Insurance, prudence and economic growth

Article published exclusively on the Montreal Economic Institute’s website.

Whichever side one takes in the scientific debate about climate change, we must all recognize that any political response to this challenge will have significant economic repercussions. This is why it seems important to me to set the record straight regarding certain economic arguments making the rounds that, in my opinion, are sophisms.

Faced with the eventuality of any change, be it due to globalization, technological progress or climate change, economists concentrate on analyzing the costs and benefits of the phenomenon and of the actions that might be undertaken to prevent or mitigate its negative effects.

Just like insurance?

Some commentators argue that taking costly action today to mitigate global warming is imperative. Such drastic actions are often presented as being akin to buying an insurance policy for the Earth.

For one, Graciela Chichilnisky, Professor of Economics at Columbia University and architect of the carbon market of the Kyoto Protocol, asserts: “With a 25 percent chance of a home fire it would be considered irresponsible and antisocial not to buy fire insurance. For the same reason we must insure against climate change.”

The analogy is seductive at first sight. After all, we know that it is a good idea to buy insurance against certain risks. Among these are the risk that one’s house goes up in flames, that one gets into a car accident or that dependants face financial hardship due to one’s unforeseen death.

In fact, though, this comparison is fallacious. Insurance is indeed worthwhile at the household level, because an insurance company can pool risks. Every year, the premiums it collects roughly cover the reimbursements to its unfortunate clients. For example, if over a year 1% of houses burn down on average, each household will pay 1% of the value of its home in premiums every year. After a fire, the unfortunate households will receive an insurance payment equivalent to the value of their home (before it went up in flames). Therefore, the wealth of a household that owns fire insurance does not depend on whether or not its house burns down. Because there is no risk at the collective level (in any given year, roughly the same number of houses burn down), it is possible to insure households against the idiosyncratic risks that they face. This increases welfare if people are risk averse.

However, the same cannot be said anymore when there is only one risk that affects everyone. If, for example, there is a 90% chance that no house burns down and a 10% chance that they all burn down at the same time, no insurance scheme can be imagined to mitigate the risk. In this context, the only way to benefit from insurance would be to trade insurance claims with other planets facing similar potential risks. For example, a contract could specify that if the Earth’s climate deteriorates whereas the climate of another given planet does not, the inhabitants of that other planet should transfer some resources to us as a form of compensation. (If NASA hired economists, they would probably use this as an argument to justify space exploration!)

Furthermore, even if scientists can agree on a set of future scenarios, it is an understatement to say that there is no consensus regarding their respective probabilities. Therefore, the Earth is facing unquantifiable uncertainty, not quantifiable risk. The principle of insurance, however, requires that the probabilities of ‘‘accidents’’ be approximately known. Otherwise, an insurer cannot price an insurance policy, and a household cannot know if it should subscribe to it.

A question of prudence?

There is another argument that is sometimes invoked to justify taking action to mitigate climate change in the face of uncertainty: if individuals are prudent and are especially averse to a catastrophe, they should spend more resources today to avert such a future catastrophe.

In fact, this does not follow, because prudence and prevention are not equivalent. A prudent person is one who accumulates wealth in the face of a future risk, whereas one who favours prevention would try to reduce the probability of a bad outcome. In the case of global warming, prevention means introducing policies—such as carbon taxes, caps on carbon emissions, etc.—that tend to reduce growth.

Under a set of quite plausible assumptions about peoples’ preferences, professors Louis Eeckhoudt and Christian Gollier demonstrate in an article from the journal Economic Theory that ‘‘prudence favors the accumulation of wealth to face future risks. As a consequence, prudence induces agents not to spend money ex ante on preventive actions.’’

Intuitively, a wealthier and more productive future society will be better equipped to deal with climate change. This suggests that a prudent approach to climate change would be to focus on economic growth rather than invest in costly preventive measures.

Pierre Chaigneau is Assistant Professor of Finance at HEC Montréal.

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