Public funding of private risk

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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.

9 Responses to "Public funding of private risk"
  1. The trouble with “it’s up to you, not governments, to decide your own place on the Risk/Reward tradeoff” is that many  risks are uninsurable, for various reasons.  In the case of things like flood insurance on a flood plain, it’s because of adverse selection problems, not because of the expense of insurance per se.

    This is NOT an argument for this particular blatant piece of pork (worse, wasted pork because few small businesspeople would vote Labor in a pink fit).

    But it is important to bear in mind that the superior efficiency of universal compulsory social insurance in some areas (health and welfare mostly) comes from providing insurance against risks that no private market can insure against, not just from the “declining marginal utility of money” argument for transfers from rich people to poor people.  Bear that in mind next time you hear the misleading pejorative “middle class welfare”.

  2. Interesting article with some good points.
    What would be really interesting would be to think about the implications and knock-one effects of ‘enforced’ insurance in flood-prone areas. Let’s take Qld as an example. A hypothesis could run as follows:
    Farmers are required to purchase flood insurance – which leads to higher costs of bananas, sugar, meat (and other?) products as this cost is passed through, which leads to higher prices of export products (not to mention higher prices for domestic consumers), which may decrease the international competitiveness of these industries – in a time where a strong AUD is already making life tough for exporters – and so on. If there was a risk of such a scenario playing out, it may not be desirable to force producers to internalise risk.
    I can see the logic in ‘user pays’, but the implications and knock-on effects need to be thoroughly thought through.

  3. Sam, Are there not some positive externalities from helping businesses to recover quickly after a disaster?  In this sense, recovery from disaster is (partly) a public good and so there is an argument for it to be State-subsidised. You seem to be concerned abour moral hazard (although you do not mention it explicitly): ie if businesses expect State support after a disaster, they are less likely to take out disaster insurance.  Do you think moral hazard is significant?  If so, where is your evidence?  If not, what is the problem?

  4. Well, it is a public good locally.  Everybody suffers (to some extent) in a locality if local businesses and services are destroyed, not just those who own the businesses. So, conversely, everybody benefits when the businesses recover.

  5. Interesting article, but a couple of points on flood risk in Australia.

    1. If you price a premium for flood risk against the true cost of the risk in a tightly defined underwriting model (ie. they who bear the risk, pay the premiums) then you would price the length of the Brisbane River out of the insurance market. They are simply too high a risk and would face unjustifiable premiums. The premiums would also be volatile because not only is the risk relatively frequent, its quantum is large.

    This is a problem which can be adddressed of course by not building on flood plains in the first place, but the horse has bolted in the case of Brisbane. 

    So, let’s cross-subsidise and move away from the pure model of underwriting.  By raising the price of insurance for policyholders who have NO risk of flood (which is a vast majority of Australia) we can all share Brisbane’s risk, but unfortunately, any increase in premium inevitable drops people out of the price-sensitive end of the market, which in turn just perpetuates upward pressure on premiums and repeats that cycle.

    2. The recent floods have proven that the national interest can be damaged by flood, with the loss of much infrastructure.  As QLD and WA basically prop Australia’s economy up with their mining industries and agricultural industries, it is clear that the problem for the nation can be more than just direct losses.  This is one reasonable justification for some kind of public ‘contribution’ to the insurance pool – just as there is for risks such as terrorism, and medical professional indemnity cover.

    3. Public ‘contribution’ need not be in direct cash from Govt revenue sourced from direct taxes such as income tax or a direct levy – it may be via providing the infrastructure for a scheme or reinsurance funding arrangement.  Ultimately the public themselves will need to contribute the funds (eg. through premiums), but how that is done exactly could be handled in a number of ways.  If we had such a fund for flood, there is no reason why we would not include earthquake, and possibly cyclone / bushfire.

    Whatever the viewpoint you hold, there is probably some warrant for serious debate on the subject of a public vehicle to ensure cover is available.  The reality is that the market current does NOT support uniform flood cover, and the reasons for that are related to price sensitivity of the market to that particular risk.

  6. Recovery a public good? I don’t see it.
    Clean air is a public good. Getting the Coles down the road back in business is not.

    Of course the local community will suffer if businesses close. But if those businesses have insurance, they’ll reopen (or switch their investment to something less risky). If not, it’ll be an opportunity for someone else to address the needs of the local community.

    If there a a community with willingness to pay, someone will be willing to profit.

  7. One reason why assistance for farmers may be more socially acceptable is the fact that people worry (however unrealistically/irrationally) about “food security” i.e. being able to produce our own food. Don’t have a tourism sector for a while? Okay. Wear clothes made in Asia? Sure. Import our foodstuffs from overseas? Oh, no, we wouldn’t want that.
    The rational way to protect the farming industry from shock-induced fluctuations (under the assumption that we value food security) would be to a) make insurance compulsory or b) provide a(n implicit) guarantee and bail it out when a shock does come along. We’ve obviously chosen the latter course.
    I don’t claim that this is the only reason, (nor that it’s sensible, given the surplus of food we produce) but it’s definitely part of it.

  8. Investing a house on a farm on a river is not a public activity

    the rich householder can downsize if they failed to get insurance – albeit available or not – since it will be reflected in the value of the property.

    a rich retiree does not get insurance from the gfc storm 

    the farmer also probably good water rights for free some time ago

    lots of poor public policy and voter buying after not selling good publicy policy well ..ie the super profits tax 

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