What Insurance Is Not

24 understanding disaster insurance

premium only to receive money if the heirloom is damaged. For example, you may want to think twice about insuring the table you love because it was built by your great-grandfather. You could get money to buy a new table if your house and all its contents burned down, but that table would be a sorry replacement for the one you knew was made by your ancestor. This example reinforces the point that reducing risk is necessary in addition to insurance, as there can be lots of losses from disasters that are fundamentally uninsurable. The best way to preserve those items is to prevent the loss in the first place.

Insurance is a bit of a Goldilocks product: it works best for risks that are not too small and not too big, but just right. Very small risks will cost too much to insure. Consider something very small, like breaking a plate. It would not make economic sense to insure even an expensive plate because your insurance premium will reflect the transaction costs of writing the policy and processing the claim, as well as a profit margin for the insurance company. It makes a lot more sense to just save the money needed to replace that plate. While it may seem silly to think about insuring a plate, it is the same challenge that makes it difficult to bring the benefits of insurance to groups that would only need a small amount of coverage, such as pastoralists in Africa or microloan recipients. Innovations to help harness the financial benefits of insurance for small coverage levels and lower-income groups will be explored deeply in chapter 11.

Very large and very widespread risks also cannot be insured for the simple reason that an insurance company would not have enough capital to pay all the claims. Consider the COVID-19 pandemic and the resulting economic downturn from government-mandated business closures. Through the spring and summer of 2020, many businesses were hopeful that their insurance would cover the lost revenue from having to shut down. Unfortunately, in most cases, pandemics were clearly excluded from business interruption insurance policies. Why? Because

what is insurance , and what is it not ? 25

insurance companies knew that they could not insure such a large-scale and widespread risk. The P&C industry in the United States estimated, for example, that just one month of business interruption losses from the pandemic was more than ten times the amount of claims handled by the industry over an entire year and that just two to three months of such losses exceeded the total industry surplus (the difference between assets and liabilities, or net worth).3 To have access to enough capital to cover such staggering losses, the insurance would need to be so expensive that no one would have been able to purchase it in the first place.

How big is too big to insure is an ongoing debate in the industry and among academics. A global shutdown is clearly too big, as are things like a nuclear attack or war more generally. But what about a supervolcano? A Category 5 hurricane? A massive earthquake? Many countries around the world have developed quasi- or fully public insurance programs to help with disasters that might be too big for the private sector to handle on its own. In chapter 4, we will explore these programs in more detail. For now, note that for risks where insurance is feasible and affordable, insurance plays a critical role in the financial well-being of households and businesses and therefore in the functioning of the greater economy. Despite these benefits, however, and even when disaster insurance is available, many people don’t buy it.

The protection gap is a term used globally to refer to the difference between the total economic costs of a disaster and the share of those losses that are uninsured. The protection gap is surprisingly large. Globally, it is about 75 percent: only about one-fourth of economic losses from disasters are insured. Even in North America, with well-developed risk transfer markets, it is still around 60 percent.4

The disaster insurance gap may also be discussed as the percentage of buildings or households that are at risk of a disaster but do not have