Climate Insurance and the Pricing of Risk in an Uncertain World

The world’s scientific community is in near unanimous agreement that human activity is causing rapid climate change, with noticeable changes occurring even during the length of a human life span.  By contrast, natural climate changes during prehistoric eras took much longer to occur.  In recent decades, climate change has come to create weather hazards affecting homes, businesses, shipping, agriculture, and human health.

What Human Activities Are Causing Climate Change?

Scientists agree that the large-scale burning of fossil fuels over the last 150 years has driven man-made climate change.  This activity has led to the buildup of greenhouse gases, especially carbon dioxide, in the Earth’s atmosphere.  These greenhouse gases trap heat from sunlight instead of allowing it to radiate back into space, warming the planet over time.  In recent years, governments have promoted plans to reduce carbon emissions, often through tax credits, to hopefully slow the greenhouse effect.  A common goal is to reduce the use of fossil fuels as an energy source and replace them with clean energy sources like wind, solar, hydroelectric, and perhaps nuclear power.

How Does This Climate Change Cause Economic Harms?

Man-made climate change, often referred to as global warming, is complex.  While many may not consider slight increases in average temperatures to be alarming, these small increases lead to greater incidences of extreme weather.  This includes heat waves, droughts, hurricanes, flooding, and lack of snowpack.  Due to natural weather changes, seasons, and cyclical climate patterns like El Nino and La Nina, it can be difficult to predict when and where the effects of climate change will strike.  On a longer time scale, global warming is anticipated to melt significant amounts of polar ice, raising sea levels and directly affecting coastlines.

In the short run, extreme weather events can cause substantial economic harms: heat waves can overwhelm power grids and cause heat-related illnesses, droughts can harm agriculture production, hurricanes and flooding can destroy swaths of cities, and lack of snowpack can deprive areas of springtime snowmelt water and end snow-related tourism.  Many scientists agree that climate change is making extreme storms, often described as once-in-a-______-year storms due to their statistical rarity, more common.  These extreme events typically overwhelm existing infrastructure and safeguards meant to handle them.

Changes to Insurance Markets due to Man-Made Climate Change

The costs of man-made climate change cannot be denied: property insurance premiums (monthly costs) are rising, especially in areas believed to be at elevated risk for extreme weather events.  Insurance companies use historical weather and climate data, coupled with scientific modeling of future trends, to determine which areas are more vulnerable to natural catastrophes that will lead to increased insurance claims.  Many coastal areas now have much higher premiums for property insurance, and some have even seen insurance companies exit the market due to anticipated risks being judged too great.  Further inland, crop insurance has become more expensive as weather-related claims of crop failure have increased.

Risk of Insurance Market Failure due to Climate Change

Insurance companies exiting markets in areas deemed high risk for extreme weather has been alarming, especially to homeowners.  In some places, homeowners struggle to find private insurance companies willing to insure their properties.  As a result, governments have created state-run insurers of last resort to properties deemed high-risk.  In the United States, this plan was created in 1968 with the Urban Property Insurance Protection and Reinsurance Act and has since expanded to most of the fifty U.S. states.  These insurance plans, known as FAIR plans, can only be accessed by property owners who are current on all tax and legal obligations and have been denied by multiple private insurers.

The increased use of FAIR plans raises questions about insurance market failure and the government’s obligation to property owners.  As climate change continues, how many more areas will see an exit of private insurers?  At what point will FAIR plans become prohibitively costly for state governments?

Inability to Grow Risk Pools Could Segregate Insurance Markets

Premiums for insurance policies are kept relatively low for most consumers due to risk pooling, or spreading the risk of a claim across many consumers.  In health insurance, premiums are kept lower for everyone when costs are spread among young, healthy customers who rarely need to make claims.  As the incidence of claims rises, however, everyone’s premiums tend to rise.  The only way to keep premiums low is to find new customers who are unlikely to make claims - ideally, customers who are young, healthy, and risk-averse.  

With property insurance, however, there are rarely new markets into which major property insurers can extend.  Low-risk markets are usually already saturated by insurance companies, keeping premiums low due to competition.  Insurance companies that are prominent in coastal areas may, therefore, be stuck with a worsening situation: increase payouts and no new markets to broaden the risk pool.  However, companies with nationwide risk pools may not be in a much better position as customers in low-risk areas chafe at their premiums continually rising to pay for those in high-risk areas.

As climate change continues, it is possible that consumers in low-risk areas will urge the creation of region-specific property insurance companies to improve the risk pool.  By excluding high-risk areas, they can enjoy lower premiums.  New insurance companies may struggle due to the need for government charters, or approvals, to enter the market.  Existing property insurance companies and their higher-risk customers will almost certainly lobby to prevent the creation of new insurance companies in areas at lower risk of extreme weather.  Governments will likely deny the application of new property insurance charters due to the likelihood of insurance market failure in high-risk areas: existing insurance companies serving high-risk areas will collapse if their low-risk customers switch to new, low-risk-area-only insurers.

Government Intervention due to Threat of Market Failure

So, what can be done?  In the long run, it is highly likely that the government will have to increasingly subsidize property insurers, and thus homeowners, to prevent insurance market failure.  This raises the risk of moral hazard, where those who are insured take greater risks because they know they are protected from loss.  Subsidized insurance companies will keep premiums for homes in high-risk areas lower than the free market would, tacitly encouraging too many people to build homes and businesses in these areas.  This can lead to repeated claims as extreme storms repetitively damage these properties.

To reduce moral hazard, government restrictions on property development will almost certainly follow any increase in subsidies to insurers.  In exchange for a short term bailout, property insurers will have to tighten their requirements for properties going forward - constructed further from waterways, built with more durable materials, multiple required surveys for land stability and drainage, etc.  More rigorous requirements for new construction will likely occur across nations as climate change subjects houses and buildings to increased stress, both to protect occupants and to reduce the need for insurance and/or government assistance.