Masters of Disaster

At Wharton’s Risk Management and Decision Processes Center, researchers are investigating why humans do such a poor job planning for, and learning from, catastrophes.

By Jason Fagone

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Howard Kunreuther and Robert Meyer have staked their careers on the belief that human beings are at heart irrational, doomed to repeat the same mistakes over and over—unless we find a way to overcome our wiring.

But even they have been surprised by the results of Quake.

Quake is a computer simulation that Meyer, the Gayfryd Steinberg Professor and co-director with Kunreuther of Wharton’s Risk Management and Decision Processes Center, helped design to test certain ideas about how humans perceive “risk.” Quake is very easy to play, but, as it turns out, very difficult to win—though not because the mechanics of the game are all that tricky.

Rather, it’s our brains that make it difficult.

It works like this: Quake players are presented with a little icon of a house on a map of a hypothetical country. They also get a pot of digital cash—$20,000. Players are told at the start of the game that at any time, an earthquake can hit, either severe or mild, and that three to five quakes will hit during the course of the game. Then all the players have to do, it turns out, is decide what to do with their money: they can pump it into their homes, making them safer by purchasing a series of structural upgrades (to the chimney, the door frame, the roof, etc.) or they can leave it in the bank and earn 10 percent interest. The game unfolds in real time, and up to 10 people can inhabit the same Quake world at one time. Players can see other people’s houses and observe their decisions.

Kunreuther, the Cecilia Yen Koo Professor, and Meyer have run the Quake simulation for the past four years, using students in Kunreuther’s Risk Analysis and Environmental Management class as the guinea pigs/gamers. By now, about 500 students have played the game, and every time, they play it essentially the same way.

They tend to begin the game cautiously, spending money to build stronger roofs and walls. But as the game goes on, they take more risks. Instead of spending their money to avoid disaster and death, they keep it in the bank to earn interest.

“They think, ‘Can I get away with the next 30 seconds in the game?’” says Meyer. “‘What are the odds of getting destroyed in the next 30 seconds? Well, probably very little.’ So they think, ‘OK, I’ll go a minute.’ And of course eventually they get destroyed.”

Meyer and Kunreuther have found that there’s nothing they can do to prevent the students from destroying themselves. Even if one of them pulls a student aside and explicitly tells her how to “win” the game—i.e., by building the strongest house possible, as quickly as possible, and then just sitting on it—the student still won’t do it, preferring to rack up those sweet interest payments.

It’s not like the students don’t know what’s coming, either. When asked if they understand what’s going on, they always say, yeah, they get it: they’re about to get hit by an earthquake. So if it’s not stupidity or ignorance, why do the students keep losing? Kunreuther and Meyer believe the game demonstrates a psychological bias toward short-term maximization instead of long-term planning—a psychological bias all humans share.

Meyer has tried out the Quake simulation with groups of corporate executives, and the results are the same. The players always see the quake coming, and they always “have a difficult time translating that belief that it’s going to happen to a short-term action”—much the same way, in fact, that the government of Haiti failed to adequately prepare for the possibility of a major earthquake.

The Quake players derive a sense of security from observing the flimsiness of one another’s houses. If everyone around you has a house of straw, having a straw house yourself seems somehow safer.

Of course, this is wrong.

Searching for a ‘Systematic Answer’

When a 7.0-magnitude quake rocked Haiti on January 12, the brittle housing stock of that small island crumbled en masse, and more than 200,000 were killed. The world saw the pictures, the suffering—the people trapped in the rubble, the newly homeless forced to scavenge the ruined streets for food and water—and many felt compelled to get out their credit cards and donate to Haitian relief charities. But for Kunreuther, Meyer and Erwann Michel-Kerjan, who serves as managing director of the Center, the images carried a different sort of resonance. Those images signaled that a clock was now ticking, and an opportunity to transform Haiti in a lasting sense was about to slip away, for reasons similar to the reasons that players of Quake maximize their short-term gains at the expense of long-term fixes: human psychology.

In late January, the world was watching Haiti, but Kunreuther, Meyer and Michel-Kerjan reasoned that pretty soon there’d be another earthquake or tsunami or hurricane someplace else (they were right, as Chile was hit by its own quake in early March); attention would suddenly shift, and nothing would be done to prepare Haiti for future disasters. Just as New Orleans today is not ready for another Katrina. Just as not enough has been done to prevent the next Wall Street collapse (the financial crisis is a good example of the straw-house fallacy, Center leaders say: Those young bankers converting worthless mortgages into AAA-rated securities and selling them to the Global Pool of Money felt better about what they were doing because everyone around them was doing it, too).  “Yes, we all feel very bad about all these people, [the] same way we felt bad about the earthquake in China two years ago,” says Michel-Kerjan. “But how do you create a more systematic answer to these issues?”

