UK: Feeling The Heat: Dealing With The Impact Of Climate Change

Climate change could significantly increase premium prices, reinsurance costs and solvency requirements. Ultimately, it could stretch the limits of insurability.

‘It is no longer a question of whether the earth’s climate will change, but rather when, where and by how much’, said Robert Watson, Chairman of the United Nations Intergovernmental Panel on Climate Change (IPCC).¹

While views on the scale and implications of global warming and other aspects of climate change naturally vary, what is certain is that insurers will be at the frontline of any financial impact. The difficulties of anticipating and managing the effects of climatic instability were highlighted in the US in 2005, when an exceptionally severe Gulf windstorm season which included Hurricane Katrina led to the highest insurance losses in history.

Many European insurers and, in particular, reinsurers were among those worst affected by Katrina and its sister storms Rita and Wilma. Although they had made strenuous efforts to quantify and set limits for their exposures through use of the latest modelling techniques, the actual losses far exceeded expectations. In particular, few companies had taken full account of the potential for a ‘storm surge’ in which wind losses are compounded by resulting fl ooding. Few companies had made adequate provision for the pressure on supply and resulting escalation of expenses arising from a ‘demand surge’ for loss adjusters, emergency repair and rebuilding teams. Moreover, many had also underestimated the level of business interruption claims, both through loss of trade and the demand for temporary relocation.

Closer to home, the potential impact of climatic instability was highlighted by the effects of the searing European heatwave of 2003. The hottest summer since records began claimed an estimated 20,000 lives across Europe. The financial costs included some €13 billion in crop losses and a bill of €1.7 billion from the forest fires in Portugal. Simulations carried out by researchers at the Swiss Federal Institute of Technology estimated that by the end of the century every second summer in Europe could be as hot and dry as 2003.²

Wind and flood

The potential fallout from climate change facing European insurers also includes the heightened risk of damage from severe windstorms. Recent instances include Windstorm Gudrun in Sweden in 2005, which led to the country’s largest ever insured losses. Looking ahead, research by the Association of British Insurers (ABI) estimates that average annual wind-related insured losses from extreme windstorms in Europe (one in 100 to 250-year events) could increase by at least 5% by the 2080s to reach €25-€30 billion (on current prices).³

The risk of severe and hugely costly flooding has been highlighted by the events in the UK over the summer, which left large parts of the country underwater and forced thousands to leave their homes, some of whom will not be able to return for many months. The fl oods in Prague in 2002 and Carlisle in 2005 give some indication of the challenges now facing insurers in dealing with the aftermath. These events were particularly notable for a resulting demand surge comparable to Hurricane Katrina. This included a shortage of local loss adjusters, forcing insurers to foot the bill of bringing in professional personnel from other parts of the country and even abroad. Looking ahead, the ABI report concluded that if carbon emissions continue to increase, average annual insurance losses from fl ood damage in Europe could rise by €100-€120 billion by 2080 (on current prices).³

The potential insurance cost of climate change is compounded by the increase in property prices and other asset values, which in many countries continue to outstrip rises in premiums. Some of the most valuable newly built properties have been sited in waterfront locations. As cities expand, there has also been considerable development in flood plains and other potentially high-risk zones. Moreover, as companies seek to develop business in emerging markets, they could face a broader and often more severe range of climatic risks.

Any estimation of the future liabilities also needs to take account of the cumulative impact of drier weather on buildings, including an increased risk of subsidence. In turn, life and health insurers may face a rise in respiratory illnesses as lower rainfall leads to a decline in air quality.

Valuation challenges

While research by the ABI and others is clearly helpful, precise estimates of the potential insurance losses arising from climate change will always be open to revision and debate. Indeed, this is the crux of the challenge facing insurers – just how much they need to build into premium and provisioning evaluations for what are a highly volatile and uncertain set of potential weather-related liabilities.

In turn, any such uncertainty could increase reinsurance prices, solvency requirements and the cost of capital. IFRS presents a particular challenge by requiring insurers to disclose the assumptions underlying their claims reserves, opening them up to critical comparison with competitors. Under plans for EU Solvency II and a future IFRS for insurance contracts, companies may also be required to include a risk margin for any uncertainty in their liability evaluations.

The quality and reliability of risk evaluation is therefore likely to be critical in managing the bottom line impact of climate change. Although flood, wind and other weather-related claims reserving has tended to be based on historical data, it is increasingly clear that the past is no longer an accurate indicator of the future. Insurers will need to model their liabilities against a wide range of possible future scenarios. This includes mapping the correlations of multiple scenarios such as earthquake and resulting flooding as seen in the Asian Tsunami or the effect of drought on health and asset values, along with the impact of any post-catastrophe demand surge.

