The Theory of Mutual Insurance: Some Notes on History, Theory, and an Application to Climate Change

Abstract

We observe dynamic trends of increasing magnitude in natural disasters and climate-related damages, which ultimately lead to probability distribution functions with very fat tails. This implies a “race in the extreme tail between how rapidly probabilities are declining and how rapidly damages are increasing” [Weitzman, 2009, p. 1]. To cope with these significant long-term risks, characterised by a high degree of uncertainty and correlated events, standard economic instruments and insurance products are inadequate. Even the appeal to capital markets and the securitisation via ILS leads to a huge remaining protection gap. Therefore, either a very high level of capital reserves is needed (in the reserve theory of insurance) with all its associated problems, or an intergenerational allocation is called for, which can only be provided by the State or Mutual Insurance. The goal of this paper is to convince readers that mutual insurance is the only solution for coping with these disaster risks. It therefore starts with a short history of Mutual Insurance, gives a concise introduction to the Mutual Insurance Theory, and ends with an application of this theory to the risks and damages of climate change.