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Adaptation to Climate Change Risks and Regulation Through Insurance: The Case of China

Adaptation to Climate Change Risks and Regulation Through Insurance: The Case of China 1Introduction*The link between climate change and weather-related disasters is increasingly well understood. Climate change ‘leads to changes in the frequency, intensity, spatial extent, duration, and timing of extreme weather and climate events, and can result in unprecedented extreme weather and climate events’.1 Floods have impacted India, Germany, and China with greater frequency; more-frequent wildfires have ravaged Australia and the western United States; hurricanes and typhoons have wreaked havoc in the United States and China with greater regularity; and rising sea levels (a climatic event) threaten coastal settlements and islands in the Pacific by making the impacts of extreme weather events more severe.2 A marked increase in economic losses from weather-related events has paralleled their increasing frequency.3One way to avoid climate-related losses is adaptation,4 which generally involves a change in policy to adjust to the actual or expected climate and its impacts.5 The debate on adaptation often focuses on infrastructural measures that public authorities could promote. Another focus has been on how the legal system should deal with the damage that will result, including how compensation can be provided in the wake of climate-related disasters. Several instruments could be used to raise funds for compensation. Those suffering damage could rely, for example, on tort law or social-security provisions already in place. Another possibility is a governmental ad hoc grant or a special fund paid for by the tax payer. Yet another solution is insurance coverage, for example through measures to maintain the insurability of properties in at-risk areas.6 A public-private partnership, whereby the government facilitates private insurance or acts as a reinsurer to support private insurance, is an extension of that solution.Adaptation policy is thus partly about costing and financing damage and providing incentives for risk reduction.7 The government alone cannot prevent or defray all climate-related disaster risks. Insurance has received increased attention due to its emphasis on risk management, which includes stimulating individuals to take measures aimed at preventing damage from occurring.8 The unfccc calls upon parties to consider insurance-related instruments to cope with the risks of climate change.9 The Paris Agreement also promotes insurance solutions.10 There is no indication, however, about how insurance could be implemented to cope with the risks in question.We will focus on climate-related insurance as a form of private regulation, namely a contractual device motivating behaviour to avoid losses.11 One reason for this focus is the efficiency of private insurance as a financial instrument to compensate for climate-related disasters and to fund climate adaptation. Another is the insurers’ incentive, when underwriting climate-related risk, to mitigate that risk and any ensuing losses in order to reduce payouts. Regulation via insurance has both an ex-post function in providing compensation and an ex-ante function in stimulating loss prevention. Both are obviously important aspects of adaptation.The potential of insurance as an adaptation instrument is still largely unrealized. A large proportion of financial losses caused by disasters related to climate change are not covered by insurance.12 The global protection gap in 2020 was approximately US$113 billion – larger than the gap of US$87 billion in 2019, but lower than the ten-year average of US$143 billion up to that point.13Because the topic of insurance in climate-related compensation is closely related to the topic of compensation for victims of natural catastrophes, we will draw on the literature on catastrophe-insurance in general. We will show that the findings on the optimal compensation for victims of disasters are an important source of inspiration for the design of an optimal level of adaptation to climate change as well, in the specific context of compensation and prevention via insurance.The relevant literature14 establishes that insurance can reach its potential only on the condition that a legal and regulatory framework exists on the relationship between the government and the market, to prevent the government from undermining well-functioning market operations. Absent such a regulatory framework, there is a danger of insufficient supply or demand for climate insurance. We add to this earlier literature by focusing on the case of China. China is the world’s leading emitter of greenhouse gases and continues to suffer from the adverse consequences of climate change.15 Disasters in China related to climate change are likely to increase dramatically.16 In July 2021, Zhengzhou, the capital of Henan Province, was deluged by a ‘once in a thousand years’ rainfall; the devastating floods caused unprecedented damage to life and property.17 A marked increase in economic losses caused by such disasters between 1984 and 2018 has been noted.18 According to China’s National Bureau of Statistics, direct economic losses of this kind totaled 264 billion yuan in 2018, 327 billion yuan in 2019, and 370 billion yuan (about US$56.7 billion) in 2020.19 Despite the enormity of such losses, China lacks a legal framework on climate change adaptation in general or on climate insurance.In Section 2, below, we outline the thinking about how insurance could contribute to adaptation. Section 3 examines the role of insurance in climate change adaptation in the case of China. A discussion of the lessons for law and policy, drawing on the case of China, follows in Section 4.2Insurance as Adaptation2.1Insurance to Underwrite Climate-Related RiskThe ipcc in its Fifth Assessment Report defines adaptation as: ‘The process of adjustment to actual or expected climate and its effects. In human systems, adaptation seeks to moderate or avoid harm or exploit beneficial opportunities.’20 Adaptation includes the issue of how to deal with the damage caused by climate disasters.A legal regime should consider the connection between climate adaptation and disaster management for several reasons. Disaster prevention, emergency response, recovery, and reconstruction are basic, fundamental functions of government. The potentially devastating losses and damage caused by climate disasters might lead to political or economic instability, and therefore justify and require an efficient compensation system. Lastly, leaving victims of such disasters without relief or compensation is incompatible with social solidarity in modern welfare states.21The risk-management process embedded in insurance includes risk assessment through underwriting, risk control through claim management, and risk finance through pooling.22 Facing the uncertainty of future climate disaster, an individual may reasonably be assumed to be risk-averse ‘if she considers the utility of a certain prospect of money income to be higher than the expected utility of an uncertain prospect of equal expected monetary value’.23 A risk-averse person might prefer to transfer risk by paying the premium, while insurers are well placed to accept the transferred risk, as they can reduce the risk through risk assessment, risk control, and risk pooling. Insurance could, at least in theory, play a role in responding to those affected by climate disaster if they have purchased an appropriate insurance policy in advance.Insurance satisfies Pareto efficiency,24 a condition in which no-one is worse off and an individual increases his or her expected utility through transferring risk. Compared with government-provided compensation, insurance can lower transactions costs, lower adverse selection, and increase efficiency as a result of competitive markets.252.2Insurance-as-Governance in Stimulating PreventionInsurance economists have examined the role that insurance, coupled with cost-effective preventive activities, can play in managing the catastrophe risk of climate disasters.26 Insurance is seen as a tool to ‘outsource’ government regulation through the behaviour-control function it exercises on policyholders.27 The theory of insurance-as-governance (or regulation-by-insurance) assumes that insurers, to minimize their financial losses, will attempt to shape policyholder conduct by employing private regulatory measures, primarily through underwriting and contractual loss-prevention methods.28Any insurance coverage is faced with the challenge of moral hazard. The insured person facing climate-disaster risks may exercise less care to avoid losses than he or she would have done had the losses not been insured.29 Nevertheless, compared to the state, insurers are well equipped to manage moral hazard, because of their access to superior information and the competitive environment in which they operate.30Insurance uses regulatory techniques such as risk-based pricing, deductibles, exclusions, and loss-reduction services to give policyholders the incentive to reduce risks and invest in prevention measures.31 Amongst these techniques, risk-based pricing is regarded as the central approach of insurers to control moral hazard and promote risk mitigation.32 The premium-setting process gives policyholders the financial incentive to take risk-mitigation measures. In theory, the premium is based on the expected overall losses, derived by multiplying loss