We Are Not Prophets II – Back to Deniers and Skeptics and Forward to Insurance.

The issue is not so much the accuracy of the prediction as the magnitude of the impact when the predictions are coming to roost. Our difficulties in predicting the future do not guarantee that the future will be better, there is probably equal chance that the future will come out worse than predicted (from the August 13 blog).

Up to now, the most intense reactions to my blog came in response to my comparisons between climate change deniers and Holocaust deniers. Climate change deniers have expressed resentment toward this analogy, wanting to be labeled skeptics instead. I sympathize with this sentiment, and over the last few blogs I have tried to stop using the term. Here I am returning to this issue – the main reason is that over the last blog I have tried to make the case that we are not prophets and nobody is certain about trying to predict the future. In a sense – we are all skeptics.

Let me frame this as a global insurance issue, by directly quoting a few paragraphs from the last chapter of my book [“Climate Change: The Fork at the End of Now”; Momentum Press – 2011].

Can we insure the survival of the planet as a habitable environment? If the answer is yes, then who will pay the premium?  If climate-change is just a big catastrophic event, then the mechanism of financial preparation should not be much different than the insurance of present catastrophic events. The trouble is that we are not very good at insuring catastrophic events. The present situation of flood insurance is a good example. In the United Kingdom, flood insurance is provided by private insurance, but in the United States it comes through a federally backed insurance system. In France and Spain flood insurance is bundled with other natural perils into a national pooling arrangement, and in Holland it is completely unavailable. The insurance industry is heavily involved in the debate on climate change. “Climate Change is a clear business opportunity for the insurance industry,” declared Shinzo Abe, former Prime Minister of Japan, at the Geneva Association meeting in Kyoto on 29 May 2009 [The Geneva Reports, www.genevaassociation.org, “The Insurance Industry and Climate     Change – Contributions to the Global Debate”, No. 2, July 2009].

The main reason is defensive – the worst thing that can happen to the insurance industry is to grossly underestimate risk. If the planet is becoming progressively more risky after the policy is drafted, then the industry will lose. The objective of insurers is to form a community of the insured where premium payments are sufficient to cover the cost of repairing the damage. The profitability of the insurance industry critically depends on its ability to assess risk, defined as

                        loss potential x occurrence frequency.

To illustrate the risk-premium dynamics of the insurance business, famous Swiss reinsurance company Swiss Re [Peter Zimmerli; Natural Catastrophe and Reinsurance”, Swiss Re Documents (2003)] uses a dice game analogy. The number on the die is the severity of the loss; the frequency is how often the number is rolled.  “Catastrophe” is defined as the point at which 6 is rolled 10 consecutive times or more. We can calculate the probability exactly for such an event to take place, but are we willing to pay against such a low probability event? Insurance is against future losses, not past losses. For past losses we rely on sympathy.

Natural catastrophes such as major floods or earthquakes remain unpredictable in spite of huge technical and scientific advances. According to Swiss Re there is a tendency to underestimate risks relating to natural hazards when a catastrophic event has not occurred for a long time (Just World Hypothesis again).

The loss potential (i.e., direct human loss not planetary loss) of climate change is a direct function of population growth and GDP growth and thus predictable (Special Report on Emission Scenarios [SRES] scenarios). The issue, however, is the frequency of the occurrence. One prediction of the climate change model is the increased intensity of extreme events. Is this prediction solid enough to put our money on (or rather strong enough for the insurance and Re-Insurance companies to put our money on?). Local catastrophic losses can be put in a pool along with a large number of  separate geographical locations with the assumption that the frequency of occurrence in these locations is independent. They must include willingness to pay by policy holders in the pool formation.  If there is a tendency to underestimate risks relating to natural hazards when a catastrophic event has not occurred for a long time, then it is difficult to find payers. One possible solution is differentiated-premium pricing even on a global scale. With sovereign states in control, how this will work within the confines of a regulated insurance environment remains an issue.

The insurance premium is being paid here to take the appropriate steps to minimize the odds for the catastrophic event to take place (in climate change lingo we call this remediation) and not to collect the insurance after the event. It is an insurance we transfer to our grandchildren.