TODAY’S STUDY: WHAT THE PEOPLE WHO WILL FINANCE CLIMATE CHANGE ARE PLANNING FOR

Climate Risk Disclosure by Insurers: Evaluating Insurer Responses to the NAIC Climate Disclosure Survey
Sharlene Leurig, September 2011 (CERES)

Executive Summary – Trends, Findings & Recommendations

The insurance industry is a key driver of the global economy, its products and actions stimulating trillions of dollars in private investment and influencing business activity across all sectors. Insurance also deeply affects societal behaviors from driving habits to personal health decisions to corporate investments.

But climate change is altering the industry’s global business landscape and the risk models on which it crucially depends. After centuries of operating in a relatively stable global climate, insurers are facing more volatile weather patterns driven by rising temperatures and human activities likely causing them.

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As the National Association of Insurance Commissioners (NAIC) itself has noted1, this fast-emerging threat will have broad impacts across the industry, clouding its ability to price physical perils, creating potentially vast new liabilities and threatening the performance of its huge investment portfolios.

This Ceres report is the first attempt using public disclosure filings to evaluate the extent to which US insurers consider climate change a key risk factor to their business, and if so how they are factoring it into governance practices, management strategies and day-to- day decision making. The analysis is based on responses by 88 insurers to a 2010 survey from the NAIC. The disclosures were filed with insurance regulators in six states: New York, New Jersey, California, Oregon, Pennsylvania and Washington.

The NAIC survey, while incomplete, provides an unprecedented view into climate risk perception and management within the insurance industry. The survey responses paint a picture of an industry that, outside of a handful of the largest insurers, is taking only marginal steps to address an issue that poses clear threats to the industry’s financial health, as well as to the availability and affordability of insurance for consumers.

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KEY FINDINGS OF CERES’ ANALYSIS INCLUDE:

1-There is a broad consensus among insurers that climate change will have an effect on extreme weather events.

More than three-quarters of insurers responding to the survey name perils that may be affected by climate change. More than half name market segments, such as homeowners or marine insurance, which may be affected by climate change. And a third of insurers name climate-affected geographies. Even those insurers with no formal climate policy, no climate risk management structure and a stated belief that the company is not vulnerable to the effects of climate change still name perils that may be affected by climate change 20 percent of the time.

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2-Yet despite widespread recognition of the effects climate change will likely have on extreme events, few insurers were able to articulate a coherent plan to manage the risks and opportunities associated with climate change.

Of 88 companies surveyed, only 11 reported having formal climate change policies, and more than 60 percent of the respondents reported having no dedicated management approach for assessing climate risk. This was not true uniformly across the industry, however.

3-The survey found that U.S. insurers’ perceptions about and responses to climate
change vary significantly by segment and size, suggesting the potential for
significant market dislocations and potential contraction as insurers with less
capacity to identify and manage climate risks experience excessive capital losses.

Some of the largest players in the industry—particularly in property and reinsurance— are investing considerable resources into understanding the risks and developing strategies that may drive more climate-resilient underwriting practices and capital decisions. Seven of the 11 companies that report having formal climate policies are multi-line insurers (those with diverse business, including life & health in addition to property & casualty) and one is a global reinsurer, most with annual premiums well above $1 billion. Only two life insurers, Prudential Insurance Co. of America and Genworth Life Insurance Co. of New York, report having a formal climate policy.

None of the 18 property & casualty companies surveyed have formal climate change policies or explicit board or executive oversight of this key issue.

Based on these disclosures, there appears to be significant asymmetry between market segments in climate risk management, with broad cross-sections of the market having no apparent system for identifying or addressing climate risks. Of particular concern to regulators, the most vulnerable companies tend to be within the segments of the market that are closest to consumers.

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4-The industry is focusing most of its attention on a narrow set of risks, ignoring issues like non-coastal extreme weather and climate liability, which may prove to be significant.

With some important exceptions, the industry is largely focused on the implications of climate change for hurricanes and other coastal events. While this is understandable given the financial risks associated with major hurricanes, recent years have demonstrated that the climatic effects of rising temperatures are likely driving up aggregated losses from smaller, non-modeled events—including perils such as floods, droughts, snowstorms, hailstorms and tornadoes—in ways that severely cut into insurer profitability.

Climate change has also become the subject of significant litigation in recent years, a trend which is likely to grow as the physical impacts of climate change become more pronounced and affected parties seek redress in the courts.

Litigation risk is conspicuously absent from the disclosure filings of some insurers indemnifying defendants in ongoing litigation. In fact, no insurers name any historic or ongoing litigation in which they are implicated through liability contracts. Given the significant defense costs associated with these cases, and the scale of the potential liability (which many in the industry have likened to losses sustained through asbestos and tobacco liability), the omission of liability risk exposure should be of particular concern to regulators and shareholders.

There are important exceptions to the overall scant disclosure around the specific risks that insurers face from climate change. For instance, the filing by Harleysville, a relatively small P&C insurer, contains an account of historical changes in tornado events which provides a clearer picture of an insurers’ view about changing extreme event trends.

PMA Group’s Pennsylvania filing also captures an unusual degree of specificity between discussion of perils and geographies, and provides a window into the uncertainty inherent in risk modeling and emerging liability exposures that may compound insurance losses from more volatile or extreme weather.

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5-The majority of insurers that report using catastrophe models describe them in terms that suggest their company does not have a clear understanding of how the models can or cannot be used to anticipate changing risk.

Most of the industry relies on third-party catastrophe risk models that only marginally integrate changing extreme weather.

