Ringing the bells of climate change

Sharanjit Paddam looks at the different ways climate change can affect insurers and their financial stability in light of a notable Bank of England report.

On 29 September 2015, Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board stood in front of the historic Lutine Bell at Lloyd's of London - the spiritual home of the insurance industry - and announced to the gathered captains of the industry that the risks of climate change were real.

He noted three broad channels through which climate change can affect insurers and their financial stability:

• Physical risks - the impacts today on insurance liabilities and the value of financial assets that arise from climate and weather related events, such as floods and storms that damage property or disrupt trade;
• Liability risks - the impacts that could arise tomorrow if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible. Such claims could come decades in the future, but have the potential to hit carbon extractors and emitters - and, if they have liability cover, their insurers - the hardest; and
• Transition risks - the financial risks which could result from the process of adjustment towards a lower-carbon economy. Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent.

Carney's views came from an extended period of consultation with the insurance industry in the UK, which were summarised in a Bank of England Prudential Regulation Authority report " The impact of climate change on the UK insurance sector ".

Physical risks

Notable conclusions of the report include:

• There is growing evidence that the insurance losses arising from global natural catastrophes are increasing;
• While increasing exposure is the primary factor driving these increases, there are indications that climate change is also having an impact. For example, Lloyd's of London estimates that the 20cm of sea-level rise since the 1950s increased Superstorm Sandy's surge losses by 30% in New York alone;
• Climate change is likely to drive reassessments of prudential capital requirements for insurers;
• The increasing globalisation of the supply chain increases the systemic risk. For example, the 2011 Thai floods resulted in US$12b of insurance payments including claims arising from the interruption of the supply chain for global manufacturing firms.

Australia is not immune to these conclusions.  Indeed Australia ranks as the most exposed developed nation to natural perils, and so is highly exposed to physical risks. The recent increase in premium rates for property insurance in northern Australia reflects the growing realisation of the industry that the risk can no longer be cross-subsidised across Australia in the presence of a competitive market.

Liability risks

The Bank of England, cognisant of the impact of historical latent liabilities such as asbestos and pollution losses, sees the potential for increased claims in general liability classes of business (such as public liability, directors and officers and professional indemnity) due to a failure to mitigate, a failure to adapt or a failure to disclose.

Whilst litigation has generally been unsuccessful to date, the Bank notes that there is a risk that just one successful action will open the flood gates for other actions.  Of note is the recent investigation by the New York State Attorney General into whether or not Exxon Mobil mislead the public about the risks of climate change, or mislead investors about how such risks might hurt the oil business.

Transition risks

Not only does Australia have the largest exposure to natural perils of any developed nation, its economy is more reliant on coal than any other developed nation.

At the recent COP21 meeting in Paris, nations around the world reaffirmed their commitment to reduce greenhouse gas emissions.  Such actions in the longer term are likely to lead to a reduction in demand for fossil fuels, and there are risks of a sudden revaluation of such assets.  Where insurers are exposed, directly or indirectly, to the fossil fuel industry, this leaves an exposure to the risk of a sudden reduction in asset values.

More broadly, the transition to a low-carbon economy will see a fundamental shift in areas of production, leading industries, infrastructure demands and population centres in Australia.  These will have a long-term impact on the demand for different types of insurance, and associated risk management, underwriting, and claims expertise.

This transition also brings opportunities for insurers. Swiss Re released a report in 2015 "Profiling the risks in solar and wind" , which identified new risk management approaches in the renewable energy sector, including the opportunity to use weather derivatives to manage the variability in revenue from renewable energy sources due to variability in output.  They noted that "By the end of this decade, a 50% increase in renewable energy investment is likely to produce more than a doubling of insurance spending."

How can Australian insurers respond?

While insurers have the option to walk away when physical risks increase, this is by no means a long term solution. Walking away can mean:

• Loss of revenue - insurers need to grow their business, and the more risks that become uninsurable, or premiums unaffordable, the smaller the potential market for insurers to operate in. From this perspective, the long term reduction in premium income is the greatest threat to the industry.
• Adverse publicity - unaffordable premiums increase the risk of adverse publicity and the risk of government interventions in the market, which are generally not in the interests of insurers.
• Capital requirements - the potential increase in capital requirements to support larger variability in losses, will act to reduce returns on equity, or increase the affordability problem.

Insurers need to

• engage governments and policy makers into adapting for climate change - e.g. through better protections from flood, stronger building standards to reduce cyclone losses, and better planning controls to reduce development in high-risk areas.
• identify and measure their exposure to transition risks - through existing investments in carbon-intensive assets. Where material exposures are identified, insurers will need to consider the best approach to reduce their risk.
• examine their exposure to liability risks - considering both potential losses from historical policies, and changes in underwriting standards for future business.

A version of this article was first published in the JP Morgan Taylor Fry General Insurance Barometer 2015 .