As I mentioned in my previous post, “A Stormy and Uncertain Future for Property Insurance in New Zealand and Around the Globe…” climate change has the potential to pose threats to the industry’s financial stability. As we know insurance has been so intrinsically woven into the very foundation of our society – in the event that its availability is lost or its stability undermined then the outcomes look potentially gloomy for consumers and their governments. So the need to pre-empt the likely arrival of climate effects becomes critical.
Along with increased weather events we are seeing an ever-increasing rise in property insurance rates for catastrophe-exposed risks i.e. consumers are having to pay more for their cover. Homeowners in the U.S. for instance, living in wind exposed areas, such as coastal regions are seeing rate increases and many insurers are restricting capacity, decreasing deductibles and requiring wind mitigation construction.
Insurers are having to foot the costs of rising payouts while at the same time they are confronted with historically low investment returns and a dubious global economy. The insurance industry’s overall financial performance (as measured by average return-on-equity) lags behind other industries. The threat of rising catastrophic losses triggered by increasing concentrations of insured assets do present very real and significant challenges to the sector’s financial future. Insurance sector losses and poor financial results have the potential to undermine the industry’s financial ability to weather the storms.
One of the other big risks for the insurance industry lies in that industry’s interconnectedness and interdependency in the global marketplace. For example, the extreme flooding in Thailand, with associated loss estimates now at US$15 billion, testifies to the economic damage that can be caused by supply chain disruptions. As a result of the flooding, home computer shipments to the U.S during the first quarter of 2012 were expected to drop more than 20 percent from the previous quarter. (See http://www.boston.com/business/technology/articles/2012/04/27/thai_flooding_impact_on_tech_companies_suppliers/).
In Japan similar difficulties arose after the earthquake and subsequent nuclear plant melt down in 2011. Where one of the most uncertain elements is the insured loss associated with large international (non-Japanese) corporations, primarily insured by major international insurers. Insurance protections business interruption, extra expense and contingent business interruption (CBI) cover, when suppliers can’t supply needed production materials to customers. The CBI element becomes difficult to estimate because the financial effects of supply chain interruption are not usually known for some time.
The potential for third-party liability claims from climate change is less well understood but has even greater potential to affect the industry. Financial assets held to meet claims and provide a capital buffer may also be affected. Therefore the balance sheet of an insurer may be damaged from all sides.
In addition there has been an extended period in the U.S. of near-zero interest rates which was designed to assist the ailing economy. This too, poses significant challenges for insurers and profitability. The economic uncertainty with the situation in Europe has also contributed to ongoing market volatility. Yet in order for property insurance companies to benefit financially, what is required are safe, predictable investment returns in order to pay claims.
In the wake of heavy catastrophe losses of 2011 and with an eye to maintaining enough cash on hand, insurers began moving some of their money into short-term bonds. Short term bonds produce lower yields which in turn have led to a further decrease on companies’ investment income. It is also true that the full extent of recent catastrophe losses on insurers’ solvency may not be seen for several years to come. Usually, even in the face of extreme losses, insurers can support solvency or capital adequacy and profitability ratios for several quarters, particularly as they hold onto reinsurance funds avoiding claim settlement. They do this by being propped up by reserve releases, only to become later financially impaired by unforeseen shock losses.
Insurers have been ‘sticking their hands in the financial cookie jar’ for the past few years by releasing reserves to help boost financials. The time may have come where the jar is empty with significant implications for sector profits and capital growth. (See Guy Carpenter & Co., Catastrophes, Cold Spots and Capital, Navigating for Success in a Transitioning Market. January 2012 Renewal Report.)
Standard and Poor has said in its 2012 Industry Outlook, Looking ahead, we believe higher catastrophe losses, a relatively weak macroeconomic environment, lower investment yields and the tapering off of the benefit of reserve releases are likely to weigh on profitability for the overall Property/Casualty industry.
The Conclusion: it is clear that if climate change were to be severe enough to impact the investment environment which in turn drives insurers’ investment yields, this would further compound the operating risk posed by climate change. Consequently the industry’s ability to honour its obligations to policyholders and deliver returns to its shareholders will depend increasingly on its ability to manage climate risk. Is this a risk that can be feasibly managed? For a period perhaps – but for how long – that is the trillion dollar question!
Trevor Maynard in “Climate Change: Impacts on Insurers and How They Can Help with Adaptation and Mitigation,” (2008, The International Association for the Study of Insurance Economics 1018-5895) stated,
Insurance is adaptation; there are a surprisingly large number of small to medium companies that do not have catastrophe cover, so increasing insurance penetration of these markets would be an adaptive measure. Insurers will continue to lobby governments for appropriate weather defences to keep areas insurable for as long as possible. Non-traditional forms of insurance are available (such as those based on weather indices with parametric triggers) and it may be possible to continue to offer these for longer than traditional insurance. They do bring basic risk with them, and therefore possibly reputational risk to the industry.
So in the long run what are the likely effects of increasing numbers of catastrophic global weather incidents on the insurance industry and policyholders. And what can be done to mitigate these effects? No doubt the insurance industry will be throwing much money at actuaries and weather modellers in an attempt to get control of the beast.
According to the Ceres Report of September 2012, While the industry has historically been able to weather each of these challenges, in combination they have significantly undermined the profitability of insurers’ business models. On-going under-pricing of risks, especially in light of significant changes in weather patterns, and a general depletion of the sector’s reserve cushion, may spur a future increase in insurer impairments and possibly insolvencies.
In New Zealand we have already seen this take place with the failure of AMI, Western Pacific and the withdrawal from the market of Ansvar Insurance.
~Future Proofing for a sustainable, participatory, democratic society.
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