December 2nd, 2008

Climate Change: A Debate Reshapes (Re)insurance

Posted at 1:00 AM ET

By David Priebe, Chairman of Global Client Development
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The climate change debate is likely to continue unabated well into the future. Even if it is not settled anytime soon, the debate itself has already begun to affect the (re)insurance industry. Risk-bearers deal in probability routinely, making climate change another likelihood to consider. In this manner, it has entered natural peril models, risk management assumptions, and risk transfer strategies. Consequently, climate change has become part of the (re)insurance lexicon, despite the fact that scientific, sociological, economic, and political authorities have not reached a universally accepted conclusion. The absence of a definitive answer does not preclude the use of climate change-related information in risk portfolio management.

For (re)insurers, the issue of climate change is fairly straightforward. By removing the aspects of the debate that may be politically-, socially-, or emotionally-charged, carriers can focus on the core challenge. Specifically, the industry needs to find new ways to quantify risk and develop the products necessary to use this new data to optimize capital management practices. The progress made by risk-bearers in this regard is particularly evident in the Asia/Pacific region. Natural catastrophe knowledge is growing rapidly, likely at a faster pace than in other regions. The continued release of new models, investments in climatological research, and innovative risk-transfer vehicles is empowering carriers to take control of their portfolios in the face of a climate change likelihood.

Where Do You Stand?

Three fundamental positions characterize the debate on climate change. Some firmly believe that this phenomenon does not exist. Others acknowledge that climate change is, in fact, occurring, but they hold that it is both natural and unstoppable. Human beings, they say, are powerless to slow or stop it. The third major position is that climate change, which does exist, is primarily the result of human activity (e.g., via carbon emissions) and at least can be slowed through changes in behavior—from the micro (e.g., limiting personal energy consumption) to the macro (e.g., the formulation of national and international energy policy). Various other stances do exist, though they tend to be nuanced versions of those stated already.

The debate among these parties is both long-standing and intense. Each has appealed to a set of sympathetic experts, and the presentation of evidence by any one group tends to be viewed skeptically by the others. Proof, the basic currency of argument, is impugned, rendering it only as potent as opinion. Resolution, therefore, remains far in the future—if it will ever be attained at all.

Nonetheless, a considerable amount of information has been identified to support the likelihood of climate change. For example, a common perception is that a changing climate is evidenced by an increase in tropical cyclone frequency and intensity—not to mention landfall—and it is grounded in research that reaches as far back as the 1970s. Yet, this view is countered by other scientists, who assert that tropical cyclone activity was almost as high in the 1950s and 1960s as it is today. Another criticism lobbed by opponents is that weather satellites were unavailable prior to 1965, resulting in the underestimation of storm frequency and intensity before that date.

The notion of increased landfall, it seems, is open for debate, as well. While the number of storms reaching land is growing in some parts of the Asia/Pacific region, it is decreasing in others (e.g. Philippines and south China coast). The rise and fall of storms attaining landfall sometimes occurs in tandem with higher atmospheric temperatures … but it can happen in the opposite manner, too. The argument is mired in doubt.

And, other hazards have yet to be explored, such as variations in intense rainfall and flooding, winter freeze, and intense low pressure systems in winter. The possible connections involving hail and extreme temperatures with climate change should be probed. Much remains to be considered, so the debate is far from over.

Of course, every conjecture is met with a refutation. Proponents citing the rising number or intensity of natural catastrophes as evidence of climate change are rebuffed by opponents doubting the viability of the proof. Science, as prominent philosopher Karl Popper noted, moves forward through a process of conjecture and refutation, a dynamic clearly at play in the investigation of climate change. For now, the market must be content to further the research and evaluate the findings in an unbiased manner.

