Adverse Selection and Moral Hazard in Natural Disaster Insurance Markets:

Empirical evidence from Germany and the United States

Paul Hudson1, W.J. Wouter Botzen1, Jeffrey Czajkowski2, Heidi Kreibich3

1
Department of Environmental Economics, Institute for Environmental Studies, VU University

Amsterdam, the Netherlands.

2
Wharton Risk Management and Decision Processes Center, University of Pennsylvania, U.S.
3
GFZ German Research Centre for Geosciences, Potsdam, Germany.

Abstract

Adverse selection and moral hazard are commonly expected to cause market failures in natural

disaster insurance markets. However, such problems may not occur if individuals mainly buy

insurance based on risk preferences. Advantageous selection can occur if individuals with

insurance are highly risk averse and seek to reduce risk. This is the first empirical study of

adverse selection and moral hazard effects in natural disaster insurance markets. Statistical

analyses are based on survey data of individual purchases of disaster insurance and risk

mitigation activities in Germany and the United States. Consistent results are obtained in both

countries supporting advantageous selection.

Keywords: Adverse selection, Heckman sample selection model, Propensity Score Matching,

Moral hazard, Natural disaster insurance

JEL codes: G22, Q54

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1. Introduction

Over the last decades economic damages from natural disasters have been increasing and this

trend is likely to continue (IPCC, 2012; Munich Re, 2013). Insurance could play an important

role in managing natural disaster risks and promoting recovery from disasters, because it reduces

financial risks for individuals by spreading risks over many policyholders, helping people to “get

back on their feet” after a disaster occurs (Botzen, 2013). Moreover, insurance can provide

incentives for risk reduction by charging premiums that act as a price signal of risk, or by

providing premium discounts to policyholders who protect their property against disaster damage

(Kunreuther, 1996). On the other hand, insurance coverage may result in a moral hazard effect in

that individuals take fewer measures to limit risk if they expect that insurers will compensate

their damage irrespective of their mitigation efforts (Arnott and Stiglitz, 1988). This poses

problems if the behavior leading to moral hazard cannot be observed by the insurer, meaning that

actual risks are not reflected in the insurance premium (Chiappori and Salanie, 2000). Moreover,

adverse selection may obstruct the adequate functioning of natural disaster insurance marketsi if

mainly individuals who face a high risk demand insurance, while insurers do not adequately

factor such risks into higher prices because of information asymmetries between the insurer and

the insured (Akerlof, 1970; Rothschild and Stiglitz, 1976)ii.

It is, however, not evident that adverse selection and moral hazard problems arise in

insurance markets. Adverse selection may not occur if individuals are characterized by “bounded

rationality” and misperceive the risk that they face (Kunreuther and Pauly, 2004). In other words,

it is not necessarily the case that individuals facing a high objective risk have a high risk

perception (Botzen et al., 2009) or a high demand for natural disaster insurance coverage (Botzen

and van den Bergh 2012a,b). In general, a lot of evidence shows that individuals have difficulties

with assessing low-probability/high-impact risks (Kunreuther et al., 2001) which may translate

2
into poor decision making with respect to natural disaster insurance purchases (Kunreuther et al.,

2013). Moreover, adverse selection and moral hazard may not be an issue if insurance purchase

decisions are mostly driven by risk aversion, and if highly risk averse people who purchase

insurance also take other precautionary measures which limit risk (Finkelstein and McGarry,

2006; Cohen and Einav, 2007). Such an advantageous selection effect is theoretically supported

by de Meza and Webb (2001). This theory may hold in practice since, for instance, Thieken et al.

(2006) showed that insured households during a 2002 flood in Germany had better risk

awareness and mitigation strategies in comparison with uninsured households. It is an empirical

question whether moral hazard and adverse selection effects dominate advantageous selection

effects based on preferences, like risk aversion, and potential risk-reducing incentives provided

by insurance.

Several empirical studies conducted on the health insurance markets show that adverse

selection is present (Sloan and Norton, 1997; Finkelstein et al. 2005; Finkelstein and McGarry,

2006; Courbage and Roudaut, 2008), although there are studies that argue the opposite. One such

study is Cardon and Hendel (2001) who provide evidence that information asymmetries are not

significantly present, by showing that observable traits are important drivers for health

expenditure. However, Finkelstein and McGarry (2006) arrive at an opposite finding to that of a

moral hazard effect since individuals with health insurance in the U.S. take more measures to

reduce health risks than uninsured individuals, which may be explained by risk aversion. Einav

et al. (2013) find that greater U.S. health insurance coverage is driven by increasing expected

health risks, risk aversion and moral hazard. Their results show that altering the level of risk

aversion only has small effects on the size of the chosen deductible, while moral hazard and

expected health risks have roughly equal driving effects on the size of the deductible. Moreover,

3
they find that moral hazard is driven by the expected incremental increase of health expenditure,

which implies that individuals who take measures to reduce their marginal health care costs can

display advantageous selection. Likewise, in their investigation of life, acute health, annuities,

long-term care, and Medicare supplemental insurance markets, Cutler et al. (2008) find that those

individuals who engage in less risk reducing behavior (i.e., moral hazard) are less likely to have

each of these insurance types. To the best of our knowledge, a systematic empirical analysis of

the presence of moral hazard and adverse selection in natural disaster insurance markets is

lacking.

This paper aims to fill this gap by presenting an analysis of how flood insurance

purchases relate with experiences of flood damage and flood risk mitigation behavior in

Germany and in the U. S. In particular, for Germany, this paper examines the individual

behavioral component of adverse selection, namely whether people who take out flood insurance

face a higher flood risk. Moreover, it is estimated whether after correcting for adverse selection,

individuals who have flood insurance experience more flood damage than uninsured individuals,

which can be related to moral hazard when insured individuals take fewer flood damage

mitigation measures. The absence or presence of moral hazard in Germany may be related to risk

preferences of individuals, or the deductible on the flood insurance policy for which we cannot

control directly. However, we expect the influence of the deductible to be small. This is

confirmed by our complementary analysis for the U.S. which shows that the deductibleiii has a

negligible impact on policyholders risk mitigation activities. In particular, for the U.S. it is

examined whether people who have taken out separate homeowners insurance (which covers

wind damage only) and flood insurance policies are more, or less likely to take other measures

4
that limit hurricane damage. This analysis provides insights into moral hazard, and controls for

risk perception, past hurricane experience, and deductible levels.

