The Natural Disaster Protection Act; G. Wolfram

ance programs: (i) a primary insurance pro gram and (ii) a reinsurance program whose rates would be set by FEMA; (4) create a new natural disaster mitigation and planning advisory panel to FEMA; and (5) require insurance companies to notify their policy holders of their nonparticipation in these new programs ifthe insurance company fails to participate and require insurance compa nies that participate in the current federal flood insurance program to notify FEMA of policyholders living in flood plains and re quired to have flood insurance who refuse to purchase the flood coverage. Can anyone look down this list and an swer "no" to the question Albert Jay Nock suggests we put to any federal program: "Does this add to the power of the state?"s There is no question that this bill further extends the arm of government into the lives of everyone and will add to the cost of construction. But will it accomplish its pur pose and at reasonable cost? In order to answer this we must go back to Bastiat: In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these, the first alone is immediate; it appears simul taneously with its cause; it is seen. The other effects emerge only subsequently; 417 418 THE FREEMAN • AUGUST 1994 they are not seen; we are fortunate if we foresee them.

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen. 6 As the new Act adds ten new purposes to the Stafford Act (as well as 29 new defini tions), we can be excused for summarizing them in order to simplify our answer. The Act itself is really a response to the large losses suffered in the United States in recent years due to natural disasters. In the past two years we have had hurricanes in Florida and Hawaii, floods in the Midwest, and earthquakes and fires in California. This has led to concern that insurance companies will become insolvent, reinsurance will be un available, and the federal government will be saddled with huge payments for disaster relief in the face of ongoing attempts to reduce the deficit. Let us, for now, take as given the fact that the Act will mean a large intrusion of the federal government into the building industry and the insurance indus try. Will this result in improved solvency of insurers? Promote reinsurance? Reduce ex posure to (or at least reduce the cost of) natural disasters? Reduce the taxpayer bur den for natural disasters? Unfortunately the answer to each of these is "no."

Solvency of Insurers Let us take these questions in order. Why would the Act not improve the solvency of insurers? The answer is to be found in acknowledging that the bill is really what Gordon Tullock identified as rent-seeking behavior,7 in this case of the property ca sualty insurance companies. The insurance companies are seeking to get the govern ment (taxpayers) to share the risk of insur ance against natural disasters. How could the insurance industry be in danger of in solvency from natural disasters? There is only one answer: they have been selling insurance at too low a premium. Premiums, in a freely operating industry, will cover losses after accounting for the investment earnings of the insurance com pany. If a company is selling insurance for a premium which does not cover the ex pected loss minus the investment earnings, it will eventually go out of business. This is the discipline of the market. As Ludwig von Mises pointed out, it is this market discipline which results in efficient use of resources, insuring that the value of the resources used in production at least equals the value to consumers of the service or good produced with these resources. 8 What the Act will do is to allow insurance companies to sellinsurance at below-market rates, with new federal programs acting, in effect, as the subsidizingagent. If the market is not providing reinsurance because the expected losses (the probability of the oc currence times the loss) are not calculable, then why should we expect that FEMA can figure out what the premiums should be?

Since this is a government program, and thus rates will be set through the political process no matter what the statute says, we can expect the rates to be underpriced. The net result is that insurance companies which would not survive the market test will con tinue to survive, and thus improperly price resources, and all insurance companies will take on greater risk than they otherwise would. This must result in either increased paid losses from natural disasters, and thus create just as much danger of insolvency for insurance companies, as it will now be cheaper to locate in disaster-prone areas, or increased government regulation of the in surance and building industry in order to offset this incentive. Reinsurance The Act surely will not promote the strengthening of the reinsurance market. The fundamental problem, as has been pointed out in a recent article in the Federal Reserve Bank of Cleveland's "Economic Trends," is that natural disasters are low frequency, high-impact events.9 As such they create two problems for insurance.

First, they are difficult to predict and thus THE NATURAL DISASTER PROTECTION ACT 419 price. Second, they are subject to "adverse selection": those most likely to purchase disaster insurance are the ones most likely to need it. Persons living in the San Fer nando Valley of California are much more likely to purchase earthquake insurance than those living in Michigan or Ohio. The people who purchase insurance will be much more likely to suffer from a disaster than the average person. 10 This complicates the insurance market because insurers at tempt to assemble a pool of uncorrelated risks. There also is the problem of "moral hazard": once I am insured against an accident, I am less likely to take precautions to avoid the accident. 11 Is there any reason to believe that a federal government rein surance program, managed by FEMA, and advised by a newly created, politically ap pointed board, is capable of solving these problems? Even if it could, what if the actuarially sound premiums for reinsurance were so high that no one would participate?

Is it likely that FEMA would stick to these premiums? Isn't it more likelY that there will be political pressure to set premiums sufficiently low to give the appearance that the problem has been solved? Exposure to Natural Disasters By reducing the cost of insurance, and by increasing the number of persons who pur chase insurance, the Act will result in greater exposure to natural disasters. Sup pose I have just had my house destroyed by an earthquake around Malibu. My insurance company says, "Fine, we will pay for this damage, but there is no way we are going to get stuck again and we are not willing to provide you with further insurance. " I now find that I must bear the whole risk of building another $2 million home in an earthquake-prone area. Am I less likely to build my home in this area under these circumstances than if my insurance com pany says: "We now participate in the new Primary Insurance Fund and thus can now provide you with insurance for your home at reasonable cost"? To ask the question is to answer it. It is obvious that reducing the cost of locating in disaster-prone areas must do only one thing: increase the amount and value of buildings in such areas. When disaster does strike, as it inevitably will, then my house will now be standing there to be destroyed.

