For years the insurance industry has debated whether climate change is real and the cause of increasingly severe and numerous weather-related catastrophes, or political hype designed by various environmental and regulatory bodies to force emissions control and reform.
Today, insurers are still playing a game of climate-change "connect the dots." For example, consider the scientific fact that ocean temperatures are rising. Played forward, arguments still ensue over whether the rising temperatures are the direct result of an increase in greenhouse gases, solar activity or the earth's reflectivity. These discussions lead to more uncertainty: Are the rising temperatures directly responsible for the increase in weather-related catastrophes?
Two things are certain: the frequency and severity of weather events are increasing dramatically, as are the insured costs associated with those increases. It's how the industry is responding to these two certainties that has become the biggest topic for discussion.
In January, Bob Hartwig, president of the Insurance Information Institute, reassured attendees at the 2013 Property/Casualty Insurance Joint Industry Forum in New York that the industry is prepared to weather future storms. He said the industry "both entered and emerged from the 2012 hurricane season very strong financially, stating "There is no insurance industry 'fiscal cliff.'"
Superstorm Sandy alone, however, may have caused anywhere from $20 to $25 billion in insured auto, home and commercial lines claims, notes the Insurance Information Institute. Munich Re offers a broader look, stating that in 2012, the United States accounted for 67 percent of overall natural catastrophe losses and 90 percent of insured losses-compared to an average of 32 percent of catastrophe losses and 57 percent of insured losses-with Sandy and the 2012 drought the costliest of those events.
"[Sandy] probably also highlights the whole issue that the industry is trying to deal with, which is 'what is the new normal?' as far as level of catastrophe losses," said Vincent Dowling, managing partner, Dowling & Partners, at the Property/Casualty Insurance Joint Industry Forum. "The last few decades, the losses relative to premium continue to increase, and we have not had 'The Big One' yet."
Upward trends in catastrophe events can be explained by both the growing value of assets damaged, growth of urban areas, and the impacts of increasingly frequent and unpredictable severe weather events, notes Cynthia McHale, director of the insurance program at not-for-profit advocacy group Ceres. "Stormy Future for U.S. Property/Casualty Insurers," a report co-authored by McHale and Ceres senior manager of insurance and water programs Sharlene Leurig, illustrates how during this same 30-year period "the number of natural disasters has increased, particularly those related to climatological events: extreme temperatures, droughts and wildfires, and meteorological events: storms."
From investment information site Motley Fool's long-term warning to investors of insurance securities to "prepare your portfolio for climate change," to S&P's short-term advisory stating that the rating impact on all insurance sectors will be stable to modestly negative in 2013, concern is growing over insurers' ability to weather long-term climate-change related losses.
In the report, McHale and Leurig cite $32 billion in costs to property/casualty insurers related to extreme weather events in 2011. "While 2012 insured property losses to date are lower, the pattern of extreme weather and associated economic costs are continuing," she states. "These rising payouts come as insurers are simultaneously confronting historically low investment returns and a sluggish overall economy. Even before the recent spate of underwriting losses, the insurance industry's overall financial performance, as measured by average return-on-equity, lagged significantly behind other industries."
The Need for Models
It's clear why stakeholders from the scientific, technology and business communities agree on the need for models that incorporate, at a minimum, the potential uncertainties of climate change projections into climate model outputs.
All three of the major vendors in this space, AIR Worldwide, Risk Management Solutions Inc. (RMS) and EQECAT, have reviewed or updated their climate models within the past few years. Yet climate change, by its nature, purports a certain amount of uncertainty, admits David Simmons, managing director, analytics at Willis Re, making this modeling difficult at best.
"Climate cycles, El Nino/La Nina and climate change, are poorly modeled if at all," says David Simmons, managing director, analytics at Willis Re, a global reinsurance broker. "This implies that catastrophe modeling companies must be more open about the assumptions used in their models and how those assumptions were derived."
Peter Dailey, director of atmospheric science at AIR Worldwide, agrees that climate signals such as ENSO (El Nino/La Nina) and the North Atlantic Oscillation are difficult to predict precisely, and that climate trends make such predictions even more uncertain, yet scientists still turn to climate models as their best tools to understand our changing climate.
"In fact, without climate models, currently well-known connections between El Nino and global weather patterns would not be as predictable as they are today," Dailey says. Like its competitors, AIR employs stochastic models that account for expected risk, the uncertainties around those expectations and a full range of potential future outcomes. "This modeling framework lends itself nicely to incorporating and quantifying uncertainties associated with climate change," says Dailey.
Adding to this complexity is the idea that different segments of the insurance marketplace have business models operating on time scales that vary from months to years to decades, Dailey adds. "At the same time, each insurer has varying exposure to atmospheric perils worldwide. For these reasons, the sensitivity of each insurer's exposure to climate is unique."
Lindene Patton, Zurich Financial Service's chief climate product officer, agrees. "The big problem is that the models are not on the same time scale," she says. "Sandy created a moment in time with this, which may lead to incremental progress, but there are situations that continue to push back against people trying to figure out how to match these time scales."
Other Challenges
Time scales are but one challenge: AIR's Dailey says that actuaries, who are in high demand, along with statisticians, scientists and engineers, are all needed to fully understand the connections between climate and insured risks.