Understanding the potential moral hazard and adverse selection effects in the market for

natural disaster insurance has important public policy relevance in these two countries. In

Germany it has been argued that adverse selection is one of the reasons for the observed low (5-

10%) market penetration of natural hazard insurance, which has resulted in calls for introducing

mandatory disaster insurance (Schwarze and Wagner, 2007; Seifert et al., 2013). In the U.S.,

where flood insurance is primarily a publically underwritten insurance vehicle through the

National Flood Insurance Program (NFIP), there have been recent calls for reform including

more private market involvement (Michel-Kerjan and Kunreuther, 2011). Adverse selection

would be a deterrent in this regard. Moreover, the movement toward risk-based premiums as a

part of the recent flood insurance reform actsiv is aimed at providing incentives for mitigation for

which it is relevant to know how far insurance acts as a mitigation disincentive (moral hazard).

In the U.S. wind insurance market significant wind and hurricane deductibles are a part of a

homeowner’s insurance contract to help avoid potential moral hazard. However, such

deductibles may substantially lower the attractiveness of the insurance for consumers, and

whether these can be applied in recent major events, such has Hurricane Irene and Sandy, has

been a contestable legal issue (Pomerantz and Suglia, 2013). It is, therefore, of interest to

examine whether moral hazard is a major issue in the U.S. natural disaster insurance market, and

whether high deductibles are effective in stimulating policyholders to mitigate risks, as will be

studied here.

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 The remainder of this article is structured as follows. Section 2 describes the methods and

data used. Section 3 presents the results about adverse selection and moral hazard in Germany

and the U.S. Section 4 concludes.

2. Methods and data

Statistical methods

Two methods are applied to examine adverse selection and moral hazard effects in flood

insurance markets in Germany. First, an estimation of how average flood damage differs

between individuals with, and without, flood insurance provides an indication of both adverse

selection and moral hazard effects on flood damage. For example, experienced flood damage

may be higher for individuals with flood insurance because they face a higher flood risk (adverse

selection) or because such individuals take less damage mitigation measures (moral hazard). In

contrast, flood damage of insured individuals could be lower if they have taken more damage

mitigation measures, for example, because individuals with flood insurance are very risk averse.

Alternatively they may have received incentives from their insurer to reduce flood risks,

although the latter is uncommon in Germany (Thieken et al., 2006). Second, this study aims to

estimate the independent effect of moral hazard on experienced flood damage by correcting for

the effects of adverse selection on flood damage by insured individuals using Propensity Score

Matching (PSM).

The reason for using PSM is that taking only a simple comparison of average damage

between the insured group and non-insured group of survey respondents for estimating moral

hazard would likely suffer from selection bias (SB). This is formalized in Equation 1 which

shows that the difference between the damage outcome of people with flood insurance (the

6
treatment group) 𝑦1 and people without insurance (non-treatment group) 𝑦0 is a combination of

the average treatment effect on the treated (ATT) and SB. T is a binary variable for participation

in the treatment group. The ATT is the independent influence of having an insurance policy on

flood damage, which can be influenced by a moral hazard effect. SB arises as a result of the

influence of factors that jointly affect flood damage outcomes and having purchased flood

insurance. Selection bias can be viewed as an adverse selection effect because it represents the

influence of the confounders, such as hazard, exposure and vulnerability characteristics of

households. The effects of adverse selection are due to the individuals with high(er) risk traits

having a higher tendency to buy insurance, which will mean higher expected damage to be

suffered. The higher expected damage will remain even if the individuals with higher risk traits

are charged higher premiums.

𝐸(𝑦1 | 𝑇 = 1) − 𝐸(𝑦0 | 𝑇 = 0) = 𝐴𝑇𝑇 + 𝑆𝐵 (1)

PSM is able to remove the SB from a comparison of average damage, and estimate the ATT,

which provides an indication of the presence or absence of moral hazard. PSM is most

commonly used in cases where non-random entry into the control and treatment groups means

that traits that affect both outcomes and treatment participation (confounders) can introduce bias

into evaluation attempts. Important confounders in this application are the characteristics of the

flood hazard faced by individuals and characteristics of their assets exposed to floods which have

made them select into buying flood insurance (adverse selection). Both characteristics include

factors that significantly influence the damage that individuals suffer when a flood occurs. Our

7
approach is in line with other studies that use matching methods to investigate moral hazard in

insurance markets (e.g., Barros et al., 2008).

Rosenbaum and Rubin (1983) developed PSM to provide unbiased evaluations of

observational data, such as survey data that will be used here. Only 𝑦1 or 𝑦0 can be observed for

each agent, which implies that we do not observe the level of flood damage insured households

would have suffered in case they would not have purchased flood insurance coverage. Members

of the non-treatment group can be used as the required counterfactual observation for treatment

group members, if SB shown in Equation 1 can be removed. Removing this bias requires the

following conditions to hold, where represents independence, and 𝑝(𝑋) is the estimated

propensity score (PS) as a function of the confounders X (Rosenbaum and Rubin, 1983; Hudson

et al., 2014):

Condition 1: Unconfoundedness – (𝑦0 , 𝑦1 ) 𝑇|p(X)

Condition 2: Balancing – 𝑇 ∐ 𝑋|p(X)

Condition 3: Overlap – The PS distributions for the control and treatment groups share a

common support, i.e. only observation with a PS within the range :

control treatment control treatment v

[max(PSmin , PSmin ), min(PSmax , PSmax )] .

