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Risky Business

Posted by Danny Morris on December 9, 2009

This post originally appeared on Weathervane, RFF’s climate policy blog.

If you’re looking for an industry that is on the cutting edge of assessing the effects of climate change and forming appropriate responses, look no further than the insurance industry. At a small side event sponsored by Climate Consortium Denmark, experts from major European insurance companies came together to call for a larger role for governments in the industry through public-private partnerships. The insurance industry has been dealing with nasty weather as long as it has been around, but the steroid injection of climate change into weather systems creates a whole new ballgame.

With those future risks in mind, Richard Ward, CEO of Lloyd’s, asked policymakers here at Copenhagen to help level the playing field amongst companies by strongly regulating the entire industry. While it’s not often you hear the CEO of a major corporation asking for stout government regulation, Ward emphasized the need for more clarity for future planning and investment. He also called for the formation of national adaptation plans, especially in developing countries, to provide the industry insights that can help move capital into new or burgeoning markets.

His calls were echoed by Patrick Liedtke of the Geneva Association, an international industry think tank, who said that the industry wants stronger partnerships with governments. He pointed to the Kyoto Statement, in which 56 insurance companies state their great concern about extreme climate change, as an example of the commitment of the industry to addressing climate change.

Two major issues popped up throughout the presentations that highlight the unique tension the industry faces. First was the role of insurance in the developing world. Insurance companies can encourage both mitigation and adaptation through investments in renewable and sustainable technologies and offering products that encourage adaptive measures and better building codes. Unfortunately, it can be difficult for companies to establish themselves in developing countries. Insurance is a luxury good, and poor farmers are more likely to spend money on extra livestock or seeds than on floor insurance. Consumers need much more education before they will try to access insurance markets. Moreover, many of these markets are still primitive and require government action to get firmly established. And while insurance companies can manage risk, they can’t reduce it alone, further showing the need for private-public partnerships.

Second is the issue of data. Both Ward and Liedtke emphasized the importance of robust data and the need for more data collection and data sharing from national governments. Better information will inform the risk assessments that are critical to the insurance industry and this need for better data has driven the industry to be on the forefront of climate assessments for years. “Good risk management needs good risk data,” according to Ward and he made a strong plea for governments to make more data freely and publicly available.

Data sharing is a two-way street however, and one (like me) could argue that the insurance industry needs to be more transparent with its risk assessments and make its data more accessible to the public. Prices that reflect true risks are the best way to make them clear to consumers, but there are other means to achieving clarity as well, including data and information sharing.

At the end of the day, it’s still the price tag that drives behavior, especially in insurance markets. Profit drivers are still an essential part of the system, so there is a limit to how much coverage can exist, especially in areas highly exposure to climate change risks. As national governments continue to devise ways to grapple with the effects of climate change, they may need to provide the insurance industry with a little more assurance that they won’t leave it over-exposed.

Posted in Climate Change, COP, Insurance | 2 Comments »

Moment of clarity

Posted by Danny Morris on June 11, 2009

Something was made very clear to me last night, courtesy of Coors Light (it was not the kind of moment of clarity referred to at 4:09 in this video). As part Coors’ bludegeoning advertising campaign surrounding  cans that turn blue when cold, the announcer in at least one tv commercial claims the cans offer an ‘insurance policy for cold beer.’ Sounds pretty awesome, right? Not so fast. At that exact moment, fine print appears at the bottom of the screen to inform viewers:

There is no insurance policy for cold beer.

My first thought was ‘That’s a huge bummer.’ Then my inner nerd kicked in and brought about my moment of clarity. My corresponding thought was ‘There’s no real insurance policy for climate change either.’

The environmental news gods are smiling on today because the first article I saw on ClimateWire was a rundown on a new study (sub req’d) being conducted by FEMA on the effects of climate change on the National Flood Insurance Program. In my past ravings about insurance and climate change, I haven’t made much mention of the flood insurance program, but it is a massive piece of the puzzle to figure out how the nation can adapt well to climate change.

The NFIP was designed to protect people from being totally exposed to losses from major floodsthat tend to hit the southeast and midwest every year or so. Unfortunately, because people no longer had to worry about losing everything (i.e. they could not fully internalize their risk), they moved into floodplains and coastal areas that before were too dangerous to live in. Now, you have trillions of dollars in sunk capital all over the nation in areas where the risk is changing rapidly and in a way that we don’t fully understand.

The new FEMA study is trying to identify how climate change will affect inland floodplains, coastal areas, and how sea level rise will affect the program. The outcomes of the study could lead to redrawing of 100-yr floodplain boundaries, resulting in higher premiums. The study will not be complete for another year or so, but things do not look good already. According to one of the authors:

“There may be no solid projections. We’re not even coming up with squishy assumptions.”