That’s the Risk Center’s raison d’etre. It was founded in 1984 with the goal of providing guidance to companies and governments on managing “low-probability, high-consequence events;” a less technical way of putting this is to say that the Center is a think tank for a world facing guaranteed disaster. The Center is a highly interdisciplinary place, calling on the expertise of professors who study economics, statistics, mathematics, insurance and risk management, marketing, psychology, environmental science, political science, geography and meteorology, not only from Wharton but also from universities across the world.

The troika of co-directors reflects this approach. Michel-Kerjan, 34, a finance expert, is a native of France who wears suave-looking pinstriped jackets and open-collared white shirts. Since 2008 he has been serving as Chairman of the advisory board to the OECD Secretary-General, which advises top government officials of over 30 countries on catastrophe issues. Meyer, 57, is a weather maven from Florida. Before becoming an esteemed marketing professor, he was an undergraduate meteorology major and has a Ph.D. in Geography. Kunreuther, with a Ph.D. in Economics, is the 71-year-old sage, the éminence grise. He is a leader in the academic discipline of risk analysis, and co-founder of the Center (along with former colleague Paul Kleindorfer, Anheuser-Busch Professor of Management Science, Emeritus).

From the outset, the Center’s mission has focused on how individuals and private and public sector organizations deal with low-probability, high-consequence events—and how the behavior of these key stakeholders can be improved. The idea, says Kunreuther, is to gather key individuals who come at the problems from different perspectives and normally wouldn’t talk to each other—scientists, top elected officials, CEOs—and sit them down at the same table, not only to reach agreement on what the scientists are discovering about, say, global warming, but also to figure out what concrete policy steps make sense, given the science. “We’re a neutral party,” says Kunreuther. “We have sort of stayed out of the fray. The Center will never tell anyone, ‘This is what you must do.’ Rather, our approach is to suggest a rationale for thinking about a problem and understanding the impact of different strategies for reducing the potential consequences of future events that people prefer not to think about.” The approach has yielded results for disasters as diverse as chemical spills, floods, hurricanes and terrorism.

In 2005, after Hurricane Katrina resulted in nearly $50 billion in insurance claims, the academics at the Center brought together about 20 of the largest insurance and reinsurance companies in the world to try to figure out how much the next monster hurricane might cost and how the cost might be equitably spread across all the stakeholders—local governments, the federal government, insurance companies and homeowners. The team, which included not just these firms and the Center, but many other organizations, among them the Department of Homeland Security, the World Bank, and experts in catastrophe risk modeling and financial markets, pulled together a first-of-its-kind set of data about hurricane and flood risk in four states—Florida, New York, South Carolina and Texas. Last year, Kunreuther and Michel-Kerjan published with their colleagues an influential analysis of the data in their book, At War With the Weather.

This project came on the heels of the Center’s key role following 9/11, when insurance companies in 45 states decided not to cover terrorist acts in their policies anymore (after they had to pay $35 billion in claims) and Congress put in place the Terrorism Risk Insurance Act (TRIA) as a temporary measure. The Center worked for 15 months on a sustainable solution to this problem. The large study they published in 2005 drew enough attention to land Kunreuther a seat before Congress, and Michel-Kerjan in meetings at the White House. Congress and President Bush eventually opted for a longer-term public-private terrorism-risk program along some of the guidelines suggested by the Center. This is work that stretches “far beyond the traditional academic world,” says Michel-Kerjan.

Still, the fact that the Center serves as an impartial broker to the world’s decision-makers doesn’t mean that it lacks a viewpoint. The Center relies on a set of fundamental principles and convictions that drive its methods. Its research team understands that people often act in ways that would be considered “irrational” when viewed against conventional economic theory. These concepts have gained enormous currency in the last several years thanks to The Tipping Point author Malcolm Gladwell and hedge-fund manager Nassim Nicholas Taleb, whose bestselling book The Black Swan gave a catchy name to the sorts of rare disastrous events the Center studies.

But the Center’s creators were here long before this study of the unlikely became fashionable. Kunreuther, in particular, was a pioneering critic of the notion that human beings are always rational actors and that markets are always “efficient.” It’s a line of thinking closely identified with the “Chicago School” of economics that has driven the global economy for the past 30 years. But back in the late 1960s and early 1970s when Kunreuther was teaching at Chicago, he began studying the behavior of individuals in hazard-prone areas, which led to the pathbreaking book Disaster Insurance Protection, written with the psychologist Paul Slovic and other social scientists.  Their studies showed that people did not actually behave according to standard models.

At the time, this type of research was seen as heretical. One of Kunreuther’s fellow professors at Chicago actually took him aside and said that people were worried about him. “I wasn’t talking like an economist,” he recalls, laughing.