The PSM analysis is complemented by an analysis of homeowner and flood insurance

purchases in the U.S. which uses binary discrete choice (probit) models to examine whether

insured individuals are more or less likely to implement any measures that reduced hurricane

8
losses. The initial approach employed with the U.S. data is similar to the analyses of moral

hazard in health insurance conducted by Cutler et al. (2008). Specifically, the likelihood of an

individual having either a homeowners or flood insurance policy is estimated as a function of the

implementation of any behavioral risk reducing short-term preparation or long-term mitigation

activities that were undertaken prior to the arrival of an impending hurricane. Undertaking these

behavioral measures are hurricane risk reducing in that they could reduce damage to one’s

property (putting up storm shutters, taking in furniture, permanent modifications to one’s home,

etc.) or oneself (purchase of food and water supplies, made reservations in case evacuation is

needed, plan to evacuate, etc.). We additionally control for an individual’s risk perception of the

storm through a variable that indicates how safe one feels in staying in their home throughout the

hurricane event. Moreover, additional analyses examine the influence of the insurance deductible

on mitigation activities.

Data collection

The German data are obtained from surveys carried out in the Elbe and Danube river catchment

areas in response to flood events occurring in 2002, 2005 and 2006. The sample population was

collated by using official data to collect all of the streets that suffered from a flood. The sample

population was refined into the experimental sample by drawing a random sample of households

from the identified addresses. The survey was conducted as a 30 minute telephone interview

directed to the head of the household. The surveys provide approximately 2,000 respondents in

total (Kreibich et al., 2005; 2011). Of the usable 640 observation for PSM about 42% have flood

insurance. The surveys were intended to explain both damage outcomes from the flood and if a

respondent had undertaken precautionary flood risk mitigation measures; the overlapping

9
variables are the confounders required for PSM to be successful. These variables which are

included in estimating the propensity score are related to the flood hazard, exposure and

vulnerability, which are of influence on the actual flood risk faced by the respondent and may

indicate the presence of adverse selection. The variables are described in Appendix A. Several

different methods of matching have been employed in order to assess the appropriateness of the

supposed confounders. More detailed information on the applied methodology can be found in

Hudson et al. (2014) who apply PSM to evaluate damage savings from flood preparedness

measures other than insurance.

The U.S. data are obtained from field surveys that measured the evolution of coastal

residents’ risk perceptions and preparation plans as three hurricanes ─ Irene (2011), Isaac (2012),

and Sandy (2012) ─ approached the U.S. during the 2011 and 2012 hurricane seasons. In these

studies, perceptions and preparation decisions were notably measured in real time as they were

being made by residents threatened by the storms. The surveys for these three storms provide

1,698 respondents in totalvi and include information on whether respondents had a homeowner’s

insurance policy that would pay for damages to one’s home resulting from the storm, if they had

a separate flood insurance policy, and whether they knew the amount of their insurance policy

deductible or would have to look it up. In the U.S., homeowner’s insurance policies cover only

wind-related hurricane damages, not any damages due to flooding from the storm. While 85

percent of total respondents indicated having a homeowner’s insurance policy, only 32 percent

answered having a separate flood insurance policy. Answers to these two questions serve as our

indicator variables for whether a respondent has homeowner’s insurance or flood insurance.

We utilize four categorical variables for the behavioral moral hazard measures: no

preparation = 1 if have not undertaken any of the presented short-term preparation activities, 0

10
otherwise; no window protection = 1 if answer “no” to whether their home has any sort of

window protection, 0 otherwise; no mitigation = 1 if answer “no” to whether ever modified their

home to reduce the amount of hurricane wind damage other than having window protection, 0

otherwise; and no evacuation plans = 1 if answer “no” to whether they plan to evacuate to

someplace safer, 0 otherwise. Short-term preparation activities identified included whether

purchased supplies for the home such as food, water and batteries; filled car with gas; filled

generator with gas (or readied generator); put up storm shutters; took in furniture or other outside

precautions; and made reservations or plans in case evacuation is needed. While only eight

percent of total respondents indicated not doing any short-term preparation activities, 67, 78, and

71 percent did not undertake any window protection, long-term mitigation, or evacuation plans

respectivelyvii. Lastly, in order to account for individual risk perception of the event in relation to

undertaking any risk reducing activities we include a measure of safety perception. Responses to

the following question were given on a 0 to 100 scale: “How safe did one feel about staying in

your home through the storm, considering both wind and water?” “0” indicated “certain that it

will not be safe” and “100” indicated “certain that it will be safe”viii. The mean perception of

safety values for any one storm were all above 75 indicating that survey respondents felt

relatively safe concerning the impending hurricanes. More detailed information on the real-time

hurricane survey methodology, data, and specific questions can be found in Meyer et al. (2014).

3. Results

Results for Germany

Flood risk is a function of exposure (the value of what can be damaged), hazard (the probability

and intensity of a flood), and vulnerability (susceptibility of the building or contents to damage)

11
(Kron, 2005), while flood damage is a single realization of the risk faced. The presence of

adverse selection or moral hazard would cause systematic differences in these variables between

the insured and the non-insured samples. A mean comparison of experienced flood damage

between groups of individuals with, and without, flood insurance (Equation 1) reveals that

insured individuals in Germany suffered significantly higher flood damage to contents and

buildings (Table 1). It can be argued that because a mean comparison contains the ATT and a

selection bias (Angrist and Pischke, 2008) it estimates the combined effect of adverse selection

and moral hazard. Selection bias would contain a type of adverse selection effect as high risk

individuals have a greater incentive to buy insurance. Moral hazard is captured by the ATT

(presented in Table 1) which represents the influence of having insurance on the outcome of

flood damage, while correcting for effects on this damage caused by selecting to buy insurance

(adverse selection). Adverse selection would be expected to increase damages, while the moral

hazard effect is more ambiguous as insurance could cause individuals to become more lax or

insured individuals may take more mitigation measures because they are generally very careful

(risk averse). It is thus an empirical issue to estimate whether individuals with flood insurance

experience higher, or lower, flood damage than uninsured individuals.

