Hot Topic: Climate Change and Insurance

More and more companies are persuaded that climate change is real. So why aren’t insurers factoring it into property insurance premiums?
David McCannMarch 23, 2016
Hot Topic: Climate Change and Insurance

(Listen to an interview with the author about climate change and insurance.)

If you’re a doubter on climate change, take notice.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

The 2016 edition of the World Economic Forum’s annual Global Risks Report lists “failure of climate-change mitigation and adaptation” as the greatest risk facing the world over the next 10 years. That was the collective judgment of 742 surveyed experts and decision makers drawn from business, academia, civil society, and the public sector.

Also, at the November conference in Paris hosted by the United Nations, 196 countries vowed to take actions designed to limit global warming. At press time, a total of 154 U.S. corporations had pledged their support for the U.S. effort.

“That global event engaged a lot of corporate leaders,” says David Gardiner, a sustainability consultant to businesses and nonprofits and an environmental adviser to the Clinton administration during the 1990s. “Neither countries nor companies take these kinds of public pledges lightly. They know they’re going to be held accountable, at least by the public, if they don’t do what they said they would.”

Indeed, on top of polishing their public image, companies are being good citizens of the world when they pitch in with initiatives like reducing greenhouse-gas emissions, increasing their use of renewable energy, and being more energy efficient.

From a more purely business standpoint, considerations of where and how to build facilities (or alter existing ones) to lessen climate risk have moved up the risk management priority list. Such moves can ward off costly business stoppages in the event of extreme weather events. Perhaps more significant, on an ongoing basis, they also earn lower property insurance premiums.

That would seem to suggest that property insurers are taking climate change into account when underwriting policies. Oddly — at least to anyone who’s not close to the insurance industry — insurers are not doing so, for the most part.

Business as Usual?
Even with the world increasingly gripped by concern over climate change, and despite insurers looking closely at the implications of a warming planet for their business, the industry appears to be pretty much in business-as-usual mode.

“There is work being done to incorporate climate risk as a reasonable consideration in pricing and reserves as an industry-standard best practice,” says Lindene Patton, an attorney and independent consultant who worked for Zurich Insurance for 17 years before leaving in 2014 as chief climate product officer. “But it’s not there yet.”

Not only is that work “not there yet,” there doesn’t seem to be a particular sense of urgency to get there.

“It’s not presently possible, given the current state of climate science, to take the output of climate-change models and apply them directly to insurance pricing,” concurs Bob Hartwig, who as president of the Insurance Information Institute serves as a de facto spokesperson for the industry.

16Apr_SR_LineAnd that’s not a huge problem, he suggests, pointing out that regardless of public impressions of climate-change-driven devastation, storms have wreaked relatively little damage to insured property since Superstorm Sandy flooded the Northeast in October 2012. (See chart, left.)

“Coming out of Paris we heard a lot about the negative consequences of climate change, and very good points were made, but as a very practical consideration, the amount of capital available to insure against natural perils has never in history been as great as it is today,” Hartwig says, noting that it’s been 10 years since a hurricane last made landfall in Florida.

That’s the kind of talk that is maddening to climate change scientists and activists.

There is great variability from decade to decade in terms of how many tropical storms mature into hurricanes and become damaging landfall events, notes Kathleen Miller, an economist and scientist with the National Center for Atmospheric Research. “People get lulled into a false sense of security when we go through a quiet period,” she says. “While there are questions as to the number of hurricanes [there will be over time], results of work done in this area indicate that the ones that do form will be more intense and damaging.”

Last October’s Hurricane Patricia became the most intense storm on record in the Western Hemisphere just before slamming into the southwestern coast of Mexico. It did not, however, hit a heavily insured area. The same was true of other big storms that have struck Central America and Southeast Asia in the past few years.

“There have been significant losses that don’t show up on insurance companies’ balance sheets,” notes Cynthia McHale, a former underwriter and manager of Accenture’s insurance practice, who is now insurance program director at Ceres, a nonprofit sustainability advocate. She adds, “The industry tends to speak in generalities and not engage in deep or complete discussions on the issue of climate change and insurance. We’re pushing them to get deeper into it.”

