The Role of Insurance and Risk

Spreading in Climate Change

Innovation and Resilience

Mark Pauly

Howard Kunreuther

Purpose of this talk

• We stipulate that there is an increasing risk of harms to property

and life from future climate change: a higher and growing

expected value of losses.

• We approach this question from the perspective of normative

insurance theory: in concept, when can insurance help reduce

these losses appropriately or provide financial protection?

• Insurance is useful in giving those at risk an opportunity to pay a

relatively small premium to provide financial protection against

low probability high loss events.

• Insurance can also encourage beneficial investment in loss

reduction measures by providing premium reductions to reflect

lower expected claims.

From: Amarakoon Bandera, “Climate Change and its Impact on Insurance in Developing Countries” (18th

Insurance Congress of Developing Countries, Victoria Falls, Zimbabwe, 28 – 30 September 2014).

http://www.airdc.org/news-bulletin/207-7-technical-sessions-of-18th-icdc-in-victoria-falls-zimbabwe.html

From: Bandera, “Climate Change and its Impact on Insurance in Developing Countries” (2014).

From: Bandera, “Climate Change and its Impact on Insurance in Developing Countries” (2014).

The immediate problem is the long run

• Not so hard to think of how to cover losses next year with

insurance, and insurers are not threatened financially by

rising risks if they can have rising premiums.

• But the problem, according to Shiller, is dealing with the

uncertain long run effects of climate change. “The

increasing cost of disasters over distant future years,…

when severity may build in slow hard-to-predict processes

and in complex geographical patterns.”

• This theme will weave in and out of our discussion.

Basic insurance theory

• An agent with wealth W facing a prospect of loss L

(L<W) with probability p should be willing to pay a

premium of pL to provide insurance with benefit B=L.

You trade the “maybe bad, maybe good” for “sure thing.

• In ordinary language, insurance protects agents against the

risk of uncertain loss.

• Premiums from the lucky ones who don’t suffer a loss are

used to help the unlucky ones who are adversely affected

by a low probability event.

• In other words, you protect yourself by a exchanging a

risky prospect for a sure premium payment. Risk averse

people should be willing to pay a premium that is equal to

or moderately above the expected loss.

What insurance cannot do

• It cannot insure against the end of the world—my loss

must to some extent be uncorrelated with your loss.

• It cannot insure against bad events that have already

happened: high water levels eroding the local beach.

• It cannot insure against future events already known to be

more likely to occur than formerly. If there is information

already out there which says that p will be higher at some

future date, premiums will have to be higher than today.

• It cannot prevent undetectable inadequate mitigation: there

can be “moral hazard” where insurance causes people to

take too little care.

• It cannot solve the problem of global poverty.

The best case scenario

• Experts know that the risk of a damaging cyclone hitting a

set of 100 independent exposures is 0.01: one exposure

(“island”) will be hit by the cyclone and 99 will not.

• Then all agents with exposures should be willing to pay a

premium of 1/100 the cyclone loss, and all will be

protected against “high” loss.

• If the exposure is a small business (farm or other) the

owner will be protected against risk of low consumption,

and assisted in taking other business risks.

Our hypotheses about climate change risk

• There is some reliable information about future loss

probabilities but neither perfect information nor estimates of

probability of climate changes where the scientific community

is in agreement.

• There is uncertainty about the magnitudes of the losses due to

climate change and who will be affected by these changes.

Losses are correlated within geographic areas but not perfectly

so. They are even less correlated around the world or within the

region.

• Climate change risk is uncorrelated with other risks to wealth:

e.g., war, cost changes, and disease, but may be the cause of

other natural disasters, e.g., floods, intense hurricanes.

The bad news: threats to insurability and

efficient mitigation: the three “I’s”

• Inadequate Supply: Highly correlated weather related losses

may be large in total in any given year relative to insurer

capacity: large scale disasters may be (partially) uninsurable

without reinsurance. (Said to be a threat to microinsurance.)

• Inadequate Demand: if expected loss increases, agents may not

be able to afford the higher premiums to cover. Many

individuals may use simplified decision rules or exhibit

systematic biases.

• Inefficiency: Why buy insurance if the government will assist

me if I have a large loss, and why try to hold down my loss if I

have insurance?

Insurance innovations in theory: supply

problems and solutions

• Total losses from a climate related catastrophe can be

“large.” Insurers claim there reserves set limits to their

capacity to cover risks.

• But fraction of global capital at risk for weather related

losses in any one year is small. So we look for ways to

expand the pool of agents willing to commit reserves.

• We might be able to pool climate risk in the global capital

market with other risks. Diversification helps.