Table 2 panel A presents summary statistics of the hazard experience. It shows that an

element of adverse selection may be present because the treatment group scores higher on

various hazard indicators than the control group. In other words, respondents with flood

insurance suffered from a worse flood event, as the difference in water levels shows. This

suggests that households with flood insurance face a higher flood risk as the overall shape of the

water-level distribution can be argued to be the same across different flood magnitudes, although

it is centered around different locations. Furthermore, water-level can be considered to be the

12
most important variable of influence on flood damage (DEFRA, 2006; Merz et al. 2010). In

conclusion, adverse selection may be present in the German flood insurance market since the

insured households faced higher risk than non-insured households; indicating that higher risk

households have a greater incentive to purchase flood insurance coverage. Such problems with

adverse selection can, in practice, be limited by reflecting in insurance premiums the higher

flood risks of individuals in floodplains who demand flood insurance than individuals in

floodplains who do not buy flood insurance.

The PSM estimates can be regarded as providing an indication of the presence of a moral

hazard effect, because the confounders remove selection effects on flood damage. Table 1 shows

that the expected difference in flood damages between the groups with, and without, flood

insurance is lower once adverse selection has been controlled for using PSM. The latter removed

effects on flood damage resulting from risk-related factors (hazard and exposure) that determined

whether people purchased flood insurance. The ATT estimates suggest that moral hazard is not a

problem, because the difference in damage between the insured and non-insured is statistically

insignificant. For this to be the case the behavior of the two groups must be rather similar with

respect to vulnerability to flood hazard which is influenced by the undertaking of damage

mitigation measures. For moral hazard to be present the insured group would have to undertake

fewer protective measures. The summary statistics displayed in panel B of Table 2, imply that

both groups have an equal probability of employing at least one damage mitigation measure.

Moreover, the insured group also seems to be more informed about the risk they face as well as

being more likely to be a part of a flood support network. It is also arguable that the insured

group is more risk averse than the non-insured group, as every member of the insured group

employed at least one of the flood coping measures indicated in Table 2, while only 56% of the

13
non-insured group did soix. Therefore, it is possible that the higher level of risk aversion has

reduced any negative moral hazard effect. It may be the case that insurance has directed

individuals to undertake actions that improve their ability to cope with floods, such as joining a

flood support group, although this is unlikely based on the results of Thieken et al. (2006).

The results in Tables 1 and 2 are based on data from both the Elbe and Danube River

catchment areas; however, there may be differences between these two catchments. Because of

historical reasons the flood insurance cultures in the two catchment areas have developed

differently. The Elbe catchment is mainly located in the former German Democratic Republic,

where flood insurance was a part of the compulsory insurance policies household must have.

Even after the reunification of Germany, a large number of households in that area still have an

equivalent set of contracts, while insurance penetration in former West Germany (including the

German part of the Danube catchment) is much lower (Thieken et al., 2006). Therefore, although

the factor is controlled for when estimating the propensity score, there is the potential that

households located in the Elbe catchment are being compared with households in the Danube

catchment area. In order to investigate if the results of Table 1 are being driven by regional

effects, the model was estimated using only the sample of households located in the Elbe

catchment area, and again, but restricted to, the Danube catchment. The results of these spilt

sample models are presented in Table 3.

Several new insights emerge from the split sample approach. The overall results of the

combined sample in Table 1 appear to be mainly driven by significant mean comparison

estimates for contents damage by the Elbe catchment area and building damage by the Danube

catchment area. Consistent with Table 1 is that within both catchment areas there is no

conclusive evidence for the presence of moral hazard, because the ATT estimates are

14
insignificant. There remains evidence for the presence of adverse selection from the results of the

mean comparison: namely, for contents damage in the Elbe catchment and property damage in

the Danube catchment. However, although building damage in the Elbe and content damage in

the Danube appear to be higher for households with flood insurance, this difference compared

with uninsured households is insignificant. Where the results are statistically significant we see a

strong potential for adverse selectionx.

The difference in insurance culture between the two regions in Germany provides an

opportunity for examining how this translates in different flood protection behavior. In

particular, in the Elbe area insurance is acquired as a matter of habit, while in the Danube area it

is more of a conscious decision to buy insurance. This allows investigating if the risk averse

population has a higher tendency to buy insurance, which could be reflected by the more choice

based insurance culture of the Danube catchment area displaying a higher portion of the insured

population taking measures to protect themselves. While focusing on the Elbe catchment area on

the other hand provides an opportunity to investigate if whether a more social consensus based

reasoning behind insurance purchase encourages less personal risk mitigation. Table 4 provides

an indication of the difference in damage mitigation attempts between the insured and non-

insured population. On the whole, it appears that the insured group has a greater proportion of its

population employing various damage mitigation measures. In the Elbe catchment area this is a

modest increase across all the measures investigated, while for the Danube catchment area

especially large differences can be found in the use of water proofing and water barriers. This

finding indicates that in general those who purchase insurance have also carried out more

damage mitigation actions, and that this effect is greater when the decision to buy insurance is

more consciously made.

