The Economics of Endogenous, Climate-Driven Extreme Events and Insurance

In this article we extend the literature on climate change and economic growth in two ways. Firstly, we allow for endogenous extreme events both in strength and frequency. Secondly, we introduce insurance in this framework. We build a theoretical growth model and discuss the role of precautionary decisions, which we find to have ambiguous effects on consumption and abatement growth. We observe that the theoretical model analytically corresponds to the DICE model if we allow for a fair insurance premium which is fully internalized. We then develop a fully calibrated integrated assessment model. Our main results are that transparency of the insurance sector is the most important determinant for the evolution of the main economic and environmental variables; different Poisson paths may lead to vastly different outcomes; the expected Poisson path nearly coincides with an internalized full insurance scenario; false beliefs on the frequency of extreme events play a minor role; technical change does not lead to a qualitative change in the ordering of the paths but will be more in line with sustainability criteria. JEL Classification: Q5; O1.