Tag: insurance

Many UK coal mines closed in the 1970s and 80s. Coal extraction was too expensive in the UK to compete with cheap imported coal and many consumers were switching away from coal to cleaner fuels. Today many shale oil producers in the USA are finding that extraction has become unprofitable with oil prices having fallen by some 50% since mid-2014 (see A crude indicator of the economy (Part 2) and The price of oil in 2015 and beyond). So is it a bad idea to invest in fossil fuel production? Could such assets become unusable – what is known as ‘stranded assets‘?

In a speech on 3 March 2015, Confronting the challenges of tomorrow’s world, delivered at an insurance conference, Paul Fisher, Deputy Governor of the Bank of England, warned that a switch to both renewable sources of energy and actions to save energy could hit investors in fossil fuel companies.

‘One live risk right now is of insurers investing in assets that could be left ‘stranded’ by policy changes which limit the use of fossil fuels. As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit. There are already a few specific examples of this having happened.

… As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit. There are already a few specific examples of this having happened.’

Much of the known reserves of fossil fuels could not be used if climate change targets are to be met. And investment in the search for new reserves would be of little value unless they were very cheap to extract. But will climate change targets be met? That is hard to predict and depends on international political agreements and implementation, combined with technological developments in fields such as clean-burn technologies, carbon capture and renewable energy. The scale of these developments is uncertain. As Paul Fisher said in his speech:

‘Tomorrow’s world inevitably brings change. Some changes can be forecast, or guessed by extrapolating from what we know today. But there are, inevitably, the unknown unknowns which will help shape the future. … As an ex-forecaster I can tell you confidently that the only thing we can be certain of is that there will be changes that no one will predict.’

The following articles look at the speech and at the financial risks of fossil fuel investment. The Guardian article also provides links to some useful resources.

Articles

Bank of England warns of huge financial risk from fossil fuel investments The Guardian, Damian Carrington (3/3/15)
PRA warns insurers on fossil fuel assets Insurance Asset Risk (3/3/15)
Energy trends changing investment dynamics UPI, Daniel J. Graeber (3/3/15)

Speech
Confronting the challenges of tomorrow’s world Bank of England, Paul Fisher (3/3/15)

Questions

  1. What factors are taken into account by investors in fossil fuel assets?
  2. Why might a power station become a ‘stranded asset’?
  3. How is game theory relevant in understanding the process of climate change negotiations and the outcomes of such negotiations?
  4. What social functions are filled by insurance?
  5. Why does climate change impact on insurers on both sides of their balance sheets?
  6. What is the Prudential Regulation Authority (PRA)? What is its purpose?
  7. Explain what is meant by ‘unknown unknowns’. How do they differ from ‘known unknowns’?
  8. How do the arguments in the article and the speech relate to the controversy about investing in fracking in the UK?
  9. Explain and comment on the statement by World Bank President, Jim Yong Kim, that sooner rather than later, financial regulators must address the systemic risk associated with carbon-intensive activities in their economies.

Britain has faced some its worst ever weather, with thousands of homes flooded once again, though the total number of flooded households has fallen compared to previous floods. However, for many households, it is just more of the same – if you’ve been flooded once, you’re likely to be flooded again and hence insurance against flooding is essential. But, if you’re an insurance company, do you really want to provide cover to a house that you can almost guarantee will flood?

The government has pledged thousands to help households and businesses recover from the damage left by the floods and David Cameron’s latest step has been to urge insurance companies to deal with claims for flood damage as fast as possible. He has not, however, said anything regarding ‘premium holidays’ for flood victims.

The problem is that the premium you are charged depends on many factors and one key aspect is the likelihood of making a claim. The more likely the claim, the higher the premium. If a household has previous experience of flooding, the insurance company will know that there is a greater likelihood of flooding occurring again and thus the premium will be increased to reflect this greater risk. There have been concerns that some particularly vulnerable home-owners will be unable to find or afford home insurance.