15
Results for the United States

Table 5 presents for each hurricane the relationship between the lack of undertaking any

hurricane risk reducing behavior and having homeowners and flood insurance coverage in the

U.S. Negative coefficients signs across all three storms indicate that those survey respondents

that engage in no short or long-term ex-ante property risk reducing behavior are less likely to

have homeowner’s or flood insurance. That is, those without homeowners or flood insurance are

more vulnerable due to a lack of risk mitigation measures, and thus those that have insurance do

not exhibit evidence of moral hazard. However, the statistical significance of this relationship

differs between the hurricanes. For example, those survey respondents that conduct no

preparation activities for Hurricane Irene (the largest proportion across all three storms at 11

percent of respondents) are 55 percent less likely to have homeowners insurance and 38 percent

less likely to have a separate flood insurance policy.xi These effects are statistically significant at

the 1 percent and 5 percent level respectively. Respondents from Hurricane Sandy produce a

similar result in that those that conduct no preparation activities are 64 percent less likely to have

homeowners insurance, which is statistically significant at the 1 percent level xii. For all three

hurricanes those that felt safer are more likely to have homeowners insurancexiii. Furthermore,

those respondents that engage in no ex-ante personal risk reducing behavior (have no plans to

evacuate) are more likely to have homeowner’s insurance. These results suggest a trade-off in

risk aversion to property losses vs. risk aversion to personal harm among our respondents.

The results in Table 5 do not indicate the presence of moral hazard in regard to natural

disaster coverage. However, if insurers are concerned that moral hazard may be occurring one

way to offset this is through the use of a deductible. The deductible forces the insured to have

16
“skin in the game” by making them at least partially responsible for any losses incurred.

Moreover, in the U.S. for wind events, like hurricanes, this amount is likely substantial as

separate wind and hurricane deductibles are typical for homeowner’s policies and range from 1

to 5 percent of the insured value of the home. Unfortunately for insurers relying on a deductible

to offset moral hazard, our survey data suggest that homeowners are not aware of their

deductible amount, or if they are aware believe it to be relatively low. For example, from our

1,442 respondents who indicate that they have homeowners insurance, 62 percent do not know

what their deductible isxiv. Furthermore, only 12 percent believe it to be greater than $1000.

Table 6 presents the coefficient results from a series of estimations aimed at primarily

investigating the deductible’s role in the likelihood of undertaking any short and long-term

preparation activities in addition to controlling for having flood insurance in-place, previous

hurricane damage experience, and the perceived level of safety. Specifically, for each storm and

for only those respondents indicating having homeowners insurance we undertake three separate

statistical estimations: 1) Heckman sample selection model where the selection stage is a probit

model of the likelihood of undertaking any short-term preparation and the outcome component

of the model estimates effects of the explanatory variables on the actual number of preparation

activities undertakenxv; 2) a probit model of the likelihood of having window protection in-place;

and 3) a probit model of the likelihood of having done any other home mitigationxvi.

Similar to the Table 5 results we see little evidence of moral hazard for the insured, as the

likelihood of undertaking any short or long-term preparation activities as well as the number of

preparation activities undertaken has a positive and mostly statistically significant relationship

with having flood insurance in place. As would be expected, having experienced hurricane

damage in the past and feeling less safe are generally positively related to undertaking more

17
preparation activities, although not always statistically significant. In terms of the deductible

coverage, model (1) selection stage coefficient values of having a known low deductible suggest

this is a deterrent to the likelihood of undertaking any preparation activities for Hurricanes Isaac

and Sandy. From the model (1) second stage results in comparison with those having an

unknown deductible amount (the omitted category), coefficient signs generally indicate that

knowing one’s deductible increases the number of preparation activities undertaken, but not

always as is apparent from the Sandy results. Similarly, from models (2) and (3) having higher

levels of known deductible coverage does not always translate into an increased likelihood of

undertaking window protection or other home mitigation as would be expected. As our surveys

were not conducted on a panel of respondents over time and were drawn from different

geographic areas for each storm, these types of differences across storms are expected. For

example, while Irene made landfall in New York in 2011, our Sandy respondents were all from

states outside of NY – VA, MD, DE, and NJ – whereas Irene respondents were drawn from NC

and NY. Despite these inherent differences in respondents however, most notable is the general

lack of statistical significance on any of the deductible variables in the three models, indicating

its lack of importance in incentivizing short-term preparation or longer-term mitigation ahead of

the hurricane for our insured respondent samplexvii.

4. Conclusion

It is often suggested that adverse selection and moral hazard create problems in establishing

well-functioning markets for natural disaster insurance. According to our knowledge, this is the

first systematic empirical study that estimates both of these effects for flood insurance. In

particular, Propensity Score Matching has been applied to estimate the influence of adverse

selection and moral hazard on experienced flood damage by households living along the Elbe or

18
Danube Rivers in Germany. The results show that adverse selection can occur since households

with flood insurance experienced a worse hazard during past flood events in the Elbe or Danube

catchments. However, flood damages do not significantly differ after controlling for this adverse

selection effect, meaning that moral hazard has not heightened the vulnerability of insured

households to floods. Actually the opposite of a moral hazard effect may be present since

individuals with flood insurance in Germany are more likely to have undertaken one of the

suggested flood coping measures than uninsured households.

These findings are overall robust to a split sample analysis of respondents located in the

former German Democratic Republic and former West-Germany. This split sample approach is

of interest since flood insurance purchases in the latter may be more of a conscious choice and

less driven by habits than in the former German Democratic Republic, where flood coverage was

compulsory. An insight obtained from the split sample analysis is that more conscious choices

for flood coverage are related with more other activities to mitigate flood damage. This supports

other studies conducted on health insurance that higher levels of risk aversion among insured

individuals may imply the opposite of a moral hazard effect.

The evidence from Germany is complemented by a study of moral hazard in the markets

for flood insurance and homeowner’s policies that cover wind damage in the U.S. That analysis

uses real time data on hurricane preparedness and shows that those households that engage in no

short or long-term ex-ante property risk reducing behavior are less likely to have homeowner’s

or flood insurance. This also points towards the opposite of a moral hazard effect. Moreover,

respondents have little specific knowledge of their deductible amount and the complementary

statistical analyses show that deductible levels have no significant influence on undertaking short

or long-term hurricane preparations.

19
 Results of this study have implications for ongoing discussions about reforming natural

disaster insurance markets in both countries. The results for Germany confirm concerns that have

been raised about the presence of adverse selection. Insurers should reflect this higher risk

profile of individuals who demand flood insurance in a risk-based flood insurance premium.

