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Expert: Mandate ‘FEMA premiums’ for disaster-prone areas

Tatyana Deryugina
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L. Brian Stauffer

Tatyana Deryugina, a lecturer of finance in the College of Business, says one way to limit the amount of money the federal government doles out to repair damage would be to mandate disaster-prone areas pay "FEMA premiums."

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12/6/2011 | Phil Ciciora, Business & Law Editor | 217-333-2177; pciciora@illinois.edu

CHAMPAIGN, Ill. — With seemingly more extreme weather on the horizon, should Uncle Sam have to foot the bill every time a natural disaster strikes? According to a University of Illinois expert in environmental economics, one way to limit the amount of money the federal government doles out to repair damage would be to mandate disaster-prone areas pay “FEMA premiums” to the federal government.

Tatyana Deryugina, a lecturer in finance in the College of Business, says since the government can’t completely walk away from its responsibilities after an act of God occurs, it needs to create the right incentives for states through area-based insurance.

“Obviously, it would be very hard for the government to say that if a disaster occurs, we’re not going to pay for it,” she said. “But what the government can say is you have to pay these premiums.”

Deryugina says the implicit promise of federal aid may actually encourage some people to live in high-risk areas.

“It’s not bad to have people living in risky areas per se, but it’s also not good to have people living in areas where they wouldn’t normally live if they had to pay the actuarially fair price of the insurance themselves,” she said. “If they’re choosing to live there because they’re not internalizing the full risk, or if they’re betting the government will bail them out afterward, then that’s problematic.”

Between 1983 and 2008, the U.S. spent a little more than $80 billion (in 2008 dollars) on disaster aid, an average of $3 billion per year. While spending on defense and entitlements dwarfs that number, not only is the distribution of those funds unequal, it’s also money that could probably be better spent elsewhere, Deryugina says.

“In 2008 dollars, the disaster aid received between 1983 and 2008 ranged from $74 per capita in Washington, D.C., to about $217,000 per capita in Louisiana, for a person who lived there for the entire 25 years,” she said. “Clearly, there is a difference in the amount of money going to different states and locations, and a lot of disasters are not so unpredictable that you can’t make states account for them in advance.”

Disaster aid also is notable in that states don’t usually bear the full financial burden of compensating victims. States are responsible for at most 25 percent of the cost, and often pay less than that, which creates disincentives for states to invest in mitigative measures, Deryugina says.

“There are a lot of distortions in that market, with a lot of states trying to regulate the insurance companies while also capping the rates they can charge to homeowners,” she said. “Consequently, many insurance companies have been pulling out of disaster-prone areas because they’re not allowed to charge the rates they would like.”

A reliance on the federal government for disaster-relief funds also discourages individuals and municipalities from implementing preventive measures that could reduce the amount of damage in the event of a natural disaster.

“Although it’s somewhat difficult to measure how much damage preventive measures actually prevent, one estimate we have says that every dollar invested mitigates about $15 in damage,” Deryugina said. “That’s a huge return on investment, which suggests that the government needs to do more to incentivize cities to build levees, get people to install hurricane shutters and construct buildings that can withstand earthquakes and high winds.

“You can deduct damages from your taxes, but you can’t deduct insurance premiums. That’s another example of a perverse incentive where the incentive to get insurance is reduced.”

Natural disasters are costing state and federal governments much more money than they might think, Deryugina says.

“It’s not only spending by FEMA that’s affected by extreme weather events, it’s also all these other social safety net programs that we don’t immediately think of when we think disaster,” she said. “For example, both Medicaid and unemployment insurance payments go up, and stay high, following a hurricane. So when we account for what this is costing the federal government, it’s not just the disaster-specific aid that’s being disbursed. It’s also other programs that are triggered by the occurrence of these events. And if we’re not accounting for that increase in spending, we’re going to underestimate the true cost of natural disasters.”

The big question is how such a disaster-aid premium system could work. The answer, according to Deryugina, is to make it similar to unemployment insurance.

“With unemployment benefits, the premiums are paid by companies based on their layoff history, so the more people you lay off, the higher the premiums you have to pay,” she said. “You could think of the same thing applying to cities: The more disaster-prone you are, the more in premiums you pay per resident.”

Deryugina says the benefits of such a system are that the state, county or municipality could think of the best way to implement a tax to pay for the premiums.

“If you’re a tourist town, you could make the out-of-towners pay for it, or if you want to attract more tourists, you could implement a sales tax or a city-based income tax,” she said. “It wouldn’t probably be a huge tax, given the rarity of catastrophic events, and if one is worried about distributional effects, you could certainly make it progressive.

“You could find other creative ways to reduce the amount of premiums paid, such as buying insurance or implementing other preventative measures, so the expected cost to the government of bailing you out is lower.

“If the government wanted to help cities out, they could pay part of the premium for each citizen below the poverty line. But the important thing to do in that situation would be to grandfather that payment, because otherwise you would create incentives for more poor people to live in disaster-prone areas.”

Editor's note: To contact Tatyana Deryugina, email deryugin@illinois.edu.

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