Climate change increases the risk of natural disasters and, with it, the cost of insurance, rendering more people vulnerable to destructive weather. In her new book, Understanding Disaster Insurance, Resources for the Future scholar Carolyn Kousky examines the function of insurance as the climate changes and how innovations in insurance are critical in protecting people from the financial impacts of climate change.
This excerpt has been reprinted with minor changes and permission from Island Press.
Using nature for risk reduction, sometimes referred to as nature-based solutions, is attractive because the ecosystems can also provide an array of other benefits to people, such as recreational opportunities, habitat preservation, and air and water purification. For instance, Napa, California, and Reno, Nevada, have invested in conserving riparian lands along their rivers to lower flood damages, but this move also spurred economic growth as businesses took advantage of the aesthetics and recreational opportunities of the preserved lands. As another example, Boston conserved land around its drinking water sources to filter out contaminants. Managers felt having clean water to begin with was safer than having to clean it up later and minimized the possibility of human and technological failures.
A few environmentally conscious firms in the insurance sector, regulators, and nongovernmental organization partners are now thinking deeply about how insurance can contribute to a nature positive world. There are three specific areas in which the insurance sector could have impact. First is making sure that the price of disaster insurance accounts for any risk-reduction benefits provided by natural systems. Second is actually insuring natural assets themselves if they are at risk. And third is providing new risk-transfer approaches, underwriting practices, and investment strategies that are nature positive.
The cost of insurance reflects the underlying risk. In theory, then, if a natural system reduces the disaster risks to a property, the cost of insurance should be lower, reflecting this benefit. Lower costs can create a financial incentive to conserve ecosystems where they provide these benefits. For such pricing to actually incentivize new investments in conservation and restoration, however, two challenges must be overcome.
The first is that the insurance industry must have sound models that can quantify these benefits from nature. Investments in such models have been growing, but some are not yet advanced enough to be used in rate-setting at a property level. The second challenge is institutional: investments in nature tend to protect many properties, but it is difficult to harness small premium reductions spread over many property owners to actually fund additional investments in conservation.
Let’s look at these challenges in the case of wildfire in the US West. Several forest ecosystems depend on fires, which open seeds for certain species and keep out competitors. Before European settlement of the West, these fire-dependent forests would have mature trees that were resistant to the low-grade fires that would occasionally burn. After colonization, however, fires were routinely suppressed, disrupting the natural ecosystem. The mature trees were harvested and thick brush allowed to establish itself. The conditions for catastrophic fires were thus created. When the forest now burns, the buildup of fuel makes the fires hotter, larger, and much more life-threatening and destructive. In addition to the devastation to property, these catastrophic fires kill trees, further harming the ecosystem. Certain forest management practices, such as prescribed burns and fuel thinning, can help restore the forest’s healthier condition such that fires, when they ignite, stay low to the ground, do not climb up the trees, burn less hot, and create less catastrophic damage.
Broker and consulting company Willis Towers Watson and The Nature Conservancy recently modeled the impact that these ecological-forestry approaches, undertaken at a landscape scale, could have on reducing wildfire risk and thus insurance premiums. They found that such landscape approaches can have enough impact on lowering risk levels to justify reductions in annual insurance premiums for residents, which they estimate to be roughly 10 to 40 percent in their study area. The ecological forestry interventions would also dramatically reduce uninsured wildfire damages, particularly to utilities.
The question, though, of how to use those premium reductions to finance the investments in ecological forestry is trickier. Willis Towers Watson and The Nature Conservancy’s exploration suggested that the premium reductions could be sufficient to finance the debt service on a bond to undertake the restoration work—but only when accounting for the many property owners who would benefit. The premium reductions are not enough to offset the restoration activities if only a single insured—even a large insured, such as a utility or timber company, is considered on its own. Thus, harnessing the premium reductions to finance nature-based solutions requires an institutional mechanism for all the beneficiaries to join together in support of the ecological forestry.
That is a problem that plagues all investments in conservation. Natural systems are what economists call public goods, which means that the benefits are enjoyed by everyone and that it is not possible to prevent anyone from enjoying those benefits. It also means that when one person or entity benefits, the benefits for others does not diminish (unlike, say, a cookie, which once I enjoy, can no longer be enjoyed by others). Public goods are what economists call a market failure. Markets don’t provide enough public goods because no one can profit off them, and everyone has an incentive to free ride—to let others pay to provide the public good while they enjoy it for free.
Natural systems are what economists call public goods, which means that the benefits are enjoyed by everyone and that it is not possible to prevent anyone from enjoying those benefits. It also means that when one person or entity benefits, the benefits for others does not diminish (unlike, say, a cookie, which once I enjoy, can no longer be enjoyed by others).
This idea of using premium reductions to finance investments in nature presents two challenges, however: (1) how to develop an institutional structure that can overcome the free riding and (2) how to “claim” the reduced insurance premiums from dozens to thousands of individual policyholders and use that as a financial flow to pay for the ecological investments.
Such institutional structures have been difficult to establish. Property owners have their insurance with many different firms, which makes the transaction costs of establishing a program high. In addition, few insurers are willing to offer any type of multiyear price guarantee that would be needed to link the insurance savings to a loan that could be used to get the savings up front for the needed investment in nature.
One approach is for a local government to take out a bond to pay for the investment in nature that lowers risk, such as ecological forestry, and then assess property owners a fee to cover the debt servicing, knowing that these property owners should see reductions in insurance premiums to offset the fee. This approach would require a partnership with insurance firms to guarantee that those savings would be passed on to residents, but it may not be possible to perfectly match the insurance reduction with the fee or to guarantee that match over the entire life of the bond. The investment in nature, however, would provide myriad additional benefits to the residents of the community, so in an area with political support, this model might be viable, particularly if the fee were means-tested so that it did not disproportionally burden lower-income residents.
Another institutional model that could harness these benefits is community-based catastrophe insurance (discussed elsewhere in the book). In one of multiple approaches to implementing this concept, a community would purchase insurance on behalf of many residents. There would therefore be just one policyholder, the community, which was already collecting fees from residents to pay for the insurance. It would then be more straightforward for the community to invest in nature-based solutions, realize a reduction in the cost of its insurance, and then translate that back to residents in the form of lower assessments.
From Understanding Disaster Insurance by Carolyn Kousky. Copyright © 2022 by the author. Reproduced by permission of Island Press, Washington, DC.