Climate change - a business interruption crisis on the horizon
Climate-related risks are accumulating in supply chains, posing a growing threat to business interruption insurers and their clients.
Accurately mapping and quantifying supply chain risk is already a top priority for insureds and insurers. In an increasingly interconnected world, systemic events like Covid-19 and the Russia-Ukraine conflict have highlighted how vulnerable businesses and economies are to disruptions in trade, movement and inflation, as well as the scale of business interruption exposures lurking in the global system.
Climate change is a slow-moving crisis that could eventually overshadow even today’s complex supply chain risks. In fact, many insurers and clients may not fully understand the value of climate-related exposures already accumulating in supply chains and business interruption (BI) portfolios.
Since April 2022, more than 1,300 of the largest public and private companies in the UK have been required by law to quantify and disclose the climate-related financial risks and opportunities they face in line with Taskforce on Climate-related Financial Disclosures (TCFD) recommendations. This includes many large insurers, who must prove they have a good grip on how climate change risk could affect their insurance portfolios. The BI exposures alone, for example for the increased frequency of severe individual Nat Cat events, could be very significant.
Swiss Re Institute recently identified climate change as the biggest long-term threat to the global economy – threatening to shave 18% off global GDP by 2050 if no mitigating actions are taken, 11% off if global warming is kept to a 2°C increase on pre-industrial temperatures, or 4% off if Paris Agreement targets are met (under 2°C). Economies in Asia would be hardest hit, it said, with China – a huge producer of components feeding the global manufacturing supply chain – at risk of losing nearly 24% of its GDP in a severe scenario, while the US could lose close to 10% of its GDP and Europe almost 11%.
The (re)insurance industry has already felt the direct financial impact of climate change-related weather events, with six of the costliest years of all time for weather-related insured losses occurring between 2011 and 2021, according to Swiss Re. BI has significantly exacerbated the financial fallout from these events, and the risks posed to global supply chains escalate as climate change worsens.
McKinsey projected, for example, the probability of a hurricane of sufficient intensity to disrupt semiconductor supply chains may grow two to four times by 2040. The Intergovernmental Panel on Climate Change (IPCC) also warns extreme weather and global warming will drive up prices for essential goods. We have already had a taste of how that feels in 2022 and inflation could get worse if floods, wildfires, droughts and extreme weather events create new energy shortages, socio-political tensions and trade disruptions.
Identifying a high-risk supplier that sits in a hazard zone today requires complete supply chain transparency. However, the harder – and increasingly important part – is identifying how loss patterns will evolve over time and which new sites and supplies could be exposed to climate-related perils in 10, 20 or 50 years’ time. A location that may only have limited exposure to physical peril today could be in a drought, flood or wildfire zone in the future.
Predicting which sites and suppliers in supply chains could be impacted, and what the financial implications could be, is extremely important for insurers and supply chain-dependent clients alike – but it is not an easy task.
Quantifying BI exposures in supply chains and insurance portfolios is already complex. Many multi-billion-dollar industries, including batch and complex manufacturing, motor, pharma, biotech, medical devices and power to name a few, are reliant on complex multi-supply chains, with interdependent suppliers dotted all around the world. The shortage or delay of an input component worth a few dollars manufactured in one part of the world can cause millions in lost profits and BI claims downstream.
The first step is to identify which supply nodes are critical to the manufacture of goods and what physical and non-physical perils they are exposed to. Improvements in the granularity and availability of data is enabling accurately geocoded property attributes like elevation, building materials and transport links or even non-physical factors like political or compliance risks to further refine the risk assessment.
Mitigations should then be put in place to manage those risks (such as stock redundancies, alternative suppliers and adaptive protective measures). This then feeds into a projection of the total profit at risk from any supply chain disruption. These exposures and outage values must continually be monitored and revisited at both a client and portfolio level.
It is extremely prudent to overlay climate change scenarios onto those calculations, as the profit at risk in these scenarios will vary significantly. Given their modelling capabilities, insurers are in a great position to help clients with these assessments. Failing to attempt this will increasingly be seen as negligent – illegal even – though it is not as straightforward in practice as it sounds.
As loss patterns evolve, traditional weather and catastrophe exposure models based on historical losses become increasingly redundant, so insurers need reliable predictive models to project future losses across various global warming scenarios. The world’s largest and most sophisticated carriers and cat modelling firms are making good headway on this; many insurers already lean on Munich Re’s NATHAN, for example, or other third-party modelling tools for their predictive climate scenario capabilities, though many are still working out how best to embed climate change risk into their methodologies and decision-making processes.
It will soon be possible to integrate climate scenario models from leading providers directly into supply chain risk assessment tools and it is essential insurers recognise the value this will bring – from enabling reporting and compliance and helping clients manage risks more effectively, to selecting and pricing risks more accurately, setting appropriate limits and avoiding unmanageable BI exposures aggregating.
This year has shown us climate change is not a future risk – it is already here. Insurers need to start mapping and quantify the risk this poses to supply chains today, or the financial implications they and their clients could face tomorrow will be increasingly severe.