Of all the forthcoming impacts of increasing climate volatility, the one that seems to be hitting the developed nations first is the topic of increased flooding and the severe impact this phenomenon is having on traditional flood insurance schemes.

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As the FT recently noted, when writing about the UK government’s pending decision to exclude homes in some high-income areas from the national flood risk pool:

Pressure is mounting on government officials to backtrack on plans to exclude the most expensive properties from the new national flood subsidy fund after insurers withdrew their support for the exclusion.

The Association of British Insurers has written to Owen Paterson, environment secretary, to call for more properties to be protected under the Flood Re scheme.

Officials at the Department for Environment, Food & Rural Affairs said on Monday that the ABI’s intervention would not change their stance. They argue that if expensive riverside homes are included, poor households would effectively be subsidising the wealthy who chose to live on floodplains.[i]

The officials quoted are technically correct, of course, since rich owners would in fact be sharing their high cost of flood insurance with owners of much lower risk properties. This issue is yet another example of a situation that needs to be viewed through the lens of a concept we call Cost of Risk, which is defined as the present cost of more than one possible outcome (of unequal value) in the future.[ii] Applied to this case, it’s easy to see that in the UK, as well as places like Miami and New York the cost of risk of waterfront housing has started to increase dramatically and to undergo a transformation from an economic CoR factor (i.e., present but not accounted) to a financial CoR factor (i.e., present and accounted). For over a decade, owners of waterfront properties in many cities have been carrying an ever-increasing economic CoR that, in the near future will convert to a financial CoR with possibly devastating consequences. As has been noted elsewhere, when economic CoR elements convert to financial CoR this conversion usually exhibits two characteristics: the conversion happens in sooner than typically predicted and the impact is usually higher than expected.

This eCoR to fCoR conversion is happening not just with flooding of course. It is also happening with temperature, water access and other important environmental factors. It’s not too hard to imagine that in the near future some localities will be hit with multiple weather-related fCoR conversions, which, taken together, will make the cost of inhabiting those locals too expensive for all but the wealthiest individuals because the ability of insurers to price and transfer that fCoR simply will cease to exist. In other words, one can easily imagine a scenario in a city such as Miami where rising sea levels (making current access methods untenable) combined with increasing ambient temperatures (making current structures unsafe) simply make all current private and state/municipal insurance models unviable. In a rich nation like the U.S., the federal government would in all likelihood step in to provide some sort of risk transfer mechanism (albeit at a huge cost), but what would happen if the same phenomenon appeared in a much poorer location? What would such an event look like structurally and is there a solution that could be designed to deal with such a scenario? We argue that (a) there is an existing model that can be used to analyze this potential scenario and that (b) the solution is something we are calling The International Environmental Monetary Fund, i.e.,: “The IMF of Weather.”

How Weather CoR is Like Currency CoR

The basis of our argument for an IEMF is our belief that at the structural level, and from a CoR perspective, a sudden weather-driven elimination of standard risk transfer options in a given location has startling similarities with a currency crisis. To illustrate this point, let’s review, for a moment, the typical sequence of events in a standard IMF currency rescue episode:

  • Money flows into Location A as investors misprice the eCoR of holding the local currency or local-currency denominated financial instruments (bonds, etc.).
  • Some event, either indigenous (government over-borrowing) or exogenous (turmoil in the financial markets) suddenly converts the currency’s eCoR to fCoR in an unexpected, violent and usually rapid manner
  • The CoR of holding the currency increased dramatically, forcing the local government to pay increasingly high premium to anyone willing to lend it money or, in extreme cases, simply losing the ability to borrow at any premium.
  • The IMF steps in and assumes all or part of the momentarily excessive fCoR which allows the local government to borrow (usually from the IMF at first but then from other entities).
  • The local government is then given a multi-year plan to restructure its finances until such time as fCoR is lowered to a point that is tenable.

Now, let’s imagine a similar sequence in the weather scenario we noted earlier. In this case the events would follow this sequence:

  • Homeownership funds flows into Location B, which is located next to a high eCoR location (Miami, Mumbai, Amsterdam, etc.)
  • Water, temperature, etc. volatility increase in Location B suddenly converts the weather-driven eCoR to fCor in a sudden and catastrophic way (basically what is happening in the UK example noted earlier)
  • The fCoR for Location B is now so high that traditional risk transfer agents (for example, insurance companies) find that the cost of insuring Location B is unacceptable, or even impossible to calculate (the more likely in the near future). Homeowners are forced to pay increasingly desperate risk transfer premiums, or, in extreme cases, are unable to transfer weather risk at any premium.
  • The IEMF steps in and assumes all or part of the momentarily excessive weather-related fCoR which allows Location B to continue to function.
  • Location B is then given a multi-year plan to change its infrastructure until such time as weather-related fCoR is lowered to a point that make risk transfer viable.

