Behavioural biases can prevent investment in measures to protect against catastrophes

Several behavioural biases prevent individuals and firms in the private sector from investing in adaptation measures that can help protect against catastrophic risks, making the case for public-private partnerships, suggests a recently released paper.

Behavioural biases include budgeting based on experience rather than analysis, discounting the benefits of reducing potential losses from future events relative to immediate upfront costs of protection, and interdependencies, meaning response depends on how others behave, Howard Kunreuther of the Wharton School at the University of Pennsylvania and Geoffrey Heal of Columbia Business School note in their paper, Managing Catastrophic Risk.

“In an interdependent world with no intervention by the public sector, it may be economically rational for those at risk not to invest in protective measures,” Kunreuther and Heal write.

“Risk management strategies that involve private-public partnerships are, thus, crucial for addressing these issues and reducing future catastrophic losses,” the paper states. These strategies may include multi-year insurance contracts, well-enforced regulations and third-party inspections.

“A principal reason that losses from catastrophic risks have been increasing over time is that more individuals and firms are locating in harm’s way while not taking appropriate protective measures,” the paper notes.

Individual decisions regarding risk-reducing measures will be influenced in fundamental ways by the biases and behaviours of others. “In particular, the reliance on pure private market solutions that depend solely on individual initiatives may fail in these environments,” the authors say.

“If we continue to refrain from taking steps to reduce our vulnerabilities to potential catastrophes, the seeds of future disasters are created,” Kunreuther and Heal say. “This is true for floods, hurricanes, earthquakes, terrorism threats, financial crises, oil spills and other extreme events waiting on the horizon.”