A Portfolio Approach to Addressing Catastrophic Risk

Catastrophic events, such as oil spills and hurricanes, result in high numbers of fatalities and significant property damage. Given their relative rarity and potentially massive losses, catastrophes pose substantial risk-management challenges especially given the range of threats they create and a broad number of potential responses.

In their chapter in the new book Regulatory Breakdown, W. Kip Viscusi of Vanderbilt Law School and Richard Zeckhauser of the Harvard Kennedy School of Government describe how catastrophic risks are often “fat-tailed,” in that their occurrence and consequences are virtually unpredictable. As a result, entirely preventing such risks may be impossible or in some cases undesirable, as the only way to completely avoid the risk from otherwise socially valuable activities may be to prohibit those risky activities altogether.

According to the authors, no single institutional mechanism can be alone effective in mitigating all catastrophic risks, as each type of risk exhibits distinct characteristics and challenges.  Catastrophic risks can be caused by human behavior or by nature. They can vary greatly between different categories, from earthquakes to oil spills, and even within each category, such as oil spills from offshore drilling versus spills from leaky tanker ships.

Good public policy requires a variety of responses to respond to the variety of risks. Viscusi and Zeckhauser propose a “portfolio approach” that uses a “mix of policy instruments tailored to each particular situation.”  Specifically they urge public and private responses that rely on regulation and taxes, civil liability, and voluntary risk-sharing bargains.

According to the authors, addressing human contributions to catastrophes is essential to an effective portfolio strategy combatting risk. The authors claim that human behavior even causes or contributes to the negative consequences of many natural catastrophes. For example, by channeling the Mississippi River humans removed protections afforded by the river’s delta and ultimately exacerbated the flooding caused by Hurricane Katrina. As Viscusi and Zeckhauser explain, “nature usually needs a partner to wreak extreme damage on society.”

Individuals may also more directly contribute to catastrophes. They may do so collectively, such as by contributing emissions that lead to ozone layer depletion. In other cases, a small number of responsible parties may be responsible, as with the 2010 Deepwater Horizon oil spill.

Blameworthy individuals and organizations may belong to the harmed group, resulting in a “commons catastrophe,” or they may impose losses onto others, resulting in an “external catastrophe.” These two forms of catastrophe, commons and external, require different responses, write Viscusi and Zeckhauser, further reinforcing the need for a portfolio approach to catastrophic risk policy.

Viscusi and Zeckhauser’s “portfolio regime” would center on a system of liability that encourages risk management via financial incentives and shifts major responsibilities from government regulators to those parties generating the greatest amount of risk.

They consider civil tort liability to be critical in catastrophic planning and argue that it has proven effective as a mechanism for controlling risk and compensating the injured when harms are man-made. Nonetheless, the authors recognize the limitations of civil liability for addressing risks with extremely low probabilities of harm.  Furthermore, tort liability is generally available only to compensate for foreseeable harms, and so it is often unavailable for harms caused by catastrophic risks that are hard to predict.

Viscusi and Zeckhauser propose a two-tier system of liability to increase the effectiveness of tort liability in responding to catastrophic risk.  The first tier would make a firm engaging in potentially risky activities subject to strict liability for all resulting damages and would require the firm to provide evidence of its financial resources, such as insurance or a catastrophe fund.  Under the second tier, a firm would be taxed according to the expected valued of harms its risks impose beyond what the firm might compensate with its demonstrated financial capabilities.

According to the authors, their proposal would impose upon a firm the costs of the risks it creates and encourage that firm to internalize the full costs of its risky behavior.   Businesses engaging in risky activity would be more likely to adequately plan for risks and find ways to share such risks through risk-sharing bargaining.

The authors indicate that regulators can play a valuable but limited role in their proposed system. Government contributes to market-driven risk-sharing bargains by providing information and assessing risk.  It plays a necessary role in setting an appropriate level of taxation of risk.  Government inspections can also be helpful, even though the private sector’s technical expertise puts firms in a better position to monitor employee behavior and effectively address catastrophic risks.

Viscusi and Zeckhauser conclude the while catastrophic risks are inevitable, “a judicious choice of policies from the entire portfolio of public and private institutional mechanisms” can be used to reduce the significance and consequence of these risks.