Insurance Markets and Climate Change

Eakinomics: Insurance Markets and Climate Change There’s been a lot of talk lately about climate change and financial markets. See, for example, the discussion by Ewelina Czapla and Thomas Wade on the Financial Stability Oversight Council report on Climate Related Financial Risk. Yesterday, I participated in a panel discussing property and casualty (P&C) insurance and climate change. The basic question was: What should the P&C industry do in response to climate change? Let’s begin with what it should NOT do. Other than within its own physical footprint, the P&C industry should not be in the business of abating emissions or mitigating systemic climate risk. The basic character of the climate change issue is such that it never makes sense for a private actor to take on greenhouse gas emissions; the costs are direct and immediate while the benefits diffuse and spread across many actors. Really addressing climate change requires collective action such as a carbon tax. A slightly different issue is mitigating the financial cost of climate-related floods or fires. If there are building standards or geographical decisions that affect future costs, it may make sense to bake these into the contract. From a first-principles perspective, there are two other primary roles: pricing risk (premiums on policies) and investing (building reserves against future losses). Rigorous, actuarially fair premiums that fully incorporate the flood, fire, and other risks in each geographic location send important signals about their undesirability, the unworthiness of some construction codes, and other manifestations of climate risk. Here the industry would be doing the people a favor by providing this information and the taxpayer a favor by keeping it off the government tab (as opposed to lacking insurance and ending up getting disaster relief.) Unfortunately, the major obstacle to charging accurate premiums is the government itself, as politicians work very hard to keep people from paying the real price of products and services. The second activity is investing. There have been some suggestions that insurers should not invest in fossil fuel companies, for example. But if climate change is a threat to fossil fuels, then it does not make financial sense to invest in that sector; the industry’s natural need to earn competitive returns will channel capital elsewhere. In short, the basic principles of insurance are already the right tools to take on climate change. Of course, some climate change has already taken place and extreme rains and flooding remind us that flood insurance is no longer exclusively for those on the oceanfront or in a 100-year flood zone. There may be the need for new products and sales to provide coverage that allows the United States to adapt to the changes that have already taken place.