Climate change - Shifting weather and geological patterns due to human activity are, for the first time in history, causing alarm at individual, corporate and state level.
Health - Issues such as obesity, stress, ageing populations, pandemics, substance abuse, allergies and industrial illnesses will be a major driver of government action and socioeconomic behaviour. Climate change is exacerbating a number of these issues.
Water - Increasingly unpredictable and more severe weather patterns are likely to increase occurrences of flooding and drought, creating significant risks for insurers. Higher water temperatures and changes in extremes are projected to affect water quality and exacerbate many forms of water pollution. As water supply, quality and scarcity are made increasingly
vulnerable via climate change, there is the likelihood of significant and broad ranging impacts on ecosystems and societies. In the worstcase scenarios, such severe impacts on water resources may lead to more deaths from disease, and even political unrest and dislocation in some economies.
Ethical consumerism - The significant trend of consumers and businesses increasingly expecting to be able to exercise choices that promote responsible and sustainable practices, and avoid harm to the environment and society (eg. pollution, loss of biodiversity, unfair treatment of workers, negative impacts on local communities) is set to continue apace.
Climate change is one of the most significant long-term risks to companies of all sectors. The insurance sector in particular is experiencing one of the most direct impacts of climate change; it is estimated that around one-third of all overall insurance claims are from weather-related natural disasters. Increased losses, in turn, could raise the cost of capital and increase the volatility of insurance markets.
The importance of climate change to business is indicated by companies' phenomenal response to the annual Carbon Disclosure Project [1] (CDP) survey. Since 2000, the CDP has, on behalf of institutional investors, challenged the world's largest companies to measure and report their carbon emissions, integrating
[1] The Carbon Disclosure Project (CDP) is an independent not-for-profit organisation, which holds the largest database of corporate climate change information in the world.
the long-term value and cost of climate change into their assessment of the financial health and future prospects of their business.
The CDP's sixth, and most recent request for information (CDP6), was sent to more than 3,000 of the world's largest corporations requesting information on greenhouse gas emissions, the potential risks and opportunities climate change presents and strategies for managing those risks and opportunities. The request was backed by 385 leading institutional investors representing more than US$57 trillion of funds under management.
The logic for the CDP is simple: addressing the climate change challenge depends on a dialogue between shareholders and corporations, supported by high-quality information. PricewaterhouseCoopers, the CDP's global adviser, analysed the responses from the 500 largest corporations in the FTSE Global Equity Index Series, the 'Global 500'. As of March 2008, the market capitalisation of these companies was US$22 trillion.
A total of 19 insurers worldwide responded to the CDP request. The responses reveal the sector does not believe there are any significant physical risks to its own operations with the exception of branches located in flood-risk areas. However, insurers recognise that there are significant indirect physical risks to investment portfolios, life portfolios and general insurance exposures (see Figure 1).
The CDP 2008 report praised insurers for their transparency in terms of carbon disclosure. An analysis of results from companies in the financial services sector demonstrates that the sector is particularly strong in disclosing risks and opportunities relative to other sectors that is their identification, management and assessment of business impact.
This may be a result of the industry needing to integrate climate change risks and opportunities into its day-to-day investment, lending and contract decisions to run a successful and sustainable business, although several recent reports on the industry have found that such integration efforts are often patchy and incomplete.
The financial services sector disclosures suggested that the three key risks for the sector are:
By the same token, insurers face many challenges since their products and services are embedded across all industry sectors and in almost all spheres of human activity.
The following sections analyse the risks and challenges that insurers face in their main business areas: general insurance, life assurance and asset management.
The impact of climate change on the general insurance industry is likely to be far-reaching and insurers will encounter a number of new types of claims and seek to develop a raft of new products.
Changing climate is likely to have a profound effect on the risks that insurers seek to cover. In the recent past there has been heightened hurricane activity in the Atlantic Ocean which has produced record property losses in the US.
In addition, bush fires, flooding and other major catastrophes around the world have heavily impacted insurers' balance sheets.
Aside from the direct impact of weather-related catastrophes, climate change may also result in increased liability claims. In the US, for example, a number of court cases have been brought seeking damages against companies that have emitted large amounts of carbon dioxide and other greenhouse gases.
