From Australia to Davos: The Challenge of a New Risk Architecture (Jan. 2011)

Since December, Australia has been facing historical flooding that surprised the entire country. Although the risk was known, many were ill-prepared because these floods are not just another average flood, they are of very large-scale magnitude. Three-quarters of the state of Queensland has been declared a disaster zone; as I write this article from the United States I’m reminded that this is an area larger than California and Texas, combined.
In the immediate aftermath, most of the efforts need to be focused on rescuing and helping the victims of this disaster. But what happens after that?
From my experience working with several other countries Australia’s political leaders will soon have to address the following questions: First, who will be responsible for uninsured losses? Most likely the answer will be government relief. This is problematic, because it creates a high level of expectation down the road, which given the growing public debt may be hard to fulfill. Politically, however, this is what governments are often called upon to do. So, there will likely be massive relief, but how much and under what criteria, and how quickly victims will receive it still needs to be decided.

Second, what should be done to better prepare the country for large-scale events? Where should we start and with whom? This will be about improving risk assessment, land use regulations, limiting new construction in high-risk areas, investing in individual and collective risk reduction measures to make communities safer, improving the quality of the warning systems and scaling-up rescue teams’ capacity. Beyond good words, this will be hard to do; it is everywhere.

Third — and this is critical — how can the country organize a national sustainable financial protection against future extreme events?
These tragic floods provide a real opportunity to think strategically about catastrophe management in the 21st century. As such, Australia is not unique. Rather it has joined a growing group of countries that have faced truly historical devastation from natural disasters in recent years. One figure is eye-opening: direct economic cost of natural disasters worldwide between 1980 and 1989 was about USD250 billion. It quadrupled to over USD1 trillion between 2000 and 2010.
In the United States, Hurricane Katrina which made landfall in August 2005 inflicted economic losses from wind and storm surge estimated around USD165 billion (2010 prices), about one-third of which was paid by private (wind) and public (flood) insurance. Last summer, the worst floods in decade in China cost USD50 billion, virtually all of which paid by the government since insurance penetration is really low. Last year, too, one-fifth of Pakistan was under water and 22 million people (equivalent to the entire population of Australia) were affected; another example of truly large-scale floods.

The driving force for this rapid increase in the cost of disasters is fast population growth (there are today one billion more people on planet Earth than 10 years ago, and in the next 15 years another billion will be added) and much larger asset value in exposed areas. Climate variability toward more extreme events might also be to blame here. Because of that, and unless we start profoundly rethinking the way to look at these vulnerabilities, the coming years will bring even more devastating catastrophes, in many more parts of the world, affecting many more people. Think also droughts, hurricanes, earthquakes, wild fires…

For Australian leaders, it might be tremendously helpful to look internationally for benchmarks on flood risk financing. In the United States, flood risk has been mainly covered by the federally-run National Federal Insurance Program since its creation in 1968. This is a public-private partnership in which the federal government creates flood zone maps and sets premiums. Private insurers sell the flood policies on behalf of the government and handle claim assessments. (As such they play the role of financial intermediary but do not bear any of the risks.) The NFIP covers $1.2 trillion in assets today.In the aftermath of Hurricane Katrina in 2005, the program did not have sufficient reserves to pay the historical amount of claims it faced. Between 2005 and 2008, the program had to borrow $19 billion from the U.S. Treasury. This raised major concerns about its ability to sustain itself after truly catastrophic floods. Enforcement of mandatory insurance requirements in high-risk areas has also been a problem. Discussions in the U.S. Congress and at the White House and with experts in the field are currently underway to determine how best to reform this program set to expire this year.

In the United Kingdom, flood insurance is provided exclusively by private insurers and is usually included in homeowners’ insurance policies. Mortgage lenders require that a property to have full insurance coverage, and in this way, many homeowners are de facto covered against flood. The government has the responsibility of mitigating the risk of flood and there has been debate about government responsibility after the major floods in 2007.

In France, insurance coverage against flooding and other natural hazards is mandatorily included in homeowners’ policies sold by private insurers as well (independent of one’s level of exposure to the hazard; national solidarity principle). Homeowners’ insurance itself is mandatory and well-enforced. Flood insurance penetration is thus virtually 100 percent in that country. In return for providing this coverage, French insurers benefit from reinsurance capacity at a very competitive price via the government-run reinsurer, which benefits from an unlimited guarantee from the French Treasury.

In Germany, flood insurance is provided exclusively by private insurers but on a voluntary basis and as a supplement to homeowners’ insurance coverage. Although homeowners’ insurance penetration is high in the country (nearly 90 percent) flood insurance penetration is only about 10 percent for single homes. This means that the entire country accepts de facto to pay for future victims of flooding, as it happened in after the Elbe floods in 2002.

In the coming weeks and months, Australia will have to decide what catastrophe management and financing solutions would best be aligned with its social, economic and political priorities. Ideally, the answer will provide signals as to the level of exposure people face and increase personal responsibility toward mitigating those risks. It will also consider equity and affordability into the balance.

These questions have been at the forefront of the activities of the Wharton Risk Center for over a quarter of a century and also triggered, more recently, innovative initiatives by boards of multinational corporations, the OECD, the World Bank, the United Nations and the World Economic Forum. Not surprising, these will be central to our discussions in Davos end of January.

Erwann Michel-Kerjan is Managing Director of the Wharton Business School’s Risk Center (USA) and Chairman of the OECD Secretary-General Advisory Board on Financial Management of Catastrophes. His most recent books are available at: www.AtWarwiththeWeather.com and www.TheIrrationalEconomist.com

  • This article appeared in The Australian, the leading national newspaper in Australia in their January 17, 2011 edition.