For an insurer, understanding climate change is a matter of understanding trends in risk and changes in those trends. For Wendy Baker, president of Lloyd’s America Inc., staying on top of those trends in the United States — where her company does around $12 billion worth of business — is a both a responsibility and an opportunity.
Climate change, shifting demographics and economic factors all add up to a scenario in which a mega-catastrophe with $100 billion in insured loss is a matter of when, not if, Baker recently told attendees at the 2007 Mid-Year Property & Casualty Insurance Symposium sponsored by the Association of Fire and Casualty Companies in Texas and the Insurance Council of Texas.
“We need a radical rethink of public policy. We need an insurance industry that is financially strong and free to operate within the market. We need a coordinated action on climate change,” Baker said.
She added that “at Lloyd’s, we believe the time for action is now.”
While the dire predictions of the 2006 hurricane season did not come to pass, Baker doesn’t think the forecasts were overblown. She noted that although only two years out of the past 20 had lower catastrophe losses than 2006, the number of natural catastrophes doubled between the 1960s and the 1990s, with insured losses increasing seven-fold during that time.
The year “2005 was the worst ever year with total world insurance claims of $85 billion, 80 percent of it from U.S. hurricanes,” Baker said. “That’s about $62 billion from Katrina, Rita and Wilma. Our share of that was about $6 billion, so this is very important to us at Lloyd’s.”
Baker explained that the impact of climate change will test the principles of insurability.
“All insurable risks ideally have the following characteristics,” Baker said. “They should be identifiable — they will not happen all at once. They should be quantifiable — exposure can be assessed based on likelihood, spread and past data. Fortuitous — may or may not happen. Economic — the policyholder can afford to pay the premium.”
With climate change, she said, identification and diversification may be difficult as aggregations of claims are likely with severe windstorms, floods and droughts. Losses can occur across classes of insurance, with claims from property damage, liability, auto and even political risk possibly coming into play.
As a result of the catastrophes of 2005 the industry realized that past data was not as relevant as previously thought, and, that it’s a matter of when, not if, a major loss will occur. Additionally, she said, “In some cases we may have to charge more than the policyholder can afford to pay.”
Because “climate change can happen in discrete jumps,” the industry’s fundamental assumptions may prove wrong, especially if the “data is sparse,” Baker said. In which case, “an underlying trend can be hidden for years and only pop up as it did in 2004 and 2005.”
Primary and secondary issues
An increase in average losses, as well as in the volatility and frequency of extreme losses, is possible in the next few decades as a result of climate change. With more humidity in the air and all other factors being equal, “after a hurricane, homes and buildings take longer to dry out. This leads to more time in hotels for homeowners, longer business interruptions and thus larger claim costs. It can lead also to operational issues, such as more complaints, meaning higher claims expenses,” she said.
Claims drag out, reserves and capital are tied up and financial results are subject to uncertainty when that happens. Inevitably, those secondary issues lead to lost opportunities for insurers.
“The primary issue is that hurricanes and other risks have increased in many regions in the world, causing increased losses,” Baker said. “The secondary issues, however, will magnify these losses and make it even harder to forecast and to model them.”
She noted that after a mega-catastrophe like Hurricane Katrina, premiums are typically adjusted to recoup losses and insurer profits rise substantially in the following year. “When major events are rare as they have been in the past, this method works pretty well,” Baker said. “But as large events occur more frequently, as is expected, the chance of several poor underwriting years in a row increases.”
The question for insurers is, will capital providers continue to return to the market again and again?
Affected insurance products
Property — both personal and commercial — business interruption, and directors and officers are among the many classes of insurance that can be affected by climate change, Baker said. For insurers, those classes represent not only increased risk but opportunities as well.
“As perils change and move, new groups of policyholders will need coverage,” she said. “They will wish to protect themselves from this new risk, and we can help them. But we can only help them if we gain a better understanding of how the peril has changed.”
Using its own proprietary risk models, called realistic disaster scenarios, Lloyd’s assesses the market against large disasters around the world. For a hypothetical Florida windstorm event, since 2005 the estimated losses have jumped from $70 billion to $100 billion in 2006 to a current figure of $108 billion.
“Part of the increase is due to our view that risk of extreme events due to climate change has changed dramatically. Part of the increase is due to the very significant impact that demographic and economic trends have on risk,” Baker said.
“Between 2006 and 2007 we did not change the event details at all. They’re the same storm strength, the same landfall location, the same track,” she added. Demographic shifts, more people living in exposed areas, economic effects, higher contents values and higher construction costs all contribute to higher loss costs.
The industry cannot force customers to reduce and offset carbon emissions or build with green materials, she said, but insurers can take steps to reduce negative results from climate change. The industry can: promote loss prevention by encouraging policyholders to become risk managers in partnership with the industry; design innovative products in response to changing climate, demographic and economic influences; and take part in the public debate.
“We need to talk about it,” Baker concluded.
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