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Sangho Chung

A Market-based Approach to Natural Disasters

CHUNG Sangho

Oct. 5, 2005

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We humans settled down to a farming life about 10,000 years ago, as we opened ourselves to vulnerabilities of natural disasters, and as the price for a stable food supply and a longer life span. Prior to that, hunter-gatherers didn't have to cope with life-threatening cycle of disasters such as hurricanes or floods, because they could simply move for better gaming or fishing grounds when their living environment became too frail to support them.

Farming as a way of life led to clearing forests, building canals or dykes, and even dredging riverbeds in the later phase of evolution. The aim of these exertions was of course to ensure a sustained food production as well as protection from natural disasters.

However, to challenge nature has its price. It entails sacrifices of human life as well as exhaustion of natural resources. The so-called environmental engineering often tricks us into believing that the nature can be easily tempered to suit our needs. In exchange for our life sustainability or physical protection, we run into the danger of inviting catastrophes on an ever-grander scale.

Is there a choice?

Hurricane Katrina was a powerful reminder of how merciless Mother Nature can be. It flattened and submerged the city of New Orleans built on vast swamp along the Gulf Coast of the United States. Resting below the sea level and still sinking, the city has been descending more quickly because of depletion of groundwater, gas and oil. It was a disaster in the making.

Is there a choice of avoiding this sort of catastrophe? The answer is 'No,' but the extent of disaster can be mitigated, depending on where you live. In principle, no one is safe from danger of natural calamity irrespective of where we live. Cities, large or small all over the world, are vulnerable to different forms of catastrophes, such as earthquakes, floods or even tsunamis if your city happens to face the sea. Like it or not, life in a modern metropolis requires making the best out of our natural conditions.

Most of these disasters are unavoidable, but at least we can prepare ourselves against them with the help of technology. The way Japan systematically prepares itself against the ever-present tremors and how the municipal governments train people against damage to life and property is a good example of this readiness. Today, Japan has accumulated the largest body of knowledge in the world on earthquakes and tsunami.

Florida's Lesson

You can also take a market-based approach to natural disasters and loss reduction. In 1992, Hurricane Andrew, one of the most powerful tropical storms to hit the US in history, devastated Florida. A great amount of property and casualty insurance companies in the state were financially brought to their knees after paying out no less than $15.5 billion in damage claims. Those that survived the massive payouts-such as Allstate and State Farm-reeled under the blow of post-hurricane financial cost. Business-wise, the storm staggered them to the point that some insurers refused to underwrite any more homeowners' policies.

The Floridians were beaten but not bowed by Andrew. The Florida State Government soon set up a Hurricane Catastrophe Fund, to which the government and insurers both contributed, with surcharges assessed on homeowners' policies. In this way, the fund raised US$6 billion in the past 10 years. The system works this way: if damages occur from hurricane or other disasters, insurers pay the first 75% of the insured loss, while 90% of the remaining 25% is covered from the state hurricane fund.

This way, insurance companies would survive a staggering payout while part of the financial burden is born by the state from its disaster relief fund. Through such mechanism, the insurers-in addition to the disaster-prone Florida state-can cushion themselves against financial devastation.

It all boils down to the wisdom of making people living in a more hazardous place pay higher insurance premium. The system prevents payment to people who repeatedly claim damage compensation from hurricane year after year. This kind of market-based approach can change the behavior of people in choosing where to live. Of course, this is done not only by efforts of private insurers but also by the government's active involvement. Under such arrangement, the government is no longer expected to rescue financial damages of people choosing to live in a disaster-prone area.

It also assumes that people are free to do whatever they want with their land, with just one caveat: They can build homes cantilevered over canyons, or beach houses standing on stilts, as long as they are ready to pay high insurance premiums.

Insuring Against Disaster

What are the lessons we can learn from the Florida case? In Korea, the government is always considered as the institution of last resort. People build and rebuild their homes or commercial establishments on storm paths or floodplains because they know all too well the government will pay for damage if a river overflows or typhoon wipes out properties.

Indeed, the government pays for rehabilitation whenever disaster strikes. The central government has coughed up more than 5 trillion Won (approximately US$5 billion) when Typhoon Rusa hit Korea in 2002. It did so again in 2003 when Typhoon Maemi inflicted damages worth 4.5 trillion Won. What the taxpayers' burden will be from payouts to the victims of recent Typhoon Nabi is yet to be known, but some sort of payment is a near certainty.

According to a report from Korea Insurance Development Institute, the ratio of insured damage to the total damage in a typical Typhoon is less than 10%. In the U.S. and Europe, this ratio goes as high as 50%. It means that in Korea, most of damage compensation comes mostly from the government while insurance company stays away from underwriting disaster insurance policies in the first place. This will soon change. The KIDI report calls for storm-flood insurance scheme for which the government will introduce relevant legal provisions early next year.

How effective this scheme will change the existing behavior pattern is too early to tell, but it clearly represents an important break from the deep-rooted expectation that government will do everything for everyone. That psychology will have to go now. The question facing Korea today is how well the insurers will design their disaster insurance products so that people-as well as businesses-can change their behavior to become more prudent and safety-conscious.

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