• Mutual insurance: Pool within reasonably homogenous

risks and either reinsure or leave off coverage of pool-level

catastrophic events. Will work to cover above average

losses but may not work for changes in climate change risk

Insurance innovation in theory:

demand problems

• Make demanders aware of risk—perhaps by

bundling insurance with loans.

• Offer insurance against reclassification risk:

coverage against redrawing the flood map

• Mutual insurance again: will work even if agents

differ widely on their estimates of p as long as

they agree that p is the same for all. A way to deal

with climate change sceptics? (I will explain.)

Microinsurance and microdemand

• Many small low wealth businesses are at risk for

damage from climate change.

• The good news: your total losses will add up to

only a small share of global wealth.

• The bad news: paying even reasonable premium

may be “unaffordable,” pushing income below

minimum needed for family consumption and

level needed to operate business as a going

concern.

Facing the poverty issue

• Generally the best thing for the poor is not insurance but is money spendable on anything.

• If you have an asset worth $X if weather is good and zero if it is bad with probability p, you should prefer an asset of X-pX and full insurance to an asset of X and going without insurance: you can less well afford to be uninsured than insured.

• If X is below the subsistence threshold—so paying pX (compared to not) pushes consumption too low--the only answer is a subsidy to low wealth populations. If they misperceive but can afford (barely), it is harder.

Insurance innovation in theory:

incentives for mitigation

• Make preventive activities easily observable and then either: (a) adjust premium for prevention-effects on risk; or (b) have insurer cover the cost of cost-effective prevention.

• Second best parametric coverage: base insurance payout on average loss in your region, not your loss. (E.g., all insureds in an area get $X if there is a drought in that area.)

• Multi-period insurance: the insurer offers a stable annual premium over a fixed time period which is reduced if the insured invests in cost-effective loss reduction measures that can be financed by a loan. The premium reduction will be greater than the annual loan cost.

From theory to reality

• Obviously it is not easy to get international entities to

design and pay subsidies.

• Motivating insurers: high future losses are not a strong

motivation if risks can evolve slowly and can be predicted

well in short run so that insurers can raise premiums if they

need to: statesmanlike platitudes are a change barrier. But

multi-period arrangements (more below on this) can help.

• Motivating governments: disaster relief crowds out

insurance. Cooperative subsidies and affordability transfers

are politically challenging.

• Regulation often impedes the supply of coverage.

Practical developments to watch

• Index-based micro insurance for some climate

change losses (e.g., Malawi): hopeful watching

• Better capital market instruments: cat bonds and

weather derivatives.

• Tiered and coordinated international policy

interventions: Caribbean and island nations

• Who can be trusted to manage this, for the most

misunderstood industry?

Some more speculative suggestions

• Solve the problem of insurance capacity by making benefit

depend on your loss and the total loss. Reduce your benefit

if total loss is large. New contract forms or mutual

insurance?

• Reinsurance as a solution to the capacity problem.

• Mutual insurance with reinsurance and prevention-

dependent grouping as a solution to everything. We only

need to agree that we all have the same p, not on what the

value of p is. Will bring in climate change sceptics and

doomsayers.

• Guaranteed renewability at class average premiums (also

known as insurance futures): add protection against above-

average future premiums. (I will explain.)

Who should do what to get things

moving?

• The big issue: who can you trust? Insurance firms?

Governments? International bodies?

• Given you have found a trustworthy agent, partner

with private insurance and technical experts to

design attractive insurance contracts sold in an

affordable way.

• Find some way to get agents to be more

deliberative in their thinking.

Some examples that sound

promising to me

• Criteria: short term protection with high liquidity,

long term protection, mitigation

• Caribbean Catastrophic Risk Insurance Facility

• Micro weather insurance

• Small Island Nations (under construction)

• Some examples from Nepal?

CCRIF

• Since 2007

• Initial capital from 13 Caribbean countries (pooled

disaster funds) and donors

• Annual risk rated premium and decision on

coverage

• Parametric benefits tied to cyclones, earthquakes,

and heavy rain. Benefits very liquid and quick.

• Moderate links to mitigation

Micro weather insurance

• Extensions of existing weather insurance in

Mongolia, India, Malawi, etc.

• Parametric benefits

• Low and heavily subsidized premiums

• Targeted at poor farmers

• I will provide more details for Nepal and ask some

more questions.

Munich Climate Change Initiative

• Started by Munich Re in 2007

• Goals are to develop solutions to climate change

threats through insurance and insurance related

mitigation

• Mostly a consulting/convening entity, but does

pilot projects

• Could it pilot long term insurance—direct or GR?

Conclusions

• None of this directly affects carbon emissions or

other causes of climate change—it is a way of

making the best adaptation to a potentially bad

situation.

• But a lot of opportunities for improvement as long

as not too much is expected

• Will governments be up to the task—actually put

resources and effort in, avoid politically based

management and pressures?