Newsletter No 2 June 2013

New book Managing Extreme Climate Change Risks through Insurance published by Wouter Botzen at Cambridge University Press

ee groot It has been projected that natural disasters will become more frequent and harmful as a result of climate change and socio-economic trends. An important question that arises is how to design effective policies that limit the expected increase in these risks and reduce the impacts of natural disasters on societies.

This new book examines the role that insurance arrangements can play in increasing economic resilience to natural disasters. The author combines theory with empirical case studies from the Netherlands together with perspectives, studies and examples from around the world.

In recent decades, the economic damage caused by natural disasters has increased considerably worldwide. A review of studies on the causes of this development shows that increases in natural disaster risks have been mainly attributed to socio-economic change, such as a higher economic exposure in disaster-prone areas. The research summarized in this book shows that in many regions these trends are expected to continue in the future and, in addition, climate change can have profound effects on the risks from extreme weather events, such as more storms and floods.

The approach followed in this book involves dealing both with the effects of climate change on natural disaster risks and with the implications of these effects for insurers. Sharp increases in the frequency and severity of natural hazards can put limits on the insurability of natural disaster losses. In fact, low-probability/high-impact risks are already challenging to insure at affordable prices. This is problematic since insurance can provide a valuable societal function of spreading risks, and helping households to ‘get back on their feet’ after a disaster. Public-private partnerships in risk sharing are explored as a possible solution for such complexities. In such a partnership, insurers provide compensation for a middle-sized layer of losses. The government acts as an insurer of last resort for very large and unlikely losses, which are otherwise expensive to insure in private markets. This arrangement is proposed as a solution for insuring flood losses in the Netherlands, where a broad insurance coverage for flooding has been absent since a catastrophic storm surge occurred in 1953.

The important role of insurance for individuals in preparing for disasters and purchasing natural disaster coverage is recognized, as well as aspects of the ‘bounded rationality’ of individuals in dealing with infrequent risks. In particular, material is included about individual risk perceptions, risk aversion, willingness to pay for natural disaster insurance, and applications of utility theories to insurance demand, including prospect theory. Overall, empirical results show that perceptions of natural disaster risks are low, and that individuals insufficiently prepare for natural disasters. In this respect, insurance with risk based premiums could play an important role by increasing risk awareness, and by stimulating individual investments in measures that reduce natural disaster damage. An example of the latter is granting discounts on flood insurance premiums to policyholders who ‘flood-proof’ their house, for instance, by installing water-resistant floors. Carefully designing insurance arrangements in a way that they contribute to the reduction of natural disaster risk can be very beneficial for increasing society’s resilience to the impacts of climate change.

Contact: Wouter Botzen