But to Kunreuther, economics should be the study of human beings; not how they are supposed to make decisions in an ideal world but how they actually make decisions in the real world. This point is reinforced by Meyer, who often gives presentations to Fortune 500 marketers. When he starts to explain to them what the latest science tells us about what a rational decision-maker should do and what people actually do, “most marketers look at me and say, ‘Why would you ever think that people would be rational? We’ve known people are crazy for years. That’s how we make money.’”). If human beings were truly rational actors, then Americans wouldn’t have built an entire economy on overleveraged banks, and the Haitian government would have imposed some kind of building code on its construction industry.

Instead of rationality, the world seems to be driven by randomness, ignorance, venality and procrastination, and good intentions are stymied by the quirks of human psychology. The question, then, is what to do about it—how to anticipate and mitigate human misperceptions of risk, before we make another round of doomed decisions.  This complex problem is the focus of a recent book edited by Michel-Kerjan and Slovic called The Irrational Economist (written in honor of Kunreuther) in which many of the world’s top behavioral economists express their own ideas about human decision biases and how to avoid them.

Preparing for What’s Next

Studies have shown that subtle changes in the way humans are presented with information can have significant effects on what choices they make about that information. For example, a country that wants to dramatically boost rates of organ-donation need only change the organ-donation check-off from an “opt-in” choice to an “opt-out” choice. Same with enrollment in 401(k)s. People can be “nudged” in the correct direction, policy-wise, without even knowing it.

Of course, there are problems far too vast to be “nudged” out of existence. Most of them require international collaboration among top decision makers, which is why Kunreuther and Michel-Kerjan have flown several times in recent years to the World Economic Forum, the annual gathering of industry leaders and heads of state at Davos, Switzerland.

Haiti is an obvious example. With Haiti, you have to go big. You have to aim for large-scale, structural change. So in advance of the 2010 Davos conference, Kunreuther shipped ahead 50 copies of the Center’s recently published Learning From Catastrophes, with the goal of convincing major players to create a long-term strategy for rebuilding Haiti so as to reduce losses from future earthquakes, hurricanes and floods in the country. He personally pressed the book into the hands of the managing director of the World Bank and the head of the United Nations’ Haiti desk. The next two weeks, he trekked to Washington and New York City for follow-up meetings, offering the services of the Center to assist in designing a long-range planning and needs assessment for Haiti’s future. Other people were handling the short-term assistance, the relief flights of water and food, but Kunreuther was more interested in the really hard stuff, the nuts and bolts of reconstruction: designing Haiti’s first-ever building code (and getting the construction industry on board), dealing with corruption in the Haitian government and rethinking the urban layout of Port-au-Prince. “If you don’t get these measures into place now, you’ll never do it because another crisis will take center stage,” Kunreuther says. “This is really now a passion for us. We really, really want to help.”

Beyond Haiti, the Center is preparing for the next wave of catastrophes, particularly those related to the weather, because the story of the next 10 years will be the story of human response to an ever-intensifying series of hurricanes and floods. That’s the prediction of the latest Global Risk report, a World Economic Forum-generated publication, for which the Center serves as the academic partner, that attempts to look into a crystal ball and see what’s coming down the pike on a long time scale. “When you give yourself five to 10 years’ horizon,” says Michel-Kerjan, “you see things coming from very far.” Previous Global Risk reports have correctly predicted things like collapses in asset prices and food shortages.

These days, Michel-Kerjan is increasingly interested in truly large scale catastrophes and in developing innovative solutions that create value (a topic he teaches in the Wharton MBA program).  Looking at the U.S., “I think Katrina may look like a baby in the next few years,” he says. “Do you know what the insured exposure on the coast of Florida is, for example?” By “insured exposure,” he means the total dollar amount of all property that could be obliterated in a hurricane or a flood. “Is it $100 billion? Five hundred billion? What do you think?”

Five hundred billion?

“It’s 2.5 trillion dollars,” he says. “It’s close to $1 trillion for Texas. And it’s $2.4 trillion for the state of New York. From the Texas to Maine coast, you’re talking close to $8 trillion of insured assets on the coast. Just the coast. If you combine that with the potential for more intense hurricanes in the next few years…” He pauses. “That might be very bad. If we don’t mitigate it. If we don’t invest in risk-prediction measures.” Now you are warned.

Ah, but now we’re back to where we started.

Once again, we return to the paradox of Quake, Meyer and Kunreuther’s earthquake simulation, which tells us that we are constantly fighting a losing battle when we try to hedge against catastrophe. And it is not exactly the battle that we think we are fighting, because the very thing that is feeding us data about the battle is a faulty piece of equipment. The war we have to fight is “not a war like the War on Terror, against other people,” Michel-Kerjan says. “It’s mainly a war against ourselves. And that may be harder.”

Jason Fagone is a freelance writer based in Philadelphia. His work has appeared in GQ, Esquire, The Atlantic Monthly and Slate. This is his first piece for Wharton Magazine.

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