my house against damage from storm surge from a hurricane or flooding, and yet the cost of doing that is extraordinarily high. And I’m really only concerned about what’s going to happen in the next two or three years. And I can’t justify taking those steps, even though they would be available for the length of the life of the house. And so it’s not just a one or two year proposition when you actually make your house safer, it’s 20 or 30 years.

Stone: So the two sides to this one is buying insurance, for example, to prepare for that disaster. So you can recover. And the other is actually doing the measures that are needed now that when that disaster comes, for example, a flood associated with a hurricane, your basement doesn’t flood because your house is up on stilts.

Kunreuther: Exactly. Right. Or you flood proofed your house or you did something. Right, exactly. So, and those two things go together. If you take those steps as you’re suggesting, then your insurance premium should actually be decreased by you doing that. But if you’re not thinking about taking those steps or buying insurance, it’s out of sight out of mind, in which case, you’re not going to do anything. 

Stone: Don’t we learn from the past?

Kunreuther: We sure do, but it takes a disaster for us to learn. And that’s the real problem. It’s only after a disaster that people say, I wish I had bought insurance and sometimes they buy it and oftentimes they’ll take some steps to protect.

But in the case of insurance, they may buy and then they don’t have a disaster for the next three or four years. And they say, my premium is wasted. I’m going to cancel my policy. And that’s not what insurance is about. It’s protection. It’s not an investment. And you should celebrate the fact that you haven’t had a disaster, right? The best return on an insurance policy is no return at all. So you can say, look, I’ve been lucky. I’ve been fortunate, but that is in the way people see it.

Stone: Well, there’s an issue with flood insurance. It’s not required in this country, as I understand, in many regions, or it may be required. If it’s tied into a federal initiative…

Kunreuther: Well it is required.

Stone: Is it? Okay.

Kunreuther: It is required if you’re living in a flood hazard area and your community is part of the National Flood Insurance Program, which is a federal program. Then individuals are required to buy it. But it’s not very clear from all the data we’ve collected how many people actually have it. They may buy it initially and then cancel it and banks may not follow up. And so, as a result of that, we don’t have a lot of people in these areas who are protected, many of whom should be protected because they are required for a federally insured mortgage.

Stone: The National Flood Insurance Program was developed in the late 1960s, I believe, to help make flood insurance more affordable, whether that program has been a success or not is somewhat up in the air?

Kunreuther: Well, the program was started in 1968 and just a little bit of background, the private insurers had been marketing flood insurance up till 1927 from the late 1890s. They had a couple of very serious floods in the Mississippi and they decided that the risk was uninsurable. So there was really no flood insurance available for almost all homes and flood prone areas when this program was started.

What happened basically was that when they started it, they said, we are going to have rates that are subsidized for those who are currently there to preserve their property values. And the idea was that over time the rates would reflect the risk. That hasn’t quite happened the way it had been anticipated. And so right now, what we have a program that a large number of people are not insured who are in the flood prone areas, as we’ve said a minute ago, and there is a concern with respect to trying to have premiums that reflect risk so that you can actually let people know what their risk is and possibly charge people for that.

But there is then an issue of affordability, what’s going to happen to the low income people whose premiums may go way up given the fact they’re in a high hazard area. And that’s an issue we’re very concerned about. How do you deal with those individuals?

Stone: I want to come back to that issue of affordability in just a moment, but you know, when we’re talking about setting rates for this insurance, there’s obviously a quantification of that future risk. How is that risk quantified? And how does that, you know, that quantified risk then relating to what the insurance premium may be?

Kunreuther: It’s a really important question. And because if you don’t have some quantification of the risk and know what the risk is, you can’t even deal with issues like affordability and mitigation. Cause you got to know what you’re facing. And so, I think the big issue right now that is facing the country, Congress, and the Federal Emergency Management Agency is how do you move towards at least data that enables you to talk about what a risk-based insurance premium is? Forget about charging it, what would it be? So people understand what their risk is. And that requires much better mapping than they currently have.

Stone: You mean mapping of the actual communities in flood areas or?

Kunreuther: No, no map mapping of the community and the river to understand essentially what the likelihood will be a floods of different magnitudes. It requires elevation certificates on homes to say how much damage the home would face. And it then requires one to put these together in a way to say, here’s what your insurance premium would be if it turns out you are living in a community that’s flood prone, you are located in a particular spot relative to the river or the coast, because this is a problem that Miami and New York City and coastal areas face with storm surge from flooding.

And here’s what you, what your risk is. Now we can tell you what you can do about it. And at the same time, we can provide you with insurance that will hopefully protect you out of premium. And this is the question, what do you charge people for this rate, for this risk, but at least let people know. That’s step number one.