Regardless, the big capital pool Hartwig mentioned has been the driver of falling catastrophe insurance premiums over the past two years. Risk adviser and insurance broker Willis Group Holdings predicted in an October 2015 report that such premiums would decline further this year, by up to 15%.

Even times of heightened extreme-weather activity, such as 2005, a record year for hurricane damage, don’t change industry fundamentals. “It’s not for the insurance industry to pass moral judgments on climate change,” says Hartwig. “It’s for insurers to assess their risk and price it accordingly.”

Indeed, insurers may not even be trying to take “climate change,” per se, into account at all. “The risk is about probable loss, frequency, and severity,” says Christopher Smy, global environmental practice leader for Marsh, the world’s biggest insurance broker. “They don’t necessarily have to label it.”

For commercial-property insurance buyers, even if their premiums are not at risk, their credit ratings may be. Standard & Poor’s said in an April 2015 report that since 2005 it had identified at least 60 instances where natural catastrophes were the main or a material contributing factor in corporate credit downgrades. “The more frequent extreme climatic events many scientists predict could adversely affect companies’ credit profiles in the future,” S&P wrote.

Technical Challenges
Just why is it so difficult to incorporate climate risk into property insurance premiums?

It’s particularly puzzling given that climate scientists are now able to confidently state that climate change is a probable contributing factor in certain extreme weather events. A report from the American Meteorology Society (AMS) that assessed 2014 weather events identified human-caused climate change as a partial or likely factor in California’s wildfires, Argentina’s heat wave, droughts in two African areas, and extreme rainfall and heat waves in Europe.

Climate modelers use present and historical weather and climate data, as well as knowledge of atmospheric physics, to create models that can replicate weather patterns of the past. Once a model can do that consistently, it can then be used to more confidently forecast future patterns, explains the editor of the AMS report, Stephanie Herring, a scientist with the National Oceanic and Atmospheric Administration.

But forecasting — beyond the very short term, that is — inevitably is more difficult, particularly when it comes to hurricanes. While there are precipitation records going back more than 100 years and temperature records much older than that, the hurricane observation record did not begin, for all practical purposes, until the satellite era, Herring notes.

16Apr_SR_BarAmong 76 catastrophe modelers surveyed at the Reinsurance Society of America’s 2015 convention, only 6% said they consider climate change in their work more often than “somewhat frequently,” and 50% said they rarely or never do so. (See chart, left.)

“There are more technical challenges in using models to replicate hurricane activity in the future,” says Herring. “I can imagine what the insurance industry is struggling with.”

A Nuanced View
Patton, the former Zurich executive, has a unique perspective on the relationship between climate change and the insurance industry. In addition to being an attorney, she has a degree in biochemistry and a master’s in public health with a focus on pollution engineering.

“At Zurich and in my jobs prior to that, I always worked in a space where science, underwriting, and the law met,” says Patton, who co-authored a book called Climate Change and Insurance that was published by the American Bar Association.

Her background gives rise to a nuanced view on forces that have so far caused climate change to have little observable impact on property insurance pricing.

Much civil litigation, Patton notes, turns on the concept of what “a reasonable person” would have done, as well as the related concept that personal experience informs what a reasonable person would do.

“That idea is embedded in the fabric of our society,” she says. “For example, procurement regulations say you’re going to build this bridge or waste-water treatment plant or levee using 1970s rainfall tables, because what happened then is what’s going to happen now. There’s a socioeconomic structure that’s supported by different types of law, like litigation and administrative law, in which the environment is considered consistent.

“So, climate change upends what people in their personal experience know about weather. That’s why, in the debate that’s been going on for the past 10 years, there’s been a tremendous focus on challenging the science. How precise is it? How much do we really know?”

Insurance, she points out, in theory is supposed to be an ex ante financial instrument, where insurers over time build up capital to use for paying damages that occur later. But today, the vast majority of property insurance policies carry 12-month terms.

“Pricing is complicated for events that are low-frequency and catastrophic,” Patton says. “There is a ‘who should pay’ question. When regulators evaluate insurers’ price projections, they wonder why an insured that has a policy with an insurer in state A for this year, but is planning to move to less-risky state B next year, should pay for a loss that probably won’t happen in state A for several years or longer.”

