Challenging Climate

Climate change is one of the most pressing issues that society faces, and with it comes a wide array of environmental, economic and social challenges.

That message is clear in the Intergovernmental Panel on Climate Change (IPCC) report, Climate Change 2014: Synthesis Report. “Warming of the climate system is unequivocal. The atmosphere and ocean have warmed, the amounts of snow and ice have diminished and sea level has risen,” the report points out.

And all these changes seem to be contributing to damaging, sometimes disastrous, events.

Thomas Coleman, Chief Research Officer, Global Risk Institute

In a set of comprehensive reports, the IPPC has linked climate change to an increase in the prevalence and severity of extreme weather events, including flooding, cyclones and wildfires, as well as detailed the widespread impact of climate change on food production, health and other segments of the economy.

Sufficient mitigation of climate change risk and the circumvention of the most severe effects of climate change will require both governments and private sectors to work together to achieve a resilient, low-carbon world.

The insurance industry, which provides protection and risk transfer to all sectors of the economy, is inherently susceptible to climate change-related risks. “[S]hifts in our climate bring potentially profound implications for insurers, financial stability and the economy,” Mark Carney, Governor of the Bank of England, suggested during a recent speech at Lloyd’s of London. “While there is still time to act, the window of opportunity is finite and shrinking,” Carney noted.

Consequently, the insurance industry should promote the timely development and implementation of long-term business strategies, risk management procedures and proper reporting frameworks that explicitly consider climate change.

IN THE KNOW

Given the nature of the business, climate change is certainly not a new concern to the property and casualty insurance industry. In fact, the first reinsurer reports on the potential rise in climate-related natural disaster losses were drafted in the early 1970s.

Alex LaPlante, Research Associate, Global Risk Institute

Since then, the insurance industry has continued to participate in climate-related efforts by collaborating with the scientific research community, developing climate-responsive products and performing internal assessments of climate change-related risks and opportunities.

Despite these efforts, the number of weather-related loss events recorded worldwide has more than tripled since the 1980s, Munich Re reported last year.

That increase has, in turn, resulted in corresponding inflation-adjusted insurance losses rising from an annual average of US$10 billion to almost US$50 billion over the past decade.

A new study from the Global Risk Institute, Climate Change: Why Financial Institutions Should Take Note, examines global warming’s impact on the world’s banks, insurers and pension funds.

For insurers, “as time goes on, climate change may undermine the soundness of insurers’ current catastrophe models, as well as diminish the effectiveness of existing portfolio diversification and risk transfer practices,” the study reports.

Attributing the observed growth in claims to a particular set of causes is difficult; however, research has shown that insurers have borne substantial costs as a result of climate change.

A 2014 report by Lloyd’s of London, for example, estimated Superstorm Sandy’s ground-up surge losses were 30% higher than they would have been if the sea level near Manhattan had remained at its 20 centimetre-lower 1950s level.

These costs will continue to grow as climate change progresses. In Florida, rising sea levels are projected to put an additional US$69 billion of coastal property at risk of inundation by 2030, and this figure will rise to US$152 billion by 2050, states the Risk Business Project report, Come Heat and High Water: Climate Risk in the Southeastern U.S. and Texas.

Moreover, in addition to direct losses due to climate-related weather, insurers have suffered – and will continue to suffer – indirect losses caused by climate-related resource scarcity and disruptions to global supply chains.

STRONG INCENTIVE

The insurance industry has a strong incentive to understand the full scope of the impacts of climate change – which are diverse, complex and uncertain – and manage all foreseeable material risks.

Clear risks

In a report last year, the Bank of England’s Prudential Regulation Authority detailed the three main avenues through which the insurance industry in the United Kingdom is susceptible to climate change: physical risk, liability risk and transition risk.

The most obvious implications of climate change – an increase in the frequency and severity of extreme weather events – pose direct physical risks by means of property insurance liabilities, devaluation of financial assets and real estate investments, and increased morbidity and mortality.

In addition, secondary events, including the disruption of global supply chain, resource scarcity or other macroeconomic, political or societal shocks, pose equally devastating indirect physical risks that have real implications on an insurer’s bottom line.

