Climate change is rising up the insurance agenda but so far the industry has lacked a holistic approach to the risks it poses. Inaction will be extremely expensive, warn Keith Leung and Ed Messer.

Change is one of the few things in life that we can be certain about. In many respects, climate change is no different from any of the transformations the world has faced in the past. Indeed, the climate has always changed and always will. What is uncertain is the magnitude of the anthropogenic contribution and the speed and severity of the consequences.

Over the past few years there has been a significant shift in relation to climate change, on both scientific and political fronts. The latest Inter-Governmental Panel on Climate Change (IPCC) report states that the scientific evidence of human-induced warming is irrefutable and that rapid adaptation measures are essential. The Stern Review supported this view, stating that the negative economic consequences of inaction far outweigh the costs of immediate actions. Political parties seem to be heeding this ominous statement, with many vowing to take action.

Within the insurance industry the response to climate change has been somewhat fragmented. Understandably many businesses view the risks associated with climate change as too broad, too vague and too complicated. This is due to the complex, multi-dimensional nature of the geophysical, political and social dimensions involved.

Charting the risks

The climate impacts on virtually every aspect of the insurance industry. Property, liability, casualty, business interruption and agriculture will all feel the impact of climate change to varying degrees. However, a unified approach to tackle a singular but broad risk such as climate change is an overwhelming challenge. Many choose to hide behind the unclear definition of climate change and adopt a “business-as-usual” mentality. The reactive nature of many in the insurance industry has generally led to an atmosphere of inertia on this issue.

However, the risks arising from climate change need not be regarded as vague, in fact quite the opposite. They can be broken down in a way that is tangible and can be acted upon.

An example of how risks from climate change can be broken down and classified is shown in figure 1. The chart shows the “knowledge” dimension on the vertical axis and the “speed” dimension on the horizontal axis. Having positioned the risk on the chart, a company can then adopt an appropriate strategy of risk management. This could be a specific risk transfer product in the insurance and reinsurance market, the desire to absorb the risks as a market in return for an adequate risk premium, or even the retention of such risks. It is possible to shift the risk up the vertical axis through better understanding as more research and analysis takes place.

Physical impact

Geophysical risks arise from anthropogenic warming, largely due to the emission of greenhouse gases during fossil fuel combustion. Such warming leads to unnatural fluctuations in the Earth’s meteorological cycles and ocean circulations. The anticipated impact includes sea level rise, shifts in seasonality and changes in precipitation. These irregularities add complexity to the weather system and affect the predictability, frequency and severity of storms.

Within the insurance industry, one could argue that the financial impact of natural hazards is fairly well modelled. All three major commercial vendors of catastrophe modelling software provide state-of-the-art natural peril models. However, after unexpected natural disasters, particularly a devastating hurricane season in 2005, catastrophe models were widely criticised for not anticipating the widespread damage and underestimating the insured losses.

These criticisms are not entirely the result of weaknesses in the models themselves. There is a blind obsession with benchmark figures derived from the models and these figures can be dangerously misleading. Models are still based on trends in natural variability and can therefore never be totally accurate, as nature is intrinsically dynamic. Models, and the modellers themselves, have growing responsibilities to improve methodology and to quantify uncertainty.

For insurance and reinsurance companies, there are additional steps that should be taken to fully understand exposures to the risks posed by climate change. For instance, how resilient are you to extreme losses? What kind of scenario could give rise to such losses and if the extreme losses were to become more frequent, what risk strategies could be adopted?

Emerging technologies

Mitigation or adaptation strategies for climate change give rise to new insurable risks that present opportunities for the industry. An obvious example is renewable energy. The global renewable energy market is projected to grow from $40bn in 2005 to $150bn in 2015. At present, wind power generation accounts for the majority of renewable energy. In the US for instance, wind power accounts for some 90% of renewable energy sources.

Wind power generation is a relatively new industrial process but shares many similar risk elements with more traditional forms of energy production. These include the construction of the turbines, the wind farms’ vulnerability to natural hazards (such as lightning, earthquakes etc) and the delivery of electricity.