Alternatively, a solution is to introduce mandatory natural disaster insurance. Concerns that a

broader insurance coverage would result in fewer mitigation activities by policyholders are not

supported since we find no evidence of moral hazard. Similar findings are obtained for the U.S.

This questions the use of high deductibles by insurance companies in the U.S. for preventing

moral hazard, and supports ongoing reforms to use insurance for providing financial incentives

that stimulate risk reduction.

Appendix A. Variables used in the Propensity Score Matching analysis

1. Household contents damage: damage to household contents, where contents are all

moveable items in the home. Measured in euros, and as replacement costs.

2. Household building damage: Damage to the building – repair costs. Measured in euros.

3. Household contents value: The value of all moveable items within the home. Measured in

Euros.

4. Flood duration: The length of time the building was flooded in hours. Measured in hours.

5. Flow speed one: low water speed (stationary water is the base group). From a 0-4 scale

based on the scale developed by the Bureau of Reclamation (Thieken, 2005). This is a

dummy variable taking the value of 1 if the respondent provided a value of 1, and 0

otherwise.

20
6. Flow speed two: medium water speed (stationary water is the base group). From a 0-4

scale based on the scale developed by the Bureau of Reclamation (Thieken, 2005). This is

a dummy variable taking the value of 1 if the respondent provided a value of 1, and 0

otherwise.

7. Elbe: A dummy variable taking the value of 1 if the respondent lived along the Elbe

River, and 0 otherwise.

8. Urban area: A dummy variable taking the value of 1 if the respondent lived in an urban

area (greater than 50,000 residents), and 0 otherwise

9. House age (1948): A dummy variable taking the value of 1 if the respondent’s building

was constructed between 1948-64, and 0 otherwise.

10. House age (1964): A dummy variable taking the value of 1 if the respondent’s building

was constructed between 1964-90, and 0 otherwise.

11. House age (1990): A dummy variable taking the value of 1 if the respondent’s building

was constructed between 1990-2000, and 0 otherwise.

12. House age (2000): A dummy variable taking the value of 1 if the respondent’s building

was constructed after 2000, and 0 otherwise.

13. House quality 2: A dummy variable taking the value of 1 if the respondent said that the

quality of their building was 2 on a 6-point scale (1 is highest quality).

14. House quality 3: A dummy variable taking the value of 1 if the respondent said that the

quality of their building was 3 on a 6-point scale (1 is highest quality).

15. House quality 3 plus: A dummy variable taking the value of 1 if the respondent said that

the quality of their building was 4, 5 or 6 on a 6-point scale (1 is highest quality).

21
16. Flood risk 1: A dummy variable taking the value of 1 if the respondent said that a flood

had only affected them once before.

17. Flood risk 2: A dummy variable taking the value of 1 if the respondent said that they

have suffered twice from flooding before.

18. Flood risk 3: A dummy variable taking the value of 1 if the respondent said that they

have suffered 3 flood events before.

19. Flood risk 4: A dummy variable taking the value of 1 if the respondent said that they

have suffered from 4 flood events before.

20. Flood risk 5: A dummy variable taking the value of 1 if the respondent said that they

have suffered from more than 5 flood events before.

21. Water height: The height of floodwaters entering the house in meters.

22. Contaminated water: A dummy variable taking the value of 1 if the respondent’s house

was contaminated by sewage or oil, and 0 otherwise.

23. Warning duration: The length of time before a flood that a warning was issued in hours.

24. Return 1: A dummy variable taking the value of 1 if the flood recorded at the nearest

gauge was between 1 in 10 years to 1 in 50 years, and 0 otherwise.

25. Return 2: A dummy variable taking the value of 1 if the flood recorded at the nearest

gauge was between 1 in 50 years to 1 in 200 years, and 0 otherwise.

26. Return 3: A dummy variable taking the value of 1 if the flood recorded at the nearest

gauge was over 1 in 200 years, and 0 otherwise.

27. Cellar: A dummy variable taking the value of 1 if the building has a cellar, and 0

otherwise.

22
28. Floor size: The total floor space of the home, including the size of the cellar if present.

Measured in m2.

29. House price: An estimate of the house price based on the M1914 criteria. Measured in

euros.

30. Warning quality 1: A dummy taking on the value of 1 if the perceived quality of the flood

warning is given a value of 1, 2 or 3 on a scale of 0-11, and 0 otherwise.

31. Warning quality 2: A dummy taking on the value of 1 if the perceived quality of the flood

warning is given a value of 4, 5 or 6 on a scale of 0-11, and 0 otherwise.

32. Warning quality 3: A dummy taking on the value of 1 if the perceived quality of the flood

warning is given a value larger than 7 on a scale of 0-11, and 0 otherwise.

33. Renter: A dummy variable taking the value of 1 if the resident rents their residence, and 0

if they own their place of residence.

34. Detached house: A dummy variable taking the value 1 (0 otherwise) if the building is a

detached house (this variable is the core base category for housing type)

35. Semi-detached house: A dummy variable taking the value 1 (0 otherwise) if the building

is a semi-detached house.

36. Town house: A dummy variable taking the value 1 (0 otherwise) if the building is a

detached house.

37. Multi-family house: A dummy variable taking the value 1 (0 otherwise) if the building is

a multi-family house.

38. Commercial building: A dummy variable taking the value 1 (0 otherwise) if the building

is a commercial building.

23
 39. Secured documents: A dummy variable taking the value 1 (0 otherwise) if the responded

secured their valuable documents before the flood.

40. Move cars: A dummy variable taking the value 1 (0 otherwise) if the respondent moved

their car to a flood safe-area before the flood.

41. Move animals: A dummy variable taking the value 1 (0 otherwise) if the respondent

moved animals to a flood safe location.

