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theoretical questions will come closer to the heart of the debate on the evaluation and management of climate change. Up to now, most economists who specialized in climate change focused their attention on the production of Integrated Assessment Models that combine a climate module and an impact module, with a relatively crude approach to risk evaluation. The extraordinarily vivid debate that followed the publication of the Stern Review in the fall of 2006 was mostly concentrated on the treatment of risk and time. The prospect that much progress will be achieved in the next few years is considerable. As evidenced by the path-breaking career of Howard Kunreuther, an economist who is not so irrational himself, this will take place at the boundary of various disciplines: psychology, sociology, political science, neuroscience, and economics.

RECOMMENDED READING

Dasgupta, P., and J. E. Stiglitz (1971). “Differential Taxation, Public Goods and Economic Efficiency,” Review of Economic Studies 38: 151-174.

Gollier, C. (2001). The Economics of Risk and Time. Cambridge, MA: MIT Press.

Hogarth, R.M., and H. Kunreuther (1989). “Risk, Ambiguity, and Insurance.” Journal of Risk and Uncertainty 2: 5-35.

Kunreuther, H., R. M. Hogarth, and J. Meszaros (1993). “Insurer Ambiguity and Market Failure.” Journal of Risk and Insurance 7: 71-87.

Kunreuther, H., J. Meszaros, R. M. Hogarth, and M. Spranca (1995). “Ambiguity and Underwriter Decision Processes.” Journal of Economic Behaviour and Organization 26: 337-352.

Savage, L. J. (1954). The Foundations of Statistics. New York: Wiley. Revised and enlarged edition, New York: Dover (1972).

24

Climate Change

Insuring Risk and Changes in Risk

NEIL DOHERTY

INTRODUCTION

The defining feature of climate change seems to be uncertainty, and uncertainty, it seems, deters the functioning of insurance.1 There is an emerging scientific consensus that anthropomorphic factors are changing the atmosphere. However, projections of the resulting climatic impact vary. Most scientists agree that temperatures and sea levels will rise if we continue to pump out greenhouse gases, but the extent and timing of anticipated changes are surrounded by a large margin of error. When it comes to extrapolating from broad indicators of climate change (mean global temperature and sea level) to changes in natural hazard risk (storms, droughts, etc.), the belt of uncertainty expands. If we drill down to the impact of climate change on regional hazard risk, our knowledge of future risk levels is scant. Thus, we summarize the potential impact of climate change on the hazards we typically insure by the phrases increasing risk and enormous uncertainty. We simply do not know with any precision how the risk that we seek to insure will change over time.

How will insurance function under such conditions? If climate change follows a slow evolution, the problem might take care of itself. Insurance contracts typically are for short periods, typically one year, and each year insurers and policyholders will update with the latest information and write new contracts. True, risk levels may change a little, but premiums will be fine-tuned, and the impact will be gradual.

But what if climate change is more rapid and sudden? In this case, actuaries cannot rely on a long historical data record to estimate future loss distributions. Old data degrade, thus compromising the sample size. This implies that statistical updating on the basis of very recent loss experience can be quite dramatic. Rate increases following single events such as Hurricane Andrew in 1992 or the cluster of storms that occurred in 2005 (including Katrina) were large.2 In an unstable climate, much of the risk that people face is the risk that risk itself may change. Thus, even if insured over the long haul, people face the risk that future premiums may change dramatically, and quite fast. Accompanying these changes in the level of risk will be changes in the market values of assets that are exposed to risk. We may expect climate change to affect home