The Role of Insurance in the Economy

22 understanding disaster insurance

which provides financial protection against certain legal liabilities. P&C insurance includes automobile and homeowners insurance, as well as commercial insurance. This book is limited to consideration of property insurance for disasters.

Although we will be primarily examining personal insurance in this book, or insurance products that individuals or households purchase, it is important to note that insurance can be purchased at all scales. There are very small insurance policies, referred to as microinsurance (we will come back to these in chapter 11), and very short duration insurance policies, such as automobile insurance for gig drivers that is only in effect when a driver turns it on. Insurance can also be purchased by firms and larger entities. These groups may also buy insurance on behalf of a group of people, such as employees or members of a community. Finally, risk transfer has also been used by entire countries. There it is referred to as sovereign insurance. We will discuss its use for disasters in chapter 11.

Risk transfer is foundational to a thriving economy. Insurance enables high-risk, high-reward activities that otherwise might not be undertaken at all. A surgeon may not perform a risky procedure without liability insurance guaranteeing that he or she will not be bankrupted if something goes wrong in the operating room. A family cannot obtain a mortgage without homeowners insurance, which assures the lender that if the home is damaged, the bank will not have lost its collateral. Businesses may not undertake large investments if the owner of the company would lose everything if something unforeseen happened.

Although disaster insurance provides financial protection to the household or business, it also has spillover benefits to the larger economy. If households or businesses have the proceeds of insurance, they can rebuild and reopen sooner than if they did not have insurance, allowing normal economic activity to begin more quickly. Research has found that uninsured losses from disasters can harm economic output, but if disasters are well insured, economic growth is less likely to be impacted, and the overall economy recovers sooner.2

what is insurance , and what is it not ? 23

There is currently growing excitement about the potential of insurance to help solve social and environmental problems—the focus of part 3 of this book. Enthusiasts, however, can sometimes assume that insurance is something it is decidedly not, thus hamstringing innovation. To start with, insurance is not funding. It is not a source of money; in fact, it costs money. Insurance costs will always exceed expected payouts because the premium, as will be unpacked in chapter 7, must also include the administrative costs borne by the company, as well as its profit. In other words, it doesn’t always make financial sense to buy insurance. Some risks are more cost-effective to manage through savings, credit, aggressive risk reduction, or a combination of those methods. We will discuss this issue further in chapter 5.

Insurance is not risk reduction. It is risk transfer, which means that insurance does not change the underlying risk. For example, when you insure your house with a homeowners insurance policy, you don’t make it any less likely that the roof will be damaged in a storm. Your insurance purchase simply means that you will have funds to pay for repairs. As such, insurance is only one piece of risk management. It needs to go hand in hand with investments to actually reduce risks. At a household level, it could be upgrading to a fortified roof if you live on the hurricane-prone coast (a building standard developed by the Institute of Building and Home Safety) or undertaking a “brace and bolt” for your home if you live somewhere that is earthquake-prone. Of note, and a point returned to several times in this book, when risks are reduced, insurance is cheaper, such that risk reduction is a critical complement to insurance. We need both.

Also, you cannot insure everything. First, it makes little sense to insure items that money cannot replace. Insurance is about having funds to pay for costly impacts. Having money after the loss of a sentimental family heirloom will do nothing to bring it back or replace the emotional value lost. Hence, there is probably no reason to pay an insurance