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Climate change risk is rising, and yet behavioral economics research argues that we are collectively underinvesting in protecting ourselves. In The Ostrich Paradox: Why We Underprepare for Disasters, Robert Meyer and Howard Kunreuther point to several personal traits that expose us to greater risk from natural disasters. First, individuals focus on short time horizons and thus underprepare for future threats. Second, when major disasters do occur, individuals are shocked but quickly begin to let their guard down again. Third, people are over-optimistic and thus underestimate their own risk exposure.

And the risks are real: Zillow’s research predicts that $400 billion dollars of real estate value in Florida could be at risk from climate change by the year 2100.

It might seem, then, that private insurance can be of little help in addressing climate change. There’s concern that for-profit insurers won’t want to insure risky properties, and that individuals won’t have the wherewithal to buy insurance plans in the first place. It’s certainly true that private insurance is not enough, on its own, to mitigate and adapt to climate change. Nor can insurance fully prevent the massive harm caused by storms like Hurricane Harvey, which recently struck Houston, killing at least several residents and causing considerable damage.

Nonetheless, private insurance has a significant role to play. And we believe that the concerns raised by behavioral economics are overblown. Sure, we aren’t perfectly rational. But the emerging challenge of reducing risk exposure for coastal residents creates new opportunities for firms that can innovate and provide new solutions. Innovations in spatial sciences, combined with big data, raise the possibility of the insurance industry introducing innovative pricing strategies that induce private real estate owners and local governments to take efforts that together yield a more resilient real estate capital stock. In short, the insurance industry is adapting in order to profit from climate risk, and in doing so it will help society adapt as well.

Better Data Can Help Insurers More Accurately Price Climate Risk

Dating back to at least F. A. Hayek, economists have emphasized the central role that price signals play in markets. If it’s expensive to insure a house on the coast, individuals will have an incentive to live elsewhere. If insurers offer a discount for climate-proofing homes, homeowners will likewise have an incentive to make that investment.

But for insurers to play such a role, they have to improve their use of data.

Imagine a case where everyone who lives in the same zip code is charged the same home insurance premium. Given that zip codes can cover a lot of area, such a pricing policy would implicitly subsidize those members of the zip code who live in the risky coastal part, at the expense of those who live farther from the water. However, improvements in geospatial sciences create the possibility of much more precise price discrimination.

Differential pricing (or price discrimination) is common in other areas of insurance. When determining car insurance rates, insurance companies consider several individual customers’ characteristics, including gender, age, and accident history. Medical insurers raise premium rates on smokers.

Until recently, though, property insurance has lagged in its use of data to engage in price differentiation. But we now see insurers exploiting geographically refined data to more precisely estimate land parcel risk. Aviva Insurance uses detailed topographical data to assess varying flood risks for coastal houses, such as those at the tops of hills versus houses at lower elevations. As insurers such as Aviva engage in price differentiation for property insurance, holdouts in the industry will face a choice: embrace individualized insurance or lose out on the low-risk insurance seekers. Low-risk customers will seek insurers that recognize their risk levels and lower their premiums. And as more and more insurers appropriately price climate risk using more fine-grained data, individuals will face clear incentives to consider those risks when deciding where to live.

Insurers can further individualize pricing by offering discounts to customers who invest in self-protection and hence lower their risk rates. For example, USAA now offers discounts for homeowners in seven fire-prone states who take steps to protect their houses from wildfires.

Premiums discounts incentivize resilience measures, which can help prevent property loss in the first place. Product improvements such as hurricane-resistant doors can nearly eliminate certain disaster risks and have relatively low installation costs. By investing in these durable improvements, real estate owners can lower their premiums because they have reduced the risk that their real estate assets face. The insurer benefits because insured property owners are less likely to file a claim in the aftermath of a hurricane if the premium owner has been incentivized to invest in resilience precautions. When implemented on a large scale, these policies can play a significant role in mitigating the potential damage inflicted by climate change.

Insurance Can Encourage Governments to Invest in Climate Resilience

During a time when the U.S. federal government is retreating from efforts to both reduce the nation’s greenhouse gas emissions and invest in coastal protection, insurance products can nudge local governments to invest more in climate resilience.

Catastrophe bonds are high-yield bonds, sponsored by local governments and issued by reinsurance companies, that do not pay out in the event of a catastrophe. These bonds act as insurance for local governments, protecting them from the financial risk of disasters. Catastrophe bonds are triggered when specific parametric triggers are reached by a disaster, such as a specific storm surge height for a hurricane.

Catastrophe bonds are rising in popularity because they fill a temporal gap left by traditional insurance companies, whose time horizons only reflect the one-year policies they offer. Municipal governments seek to plan development in terms of decades, while insurance companies are reticent to move beyond an annual time scale when assessing property risk. Catastrophe bonds provide the long-term protection against risk that governments seek and that insurance companies have failed to provide.

These bonds provide needed private-sector capital for affected areas, but this type of insurance can raise the risk of moral hazard such that municipalities underinvest in resilience measures because they know that they are insured. To mitigate this moral hazard problem, one firm, re:focus partners, in partnership with Swiss Re, a reinsurance company, proposed a new type of catastrophe bond. Re:focus’s variation adds a rebate option to these bonds, rewarding municipalities that invest in disaster protection. Re:focus assesses the degree of risk reduction for a given protection measure and then cuts the rates that a municipality must pay its catastrophe bondholders, reflecting the lower risk that these bonds will be triggered. That way, the government is insured in the case of disaster but still has an incentive to invest in resilience.

When valuing these rebates, Re:focus relies on Risk Management Solutions’ modeling software to accurately judge how much a project reduces disaster risk. The combination of disaster modeling and these modified bonds has already been employed by coastal municipalities in the U.S., with the construction of flood walls around Hoboken, New Jersey, and Norfolk, Virginia. The company used flood data from these cities after Superstorm Sandy as well as existing geographical data sets to model the effectiveness of potential flood defenses. This analysis allowed re:focus to determine the optimum height for seawalls in each city.

Using this modeling strategy, cities can determine which protection measures are most cost-effective. Thus municipalities can achieve greater disaster risk reduction and minimize the tax burden that constituents pay to fund these measures. The catastrophe bond rebates deliver direct financial benefits to municipalities for their adaptation efforts, whereas previous adaptation efforts would only benefit constituents in the rare event that a disaster occurs. Constituents who underestimate disaster risks will be more likely to accept the tax burden of disaster risk reduction when they can see direct payoffs in the form of a rebate.

Where Would You Rather Live?

Imagine a scenario where there are two identical coastal communities: One has traditional insurance, while the other has purchased insurance from the innovative companies we have named above — and insurers have worked to incentivize the city’s government to take action. Our claim is that the latter community will be more resilient in the face of future natural disasters.

While behavioral economists can sometimes imagine people as dupes, with little ability to make good choices in their lives, it is reassuring to note that the profit motive drives insurers to innovate and to use the cutting-edge tools now available. Again, insurance can’t fully address the challenges of climate change, and individuals’ bias toward the near term remains a challenge. However, the insurance and the financial industries will play a key role incentivizing needed changes — by individuals, firms, and governments — that will enhance society’s climate resilience.

Original Article