probability by loss severity.33 Reducing the probability or the severity of loss may lower the premium.Consider homeowner insurance in the United Kingdom covering households against floods.34 Insurers charge heavy premiums for households located in low-lying, flood-prone areas, where flood claims have previously been made.35 By setting higher premiums, insurers deter the insured from choosing to locate themselves in a high risk area.36 As long as the cost of reducing the probability or the severity of loss is lower than the discount of the premium, policyholders are likely to undertake risk mitigation.37 If the loss probability and loss severity are too high, insurers may refuse to underwrite the risk.38 It is therefore important that the law is shaped in such a way that rate classification based on controllable characteristics (i.e. premium discrimination) is facilitated, or at least not prohibited, in order to support the behaviour-control function of insurance.39Insurance companies also provide risk-management services which could assist in adaptation to climate change. Some insurance companies, such as Insurance Australia Group and Allianz, offer carbon-risk management services for carbon-emission-reduction projects on the strength of their combined expertise in risk assessment and finance.40 Insurance could also assist with the development of innovative products that make an important contribution to adaptation, such as the Clean Development Mechanism, by providing risk-management services as well as capital.412.3Comprehensive Mandatory InsuranceThe type of insurance we focus on in this article is first-party insurance. It is a system whereby insurance coverage is provided and compensation awarded directly by the insurer to the person affected by climate-related losses. There are many benefits to this type of insurance, including, as discussed, the insurer’s control of moral hazard.42There may be a variety of reasons why first-party insurance is not used to its full potential. One is that demand may be too low because of informational or behavioural issues. Potentially affected people may systematically misjudge risk, thinking that ‘it will not happen to me’. Risks with a low probability of occurring, such as a climate-related hurricane or flood, might be systematically ignored.43 Issues can also arise on the supply side, for it is difficult to predict the nature of climate-related losses. Moreover, the magnitude of the losses could be such as to endanger the financial viability of the insurer, making insurers reluctant to cover this type of risk.44 Another problem relates to the fact that some individuals (especially in low-income countries) may be exposed to climate-related risks but simply be unable to afford the premium.There are remedies for all the above problems, but the crucial point is that they necessitate governmental engagement and specifically a regulatory framework. Low demand arising from an underestimation of, or disregard for, risk can be solved by making insurance mandatory.45 Several countries, including France, Belgium, Norway, and Spain, have introduced various forms of mandatory comprehensive insurance which could just as well cover climate-related losses.46 Lack in supply arising from insurers’ fear of large losses can be remedied by a regulatory intervention whereby the government insures large losses as a reinsurer of last resort.47 Inability to pay the premium may be overcome through a regulatory intervention whereby the government (partially) subsidizes payments of premiums, conditioned on the taking of particular preventive measures.48In the following section we examine how insurance has begun to be used to contribute to climate change adaptation in the case of China.3Practice of Insurance-as-Adaptation in China3.1Insurance Products or Programs Covering Climate-Related RisksThe Chinese government has played a major role in compensating victims of climatic extremes. China’s mechanism for managing natural disasters in general is known as the ‘Whole-Nation System’. It refers to the government’s effort to deploy the whole of the nation’s resources to fulfill emergency-driven disaster relief. It consists of emergency response, victim compensation, and reconstruction.49The Whole-Nation System has played a valuable role in dealing with catastrophic loss in China. Fiscal support serves as a major capital source under this system.50 The impact of the 2008 Sichuan earthquake51 brought to the attention of policymakers the importance of improving the Whole-Nation System, especially in pre-disaster prevention and post-disaster compensation. While effective in delivering governmental relief in the short-run, the system may not work in the long-run due to inevitable government failures, including the so-called Samaritan’s Dilemma, which reduces incentives to invest in protection and mitigation measures, burdening public budgets, placing a drag on economic growth, causing a lack of risk financing, and creating perverse incentives for rent-seeking and corruption. Only 0.3% of total losses of the 2008 earthquake were covered by insurance. The disaster brought home to the Chinese government the importance of reshaping insurance to save lives and reduce potential economic loss.52For natural disasters, there are currently two kinds of insurance system in China: social insurance and private insurance. With regard to the former, basic medical insurance and other compensation programs, including occupational-injury insurance, provide basic financial protection in the case of a disaster, such as those caused by typhoons.53As to private insurance, the most widely used relevant insurance policy is catastrophe insurance, mainly covering catastrophic property loss, including damage to houses and factories and interruption of business caused by weather-related extremes. Because insurers have been reluctant to provide catastrophe-insurance coverage, the Chinese government has encouraged private insurers to participate in national and local climate-disaster-management pilots. In 2014, the city of Shenzhen’s Catastrophe-Insurance Program pilot made private catastrophe insurance available for the first time, enabling catastrophe risk to be shared between insurance firms and individuals.54 Since then, more catastrophe-insurance programs have been established, as shown in Table 1.The second type of insurance policy suitable for climate disasters is crop insurance, which covers the loss of crops from flooding, hail, drought, and so forth.55 This type of insurance has already played a crucial role in protecting farmers from weather-related extremes, with increasing liability and coverage between 2007 and 2018.56There is also parametric insurance. Catastrophe insurance and crop insurance are both forms of indemnity insurance, which requires proof of actual loss suffered.57 Parametric insurance, by contrast, provides payment when a predefined trigger event occurs or a particular index level is met, such as a flood or a certain amount rainfall.58 Parametric insurance potentially overcomes causation problems in climate-related disasters and provides for speedier payment. As of 2016, Guangdong Province provided a Parametric Meteorological Catastrophe Insurance to pay for damage caused by typhoons and rainstorms with a particular index level based on meteorological data.59Another possibility is liability insurance. Corporations such as power suppliers and vehicle manufacturers bear various forms of liability which might trigger an insurer’s duty of indemnity to policyholders for losses caused by climate change.60 However, such legal actions, particularly in relation to environmental causes, are not well developed in China.61 Hence, it is doubtful that liability insurance could play a role in adaptation.3.2Catastrophe Insurance as Governance in Managing Climate-Related DisastersCatastrophe insurance has gained attention as a means to adapt to climate change risk, both in theory and in practice.62 This section explores how catastrophe insurance might be used to supplement or even supplant state governance in China through the Whole-Nation System. The possibility and feasibility of regulation by catastrophe insurance in China will be discussed through an examination of its regulatory techniques. As private regulation, insurance operates stealthily by using technical tools to reduce moral hazard and by influencing risky behaviour so that more preventive action is taken.63 The regulatory techniques of catastrophe insurance include risk-based pricing, contract design (e.g. limits, deductibles, co-payments, and exclusions), loss prevention, claim management, and refusal to insure. As indicated earlier, these techniques both control the behaviour of the insured individual via adapted insurance-policy conditions and partially expose the insured person to risk.64Risk-Based Pricing. According to research carried out in China on ‘Willingness to Pay’ (wtp), many people are willing to pay a higher premium in order to acquire full coverage of property loss in catastrophic disaster.65 In setting such premiums, regional differences and construction types must be taken into account. For example, Shenzhen’s Catastrophe-Insurance Program includes two different interacting tiers of insurance. The first is the government’s catastrophe-assistance insurance which supplies a basic level of assistance to all citizens. In the case of low-income homeowners, Shenzhen’s municipal government will pay the cost of insurance in order to guarantee coverage. The next