Today we have insurance policies for almost everything – health, house and content, fire & theft, life, disability, income protection, mortgage, motor car, travel, and so on. We even have funeral insurance. One insurance provider politely sells it as “to protect your loved ones from the potential financial burden of paying for your funeral costs”. Yes, we want to be insular from every possible unknown. But how does insurance work? Its pretty simple – people pay money called an “insurance premium” to an insurer. In return, the insurer promises to make some payments to the insured party if an adverse event occurs.
Why do people buy insurance? Uncertainty is a fact of life. People face risks every time they take a shower, drive a car, board a plane, walk across the street or make an investment. Insurance can mitigate at least some of these risks. Presumably, an insurance buyer is concerned with the probability of various outcomes. Economists refer these different outcomes as ‘probability distributions’. For many environmental problems, it is not possible to state with certainty what potential outcomes a particular policy will have. This is because scientific forecasts themselves often are uncertain. For example, consider the potential damage from climate change. Most scientists now agree on the potential impacts of climate change, such as sea level rise, species losses. But the timing and extent of those losses are uncertain. Can the insurance industry handle future catastrophe risks?
The insurance industry faces a number of problem here. The insurance premiums required for all types of aforementioned insurance policies bar climate change can be easily estimated because such events have happened many times in the past and therefore insurance companies have a fairly good understanding of probability distributions associated with each potential outcome. Climate change, however, is a different kettle of fish. It involves catastrophic events.Therefore, probability distributions are not known. Catastrophic events can strain the capacity of the insurance companies and their ability to cover such losses and private insurers may be reluctant offer insurance without a government guarantee.The available evidence also suggests that reinsurance is heavily skewed toward the coverage of relatively small catastrophes.
Another non-trivial issue is what economists called ‘adverse selection’. By definition, those who are willing to buy a flood insurance are those who live in a high flood risk area. The implicit assumption here is that people only buy insurance if it is profitable for them to do so.Therefore, insurance providers lose money or the insurance is “too expensive”. Flood insurance is different from other natural disasters where insurers can effectively take risk by pooling across different regions.
The issue is further complicated by the expectation that governments should bail out people in every possible natural disaster. This is a valid premise as far as the disaster is unprecedented or catastrophic. Of course, the immediate humanitarian assistance by the government to victims of natural disaster of any magnitude makes sense. If an individual built a house on a flood plain knowing the potential risks and then demands compensation from government in every single flood event then it equals to abuse of public funds. Governments may consider imposing mandatory flood or fire risk insurance in such cases. This would help the insurance industry to develop insurance products and to bring down premiums as many people buy the insurance. By the way, after the floods in Queensland last year, people who had insurance could not recover costs because of the ambiguous interpretation of flood definition by the insurers. Since then, much work has been done to rectify the issue.
Coming back to climate change insurance, many who advocates immediate action to climate change interpret greenhouse gas abatement as an insurance and argue that for the same reason as people are willing to secure against hazards of all sorts, society should be willing to spend some money to protect itself against adverse climate effects, particularly since these may be irreversible and potentially disastrous.
A few insurers are ready for climate change – See the Sydney Morning Herald article here.
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