Patton agrees that there is a lack of skilled actuaries, but says other challenges affecting climate-change models also exist. "There is little precedent-internally or industry-wide-for a scale of global impact of greenhouse gas exposure on products and markets, making it difficult to model for climate-change-related assumptions."
Still more incongruity exists on whether advanced technology, such as analytics, can provide carriers with the insights necessary to make comprehensive judgments on pricing, risk concentration and even decide which risks are appropriate for an insurer's portfolio.
Notwithstanding its etiology, new industry-wide data about to be released from Zurich seems to suggest that the industry “is insuring less and less impacted assets from natural disasters,” notes Patton. "It's not good if that is what is happening," Patton says. "We should be more relevant, but we are turning out to be less relevant because people are saying 'I can't afford it, so I guess I'll go bare.'"
Patton believes this trend has less to do with catastrophe models and more with how to make sure the instrument itself is used in its "best and highest" way. "In the long run, insurance is supposed to help people, so the challenge is how to make it work in a circumstance where your buying public says 'I can't put this in my personal economic model.' There are many complicated layers to this, but primarily, they don't understand the instrument any more. And while actuaries are in high demand, they are not necessarily looking at this aspect. Instead, they might be looking at it in a way that is consistent with the timing of the instrument-so it's short term, not long term."
Adding to this challenge, notes Willis Re's Simmons, is the growing pressure to honor regulatory reporting requirements. "Due to disclosure requirements, such as Own Risk Solvency Assessment Act (ORSA) and Solvency II among others, insurers must explain how and why they have chosen their particular catastrophe model and/or their approach to quantifying catastrophe risk," he says. "These requirements also imply that senior members of insurance management understand all of the limitations of the modeling. Where there is little/no perceived catastrophe risk, insurers will be required to justify ignoring the peril."
McHale's report confirms the importance of understanding the risks carriers undertake, noting that connecting the linkages and impacts between rising temperatures and extreme events remains a highly technical exercise fraught with uncertainty. "As a result, many insurers now and increasingly in the future will be underwriting business without fully comprehending the probability and severity of the losses they may sustain."
Simmons believes the opportunity now exists, thanks to looming new laws governing capital requirements, to replace all or some of the standard formula with approved internal models. "Catastrophe risk is an obvious candidate for replacement since it's outdated."
If the notion of replacing a catastrophe risk model seems overwhelming, it should, notes Simmons, but the bigger picture is that it forces a better understanding of the insurer's portfolio. "It should not take 10 years to get from 'A' to 'B.' That said, you need to prioritize and pace yourself carefully. Don't expect your board of directors to understand everything, but do focus on obtaining a better understanding of your portfolio, where your risks are and what your risks are. Then refine the modeling, take expert advice, build up an in-house team and educate your business leaders on what the models can and cannot do."
Forward Thinking
Because the future of climate change and related severe weather events is uncertain, climate-change models will continue to be regarded as crucial elements in an insurer's larger catastrophe scheme. Simmons believes that companies' cultures will change and, in addition to chief risk officers, there will be more chief climate officers. "Actuaries and modelers, already scarce and expensive resources, will become more so," Simmons adds.
The Intergovernmental Panel on Climate Change (IPCC), an international body for the assessment of climate change, calls for a broader plan that includes models along with a focus on social welfare, quality of life, infrastructure, and livelihoods. In its report, "Managing the Risks of Extreme Events and Disasters to Advance Climate Change Adaptation," the IPCC suggests that incorporating a multi-hazards approach into planning and action for disasters in the short-term facilitates adaptation to climate extremes in the longer term.
Insurers as Climate Change Agents?
From seat belt usage to smoke detectors, insurers historically have been successful in helping influence society on the importance of risk reduction. When discussing ways to counter climate change, however, insurers face challenges.
"As unpopular as climate change may be, reality has a way of intruding on political views and, because there is such an expense for natural disasters, the insurers and reinsurers can lead on this," notes Andrew Winston, author of the books "Green to Gold" and "Green Recovery."
Lindene Patton, chief climate product officer at Zurich, says there have been more developments that show why insurance is important as a social shock absorber, but is realistic about quick outcomes. "We need to talk about how to do more coordination on a public policy basis, but this discussion has taken place within an economic crisis, which doesn't seem to get better no matter what we do," she says. "In the meantime, we need to focus on getting to a 'resilience state,' assuring economic sustainability and resilience in the face of climate change."
Winston agrees. "You are seeing companies and sectors starting to talk about resilience, such as IBM's Smarter Planet initiative, or engine-idle devices retrofitted on 18-wheel trucks that help reduce emissions while the driver stops to rest. Can we put a price on this? What is the return? Companies need to put a value on the risk to their business, and insurers need to do the same. But I don't think we are that far along."
"Stormy Future for U.S. Property/Casualty Insurers," a report from sustainability advocacy organization Ceres points to the importance of stronger resiliency to extreme weather.
"Insurers have much to offer, and much at stake, in helping governments and private markets to further understand and develop solutions to better predict and prevent losses from extreme weather events," the report states. "We have seen excellent examples of insurer sector leadership in addressing climate risks, but industry-wide engagement and action in this regard is nowhere near its potential."
