Disaster Myopia

Have you ever wondered why, despite the lessons of history, societies repeatedly fail to prepare for disasters they know could strike? Last week, we launched our series on Cognitive Biases in Risky Decisions ; today, we delve into 'Disaster Myopia'. This term, coined by economists Guttentag and Herring, describes our collective inclination to downplay the chances of adverse events, particularly those not recently experienced or perceived as distant threats. It's a bias that doesn't just affect individuals but seeps into the core of our corporations and governance, influencing decisions with far-reaching consequences. Why do we fall prey to this bias, and what can we do to counteract its effects? Join me as we explore the depths of Disaster Myopia, uncovering insights that challenge our perception and prepare us for a future where the unlikely is not impossible.

Reflecting on the nature of financial crises, Carmen Reinhart and Kenneth Rogoff insightfully noted,

"The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes."

This observation underscores a universal truth about myopia: it blinds us to the cyclical nature of disasters, leading us to overlook past lessons in the face of perceived progress and uniqueness.

Warren Buffett's analogy,

“It's only when the tide goes out that you learn who has been swimming naked”

aptly encapsulates the harsh reality of unpreparedness, laying bare the consequences of neglecting long-term risks for immediate gains. Through the lens of historical financial downturns, recent natural calamities, and the insights of renowned economists, we explore the pervasive impact of myopia in risk management. This article aims to illuminate the crucial influence of cognitive biases on our decisions, advocating for strategies to mitigate their effects through education, regulatory reform, and a commitment to foresight.

As we unravel the complexities of myopia, let us embrace awareness as the catalyst for transformation. Acknowledging and addressing our biases empowers us to make informed decisions, safeguard our futures, and ultimately, preserve lives.

Hyperbolic Discounting

In the realm of risk management, the phenomenon of hyperbolic discounting plays a pivotal role in amplifying the Myopia bias among decision-makers. This concept describes a cognitive shortcut where future events, particularly those perceived as distant, are undervalued or discounted more steeply than economic models would suggest. This disproportionate discounting of future risks leads to a skewed perception, where immediate rewards or costs are given undue precedence over potentially significant future outcomes. For instance, the investment required today to bolster flood defenses or upgrade infrastructure is often viewed through the lens of hyperbolic discounting, making the cost seem unjustifiably high compared to the perceived 'distant' benefit of mitigating a disaster that might occur decades later. As a result, this leads to a paradoxical situation where, despite understanding the potential for catastrophic events and their long-term impacts, decision-makers may still opt to defer essential preventive measures, prioritizing short-term gains or savings. This bias not only underscores the challenges in persuading individuals and institutions to invest in long-term risk mitigation strategies but also highlights the critical need for developing more effective approaches to decision-making that accurately weigh the future consequences of today's actions.

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A Tale of Two Storms: Hurricanes Katrina and Sandy

The disastrous societal effects of Myopia bias are clearly demonstrated from two recent hurricanes that impacted the US coastline in the last 20 years. Both Hurricane Katrina and Hurricane Sandy impacted densely populated metropolitan areas, where decision-makers had ample motivation to implement prudent risk management.

Hurricane Katrina (2005) is by far the largest natural disaster to have impacted the USA. The New Orleans city was flooded, ~1,500 lives were lost and more than $125 B in economic loss was incurred - the costliest on record. The unfortunate reality is that it had long been well-known that the New Orleans levees were not designed to protect the city from a 100-year hurricane (a strong Category 3). Over the decades, several scientific studies and commissioned reports highlighted the risk and identified the required protection measures and the cost outlay.

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Further, in 2004, a year before Hurricane Katrina, New Orleans even received a very close call in the form of Hurricane Ivan, when, as a Category 4 hurricane, it threatened to bring just such a disaster scenario, only to swerve away at the last moment and go on to devastate the Mississippi/Alabama coastline.

Despite the well-recognized nature of the impacts, every time an investment decision needed to be made regarding the New Orleans Levees, it would be pushed out in favor of other alternate projects that had greater short-term priority. Unfortunately, in 2005, Hurricane Katrina resulted in just the nightmare disaster scenario that studies had portended. Of course, it was too late by then. Not only did the disaster expose the compromised infrastructure, but also the questionable readiness of the overall emergency management system.

Despite having access to all the crucial risk information, why did decision makers fail to take prompt action? Myopia bias may have had a role to play. One of the greatest weaknesses of decision makers is that intuitive planning horizons tend to be much shorter than those needed to see the value of the actions. There is a (mistaken) perception that rare events (such as a 1 in 100 years return period event) are far out in the future, at least beyond the current decision horizon – even though the reality is that the event can happen at any moment. Due to the tendency for hyperbolic discounting, the present value impact of a New Orleans levee failure was grossly underestimated, especially, when compared to the impact of other more competing and tangible priorities. Consequently, whenever a decision on levee investment was considered, it was passed over in favor of other investments.

