Katrina The Compensation Question

Now that the immediate crisis is over, the question arises of the amount and form of compensation of the victims. My answer to the question is twofold. First, there should be no compensation to affluent people who could have insured against their loss, whether or not they actually bought insurance. Second, in determining compensation for uninsurable losses (or losses by people who cannot afford insurance), the amount should be determined by reference to the practices of insurance companies.

Just because a person loses his house in a flood that destroys hundreds of thousands of other houses, rather than in a fire that destroys just his house, is no reason for the taxpayer to reimburse him for the loss. The fact that most people do not buy flood insurance, just like the fact that most Californians don't buy earthquake insurance, is no reason for me to insure them. Only if they can't afford insurance, or if the insurance industry refuses to insure against a particular risk (generally these are cases in which either the risk is impossible to quantify, so that an insurance premium cannot be calculated, or the aggregate risk is so great that the entire insurance industry does not have the resources to insure it), is there a compelling case for government intervention.

Flood insurance is federally subsidized, and as a result the annual premium is quite low. The average premium in 2000 was $353, and it started at only $112, though coverage is limited to $250,000 per house plus $100,000 for the contents of the house. It's a puzzle why so few people buy flood insurance even in areas of the country that are prone to flooding. People may feel--and they may be right!--that the government will pick up the tab if there is serious flooding. If so, that is a compelling reason why federal disaster relief should be limited to people who can't afford insurance. (Most people too poor to afford flood insurance don't own homes or have many possessions, but they need compensation for the loss of what they do have.)

I grant that there may be a considerable degree of readily understandable thoughtlessness in failing to buy flood insurance; it is not part of the standard homeowner's policy, so people may just overlook it. But this negligence is difficult to understand in flood-prone regions such as southern Louisiana. Nor should we be subsidizing carelessness. It appears that total losses from Hurricane Katrina may reach $200 billion, of which insurance is expected to cover only 10 to 25 percent. Obviously the other 75 to 90 percent of the losses are not losses suffered by individuals too poor to afford flood insurance. Hard questions need to be asked before the taxpayer is asked to pay the difference between insurable losses and losses actually insured.

It might seem that flood insurance would not cover the indirect costs of a flood, such as having to find another place to live while the flood damage is being restored. But such costs are routinely covered by fire-insurance policies and I assume (without knowing) by flood-insurance policies as well.

I have no objection to government's compensating the losses of those too poor or otherwise unable to obtain insurance (to repeat, not all losses are insured by the private insurance industry), including life insurance for persons killed in the New Olreans flood. Social insurance is a legitimate utilitarian device. But the form and limits of this compensation should be similar to those of the insurance industry. People do not buy insurance against the emotional distress caused when their house or other possessions are destroyed by fire, and neither, therefore, should the government "insure" against such losses by means of its disaster-relief programs.

There have been suggestions to create a victims' compensation fund that would be similar to the fund created for the victims of the 9/11 attacks--a fund that, unlike insurance, would pay large amounts to cover the human suffering inflicted by the disaster, for example paying the survivors of people killed in the New Orleans flood amounts vastly greater than the typical life insurance policy would pay--in fact amounts calculated the way damages are calculated in personal injury and other tort suits.

Such funds make no economic sense even though a harmful action, whether of man or by nature, can inflict a loss greatly in excess of any insurance that the victim may have had. A person who has no family may see no point in buying life insurance, but that doesn't mean he doesn't value his life; current estimates by economists of the value of the life of an average American, as I mentioned in last week's posting, are in the neighborhood of $7 million. So if the victims of the 9/11 attacks could sue Osama bin Laden, they would be entitled to claim their full losses, irrespective of insurance (insurance just shifts part of the loss to the insurance company--it doesn't reduce the loss). By making the full losses a cost to the injurer, the law charges a "price" for the harmful activity that operates as a deterrent. This rationale for full compensation has no application to social insurance, which is intended as a substitute for private insurance rather than as a substitute for the tort system. To the extent that losses caused by nature or the public enemy are aggravated by venal or incompetent officials, those officials can in some instances be sued (and the full losses traceable to their misconduct recovered as damages) and in others punished by humiliation or loss of office.

