In early February of this year, the International Panel on Climate Change, in the process of completing its Fourth Assessment Report, or the 4AR, released its finalized Working Group 1 Report on climate change. The complete 4AR report will be ready by the summer, but the Working Group 1 Report was enough for insurers.
The picture painted by the science of global climate change is a stark one for the insurance market. The likelihood is that many catastrophic events will increase in frequency and/or severity, ranging from the obvious--such as tropical cyclones and flood events--to the not so obvious--such as wildfires increasing due to drought and the climate-change-induced activity of insects.
The science surrounding climate change has improved markedly in the six years since the last assessment. It has removed any doubt concerning the veracity of climate change. The working group report concluded that there is very high confidence (90 percent probability) that the Earth is warming due to human activity.
It determined the likely change in average surface temperature over the next 100 years to be 1 to 6 degrees Celsius, the likely rise in sea level to be 0.2 to 0.5 meters. In terms of catastrophic weather events, the 4AR working group concluded that:
* It was very likely (greater than 90 percent probability) warm spells/heat waves would increase in frequency.
* It was very likely the frequency of heavy precipitation events would increase.
* It was likely (greater than 66 percent probability) that intense tropical cyclone activity would increase.
But in the aftermath of the 2005 hurricane season, the industry proved itself able through a variety of mechanisms to replace the capital lost to catastrophes--from stock issuance to sidecars to the formation of new reinsurers.
It attracted an unprecedented amount of capital from the broader financial community, but the large amount of time and energy expended by the industry in attracting this capital largely took away from the business of writing insurance. If we take the view that extreme catastrophe years such as 2005 are becoming more likely to occur, can the industry really cope with massive capital raising activities every few years?
However, with every crisis comes opportunity. The industry as a whole has the benefit of being forewarned by the IPCC when it comes to managing capital in the context of climate change. The opportunity the industry has now is to harness some of the tools used by the broader financial community, such as futures and options markets, to put in place risk management structures that will allow it to weather more frequent extreme catastrophe years without the upheaval we saw in the wake of 2005.
We should not forget the other risk management tools that the industry uses, most importantly catastrophe models, which also need to be examined with climate change in mind. CAT models never stay the same simply because each new CAT event adds more information to the process. With climate change, we will see a systematic change in frequency and severity of some catastrophes, and the modelers are starting to address this issue. In the interim, however, using CAT models to manage risk over a long period of time (say 20-plus years) is ill-advised.
The IPCC has reported that the risks posed by climate change have increased and, more importantly, have become more certain. Climate change will impact the insurance market significantly as catastrophic events become more frequent. The challenge faced by the insurance market is how it will consistently raise the capital to address these events.
is vice president of reinsurance intermediary Carvill America Inc.
May 1, 2007
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