insurance tier is pure private catastrophe insurance to cover property loss, which will thus charge risk-based premiums. It provides a discount to those who adopt cost-effective risk-mitigation measures (e.g. against floods), thus providing a clear signal to those contemplating to locate to a hazard-prone area.66Contract Design. Survey respondents who have poor housing conditions tend to be more aware of disasters and have a strong desire for insurance.67 High deductibles may induce people to locate away from hazard-prone areas and opt for better construction. When setting deductibles for policies, construction type, house condition, and location should be important considerations. These tools of contract design are a common choice in China’s five catastrophe-insurance pilot programs.Loss Prevention. A significant proportion of survey respondents (24%) are not willing to purchase house insurance to cover disaster because they claim not to know much about insurance or they distrust insurers.68 Education, therefore, should be included in insurers’ loss-prevention services in order to create public awareness of mitigation of catastrophe risks, although this could also be a role for the government given the issue of mistrust.Claim Management. Insurers in China do not perform well on loss adjustment and claim settlement. A considerable section of survey respondents (23%) indicate that they do not trust insurers’ claim management.69 Fearful of receiving no payment at all after a disaster, they are not willing to purchase catastrophe insurance. Insurers, therefore, should increase their transparency and efficiency in order to gain the public’s trust.70Refusal to Insure. In 1998, the People’s Bank of China (the Central Bank) issued a Residential Mortgage Regulation.71 It states, in Article 25, that before a mortgage contract is concluded, the mortgagor is required to obtain household insurance or to relegate this task to the mortgagee. However, in 2006, China’s Banking Regulatory Commission issued a notice forbidding banks from stipulating with mandatory effect that residential mortgage insurance must be acquired.72 Although acquiring household insurance is not related to a mortgage, to loans, or to other financial services, it would be beneficial to review the feasibility of putting such concerted regulatory measures to use for the take-up of catastrophe insurance.Since China is not a purely market-based economy, its catastrophe/crop-insurance market faces special challenges. There is no specific catastrophe-insurance law or regulation in the country. However, there is in place a relevant Regulation on Agricultural Insurance. It was promulgated in 2013, and includes provisions on government-subsidized agricultural catastrophe insurance.73 Article 8 provides that the central government should establish subsidized agricultural catastrophe insurance. Local governments are encouraged to follow its lead and contribute to the pool. Article 17 prescribes that any insurance company wishing to underwrite an agricultural insurance policy must include coverage of catastrophe insurance. However, the regulation lacks detail about how the system will be established, the extent to which the government will subsidize policyholders, what it is that insurers should do in relation to catastrophe-insurance coverage, and other questions of implementation. Only Shenzhen’s Catastrophe-Insurance Program provides a diversification of climate-disaster risks through a public-private partnership involving the (local) government and the private market.3.3Limitations and Barriers to Climate Insurance as GovernanceIn general, both insurers and consumers may limit the effectiveness of regulation-by-insurance, as discussed above. Insurers face a number of obstacles in underwriting climate-disaster policies. The nature of the risks makes it difficult to fulfill insurability requirements. First, poor information impedes insurers’ efforts to identify, quantify, and estimate the chances of climate-related disaster and to set premiums. Second, China’s primary-insurance industry does not have the capacity to deal with climate-related catastrophes, as property-insurance companies do not have the capital fully to cover this type of loss.74 As a result, the supply of climate insurance is limited and volatile. Consumers, for their part, may ignore insurers’ risk-management advice, or have little interest in buying insurance at all.75 Due to the low probability of climate-related disaster, coupled with non-rational consumer behaviour, awareness of loss prevention is weak.76Consumer demand for catastrophe insurance in China has also been blunted by expectations of a government bailout. There has been a long history of preventing or responding to disaster losses. (In the Qing Dynasty, for example, the Records of Laws and Systems of the Qing Dynasty (大清会典事例) listed twelve articles on Disaster Defense and Reduction Policies.77) Because of China’s state-controlled economy and the lack of a private insurance sector in the period 1950–1978, the Chinese are more reliant on government bailouts than people in developed countries. Even now, under the Whole-Nation System, China’s citizens can count on government compensation, which reduces their incentive to purchase insurance cover and pay the corresponding premium.784Implications for Law and PolicyWhat are the implications of China’s case for adaptation law and policy?4.1Establishing a Legal Framework for Climate InsuranceThe prospect of the current catastrophe-insurance programs in China is uncertain. No specific climate-disaster or similar legal framework exists.79 Yet, insurance can only play its full role in adaptation where a legal framework is in place to facilitate this. In order to establish a well-functioning climate-insurance market, the different roles of government and the market will need to be clarified. The government needs to help solve market failures in climate insurance, secure insurers’ business operations using market mechanisms, and promote insurance techniques as forms of governance, rather than creating new government institutions to supplant private solutions.80 The Whole-Nation System needs to be reformed so as to avoid crowding out private insurance – it should instead enhance the collaboration between the private insurance industry and the government. Regulatory intervention should be geared toward establishing a mandatory climate-insurance system, to solve both supply and demand anomalies, while providing affordability measures. As Telesetsky argues, ‘the most important reason for mandating catastrophe risk insurance is to compel industry actors to take action under the supervision of the profit-motivated insurance’.81 Some of the detail of the needed legal infrastructure will be clarified in the subsections below.4.2Affordability of InsuranceIt is undeniable that ‘money talks’ in the implementation of adaptation measures relating to disaster prevention, recovery, and reconstruction.82 If insurance were made mandatory to compensate for climate-related losses (as we suggest), an affordability problem would arise for individuals living in poverty and exposed to climate risks. China’s local governments participating in the catastrophe-insurance pilot programs purchase only basic coverage for citizens; and insurers only pay for medical costs or pension costs in case of injury or death.83 However, in the case of an earthquake-insurance pilot program in Chuxiong county, Yunnan Province, the state paid the cost of every rural community’s insurance in response to their economic vulnerability.84 Various other remedies are possible to deal with the unaffordability of premiums.It is important that insurance premiums reflect risk.85 If individuals in disaster-prone areas lack the capacity to pay insurance premiums, the government could provide insurance vouchers, or policyholders could be reimbursed by the government for a portion of the costs of insurance coverage. A voucher system could incentivize individuals to adopt risk-mitigation measures. Coate has argued that, if the government makes in-kind transfers of insurance to the poor, they will not be dependent on disaster relief ex post in the case of loss.86 Subsidization of insurance premiums can avoid the charity hazard.87 There is indeed a trade-off between, on the one hand, the efficiency requirement of charging risk-dependent premiums, and, on the other hand, the equity problem that risk-dependent premiums will lead to unaffordability issues.88 Yet, there are many examples of innovative insurance solutions tailored to the circumstances of developing countries. Several countries have developed micro-insurance for natural disasters.89 Indonesia and Bangladesh have private micro-insurance for flood risk.904.3Public-Private PartnershipsAs noted above, due to various limitations, insurers may not be able to provide full coverage. After extensive flooding in Henan Province in July 2021, only 10% of total economic losses were covered by insurance companies.91 China’s Banking and Insurance Regulatory Commission has implemented the so-called Risk-Oriented Solvency System ii, commencing in 2022.92 This solvency regime requires insurers, as in the European Union,93 to hold sufficient asset capital in their reserves, including for catastrophe risks they are facing. In order to underwrite climate-disaster risks, insurers clearly require more financial capacity, as well as the ability to place a significant portion of the insured losses on reinsurers – private or government. It