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Adaptation, Mitigation, and Insurance

In our discussions so far, we have had very little to say about adaptation strategies. For the governments of many countries, so far, adaptation strategies are nonexistent. This state of affairs is not just for the developing countries. For example, in the “Status of State Climate Adaptation Plans” in the US, most of the states have no plans at all.[1] This is the status in a developed country. Not surprisingly, in the developing countries, adaptation is not even on the radar of the policymakers.

At the international level, the Adaptation Fund was established to finance concrete adaptation projects and programs in developing countries which are signatories to the Kyoto Protocol and which are particularly vulnerable to the adverse effects of climate change. Essentially, the Adaptation Fund finances projects and programs to help developing countries adapt to the negative effects of climate change. It has funded projects in two dozen countries with a total commitment of 166 million dollars, with about a quarter of it spent by the end of 2012.[2] The Adaptation Fund is financed mainly from the share of proceeds on the CDM project activities. The share of proceeds amounts to 2 percent of certified emission reductions (CERs) issued for a CDM project activity.

In summary, there is very little that is being done either at the level of international institutions or at the state and local government level. This is one area where private insurance and reinsurance companies can make a substantial contribution by teaming up with governments. Most individuals and companies avoid risks. Insurance companies, on the other hand, create business by accepting risks.

The four trillion dollar insurance industry is at the vanguard of climate change. The reason is obvious. Many risks that insurance and reinsurance companies cover are related to weather. Flood insurance, hurricane insurance, windstorm damage insurance, crop insurance (along with more recent synthetic insurance policies with features of put options) are staples of the insurance and the reinsurance business. At least half of the world’s population lives in regions highly exposed to natural disasters, but only a small fraction of them are insured. Insured losses alone from weather-related disasters have jumped from USD 5 billion per year in the period between 1970 and 1989 to USD 27 billion annually over the last two decades. Events such as Hurricane Katrina pushed the annual cost of catastrophes to over USD 100 billion in 2005.[3] While the actual losses from Katrina were over USD 113 billion, less than half of it was insured. More recently, in October 2012, Hurricane Sandy caused losses over USD 71 billion.[4]

In theory, any risk whose probability distribution and loss magnitude can be quantified can be priced and insured. So, it is possible to insure against natural catastrophic losses. The problem is that such risks are changing over time and the volatility of such risks is rising. That makes forecasting future losses a challenge. Many such risks are insured on a year by year basis. But if the underlying variability of such risks changes, that is, events that were once in a hundred years become once in thirty, it may take the insurers a long time to find that out. When they do find out, it may make them insolvent.

Consider crop and flood insurance products. They are related to the amount and the variability of rainfall. Over time, rainfall in a given area is changing. It is not a simple matter of more or less rain—the entire distribution of rainfall is moving in unexpected ways. In Figure 7.10, we examine the rainfall in the Sahel region of Africa. It shows (the kernel density) of the monthly rainfall distribution over a period of 113 years. The figure shows that rainfall in that region has become sparser

Distribution of rainfall 1900-2012

Figure 7.10 Distribution of rainfall 1900-2012

(the median of the distribution has moved to the left). Moreover, the shape of the distribution itself has changed dramatically making extreme events more likely.

Most of these extreme events are not insured by ordinary insurance companies but by reinsurance companies. Naturally, large global reinsurance companies like Munich Re and Swiss Re have taken great interest in this field.[5] They take the IPCC Reports very seriously. It provides a market test: they have a financial stake in climate change in the long run. Thus, they take climate change more seriously than politicians, many of whom, by the nature of their business, have very short-term interests.

Specific actions have been suggested by many governments. For example, the October 2010 report on climate change from the White House suggests that the government needs to “facilitate the incorporation of climate change into insurance mechanisms.”[6] Particularly, insurance markets may have insufficient capital to cover increasing catastrophic losses, especially if rates cannot track climate risks. It also encourages public-private partnerships to produce an open-source risk assessment model.

For the developing countries, the stakes are higher. For some countries, like the small island nations around the globe (the Maldives, for example), the rise of sea water level is critical to survival. Low lying countries will have higher likelihood of inundations. They are the most vulnerable ones. Other countries will face challenges as well. For example, many large cities in Latin America have grown without any plan. There is urban poverty and precarious living conditions. Climate change will cause rising sea levels, more violent storms, flooding, and extreme temperatures. There will be problems of water supply, food will be scarcer and there will be threats to health and sanitation.[7]

The lack of maturity of capital markets brings additional challenges for the developing countries. Routine synthetic financial products (such as rainfall insurance) are simply not available in most developing countries. This is where international multilateral organizations such as the World Bank, International Monetary Fund, Inter-American Development Bank, and Asian Development Bank can play an important role in providing private-public partnerships in the form of microinsurance and other innovative products that are normally not available in such markets.

