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Can finance reform keep pace with global change?

Insurance. Dull, isn’t it? No, actually. It is not just that it suddenly becomes intensely interesting when you need to make a claim. Viewed broadly, insurance is a complex social institution for managing life’s uncertainties better. And when you live in “interesting times”, that institution is tested to its limits.

That has already happened with natural disasters in recent decades, and the industry has responded with some big changes in policy, practice and regulation. Now, as further disasters caused by global environmental change loom, moves are afoot to transfer what big insurance companies have learnt to the way the rest of the financial system treats long-term risk.

What the major players in this arena – who include governments, the World Bank, and the World Economic Forum as well as regulators and investment banks – hope to achieve will be announced at the UN Climate Summit today.

If it bears fruit, it could be transformative. The global financial system would become a stronger influence in favour of meaningful action to reduce climate change and cope with its effects. So what lies behind this initiative? The recent history of the insurance market offers some answers.

Here’s the thing. It is obvious perfect knowledge destroys an insurance market. If you know a Bad Thing won’t happen, why waste money on an insurance premium? If it is certain that it will, no-one will come forward to underwrite your losses.

But if knowledge is too imperfect, the market may also falter. Too many major payouts may come together, and insurers go bust. So insurers need to operate in a zone of uncertainty where they can rely on reasonable ways of estimating risks. And they find ways to spread the large ones. Reinsurance is a $200 billion annual slice of a global market worth trillions.

Now suppose something was liable to increase the incidence of natural disasters, but how or when was poorly understood. Such a development could wreak havoc with insurance. It is pretty much what we expect from global climate change. Droughts, heat waves, forest fires, flash floods, storm surges, hurricanes, perhaps even tornadoes, are predicted to increase in frequency, or severity, or both.

For some of these impacts, like rising heat extremes and extreme rainfall, there are clear trends globally, according to the Intergovernmental Panel on Climate Change (IPCC). For others, the evidence is weaker. It remains difficult to extract a climate signal from the noise of natural disasters. Disaster costs are definitely on the rise. But that is partly explicable from increased exposure of people to disaster risks – an extreme weather event in a place no-one lives is of no consequence. And development can increase disaster claims because there is more, and more expensive property to damage (though good design can also reduce damage, as well as loss of life).

All that helped fuel a surge in mega-insurance claims that focussed the industry’s attention on risk management, and then on how global change will alter their risk profiles.

The first phase of this change, after a series of natural disasters in the 1980s and early 1990s, already challenged insurance industry practice. It used to be reasonable to assume the past was a good guide to the future, statistically at any rate. But historical data now has to be augmented to produce a useful working estimate of future risks. That change is still under way. A report in 2013 from The International Association for the Study of Insurance Economics (AKA “The Geneva Association”), called for “A paradigm shift from historic to predictive risk assessment methods”.

That includes using results from global climate models, which are broadly consistent but still generate large uncertainties when applied annually, seasonally, or regionally – exactly the level insurers are interested in. As the same report concludes, when it comes to extreme events, limitations of data and modelling mean there are two kinds of uncertainty. We cannot derive where a given year will fall in a distribution of probabilities – that is why they are probabilities. But the probability distribution is itself also uncertain. The report dubbed this double uncertainty risk “ambiguity”.

There is no easy solution to this, but there has been a strong institutional and regulatory response. For example, a key innovation was government and regulatory agreement that insurers should have capital on hand to cover worst-case scenarios assessed as one in 200 year possibilities.

Growing awareness of these issues is also leading insurers to go beyond backing efforts to improve risk prediction. They are also expanding risk management into new realms, throwing their weight behind broader efforts to tackle climate change.

The Geneva Association, which brings together the biggest insurers and reinsurers, announced in May that 66 insurance company CEOs have endorsed a Climate Risk Statement committing them to work with governments and the United Nations to boost efforts to reduce climate impacts.

This makes insurance probably the biggest sector of big business to press for more effective action on climate change – the Association’s members reckon their collective assets at almost $15 trillion. Part of that is the move to spread the new insurance industry standards to other sectors.

The Willis Research Network, an industry-backed network of universities and research institutes, says that at the moment the financial sector beyond non-life insurance ignores natural disaster risk. “Investors do not factor it into their valuations, creditors do not systematically assess natural hazards against their loans books and real estate markets largely ignore extreme event risk, even in highly exposed locations”, it says in a concept note issued in June.

The note, written by Network chairman Rowan Douglas, calls for a wider effort to integrate disaster resilience into the financial system. He suggests this could have effects similar to those of earlier insurance standards, which helped promote things like fire safety regulations, building codes and zoning laws. One consequence, aside from making it easier to insure your building against fire, was that city-wide conflagrations generally now only occur in wartime. If a new buildings had to be proof against a once in a hundred year flood, for example, a lot of housing developments might look very different.

The note calls for a suite of reforms to global financial systems, integrated with local and regional action to drive disaster risk reduction, to be in place by 2020. The template for such reforms would be changes in the insurance sector following its “near existential crisis” following the earlier string of disaster payouts and company bankruptcies, they suggest. Similar long-term risk considerations should be included in management of other financial sectors – including investments and securities, borrowing, and accounting and reporting.

If that works through, it would also bring finance and science closer together, increasing demand for more, and more usable, models and forecasts to help assess risks. Future Earth, working in tandem with the International Research on Disaster Risk programme, is committing to support research that quantifies risks, contributes to resilient options and works to monitor and evaluate such measures. In particular, these programmes will work to deliver usable information on the scales climate models still find hard to address. Eventually, this ought to speed up emergence of agreed standards for modelling catastrophic risks that would meet the needs of regulators and investors.

If these changes are instituted, they would potentially have massive effects on the working of markets through adjustments in the value of assets and liabilities to take account of new, and increasing risks. That in turn, ought to drive investment in solutions to (some of) the risk. Resilience to disasters is seen as part of green and sustainable growth. And the signs are pointing that way. The rating agency Standard and Poor recently issued a report laying out how climate change will affect “sovereign creditworthiness” – that is, whether states are a good credit risk.

That report concludes that poorer countries will be hardest hit, making it more expensive for them to borrow, thus magnifying international inequalities. That is a serious problem, and calls for separate measures to mobilise the capital needed to improve resilience in less developed regions. However, the wider moves now envisaged could help by boosting efforts to limit climate change, as well as to cope with its effects.

There is, after all, one simple mathematical fact that remains true throughout the discussion, and encourages the hope that the world of finance will have to confront global change. In financial terms, anyway, the rich always have more to lose.

Further reading

Warming of the Oceans and Implications for the (re)Insurance Industry. Geneva Association, 2013.

Integrating Natural Disaster Risks and Resilience into the Financial System. Willis Research Network, June 2014.

Climate Change is a Global Mega-Trend for Sovereign Risk. Standard and Poor, May 2014.