Market-based mechanisms for climate change adaptation

The economic and insured costs of natural disasters due to extreme weather – tropical cyclones, floods, bushfires and storms – are rising in concert with growing concentrations of population and wealth in disaster-prone regions. A contribution to these rising costs has not yet been attributed to anthropogenic climate change, although such a contribution cannot be ruled out. This finding is in accord with the IPCC SREX report (2012). 

Extreme events are, by definition, rare, and so detecting a signal of climate change in volatile time series of economic losses faces a challenging signal-to-noise problem. This situation is unlikely to change any time soon and so, in the absence of scientific clarity, decision-making in relation to climate change adaptation to extreme weather events of the types considered here, will of necessity take place in an ‘environment’ of uncertainty and ignorance; this reality strengthens the case for expanding disaster risk reduction as part of any climate change adaptation policy.

Given the rising cost of natural disasters, we also reviewed the provision of insurance products by the public sector in a number of countries and the role they might play in encouraging risk reduction and resilience building. Examples of these residual market mechanisms (RMM) were drawn mainly from the US, Spain, France and New Zealand. RMM structures vary between countries as does the hazard profile: government involvement in catastrophe insurance in the US, for example, has usually arisen in the face of perceived failures of the private insurance market, often following a significant natural disaster. In the wake of such events, RRM have assumed the legacy of inappropriate land use, unrealistic risk assessment and lack of consideration to mitigation. 

In undertaking this review of residual market mechanisms, we expected to identify preferred approaches or elements of the various schemes that might profitably be employed to incentivise behavioural change, at least in respect of extant risks. However none of the schemes examined could truly be said to be successful in this regard and many have led to perverse outcomes. Other key observations include the following:

(a) transferring risk to the public purse does not reduce risk
(b) governments can spread the cost of losses across time rather than space
(c) governments can force home-owners in low risk areas to cross-subsidize the insurance premiums of those in high risk areas
(d) cross-subsidisation is increasingly difficult for private sector insurers operating in a competitive market, and
(e) governments can tax people to pay for tomorrow’s disaster.

The equity of (b), (c) and (e) needs careful reflection by policy makers.

Given that the typical duration of an insurance policy is 12-months, pricing will not reflect any future changes in risk that may arise due to increasing exposure concentration or anthropogenic climate change affects on severe weather. This being the case, the best insurers can do to is provide incentives to reduce vulnerability by sending price signals on an annual basis reflecting the extant risk. To the extent that this were to overcome what might be called the adaptation-deficit, that is the degree to which society is mal-adapted to cope with current climate variability, this would also have long term benefits in respect to any additional risks posed by a warming climate. 

Notwithstanding the above, some insurance companies already encourage climate change adaptation by underwriting green projects, undertaking research and generally engaging in policy debate on climate change issues. 

We expect this to continue. However it is not the key objective of these commercial companies that in the end must answer to shareholders and annual reporting periods.

To deal with existing concentrations (legacy issues) of risk that might struggle to obtain affordable insurance from the private sector, we examine relatively new financial instruments called Catastrophe (CAT) bonds that transfer insurance risks to the capital markets. In particular we consider a hypothetical Sydney flood CAT bond for residential buildings and contents in the Hawkesbury River basin. The methodology is easily transferrable to other location-specific perils such as bushfires. The cost of transferring flood risk in the Hawkesbury River basin using a Catastrophe (CAT) bond was estimated to be around 15 to 75% higher than that of traditional reinsurance. Whether this difference is too much to pay for guaranteed security is a business decision for individual insurers and/or governments.

The real issue here is that climate change is a complex policy area and no easy answers emerged from our deliberations, at least in respect to the employment of insurance instruments. It should be clearly kept in mind that insurance is a mechanism that transfers disaster risk; it does not do away with the risk. On the other hand, measures such as risk-informed land-use development and risk reduction infrastructure can dramatically reduce the risk in exposed areas and thus the need to transfer this risk. Any gains achieved here will put us in good stead for additional changes that a warming climate may eventually throw at us.

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