Climate change may undermine soundness of insurers’ current cat models: Global Risk Institute study

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, suggested a recent report from the Toronto-based Global Risk Institute (GRI).

“On the bright side, advances in clean technology and low-carbon infrastructure will open up new sources of premium growth through products such as renewable energy project insurance,” GRI said in a statement on Wednesday. “Similarly, new insurance products related to public policy risk, such as protection against the unforeseen withdrawal of environmental subsidies, could generate extra revenue.”

The report Climate Change: Why financial institutions should take note, released on Tuesday, was authored by Prof. Thomas Coleman, GRI’s chief research officer and Alex LaPlante, GRI’s research associate.

The report, which also examined implications to the banking industry and pension funds, noted that climate change has been a major concern for the insurance industry for many years, with the first reinsurer reports on the prospective rise in natural disaster losses due to changes in climate appearing in the early 1970s. Despite several (re)insurers participating in climate-related efforts, “the number of worldwide weather-related loss events has tripled since the 1980s, and inflation-adjusted insurance losses from these events have increased from an annual average of around US$10 billion to around US$50 billion over the past decade.”

GRI suggested that that ways in which the insurance industry may be impacted by climate change are “diverse, complex and uncertain. However, it is crucial for risk management and loss reduction purposes that all foreseeable material risks are considered.”

“The implications of climate change, including the increase in the number and severity of extreme weather events, pose obvious direct physical risks to insurers by means of property insurance liabilities, devaluation of financial assets and real estate investments, and increased morbidity and mortality due to severe weather conditions,” the authors wrote. “There are also secondary physical risks to consider which arise indirectly through subsequent events such as disruption of global supply chain, resource scarcity, or potential macroeconomic, political or societal shocks.”

Indirect physical risks could include financial market losses due to economic damage, declines in resource production resulting in scarcity an increased morbidity and mortality caused by indirect impacts of rising temperatures such as the increase in vector-borne diseases.

While in the short term, insurance companies are “quite well-equipped” to assess and manage their physical risks by way of cat modelling, portfolio diversification and risk transfer, the report said, in the long term, the effects of climate change may impact the soundness of current cat models and may reduce the efficacy of portfolio diversification and risk transfer. Consider that over the past 20 years, cat models have been extensively developed to simulate the physical characteristics of likely events and quantify their effects.

“These models are complex and have inherent uncertainty which will only be exacerbated by the uncertainties associated with climate change,” the authors wrote. “In particular, climate change intensifies properties such as global microcorrelations, fat tails and tail dependence which can greatly impact environmental risk estimations, and influence the effectiveness of diversification strategies.”

In addition, liability insurance poses a large risk to insurers over a broad timeframe. “In the context of climate change, there is already evidence of liability risks with existing cases suggesting three primary lines of argument: failure to mitigate, failure to adapt and failure to disclose.” While climate change litigation remains in its early stages, “as it evolves, insurers will have to consider how the climate change exposure of the parties they insure impact their own liability risks,” the report said, adding that there will likely be several changes and additions to existing climate change-related policies and regulations in the near- to mid-term.

Transition risk may impact both the liability and asset sides of an insurance company’s balance sheet. “By inducing uncertainty about the timing and extent of future climate change, transition risk creates additional uncertainty about claims stemming from climate-related events. In addition, mispricing of insurers’ assets may also occur if assets prices do not fully reflect the risk associated with climate change-related transition pathways.”

Despite the challenges, climate change introduces many new opportunities, the report said. The advancement of clean technologies and low carbon infrastructure offers new sources of premium growth by providing new insurance products, such as renewable energy project insurance. Similarly, new products relating to public policy risk, including those to cover unforeseen withdrawals of environmental subsidies, can also provide revenue growth.

Climate change also brings new investment opportunities in clean technologies, emerging carbon trading markets, and in “green” bonds, as well as in the financing of the decarbonization of the economy. “While there is still time for insurance companies to effectively manage climate change, the window of opportunity for economical mitigation is shrinking,” the report concluded. “In order to promote global resilience to climate change and support an orderly transition to a lower carbon economy, insurance companies should be willing to participate in international collaboration, engagement and research and unrelenting stress testing and risk modelling.”