Excercise 25 Econ 417: Federal Emergency Management Agency

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EXCERCISE 25 ECON 417
Q: Suppose you are an analyst for FEMA (Federal Emergency Management Agency). Would you use the above model with person n replaced by region n and L replaced by disaster and H replaced by no disaster? Explain.
There are various hazard potential damages that are likely to occur and challenge then is to overcome these hazards and identify mitigation measures to minimize the impact of these hazards. FEMA (Federal Emergency Management Agency) considers risk management practices to eliminate the severity of disaster consequences and also seek to use resources more efficiently. Similar to the insurance model that considers the probabilities of disasters occurring and failing to occur is considered in risk mitigation, risk control measures include activities to limit and avoid the risks and when there are unavoidable risks, these are transferred to other parties. At other times, the insurance companies take care of the unavoidable risks through financing. Insurance is necessary to transfer the insurable risk to the insured. This paper looks at the appropriateness of a model depicting independent risks and insurance as is applicable to FEMA.
The proposed model assumes that there are two scenarios, either no disaster happening (Wh)/ H (probability π) or there is disaster (Wl)/ L (probability (1-π). For the insurance risk to work, it is assumed that the likelihood of an event occurring is quantifiable, and in this is the case as there are the damage causes by the hazard or disaster. The probability of occurring and not occurring all add up to one, as it is assumed that the event may either occur or not occur. Similarly, FEMA can use the proposed model as there are two scenarios depicting the likelihood of disaster and the likelihood that there will be no disaster.
The case for the proposed model is that FEMA would use past information and predictions to determine likelihood of disasters occurring and the resultant damage. Even though, FEMA would have no access to all the information, the example of relying on the insurance example is that it is possible to make decisions based on the information available. The challenge then is determining what information is appropriate in making decisions and what has no impact. Failure to make these distinctions means that FEMA is likely to make decisions that grossly underestimate or overestimate the impact of disasters. This is common in cases of asymmetric information where one entity has some information that the other entity and since there is hidden information that is not available to all there are cases of adverse selections in the insurance market.
When making decisions under uncertainty it is necessary to consider the case of state preference as this affects the investment decisions. In the complete capital markets there is symmetry of information such that the value of the firms is independent of the capital structure (Hirshleifer 264). Similarly, FEMA, would consider the expected losses when choosing the most optimal insurance and financing options. The case for this is that the capital budgeting decisions determines the expected returns, and the dollar claim is dependent on the calculated value of the insurance cover...