The Queensland Premier Anna Bligh is proposing that the Federal Government assist in doubling the low interest loans available to small businesses that have been hurt by the floods and cyclone Yasi. That would take the loans to $500k at 4% for up to five years with no payments in the first two years. It is hard to understand why this is good public policy. Why don’t governments insist that firms simply insure themselves against flood and cyclone.
For the most part the social view of risk taking is that if you can’t take the consequences then don’t take the risk. If you invest in risky stocks instead of putting your money in the bank, and then the market rises, well good for you; but if the market goes down, then that is your problem. The same if you start a risky business. The same if you risk your life, instead of your capital, with skydiving or smoking.
It is a pragmatic and liberal point of view, that gives individuals and families the freedom to undertake risky activities within society, so long as they don’t burden society if things go wrong. It is not that society abhors risk. Risk taking in the name of science, art or commerce is often admired in a progressive society. It is just that society sees private risk taking as resulting in private rewards and private losses. If risk is taken on behalf of society through military service or other public service, then society feels an obligation to the individual and their family if losses are incurred in the service. But otherwise, if risk is taken for individual gain, then it is up to a household or a firm to bear the risk, or else to pay to transfer the risk to another party through insurance contracts, options, forwards, swaps or other hedging instruments.
Economics sees risk as a cost that arises, in some measure, from any activity. Consumption, production or exchange activities create risk. If the creator of the risk bears the risk then the risk is internalised. Otherwise, if individuals or firms enjoy the benefits of an activity but not the cost of the attendant risk then an externality is created, along with the economic inefficiency caused by the externality.
A notable exception to the general social view of risk is the way that risk taking by farmers is treated by society. There is usually little objection in society to payments to farmers who suffer losses because they have failed to insure their wheat crop against hail, or their herd against drought or their bananas against cyclones. The fact that the farmers enjoy private benefits of farming during good times and social insurance during bad times causes little objection. For the tourist businesses who face a rising $A, or property developers who face rising interest rates — tough luck. But farmers in the face of bad weather receive payments from state and federal governments. Farming is seen as somehow more noble and essential that other commercial activities, and therefore deserving of support. This is nonsense, of course. Farms are businesses like any other business, and farmers are seeking the private benefits of commerce, rather than performing a public service.
Again, why are governments providing implicit flood and windstorm insurance rather than leaving it up to businesses to insure themselves? Is there a market failure in the flood insurance market that the government can solve by providing implicit, partial insurance for free?
In general there are three reasons that insurance markets might be ‘missing’ – in which case government intervention may be economically efficient. First diversification of risk may be impossible. Second there may be insurmountable information asymmetry problems. Third there may be no way to accurately estimate the risk of a claim.
In two respects flood risk is ideal for insurance. First, flood risk is diversifiable. Local insurers cannot achieve full diversification, since a flood will hit lots of their customers at the same time. But, diversification can be achieved by ceding risk to global reinsurers which are diversified across the globe. Second, there is no information asymmetry. That is, the provider of flood insurer doesn’t have to worry that the parties seeking insurance know more about the danger of flood than the insurer does. This adverse selection problem is faced by health or life insurers — the insured party knows much more about their likelihood of making a claim — but there is no hidden information in flood insurance. Nor is their any hidden action. A person might take out life insurance and then once they are insured conduct activities that increase the probability of a claim (like smoking on the sly). But not such hidden action occurs in flood insurance.
The third problem regarding uncertainty about the probability of a claim is more problematic. Global warming may be taking the insurance of flood risk from assessable ‘risk’ to Knightian ‘uncertainty’ about the probability of claims. In that case flood insurance, or reinsurance, may become problematic. But even if that is true, it is not obvious that implicit government insurance through ex-poste handouts is a solution.
I think the government needs to push back on the type of claims on public finances that Anna Bligh wants to make. The Government needs to be clearer that if you live in danger zones then you have to insure yourself against flood, or cyclone or fire or whatever it is. Certainly the government should rebuild local infrastructure, but it is better for the government to insist on no building in flood plains and higher construction standards in cyclone areas than to hand out ever larger grants to uninsured firms.