Let me in closing give some examples to illustrate how my proposal would operate. In case number 1, an affluent couple loses its house to the flood; the house was not insured against flood damage. The couple would receive no government compensation. In case number 2, the same thing happens, except because the couple had all its money tied up in the house, the loss of the house, without insurance, renders the couple destitute. The couple would be eligible for Medicaid and other welfare benefits, as well as for private charity, including assistance from family members, but would not (under my proposal) be entitled to any special government compensation. In case number 3, a poor family, which already receives welfare benefits, owns a modest home, which is destroyed in the flood and, again, is not insured. I would favor the government's compensating the family for the value of the home. In case number 4, an affluent couple would like to buy flood insurance, but it is not available. Whether compensation for the loss of their home should be paid by the government should depend on why the insurance is unavailable. If it is unavailable simply because the risk of a flood is so great that there is an insufficient market for insurance to interest any insurance company, compensation should be denied so that people aren't encouraged to build in flood-prone areas. But if insurance is unavailable because of a genuine market failure, I would favor government compensation (i.e., social insurance); an example would be if no insurance company offered such insurance because the industry incorrectly believed that there was zero probability of a flood in the area of the couple's home and concluded that therefore there would be no demand for insurance.

The first comment I would like to respond to is Professor Becker's. It flags an issue that I did not discuss adequately in my posting. He argues that the fact that an individual loses property or for that matter life in conjunction with similar losses of other individuals in an event reasonably classified as a disaster or catastrophe is no reason to stretch the social safety net beyond its usual dimensions; the individual should be treated identically to a person who sustained the identical loss in a noncatastrophic setting--say as a result of a pipe's bursting while the owner of the house was away for several weeks and when he returned the house was so flooded as to be completely ruined.

I think Becker is basically right, and indeed I made a similar point in my posting but then wandered away from it. But I also think that there are some differences between the disaster and nondisaster settings. In my hypothetical bursting-pipe case, there would be no occasion to evacuate the owner to another city. As in this illustration, the disaster setting is likely to involve costs that would not be incurred in the nondisaster case, and the social safety net may not have been designed with that possibility in mind. Of course it would be better to alter the net to take account of the possibility, rather than, as we are doing in the aftermath of Katrina, responding ad hoc, excessively, and probably wastefully.

My posting distinguished between insurance against loss and damages for a wrongful act; damages are more generous, including for example monetary compensation for pain and suffering. Several comments question the distinction. Let me offer two responses. First, if there was culpable negligence in the handling of the catastrophe by officials or public employees, it is conceivable--no stronger word is possible--that victims of the hurricane and of the ensuing flood may have a legal claim. I say "conceivable" rather than "possible" because there are a number of limitations on suits against public officials, especially suits based on their discretionary acts or their policies, as distinct from execution (usually by lower-level officers such as policemen). Second, the demand for insurance and the (social) demand for legal liability are quite different. The demand for insurance is based on risk aversion, which is based in turn on the declining marginal utility of money. Ask yourself whether you would pay $10 to avoid a one in ten thousand chance of having to pay $100,000. These are actuarial equivalents ($10 = $100,000 x.0001). So if you would prefer the riskless alternative (pay $10), you're risk averse and a potential customer for insurance.

So if, as in the usual case, pain and suffering would not reduce your money income, there would be no point in your buying insurance. But since pain and suffering are a real loss, optimal deterrence of acts that cause such a loss require the courts to try to put a price tag on the loss and include it in damages.

I was intrigued by the suggestion in several comments to make the purchase of flood insurance mandatory in areas where the risk of flooding is significant. It sounds like a good idea, provided those areas can be defined (the alternative of making flood insurance mandatory for everyone, even in deserts where the premium presumably would be close to zero, is objectionable as being administratively cumbersome) and that the insurance is not subsidized by the government. If it is not subsidized and therefore represents the insurance industry's best estimate of the expected financial losses from flooding, then requiring it will discourage construction in flood-prone areas (by making it more costly to live in such areas) and by doing so will reduce losses from floods and reduce demands for government bailouts--demands that appear to be leading to extravagant federal programs for compensating victims of Katrina.

Compulsory insurance is a second-best solution from an economic standpoint; first best would be letting people choose whether to insure or "go bare" but not compensate them if they chose not to insure and then suffered a big loss. But it is unrealistic to expect government to take such a hard line in the disaster setting, where the number of victims is so large as to place the government under irresistible pressure to compensate--unless the victims are privately compensated through insurance.