Use the Debate Itself

Absent a sense of scientific certainty, it would seem that the issue of climate change offers little value to (re)insurers. After all, carriers rely on data whenever possible, and the continual questioning of supplied evidence does not leave much reliable information available. Fortunately, the climate change debate is rich in probability, also the fodder of actuarial assumptions, modeling, and (re)insurer risk management decision-making. The progress demonstrated by carriers signifies that they have been able to derive tangible benefits from the ongoing dialogue.

The process of actuarial prediction is grounded in the notion that studying the frequency and severity of past losses can provide some indication of what the future may hold. Past events—and loss histories—thus become important tools in the portfolio management and risk-transfer decisions made today. The possibility of climate change, though, complicates this effort. If conditions are changing, either through natural or manmade causes, the reliability of historical events is eroded. Of course, actuaries can compensate with assumptions drawn from evidence supporting climate change, but this implies a stance on the issue. By accounting for the possibility of climate change, carriers can reshape assumptions based on the past and model more accurately for the future.

To this end, most of the research sponsored by the (re)insurance industry has not focused on the causes of climate change. To a certain extent, this is the domain of policymakers and other government and world leaders. Instead, carriers are focused on the implications of climate change. How a phenomenon such as global warming can influence weather patterns, storm activity, and ultimately insured losses is the industry’s top priority. Seeking resolutions of these types can support model and assumption refinement and improved risk and capital management practices.

Doubtless, the goal of these efforts is to facilitate action. Information is the fuel used to identify, evaluate, and transfer risk. Thus, it is unsurprising that the scope of most of the research conducted so far has been short-term to medium-term. This pragmatic approach reflects prevailing property reinsurance pricing and coverage practices, which tend to focus on 12-month increments. This mindset will ensure that investments in climate change research will remain focused on the needs of (re)insurers and thus be relevant in the ongoing management of carrier portfolios and capital.

Take Action, Protect Capital

Information pertaining to climate change may help carriers with Asia/Pacific natural catastrophe exposure to make risk management decisions, but they must have access to the appropriate tools in order to take action. The growth of the catastrophe bond market in the region suggests that the ability to protect capital is advancing alongside improvements in understanding the risks that carriers face.

Most catastrophe bond issuance activity has addressed natural catastrophe exposures in Japan. Since 1997, 15 bonds have been issued, with total capacity of USD2.9 billion. Japanese earthquake is the most common of the perils covered by catastrophe bonds in the Asia Pacific region: eight have come to market in the past 11 years. Four catastrophe bonds for Japanese typhoon have also been issued, as well as three for combined perils in the country. Only one Asia-exposed catastrophe bond has been issued outside Japan. An indemnity triggered bond with USD100 million in principal was issued for Taiwanese earthquake in 2003.

Click image to see full-sized chart

While Asia-exposed catastrophe bonds are still heavily concentrated in Japan and comprise a small percentage of worldwide issuance, the fact that the perils covered vary suggests that the region is becoming increasingly comfortable with the use of capital markets to transfer risk. As carriers become more familiar with the specific exposures faced in Asia, they will have the tools necessary to protect their capital.

Charting a Course

As the climate change debate rages on, carriers with exposure to Asia/Pacific perils are using the results of the dialogue to manage their portfolios more effectively. Information has been generated as the disparate positions seek to prove their points; research is ongoing, with the results ultimately educating the entire marketplace. Regardless of which stance prevails, the winner is the (re)insurance industry, which is gaining a richer understanding of the factors that can influence catastrophe losses in this part of the world—whether they are caused by climate change or not.

While the market has made plenty of progress, more work remains. Carriers need to take what they have learned and apply it to the risks they cover, striking that precious balance between cautious underwriting and earnings maximization. The maturation of the use of capital markets to transfer insurance risks will help in this process. As the market for Asia-exposed risk gains both understanding and risk-transfer sophistication, market entry, growth and optimization will become easer … and more profitable.

Additional Contribution

  • Professor Johnny Chan, Director of Guy Carpenter Asia-Pacific Climate Impact Center, City University of Hong Kong

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