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Climate change and insurance: time to face the risks

With substantial challenges from climate change set to loom over the insurance industry for decades to come, the underlying risks need to be faced and understood

Calving Glacier Alaska - Hubbard Glacier - a huge iceberg calves into Disenchantment Bay - St. Elias Alaska. Taken from an Alaska cruise ship - near Yukon, Canada
Don Mennig/Getty Images/iStockphoto

The signals coming from climate change are increasingly hard to ignore. Climate change records are constantly being broken.

At 415 parts per million, carbon dioxide concentration in the atmosphere is at its highest level in 650,000 years. Global temperatures have risen by 2.1 degrees Fahrenheit since 1880. Nineteen out of the twenty hottest years have occurred since 2000. The world is losing 428 billion metric tons of sea ice each year, and global mean sea level is rising by 3.3 millimeters per year.

And for the insurance industry, climate change risk is already impacting the bottom line. Every business sector is being impacted to some extent, but insurers are on the receiving end of losses attributed to climate change which are already large - and the risk is accelerating.

In the US alone, (re)insurers are challenged by weather-related economic losses of $500bn over the last five years, according to the NOAA National Centers for Environmental Information.

And another $14.2tn more in assets are at risk due to coastal flooding, just one of the many perils impacted by climate change, according to research led by the University of Melbourne.

But what should insurers do - climate change is a long-term issue and insurers are in the business of insuring today’s risk. How can an insurer use climate change scenarios from organizations such as the Intergovernmental Panel on Climate Change (IPCC), that project atmospheric carbon dioxide concentrations over the mid- to long-term? The growing severity of the impacts is also wedded to many long-term factors on how the world tackles carbon dioxide emissions in the coming years.

The insurance industry might then take solace from the fact that insurance contracts are focused on the short-term, typically just a year. How do you tackle a long-term problem in a short-term focused business? And surely this short-term focus would limit any possible impact from climate change driven events?

It is not a sustainable approach to business, not knowing what the future might have in store, moving a year at a time and hoping not to get too badly stung. With such big risks looming over the industry, for decades to come, they need to be faced and understood.

You set a Big Hairy Audacious Goal (BHAG) to quantify and understand climate change risk in your business. But it is complex. Different perils respond in different ways to climate change, different regions are more under threat than others. The overall risk is interconnected and systemic; you need to distinguish between climate change which has already occurred and climate change in the future. And looking to the future, there is no one estimate for these future climate states. This all sounds too tough already.

Your business also needs the skills and capabilities to do this. Property and casualty (P&C) insurers, are adept at using sophisticated cat models for day-to-day risk management and pricing, from individual location to portfolio level.

But there is a gap on climate change risk, as almost half of P&C insurers lack a risk management climate change policy. To close that gap, investment is required, in tools and expertise that can provide answers to these climate change challenges.

It is not all doom and gloom. Insurers have deep experience in the risk management business, and although climate change is a big risk for the industry, like all risks, it also offers opportunities to outperform and move ahead of the competition. Simply put, the better you understand the risk, the more you can make of these opportunities.

One metric that is essential for all insurers is the combined ratio – is the business profitable? Assuming that climate change will continue to accelerate losses, without changes to your view of risk, risk selection, and the ability to price correctly, pressure from climate change impacts will push combined ratios over 100.

Having a view on the risk will mean you can quantify the impacts of climate change more accurately. For instance, being able to identify opportunities where market perceptions on climate change are maybe more pessimistic than the actual impact on risk. Or holding off on growing in markets where the risk and pricing are moving out of sync.

How else will having a grasp on climate change risk help your business?

  • Where a risk is poorly understood, there could be pressure to hold more capital. Demonstrating that you understand your climate change risks, and regularly conducting climate change specific stress testing to gauge the impacts, gives you answers to any questions around capital requirements.

  • Regulators are looking to establish the collective risks from climate change, with their own stress tests, such as the Bank of England Climate Biennial Exploratory Scenario (CBES) exercise which launches in June, with other regulators set to follow suit.

  • These demands for regulatory submissions are going to increase in regularity, rather than being a one-off. With this in mind, you will need to have a framework which is fit for purpose, is embedded in your processes, and which is efficient and repeatable. Having to reinvent the wheel each time a climate change regulatory request comes in will divert resources and bloat the expense ratio.

  • Increasingly, your counterparties and ratings agencies are going to expect a systematic understanding and integration of your climate change risk into your underwriting and risk management practices. By doing that, you can ensure your credit rating is stable and robust in the face of climate change and, as a reinsurer, expand the pool of cedants who will pay to transfer their risk to you.

Satisfying your regulator with submissions to climate change stress tests might represent the first time your business has to do an assessment of the physical impacts from climate change on your portfolios. Although these stress-test exercises are useful for all parties concerned, and RMS has helped many clients to do these, getting your own view of risk that not only satisfies reporting needs, but allows you to explore and take advantage of opportunities as mentioned before, is a recommended approach.

RMS is happy to share our experience of working with clients who want to better understand how the physical risks from climate change will impact their business, now and into the future. Our climate change pedigree extends back nearly 15 years, with RMS contributing to the IPCC Fourth Assessment report, and we are active with many industry, governmental bodies and NGOs.

Our work has been focused on quantifying both the economic impact of climate change, but also wider issues, such as the impact of changing land-use and natural habitats on economic losses.

This is a pivotal time to act on climate change risk within your business. Our consulting teams can help identify where the risks are within a portfolio, how they will look over time, and introduce modelling tools and best practice procedures to make the production of climate change metrics routine and embedded within your business.

Understanding climate change risk in your business could be a BHAG that can be achieved in the near future.