Black Swans, Climate Change and Insurance

Nassim Taleb in his landmark book, The Black Swan explained the difficulty that humans and societies have in understanding rare and unpredictable events that have large impacts. For example, in a “black swan” event, the US stock market had crashed 22% in one day on Oct 19, 1987. However, because of the way Taleb’s portfolio was constructed (and a bit of luck), he made a profit of $35M, a 67,000% return on the same day. “Black swan” events can be categorised in both positive (like the Internet) and negative (like the US subprime crisis) terms, but their defining characteristics are that they are irregular and hard to predict.

Climate change and its adverse impacts are increasingly being likened to a “black swan” event. In the first place, events such as hurricanes, floods and extreme weather are difficult to predict, and the impact of these crises is hard to quantify. Second, it’s hard to ascertain whether these changes are because of regular weather patterns throughout history or due to structural changes in climate because of human-induced global change. Third, if there are real and irreversible changes in climate, the results could be catastrophic. Finally, climate change sceptics argue that the probability of such a scenario unfolding is small. All these characteristics make climate change a type of “black swan” event, if and when it happens.

Any “black swan” discussion would necessarily need to include the views of insurance companies which estimate the probabilities of events happening and their impact. That’s why we pay them the premium, right? In case things don’t work out the way we expected.

Insurance companies are now coming down in favour of those who believe that climate change has negatively impacted the weather and therefore has an increased risk of catastrophic events happening. For instance, after Hurricane Sandy caused $35BN in losses in the US, homeowners can expect an increase of 7 to 25% in home insurance rates in places like Jersey City.

Of course, insurers also realise that just increasing rates on consumers because of increased risks may actually make it unaffordable for consumers and adversely impact the market. Therefore, firms are now taking active steps in financing and changing policies, such as providing innovative insurance for green buildings, so that it actually leads to a cleaner planet.

The climate change policy for India, (which has ~15% of the world’s population), is unclear. On one hand, growth is top priority in order to pull large parts of the population out of poverty. Low cost pukka housing is a big focus area for the new government since it was a major part of the Bharatiya Janata Party’s 2014 election manifesto. On the other hand, there are real risks of floods and weather-related events because of climate change. India and the current government need to think of mechanisms to recognise the probabilities and costs of these “black swan” events while pursuing growth policies. Indian and international insurance companies which are paid to risk on “black swan” events need to have a seat at the table while making critical policy decisions on growth that will have an impact on the environment.