However, although climate events can be extreme and costly, general insurance products are typically offered for a period of 12 months, so cover and price can be reviewed on renewal, limiting exposure.
See Key considerations for General Insurers for an overview of the issues general insurers face.
1. Conduct further research to fully understand the likely impact of climate change. Insurers also need to be aware of what additional data may be available to support analyses. For some organisations, this is likely to be a major project requiring strong buy-in from senior management. High-level briefings on climate change for management boards and non-executive directors are often an important pre-cursor and contributor to achieving senior level buy-in and support.
2. Conduct evaluation exercises of climate change models using 'what if?' scenarios, rather than relying on historical data. Pay increased attention to the quality of the data that is already available. Following the US hurricanes in 2005, shortfalls in the data - for example, the use of default construction type or location values - were widely blamed for inaccurate insurance estimates.
3. Enhance models to factor in newly available climate change data. Where this has happened - for example, with the modelling of US hurricanes - scientific predictions can enhance claims forecasts. However, the use of new types of data introduces new uncertainties, primarily regarding the accuracy of the science itself.
4. Review portfolios in the light of more sophisticated models and an improved understanding of the issues. One approach to reviewing portfolios is to undertake a mapping exercise to identify and understand the value at risk to assets and liabilities from climate change.
5. Review terms and conditions of contracts, re-examining whether coverage and limits and certain clauses remain appropriate. For example, business interruption and contingent business interruption can form a sizeable proportion of claims from catastrophic events.
6. At an industry level, ensure that customers are treated correctly and fairly. As a result of better portfolio management, some customers may be left with 'uninsurable' risks. If the industry as a whole cannot adequately respond to this social issue, government may intervene.
7. Perform a pivotal role in public policy formation. It is in insurers' direct interest that government is encouraged to manage the mitigation of climate-related risks and adapt to changing climates. The issues range from the construction of flood defences to the development of building codes (e.g. flood and hurricane resilient buildings) and funding of research to minimise the impact of extreme weather events. Insurers could also invest in adaptation infrastructure as a means to manage risk and also improve long-term resilience of asset portfolios.
Climate change is set to impact both the life assurance and health insurance industries through its direct and indirect effects on human health. The risks are predominantly driven by increased frequency and severity of extreme weather conditions. Colder winters and hotter summers especially put the older population at risk. In developing countries impacts of climate change are likely to include reduced water quality and availability, and elevated rates of vector-borne diseases such as malaria. Diseases, injuries and deaths are also set to increase due to more frequent natural disasters. Quantitative assessment of the risks is complex because the net effects of climate change on costs of health are highly uncertain. The impacts will depend on:
It is also possible that changes will be gradual, and difficult to separate from other, non-climate change-related trends.
1. Conduct further research to fully understand the likely impact of climate change.
2. Recalibrate and update models to take into account the greatest risks, such as:
Heat waves and cold snaps - In tropical regions, thermal extremes that exceed thresholds for human temperature tolerance will become more frequent. In Europe, the 2003 heat-wave resulted in 35,000 premature deaths.
Vector-borne diseases - Previously constrained to the sub-Saharan regions, global warming is now fuelling the spread of such diseases, with Southern Europe already experiencing outbreaks.
3. Develop sophisticated matrices encompassing geographical locations, temperature fluctuations, availability and standard of public healthcare and demographics of the regional population. Due regard should be given to medical advances and cures for diseases, epidemics and obesity.
4. Review business models. Insurers may need to evaluate whether to withdraw from certain market segments, harden rates in others or adjust the scope of cover.
5. At an industry level, ensure that customers are treated correctly and fairly.
6. Participate in public policy information.
Climate change is becoming a significant element in asset management investment strategies and one that is driving innovation, new product development and a reappraisal of existing products.
The issue is captured in Axa Investment Managers' response to the 2008 CDP. It said: 'In terms of investment policy, companies that are ill-prepared for more stringent environmental regulation may face unexpected new expenses and a decreasing ability to sustain their returns and share price, thus decreasing their value in Axa's investment portfolios.'