has therefore been suggested that the government could play a role in supporting climate-disaster insurance.94 There are several examples of governments promoting insurance capacity for disaster risks.95 We will first explain how such a regulatory model could function and then consider the example of Shenzhen’s Catastrophe-Insurance Program.4.3.1Government Acts as Reinsurer of Last ResortUnder a reinsurance contract, an insurer (the ceding company) is protected from exposure by transferring risk to a reinsurer.96 Climate-related losses might not be locally insurable for primary insurers, but might be globally insurable for reinsurers. To some extent, nevertheless, reinsurers face similar financing limitations as primary insurers, as there is often insufficient reinsuring capacity.97 The market distortions appear to be more related to supply (reinsurer) than demand (primary insurer). The explanation, focused on supply restrictions, is well documented in the law-and-economics literature.98 It demands some kind of government intervention. Still, the underlying philosophy is that private insurance should keep on playing a significant role in allocating compensation for victims of climate-related losses. This option can take the form of a multi-layered insurance programme.99 An example is the French Caisse Centrale de Réassurance (ccr). Insurers can reinsure the risk of natural hazards with ccr, which benefits from a state guarantee in the event that ccr exhausts its resources.100A government can act as reinsurer of last resort, helping to fill the ‘capacity gap’ of primary insurers in underwriting climate disasters, because governments have ‘a deep credit capacity’ and can raise money effectively and quickly through taxation or by issuing debt or government bonds in the wake of disaster.101 The government as reinsurer does not interfere with a private insurer’s business, including the underwriting of policies, the collecting of premiums, or the paying of claims, thus ensuring that the private insurance market can continue to play a leading role in climate-disaster adaptation.102 A model of reinsurance by government has been developed in several countries to deal with earthquake and terrorism risks.103 It is reasonable to assume that it could be a feasible method to deal with the risks of climate disaster.4.3.2Assessment of Shenzhen’s Catastrophe-Insurance ProgramIn 2014, Shenzhen’s Catastrophe-Insurance Program was the first of the pilots in China in which the government intervened to spread the risks associated with climate change through insurance.104 It consists of three interacting tiers of insurance or compensation funds. The first tier is the government’s catastrophe-assistance insurance, which is bought by Shenzhen’s municipal government from the People’s Insurance Company of China to supply basic assistance to all citizens. It functions as indemnity insurance: the insurance company will pay for medical and pension costs incurred from injury or death caused by a disaster. The second tier is a catastrophe fund managed by the city of Shenzhen. The fund’s capital sources include governmental appropriations and investment earnings. The third tier is pure private catastrophe insurance to cover property losses.105The Shenzhen Program applies several governance techniques of the insurance industry to minimize losses and protect those potentially affected by climatic hazards. In the Program, insurers worked in tandem with experts, the insured, and other stakeholders to identify technical and economic parameters of climate-related risks and develop system-wide technologies of loss prevention.106 Three important mechanisms of loss prevention are used.107 The first is risk research and risk education. Insurance companies are required to use 10% of the premium to organize research, disaster prevention, disaster-emergency relief drills, and disaster-emergency advertising. The second is a reporting system, by which insurers submit to the government a quarterly report on disaster-claim payments and an annual report on disaster-risk management, and they offer advice on risk prevention, emergency management, and disaster relief to the municipal government. The third mechanism is the operation of a disaster database. Catastrophe insurers are to operate such a database, including information on disaster time, location, intensity, damage, and claim payments, and share the information with the government.In addition, the Shenzhen Program offers risk-based premiums – the basic technique for creating incentives to reduce risk.108 Risk-based premiums enable insurers to provide a discount for the adoption of cost-effective mitigation measures.While the Shenzhen Program is a promising start to providing basic coverage for citizens, there are a number of issues with applying the pilot as a model for future insurance schemes designed to enhance climate change adaptation.109 The primary concern is that the government’s catastrophe-assistance insurance may inadvertently compete with the private-insurance market in the coverage areas financed by the government. A second concern is that the success of the model depends on the fiscal capability of the local government.110 Through international cooperation, the model could instead consist of private (both international and domestic) reinsurance and insurance-linked securities. These two instruments would help spread the cost of catastrophe losses covered by primary insurers in the private market and provide substantially greater capacity. Meanwhile, assuming the risks of any losses above a predetermined threshold, a government-funded backstop (i.e. government-sponsored reinsurance) could promote the entry of private insurers and also act as reinsurance of last resort.1115ConclusionIn this article, we presented insurance as an instrument of climate change adaptation. Insurance has much potential in this respect. It can provide compensation after a climate disaster has happened. Through control of moral hazard risk, insurers can act as de facto regulators by requiring preventive behaviour from insured individuals, thus reducing the potential impact of a catastrophe and contributing to adaptation. Regulation is, in a sense, outsourced to insurers. The example of Shenzhen’s Catastrophe-Insurance Program shows that, by charging risk-based premiums, incentives can be provided to prevent people from locating themselves in hazard-prone areas.By considering the case of China, we have attempted to show that advances in catastrophe insurance can be realized in practice, but that there are limitations and barriers still to be overcome. The crucial point is that there is an important role for government to play, especially in stimulating the insurability of climate-related risks. The downside, in a purely technical sense, is that the government will sometimes generously provide compensation to disaster victims, thus reducing the incentive for prevention112 and for obtaining insurance.113 This problem arises in China, with its strong reliance on the government providing compensation (the Whole-Nation System).We noted that climate-related disaster insurance is not widespread yet, for various reasons. Potentially affected people may lack adequate information about the advantages of insurance and they may distrust insurers. This problem arises in China, where the insurance gap for climate disasters is huge. It is precisely for this reason that a variety of legal interventions is indicated. A first important step is that climate insurance should be made mandatory in order to remedy the anomalies on the demand side. Persons potentially affected, especially in poor areas, may be unable to pay the insurance premium. A smart government intervention can be geared towards subsidizing the purchase of insurance rather than providing direct relief to victims. The pilot programs in China do exactly that. Given the large scope of the potential damage, insurers may be unable to provide full cover. Therefore, the development of a multilayered program is necessary, whereby the government stimulates the functioning of the insurance market by acting as reinsurer of last resort. The Shenzhen Program is a step in that direction, although a better solution would be to restructure the model so that (private) insurance and reinsurance would provide the first and second tiers of compensation, whereas the government would intervene only as a reinsurer of last resort. In this way, adequate compensation for climate-related disasters could be provided, yet the insurance sector would still exercise its de facto regulatory role by providing incentives for adaptation.China’s case helps to focus discussion on adaptation to climate change through insurance. With the possible exception of Shenzhen’s Program, China, like many other countries, still has a long way to go in this respect. Given the inevitability of climate disasters, insurance regulation is called for to make comprehensive climate insurance mandatory; to smartly subsidize premiums (on the condition of investing in prevention) in order to make them affordable; and to stimulate supply by allowing the government to act as reinsurer of last resort. Through this public-private partnership, the government can contribute to adaptation by using the de facto regulatory powers of insurers. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Climate Law Brill

Adaptation to Climate Change Risks and Regulation Through Insurance: The Case of China

Climate Law , Volume 12 (2): 22 – Feb 28, 2022