The key thing with insurance is that in order for it to be provided privately, certain conditions must hold. The probability of the event occurring must be less than 1 – insurance companies will not insure against certainty. The probability of the event must be known on aggregate to allow insurance companies to calculate premiums. Probabilities must be independent – if one person makes a claim, it should not increase the likelihood of others making claims.

Finally, there should be no adverse selection or moral hazard, both of which derive from asymmetric information. The former occurs where the person taking out the insurance can hide information from the company (i.e. that they are a bad risk) and the latter occurs when the person taking out insurance changes their behaviour once they are insured. Only if these conditions hold or there are easy solutions will the private market provide insurance.

On the demand-side, consumers must be willing to pay for insurance, which provides them with protection against certain contingencies: in this case against the cost of flood damage. Given the choice, rational consumers will only take out an insurance policy if they believe that the value they get from the certainty of knowing they are covered exceeds the cost of paying the insurance premium. However, if the private market fails to offer insurance, because of failures on the supply-side, there will be major gaps in coverage.

Furthermore, even if insurance policies are offered to those at most risk of flooding, the premiums charged by the insurance companies must be high enough to cover the cost of flood damage. For some homeowners, these premiums may be unaffordable, again leading to gaps in coverage.

Perhaps here there is a growing role for the government and we have seen proposals for a government-backed flood insurance scheme for high-risk properties due to start in 2015. However, a loop hole may mean that wealthy homeowners pay a levy for it, but are not able to benefit from the cheaper premiums, as they are deemed to be able to afford higher premiums. This could see many homes in the Somerset Levels being left out of this scheme, despite households being underwater for months. There is also a further role for government here and that is more investment in flood defences. If that occurs though, where will the money come from? The following articles consider flooding and the problem of insurance.

Articles

Insurers urged to process flood claims quickly BBC News (17/2/14)
Flood area defences put on hold by government funding cuts The Guardian, Damian Carrington and Rajeev Syal (17/2/14)
Flooding: 200,000 houses at risk of being uninsurable The Telegraph (31/1/12)
Govt flood insurance plan ‘will not work’ Sky News (14/2/14)
Have we learned our lessons on flooding? BBC News, Roger Harrabin (14/2/14)
ABI refuses to renew statement of principles for flood insurance Insurance Age, Emmanuel Kenning (31/1/12)
Wealthy will have to pay more for flood insurance but won’t be covered because their houses are too expensive Mail Online, James Chapman (7/2/14)
Buyers need ‘flood ratings’ on all houses, Aviva Chief warns The Telegraph, James Quinn (15/2/14)
Wealthy homeowners won’t be helped by flood insurance scheme The Telegraph(11/2/14)
Costly insurance ‘will create flood-risk ghettos and £4.3tn fall in house values’ The Guardian, Patrick Wintour (12/2/14)
Leashold homes face flood insurance risk Financial Times, Alistair Gray (10/2/14)

Questions

  1. Consider the market for insurance against flood damage. Are risks less than one? Explain your answer.
  2. Explain whether or not the risk of flooding is independent.
  3. Are the problems of moral hazard and adverse selection relevant in the case of home insurance against flood damage?
  4. To what extent is the proposed government-backed flood insurance an equitable scheme? Should the government be stepping in to provide insurance itself?
  5. Should there be greater regulation when houses are sold to provide better information about the risk of flooding?
  6. Why if the concept of opportunity cost relevant here?
  7. How might household values be affected by recent floods, in light of the issues with insurance?

Everyone who drives in the UK is required to take out car insurance. Whilst fully comprehensive is voluntary, it is compulsory to have at least third party insurance, which covers damage to other vehicles. Insurance premiums are calculated based on a number of different variables, such that two people driving the same car may face wildly different costs.

Although there are many insurance companies to choose from, this industry has been referred to the Competition Commission by the OFT as it was ‘worried the structure of the market was making costs and premiums unnecessarily high.’

