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Thus, an unstable climate not only generates uncertainty about future risks, it generates new risks. These new risks include uncertain premiums and uncertain asset prices. What are the challenges to insurance markets introduced by climate change? Will the normal conditions for insurability be present? Do insurance contracts need to be redesigned? Can insurance cover the new risks of volatile premiums and an uncertain real estate market? It is helpful, in addressing these questions, to examine the nature of the risk that faces people and businesses in an unstable climate.

I will argue that climate changes can be represented in a simple way as a “compound lottery” with risk present in both the first and second stages. The stage 1 risks are the instability of insurance premiums and asset price volatility, whereas the stage 2 risks are those we normally associate with insurance (i.e., whether a loss occurs or not). However, the first and second stages exhibit very different characteristics that, in turn, carry different implications for insurance. I will then use this characterization to address long-term insurance for hazard risk.

CLIMATE CHANGE AS A COMPOUND LOTTERY

The evolution of risk under conditions of climate change is depicted in Figure 24.1 as a sequence of risks, or “multi-stage lottery.” Currently, the risk for a particular insurance portfolio is to some degree known, and this can be shown as a probability distribution. How will this risk change over time? Consider the risk in some future year t, let’s say in fifteen years. We cannot specify now what the risk might be in that year. Indeed, there are many probability distributions that could occur, each with their own expected value and level of risk.3 Between now and time t, climate risk will change. I have shown three possible change, or “drift,” paths; each depicts a potential evolution of the expected value of loss at time t. As future year t approaches, we will learn more about how climate is changing and, therefore, about how uncertainty will be resolved, but only to some extent. We will still not have the luxury of a long and stable climate historical record with which to estimate the year t risk, and we will rely on other methods (e.g., meteorological models) to estimate the distribution.

FIGURE 24.1 Risk as a Multi-Stage Lottery

Stage 2 Risk

We can see different types of risk. When future time t arrives we will have conventional contemporaneous risk: There will be a more-or-less known distribution of loss, and actual losses will represent draws on that distribution. We will call this stage 2 risk. If climate change is sudden and rapid leading up to time t, we may not place much confidence in our best estimate of the distribution, and I will refer to stage 2 ambiguity. Thus, stage 2 risk is the conventional insurance risk that future underwriters will face in the future, though future actuaries and modelers may be unusually challenged when it comes to estimating this distribution. Some adjustments might be expected:

• Exposures for which risk has increased (decreased) will face higher (lower) premiums.

• If the correlation among risks increases (e.g., if there are more expansive weather systems that can cause multiple storms, or if sea-level rises make more locations vulnerable to even modest storms), insurance supply may be more constrained or capital will need to be increased or contracts will need to be rewritten to limit aggregation of risk. Such contracts will essentially mutualize risk and I will address this later. If, in addition to correlation, there is also considerable ambiguity, insurers may require more capital to cover the possibility that risk will be underestimated and therefore that premiums will be too low.

• Insurers will rebalance their exposures as the geographical exposures shifts.

Stage 1 Risk

Let me be clear about what stage 1 risk is not. If there is a foreseeable upward drift in climate hazard, then people are expected to face an increasing hazard cost, which