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Brill
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Copyright © Koninklijke Brill NV, Leiden, The Netherlands
ISSN
1878-6553
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1878-6561
DOI
10.1163/18786561-20210002
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Abstract

1Introduction*The link between climate change and weather-related disasters is increasingly well understood. Climate change ‘leads to changes in the frequency, intensity, spatial extent, duration, and timing of extreme weather and climate events, and can result in unprecedented extreme weather and climate events’.1 Floods have impacted India, Germany, and China with greater frequency; more-frequent wildfires have ravaged Australia and the western United States; hurricanes and typhoons have wreaked havoc in the United States and China with greater regularity; and rising sea levels (a climatic event) threaten coastal settlements and islands in the Pacific by making the impacts of extreme weather events more severe.2 A marked increase in economic losses from weather-related events has paralleled their increasing frequency.3One way to avoid climate-related losses is adaptation,4 which generally involves a change in policy to adjust to the actual or expected climate and its impacts.5 The debate on adaptation often focuses on infrastructural measures that public authorities could promote. Another focus has been on how the legal system should deal with the damage that will result, including how compensation can be provided in the wake of climate-related disasters. Several instruments could be used to raise funds for compensation. Those suffering damage could rely, for example, on tort law or social-security provisions already in place. Another possibility is a governmental ad hoc grant or a special fund paid for by the tax payer. Yet another solution is insurance coverage, for example through measures to maintain the insurability of properties in at-risk areas.6 A public-private partnership, whereby the government facilitates private insurance or acts as a reinsurer to support private insurance, is an extension of that solution.Adaptation policy is thus partly about costing and financing damage and providing incentives for risk reduction.7 The government alone cannot prevent or defray all climate-related disaster risks. Insurance has received increased attention due to its emphasis on risk management, which includes stimulating individuals to take measures aimed at preventing damage from occurring.8 The unfccc calls upon parties to consider insurance-related instruments to cope with the risks of climate change.9 The Paris Agreement also promotes insurance solutions.10 There is no indication, however, about how insurance could be implemented to cope with the risks in question.We will focus on climate-related insurance as a form of private regulation, namely a contractual device motivating behaviour to avoid losses.11 One reason for this focus is the efficiency of private insurance as a financial instrument to compensate for climate-related disasters and to fund climate adaptation. Another is the insurers’ incentive, when underwriting climate-related risk, to mitigate that risk and any ensuing losses in order to reduce payouts. Regulation via insurance has both an ex-post function in providing compensation and an ex-ante function in stimulating loss prevention. Both are obviously important aspects of adaptation.The potential of insurance as an adaptation instrument is still largely unrealized. A large proportion of financial losses caused by disasters related to climate change are not covered by insurance.12 The global protection gap in 2020 was approximately US$113 billion – larger than the gap of US$87 billion in 2019, but lower than the ten-year average of US$143 billion up to that point.13Because the topic of insurance in climate-related compensation is closely related to the topic of compensation for victims of natural catastrophes, we will draw on the literature on catastrophe-insurance in general. We will show that the findings on the optimal compensation for victims of disasters are an important source of inspiration for the design of an optimal level of adaptation to climate change as well, in the specific context of compensation and prevention via insurance.The relevant literature14 establishes that insurance can reach its potential only on the condition that a legal and regulatory framework exists on the relationship between the government and the market, to prevent the government from undermining well-functioning market operations. Absent such a regulatory framework, there is a danger of insufficient supply or demand for climate insurance. We add to this earlier literature by focusing on the case of China. China is the world’s leading emitter of greenhouse gases and continues to suffer from the adverse consequences of climate change.15 Disasters in China related to climate change are likely to increase dramatically.16 In July 2021, Zhengzhou, the capital of Henan Province, was deluged by a ‘once in a thousand years’ rainfall; the devastating floods caused unprecedented damage to life and property.17 A marked increase in economic losses caused by such disasters between 1984 and 2018 has been noted.18 According to China’s National Bureau of Statistics, direct economic losses of this kind totaled 264 billion yuan in 2018, 327 billion yuan in 2019, and 370 billion yuan (about US$56.7 billion) in 2020.19 Despite the enormity of such losses, China lacks a legal framework on climate change adaptation in general or on climate insurance.In Section 2, below, we outline the thinking about how insurance could contribute to adaptation. Section 3 examines the role of insurance in climate change adaptation in the case of China. A discussion of the lessons for law and policy, drawing on the case of China, follows in Section 4.2Insurance as Adaptation2.1Insurance to Underwrite Climate-Related RiskThe ipcc in its Fifth Assessment Report defines adaptation as: ‘The process of adjustment to actual or expected climate and its effects. In human systems, adaptation seeks to moderate or avoid harm or exploit beneficial opportunities.’20 Adaptation includes the issue of how to deal with the damage caused by climate disasters.A legal regime should consider the connection between climate adaptation and disaster management for several reasons. Disaster prevention, emergency response, recovery, and reconstruction are basic, fundamental functions of government. The potentially devastating losses and damage caused by climate disasters might lead to political or economic instability, and therefore justify and require an efficient compensation system. Lastly, leaving victims of such disasters without relief or compensation is incompatible with social solidarity in modern welfare states.21The risk-management process embedded in insurance includes risk assessment through underwriting, risk control through claim management, and risk finance through pooling.22 Facing the uncertainty of future climate disaster, an individual may reasonably be assumed to be risk-averse ‘if she considers the utility of a certain prospect of money income to be higher than the expected utility of an uncertain prospect of equal expected monetary value’.23 A risk-averse person might prefer to transfer risk by paying the premium, while insurers are well placed to accept the transferred risk, as they can reduce the risk through risk assessment, risk control, and risk pooling. Insurance could, at least in theory, play a role in responding to those affected by climate disaster if they have purchased an appropriate insurance policy in advance.Insurance satisfies Pareto efficiency,24 a condition in which no-one is worse off and an individual increases his or her expected utility through transferring risk. Compared with government-provided compensation, insurance can lower transactions costs, lower adverse selection, and increase efficiency as a result of competitive markets.252.2Insurance-as-Governance in Stimulating PreventionInsurance economists have examined the role that insurance, coupled with cost-effective preventive activities, can play in managing the catastrophe risk of climate disasters.26 Insurance is seen as a tool to ‘outsource’ government regulation through the behaviour-control function it exercises on policyholders.27 The theory of insurance-as-governance (or regulation-by-insurance) assumes that insurers, to minimize their financial losses, will attempt to shape policyholder conduct by employing private regulatory measures, primarily through underwriting and contractual loss-prevention methods.28Any insurance coverage is faced with the challenge of moral hazard. The insured person facing climate-disaster risks may exercise less care to avoid losses than he or she would have done had the losses not been insured.29 Nevertheless, compared to the state, insurers are well equipped to manage moral hazard, because of their access to superior information and the competitive environment in which they operate.30Insurance uses regulatory techniques such as risk-based pricing, deductibles, exclusions, and loss-reduction services to give policyholders the incentive to reduce risks and invest in prevention measures.31 Amongst these techniques, risk-based pricing is regarded as the central approach of insurers to control moral hazard and promote risk mitigation.32 The premium-setting process gives policyholders the financial incentive to take risk-mitigation