Climate change poses ‘devastating risk’ to financial services

The global financial services industry is “inherently susceptible” to the risks posed by climate change and must adapt, according to a report from the Global Risk Institute (GRI). Global investment portfolios could lose an estimated 45%, although half of that could be avoided through a reallocation of portfolios, GRI said. Banks should reduce exposure to “high carbon industries,” whilst pursuing green investments. Real estate, infrastructure and agricultural business were viewed as being at particular risk, whilst insurers also face threats.

The Insurance Industry

Climate change has been a major concern for the insurance industry for many years, with the first reinsurer reports on the prospective rise in natural disaster losses due to changes in climate appearing in the early 1970s.

Several insurers/reinsurers have since participated in climate-related efforts including research collaborations with the scientific community, raising the awareness of clients and the general public, and conducting internal reviews to assess the risks and opportunities associated with climate change. Despite this involvement, the number of worldwide weather-related loss events has tripled since the 1980s, and inflation-adjusted insurance losses from these events have increased from an annual average of around $10 billion to around $50 billion over the past decade. [4]

While the attribution of increases in claims to specific factors is complex, studies have shown that insurers have realized substantial costs directly associated with climate change. In a catastrophe modeling and climate change report by Lloyd’s, it was estimated that the 20 cm rise in sea-level observed at the southern tip of Manhattan since the 1950s equated to an increase of approximately 30% in the ground-up surge losses from superstorm Sandy in New York alone. [5] In addition to direct costs, insurers have suffered increased losses through indirect events such as the disruption of global supply chains or resource scarcity. Consequently, the insurance industry has immense incentive to understand climate change and manage the risks associated with it.

The ways in which the insurance industry may be impacted by climate change are diverse, complex and uncertain. However, it is crucial for risk management and loss reduction purposes that all foreseeable material risks are considered. In a recent study, the Bank of England’s Prudential Regulation Authority (PRA) identified three main channels through which climate change is likely to impact the insurance industry; namely physical risk, liability risk and transition risk. [6]

The implications of climate change, including the increase in the number and severity of extreme weather events, pose obvious direct physical risks to insurers by means of property insurance liabilities, devaluation of financial assets and real-estate investments, and increased morbidity and mortality due to severe weather conditions. There are also secondary physical risks to consider which arise indirectly through subsequent events such as disruption of global supply chain, resource scarcity, or potential macroeconomic, political or societal shocks. Indirect physical risks can include financial market losses due to economic damage, declines in resource production resulting in scarcity, and increased morbidity and mortality caused by indirect impacts of rising temperatures such as the increase in vector-borne diseases.

In the short term, insurance companies are quite well-equipped to assess and manage their physical risks by way of catastrophe modelling, portfolio diversification and risk transfer. However, in the long term, the effects of climate change may impact the soundness of current catastrophe models and may reduce the efficacy of portfolio diversification and risk transfer. Over the past 20 years, catastrophe models have been extensively developed to simulate the physical characteristics of likely events and quantify their effects. These models are complex and have inherent uncertainty which will only be exacerbated by the uncertainties associated with climate change. In particular, climate change intensifies properties such as global micro-correlations, fat tails and tail dependence which can greatly impact environmental risk estimations, and influence the effectiveness of diversification strategies. [7] Standard & Poor’s (S&P) recently suggested that current catastrophe losses may be undervalued by as much as 50% at the 1 in 10 and 1 in 250 return periods if the past decade were to be representative of future environmental trends. [8]

Liability insurance, which protects the purchaser of the insurance from the risk of being held legally liable for the loss and damages suffered by other parties as a result of the insured’s actions, poses a large risk to insurers over a broad time frame. In addition, the true cost of liability claims is often uncertain and complex to determine. In the context of climate change, there is already evidence of liability risks with existing cases suggesting three primary lines of argument; failure to mitigate, failure to adapt and failure to disclose. Climate change litigation is still very much in its beginning stages, varying considerably from jurisdictions to jurisdiction. As it evolves, insurers will have to consider how the climate change exposure of the parties they insure impact their own liability risks.

Given the widespread governmental acceptance of climate change and the global shift to reduce greenhouse gas emissions, there will likely be several changes and additions to existing climate change-related policies and regulations in the near- to mid-term. The severity of future climate change-related events depends on how aggressive these policies are, both in terms of the size and timing of carbon emission reduction. According to the IPCC,

Delaying mitigation efforts beyond those in place today (2014) through 2030 is estimated to substantially increase the difficulty in the transition to low longer-term emission levels.[1]

Transition risk encompasses the financial risks which may result as adjustments are or are not made towards a lower-carbon economy. These risks can be triggered by changes in public policy and regulation as well as the advent of new technologies, shifting investor preferences, physical events, and progress in climate science.

Transition risk may impact both the liability and asset sides of an insurance company’s balance sheet. This type of risk has similar effects on an insurance company’s liabilities as physical and liability risk. By inducing uncertainty about the timing and extent of future climate change, transition risk creates additional uncertainty about claims stemming from climate-related events. In addition, mispricing of insurers’ assets may also occur if assets prices do not fully reflect the risk associated with climate change related transition pathways. Studies have shown that climate change and other environment-related factors are not properly accounted for in financial and corporate decision-making leading to the possible mispricing of assets. [9, 10]

Climate change poses large challenges for the insurance industry but also introduces many new opportunities. The advancement of clean technologies and low carbon infrastructure offers new sources of premium growth by providing new insurance products such as renewable energy project insurance. Similarly, new products relating to public policy risk, including those to cover unforeseen withdrawals of environmental subsidies, can also provide revenue growth. Climate change also brings new investment opportunities in clean technologies, emerging carbon trading markets, and in ‘green bonds’ as well as in the financing of the de-carbonisation of our economy. [11]

Insurance companies provide protection and risk transfer to all other sectors of the economy, and thus have a clear role in supporting economy-wide adaptation to climate change. While there is still time for insurance companies to effectively manage climate change, the window of opportunity for economical mitigation is shrinking. [12] In order to promote global resilience to climate change and support an orderly transition to a lower carbon economy, insurance companies should be willing to participate in international collaboration, engagement and research, and unrelenting stress testing and risk modelling.