42. Turn off gas/electric: A dummy variable taking the value 1 (0 otherwise) if the

respondent turned off the mains electric and gas.

43. Evacuation: A dummy variable taking the value 1 (0 otherwise) if the respondent had to

evacuate their building due to the flood.

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29
Tables

Table 1: Estimates of the difference in average flood damages due to having a flood insurance

policy (in EUR). The average treatment effect on the treated (ATT) is estimated using Propensity

Score Matching with different matching methods.

Contents damage Building damage

Comparison of mean flood damage 3458*** 9514***

suffered by households with and without (928) (9514)

flood insurance

ATT based on PSM using as matching Contents damage Property damage

method:

-Nearest neighbour matching 2126 6337

(2241) (5852)

- Radius matching 1619 7016

(1684) (4490)

- Stratification matching 1395 6261

(1874) (4668)

- Kernel matching 1832 6196

(Gaussian) (2075) (4013)

- Kernel matching 1583 7266*

(Epanechnikov) (1978) (7266)

Average ATT estimate 1711 6615

No. Matches 270 255

Variables described in Appendix A 3-32,34-40,42-43 3-8,10-32,34-40

Notes: *,**,*** stand for statistical significance at the 10%, 5% and 1% levels. The numbers in

parentheses are standard errors. Where analytical standard errors are not available, they have been

calculated via bootstrapping with 2000 repetitions. The ATT estimates above have been rounded to the

nearest whole Euro. For a list of variables used in the PS function refer to Appendix A.

30
Table 2: Natural hazard summary statistics

Panel A

Indicator Insurance group Non-insurance group

Water level 100cm 78cm

Flood duration 192 hours 163 hours

Proportion of households suffering 63% 55%

from contaminated water

Proportion of household evacuation 63% 48%

Panel B

Collected information regarding the 43% 32%

flood hazard

Member of flood support group 33% 23%

Employing at least one damage 35% 35%

mitigation measure

Employed at least one of the above 100% 56%

3 flood coping measures

31
Table 3: Estimates of the difference in average flood damages due to having a flood insurance

policy (in EUR) for households located in the Elbe and Danube River catchment areas

separately. The average treatment effect on the treated (ATT) is estimated using Propensity

Score Matching with different matching methods

Elbe catchment – Historically compulsory Danube catchment – Historically

insurance voluntary insurance

Contents damage Building damage Contents damage Building damage

Comparison of mean flood 2838** 1253 360 6651**

damage suffered by (1149) (3411) (1694) (2961)

households with and without

flood insurance

ATT based on PSM using as Contents damage Building damage Contents damage Building damage

matching method:

-Nearest neighbour matching 1073 9571 1573 6763

(2772) (8629) (3355) (7460)

- Radius matching 1282 8436 1707 5627

(2085) (6831) (3306) (5764)

- Stratification matching 1356 8790 1228 5751

(2887) (5561) (3631) (6003)

- Kernel matching 1380 7956 1465 6315

(Gaussian) (2074) (4970) (3005) (5964)

- Kernel matching 1371 9091* 1652 5561

(Epanechnikov) (2135) (4862) (3006) (6025)

Average ATT estimate 1292 8769 1525 6000

No. Matches 203 203 43 48

Variables described in 3-6,8-22,24-26,28,30- 3-6,8- 3-6,8- 3-6,8-

Appendix A 32,36-39,42,43 34,36,38,39,42,43 34,36,38,39,42,43 34,36,38,39,42,43

32
Table 4: Difference in damage mitigation measure usage between the insured and non-insured groups

within the Elbe and Danube River catchment areas. Raw difference between the proportions of the

insured and non-insured population who employ a specific damage mitigation measure.

Damage mitigation measure Elbe catchment Danube catchment

Flood adapted use 0.06 0.02

Flood adapted interior fitting 0.04 0.01

Waterproofing 0.04 0.15

Water barriers 0.02 0.09

Note: See Kreibich et al. (2005) for definitions of the above damage mitigation measures.

33
Table 5: Probit model results of the relationship between any hurricane risk reducing behavior and

insurance coverage

Hurricane Irene Hurricane Isaac Hurricane Sandy

Risk

reducing Homeowners Flood Homeowners Flood Homeowners Flood

behavioral insurance insurance insurance insurance insurance insurance

variable (1) (2) (1) (2) (1) (2)

No
-0.8 *** [-.27] -0.48 ** [-.13] -0.28[-.06] -0.35 [-.14] -1.02*** [-.28] -0.34 [-.09]
preparation

No

window -0.29** [-.074] -0.48*** [-.16] -0.14 [-.03] -0.13 [-.05] -0.09 [-.02] -0.29* [-.09]

protection

No
-0.02 [-.01] -0.34*** [-.11] -0.31 [-.05] -0.42*** [-.16] -0.32 [-.05] -0.25 [-.08]
mitigation

No

evacuation 0.27** [.08] 0.03 [.01] 0.18 [.03] -0.02 [-.01] 0.22 [.04] -0.18 [-.06]

plans

Safety 0.07 [.002] -0.05** [-.01] 0.004 [.001] 0.003 [.001] 0.003 [.00] -0.001 [-.00]

Constant 0.92*** 0.29* 1.12*** 0.36 1.24*** -0.08

N 763 763 330 330 523 523

Log-
-361.77 -408.44 -109.64 -216.02 -163.6 -276.3
likelihood

LR chi2

(prob > 35.62 ( 0.000) 48.32 (0.000) 8.16 (0.15) 13.71 (0.02) 20.25 (0.001) 10.74 (0.06)

chi2)

Pseudo R2 0.05 0.06 0.04 0.03 0.06 0.02

Notes: *,**,*** stand for statistical significance at the 10%, 5% and 1% levels. Standard errors have been

suppressed. Marginal effects are presented in brackets.