According to Moneysupermarket, the average cost of car insurance reached a high of £554 in April 2011, but have fallen by £76 since. With tight incomes across the UK for many families, high car insurance premiums is another strain and thus this investigation will come at an apt time, even though the findings of the CC may not be reported for 2 years. The Association of British Insurers (ABI) said that the investigation would:

‘bring much-needed reforms to the market that will, in turn, result in lower car insurance premiums for consumers’.

The problem seems to be that when an individual is involved in an accident and sends their car off for repairs, their insurance company doesn’t have much control over the bills they end up paying, which can be inflated by £155 each time. This therefore leads into higher costs for the insurance company, which are then passed on the driver in the form of an increased premium. Other concerns were that courtesy cars were being offered, at an estimated cost of £560 per vehicle (according to the OFT) and that drivers were using these cars for longer than necessary, once again causing costs to rise.

Altogether, it has been suggested that the actions of the insurance company of ‘not-at-fault’ drivers, car hire companies, repairers and brokers push up the prices for ‘at-fault’ drivers’ insurance companies. Given that any insurance company is just as likely to be the ‘at-fault’ insurance company, they all face rising costs.

Back in May, the OFT had already decided that the car insurance market required a more detailed investigation, because of the ‘dysfunctionality’ of the market. Following a public consultation, the industry will now face an investigation by the CC. One additional area that may be of interest to the CC came to light last year, where it was found that insurance companies were claiming against themselves in a bid to drive up premiums. Although the investigation will take some time, it is still a timely review for many drivers, who have seen the cost of motoring reach record highs. The following articles consider the market for car insurance.

Articles

Car insurance market referred to Competition Commission BBC News (28/9/12)
No quick fix for motor insurance abuses, says watchdog Independent, Simon Read (29/9/12)
Car insurance industry faces probe The Press Association (28/9/12)
Competition Commission referral will take time to lower motor insurance premiums The Telegraph, Rosie Murray-West (28/9/12)
UK car insurance probe over-shadows Direct Line IPO Reuters, Matt Scuffham and Myles Neligan (28/9/12)
Car insurance scrutinized over high premiums Sky News (28/9/12)
Rip-off motor insurance firms face competition watchdogs probe over £225million racket Mail Online, Ray Massey (28/9/12)

Questions

  1. Why are car insurance firms willing to take on other people’s risks?
  2. What conditions must exist in a market for private companies to provide acr insurance (or insurance of any kind)?
  3. Why is third-party insurance compulsory, whereas people can opt for fully comprehensive insurance?
  4. What powers does (a) the OFT and (b) the Competition Commission have? Is it likely that this report will have any impact on car insurance premiums?
  5. What allegations have been made that help to explain why insurance premiums I this industry have increased?
  6. Is there an argument for allowing the industry itself to provide its own regulation?
  7. In which market structure would you place the car insurance industry?

Next year a government agreement with insurance companies is set to end. This agreement requires insurance companies to provide cover for homes at a high risk of flooding.

However, in June 2013, this agreement will no longer be in place and this has led to mounting concerns that it will leave thousands of home-owners with the inability either to find or afford home insurance.

The key thing with insurance is that in order for it to be provided privately, certain conditions must hold. The probability of the event occurring must be less than 1 – insurance companies will not insure against certainty. The probability of the event must be known on aggregate to allow insurance companies to calculate premiums. Probabilities must be independent – if one person makes a claim, it should not increase the likelihood of others making claims.

Finally, there should be no adverse selection or moral hazard, both of which derive from asymmetric information. The former occurs where the person taking out the insurance can hide information from the company (i.e. that they are a bad risk) and the latter occurs when the person taking out insurance changes their behaviour once they are insured. Only if these conditions hold or there are easy solutions will the private market provide insurance.

On the demand-side, consumers must be willing to pay for insurance, which provides them with protection against certain contingencies: in this case against the cost of flood damage. Given the choice, rational consumers will only take out an insurance policy if they believe that the value they get from the certainty of knowing they are covered exceeds the cost of paying the insurance premium. However, if the private market fails to offer insurance, because of failures on the supply-side, there will be major gaps in coverage.

