Sunday, May 25, 2014

Shiller on Long Run Insurance Contracts and Climate Change Risk

Robert Shiller has written an excellent piece sketching recent work on long run insurance.   For a popular audience such as the NY Times readers, he isn't able to delve into the details.   So, permit me to discuss just one.  I want to talk about incomplete futures markets caused by an inability of insurers to commit to honor future insurance contracts.  To appreciate this abstract point, consider the following example.

Matt owns island real estate and worries that due to sea level rise that my island will vanish in 50 years.   I want to buy insurance against this state of the world.  I am willing to pay a premium today and every year in return for a promise that if the disaster occurs that I will get a check from the insurance company.   Now every trade has a buyer and a seller.  On the sell side, there are a group of climate change deniers who don't believe that there will be significant sea level rise.  They should be happy to take this bet if they believe what they say.  They would agree to take Matt's money now and if the sea level rise takes place that they will pay out.  But, since the deniers think this scenario is a 0 probability event this should be an easy arbitrage opportunity for them.  Note that the disagreement about future event probabilities causes the gains to trade.  The problem here is that Matt knows that the insurance company will always have the option to go bankrupt if the event takes place and the insurance company is faced with a large number of future claims.

After the attacks of 9/11, a major issue was whether insurance companies would go broke honoring their insurance contracts.   For some economic analysis, see Dwight Jaffee's work.

As  I argue in my Climatopolis book, the real key role of the insurance market is to provide clear signals of what risk neutral informed sellers of insurance believe are the actuarial risks that different pieces of coastal real estate face.  Even a Homer Simpson will update his subjective priors if he sees that the insurance companies believe that a disaster is much more likely than he assumed.  Naive individuals who choose to live in coastal areas and take no precautions can't claim to be "victims" if such insurance pricing yells out about the actual expected dangers.  This is how adaptation takes place.  Doom and gloomers implicitly embrace a strong behavioral economics vision that people are morons who do not learn from available information.  The insurance industry's own self interested actions reduce the likelihood of this ugly hypothesis actually playing out.

Returning to the example above, if climate deniers sell Matt the contract but expect to declare bankruptcy if the event actually does take place (even though they think it has a 0% chance of taking place), then they will sell the insurance policy to Matt at a relatively low price and this will signal that the probability of risk to Matt's island is low.  Note that the key point here is that if the insurer knew that he had to honor contracts that he signs then he would have much stronger incentives to research the true likelihood of the event because he will lose a fortune if he sells premiums at too low  a price relative to the emerging truth. To appreciate this point, consider the following example;

Suppose that the insurer sells a $1 million dollar policy for $10,000.   A risk neutral person would only sell this policy (if they knew they could not declare bankruptcy and ignoring discounting considerations) if the event had a 10000/1 million = 1% or less chance of taking place.  Why?  Suppose the event has a 5% chance of taking place?  The insurer collects $10,000 but expects to pay out .05*1000000=50,000. That's a firm that is losing money.  The profit motive disciplines insurers to do their job!  Unless, they have  the future option to go bankrupt!