Naturally, scenario modelling is only as good as the assumptions that underpin it. It is notable that many insurers writing Gulf of Mexico property business significantly adjusted their actuarial assumptions following Hurricane Katrina. ‘The risk equation has changed as we face what looks set to be a higher frequency and severity of catastrophe losses’, said a CEO interviewed as part of PricewaterhouseCoopers (UK) 2006 London Insurance Market survey.⁴ In many cases, companies have also sought to diversify their risk and earnings to avoid over concentration on volatile catastrophe business.

In another indicator of emerging best practice, a number of insurers in the survey have enhanced the granularity of their actuarial evaluations by including far more detailed information about building design, property usage and potential business interruption expenses. The benefits not only include more reliable control of risk aggregation and evaluation of reserving levels, but also the ability to price premiums more accurately and keenly.

Pricing impact

Nonetheless, the clearest impact of Hurricane Katrina has been a sizeable increase in insurance and reinsurance premiums in the areas most susceptible to catastrophe risk, though these may fall back following a relatively benign 2006.

The timing and extent of any corresponding premium increases to reflect potential climatic instability here in Europe depends on events. Individual insurers are unlikely to break ranks by raising prices at a time of intense competition in the property and casualty sector. Market and policyholder acceptance of the need for any increase is more likely to follow a significant and widely publicised loss. In a comparable example, commercial premiums have risen in the UK following the Buncefield oil depot explosion in December 2005, reflecting in particular the considerable business interruption claims arising from the wide contamination of the surrounding area.

If or, more probably, when premiums do eventually increase in line with heightened climatic risk, they are likely to make up a far higher proportion of household and business expenses. Insurers could mitigate weather-related risks and reduce their premiums by working with the building industry, mortgage providers and individual policyholders to enhance safeguards. A comparable example would be fire risk, where the incentive of lower insurance premiums in return for better design, protection, early warning and interruption planning are helping to reduce the hazards and resulting claims. Effective scenario planning could also help insurers to reduce expenses and maintain services following an extreme event.

However, for some households and businesses, insurance may still become unaffordable. Others could face exclusions or escalating excesses of loss that effectively leave them without cover for certain weather-related risks such as flood or subsidence – a recent ruling in the UK allows insurers to exclude flood from household cover. ‘Withdrawal of risk coverage in vulnerable areas by private insurers’ is one of the potential threats identified in the UN IPCC’s most recent assessment report.⁵

The result of any price escalation or withdrawal of cover would be political pressure that could in turn lead to government intervention. An early example of this was the creation of the Citizens Property Insurance Corporation and Florida Hurricane Catastrophe Fund (FHCF), following Hurricane Andrew in 1992, through which the Florida state government has effectively become the insurer and reinsurer of last resort. The aggregate ceiling of losses that would effectively be covered by the FHCF was more than doubled in January 2007. The move aimed to reduce household premiums in the wake of continuing voter concerns about the price of insurance.

Although state support has helped to maintain cover for many hard-pressed Florida residents, commercial reinsurers must compete with an expanding state subsidised entity, able to offer below-market prices. While direct insurers can benefit from low-cost reinsurance offered by the FHCF, they face considerable state regulated restrictions on any weather-related terms and exclusions they may wish to impose. In particular, if they offer a type of insurance in one part of the US, they must also offer it in Florida if they wish to conduct business in the state.

An alternative to the Florida model could be a weather-related version of Pool Re, a mutual reinsurer set up by insurers in the UK in 1993 to enable them to continue to offer terrorism cover to their policyholders. Although losses in excess of Pool Re’s reserves are ultimately underwritten by the UK government in an arrangement akin to retrocessional reinsurance, the company is largely self-financing and regulated in line with other reinsurers. By taking the lead in this way and working in partnership with the UK government, insurers have helped to avoid some of the pricing, capacity and compliance issues experienced in Florida.

Capital management

Climate change could fuel further growth in alternative risk transfer as insurers seek new ways to limit the risk on their balance sheet and release some of the capital tied up in reserves. The value of new catastrophe bond issues reached a record of €3 billion in 20066 and looks set to grow still further in 2007.

Any increase in securitisation will once again underline the critical importance of effective valuation. Capital market investors expect clear and concise information about the risks they are assuming, along with demonstrable assurance that these risks are understood and mitigated effectively by management. Much of the raw material may be to hand through business plans, management information packs and internal capital assessments. The challenge is to mould it to the requirements and language of the capital markets.

Weathering the storm

Potential changes in the climate could cost insurers billions every year. It could also heighten the uncertainty in reserving and solvency calculations. The quality of modelling, analysis and underlying assumptions will therefore be critical in managing and mitigating the risk and capital impact of climatic volatility.

While premiums may almost certainly increase, insurers could help to reduce prices by working proactively with builders, policyholders and other interested parties to control the risk of damage and loss. Indeed, insurers could play an important part in encouraging governments, industry and society as a whole to address the causes of climate change, not least as insurance premiums offer a very clear indication of the financial costs.

Ultimately, climate change could stretch the limits of insurability, leaving millions of people without affordable cover. The insurance industry needs to work closely and proactively with governments to address this risk and ensure that any future arrangements are viable and sustainable.