Furthermore, even if insurance policies are offered to those at most risk of flooding, the premiums charged by the insurance companies must be high enough to cover the cost of flood damage. For some homeowners, these premiums may be unaffordable, again leading to gaps in coverage.

In light of the agreement coming to an end next year, there is pressure on the government firstly to ensure that insurance cover is available to everyone at affordable prices and secondly to continue to build up flood defences in the most affected areas. Not an easy task given the budget cuts. The following articles provide some of the coverage of the problems of insuring against flood damage.

Articles

200,000 homes ‘at flooding risk’ BBC News (3/1/12)
MPs slam government flood defences Post Online, Chris Wheal (31/1/12)
Flooding: 200,000 houses at risk of being uninsurable The Telegraph (31/1/12)
Flood defences hit by government cuts ‘mismatch’, says MP Guardian, Damian Carrington (31/1/12)
Fears over cash for flood defences The Press Association (31/1/12)
ABI refuses to renew statement of principles for flood insurance Insurance Age, Emmanuel Kenning (31/1/12)

Questions

  1. Consider the market for insurance against flood damage. Are risks less than one? Explain your answer
  2. Explain whether or not the risk of flooding is independent.
  3. Are the problems of moral hazard and adverse selection relevant in the case of home insurance against flood damage?
  4. If ABI doesn’t put in place another agreement to provide insurance to homeowners at most risk of flooding, what could be the adverse economic consequences?
  5. Is there an argument for the government stepping in to provide insurance itself?
  6. Explain why insurance premiums are so much higher for those at most risk of flooding. Is it equitable?

Most people are risk-averse: we like certainty and are generally prepared to pay a premium for it. The reason is that certainty gives us positive marginal utility and so as long as the price of insurance (which gives us certainty) is less than the price we place on certainty, we will be willing to pay a positive premium. By having insurance, we know that should the unexpected happen, someone else will cover the risk. As long as there are some risk-averse people, there will always be a demand for insurance.

However, will private companies will be willing to supply it? For private market insurance to be efficient, 5 conditions must hold:

1. Probabilities must be independent
2. Probabilities must be less than one
3. Probabilities must be known or estimable
4. There must be no adverse selection
5. There must be no moral hazard

If these conditions hold or if there are simple solutions, then insurance companies will be willing and able to provide insurance at a price consumers are willing to pay.

There are many markets where we take out insurance – some of them where insurance is compulsory, including home and car insurance. However, one type of insurance that is not compulsory is that for cyclists. No insurance is needed to cycle on the road, but with cycle use increasing and with that the number of accidents involving cyclists also increasing, the calls for cyclists to have some type of insurance is growing. If they are hit by someone without insurance and perhaps suffer from a loss of income; or if they cause vehicle damage, they will receive no compensation. However, whilst the risk of accident is increasing for cyclists, they are still statistically less likely to cause an accident than motorists. Perhaps a mere £30 or £40 per year for a policy is a price worth paying to give cyclists certainty. At least, this is what the Association of British Insurers (ABI) is claiming – hardly surprising when their members made a combined loss of £1.2 billion!

Articles

Cyclists ‘urged to get insurance’ BBC News, Maleen Saeed (26/11/11)
Cyclists urged to get more insurance by … insurance companies Road.CC, Tony Farrelly (26/11/11)
The future of cycle insurance Environmental Transport Assocaition (24/11/11)

Questions

  1. With each of the above conditions required for private insurance to be possible, explain why each must hold.
  2. What do we mean by no moral hazard and no adverse selection? Why would their existence prevent a private company from providing insurance?
  3. Using the concept of marginal utility theory, explain why there is a positive demand insurance.
  4. What might explain why cyclists are less likely to take out insurance given your answer to the above question?
  5. Do you think cyclist insurance should be compulsory? If governments are trying to encourage more sustainable transport policy, do you think this is a viable policy?