Climate Change and Insurer Risk Management Strategy

By Ross N. Hoffman and David B. Hogan

Evidence for climate change is widespread in the geologic record and in historical and recent observations. Anthropogenic changes in land use and industrial pollution, particularly greenhouse gases (GHGs), are now significant. The impact of climate change will have many implications for society — moral, political, economic, and scientific.

As climate changes, there will be both winners and losers. Businesses will face evolving risks and opportunities. Those risks and opportunities will have operational, economic, regulatory, and reputational impacts (Figure 1). While there is risk and uncertainty everywhere, opportunity also abounds. The industry as a whole and individual insurers and regulatory organizations should lead society's response to climate change.

Climate Change Statistics (operational risk and opportunity)
For insurers, an important operational climate risk is that idealized statistical underwriting assumptions may not hold in a warming world. First, as climate changes, global patterns of weather events change. This interdependence complicates risk analysis since it implies exposures at different locations are not independent and may be correlated. Second, when statistical properties are nonstationary, caution is required in using empirical probabilities, especially for rare events. At AER and AIR Worldwide (as well as at numerous other companies and government labs), scientists use modeling tools to fashion possible future scenarios that can be used to estimate risk. While we cannot predict the future, we can put bounds on likely outcomes. This information provides an opportunity to refine rate-setting procedures.

Climate Change Strategies (economic risk and opportunity)
Responses to climate change are commonly divided into mitigation strategies (strategies that actually fix the problem) and adaptive strategies (changes to our practices and/or increased protective measures that accommodate climate change). Both mitigation and adaptation are required — with mitigation more a national government and international function and adaptation more a local government, industry, and individual activity. New adaptive strategies may provide opportunities for new business.

In a changing climate, strategies must work well over an expected range of possibilities. Such strategies are termed resilient. There is a need for such a strategy to mitigate the risk to coastal property values as sea levels rise. That will require fine-tuning the interplay of various adaptation strategies, including development and enhancement of coastal defenses, planning and zoning regulations, and building-code strengthening and enforcement, as well as insurance rate inducements to avoid development in particularly threatened areas.

Enterprise Risk Management
Today, an integrated enterprise risk management system that engenders situational awareness is a necessity for a well-managed company. With respect to climate risk, situational awareness will be enhanced by the development and maintenance of a climate change road map and regular climate change risk audits. The road map must consider the full range of climate business risk discussed here. To be useful for business planning, the audited risks must not only be properly identified but also quantified. Since economic climate change risk pervades all investment types, particular care is required to account for correlations of risk between different, seemingly unrelated investments.

Climate Change and the Insurance Industry (regulatory risk and opportunity)
Both underwriting procedures and regulations can evolve more quickly than climate can change. The insurance industry has a clear opportunity to lead proactive risk management addressing impending climate change exposures through measures that encourage both mitigation and adaptation. To accomplish this, the insurance industry needs to speak with one clear, well-informed voice.

Climate Risk Disclosure
A soft form of regulation is a disclosure survey. Increasingly, industries are asked to disclose their policies, procedures, and risk mitigation actions regarding GHGs and climate change. Already, the Carbon Disclosure Project (CDP) has achieved good response rates from the energy industry and is now engaging the insurance industry. One outgrowth is a recent National Association of Insurance Commissioners (NAIC) survey that contains several questions patterned after the CDP questionnaire. In the NAIC ­survey, seven out of eight questions ask if one aspect or another of an insurer's enterprise risk management system addresses ­climate change.

Risks in Managing Risk
Once a disciplined enterprise risk management system is directed at climate change (a potential outcome of participation in the NAIC survey), significant actions by that enterprise are expected in response to perceived risks. Such actions might result in unintended consequences if not informed by an adequate understanding of the scientific issues. Therefore, an efficient, calibrated response is required commensurate with the actual risks.

Time for Action (reputational risk and opportunity)
If climate change increases losses and premiums, public perception of the insurance industry may be adversely affected. Conversely, enhancing image, consumer trust, and reputation through climate change activities can garner crucial advantages for insurers. A proactive response should include staff education, public outreach, engagement with others players, climate risk management, and contingency planning. Policies that promote mitigation and adaptation by policyholders should be encouraged.

As climate change accelerates, so too will risk and the potential for new opportunities. Taking a wait-and-see approach is not advised. And a business-as-usual approach creates a distinct risk of being overtaken by events. At the same time, an effective risk management strategy must clearly determine what is important and relevant from the perspective of underwriting, investment, regulation, and public perception.

Ross Hoffman, Ph.D., is vice president of research and development and a principal scientist at ISO's Atmospheric and Environmental Research (AER) ­subsidiary.

David Hogan is vice president of AER's Programs and Systems Division.

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