Indeed, there is widespread anticipation that climate change may affect assets directly or indirectly Climate change-related risks (and opportunities) may affect the following activities undertaken by fund and asset management businesses:
1. Provide subject matter training to analysts, fund managers and economists to improve understanding of climate change;
2. Establish a dedicated climate change team integrated into the mainstream asset management function;
3. Undertake or commission customer/market surveys to understand the extent to which current products/services meet customer requirements for inclusion of climate change criteria into investment decisions. If this is a captive asset manager, then investments should be selected to provide a hedge to climate change-related liabilities.
4. Review existing investment processes to determine the extent to which climate change criteria are taken into account. This should include:
5. Ensure internal and external reporting demonstrates the approach, process and outcomes of incorporating climate change factors, including reporting against relevant policies, targets, external commitments and KPIs.
Insurers, with their sophisticated risk matrices and overarching view of the economy, are among the best-placed companies to correctly collate and interpret data, to support their clients in managing climate risks and to benefit from climate change-related opportunities. The response from Allianz to the 2008 CDP indicates the potential for new product and service innovation: It said: 'Regulatory changes to combat climate change are providing a huge portfolio of opportunities.'
Some of the insurance products and services that have been developed, or are in development, are outlined below:
Asset management opportunities. Individuals, pension funds and other institutions are aware of climate change issues and some have even developed strict guidelines for their fund managers on sustainable or 'green' investments. This provides asset management firms with a substantial opportunity to offer a new product range. Indeed, some have done so for many years.
Indexed funds are developing engagement strategies. For 'active owners' of indexed funds, using data such as that provided to CDP to identify companies that are 'carbon laggards' and engaging with them to reduce carbon-related risks, holds out the possibility of enhanced long-term returns.
Quant funds in search of a 'green beta'. As increasingly reliable, quantitative information becomes available, this may allow for 'quant' funds to focus on achieving superior returns through overweighting their portfolios in 'carbon light' companies and underweighting 'carbon heavy' companies.
Active fund managers in search of a 'green alpha'. Active fund managers focus on companies that are expected to benefit positively from climate change, that is, companies with 'green alpha'. However, some fund managers in the CDP expressed the view that climate change as an investment opportunity could become an investment bubble.
One of the key questions today is whether the credit crisis and accompanying recession will push sustainability issues down the corporate agenda. For those insurers that have only started to address climate change, the likelihood is that greater focus on this issue will only emerge as the impact of the recession begins to subside. This viewpoint is perhaps substantiated by a recent report - Insurance Banana Skins Survey 2009 - conducted by the Centre for the Study of Financial Innovation in association with PricewaterhouseCoopers, and based on responses from over 400 insurance companies.
The report showed a marked decline in the urgency of climate change, with the issue dropping from 4th to 28th place in a ranking of risks since last year. However, for insurers that have already identified climate change as a material business issue, climate change may be assigned a lower priority, but there is anecdotal evidence that the issue is now an integral part of risk and opportunity management, as well as brand, and that any retrenchment at this point would be damaging.
Indeed, there are a number of issues to be resolved before some companies decide to act improvements in data quality, for example. Business and investors are only able to use climate-related information in a systematic way if data is quantitative and the methodology is robust, replicable and responds to changes in factors that will affect future returns.
Some parts of the insurance industry have made considerable efforts to collect and analyse data. Reinsurers clearly lead the way and it should be noted that Munich Re and Swiss Re score highly in the CDP index of leading financial services firms. Swiss Re, in particular, produced a seminal paper on the effects of climate change and is noted for its continued thought leadership and advocacy in this area.
The rest of the sector could benefit from following the lead of Swiss Re and increasing the resources it devotes to research and analysis. The CDP is likely to evolve from its initial aim of encouraging disclosure of responses to the climate change and move towards an increasingly performance-related approach. Insurers need to anticipate and prepare for this imminent shift in emphasis.
With the benchmark rising, then, collaboration between insurance industry participants will be increasingly important. Insurers will need to act more as a group and less as competitors in order to meet the challenges ahead. A number of industry groupings have marked a step in this direction, including:
Initiatives such as these can help to drive and sustain a sense of urgency and commitment among the industry to tackle climate change issues. Industrywide efforts will undoubtedly have greater impact than any single insurance company devoting its own resources to the subject. The benefits that accrue to society at large could produce a positive effect to the creditworthiness and profitability of the insurance industry, as well as its reputation. It might also go someway to helping mitigate climate change, and help economies adapt to it.