Only the largest insurers have the capacity to develop their own internal models; the vast majority of carriers rely on models provided by third-party vendors. The P&C industry’s reliance on ‘cat’ models to set pricing and exposures means its risk view is largely shaped by these vendors.

The vast gulf in scientific expertise between the largest insurers and the average company is evident in insurers’ discussions of catastrophe modeling.

In reality, and despite what many insurers seem to believe, catastrophe models shaping pricing across the industry only marginally incorporate changing climate trends.

Of the insurers with property exposures, 23 describe using cat models. Only eight suggest that today’s catastrophe models may be insufficient to help their company or the industry at large to manage climate change.

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Those companies that describe limitations of the industry’s existing risk modeling tools tend to be those with the capacity to develop their own loss models. In contrast, companies that rely solely on third-party models almost uniformly believe those models to include all relevant climate change trends. Given this market asymmetry, regulators should be aware that many of the smaller companies operating within their states are likely setting pricing based on flawed beliefs of how the proprietary models work.

In contrast, larger insurers more readily recognize the inherent limitations of current catastrophe models in light of changing climate than do their smaller competitors. These larger players have a clear competitive advantage in deploying resources to build the latest climate science into their pricing models.

Without explicit education and dialogue between reinsurers, modelers, brokers and primaries, the gulf between the most sophisticated insurers and the rest of the industry in terms of the capacity to anticipate nonlinear climate change trends will persist. This puts consumers and the industry as a whole at risk.

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6-While climate change poses significant financial risk for the industry, few insurers provided meaningful information on the potential financial impacts of more volatile weather losses.

More than 40 percent of insurers that see their company having climate risk exposure provide no information on the potential effects climate change may have on the company’s pricing, capital adequacy or reinsurance requirements. Of those that do discuss the potential financial risks from climate change, only 18 percent outline actionable steps being taken to manage those risks.

This should be of particular concern to regulators and shareholders, as it suggests that most companies may not be adjusting their pricing and capital allocation approaches despite growing evidence of the potential for extreme and volatile losses.

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7-Just as climate change may substantially increase insured losses, it also threatens the performance of the vast investment portfolios insurers rely on to meet their liabilities.

The insurance industry controls more than $23 trillion in global investments, making it one of the world’s largest investors. Investment advisor Mercer calls climate change a systemic risk, estimating in a recent report that it could introduce as much as 10 percent portfolio risk for institutional investors—including those with diversified holdings in sovereign fixed income, equity, credit and agricultural assets. Mercer suggests that traditional asset allocation strategies will not be enough for investors to manage climate risk.

Despite such recommendations, our analysis shows that only a few insurers have explicit investment policies in place for managing climate change. These exceptions include Chartis, AXA Group and Swiss Re, all three of which include climate in broader investment commitments for integrating ESG (environmental, social and governance) factors. In contrast, most companies view climate change as a slow-burning economic risk that will happen in time frames well in excess of their investment horizons.

This report is being published as the industry has begun to recognize the broad implications that climate change poses for insurers. As Allstate’s CEO recently told a group of sector analysts, the company is saying goodbye to the “good old days” of less extreme weather and is now “running our business as if this change [in extreme weather] is permanent.”2

The NAIC’s 2010 inaugural survey—and the results and findings documented in this report—provide an unprecedented view of climate risk perceptions and climate-related management strategies within the insurance industry. Our analysis shows widely varying and generally inadequate responses from US insurers—a shortcoming that limits regulators’ ability to oversee how insurers in their states are assessing and managing climate risks.

The experience of this first year suggests a number of ways in which the disclosure process can be made more useful to regulators, consumers, investors and the industry itself in the future. We recommend that regulators consider the following steps:

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●● Implement mandatory disclosure annually and make all survey responses public:

The current approach, with some states requiring responses to the survey and others making participation voluntary and non-public, has resulted in a patchwork of disclosure which does not provide a full sense of how the US industry as a whole is affected by and managing the impacts of climate change.

The information provided through mandatory public disclosure can help other market actors identify market-wide failures in risk management and push for market corrections. In this respect, disclosure results should be used not only by regulators, but also by reinsurers, primaries and brokers to understand the direction the market is moving with respect to a risk factor that will profoundly shape industry performance in the coming years.

●● Clarify disclosure expectations:

The lack of specificity in the current NAIC disclosure survey has led to responses that are frequently vague and unhelpful, with little consistency in how insurers address major trends, including pricing, modeling and governance. Regulators should consider providing more detailed guidance documents in planning future survey responses. A useful model in this regard was disclosure guidance provided in 2009 and 2010 by the California Department of Insurance.

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●● Create more shared resources to help insurers analyze and respond to climate-related risks and opportunities:

Relatively few insurers have the ability to produce fundamental research on the ways in which climate change may affect their business. Insurers and regulators would both benefit from more fundamental research in the following areas, which emerged as key areas of weakness in this year’s disclosure responses:

• Investment Risks and Opportunities: Regulators could engage with investment consultants and asset managers to better understand insurer portfolio exposure and climate-sensitive asset allocation strategies.

• Correlated Risks: An assessment of the potential for emergent correlated risks between insurers’ underwriting and investment portfolios would better inform future examination procedures.

• Loss Modeling: Regulators and carriers would mutually benefit from clarification of how today’s loss models incorporate climate parameters.

• Health and Life Loss Potential: Fundamental research on the temperature sensitivity of morbidity/mortality statistics would likely benefit insurers, regulators and public health professionals.