Both natural and man-made disasters are considered as events that can cause a large amount of losses and correlated with a small probability. It is rational for the population to have insurance against such events because most people are risk adverse: a risk adverse person means that the person will not prefer risk and will try to minimalize it. However, there is only a proportion of the population taking insurance against such events , without having insurance against such risk of losses banks were finding it a problem to issue loans and mortgages because they are exposed to the risk. To explain why there are only a small proportion of people insured (using the US as an example); the first step is to understand the insurance models, then to consider the behaviors of the demand side and supply side.
To understand why people who are at risk and not insured against it, it is important to understand how insurance works. Insurance is made to reduce risks by the purchaser paying a certain amount of money called a premium collected by the insurer. The premium is calculated by the insurer based on the probability of the occurrence of the event, the amount losses of the event and additional administration charges. The insurer collects the premiums and set up a pool of capital which is used to pay the unfortunates as coverage. Therefore it reduces the potential risk to a certain (or near) amount of losses that the purchaser paid as premium. Hence it explains why insurance is favorable to most people because most people are risk- adverse, so they are willing to pay small amount money to reduce the potential risk of large losses.
However, if insurance is favorable then why are people not insuring it, especially where the losses from disasters are great? The reason for it is because consumers do not value their insurance as much, therefore they are less likely to obtain insurance. There are a lot of reasons as to why consumers are behaving that way; firstly the consumers lack accurate information to make a decision. The consumers thinks that the probability of a disaster occurring is so low that there is no need in getting protection and keep paying premiums. However this is incorrect, because they do not realize that they are exposed to greater loss without insurance, they are only focusing on the current situation rather than maximizing the long-run benefit.
To solve this problem, it is simply to make the consumer aware of the actual risk they face. For example, it is true that some people who live in potential flooding area do not know they are at risk, so they think there is no need in getting insurance. Thus, the solution is to inform people in potential flooding area that they are at risk of flooding and it is better to be insured. To do this, the government needs to update the flood maps so they can identify the potential areas that are prone to risk and then inform them.
In addition to the reason above, the “Samaritan effect”7 also reduce the...