Cat risk assessment must shift from historic to predictive methods: report

Ocean warming and climate change can threaten the insurability of catastrophe risk in some areas and illustrates a need to shift from historic to predictive risk assessment methods, suggests a report released Monday by the international insurance think tank, The Geneva Association.

“In some high-risk areas, ocean warming and climate change threaten the insurability of catastrophe risk more generally,” states Warming of the Oceans and Implications for the (Re)insurance Industry, issued by the association’s Climate Risks and Insurance working group. “To avoid market failure, the coupling of risk transfer and risk mitigation becomes essential,” the report notes.

“By transporting vast amounts of energy and being the main source of water to the atmosphere, the oceans determine weather patterns and provide the energy needed for the development of extreme events,” the report says. “Understanding the changes of ocean dynamics and the complex interactions between the ocean and the atmosphere is the key to understanding current changes in the distribution, frequency and intensity of global extreme events relevant to the insurance industry, such as tropical cyclones, flash floods and extra-tropical winter storms.”

Sea levels have increased approximately 20 cm over the last century, a rate that is accelerating, notes a statement from The Geneva Association. “Given that energy from the ocean is a key driver of extreme events, ocean warming has effectively caused a shift towards a ‘new normal’ for a number of insurance-relevant hazards.

This shift is quasi irreversible — even if greenhouse gas (GHG) emissions completely stop tomorrow, oceanic temperatures will continue to rise,” John Fitzpatrick, secretary general of the association, cautions in the statement.

Traditional approaches solely based on analyzing historical data increasingly fail to estimate today’s hazard probabilities, notes the study’s lead author and editor, Falk Niehorster from the Risk Prediction Initiative of the Bermuda Institute of Ocean Science.

“A paradigm shift from historic to predictive risk assessment methods is necessary. As a consequence, today’s hazard probabilities become more and more ambiguous and the report calls for scenario-based approaches and tail risk modelling to become an essential part of enterprise risk management,” it adds.

“The selection of scenarios should include a reasonably wide range of hypothetical, but scientifically justifiable scenarios, including an upper limit defining the worst case,” notes the report.

The report offers two key areas for addressing challenges:

• insurers adopt as best practice using dynamic modelling approaches to estimate time-dependent, medium-term outlooks in combination with scenario-based approaches (already widely used for long-term assessment) and move away from using stationary climatological approaches for estimating shorter-term risks; and
• governments and the private sector increase the resilience of communities by managing risks through a series of means, in particular, building resilient infrastructure.

In general, ambiguity leads to increased capital requirements for constant probability of ruin when compared to a well-qualified risk in a portfolio, notes the report. “For a given portfolio, the characteristics of the scenario distribution will decide if the prices for ambiguous insurance contracts should be higher or lower relative to a situation with no ambiguity.”

The report points out the most significant driver to rising insured costs is socio-economic factors, including the increasing wealth of individuals and the higher concentrations of development in coastal areas and on flood plains.

“However, the serious challenge to adequately estimate present-day hazard risks, which follows from ocean warming, puts additional pressure on a market that is already facing the stress of upward trends in absolute disaster loss.”

The association statement notes that a lack of historical and observational data means the return periods for climate-related events are volatile, making it difficult for insurers to price risks today based on data from the past adjusted for these dynamic upward cost trends.

“Furthermore, this is true also for the timing of loss claims and the correlations of losses within portfolios. This has direct implications for the financial risk in catastrophe insurance, appropriate levels of capital requirement and the pricing of insurance premiums,” the report adds.

The report cites three main drivers of change in loss potentials:

• greater volumes of water equates to greater risks – rising sea levels increase the risk of flooding or the potential impact of storm surges, decrease the protective lifespan of coastal infrastructure, and increase the damage potential from geophysical events because the risk of inundation is greater;
• drier dry and wetter wet – a warmer atmosphere contains more water and more energy, supporting the potential for greater intensity of extreme events and associated precipitation that, in turn, can increase loss potential; and
• effects on large-scale climate phenomena – such as El Niño, various monsoon systems or the North Atlantic Oscillation – are likely, but currently unknown because of the long timescales of ocean dynamics and the relatively short length of observational data.

“In general, the only way to ensure that ambiguous risk remain insurable is to promote risk mitigation today,” notes the report. “The insurance industry should play an active role in raising awareness of risk and climate change through risk education and disseminating high-quality risk information.”