In June 2024, the City of New York thrust the question of fit-for-purpose insurance into the spotlight with a proposed bill aimed at curbing what it perceives as predatory practices by insurers amidst a climate crisis.[1]
As homeowner premiums soar and accessibility to insurance dwindles, questions arise about the efficacy and fairness of current insurance models and architecture in addressing modern challenges. To comprehend the gravity of this situation, we must first situate insurance within the broader realm of finance.
Finance here is understood not in the limited thinking of a pot of gold at the end of a rainbow, but as an enabler of human needs across a spectrum of certainty and impact.
At its pinnacle lies insurance – designed to shield against high-impact events of uncertain occurrence - “black swan” events, effectively acting as a safety net against life’s unpredictabilities.Low Impact | High Impact | |
Relatively high certainty of occurrence (if and when) | Certainty of occurrence with low impact e.g. daily transactions like going to work Personal action – Current account, MPESA Structural action – improving payment systems reliability, trust e.g. mobile services, Visa card | Certainty of occurrence with high impact (e.g. buying a house) Personal action – Mortgage, Credit history Structural action – efficient capital allocation, a banking system that takes individual savings and directs them to capital projects so that they grow over time but are also secure and available when the event occurs. |
Relatively low certainty of occurrence(if and when) | Uncertainty of occurrence with low impact e.g. from cradle to grave – when we’ll get pregnant, when we get our job, when we get married, when we die. Personal action - Savings account for a rainy day Structural action – smoothing consumption: efficient capital allocation | Uncertainty of occurrence with high impact (e.g. accidental death, terminal diseases e.g. cancer, fire, weather catastrophes, war, pandemics) Personal action – Insurance, risk avoidance e.g. migrating out of a war-torn country, mutualization Structural action – mutualization and valuation: efficient mapping and valuation of idiosyncratic shocks, and thereafter matching and allocating present cashflows to future liabilities (actuarial valuation) |
Modern day insurance is first recorded in the 16th Century – a life insurance policy taken out on 18 June 1583 by William Gybbons, a salt merchant in London with the Office of Insurance within the Royal Exchange of London. However, the concept of insurance itself traces back centuries, rooted in mutualization—a communal pooling of risks. For instance, the Masai Osotua system remains resilient to date. Osotua’s literal meaning is “umbilical cord” - a gift-giving and risk pooling mechanisms of ensuring households restore their cattle herds after a catastrophe through receiving compensation from another household that was either not or less impacted.
A simple tale can help demystify how insurance works: Imagine a village where neighbors gather under the shade of an ancient tree, their hearts bound by a promise of mutual care in times of death. Each year, they set aside 100 units, knowing tragedy strikes rarely and unevenly. When sorrow touches one home, their pooled savings of 1,000 units ease the burden. As their village grows to a hundred families, and the cost of a tragedy still 1,000 units, then each family now needs to contribute just 10 units annually, making their collective strength to multiply. As time goes by, they spread across ten villages each with 100 families but keep true to their promise. Their strength grows even more. Now if after 10 years one village faces a pandemic and tragedy visits each of the hundred families in one village at once, the combined reserves of the 10 villages of 100,000 units, built over a decade, ensure stability and better still the 9 villages stand strong to support the affected village get back up.The health and stability of the insurance system, is undergirded by three principles: insurable interest, utmost good faith (Uberrimae Fidae), and the law of large numbers.
Insurable interest demands a genuine stake in what’s insured by the person seeking to take out. In the annals of insurance-lore, there exists a tale that epitomizes the essence of this principle—albeit through a dark chapter in history. Meet the "Black" Liverpool widows of the 1880s, a misleading moniker for white English women whose husbands perished at sea, likely in the hazardous slave trade routes of their time. Left without traditional means of support in an era when women’s labor was undervalued, these resourceful widows turned their homes into havens for transient seamen—distant friends and relatives seeking respite from their maritime journeys. Drawing from their firsthand experience with insurance payouts following their husbands' deaths, the widows embarked on a deceitful scheme. They secured life insurance policies for their lodgers, only to betray their trust by administering fatal doses of poison. Their actions, though cunning, demonstrated the dangers to the stability of a mutualization system when this principle that demands policyholders stand to suffer genuine loss from the harm or loss of the insured is violated.
Utmost good faith (Uberrimae Fidae) is a cornerstone of trust and honesty between insurers and policyholders. Picture a scenario where this trust is violated: a homeowner seeks insurance coverage without disclosing previous fire incidents caused by faulty wiring. To compound matters, they neglect to lock their doors (act irresponsibly) just because they are insured, making theft easier. Meanwhile, the insurer rushes the homeowner into signing documents without fully explaining the extensive list of exceptions and terms buried in the contract.