There are many ways that insurance companies can help to address climate change.[8]

First, insurance companies can help with the understanding of the climate change problem. Insurers are beginning to share their expertise in data collection, catastrophe modeling, and risk analysis to track trends in weather related data. These activities can be used to address problems posed by climate change. Insurers are building forward-looking risk models that take climate change into account. For example, in Figure 7.10, the movement of the rainfall index over the past century can be used to create a rainfall index for the future. For planning and for insurance, such modeling will not produce unexpected losses. Such modeling is essential for the survival of the insurance industry itself. If a hundred-year flood becomes a ten- year flood, insurance companies will have insufficient capital to confront such risks in the long run.

Second, insurance can promote loss prevention through risk mitigation. Managing risks and controlling losses is central to any insurance business. The insurance industry has been setting up fire departments and advocating building codes for natural and man-made hazards for a long time. For example, after the Great Fire of London in 1666, Nicholas Barbon started an insurance company to offer protection against fire. He did two other innovative things:

  • (1) He started differential rates for different building material used: 2 percent of the rent if the houses were made of bricks and 5 percent of the rent if they were made of wood.
  • (2) He also hired the watermen from the river Thames to work as part-time fire fighters.

The first of these acts encouraged the building of brick houses in London. The second act created an eventual fire department for the city. More recently, insurance companies have been giving rebates for households with fire insurance if they do not use halogen lamps. For the insurance companies, it reduces the fire hazards and it reduces the use of electricity substantially for households, thereby reducing the GHG emissions.[9]

Third, insurance companies can encourage risk reducing behavior. Insurance contracts can design policy exclusions to instill behaviors that reduce greenhouse gas emissions and appropriate efforts to prepare for the impacts. For example, so called pay-as-you-drive insurance products are offered by insurers that recognize the link between accident risk and distance driven. In this case, the insurance company can do this cost-effectively today because it can use the GPS in the cars to monitor activities with very little cost. It encourages people to drive less. This, in turn, cobenefits the environment.

Fourth, insurance companies are promoting innovative products. Insurance companies are offering special rates for “green buildings” and products that cover risks associated with energy efficiency or renewable energy projects. This encourages the construction of more efficient buildings in the future as well as retrofitting old buildings to become more energy efficient.

Fifth, insurance companies are offering climate protection improvements. Insurance companies that also have banking operations are engaged in financing projects that (1) improve resilience to the impacts of climate change and (2) contribute to reducing emissions. Several companies are providing preferential mortgage rates for energy efficient appliances and home upgrades. Some companies are offering “Clean Car Credit” financing for low-emission vehicles.

Sixth, the so-called carbon risk disclosure requirement is being encouraged by insurance companies that insure business entities. The carbon risk disclosure requires a company to disclose information related to risk factors and calls for management discussion and analysis. This issue got a boost with the 2009 position paper of the Securities and Exchange Commission, which stated that businesses “should consider the impact of existing climate change legislation and regulation, international accords or treaties on climate change, indirect consequences of regulation or business trends, for example new risks for the company created by legal, technical, political and scientific developments, and the physical impacts of climate change.”[10] Canada has had similar requirements since 2008. In addition, in the near future, Canada will make such disclosures obligatory rather than voluntary.[11]

  • [1] See e.g. National ClimateAssessment and DevelopmentAdvisory Committee Report, 2013, 990Fig. 28.1. It shows that only 15 states out of 50 in the US have drawn up any plan at all.
  • [2] See Adaptation Fund, Funded Projects (accessed January 14, 2013).
  • [3] Swiss Re, “Weathering Climate Change: Insurance Solutions for More Resilient Communities”(2010) (accessed January 14,2013).
  • [4] See Hilary Russ, “New York, New Jersey put $71B price tag on Sandy” MSN News, November27, 2012 (accessedJanuary 14, 2013).
  • [5] See Munich Re, “Munich ReNewables: Our Contribution to a Low-Carbon Energy Supply”(2009) (accessed January 12, 2013) and SwissRe, “Managing Climate and Natural Disaster Risk” (2012) (accessed January 13, 2013).
  • [6] See The White House Council on Environmental Quality, Progress Report of the InteragencyClimate Change Adaptation Task Force: Recommended Actions in Support of a National ClimateChange Adaptation Strategy, October 5, 2010 (accessed January 12, 2013).
  • [7] This section draws on Raquel Szalachman, “Potential Impacts of Climate Change in LatinAmerican Cities” Working Paper Series of the Geneva Association, Etudes et dossiers No. 356 (January2010) (accessed January 13,2013).
  • [8] This section draws heavily on Eric Mills, “Weighing the Risks of Climate Change MitigationStrategies” (2012) 68 Bulletin of the Atomic Scientists 67.
  • [9] Erik Page et al., “New Energy Efficient Torchieres Ready For Hot Torchiere Market,” Proceedings of the Conference on Energy Efficiency in Household Appliances, November 5—8, 1997,Florence, Italy.
  • [10] Securities and Exchange Commission InvestorAdvisory Committee, Possible Refinements to theDisclosure Regime, July 27, 2009 (accessed January 14, 2013).
  • [11] Ontario Securities Commission Notice 51-717: Corporate Governance andEnvironmental Disclosure, December 18, 2009 (accessed January 14, 2013).
 
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