Model musings

Catastrophe models, which have been a key part of insurers’ risk management practices for decades, simulate the physical characteristics of likely weather events and estimate their resulting effects.

These models, paired with portfolio diversification and risk transfer, allow insurance companies to effectively evaluate and manage their physical risk in the short term. In the long term, however, climate change may impact the reliability and adequacy of these methods.

Most notably, the 2009 study, Climate Change and Risk Management: Challenges for Insurance, Adaptation and Loss Estimation, found that climate change exaggerates statistical properties such as global micro-correlations, fat tails and tail dependence that can significantly impact the efficacy of environmental risk estimations and diversification strategies.

For instance, Standard & Poor’s reported two years ago that if recent weather trends continue, current catastrophe loss estimates may be undervalued by as much as 50%.

Liability insurance, which provides protection from legal liability for damages that third parties suffer as a result of the insured’s actions, can expose insurers to considerable risk over a lengthy period of time. Additionally, determining the true cost of liability claims is complex and often uncertain.

Climate change liability

While the notion of climate change liability is still in its infancy, a growing body of evidence indicates that climate-related liability poses substantial risk to insurers, with existing litigation suggesting three primary lines of argument: failure to mitigate, failure to adapt and failure to disclose.

As laws governing climate-related liability evolve, insurers must consider how their liability risk is affected by the climate change exposure of the parties they insure.

STABLE BASE

Governments around the globe have come to the consensus that climate change is a primary threat to economic and societal stability. Although this has led to significant climate-related policy developments at both regional and national levels, there is still much uncertainty surrounding the timing, severity and regulatory mechanism of future policies, suggests a paper out of the London School of Economics and Political Science.

Transition risks are the financial risks associated with future adjustments – or lack thereof – that may be made in an attempt to achieve a low-carbon economy. These risks are driven by a wide range of factors, including modifications to public policy and regulation, technological advancement, material developments in climate science, and changes in investor sentiment.

On the liabilities side, transition risk presents itself much like physical risk and liability risk.

Uncertainty related to the choice of transition pathway and the associated climate trajectory translates into additional uncertainty about claims stemming from climate-related events.

Providing some clarity in this area, the IPCC laid out in 2014 several transition scenarios, emphasizing that “delaying mitigation efforts beyond those in place today through 2030 is estimated to substantially increase the difficulty in the transition to low longer-term emission levels.”

Failure to consider transition risks may also lead to mispricing of insurers’ assets.

Several studies have supported this notion, concluding that climate change and other environment-related factors are not being properly accounted for in financial and corporate decision-making, which may result in mispriced assets.

For example, a report last year by the University of Cambridge, Unhedgeable Risk: How Climate Change Sentiment Impacts Investment, estimated that if climate change action is not taken and appropriate climate-driven portfolio reallocation is not performed, global investment portfolios stand to lose as much as 45% as a result of short-term shifts in climate sentiment.

SOLID UNDERSTANDING

To effectively mitigate climate change risk, a deep understanding of the possible sources of exposure must be achieved. At the forefront of this discussion lies the need for clear, consistent and comprehensive climate-related financial disclosure.

To aid in this initiative, the Financial Stability Board established the Task Force on Climate-Related Financial Disclosure, which aims to develop a climate-related financial risk disclosure framework that would provide investors, lenders, insurers and other stakeholders with all of the necessary information for proper climate risk management.

Although climate change introduces unprecedented risks and uncertainties to the insurance industry, it also brings new opportunities.

At a recent appearance in Toronto, Carney pointed out that global carbon reduction commitments will generate clean infrastructure opportunities valued at about US$5 trillion to US$7 trillion annually.

For insurers, one such opportunity comes in the form of premium growth from new products such as renewable energy project insurance and public policy risk insurance to protect against unforeseen withdrawals of environmental subsidies. Moreover, there is the promise of new investment opportunities in clean technologies, emerging carbon-trading markets, green bonds and de-carbonization financing.

Climate change is a global issue that will affect all sectors of the economy.

Given their heavy integration in society, insurers are well-placed to take a lead role in promoting global resilience to climate change through the implementation of comprehensive climate-related risk management and mitigation processes, and through continued participation in international collaboration, engagement and research.

-Thomas Coleman and Alex LaPlante, Global Risk Institute