In a historical twist, in the very first recorded insurance contract involving William Gybbons taken out on 18 June 1583, the insurer attempted to evade payment following the death of Gybbons on 29 May 1584 by arguing before court that a year should be calculated at 28 days per month and therefore Gybbons had live more than 12 months! It took a two-judge bench three years, until 1587, to decide in favor of Gybbons' beneficiaries, ruling that the insurer must fulfill its promise. From its inception, the insurance industry has grappled with issues of honesty and integrity, perpetuating the belief that private insurance fails when most needed.The law of large numbers lies at the heart of the math on stability and sustainability of the insurance system. The earlier village story explains part of this law. The additional dimension is the avoidance of adverse selection. Adverse selection occurs when over time, those who are more at risk of experiencing catastrophe either by nature (e.g. being sickly or working in hazardous spaces like war zones) or by being of bad faith and violating the second principle, increase in number while the healthier principled individuals don't take up insurance either because they choose not to or they are excluded. Of course, where it is a public mandated system, this risk is naturally mitigated as there is no opt out. This lends to the argument that insurance has to be universal to work. In a private market, however, this risk of adverse selection that leads to market failure repeats itself classically – for instance the housing bubble in the USA.
The concept was well illustrated in a 1974 by George Arkelof on the “market of lemons” which has become a classic economics folklore. In a used car market, naturally, the sellers possess insider knowledge about their vehicles' quality: some are "peaches" (good cars) and others "lemons" (bad cars). Buyers, unable to discern between them just by appearance, offer only an average price that reflects the risk of unknowingly buying a lemon. Over time, frustrated sellers of “peaches” gradually exit the market, feeling undervalued. Meanwhile, sellers of “lemons” capitalize on the situation, flooding the market with their inferior vehicles. As the market becomes dominated by lemons and lacks trustworthy sellers of peaches, buyers become increasingly wary and unwilling to pay higher prices. Ultimately, this erosion of trust leads to market failure!In the practice of insuring, as the “lemons” increase the insurer is forced to increase the contributions (premiums) to meet the insurance promise of payment of now increasing payouts. It eventually gets to a point where the premiums are too high and it doesn’t make sense for the healthier lower risk “peaches” to stay on. This compounds the high premiums dilemma further and more people are unable to afford insurance — a scenario increasingly mirrored in New York's insurance landscape amidst escalating climate-related catastrophes.
In today's dilemma, however, the nexus of the climate crisis and insurance architecture presents a unique context where “all are lemons” (all are exposed to the catastrophe) and the option to exit is not feasible (no planet B). This raises the philosophical question of whether insurance, in its current form, is fit for purpose.
The climate crisis, a global challenge transcending borders and ideologies, underscores the inadequacies of current insurance frameworks. Unlike localized risks (that classically framed the insurance mathematics), climate impacts spare no region, class or creed. Historically, financial systems, including insurance, operated within imperialistic frameworks, often neglecting risks beyond geopolitical interests – recall the “black” widows in an era where “black” was a euphuism for exclusion. Devoid of bias, the insurance structures ought to have matched and allocated the profits accrued from fossil - fueled capital extraction to cater for the future high-impact loss and damages from the climate crisis.
The claim of not being aware of the catastrophe or its potential impact is null and void with a century of evidence. As early as 1896, Swedish scientist and Nobel laureate Svante Arrhenius published a seminal paper on the greenhouse gas effect. In 1974, scientists Mario Molina and F. Sherwood Rowland hypothesized the depletion of the ozone layer. Temperature records have shown unprecedented warming of the Earth’s surface since 1950. The insurance industry has had over 70 years to adapt but has failed, influenced by dominant ideological biases. The crisis we face today is not just ecological but also ideologic and systemic, resulting from centuries of inequitable practices and shortsighted policies.
The legacy of this myopic approach persists today, hindering global efforts to address loss and damages from the climate crisis comprehensively. The application of the three core principles that underpin insurance must evolve from their interpretations that perpetuated exploitation and exclusion to embrace a more inclusive, equitable and accountable approach.
At the heart of the journey towards reforming the global financial architecture, therefore, is reimagining insurance as a catalyst for resilience and equity – restructured to embody universal fairness and equitability hinged on the deeper lesson of the climate crisis that “a threat anywhere is indeed a threat everywhere”
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