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Policymakers and advocates working to reduce the impacts of climate change have a tough tightrope to walk: trying to raise awareness of the scale and urgency of the problem without terrifying people into paralysis. One way to encourage productive conversations is to balance risk explanations with concrete, actionable solutions. A new book by Carolyn Kousky, “Understanding Catastrophe Insurance: New Tools for a More Resilient Future”, provides an excellent example of how to do this.
The book explains how well-designed insurance products can provide financial support to households and businesses that are affected by climate-related events such as intense storms, wildfires and earthquakes, and highlights the limitations of our current insurance markets and programs. Some of the material is quite technical and touches on the weeds of complex financial instruments (who hasn’t heard of parametric microinsurance?). But three big takeaways are pretty simple and deserve more attention from policymakers and voters.
Most American homes and families are underinsured against weather-related stresses
Readers may ask: Why is special catastrophic insurance necessary? Two-thirds of Americans own their homes and mortgage lenders require borrowers to buy Home Insurance at the time of purchase to protect the lender’s investment. While typical home insurance covers some physical damage caused by severe weather (such as a tree falling on the roof), the policies expressly do not cover disasters such as flooding (often the most expensive damage caused by hurricanes). or earthquakes. Chapter 2 of “Understanding Catastrophe Insurance” contains revealing statistics on insurance gaps:
- North America-wide, only 40% of economic losses caused by disasters are insured.
- Of the households that live within the 100-year-old floodplain designated by the Federal Emergency Management Agency, only about 30 percent have flood insurance.
- Just over 10% of California homeowners have earthquake insurance.
- Only 40% of tenants have rental insurance.
Even for households that have disaster insurance, their policies often don’t cover the full cost of damage. Policies can have high deductibles that homeowners must pay out of pocket before the insurance kicks in. Limits on the total reimbursement amount may be lower than the cost of necessary repairs. A common problem is that consumers insure their homes for market value at the time of purchase and do not update the value of the property or their assets over time. Public insurance programs such as the federal National Flood Insurance Program and Community Development Block Grant Disaster Recovery program fill in some of the gaps, but are generally well below the total damage cost.
The fragmented disaster insurance and recovery system means that the financial costs are distributed between many individuals, private companies, public bodies and taxpayers. Climate disasters also have economic impacts on surrounding communities and the broader financial system. And families affected by natural disasters face long-term financial risksincluding mortgage defaults and declining credit ratings.
The complexity of purchasing catastrophe insurance discourages consumers
A fundamental principle of well-functioning markets is that consumers are able to make informed and rational decisions about their purchases based on the value they place on a good or service. But catastrophe insurance is a clear example of a service where consumers lack key information that allows them to determine whether to purchase insurance against a particular weather event, and at what cost. Specifically, how likely is the weather event to occur, and how much damage will it cause? Insurance companies develop estimates based on historical events and statistical models, but this information is rarely shared with consumers. Even small differences in assumptions can make insurance a “good” or a “bad” purchase, as the hypothetical examples below show.
Let’s say the annual flood insurance premium is $150. Scenario 1 estimates that the probability of a flood occurring is 1% and that the flood would cause $10,000 in damage to a house. This means that the expected value of damages is 1% x $10,000, or $100. A risk-neutral customer would not choose to pay $150 for flood insurance because the annual premium exceeds the expected value of the damage. (A risk-averse customer would be willing to pay more than $100 for flood insurance, but probably still less than $150.)
But what if the flood damage estimate is too low? Scenario 2 estimates that the flood causes $20,000 in damage. Now the expected value of damages is $200, so a risk-neutral client would be willing to pay $150 in annual premiums. And Scenario 3 shows that increasing the probability of flooding to 5% while keeping damage costs at $10,000 also makes the $150 flood insurance premium a good buy.
Even with the best climate data and analysis available today, there is considerable uncertainty about when and where disasters will occur and their severity, especially as the climate changes over time. Many consumers find insurance pricing opaque and do not understand the underlying calculations. And most people prefer not to think about unpleasant events, let alone spend money in anticipation of them.
In short, if policymakers want more households covered by disaster insurance, relying on voluntary purchases won’t do the job. The book points out that in other countries, catastrophe insurance is included in standard homeowner policies, circumventing the need for households to make separate purchasing decisions. Lessons can also be drawn from the mortgage markets: following the foreclosure crisis of 2007-2009, federal regulators require mortgage lenders to provide a standard page disclosure form summarizing key features of the loan to help borrowers understand their purchase. However, unlike mortgages, insurance is regulated by state governments rather than federal agencies, so such policies would likely require state-by-state action.
Catastrophe insurance complements, but does not replace, risk reduction efforts
Although the primary focus of “Understanding Catastrophe Insurance” is the mechanics of creating better insurance products, the author emphasizes that insurance is only part of the larger approach. of climate change. As one of the book’s most memorable lines goes, “We want to avoid dead cows, not pay for them after they’re gone.” This means we must undertake investments that reduce the likelihood of disasters and limit the extent of damage when they do occur.
Various strategies could reduce the climate risks that homes and neighborhoods face. Some strategies are expensive, such as raising houses in high flood risk areas, but others have modest upfront costs. Insurance policies can be designed to induce homeowners to undertake some of these investments. For example, some policies offer reduced annual premiums to homeowners who fortify their roofs against hurricane winds or trim trees near homes in wildfire zones (both relatively inexpensive tasks). But low-income households with limited access to credit will have difficulty paying even small investments, and so may need direct subsidies from government agencies to cover costs. And some risk reduction efforts will be costly and politically unpopular, such as relocating entire communities or designating no-build zones in places most at risk.
Increasing the physical and financial climate resilience of American homes and neighborhoods is an urgent task that will require concerted efforts by policymakers at all levels of government as well as private businesses in insurance, housing and financial services. An important first step is to educate voters and decision-makers; books like “Understanding Disaster Insurance” that make these issues tangible and accessible are part of this process.
Full disclosure: Carolyn Kousky is a nonresident principal investigator at Brookings Metro and was a classmate of Jenny Schuetz in graduate school. She did not participate in the writing of this play.
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