This idea may sound fanciful (or perhaps not), but it’s not too much a stretch to imagine something like this mechanism being necessary in the near future. The preceding year has seen crises in water access in the U.S. west, flooding in Miami and the U.K., and droughts in Argentina. If these are indicators of a forthcoming period of increased weather volatility (and there is pretty much unanimity in the scientific community that they are), then it’s time to start thinking at the macro level about adjustment mechanisms that will help cities and even nations cope with increased levels of weather-related CoR.

Imagining a Structural Solution

If one agrees, then, even hypothetically, that such mechanisms will be required in the future, the next question has to be who will create and fund those mechanisms? Three immediate options come to mind:

  • Option 1: Supra/Multi-national institutions (The United Nations, The European Community, IMF, World Bank, etc.)
  • Option 2: National institutions (U.S. and U.K. flood insurance schemes, for example)
  • Option 3: Private sector: Though current risk transfer entities are not prepared for this role, that does not mean that a new kind of private entity could not be created with this purpose in mind
  • Option 4: A hybrid model with some combination of the above

The first option has the advantage of being able to develop a global solution that would be consistent in its pricing and transfer models. It also has the great advantage of being able to aggregate CoR at the global level, and so spread it across a wide set of regions. It has the disadvantage of probably moving very slowly since enabling treaties have to be negotiated and that will depend on a broad political consensus.

The second option has the advantage of being able to move much more quickly than Option 1 and of being tailored to the needs of a specific nation and its economic and political structures. It has the disadvantage of being dependent on one nation’s ability to absorb CoR as well as one nation’s inability to spread the CoR at a global level unless some sort of nation-nation CoR transfer market is created (more on that concept a little later on).

The third option should, in theory, be the most agile and the one with a wide access to capital that is independent of any one nation or region. Assuming the economics of CoR transfer can be established and a sufficient enough return can be generated, then this could be an attractive option. Indeed, it’s also not hard to imagine that there are people working this scenario privately already, wondering where the opportunities for gain will come as a result of increase weather volatility.

The fourth option, of course, is some (ideally optimal) combination of the first three. Perhaps Option 4 takes the form of a regional weather risk transfer mechanism backed by private capital. Perhaps it is a multi-national entity that matches private sector risk-seeking capital with entities needing weather risk transfer and then backs that transfer in some way.

There are other options that could be imagined; however, the IMF-World Bank duo, which, despite their critics, have generally been successful in their missions, is a solid place to start the design. They have the economic expertise to analyze the problem, to develop the transfer mechanisms, and to work closely with booth rich and poor governments to make them functional. Their global scope and outstanding access to talent and capital put them in an ideal position to take this idea.

At the Fringes

The idea presented above may seem fanciful today, but something like it will undoubtedly become reality in the future should present trends continue. However, there are even more speculative notions that could also come into existence:

  • Bi-lateral CoR transfer agreements, i.e., “Weather Swaps” wherein one nation is paid to carry the CoR of another
  • Nationally backed weather CoR bonds, i.e., “W-Bills,” which are used to fund CoR restructuring in a region through long-term debt
  • Weather insurance at the individual residential unit level, which would drive greater transparency of the true CoR at the sub-local level

Undoubtedly, many innovations as yet unimagined will arise from the coming environmental changes. Weather risk, as noted earlier, is fast becoming a financial CoR problem, and history shows that when this shift occurs investments are made and smart minds start to develop solutions for pricing and managing that risk. Though this scenario is a particularly alarming one, with possibly disastrous consequences, it’s also possible that it will spur research and innovation into ways save society from a problem it did so much to create.

Conclusion

The world is turning a corner on the weather risk issue in 2014, brought about by the preceding half-decade of unprecedented weather-related volatility. As the current risk transfer entities (private and public) being to realize the real financial cost of the risk they are being asked to bear, many of these entities will be unwilling or unable to bear it. The time has come to start designing, at least on paper, the weather risk transfer institutions and mechanisms of the future. In short, the problem has arrived. It’s time to start working on the solutions.

[i] Insurance industry calls for government to widen Flood Re cover, FT.com (http://www.ft.com/intl/cms/s/0/7c377f64-be60-11e3-b44a-00144feabdc0.html#axzz31yGmQkeN)

[ii] See: Alvarenga, C., “A Quantitative Approach for Valuing and Managing Procurement Cost of Risk” (https://reconnomics.com/2013/10/19/new-article-preview-a-quantitative-approach-for-valuing-and-managing-procurement-cost-of-risk/)

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Posted by Carlos Alvarenga

Carlos Alvarenga is the Executive Director of World 50 ThinkLabs and an Adjunct Professor at the University of Maryland's Smith School of Business.

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