Stone: You brought up the issue of the flooding in Miami Beach, the nuisance flooding. I think this is also happening in Norfolk, Virginia and other areas. It’s related to sea level rise. And the thought is it’s related to climate change.

How does climate change alter our ability to understand risk in the future if in the past, and I’m just assuming here, we relied on reliable repeated weather patterns. If those weather patterns are changing, doesn’t that create a conundrum for people trying to understand the likelihood of a future disaster? 

Kunreuther: Absolutely. And I think that the challenge right now facing our country and facing individuals in these areas is to put climate change and global warming on the agenda. And to recognize that there are developments here that could be very, very serious for individuals and for cities, as you pointed out, Miami, Norfolk, New York City, is very concerned about that just for full disclosure, I’m on the New York City Climate Change Panel. And we have been spending a lot of time thinking about how do you get that information across in terms of what that risk will be if the sea is going to be rising as the climate scientists actually have indicated, by a few inches and by more than that, over a period of time.

And what about more intense hurricanes like Hurricane Sandy occurring in the future? What is not going to do? So we need to put that on the table because if we’re going to have development in these areas or if we’re going to talk about that as structures that are currently there, it’s going to be very important to know what’s going to happen, not just next year, but over 20 or 30 or 50 years.

Stone: Getting to the policy component of this, talking about global warming is obviously a politically charged issue at this point. Do you see that there might be a cooperation, bipartisan cooperation that would allow this type of thinking you’re talking to go forward in Washington?

Kunreuther: I sure hope so. I mean, no one, I think has an answer right now. I certainly don’t in the context of what Congress is going to do and what the president is going to do with respect to the climate change agreement in Paris, which we were a signature to. And I hope we remain one. So in that sense, I think we are waiting to see how that all develops.

I think that if one puts on the table what we know and what scientists have been saying, I’m not a scientist, I’m an economist, and interested in risk. So I look at this from the point of view of the data they’ve collected. But what has certainly been clear to me, certainly being on the Intergovernmental Panel on Climate Change for a four year period, is that this is an issue that is a real issue that we have to think about appropriate policies. And the hope is that this will be now understood. And you don’t want to wait for another disaster or you don’t want to wait for a critical tipping point before that actually happens.

Stone: Looking a little bit more locally, kind of the political perspective as well. There’s a large question, an overriding question, of do you want insurance rates to discourage people from living in certain areas, rebuilding in certain areas that have been hit by flooding? What do you do with people who may have subsidized insurance that if that insurance were truly reflecting risk, they may not be able to afford to live there? This is a huge issue as well.

Kunreuther: I agree. It’s a very important issue. We’re facing the reform of the National Flood Insurance Program and that is going to expire in September of 2017. And that issue, I think, needs to be on the table. I think that there’s a lot of discussion on the role that the private sector can play with respect to that if they were going to be providing insurance. And how that could compliment what the National Flood Insurance, the federal program, is doing.

But unless we address the fact that, yes, we do need to let people know what their rates are, premiums will be. I would feel, you know, I think the general feeling is that people move into an area and they’re settling there, they should be then paying a risk based premium, an actuarially fair premium as we often call it and that was part of the flood program back in 1968. And that’s still part of the general idea of the flood program.

But the key question that you’re raising is what happens to the people who are currently there and one needs to address the issue of how to deal with fairness. And I want to put fairness on the table. All of a sudden the rug is pulled out from under them. And now they are saying, God, I have to pay a premium. It’s a lot higher than I paid before. I’m not sure I can afford it. I don’t think this is fair and I need to somehow know how, we need to somehow address that issue. I can talk about that in terms of how we address that.

Stone: I’d love to hear more about that. I mean, that’s obviously a big policy issue at this point.

Kunreuther: Well I think the way we have been thinking about this, and a colleague of mine who has just joined the Risk  Center, Carolyn Kousky and I have written on this, but also been part of a National Academy of Sciences Committee to deal with the affordability of flood insurance. And so, spend a fair amount of time talking about this.

And I think one idea that has come out and has been mentioned in that committee report is that you tell everyone what their premium is going to be. But at the same time you say, look, we know that this is now going to be a lot higher than you can afford, and we need a criteria for what affordability would be based on income or housing costs, et cetera. And on the basis of that, we will help you out, help you out meaning the public sector will help you out with some kind of a voucher or a tax credit to reduce essentially what you have to pay.

And the point that Carolyn and I have made in this paper is that it would be very, very good if you were telling people, not only that we’ll help you out, but that there’s an opportunity for you to make your house safer in a way that is cost effective. And if you do that, your premium is going to go way down. And so we would like to tie the idea of the credit, voucher credit, or some support to help them out with the idea that they do something to make their house safer. And then that way you help them because they now have a safer house and less to worry about in the future. And climate change being a part of that problem.