measures. In theory, the premium is based on the expected overall losses, derived by multiplying loss probability by loss severity.33 Reducing the probability or the severity of loss may lower the premium.Consider homeowner insurance in the United Kingdom covering households against floods.34 Insurers charge heavy premiums for households located in low-lying, flood-prone areas, where flood claims have previously been made.35 By setting higher premiums, insurers deter the insured from choosing to locate themselves in a high risk area.36 As long as the cost of reducing the probability or the severity of loss is lower than the discount of the premium, policyholders are likely to undertake risk mitigation.37 If the loss probability and loss severity are too high, insurers may refuse to underwrite the risk.38 It is therefore important that the law is shaped in such a way that rate classification based on controllable characteristics (i.e. premium discrimination) is facilitated, or at least not prohibited, in order to support the behaviour-control function of insurance.39Insurance companies also provide risk-management services which could assist in adaptation to climate change. Some insurance companies, such as Insurance Australia Group and Allianz, offer carbon-risk management services for carbon-emission-reduction projects on the strength of their combined expertise in risk assessment and finance.40 Insurance could also assist with the development of innovative products that make an important contribution to adaptation, such as the Clean Development Mechanism, by providing risk-management services as well as capital.412.3Comprehensive Mandatory InsuranceThe type of insurance we focus on in this article is first-party insurance. It is a system whereby insurance coverage is provided and compensation awarded directly by the insurer to the person affected by climate-related losses. There are many benefits to this type of insurance, including, as discussed, the insurer’s control of moral hazard.42There may be a variety of reasons why first-party insurance is not used to its full potential. One is that demand may be too low because of informational or behavioural issues. Potentially affected people may systematically misjudge risk, thinking that ‘it will not happen to me’. Risks with a low probability of occurring, such as a climate-related hurricane or flood, might be systematically ignored.43 Issues can also arise on the supply side, for it is difficult to predict the nature of climate-related losses. Moreover, the magnitude of the losses could be such as to endanger the financial viability of the insurer, making insurers reluctant to cover this type of risk.44 Another problem relates to the fact that some individuals (especially in low-income countries) may be exposed to climate-related risks but simply be unable to afford the premium.There are remedies for all the above problems, but the crucial point is that they necessitate governmental engagement and specifically a regulatory framework. Low demand arising from an underestimation of, or disregard for, risk can be solved by making insurance mandatory.45 Several countries, including France, Belgium, Norway, and Spain, have introduced various forms of mandatory comprehensive insurance which could just as well cover climate-related losses.46 Lack in supply arising from insurers’ fear of large losses can be remedied by a regulatory intervention whereby the government insures large losses as a reinsurer of last resort.47 Inability to pay the premium may be overcome through a regulatory intervention whereby the government (partially) subsidizes payments of premiums, conditioned on the taking of particular preventive measures.48In the following section we examine how insurance has begun to be used to contribute to climate change adaptation in the case of China.3Practice of Insurance-as-Adaptation in China3.1Insurance Products or Programs Covering Climate-Related RisksThe Chinese government has played a major role in compensating victims of climatic extremes. China’s mechanism for managing natural disasters in general is known as the ‘Whole-Nation System’. It refers to the government’s effort to deploy the whole of the nation’s resources to fulfill emergency-driven disaster relief. It consists of emergency response, victim compensation, and reconstruction.49The Whole-Nation System has played a valuable role in dealing with catastrophic loss in China. Fiscal support serves as a major capital source under this system.50 The impact of the 2008 Sichuan earthquake51 brought to the attention of policymakers the importance of improving the Whole-Nation System, especially in pre-disaster prevention and post-disaster compensation. While effective in delivering governmental relief in the short-run, the system may not work in the long-run due to inevitable government failures, including the so-called Samaritan’s Dilemma, which reduces incentives to invest in protection and mitigation measures, burdening public budgets, placing a drag on economic growth, causing a lack of risk financing, and creating perverse incentives for rent-seeking and corruption. Only 0.3% of total losses of the 2008 earthquake were covered by insurance. The disaster brought home to the Chinese government the importance of reshaping insurance to save lives and reduce potential economic loss.52For natural disasters, there are currently two kinds of insurance system in China: social insurance and private insurance. With regard to the former, basic medical insurance and other compensation programs, including occupational-injury insurance, provide basic financial protection in the case of a disaster, such as those caused by typhoons.53As to private insurance, the most widely used relevant insurance policy is catastrophe insurance, mainly covering catastrophic property loss, including damage to houses and factories and interruption of business caused by weather-related extremes. Because insurers have been reluctant to provide catastrophe-insurance coverage, the Chinese government has encouraged private insurers to participate in national and local climate-disaster-management pilots. In 2014, the city of Shenzhen’s Catastrophe-Insurance Program pilot made private catastrophe insurance available for the first time, enabling catastrophe risk to be shared between insurance firms and individuals.54 Since then, more catastrophe-insurance programs have been established, as shown in Table 1.The second type of insurance policy suitable for climate disasters is crop insurance, which covers the loss of crops from flooding, hail, drought, and so forth.55 This type of insurance has already played a crucial role in protecting farmers from weather-related extremes, with increasing liability and coverage between 2007 and 2018.56There is also parametric insurance. Catastrophe insurance and crop insurance are both forms of indemnity insurance, which requires proof of actual loss suffered.57 Parametric insurance, by contrast, provides payment when a predefined trigger event occurs or a particular index level is met, such as a flood or a certain amount rainfall.58 Parametric insurance potentially overcomes causation problems in climate-related disasters and provides for speedier payment. As of 2016, Guangdong Province provided a Parametric Meteorological Catastrophe Insurance to pay for damage caused by typhoons and rainstorms with a particular index level based on meteorological data.59Another possibility is liability insurance. Corporations such as power suppliers and vehicle manufacturers bear various forms of liability which might trigger an insurer’s duty of indemnity to policyholders for losses caused by climate change.60 However, such legal actions, particularly in relation to environmental causes, are not well developed in China.61 Hence, it is doubtful that liability insurance could play a role in adaptation.3.2Catastrophe Insurance as Governance in Managing Climate-Related DisastersCatastrophe insurance has gained attention as a means to adapt to climate change risk, both in theory and in practice.62 This section explores how catastrophe insurance might be used to supplement or even supplant state governance in China through the Whole-Nation System. The possibility and feasibility of regulation by catastrophe insurance in China will be discussed through an examination of its regulatory techniques. As private regulation, insurance operates stealthily by using technical tools to reduce moral hazard and by influencing risky behaviour so that more preventive action is taken.63 The regulatory techniques of catastrophe insurance include risk-based pricing, contract design (e.g. limits, deductibles, co-payments, and exclusions), loss prevention, claim management, and refusal to insure. As indicated earlier, these techniques both control the behaviour of the insured individual via adapted insurance-policy conditions and partially expose the insured person to risk.64Risk-Based Pricing. According to research carried out in China on ‘Willingness to Pay’ (wtp), many people are willing to pay a higher premium in order to acquire full coverage of property loss in catastrophic disaster.65 In setting such premiums, regional differences and construction types must be taken into account. For example, Shenzhen’s Catastrophe-Insurance Program includes two different interacting tiers of insurance. The first is the government’s catastrophe-assistance insurance which supplies a basic level of assistance to all citizens. In the case of low-income homeowners, Shenzhen’s