Rebecca Green contributed to the writing of this blog.
On 29 September 2015 Mark Carney, Governor of the Bank of England, gave a speech at this year’s City Dinner in the Lloyd’s building.
He discussed the ways in which climate change is likely to affect the insurance sector and how climate change action could leave oil, gas and coal 'stranded' and 'unburnable'. He added that "climate change will threaten financial resilience and longer term prosperity. While there is time to act, the window of opportunity is finite and shrinking."
Changes in the last 30 years
Internationally there is growing agreement that climate change is indisputable, with research showing that:
- in the northern hemisphere the last 30 years have been the warmest since Anglo-Saxon times - eight of the ten warmest years on record in the UK have occurred since 2002
- atmospheric concentrations of greenhouse gases are at levels not seen in 800,000 years
- the rate of sea level rise is quicker now than at any time over the last 2,000 years
In the past 30 years we have seen the number of loss events associated with the weather triple and insurance losses have increased from an annual average of around $10bn in the 1980s (adjusted for inflation) to about $50bn over the past 10 years.
Risks to the insurance industry
The PRA has produced a report outlining the impact of climate change on British insurers which concludes that they are exposed to all three of the below risks, and while the sector is well-placed to manage these risks in the short-term, it does not mean that the future is secure. Longer term risks could have a severe impact on insurance companies and their policyholders, with general insurers the most exposed to these loses.
Generally, climate change can affect financial stability in one of three ways:
- physical risks such as floods and storms which damage property and disrupt trade
- liability risks from parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible
- transition risks such as those that could arise from the move towards a lower-carbon economy
Physical and liability risks
Climate change has the potential to affect the frequency and severity of extreme weather events which could results in longer and hotter heatwaves, worse droughts and an increase in the number of severe storms. While insurers are recognizing that the tails risks today are likely to be the catastrophic norms of the future, further ahead, increasing levels of physical risk due to climate change could present significant challenges to general insurance business models.
For example, although the winter of 2014 has been England’s wettest since the 1700’s, forecasts suggest that there will be a further 10% increase (if not more) in future winters. There are some estimates that currently insurance modelled losses could be undervalued by up to 50%, if recent weather trends were to prove to be the new norm.
"Insurers need to accept that climate change is becoming an increasingly important issue in the insurance market and factor this into their business models"
Looking in more detail at transitional risks, the UK insurance sector manages almost £2tn in assets in order to match their liabilities, which may span decades. Policy change towards a low-carbon economy could encourage a fundamental reassessment of investment strategy, impacting the industry as a whole. It is likely that oil, gas and coal will become unburnable without expensive carbon capture technology, leading to fall in the financial markets.
UK insurance companies are highly exposed to these shifts; currently 19% of FTSE 100 companies are invested in natural resource and extraction sectors and a further 11% by value are in power utilities, chemicals, construction and industrial goods sectors.
This is not all bad news though; taking part in financing the de-carbonisation of the economy is an opportunity for insurers to make a long-term investment in infrastructure assets at roughly quadruple the present rate.
If a reassessment of investment strategy were to occur suddenly this could potentially destabilise markets, spark a pro-cyclical crystallisation of losses and a persistent tightening of financial conditions. In his speech, Carney concluded this with the statement that “The more we invest with foresight; the less we will regret in hindsight.”
"Actuaries can play a crucial role in managing the impact of climate change"
How to manage these risks
Actuaries can play a key role in understanding and communicating the risks associated with climate change.
Pricing/Exposure management - Climate change can impact pricing actuaries in several ways. Insurance extending in to new markets not covered by existing models will pose questions. We need to understanding the business that is being written, including the varying exposure for different perils.
"Insurers can take a more active role in supporting a low-carbon economy e.g. by financing the de-carbonisation of the economy. If they don’t the potential financial losses could be significant"
Reserving - With the emergence of new risks actuaries may have to place less reliability on historical data. New methods may have to be utilised to overcome this issue.
Capital Modelling - Improvements in risk modelling must be implemented as extreme events become more frequent and more severe. Increasingly volatile weather trends and hydrological cycles make the future even more difficult to predict. In particular, it is important to understand the non-modelled catastrophes (CAT) and non-modelled regions that falls outside of the catastrophe models.
Actuaries should look to improve their understanding of the potential impact of climate change in all the areas mentioned above, for example, more stress and scenario testing can be used to help.
Investments – Investment managers can explore new capital market tools, such as CAT bonds, micro-insurance and weather-based insurance.
UN climate summit
Two months on from this speech and the UN climate summit has just taken place in Paris from November 30 to December 11. For the first time, the Paris agreement not only states that the rise in temperature needs to be kept below 2°C but that our target should be 1.5°C. The aim is for greenhouse gas emissions to peak as soon as possible, with countries aiming to achieve carbon neutrality in the second half of the century by gradually stopping the use of fossil fuels.
This is an issue that the insurance industry cannot afford to ignore!