The Economics of Insurance in the Face of Climate Change
Eduardo Porter offers a “teachable moment” thanks to his NY Times Business piece on insurance today. He writes a piece arguing that for profit “conservative” firms have a stake in fighting climate change. While I want this logic to be correct, an academic might ask whether it is correct. The insurance industry makes profit if it collects more in premiums than it pays out during disasters. So, if it sells $20 million dollars worth of insurance but only 3 guys file claims and collect $2 million in total then the insurance industry has had a great year. Porter’s logic is simple. If climate change raises the probability of horrible outcomes where the insurance companies must payout a fortune, then doesn’t this industry have an incentive to root for carbon mitigation? The correct answer hinges on risk pricing and the extensive margin. If insurance companies can raise their premiums because of climate change then their expected revenue and expected costs rise from climate change. If they can use bankruptcy to avoid catastrophic claims, then an option value model of bankruptcy would say that the insurance industry will root for climate change because this allows them to flip “one sided coins”. It is also possible that the demand for insurance will rise because of climate change. If more people now buy policies (the extensive margin) because of the perceived risk, the insurers may be even happier.
Insurance exists because demanders are risk averse but are the insurance companies risk averse? If they can spatially pool risk, then they will be risk neutral due to standard diversification arguments and if the insurer has the default option, then they have an incentive to be risk loving and to root for climate change.