What is the Role of Insurance for Addressing Climate-Driven Extreme Events? Ingmar Schumacher IPAG Business School, Paris Our Common Future under Climate Change Paris July 2015

Motivational points number of natural catastrophes quadrupled between 1970-2013 so did the economic losses associated with these events. climate change is expected to increase these insurance industry has then increasingly vital role for investment

decisions, risk pooling, wealth smoothing

Natural disasters from 1950 -2008 in EM-DAT database

Recognizing the role of insurance industry IPCC (Field and Van Aalst 2014) (p. 503) “Greater exposure to climate risk, in the absence of well-functioning insurance markets, leads... to both lower current and future farm profits (robust evidence, high agreement) (Rosenzweig and Binswanger, 1993; Hurley, 2010). ” “The Bali Action Plan, drawn up at the UN Climate Change Conference in Indonesia in 2007, called for consideration of risk sharing/transfer mechanisms, such as insurance, while insurance initiatives are already explicitly mandated under UNFCCC article 4.8:” Role of insurance - risk pooling, and risk diversification. Insurance is a predictable cost; it allows costs to be spread over society which otherwise may bankrupt an individual.

Important trade-off between insurance and mitigation (IPCC 2014 Synthesis Report (IPCC 2014b): “Risk financing mechanisms in the public and private sector, such as insurance and risk pools, can contribute to increasing resilience, but without attention to major design challenges, they can also provide disincentives, cause market failure and decrease equity.“

Take-away points

transparency of premium decisive

who should undertake mitigation policy

who should be the provider of insurance

Discussion mostly based on published article: Georg Müller-Fürstenberger, Ingmar Schumacher, Insurance and climate-driven extreme events, Journal of Economic Dynamics & Control, Vol 54 (2015), pp. 59–73.

Transparency of premium Assume insured does not know how mitigation actions depend

upon premium A fair premium -> full insurance -> no incentive for mitigation

actions (naive insurance)!

Assume insurance company fully informs insured A fair premium -> full insurance -> now role for mitigation (but if low income then no mitigation -> implications for international

inequality)

Wetlands Watch report (Stiles and Hulst 2013) notes that for (p.3)

“... insurance price and availability, we found no clear indication that a homeowner could find and understand the impacts of climate change on his/her insurance.”

Mitigation actions depend crucially on option to insure

Who should undertake mitigation policy pay-as-you-drive /protect insurance contracts are now offered Mills (2009): can reduce premiums by 60% This is now a more theoretical inquiry: Will this lead to an optimal level of mitigation? Pro: if too little mitigation then gives additional incentives Con: Insurance industry maximizes its own profits, not social welfare -> gives different incentives compared to what a policy maker would -> might inefficiently increase private mitigation while social mitigation may be cheaper Policy cocktails can lead to further market failures

Who should be provider of insurance? Pro insurance: tends to know market better; fewer inefficiencies Contra insurance: profit oriented -> overhead on premia -> less than full insurance May demand too costly premia (e.g. in US property insurance costs rise faster than income) Opens role for government! e.g. the National Flood Insurance Programme in the US Pro government: would insure everyone; leads to more certainty and higher capital accumulation Contra government: Samaritans dilemma; government `insurance’ tends to make large losses; LDCs unable to provide catastrophe insurance

Take-away points Transparency of premium decisive

No transparency no mitigation Even with transparency no mitigation if income low

Who should undertake mitigation policy

Cannot expect insurance company to induce socially optimal level of

mitigation But, if too little mitigation anyway, then welfare-improving

Who should be the provider of insurance Depends, but good grounds for government intervention