EconSouth (First Quarter 2006)

Tom Cunningham is vice president and associate director of research at the Federal Reserve Bank of Atlanta.   Disasters, Income, and Wealth
 

Disasters come in many forms, either natural or man-made, and they often cause calamitous loss of life and destruction of physical property and wealth. Although we try to minimize or mitigate the potential losses associated with disasters, some level of risk is unavoidable.

To mitigate the risk of the loss of physical wealth, we often insure our possessions. Then, if a disaster destroys these possessions, we can replace them at the expense of the insurance company. The insurance company, in turn, is willing to bear this loss because it charges its customers premiums that over time compensate it for the risk. In the case of idiosyncratic human disasters, such as fires, thefts, and auto accidents, the risk premium can be calculated on the basis of experience and individual characteristics, and these losses are randomly distributed across the entire economy.

Incalculable loss
Natural disasters, on the other hand, pose a very different problem. Earthquakes, wildfires, and violent storms tend to involve the systematic destruction of wealth in a concentrated geographic area. Natural disasters thus have a systematic impact on the economy of the afflicted region, wiping out a percentage of the area’s accumulated wealth.

This loss of wealth has two components. First, and most devastating, is the loss of life. People cannot be replaced, and the brunt of this loss is borne by the victims’ families.

A region’s economy also suffers with the loss of human capital. Individuals who live in an area and work in a job over time develop a knowledge base specific to that area and task. When those individuals are gone, their purely technical skills may be replaced, but their unique skills must be relearned by others who have to make the investment in a learning curve.

Who pays?
The second component is the more visible loss of physical wealth—the loss of, or damage to, buildings, equipment, and infrastructure. The destroyed physical capital represents a permanent loss of wealth that must show up on someone’s balance sheet.

If the destroyed property was fully insured, then the insurance companies bear the net loss of wealth. Presumably the insurance companies have managed their risk portfolios so that they are well positioned to bear these particular losses and pay off any claims. That net loss is spread over a wide portion of the economy.

Without insurance, the assets’ owners bear the entire loss. In effect, the asset side of their balance sheet is diminished by the extent of the damage and nothing happens to their external liabilities, so the disaster is a deadweight loss of net wealth to the owners.

Consider a business that is quite profitable but is wiped out by a storm. Assume the business has no insurance or is self-insured. The owner of the business suffers a loss to her assets at the time of the disaster. (In accounting terms, this loss of assets is matched by a loss of the owner’s equity.) But if the business is sufficiently profitable, it pays to rebuild it, even if the owner has to borrow to make the restoration.

Taking out a loan should not be a problem for an otherwise thriving business. The income generated locally by the restoration is essentially the same as if the business were insured, but now the restoration of the lost asset has turned into an increase on the liability side of the owner’s balance sheet—the debt to finance the restoration. The net reduction in wealth is the same, but the consequence for individual balance sheets is quite different.

Topsy-turvy income and wealth
The restoration of physical wealth has some interesting economic consequences for the local economy. The rebuilding of the physical capital generates a stream of income as the restoration takes place. Functionally, the disaster converts wealth into income. This conversion is the reverse of the typical wealth/income relationship.

Wealth is usually the result of saving from a stream of income; more income means potentially more wealth. More wealth manifests itself in more physical capital, which makes workers more productive and thus generates still more income. The key to this virtuous circle is the savings from the initial stream of income.

The conversion of lost wealth into income in the disaster-stricken area is short-lived, however, and the insured victims eventually return to something like the status quo.

No matter how well prepared insurance companies may be to pay off disaster losses, their net assets decrease by the amount of the payout. Uninsured victims pay an even heavier price and may never fully recover their previous level of wealth. As the victims of Hurricane Katrina can sadly attest, when disaster strikes, someone, somewhere, must take the loss.

 

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