Burden on Taxpayers Can the Act reduce taxpayer burden for natural disasters? It cannot reduce the value of buildings placed in disaster-prone areas by reducing the cost of insurance. The current government policy of providing de facto insurance to everyone in disaster prone areas makes the point. In The Con stitution of Liberty, Hayek warned that when the government undertakes ad hoc policies it will inadvertently be setting a principle.12 By providing disaster relief on a regular basis, people come to expect gov ernment relief in the face of a disaster. The Act itself is a response to the fact that reducing the risk of locating in dangerous areas results in activity which creates greater exposure. It is an attempt to replace the de facto insurance program with an explicit program. However, at least there was some uncertainty under the old pro gram. Congress might say "no" to relief, or provide minimal relief. With the Act, this modicum of uncertainty will be eliminated and there will be even greater reason for people to expose themselves and their prop erty to risk. The government will now be under legal pressure to provide the relief which it now grants simply under political pressure.

Is the result likely to be more taxpayer exposure, or less? People who argue that it will be less will say that persons who didn't purchase insurance before will purchase insurance now, because it will be cheaper or more available. Thus, there will be less loss to taxpayers, since the premiums willgo toward providing the relief. But with the increase in the number of persons with insurance, the adverse selection and moral hazard problems, combined with the fact that premiums must be set through the 420 THE FREEMAN • AUGUST 1994 political process, the likely result will be greater taxpayer exposure in the long run. What happens when the federal reinsurance program comes up $25 billion short? It will, of course, borrow from the Treasury under the Act. And if several hundred thousand voters who own homes are now forced to pay much higher premiums in order to pay off this debt, will there be no political pressure simply to extend the length of the debt to the Treasury? Willthis not especially be the case if the debt of the reinsurance fund is carried as an asset on the books of the federal government, and thus does not add to the perception of the federal debt? In the end, the debt of the reinsurance fund will never be repaid and it will result in the same loss to the taxpayer as if the taxpayer had directly provided relief.

Given that there is nothing inherent in FEMA to allow it to price disaster insurance and reinsurance more accurately and more cheaply than the market, what must happen as the exposure to disasters increases and the premiums rise for a large group of homeowners? The same thing that hap pened when the federal government pro vided insurance for deposits of savings and loans and banks: greater regulation. The insurance companies and homeowners will be faced with more and more government control. The types of insurance required, the premiums that may be charged, where buildings may be placed, how they may be built, what materials must go into building them, where they can be located-all this and more will be mandated by the federal government. The Act itself already sets up the mechanism for doing so and begins the process. Karl Marx was certainly correct in point ing out the inevitability of the process. 13 Eventually, just as happened with Social Security, more and more persons will be required to purchase insurance, "in order to spread the risk," which really means in order to subsidize those who are located in the most risky areas. Required premiums, set by the federal government through FEMA, will be the way that the government indirectly taxes people to pay for the results of the massive program that will have started "because catastrophic natural disas ters. . . pose particular problems in terms of substantial long-term consequences. . . and inadequate insurance and reinsurance cov erage. ,,14 Let us admit that Hayek was right, people must take responsibility for their own ac tions. 15 Harsh as it may seem, providing de facto insurance to persons who locate in disaster prone areas results in greater loss of life and property than would otherwise be the case. It took us decades to learn that our welfare policies have created a larger prob lem than they were meant to solve. Let us admit that we must simply reduce our pro clivity to rush to every disaster with "fed eral dollars. " Before we once again embark on a Promethean journey, let us simply admit that the problem of natural disasters is not too little insurance, but rather too much de facto insurance. 0 1. H.R. 2873, 103d Congress.

2. See his essay, Ce qu'on voit et ce qu'on ne voit pas. 3. This is the 50th anniversary of his The Road to Serfdom, University of Chicago Press. 4. 42 U.S.C. 5121 et seq. 5. See Our Enemy, The State (Delavan, Wise.: Hallberg Publishing, 1935), 1983. 6. See note 2. 7. Professor Tullock provided the seminal treatment of the subject in his "The Welfare Costs of Tariffs, Monopolies, and Theft," Western Economic Journal, 5 (June 1967), pp. 224 232. 8. See, for example, his major work, Human Action (New Haven: Yale University Press, 1949). 9. "The Economy in Perspective," February 1994, p. 2; 10. Cf. George Akerioff, "The Market for Lemons: Qual itative Uncertainty and the Market Mechanism," Quarterly Journal of Economics, 84 (1970), pp. 488-500. 11. For a brief discussion of moral hazard, see Hal Varian, Microeconomic Analysis (New York: Norton, 1978),chapter 8. 12. The University of Chicago Press, 1960. See the Gate way Edition, Henry Regnery, 1972, p. 111 (chapter 8, Section 6).

13. See Karl Marx and Frederick Engels, The Communist Manifesto, Pathfinder Press, 1987 (originally published 1847), especially chapter I. 14. Sec 101. 15. The Constitution of Liberty, chapter 5.