The same principle applies to a company that switches to a different insurance carrier with a different risk appetite, she notes.

As a related example of the historical-pricing bias and the who-should-pay dilemma, Patton points to a dispute between New York City electric utility Con Edison and state utility regulators following Superstorm Sandy. The storm caused enormous flood losses in lower Manhattan, including the destruction of some ConEd facilities where expensive transformers were sited. Since all of a utility’s costs must be passed through to ratepayers, ConEd submitted a budget that included work to rebuild new transformers several feet higher, which entailed physical restructuring of the facilities.

The regulators balked, saying there was no reasonable evidence that such an event would happen again, says Patton. They wanted ConEd to provide proof of climate change.

Then Columbia University’s Sabin Center for Climate Change Law filed an intervener claim in the ratemaking, saying that if ConEd rebuilt with transformers in the same locations, it wouldn’t be meeting its duty to ratepayers.

So ConEd was able to say to the regulators, in effect: Do you want us to pay the costs to fight this litigation, and pass those on to our customers? Or should we actually pay to respond to climate change?

The utility commissioners didn’t want to do either of those, so they convened a series of meetings that lasted for months. In the end, ConEd got its way.

“So, who should pay?” says Patton. “In this case, the answer was that consumers should pay, because it’s the rational, efficient thing to do in the face of climate change. But it was a big fight because there was no mechanism in the law that governed rate approvals in a way that acknowledged climate change. And it’s way more complicated to understand how that might change in the insurance industry than in the utilities industry.”

Have Catastrophe, Make Money?
Can any part of the insurance industry’s slow pace of response to climate change be attributed to willfulness? Could it be that catastrophes are good for business?

Warren Buffett, whose Berkshire Hathaway has an insurance division that contributes a large portion of the conglomerate’s income, told shareholders in a February open letter that they don’t have much to fear from climate change.

While claims costs have risen dramatically over the years, he wrote, that’s been largely a product of inflation. As inflation pushes costs up, they’re promptly matched by increased premiums. If catastrophic events do become costlier, “the likely … effect on Berkshire’s insurance business would be to make it larger and more profitable,” according to Buffett.

He added, “As a citizen, you may understandably find climate change keeping you up nights. As a homeowner in a low-lying area, you may wish to consider moving. But when you are thinking only as a shareholder of a major insurer, climate change should not be on your list of worries.”

Reinsurers, who write policies that help insurance companies pay off on catastrophic claims, have been far more vocal on climate change than their clients.

Swiss Re CEO Michael Lies told a news conference last September that governments should be out in front of the issue. “Definitely we expect political courage to move in a direction that shows responsibility towards future generations and a certain interest in defending the sustainability of this planet,” he said.

Andreas Schraft, managing director for catastrophic perils at Swiss Re, tells CFO that the risk of losses is not so much of a concern, because, to Buffett’s point, insurers and reinsurers can deal with that year to year by raising prices following catastrophic events.

“What we are concerned about is that if risks become too big, they may become unmeasurable,” Schraft says. “That’s why we want people to understand the long-term consequences of decisions they make today, so the world is resilient and remains insurable.”

16Apr_SR_TableFor example, companies should be aware that if they build a factory today, it’s going to be there, in use, for at least 25 years and probably longer, Schraft says. “We know that as it gets warmer, sea levels will rise even more. If you are on a coast, dams and levees and other flood-protection measures may not be enough.” Some coastal cities could indeed become uninsurable at some point, he warns.

Patton, meanwhile, says she can’t in good conscience blame the insurance industry for proceeding cautiously.

“People are quick to attribute bad intent, but I don’t think there’s any here,” she says. “What I think is that executives who run companies have duties to their shareholders, who expect those executives to run those companies consistently with the rules that apply. They can decide to be more sustainable, but if that will potentially affect business or shareholder returns — if they’re going to become price-noncompetitive — they must warn shareholders.”

Gardiner, the former Clinton administration adviser, is reluctant to let insurers off too easily, considering the global risks posed by climate change.

“The insurance industry can and should be an advocate for the kinds of policies that reduce climate change risk,” he says. “There’s hardly a company out there that couldn’t be more energy efficient.”