Another emerging technology is carbon sequestration. This relates to the process of storing liquid carbon dioxide (potentially generating tradable carbon “credits”). This technology is a new industrial process and carries a significant element of risk. However, because of its potential to harness carbon emissions, it could become a key mitigation strategy for many countries.

The insurance and reinsurance industry has an obvious role in facilitating the transfer of such risks. It is essential for the risk bearers to understand the processes involved in these emerging technologies along with the severity of exposure. This understanding may lead to an objective ability to charge technically sound risk premiums, to ensure profitability, as well as to set aside a reasonable reserve to ensure liquidity of the company in the event of a loss.

Environmental liability

Environmental liability insurance is becoming increasingly important, particularly after the Massachusetts vs EPA trial in the US, which unequivocally labelled carbon dioxide as a “harmful pollutant”. Another type of insurable risk arising from the emission of carbon dioxide and other green house gases relates to the delivery of credits, known as Certified Emissions Reductions (CERs), introduced under the Kyoto Protocol.

Industrialised countries can gain CERs by investing in emission-cutting projects in developing countries. These can then be traded amongst industrialised countries as a commodity. Through purchasing credit delivery guarantee insurance products, buyers can receive protection against failure or delay in the approval, certification or issuance of CERs.

Political risks

As green issues continue to climb up the political agenda, it is fair to assume that new laws will be passed in an effort to increase corporate environmental responsibilities. Currently, legislation requires companies to report on environmental risks and liabilities including climate risk management strategies. Failure to comply with such legal requirements can be treated as negligence on behalf of the company and could therefore be viewed as an insurable risk.

On an international level, climate change also presents a significant degree of political risk. Scarcity of resources has been the root cause of many international conflicts. If the Earth continues to warm, fresh water resources could easily become a leading source of international conflict as a result of irregular precipitation, changing agricultural cycles, rising sea levels and an increase in demand and consumption patterns.

The four categories of risks discussed above are pivotal when discussing climate change and related opportunities for the insurance industry. They are distinct types of risks but are at the same time very much inter-linked and should not be looked at in isolation. However, it is unreasonable to design an all-encompassing insurance product that will cover such a wide range of exposures.

A commercial solution?

Despite its broad nature, it is not inconceivable that risks arising from climate change can be insurable. Like any other industry, the deciding factor is one of pricing: are clients prepared to pay the required level of premium? It is a matter of commercial judgment whether adequate profits could be made in taking on these risks. A related and crucial question is how far such risks can be transferred to the financial markets.

In order for insurers to make informed commercial decisions regarding new products, they must have a clear and quantified view of the risk and exposure involved. This is only possible through the transparent disclosure of risk information from all players along the chain of risk transfer.

A transparent and logical analytical framework across all business units will be essential in facilitating quantitative climate-risk transfer. We need to expand the volume of information on risk by persuading governments and their agencies that climate change is a challenging phenomenon and that the physical risks are becoming increasingly apparent. The result would be to allow a much greater flow of information and expertise to be focused on potential problems and possible solutions.

To some extent, the continual advancement of techniques like catastrophe modelling will improve our understanding of climate risk. The truth is that the risks posed by our changing climate are so broad that the impact will be felt across the whole spectrum of entities. A new, holistic approach to enterprise risk management in the face of this change is not only good practice but essential for the future survival of businesses.

Taking proactive steps to understand the risks, followed by careful selection of exposure and setting an adequate level of premium is the right way forward. This is preferable to the knee-jerk reactions of policy exclusion, sub-limits, sharp rises of premium and deductibles in the wake of each unexpected loss.

The industry has evolved beyond recognition since the days of estimating the probability of a ship safely docking at its destination with no more technological aids than a telescope, a sextant and a pocket watch in the early 1800s. In one of the fiercest challenges set by the very habitat we live in, inaction is not an option.

Keith Leung and Ed Messer are associates at JLT Re.

Professor Mark Maslin, head of geography at University College London, reviewed this article.