Interdependency of Science and Risk Finance in Catastrophe Insurance and Climate Change

Abstract

This paper describes the interdependencies of science and risk finance for catastrophe insurance. While the basic arguments here apply to all catastrophe risks, including seismic and terrorism risks, I will focus on risks associated with climate change. This traditional logic of actuarial science is the starting point for the present paper. This logic calls for sound science as the foundation of risk-based rates for insurance and related securitized products anchoring national responses to natural hazards and project financing. Lack of sound science would run counter to objective insurability criteria as well as undermining the identification and implementation of cost-effective mitigation and longer-term adaptation measures. Building on this general line of thinking, the paper explores some additional complexities of science-catastrophe risk linkages related to climate change. These include the sizeable epistemic risks associated with scientific uncertainties surrounding climate change and the implications for choices of owners of vulnerable assets and for uncertainty loadings in insurance contracts and for adaptation measures. I also discuss the consequences of the same scientific uncertainty in exacerbating the problem of communicating an understanding of the financial consequences of climate change risks to policy makers and to owners of assets vulnerable to these risks. Finally, I briefly consider the implications of this discussion for the products and services that a market-oriented private insurer could offer to clients facing climate change risk. The most important new client on the block under climate change will surely be governments, which will face potentially very large new liabilities from climate change. I argue that a continuing close relationship between science and risk finance will be essential to promote viable insurance products for catastrophe risks, whether the risk capital is public or private, as well as an informed public dialog on how to face the increasingly evident risks of climate change.