Newsletter No 1 March 2010

Economics of insurance against climate change

Dr. Wouter Botzen

2eeIn my PhD thesis I examined the consequences of, and opportunities due to, climate change for the insurance sector and the role that insurance can play in the design of policies to adapt to climate change in the Netherlands. Statistical analyses indicate that climate change may increase insured damage of certain natural hazards, such as hailstorms, which could have a considerable impact on the insurance sector. Results show that by 2050 annual hailstorm damage to outdoor farming could increase by 25% to 50%. Impacts on greenhouse horticulture in summer are considerably larger with projections of an increase in damage of more than 200%.

Flooding is a major climate change risk in the Netherlands for which no private insurance coverage exists. The projected rise in flood risk as a result of climate change requires investments by the government in strengthening flood protection infrastructure. In addition, households can take measures that limit potential flood damage, while insurance arrangements can ameliorate impacts of floods.

This thesis proposes to introduce a public-private partnership to compensate flood damage, with a role for the government as a reinsurer. Private flood insurance with risk based premiums increases financial security of individuals, and provides incentives for them to invest in measures that limit flood damage. Surveys of 500 homeowners indicate that indeed incentives provided by insurance, for example premium discounts, can be effective in stimulating households to invest in flood damage mitigation, such as installing temporary water barriers or the placement of tile floors instead of carpet. Estimates of damage prevented during floods by such mitigation measures indicate considerable costs savings.

Consumer demand for flood insurance is estimated using theories of decision making under risk that allow for ‘bounded rationality’ of individuals. In addition, empirical analyses are conducted of flood insurance demand using contingent valuation and choice modelling with surveys of some 1000 homeowners, while incorporating insights from behavioural economics. Estimates of willingness-to-pay for, and potential market penetrations of, flood insurance indicate that potential demand is no impediment for a partly private flood insurance market.

As an illustration, under current conditions about 45% of homeowners are willing to purchase flood insurance for €10 per month that completely covers flood damage, while this increases to 55% if the government would not provide compensation for flood damage. Heterogeneity in flood insurance demand is estimated, which suggests that risk perceptions play a large role in decisions about taking insurance. Analyses of these individual risk perceptions indicate that individuals in areas unprotected by dikes tend to underestimate their risk of flooding. Observed relations between willingness to pay for flood insurance and flood risks are inconsistent with what would be expected on the basis of expected utility theory, the traditional economic theory of individual choice under risk.

Contact information: Dr. W.J. Wouter Botzen

More information:

Botzen, W.J.W., Bouwer, L.M. and van den Bergh, J.C.J.M. (2010). Climate change and hailstorm damage: Empirical evidence and implications for agriculture and insurance. Resource and Energy Economics.

Botzen, W.J.W., van den Bergh, J.C.J.M. and Bouwer, L.M. (2010). Climate change and increased risk for the insurance sector: A global perspective and an assessment for the Netherlands. Natural Hazards, 52 (3): 577-598.

Botzen, W.J.W., Aerts, J.C.J.H. and van den Bergh, J.C.J.M. (2009). Dependence of flood risk perceptions on socio-economic and objective risk factors. Water Resources Research, 45: W10440.

Botzen, W.J.W. and van den Bergh, J.C.J.M. (2009). Managing natural disaster risk in a changing climate. Environmental Hazards, 8 (3): 209-225.

Botzen, W.J.W., Aerts, J.C.J.H. and van den Bergh, J.C.J.M. (2009). Willingness of homeowners to mitigate climate risk through insurance. Ecological Economics, 68 (8-9): 2265-2277.

Botzen, W.J.W. and van den Bergh, J.C.J.M. (2009). Bounded rationality, climate risks and insurance: Is there a market for natural disasters? Land Economics, 85 (2): 266-279.

Botzen, W.J.W. and van den Bergh, J.C.J.M. (2008). Insurance against climate change and flooding in the Netherlands: Present, future, and comparison with other countries. Risk  Analysis, 8 (2): 413-426.

Aerts, J., Botzen, W.J.W., van der Veen, A., Krykrow, J. and Werners, S. (2008). Dealing with uncertainty in flood management through diversification. Ecology and Society, 13 (1): 41.