Buying Insurance Against Climate Change

Originally published in the New York Times on May 24, 2014.

The third National Climate Assessment report—released on May 6 by the White House, and representing the work of more than 240 scientists—warns us about our hazardous future and offers many good ideas for dealing with it. But a most important point may be lost in the crowd.

After discussing how to mitigate the coming dangers, the report says, “Commercially available mechanisms such as insurance can also play a role in providing protection against losses due to climate change.” That sentence should have been in big, bold letters and underlined.

That’s because of the substantial risk that efforts to stop global warming will fail. The implications are staggering, and we must encourage private innovation and government support to insure against the devastating financial losses that will result.

The problem is an age-old one: Each country has a strong individual incentive to take a free ride on the rest of the world—to find self-serving or nationalistic justifications for adding carbon dioxide and other pollutants to the global air supply. Such behavior, which in some ways might benefit the individual country while hurting everyone else, is known in economics as an externality problem, and the world has never solved one of this magnitude. We must face facts: There is a real risk of new kinds of climate-related disaster.

In his latest book, The Climate Casino: Risk, Uncertainty, and Economics for a Warming World (Yale University Press), my Yale colleague William D. Nordhaus describes the uncertainty of global warming’s specific effects around the world. We are taking major gambles with our environment, he says. Expect surprises.

In March, a United Nations report identified with “high confidence” a number of risks that will be visited on different people unequally. It spoke of the “risk of death, injury, ill health, or disrupted livelihoods” in low-lying coastal zones and on small islands—and that is just the start. Food systems may break down. There may not be enough water for drinking and irrigation. Ecosystems may be shattered.

In short, we need to worry about the potential for greater-than-expected disasters, especially those that concentrate their fury on specific places or circumstances, many of which we cannot now predict.

That’s why global warming needs to be addressed by the private institutions of risk management, such as insurance and securitization. They have deep experience in smoothing out disasters’ effects by sharing them among large numbers of people. The people or entities that are hit hardest are helped by those less badly damaged.

But these institutions need ways to deal with such grand-scale issues. Governments should recognize that by giving these businesses a profit incentive to prepare for these unevenly distributed disasters. After all, fire insurance does no good unless you buy it before the house burns down. And you have to diversify your portfolio before the stock market crashes.

Fortunately, we aren’t too late to take action to insure against some climate risks. And yet this has not been a major element in most of the climate debate.

We already have weather derivatives that can help, like the 50 contracts in 13 countries offered by the Chicago Mercantile Exchange. A ski resort can already buy protection against inadequate snowfall and a city can buy protection against too much snowfall next winter by, in effect, taking the opposite side of the same futures contract (through the exchange), thereby pooling their opposite risks. There are also catastrophe bonds, like the three-year, $1.5 billion Everglades Re Ltd. issue sponsored this month by the Citizens Property Insurance Corporation. It would provide relief to the insurer of Floridians hit by a bad hurricane; in such an event, the bond holders would bear losses.

But there is a problem with instruments like these: They tend to focus on relatively short-term risks, and don’t hedge against the increasing cost of disasters over distant future years. Yet if the problems of global warming become more serious, they will very likely be long-lasting, raising some complex, tough-to-quantify issues. Some kinds of crises, like hurricanes, may remain intermittent, but their tendency toward severity may build in a slow, hard-to-predict process and in complex geographical patterns.

Psychologically, it’s hard for most of us to take the initiative on long-term, ill-defined risks. Three scholars—Howard C. Kunreuther and Mark V. Pauly of the University of Pennsylvania and Stacey McMorrow of the Urban Institute—show this in their book, Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry (Cambridge University Press). But they argue that if we’re aware of them, these psychological impediments can be reduced, and they urge the innovation of long-term risk management contracts that address the problem of climate change.

Some progress is being made: The Caribbean Catastrophe Risk Insurance Facility is one recent example of institutional sharing of climate risks. Then there is the Alliance of Small Island States, formed in 1990 as a response to climate change. The group represents 5% of the world’s population, and its island members are scattered around the globe. But if sea levels rise substantially, all of them will be affected. These countries generally aren’t big enough to have a heartland that can help coastal dwellers in a climate catastrophe. The alliance has been arguing for an international approach to dealing with such loss and damage.

These are only beginnings. We have a crucial need to bring innovation to our risk-management institutions. We need to make them flexible, to clarify their long-term international legal status, to develop mechanisms and indexes that can be the basis of long-term risk management contracts, and to educate the public about them. Most important, we need concrete action now to build a mechanism that will provide real help for the victims of climate-change disasters.