But at the same time, you help out the public sector because they don’t have to pay as much because when the insurance premium goes down ,you might, you give that you give them a loan. You don’t say you have to pay the cost up front, which is what people do. You spread it over time, which is a way of dealing with the myopia problem that I mentioned earlier. And then when you look at the cost, of the loan and the insurance premium discount that they’ll get, this is going to be more affordable. And they will actually pay less. And the voucher would have to be less as a result.

So that’s the direction we would like to see. And we’d like to emphasize the fairness part of all of that, so that people see that in a way you’re doing it, you’re being fair to them. And everyone has their own definition of fairness. We would say when the rug is pulled out, when people, all of a sudden face a problem that they hadn’t faced before, it’s unfair to all of a sudden charge them that kind of a premium.

Stone: So basically somebody upgrades their home to be more resilient and with some type of subsidized loan to do that. And then over time, they actually save more on the insurance than that upfront costs?

Kunreuther: That’s correct and even next year they say more on the insurance. It’s not just over, it’s every year that they have that policy and you hope they have that policy, or may require them to have that policy for the time that they’re in that house.

Stone: Let me ask you this, in regards to some of the locations in the U.S. that we consider to be on the front lines of this issue right now, I’m thinking New Orleans, again, Miami, again, Norfolk, Virginia area. What is going on there in terms of insurance premiums? Are people taking measures to prepare for some future disaster?

Kunreuther: Well, I’ll, let me just a brief note on the history of that. In 2012, in July of 2012, three months before Hurricane Sandy, there was a bill in Congress was passed that actually indicated that you had a move towards risk-based premiums and there should be a study on affordability to deal with that.

The study got funded, but got delayed. But that’s the study I’m referring to the National Academy study that did take place. Hurricane Sandy occurred three months later and you now had a whole concern by people by Senators and Members of the House in Mississippi, Louisiana, New Jersey, New York, and a lot of other places, you know. This is really not going to help us out with respect to people having to pay a very high premium and affordability had not been really come on the table in terms of what would happen to the low income people.

So you had a new bill that got passed in the spring of 2014 that actually reduced the timing of risk-based premiums. And it wasn’t clear when they would actually occur. And there was really emphasis on affordability. You have those things happening. So what’s happening right now is you have the reform of the National Flood Insurance Program coming up with everything on the table in terms of what are we going to do with respect to the premiums? What are we going to do with respect to affordability? That’s kind of in the background, but it’s there. How do we get people to reduce their risk? But at the moment, people are clearly aware of it, but they are not necessarily being charged those premiums. And so it’s unclear what steps they’re actually going to take.

Stone: We brought up the issue, you brought up the issue, of affordability for homeowners, for insurance, but there’s obviously also the issue of the insurance companies also being able to manage these disasters. That’s what the NFIP has been about but it’s $25 billion in debt at this point, as a result from Sandy, I think hold over from Katrina. I’m not sure about that. How do we ensure that program’s survival? And I know you’ve talked about, you know, preparedness, but it is that viable?

Kunreuther: Well, I think it’s only viable if it turns out that we separate the issue of affordability from the premiums that are being charged. And it has to be a separate issue that people discuss on the, with fairness as a part of that discussion, and saying, we recognize that with the subsidized premiums, this is the program is going to continually be in debt. And so, if we’re going to really have a program that actually will thrive and also have the private sector marketing policies, they will have to charge a risk based premium, otherwise they won’t want to market that policy.

You have to have a recognition that there’s gotta be a separate set of funds, independent of the insurance aspect of the program, that addresses affordability. And that has to come at the level of either the federal government is what I would think would have to be, it could be done through the states as well in some fashion, but there has to be that recognition. Otherwise, you can’t really solve both problems. And the idea of mitigation that we were talking about a few minutes ago can help that by getting, making the houses safer. And as a result, the premiums will go down.

Stone: The NFIP, again, it needs to be reauthorized by September 30th. Will we get something?

Kunreuther: I sure hope so. I think everyone feels we have to because you need to have the program in place in some form. The question is at what, in what form will it take? And I think there’s a lot of discussion right now in Congress, both at the House and at the Senate level, on what kind of a bill will go forward for the reauthorization. And we’re very interested in that activity.

Stone: Could you briefly give us an idea of what the two sides of the discussion are in Congress right now about the reauthorization?

Kunreuther: I think that the two sides are pretty much what we’ve talked about. It’s the idea that you need to have, it would be good to have the private sector more actively involved, and that will take risk-based premiums for them to do that in some form. And if you have that, you have to have better mapping. So there’s a recognition of better mapping and better notions of what the future damage will be and models that will take them into account. So that, so that one can determine what that risk-based premium will be. That’s side number one, with respect to that, with the private sector certainly being a part of it.

