Adapt and survive?

The received wisdom is that the insurance sector will be the first to suffer from the effects of climate change. But is this really likely to be the case, asks Robert Muir Wood

Some in the reinsurance industry were among the first to warn about the potential consequences of climate change – suggesting, perhaps, that the insurance industry stands to be a significant loser from the impacts of global warming. On the face of it, the situation seems obvious: increasing catastrophe losses will fall onto insurers, reducing their profitability and even driving some out of business. But is this actually how things will play out?

Climate change promises more storm damage - but will it also batter the insurers?

Insurers and reinsurers sell a similar product – the annual contract.This could be a policy sold to a homeowner or a reinsurance contract providing coverage to a major insurer. This product is flexible – the terms can be tightened or loosened and the cost adjusted each time the contract is renewed. The insurer can also (in most circumstances) refuse to renew the contract at all. As a result, the insurance contract is highly adaptive to a changing risk environment.

The insurance industry is a market, balancing demand and supply.To understand how the market responds to the rising costs of catastrophes, we can look at what happened after recent major hurricanes. Following Hurricane Andrew in 1992, 15 insurers went bankrupt. A rapid rise in reinsurance rates was consolidated by the January 1994 Northridge earthquake.

In response, new capital entered the reinsurance market, and a handful of new technically- focused Bermudan catastrophe reinsurers were founded to take advantage of doubled reinsurance rates. For a period in the mid-1990s, reinsurers were in the driving seat, able to force changes in how policies were written in the chief catastrophe markets – including introducing 5% deductibles for earthquake coverage in the Caribbean and 15% for California.

In the four hurricanes of 2004 (with a combined US mainland insurance loss approaching $23 billion),much of the loss was picked up by the state-backed Florida insurance and reinsurance mechanisms set up after Andrew, so the year remains the most profitable yet for US insurers. The international reinsurers and nationwide US insurers were not so fortunate in 2005, when Katrina was a single massive loss in a region without statebacked insurance and reinsurance mechanisms. Hurricanes Rita and Wilma added to the pain. However, even in the face of insured hurricane losses twice as great as an inflationadjusted Hurricane Andrew, the insurance industry has coped reasonably well – with only a couple of medium-sized reinsurers on the seriously injured list.

As with all recent insured catastrophes, the financial markets were quick to spot an opportunity. In the weeks following Hurricane Katrina, some $20 billion of additional capital flowed into the Bermuda reinsurance market – in anticipation of higher reinsurance prices. However, as a result of all this extra capital, prices for 2006 renewals did not increase as much as had been anticipated. The industry is watching 2006 with nervous anticipation. Catastrophe models – such as those from RMS – will be showing increased levels of hurricane loss, as they incorporate the evidence for an increase in hurricane activity and severity.

So, where are the pressure points on the insurance industry? Could a sequence of catastrophes in a single season or across two seasons overwhelm the capacity of the market to respond?

Perhaps counter-intuitively, however, in a time of rising levels of risk, the biggest threat to the insurance industry is political interference in the efficient workings of the market.

In the US, elected state insurance regulators are unwilling to listen to arguments around the need to raise homeowners’ rates. Reinsurers would lose significant market share if the much-discussed US national catastrophe risk pooling arrangement should ever come to pass, mixing Florida coastal storm surge, New York terrorism and San Francisco earthquake risk into one pot.

However, the Bahamas is an interesting test case for a purely free market insurance system, without any regulation of insurance rates and without any prospect of government intervention. Inheriting the British insurance system, flood is a standard insurance coverage.

The insurance industry has every prospect of thriving – as long as it is politically adept, able to charge appropriate rates, and move out of providing coverage when the risk gets too hot

In the past decade, three major hurricanes have hit the northern islands of Grand Bahama and Abaco. In each case – Floyd in 1999, Frances and Jeanne in 2004 – there have been significant storm surges. On Abaco, properties in the coastal floodplain are still insurable but at double the rate (up to 2% of the value per year). On Grand Bahama in the Queen’s Cove Canal Estate (at less than one metre above sea level), flooded three times since 1999, the properties are now uninsurable. The market is responding, however, and an increasing number of Bahamian beachfront properties are today being built on concretestilts, bringing them back into the domain of insurability.

In New Orleans, and along the coast of Mississippi, similar situations are being played out, but in a context where the US federal government backs the National Flood Insurance Program (NFIP), which has inherent subsidies that prop up some situations that would otherwise be uninsurable. The NFIP has recently asked Congress for a $23 billion ‘loan’ to pay the Katrina and Rita flood claims of homeowners – including many who did not actually have any flood insurance.

There are a large number of ways that climate change is likely to destroy value – by damaging houses in the coastal floodplain, for example, or ruining farms in a region of decreasing rainfall. But, as long as the market continues to function freely, the insurance industry’s overall profitability under climate change is principally going to be determined by the fate of the whole economy. Under most scenarios, the insurance industry has every prospect of thriving – as long as it is politically adept, able to charge appropriate rates, and move out of providing coverage when the risk gets too hot.

Therefore, the real issue is less the fate of the insurance industry, than the future of ‘risk bearing’. Rising levels of risk caused by climate change mean an increased proportion of economic activity will be employed in paying for risk protection – including buying more insurance. It also means a likely expansion in the role of governments and individuals where insurers move out of offering coverage – in particular on coastal floodplains. The insurance industry has to avoid being so smart about managing the risk that it is seen to be not bearing its share of the pain.

Robert Muir Wood is London-based chief research officer at Risk Management Solutions, a US-based catastrophe and weather risk modeling and management company.

He is a lead author for the forthcoming Fourth Intergovernmental Panel on Climate Change Assessment Report.

E-mail: robert.muir-wood@rms.com