municipal government will pay the cost of insurance in order to guarantee coverage. The next insurance tier is pure private catastrophe insurance to cover property loss, which will thus charge risk-based premiums. It provides a discount to those who adopt cost-effective risk-mitigation measures (e.g. against floods), thus providing a clear signal to those contemplating to locate to a hazard-prone area.66Contract Design. Survey respondents who have poor housing conditions tend to be more aware of disasters and have a strong desire for insurance.67 High deductibles may induce people to locate away from hazard-prone areas and opt for better construction. When setting deductibles for policies, construction type, house condition, and location should be important considerations. These tools of contract design are a common choice in China’s five catastrophe-insurance pilot programs.Loss Prevention. A significant proportion of survey respondents (24%) are not willing to purchase house insurance to cover disaster because they claim not to know much about insurance or they distrust insurers.68 Education, therefore, should be included in insurers’ loss-prevention services in order to create public awareness of mitigation of catastrophe risks, although this could also be a role for the government given the issue of mistrust.Claim Management. Insurers in China do not perform well on loss adjustment and claim settlement. A considerable section of survey respondents (23%) indicate that they do not trust insurers’ claim management.69 Fearful of receiving no payment at all after a disaster, they are not willing to purchase catastrophe insurance. Insurers, therefore, should increase their transparency and efficiency in order to gain the public’s trust.70Refusal to Insure. In 1998, the People’s Bank of China (the Central Bank) issued a Residential Mortgage Regulation.71 It states, in Article 25, that before a mortgage contract is concluded, the mortgagor is required to obtain household insurance or to relegate this task to the mortgagee. However, in 2006, China’s Banking Regulatory Commission issued a notice forbidding banks from stipulating with mandatory effect that residential mortgage insurance must be acquired.72 Although acquiring household insurance is not related to a mortgage, to loans, or to other financial services, it would be beneficial to review the feasibility of putting such concerted regulatory measures to use for the take-up of catastrophe insurance.Since China is not a purely market-based economy, its catastrophe/crop-insurance market faces special challenges. There is no specific catastrophe-insurance law or regulation in the country. However, there is in place a relevant Regulation on Agricultural Insurance. It was promulgated in 2013, and includes provisions on government-subsidized agricultural catastrophe insurance.73 Article 8 provides that the central government should establish subsidized agricultural catastrophe insurance. Local governments are encouraged to follow its lead and contribute to the pool. Article 17 prescribes that any insurance company wishing to underwrite an agricultural insurance policy must include coverage of catastrophe insurance. However, the regulation lacks detail about how the system will be established, the extent to which the government will subsidize policyholders, what it is that insurers should do in relation to catastrophe-insurance coverage, and other questions of implementation. Only Shenzhen’s Catastrophe-Insurance Program provides a diversification of climate-disaster risks through a public-private partnership involving the (local) government and the private market.3.3Limitations and Barriers to Climate Insurance as GovernanceIn general, both insurers and consumers may limit the effectiveness of regulation-by-insurance, as discussed above. Insurers face a number of obstacles in underwriting climate-disaster policies. The nature of the risks makes it difficult to fulfill insurability requirements. First, poor information impedes insurers’ efforts to identify, quantify, and estimate the chances of climate-related disaster and to set premiums. Second, China’s primary-insurance industry does not have the capacity to deal with climate-related catastrophes, as property-insurance companies do not have the capital fully to cover this type of loss.74 As a result, the supply of climate insurance is limited and volatile. Consumers, for their part, may ignore insurers’ risk-management advice, or have little interest in buying insurance at all.75 Due to the low probability of climate-related disaster, coupled with non-rational consumer behaviour, awareness of loss prevention is weak.76Consumer demand for catastrophe insurance in China has also been blunted by expectations of a government bailout. There has been a long history of preventing or responding to disaster losses. (In the Qing Dynasty, for example, the Records of Laws and Systems of the Qing Dynasty (大清会典事例) listed twelve articles on Disaster Defense and Reduction Policies.77) Because of China’s state-controlled economy and the lack of a private insurance sector in the period 1950–1978, the Chinese are more reliant on government bailouts than people in developed countries. Even now, under the Whole-Nation System, China’s citizens can count on government compensation, which reduces their incentive to purchase insurance cover and pay the corresponding premium.784Implications for Law and PolicyWhat are the implications of China’s case for adaptation law and policy?4.1Establishing a Legal Framework for Climate InsuranceThe prospect of the current catastrophe-insurance programs in China is uncertain. No specific climate-disaster or similar legal framework exists.79 Yet, insurance can only play its full role in adaptation where a legal framework is in place to facilitate this. In order to establish a well-functioning climate-insurance market, the different roles of government and the market will need to be clarified. The government needs to help solve market failures in climate insurance, secure insurers’ business operations using market mechanisms, and promote insurance techniques as forms of governance, rather than creating new government institutions to supplant private solutions.80 The Whole-Nation System needs to be reformed so as to avoid crowding out private insurance – it should instead enhance the collaboration between the private insurance industry and the government. Regulatory intervention should be geared toward establishing a mandatory climate-insurance system, to solve both supply and demand anomalies, while providing affordability measures. As Telesetsky argues, ‘the most important reason for mandating catastrophe risk insurance is to compel industry actors to take action under the supervision of the profit-motivated insurance’.81 Some of the detail of the needed legal infrastructure will be clarified in the subsections below.4.2Affordability of InsuranceIt is undeniable that ‘money talks’ in the implementation of adaptation measures relating to disaster prevention, recovery, and reconstruction.82 If insurance were made mandatory to compensate for climate-related losses (as we suggest), an affordability problem would arise for individuals living in poverty and exposed to climate risks. China’s local governments participating in the catastrophe-insurance pilot programs purchase only basic coverage for citizens; and insurers only pay for medical costs or pension costs in case of injury or death.83 However, in the case of an earthquake-insurance pilot program in Chuxiong county, Yunnan Province, the state paid the cost of every rural community’s insurance in response to their economic vulnerability.84 Various other remedies are possible to deal with the unaffordability of premiums.It is important that insurance premiums reflect risk.85 If individuals in disaster-prone areas lack the capacity to pay insurance premiums, the government could provide insurance vouchers, or policyholders could be reimbursed by the government for a portion of the costs of insurance coverage. A voucher system could incentivize individuals to adopt risk-mitigation measures. Coate has argued that, if the government makes in-kind transfers of insurance to the poor, they will not be dependent on disaster relief ex post in the case of loss.86 Subsidization of insurance premiums can avoid the charity hazard.87 There is indeed a trade-off between, on the one hand, the efficiency requirement of charging risk-dependent premiums, and, on the other hand, the equity problem that risk-dependent premiums will lead to unaffordability issues.88 Yet, there are many examples of innovative insurance solutions tailored to the circumstances of developing countries. Several countries have developed micro-insurance for natural disasters.89 Indonesia and Bangladesh have private micro-insurance for flood risk.904.3Public-Private PartnershipsAs noted above, due to various limitations, insurers may not be able to provide full coverage. After extensive flooding in Henan Province in July 2021, only 10% of total economic losses were covered by insurance companies.91 China’s Banking and Insurance Regulatory Commission has implemented the so-called Risk-Oriented Solvency System ii, commencing in 2022.92 This solvency regime requires insurers, as in the European Union,93 to hold sufficient asset capital in their reserves, including for catastrophe risks they are facing. In order to underwrite climate-disaster risks, insurers clearly require more financial capacity, as well