Uttarakhand Floods — The Problem of Adverse Incentives and The Role of Markets

Carrying on from where we left last week, in this post we explore the problem of adverse incentives in disaster management and relief when carried out by the government and the possible role of markets in mitigating the disaster.

The Problem of Adverse Incentives

There is one recent example where government engaged in first declaring and then doling out disaster relieves for the most important incentive of them all — getting themselves re-elected.

UPA in the penultimate year of its first term in 2008 announced farm loan waiver scheme amounting to Rupees 60,000 crore. While the stated intentions of the policymakers — to provide relief to farmers distressed by debt — were lauded, the unintended consequences proved otherwise.

Swaminathan Aiyar in his weekly column at the time had explained how the scheme will not benefit the ones they aim to benefit.

“The aim is worthy, but not the method. The poorest rural folk are landless labourers, who get neither farm loans nor waivers. Half of small and marginal farmers get no loans from banks and depend entirely on moneylenders, and will not benefit. Besides, rural India is full of family holdings rather than individual holdings, and family holdings will typically be much larger than two hectares even for dirt-poor farmers, who will, therefore, be denied the 100% waiver.”

It is not surprising that corruption and leakages in doling out the waiver were reported in an audit conducted by the Comptroller and Auditor General (CAG) earlier this year. What is worse is the signal that was sent out to farmers and creditors promoted adverse behaviour.

Farmers who were honest and paid their loan instalments on time, were penalised for their honesty as they didn’t receive any waiver, while farmers who were defaulting on loan payments got full waiver on their liability. It incentivised people to take loans with the intention to never return as they expect to be bailed out. It incentivised bankers not to grant fresh loans even to deserving farmers.

Thus we see that good-intentioned but not thought through government policy encourages dishonest and immoral behaviour and destroys institutions. It also comes at a huge cost as resources are diverted to inefficient and unwarranted usage.

The Role of Markets

What role do private institutions have in disaster management?

It is reported that indiscriminate construction carried out in the affected area of Uttarakhand (at times on dry riverbeds) was of poor quality and had paid no attention to the building regulation codes laid down by the government, which in turn exacerbated the loss of life and property.

I do not suppose that people choose to live in unsafe homes in flood prone areas. Maybe it is just lack of awareness. Or it could be just that they do not care. However, I do believe that the universal relief and bail-outs provided for by the government in the wake of any human tragedy do not encourage people to act proactively and prepare for such an eventuality. One cannot ever be fully prepared for a flood or an earthquake, but at least people can pool and share risk across the community by buying specialised insurance products.

Insurance in India is a highly underdeveloped sector. Its spread in India both for life and general insurance is very limited. It can be imagined that in a world where insurance market is developed and competitive, insurance companies would provide varied products including flood insurance. Insurance companies would in turn also lay down construction guidelines and check before selling specialised insurance products. Buyers who choose to violate these guidelines would either fail to buy such a product or will have to fork out more as premium for buying the particular insurance.

These are the signals that would make people respond by taking adequate precautions while constructing homes and businesses so as to be able to buy insurance for their property or by avoiding the disaster-prone area altogether because the insurance premium is too high or the area is not covered by any company since the risk is too high.

Insurance companies have pegged the total value of claim caused in the wake of floods in Uttarakhand at around Rupees 3,000 crore. Given the narrow penetration of insurance in India (more so for non-life insurance), this is a very small sum compared to the destruction caused by the devastating floods.

Conclusion

Price signals (in this particular case for ‘risk’) are the best instruments to correct adverse behaviour and restore responsibility where it ideally should be — that is with the individual herself.

Varied insurance products provided by a competitive insurance sector may not be an immediate solution or a universal one. But fostering a developed insurance market by allowing foreign companies to come and price risk through their experience all over the world will go a long way in helping people look away from an arbitrary government dole. Ad-hoc provision of relief in case of death, injury or destruction of property is not a sustainable public policy response.

A sound public policy response to this should be based around building institutions that would largely take care of all such contingencies by getting incentives right. There may be instances such as the one faced by Uttarakhand today when there can be a case for interim government intervention. But knowing that the government is always there to help out in case of an emergency like natural disaster causes people not to take precautions or make arrangements to tackle it.

The policy reform needed in turn shall focus on removing barriers that would lead to a more widespread coverage of various insurance products provided by competing insurance companies.