Imagine, if you will, the political catfight that could surround this study when it’s completed. Here you have FEMA (not the most popular or trusted agency in the land) potentially coming out and saying we need to redraw our flood maps, but they don’t even have squishy assumptions. Perhaps as the study progresses, they will develop slightly more solid assumptions (think jello vs. pudding), but this may be one of the big climate change issues we have to grapple with domestically in the future and it is going to be messy. At least, that’s clear to me.

Posted in Climate Change, Insurance | Leave a Comment »

Catastrophic Understanding

Posted by Danny Morris on April 30, 2009

A little while back, Josh asked the question ‘how do catastrophes factor into our calculations?’ He asked the question in the context of cost-benefit analysis, but it’s a critical question for almost every facet of climate change research. The journal Nature used this week’s issue to shed some light on the subject. Since you have to pay to access Nature, I recommend the short but informative rundowns of the content from Environmental Capital and RealClimate. According to these studies, if we as a global society want to avoid catastrophe climate change, then we need to cap the world’s emissions at 1 trillion tons of CO2. Considering that we emitted one-third of that in the past 9 years, we could be in for a rough ride.

Science models can only tell us (to a degree of certainty) where to expect a greater chance of catastrophe, but how can we translate that into economic analysis. There are a couple ways to do it. First, you can use a low discount rate to better internalize the possiblity of a major disaster. Discount rates are often huge sticking points for economists arguing about each other’s models (take Bill Nordhaus vs. Nick Stern, for example) and there’s still no consensus as to what is the ‘correct’ rate.

Second, you can use risk analysis to better understand how bad disasters can be. A recent paper by Carolyn Kousky and Roger Cooke of RFF (which you really should read) does an excellent job of laying out some of these risk considerations, and it definitely provides some food for thought. The three major risk considerations are:

  1. Micro-correlations – The events of El Nino years are a good example. If you look at events in isolation (heavy rains and mudslides in Cali, poor fishing seasons in Peru, etc), they might not be noticeable, but that would lead you to underestimate your risk of major damages . If you take the broader picture though, you can see that disasters can be correlated and you can accordingly adjust your risk assessments.
  2. Fat tails (of a bell curve/normal distribution) – Basically, extreme outcomes are more likely. Disasters and extreme events compound on each other to create fat tails, which increases solvency risk of insurance, meaning that you might have way more damage than you can afford. A good example of that is Florida with their Citizen’s Property Insurance Corp., which has $3 billion to cover its $450 billion worth of exposure.
  3. Tail dependence – Tail dependence is essentially the likelihood that bad outcomes occur together. It is distinct from micro-correlations and fat tails, and they explain it much better than I can, but it relates to the idea that insurance lines can be independent of each other until there is a disaster, at which point they become dependent.

If you don’t account for these issues, you can severely underestimate your risk related to climate change. Cost-benefit analyses seem to have a pretty difficult time incorporating these factors, but there is still much research to be done on this front. It could be a while before we have reliable methods for incorporating catastrophes into our modeling. I don’t know about you guys, but I’m still miles and miles away from fully understanding this stuff. At least I can tell the difference between weather and climate, so I got that going for me, which is nice.

Posted in Climate Change, Cost Benefit, Insurance | 1 Comment »

Adapting moral hazard

Posted by Danny Morris on April 21, 2009

Insurance is going to play a huge role in getting policymakers and the public in general to get a tangible grip on the effects climate change will have on our daily lives. I’ve blathered blogged previously about some of the interesting moves that state regulators are making to force the insurance industry to be more transparent in how it classifies threats posed by climate change, but don’t think they have it all figured out either.

Last Friday, ClimateWire posted a fascinating little ditty on the current battle in the state insurance regulator world about a national catastophe plan. The issue at hand is whether or not the federal government should accept the risk from increases from swirlier hurricanes, twistier tornadoes, blowier winds, and other incredibly technically-termed problems. This could prove to be a boon for states like Florida, which could rely on the other 49 states if this year’s hurricane season is particularly nasty.

Florida could use a little help, especially with its state-backed Citizens Property Insurance Corp., which has up to $45450 billion in exposure and about $3 billion to cover it all. For those of you math-challenged, that is 0.67 percent of total exposure that Florida can cover, and non-Floridians can cover the rest. This of course is in lieu of private insurance, which is retreating from coastal Florida faster than a gale force wind.

The regulators haven’t approved the plan yet, not are they anywhere near doing so. Despite the reprieve, there are still reasons to be concorned. While there is not much we can do about existing infrastructure in at-risk areas, we should still reflect the actual risk we face in different areas with insurance premiums.

I know this is radical idea, but I promise I’m not out on this limb all by myself. Howard Kunreuther, an expert in risk management, said the same thing two years ago in a far-more reputable publication than this one. Not reflecting real risk in really risky areas is what we in the business call ex post moral hazard. As climate changes manifests itself in nasty ways, what with the sea level rise and all, we are going to face this type of moral hazard more and more, and we’ll have to decide how to deal with it. Hopefully, it works out better than the last one.

Full article after the jump.

Read the rest of this entry »

Posted in Adaptation, Insurance | 1 Comment »