Ppreviously laced You are two urns. Each contains 100 balls. You will be given a clear description of the contents of the first urn, which contains 50 red and 50 black balls. The economist conducting the experiment holds back on the second, saying only that there are 100 balls divided between red and black in a certain ratio. Then you will be offered a choice. Pick a red ball from an urn and get a million dollars. Which urn do you want to get from? Now try again, but select a black ball. Which urn this time?
Most people choose the first urn both times, although such a choice means there will be both more and fewer red balls than in the second urn. This fact is known as the Ellsberg paradox, named after Daniel Ellsberg, a researcher at the institute edge Corporation, a think tank best known for leaking documents regarding America’s involvement in the Vietnam War. Ellsberg, who died June 16, called the behavior ambiguity aversion. It was a departure from the rational choice model pioneered by mathematician John von Neumann, and evidence that knowing the likelihood of something can influence decision-making.
The experiment seems to be just another one of those cute puzzles economists love. In fact, it reveals a deeper problem facing the world in the fight against climate change. Not only are the probabilities of the consequences unknown – for example, the likelihood of hurricanes in the Caribbean ten years from now – but also the damage they could cause. Today, ignorance about the future has its price: ambiguity makes risks uninsurable or at least prohibitively expensive. The less insurers know about risk, the more capital they need to protect their balance sheets from possible losses.
In May, State Farm, California’s largest home insurance provider, pulled out of the market altogether, citing the cost of “spiking catastrophe risks.” Gallagher Re, a broker, estimates reinsurance prices in America have risen 50% this year after catastrophes in California and Florida. Few companies explicitly mention climate change — possibly a legacy of Republican attacks on “awake capitalism” — but it lurks behind the rising cost of insuring homeowners against fires, floods and hurricanes.
Insurance is an instrument of climate adaptation. In fact, actuaries play as big a part in the fight against climate change as activists. Without insurance, those whose homes burn in a forest fire or are destroyed by a flood lose everything. The destitute can become refugees. Insurance can also be an impetus for corrective action. Higher premiums that accurately reflect risk provide an incentive to adapt more quickly, whether by dissuading people from building in risk areas or encouraging people to leave fire-prone areas. If the prices are wrong, a hotter world will damage society more than it would otherwise. Politicians considering home insurance subsidies in flood-prone areas should take note.
Setting a reasonable price is made even more difficult by the fact that, in economist parlance, a warming world faces both “uncertainty” and “risk”. John Maynard Keynes described uncertainty as a situation in which “there is no scientific basis for forming any calculable probability”. As an example, he cited predicting the likelihood of war in Europe or whether a new invention would become obsolete. Risk, on the other hand, is understood to mean situations in which the relative probabilities are known: for example, picking a red ball from the first urn.
When it comes to climate change, the reality isn’t quite as dire as Keynes’ framework suggests, because scientists can help dispel some types of uncertainty. This is particularly true of what behavioral economists Daniel Kahneman and Amos Tversky call “internal uncertainty,” which relates to things known about the world rather than unknown future events. Unlike economists’ models, climate models are based on physical laws that have shaped the planet for thousands of years in fossils and Antarctic ice cores. It’s as if a scientist had observed the second urn for centuries and noted the number of black and red balls drawn out by different people over time. With solid evidence and a clear understanding of the process by which the observations are generated, the ambiguity disappears and the probabilities of potential catastrophes are better understood.
Natural catastrophe reinsurance is typically based on models incorporating the latest scientific evidence, rather than historical statistics, as extreme events are, by definition, rare. For reinsurers who ultimately care about their financial risk, models of the state of the built environment in vulnerable areas need to be kept up to date. This helps them calculate potential losses coupled with knowledge of the environmental conditions that lead to disasters. The former is generally a greater source of uncertainty than the latter, as the science of climate change is well understood and the data is constantly improving. Premiums may increase as a result of better knowledge rather than continued ignorance.
disaster capitalism
But even a perfect scientific model could not eliminate all uncertainties. Climate change brings with it both the chaotic world of politics and the clarity of physics. Scientists may be able to model how a planet 2°C warmer than in pre-industrial times increases the risk of wildfires in a given area, but there is no model that can predict whether policymakers are using the levers at their disposal to prevent such fires from starting. Imagine the economist conducting Ellsberg’s experiment taking bullets into the second ballot box and adding them depending on the outcome of a democratic process, international diplomacy, or the whims of a dictator.
Policies can also prevent proper risk accounting. California regulations prohibit insurers from using the latest climate models for pricing because it makes protection more expensive. The bonuses must be based on the average payout over the last 20 years and not on the latest scientific findings. It is understandable to avoid ambiguity. Sticking your head in the sand is just stupid. ■
Read more from Free Exchange, our economics column:
Erdoganomics is spreading all over the world (July 6th)
The illusion of working from home is fading (June 28th)
Can the West build up its armed forces cheaply? (June 22)
Also: Like the Buttonwood Column got his name
