Price climate risk – or perish

Image: ISTOCKPHOTO/ALEXSL

In the wake of Hurricane Irene, insurance companies are reminded of just how much they stand to lose from the impacts of climate change – insurers now face an estimated $ 5-7 billion in damage claims (though probably few from Waffle House). However, last week Ceres, a non profit American network of private investors and organizations dedicated to integrating sustainability into capital markets, published a report that showed that only 1 in 8 major US insurers had formal policies in place to deal with climate change. Although there is broad consensus among both large and small industry players that climate change poses real and present threats that need to be factored into risk models, few insurers (particularly among middle and smaller players) had formal policies in place to model or manage these risks.

Europe-based players like Allianz are building climate change into their models across all lines of insurance, including property and life insurance (looking at how climate change might affect morbidity or rates of asthma, etc), while their US counterparts are falling behind (with a couple of exceptions like Chartis and Prudential), says Sharlene Leurig, one of the major authors of the report, in an interview with Reuters. Leurig identifies the strong regulation on the industry as one of the major reasons these companies have been slow to factor climate risk into their models, and she cites shareholder pressure as a potential solution.

Last year, efforts to establish a national rule requiring large insurers to disclose their climate-change related activities were squashed by political opposition. Greater disclosure and transparency would allow for more public discourse and equip shareholders to exert pressure on regulators and insurers. Insurance companies have little incentive to lie, as a recent Bloomberg editorial pointed out – “If they are more scared than they should be in pricing risk, shareholders will punish them. If they aren’t scared enough, nature will do the job.”

However, the insurance industry typically assesses risk based on historical patterns and trends, a practice that is outdated and inadequate in a world where the nature and scale of risks from climate change cannot be predicted with any quantifiable degree of certainty. Reinsurers – the insurers of insurers – are charged with essentially modeling and quantifying the risk of every possible catastrophe that God could imaginably inflict (“the god clause,” in industry parlance). These firms protect insurers when a catastrophe causes losses on a large number of policies. In case of unforeseen catastrophe the industry stands to lose billions, and so it devotes a lot of time and resources to imagining, modeling, and quantifying “named perils” (although the risk of catastrophes driven by human error or intention like terrorism and airplane crashes remain unquantifiable).

The reinsurance industry has been using probabilistic modeling to analyze the degree of potential losses under different climate change scenarios, and has found that, irrespective of the model, it is cheaper to adapt now than to sit and wait. To this end, firms have an interest in encouraging potential consumers to minimize potential losses from catastrophes (natural or man-made). As Bloomberg reported last week, “reinsurance is a product, but also a carrot in the negotiation between culture and reality; it lets societies know what habits are unsustainable.” The article goes on to describe recent collaborative efforts between reinsurance companies and industry experts to develop methodologies “to encourage city planners to build in a way that will be insurable in the future.”

Industry pressures therefore have the ability to influence adaptation behaviors – what, then, is the potential for change in mitigation behaviors? Anthropogenic climate change is a complex interaction of human actions and natural reactions – might firms be able to pressure consumers or industries to change the behaviors that heighten climate risks?

The insurance and reinsurance industry offer interesting insights into the market’s assessment of and response to the (economic) risks of climate change – and raises questions on its hitherto untapped potential to influence adaptation and mitigation behaviors. The industry has little incentive to distort its own assessment of the risk to property or life that these threats pose, and is a less visible (to end consumers) but powerful source of pressure on policymakers to incorporate concerns about sustainability into their long term planning. Greater transparency and disclosure will force smaller players to catch up quickly with their larger American and European counterparts in factoring in climate risk – or else run the risk of extinction.

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