as the ability to place a significant portion of the insured losses on reinsurers – private or government. It has therefore been suggested that the government could play a role in supporting climate-disaster insurance.94 There are several examples of governments promoting insurance capacity for disaster risks.95 We will first explain how such a regulatory model could function and then consider the example of Shenzhen’s Catastrophe-Insurance Program.4.3.1Government Acts as Reinsurer of Last ResortUnder a reinsurance contract, an insurer (the ceding company) is protected from exposure by transferring risk to a reinsurer.96 Climate-related losses might not be locally insurable for primary insurers, but might be globally insurable for reinsurers. To some extent, nevertheless, reinsurers face similar financing limitations as primary insurers, as there is often insufficient reinsuring capacity.97 The market distortions appear to be more related to supply (reinsurer) than demand (primary insurer). The explanation, focused on supply restrictions, is well documented in the law-and-economics literature.98 It demands some kind of government intervention. Still, the underlying philosophy is that private insurance should keep on playing a significant role in allocating compensation for victims of climate-related losses. This option can take the form of a multi-layered insurance programme.99 An example is the French Caisse Centrale de Réassurance (ccr). Insurers can reinsure the risk of natural hazards with ccr, which benefits from a state guarantee in the event that ccr exhausts its resources.100A government can act as reinsurer of last resort, helping to fill the ‘capacity gap’ of primary insurers in underwriting climate disasters, because governments have ‘a deep credit capacity’ and can raise money effectively and quickly through taxation or by issuing debt or government bonds in the wake of disaster.101 The government as reinsurer does not interfere with a private insurer’s business, including the underwriting of policies, the collecting of premiums, or the paying of claims, thus ensuring that the private insurance market can continue to play a leading role in climate-disaster adaptation.102 A model of reinsurance by government has been developed in several countries to deal with earthquake and terrorism risks.103 It is reasonable to assume that it could be a feasible method to deal with the risks of climate disaster.4.3.2Assessment of Shenzhen’s Catastrophe-Insurance ProgramIn 2014, Shenzhen’s Catastrophe-Insurance Program was the first of the pilots in China in which the government intervened to spread the risks associated with climate change through insurance.104 It consists of three interacting tiers of insurance or compensation funds. The first tier is the government’s catastrophe-assistance insurance, which is bought by Shenzhen’s municipal government from the People’s Insurance Company of China to supply basic assistance to all citizens. It functions as indemnity insurance: the insurance company will pay for medical and pension costs incurred from injury or death caused by a disaster. The second tier is a catastrophe fund managed by the city of Shenzhen. The fund’s capital sources include governmental appropriations and investment earnings. The third tier is pure private catastrophe insurance to cover property losses.105The Shenzhen Program applies several governance techniques of the insurance industry to minimize losses and protect those potentially affected by climatic hazards. In the Program, insurers worked in tandem with experts, the insured, and other stakeholders to identify technical and economic parameters of climate-related risks and develop system-wide technologies of loss prevention.106 Three important mechanisms of loss prevention are used.107 The first is risk research and risk education. Insurance companies are required to use 10% of the premium to organize research, disaster prevention, disaster-emergency relief drills, and disaster-emergency advertising. The second is a reporting system, by which insurers submit to the government a quarterly report on disaster-claim payments and an annual report on disaster-risk management, and they offer advice on risk prevention, emergency management, and disaster relief to the municipal government. The third mechanism is the operation of a disaster database. Catastrophe insurers are to operate such a database, including information on disaster time, location, intensity, damage, and claim payments, and share the information with the government.In addition, the Shenzhen Program offers risk-based premiums – the basic technique for creating incentives to reduce risk.108 Risk-based premiums enable insurers to provide a discount for the adoption of cost-effective mitigation measures.While the Shenzhen Program is a promising start to providing basic coverage for citizens, there are a number of issues with applying the pilot as a model for future insurance schemes designed to enhance climate change adaptation.109 The primary concern is that the government’s catastrophe-assistance insurance may inadvertently compete with the private-insurance market in the coverage areas financed by the government. A second concern is that the success of the model depends on the fiscal capability of the local government.110 Through international cooperation, the model could instead consist of private (both international and domestic) reinsurance and insurance-linked securities. These two instruments would help spread the cost of catastrophe losses covered by primary insurers in the private market and provide substantially greater capacity. Meanwhile, assuming the risks of any losses above a predetermined threshold, a government-funded backstop (i.e. government-sponsored reinsurance) could promote the entry of private insurers and also act as reinsurance of last resort.1115ConclusionIn this article, we presented insurance as an instrument of climate change adaptation. Insurance has much potential in this respect. It can provide compensation after a climate disaster has happened. Through control of moral hazard risk, insurers can act as de facto regulators by requiring preventive behaviour from insured individuals, thus reducing the potential impact of a catastrophe and contributing to adaptation. Regulation is, in a sense, outsourced to insurers. The example of Shenzhen’s Catastrophe-Insurance Program shows that, by charging risk-based premiums, incentives can be provided to prevent people from locating themselves in hazard-prone areas.By considering the case of China, we have attempted to show that advances in catastrophe insurance can be realized in practice, but that there are limitations and barriers still to be overcome. The crucial point is that there is an important role for government to play, especially in stimulating the insurability of climate-related risks. The downside, in a purely technical sense, is that the government will sometimes generously provide compensation to disaster victims, thus reducing the incentive for prevention112 and for obtaining insurance.113 This problem arises in China, with its strong reliance on the government providing compensation (the Whole-Nation System).We noted that climate-related disaster insurance is not widespread yet, for various reasons. Potentially affected people may lack adequate information about the advantages of insurance and they may distrust insurers. This problem arises in China, where the insurance gap for climate disasters is huge. It is precisely for this reason that a variety of legal interventions is indicated. A first important step is that climate insurance should be made mandatory in order to remedy the anomalies on the demand side. Persons potentially affected, especially in poor areas, may be unable to pay the insurance premium. A smart government intervention can be geared towards subsidizing the purchase of insurance rather than providing direct relief to victims. The pilot programs in China do exactly that. Given the large scope of the potential damage, insurers may be unable to provide full cover. Therefore, the development of a multilayered program is necessary, whereby the government stimulates the functioning of the insurance market by acting as reinsurer of last resort. The Shenzhen Program is a step in that direction, although a better solution would be to restructure the model so that (private) insurance and reinsurance would provide the first and second tiers of compensation, whereas the government would intervene only as a reinsurer of last resort. In this way, adequate compensation for climate-related disasters could be provided, yet the insurance sector would still exercise its de facto regulatory role by providing incentives for adaptation.China’s case helps to focus discussion on adaptation to climate change through insurance. With the possible exception of Shenzhen’s Program, China, like many other countries, still has a long way to go in this respect. Given the inevitability of climate disasters, insurance regulation is called for to make comprehensive climate insurance mandatory; to smartly subsidize premiums (on the condition of investing in prevention) in order to make them affordable; and to stimulate supply by allowing the government to act as reinsurer of last resort. Through this public-private partnership, the government can contribute to adaptation by using the de facto regulatory powers of insurers.

Journal

Climate LawBrill

Published: Feb 28, 2022

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