new publication: Insurance and Climate-Driven Extreme Events

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I am happy to announce that my article “Insurance and Climate-Driven Extreme Events” co-authored with Professor Georg Müller-Fürstenberger (see bottom for more information) from the University of Trier, Germany, has been accepted for publication in the Journal of Economic Dynamics and Control. We would like to thank especially Professor Ireland for his help and comments.

This is a short summary of the main findings of the article:

We investigate how insurance affects agents’ decisions when being faced by endogenous, climate-driven extreme events. This is not only important in order to understand how the possibility of insurance augments mitigation and saving decisions, but it also improves our understanding of how insurance should be provided. Since there are no studies as of now that rely on such an integrated approach, we extend the literature along two lines. Firstly, we develop a neoclassical growth framework with endogenous extreme events and an insurance sector. Secondly, we introduce a simulation method that allows us to explicitly take these extreme events into account and which yields additional numerical insights. In doing so we can fully characterize and quantify the impact of different insurance policies for mitigation and economic growth decisions.

Our analytical results and computational experiments show that i) transparency of the insurance sector is the decisive requisite for abatement activities, implying substantial policy opportunities; ii) a decentralized economy will under-invest in abatement without adequate policy interventions;  iii)  precautionary beliefs on the frequency of extreme events lead to more sustainability; iv) a social security system which prices insurance fairly is preferable to an insurance industry which provides insurance with an overhead.

So why is this important?

Politicians seem to want to acknowledge more and more that it is already too late to act against human-induced climate changes. Also, they seem to start to believe that it is too costly or that the public would not support the required drastic measures.Obviously, this is the `easy way out’. In this international `game’ of climate action, a wait-and-see strategy is the most simplest and safest strategy for a politician. Furthermore, with the argument of the financial and debt crisis at hand, politicians convince themselves very often that their hands are bound anyway.

The belief that mankind may easily adapt to most climatic changes is not terribly helpful, either. Proponents of the view that mankind may easily adapt to climate change include the strong environmental economist Matthew Kahn, who has done a wealth of very good studies on adaptation. Yes, in the long-run we are likely to be able to adapt to issues like sea-level rise or to problems like desertification of certain regions. In effect, we already see adaptation to climatic changes now, e.g. via  rural-urban or international migration, but do we really want to let it come that far? What are the costs of this short-term to medium-term adaptation process? Are these costs higher or lower than the costs of reducing our emissions and our impact on the environment?

So, in the discussion around adaptation to climate change, politicians have started to favor the idea that insurance could play a major role. For, the argument goes, if we have a full insurance coverage, then the costs of disasters that potentially result from climatic changes could be born by society, and those affected may be compensated through the insurance policy. But what are really the costs and benefits from such an insurance policy?

Let us, and this is not in the paper but I just want to add this as a thought of mine, assume that it costs 100 euros per year to reduce emissions via e.g. building solar panels, more expensive cars which have fewer emissions, etc. Then these 100 euros are invested in society, add to GDP, and provide employment for someone, too. Instead, assume now that we do not reduce emissions, and that climate change leads to 100 euros of damages each year through extreme events like floods or hurricanes. Then these 100 euros are lost to society. Hence, while society may be able to compensate those affected by disasters via the insurance policies, any disaster is still a loss to society in general. Thus, we should certainly prefer most no-loss situations to a loss situation.

Ok, back to the paper. All this maths and computer-powered simulation basically gives several conclusions.

i) We find that transparency of the insurance sector is the decisive requisite for abatement activities. So, if someone who takes out an insurance policy is not informed about how his premium changes with his behavior, then it is clear that this person would not change the behavior. For example, if you pay the same car insurance premium if you drive like a maniac or leave your car mostly in the garage, then the maniac is not going to change his driving style. But if the maniac hears that an accident will result in his premium rising to a rate at which he won’t be able to afford driving any longer, then he will think twice about speeding in the city centre.

The same argument holds with climate change. If policy makers are aware of the impact of their policies on insurance premia, then this will change their incentives for dealing with climate change. Hence, we argue that the transparency of the insurance premia implies substantial policy opportunities.

ii) One of our findings is that a decentralized economy will under-invest in abatement without adequate policy interventions. An individual who sees his premium rise with climate change but who himself believes he is unable to affect the evolution of climate change is unlikely to figure his marginal impact on emissions in his decisions. This individual will, however, think more carefully about where he locates himself. For example, if he is aware that there is a likely sea level rise in the region that he would like to live in, and if the future change in emissions make this sea level rise very likely, then the fact that he will have to pay a higher premium to live in this region may make him choose a different location. Thus, while we should see more individuals adapt to potential effects from climate change if their insurance premium signals them cheaper locations, we would also argue that policy makers should carefully consider the evolution of the insurance premia given their choices for future emission paths.

iii) Beliefs about how climatic changes are going to impact losses from extreme events vary widely, and they clearly depend on a multitude of factors. Sometimes policy makers have difficulties to know what and whom to believe in, and they make take either the one or the other position. For example, in the US, beliefs about the impact of climate change has become a partisan issue, with Republicans taking in general the opposite view to Democrats. In this paper we show that precautionary beliefs on the frequency of extreme events lead to more sustainability. While this may not be optimal from a standard discounted welfarist perspective, it will be the best choice in the long-run and based on e.g. Egalitarian views of justice. For those readers who are interested in how beliefs in general affect the willingness to contribute to prevention expenditure, please take a look HERE.

iv) Now this last result in our paper gave us a bit of trouble with the company that had, some while ago, financed the first version of this research, Swiss Re, the largest re-insurance company in the world. So, one of our results was that a social security system which prices insurance fairly is preferable to an insurance industry which provides insurance with an overhead. Bäm! Sorry, Swiss Re. One has to acknowledge that Swiss Re, while not in favor of this result, left us our scientific independence. And there are certainly conditions under which this result is contestable. For example, it is well-known that insurance companies tend to possess better (local) information when it comes to the costs from natural disasters, etc. But at the same time it is clear that they are interested in generating a profit and not handing out insurance policies for the `good of society’. So they have a premium attached to whatever they do, and this premium leads to a lower than optimal insurance take-out. In some cases, insurance companies even did not provide insurance policies in some regions anymore, simply because it was too risky for them. So in these cases the government needs to jump in and provide the insurance coverage. But then one should wonder: If the insurance industry leaves the very risky cases to the government, demands a premium for the rest, shouldn’t there be a larger role for the government in this sector altogether?

So, these are the results from our paper, and we plan to build upon these. This is an exciting research field on which not much has been done lately, and there is plenty of room for further analyses.

Some information on my co-author: Georg Müller-Fürstenberger is a Professor for Urban and Environmental Economics at the University of Trier in Germany and since 2014 the Vice-President of the University of Trier. He holds a PhD from the University of Heidelberg in Germany and undertook his habilitation at the University of Bern, Switzerland. His research interests are centered on environmental economics, with a focus on climate change issues. He published in journals such as Ecological Economics, Journal of Economic Dynamics and Control, or Kyklos.

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