And then the side number two is the concern that we’ve just been talking about. What’s going to happen to the people in these areas who are going to be facing a higher premium? And how will we deal with that issue? And that has not been discussed as widely as the notion of the risk-based premiums, but it has to be in my opinion, part of the discussion. And I think we’ll probably see some of that. And you had some of that in hearings, raising that issue, some of that as part of the bill.

And I sure hope that will be the case, because if you don’t have that, what we’re going to see is a movement towards risk-based premiums, with a large number of people who are going to be in the position that you alluded to with your question earlier that they say, I can’t afford it. I don’t know what I’m going to do. I’m really in trouble here. I don’t want to move. I don’t know where I can move and I can’t move. And at that point, we don’t really know what is going to happen. They may very well be uninsured and say, I’m not going to buy it. They may be required if they have a mortgage to buy it and that’s an issue that would have to be dealt with. And then when you have the next flood and the next disaster, someone is going to have to bail them out or we’re going to have to let them suffer.

And the reason for pushing, for dealing with affordability before the disaster is to avoid a lot of very expensive disaster relief to a large number of uninsured people, plus all the pain and suffering that they’re going to have with respect to their house maybe not being mitigated the way it should be, and they’re not being insured. And so that’s the issue on the table that I think Congress has to face. How they will deal with that in the next few months is an open question, but we are very actively involved, the Wharton Risk Center, with the Kleinman Center, on that issue in terms of how we can address that and deal with that. And so the hope is that they’ll recognize both sides of the coin.

Stone: One option is that these communities don’t rebuild after disasters. And in your book, ‘The Ostrich Paradox’, you brought up a very interesting anecdote about a group of families or community, I believe it was on Staten Island in New York City, that decided not to rebuild, the whole community moved. There was some kind of deal they made as well, that, okay, if we move you can’t go ahead and flip this land to wealthy homeowners, but can you give some insight on what that might indicate?

Kunreuther: What I think it’s a very interesting opportunity for communities to ask themselves the question, are there things that we could do? And Staten Island is a great example after Sandy, where there was enough support given to the whole community and you were able to move them elsewhere. So buyouts are one possibility, but it’s very hard for any individual to think about being bought out, but it is possible for communities to take steps and communities can take other steps as well to make their community safer.

I think Miami is concerned about New York City, as I mentioned earlier, is very concerned about what the future is going to look like, as is Norfolk and New Orleans. And so I think bringing in communities in terms of what they’ll do or having policies and programs that actually think about what could be done is very, very important.

And I should mention, since you’re bringing up ‘The Ostrich Paradox’, we conclude the book with what we call a behavioral risk audit. And we use flood as our example, in that to say, what are you going to do to help individuals, communities, and decision-makers take steps to improve their actions, recognizing that you have a set of the biases we mentioned earlier to deal with that. And I think buyouts are certainly one possibility in terms of thinking about that, but it has to be done in a way that is going to make sense to the people. Otherwise, you’re never going to have it happen.

Stone: Final question, going back to the whole issue of psychology. As a country on a large scale, can we overcome our inherent, you know, sticking with inertia and not making change in a way that will allow us to prepare?

Kunreuther: I think that is the question of the decade and the century, but I’ll certainly make it the decade, or the year, or the moment since you’re asking me this question now. I think the way, the way we have been thinking about that in most all of the research we’ve been doing at the Wharton Risk Center is to say, you want to put on the table long-term strategies to deal with climate change and along the lines of what we’re dealing with. But unless you have short term economic incentives that will enable people to somehow, and decision makers and at the public sector and private sector, and individuals too, to recognize there’s some benefits in for them now, it’s going to be extremely difficult. And I will end your question with an acronym that we have used over the last few years that not only refers to politicians, but to all people, all individual decision makers, NIMTOF.

Stone: What’s that?

Kunreuther: Not in my,everyone gets that, but it’s more than that, not in my term of office. And if we can avoid it now, that’s myopia, we would rather do that. So we need the short term incentives to couple with the long term strategies.

Stone: We’ve been talking with Howard Kunreuther, Co-Director of the Wharton School’s Risk Management and Decision Processes Center. Howard is the James G. Dinan Professor of Operations Information and Decisions at the Wharton School at the University of Pennsylvania. Howard, thanks for talking.

Kunreuther: Good to be with you, Andy, 

Stone: And thanks to our listeners for listening to this episode of Energy Policy Now from the Kleinman Center for Energy Policy at the University of Pennsylvania. Keep up to date on energy policy research and events from the Kleinman Center by subscribing to our Twitter feed @kleinmanenergy. And if you liked today’s episode, let others know with a review is on iTunes or GooglePlay. Have a great day. 

Howard Kunreuther headshot

Howard Kunreuther

James G. Dinan Professor, The Wharton School
Howard Kunreuther is the James G. Dinan professor of Decision Sciences and Business and Public Policy at the Wharton School.

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.