Climate Change and Risk Management: Existence Conditions for Efficiency Optimising Insurance Portfolios with Low-probability High-impact Risks

Abstract

Climate change may be associated with an increasing frequency of natural catastrophes, and possible ways of alleviating at least the related financial burden are of high importance. Catastrophe probabilities are low, but catastrophic events can have overwhelming effects, and insurance market solutions for catastrophe risk management are often unavailable. By focusing on the insurance industry's perspective, in which risk and profitability can be key decision factors, this paper aims to highlight a possible theoretical obstacle impeding further market development. In a stylised model the findings suggest that an essential feature of catastrophe risks (the inverse relationship between risk probability and risk impact) may lead to a situation where the theoretical availability of efficient insurance for low-probability high-impact risk is highly limited. This result underlines the value of appropriate catastrophe insurance and reinsurance product design that could theoretically contribute to alleviating efficiency problems.