A similar story unfolded a few years later, in 2012, when a Hurricane Sandy-induced storm surge flooded New York City. Discovery magazine called it New York’s Self-Inflicted Calamity . Here again, there were ample scientific studies that highlighted the storm surge risk to New York City. Just as in the case of New Orleans, there was also a relatively recent close call, and a prompt to action, in the form of Hurricane Irene in 2011. However, insufficient steps were taken at that point to protect the city and its infrastructure. Just weeks before Sandy struck, geophysicist Klaus Jacob, who had been urging New York to deal more aggressively with the threat of natural hazards for a generation, noted that the city had been “extremely lucky.” He added that he was “disappointed that the political process hasn’t recognized that we’re playing Russian roulette.”?

Myopia and the Insurance Protection Gap

It would seem a straightforward extension to see how the Myopia bias might impact consumers and risk managers. Individuals and businesses are often exposed to several low frequency-high impact perils, whether in the form of natural catastrophes or the risk of fires/accidents. While several of them recognize the impacts of these disruptions and take actions to prevent or mitigate the damage, it is not consistently so. As someone who analyzes these risks closely, I often wonder why clients wouldn’t adequately invest in loss prevention and give it their highest priority. The reality is that, just like societal decision makers, individuals and businesses are faced with several competing priorities for a limited set of funds. Further, they are also susceptible to similar cognitive biases.

These risks are perceived to be farther out in the future than their intuitive planning horizons and, there is a tendency towards hyperbolic discounting of the impacts. This often leads to procrastination on loss prevention investments in favor of more tangible short-term projects. Due to hyperbolic discounting, the expected payback on investments to protect against rare events (such as a 1 in 100-year flood or earthquake or a fire) is typically only a few years, which makes these long-term investments seem unattractive. Along similar lines, there is also a tendency to underestimate the value of insurance protection, which results in many retaining significant amounts of catastrophe risk, either through outright exclusions or restrictive sub-limits. This is particularly true among individuals and small businesses.

Myopia is possibly one of the largest contributors to the global insurance protection gap. Particularly so in markets where the insurance market is well-developed and efficient. For instance, California is the most earthquake-prone state in the USA, having experienced 6 out of the top 10 costliest earthquakes in US history, yet only 10% of its residents’ purchase earthquake insurance !

Mitigation strategies

As we discussed above, Myopia bias impacts various stakeholders, from policymakers, individuals, and business decision makers. It is worth emphasizing that even professional risk underwriters, such as insurance companies and financial trades/banks, are not immune to this bias. After all, they were the key players in the 2008 Great Financial Crisis. Underestimating or disregarding certain tail risks in pricing and capacity can be a significant consequence of myopia for certain risk underwriters. Further, it can cause organizations and portfolios to assume too much exposure to certain risk factors triggering bankruptcies, systemic failures, and bailouts.

It is important to remember that the so-called rare events have a tendency to surprise us with regular frequency.

In the face of low frequency but high impact risks, it is important to help the decision maker avoid the pitfalls of Myopia bias. Mitigating myopia bias, particularly in the context of disaster-related decision-making, involves a multi-faceted approach aimed at enhancing risk awareness, improving regulatory frameworks, and fostering long-term thinking. Here are several strategies:

1. Enhanced Education and Awareness: Educate stakeholders, including the public, about the history of financial crises and the concept of disaster myopia to foster a culture of risk awareness and critical thinking about long-term consequences.
2. Counteract Hyperbolic Discounting: The tendency for hyperbolic discounting needs to be countered by reminding oneself that even though the risk event under consideration has a long return period, it has a realistic chance of occurring in the next insured period. One way to do this is to visualize the impact of the event if it were to happen tomorrow. The decision maker therefore needs to be prepared for the consequences should the event happen in the near term.
3. Improved Access to and Use of Historical Data: Encourage the use of comprehensive datasets that include rare, catastrophic events in risk modeling and decision-making processes to avoid underestimating their likelihood.
4. Strengthened Regulatory Frameworks: Implement and enforce regulations that require financial institutions to maintain adequate capital reserves, conduct stress testing against extreme scenarios, and adhere to prudent risk management standards.
5. Incentivization of Long-term Planning: Align compensation and performance evaluation systems with long-term outcomes and sustainability, rather than short-term gains, to discourage myopic decisions.
6. Diversification and Risk Management Practices: Encourage diversification in investments and business strategies, along with the adoption of robust risk management practices that account for extreme events. Internal risk controls may need to use a blend of probabilistic and scenario approaches. The scenario approach is similar to stress testing. By setting aside the probability of the event, it helps the decision maker focus on the event’s consequences and potential mitigation strategies.
7. Transparent and Frequent Communication: Promote transparency and frequent communication about risks between financial institutions, regulators, and stakeholders to ensure a shared understanding of potential threats and preparedness measures.
8. Implementation of Counter-cyclical Policies: In the case of financial markets, adopt counter-cyclical policies that help to dampen the boom-and-bust cycles, such as varying capital requirements or baseline interest rates based on economic conditions, to reduce systemic risk.

By adopting these strategies, individuals and institutions can work towards reducing the impact of myopia bias and better prepare for rare but catastrophic events.

In closing, let’s ponder on the following, somewhat existential, quote on the perils of Myopic thinking.

"We also are dazzled by the immediate benefits of our actions and are unable to focus on the long-term consequences. Thus, most of us prefer immediate rewards from actions that are slowly producing long-term disasters."

-Jared Diamond, "Collapse: How Societies Choose to Fail or Succeed"