34
Table 6: For those with homeowners insurance the relationship between the likelihood and number of preparation activities undertaken and

deductible coverage

Irene Isaac Sandy

Pre-event Window Other Pre-event Window Other Pre-event Window Other

preparation protection mitigation preparation protection mitigation preparation protection mitigation

Preparation outcome variable (1) (2) (3) (1) (2) (3) (1) (2) (3)

Flood insurance 0.19 0.55*** 0.40*** 0.69*** 0.13 0.38** 0.15 0.34** 0.28*

Experienced damage 0.39*** 0.25** 0.52*** 0.39 0.23 0.34 0.21 -0.20 0.19

Safety -.044** 0.01 -0.02 0.01* 0.003 0.002 -0.002 -0.002 0.004

$0 to $500 deductible 0.22 0.24 0.16 -0.4 0.09 0.1 0.01 -0.32 0.03

$501 to $1000 deductible 0.07 -0.17 0.15 0.08 0.48* -0.00 -0.20 -0.1 0.15

$1001 to $2500 deductible 0.31 0.42** 0.25 0.08 -0.24 -0.05 -0.79*** -0.04 0.44

> $2500 deductible 0.29 0.37 0.23 0.08 0.29 0.22 0.44 0.18 0.48

Constant 3.29*** -0.95*** -1.24*** 2.39*** -0.31 -1.07*** 3.16*** -0.76*** -1.38***

Selection Stage

Flood insurance 0.3* 0.78*** 0.10

Experienced damage -0.01 0.26 0.48

Safety -0.05 0.003* 0.001

Known low deductible (<=$500) 0.01 -0.27 -0.04

Constant 1.82*** 0.92*** 1.55***

Inverse Mills Ratio (lambda) -1.09*** 1.51*** 0.1

35
 N 612 612 612 294 294 294 469 469 469

Censored observations 40 8 18

Log likelihood -1085.3 -356.3 -276.9 -533.47 -193.79 -187.6 -750.89 -213.84 -222.94

Wald/LR chi2 (prob > chi2) 28.30 (0.00) 40.77 (0.00) 37.59 (0.00) 24.3 (0.001) 10.00 ( 0.18) 10.15 ( 0.18) 15.07 (0.035) 10.14 (0.18) 9.86 (0.19)

AIC 2200.73 728.6 569.81 1096.9 403.5 391.3 1531.78 443.69 461.8

Notes: *,**,*** stand for statistical significance at the 10%, 5% and 1% levels. (1) are the Heckman sample selection model results, (2) and (3) are probit models; each model was

estimated via maximum likelihood.

36
i
Adverse selection may not only cause market failures in insurance markets, but since Akerlof (1970) it has been

realised that adverse selection can affect markets for durable goods. For example, Peterson and Schneider (2014)

find evidence of adverse selection in the used car market.

ii
Insurers can limit moral hazard and adverse selection by risk screening and monitoring the precautionary

behaviour of policyholders to make sure that premiums adequately reflect risks. Moreover, insurers can set

deductibles to provide incentives to take measures that limit risks, which reduces moral hazard problems

(Kleindorfer and Kunreuther, 1999).

iii
Thieken et al. (2006) find that flood insurance deductibles in Germany range in between €500 and €5,000,

providing a small incentive for taking damage mitigation measures. An average annual benefit between €5 and €50

in areas with a flood probability of 1/100.

iv
Reforms of the NFIP are ongoing after the Biggert-Waters Flood Insurance Reform Act was enacted in 2012. This

act has been partly modified by the Homeowner Flood Insurance Affordability Act signed by President Obama on

March 21, 2014.

v
The data are trimmed in two respects. First, observations with over €100,000 (€300,000) of contents (building)

damage are removed as these are outlying values. Second, sample is trimmed to only observations within the

common support (Condition 3 for applying PSM).

vi
Irene respondents were from coastal counties in North Carolina and New York, Isaac respondents were from

coastal counties in Florida, Alabama, Mississippi, and Louisiana, and Sandy respondents were from coastal counties

in Virginia, Maryland, Delaware, and New Jersey.

vii
The surveys were conducted in real-time and responses are as of the time of contact. It is possible that individual

short-term behavior in regard to questions could have changed after the survey contact. Responses were not ex-post

verified. See Meyer et al. (2014) for more information on the survey application.
viii
The related safety question for Hurricane Irene, an earlier version of the field survey, was slightly different

utilizing a scale of 0 to 10 and not specifically indicating the consideration of both wind and water.
ix
It could be argued that the group employing damage mitigation measures while being insured is richer than their

non-insured counterparts. However, using the same method as employed in Hudson et al. (2014) no important

differences appear to exist in income between the insured and non-insured groups.

37
x
Adverse selection or moral hazard effects are regarded as being absent if, respectively, the mean comparison

estimate and the ATT are insignificant, meaning that their point estimates cannot be statistically distinguished from

zero.
xi
Percent determined from [1 – exp(coefficient value)].
xii
The surveys also collected information on whether respondents had ever previously experienced damage from a

hurricane. Model results for all three hurricanes using this damage information as the dependent variable suggest

that more risky behavior is correlated with less experience. Results can be obtained from the authors upon request.
xiii
See results in Table 6 for the role of feeling safer on the likelihood of undertaking preparation, window

protection, and mitigation activities.

xiv
57, 62, and 68 percent for Hurricanes Irene, Isaac, and Sandy respectively.
xv
For each storm model (1) separate negative binomial count models were also estimated with results being

qualitatively similar to those reported in Table 6, especially in regard to the lack of statistical significance on the

deductible levels.
xvi
Separate bivariate probit estimations were run for each storm model (1) to (3) with having a known deductible as

the dependent variable of the other equation. Chi-squared results on rho consistently indicated these as independent

equations.
xvii
To further judge the reliability of inference of the statistical models a post-hoc power analysis was conducted for

the models presented in Tables 1, 3 and 6. The results of the post-hoc analysis indicated that there was sufficient

power preventing type II errors. Details can be provided upon request.

38