Is a storm brewing?

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The Association of British Insurers gave a stark warning this week to international policymakers - act now to reduce the impact of climate change or face crippling costs

If we do nothing and take no adaptation measures for climate change, annual insured losses from US hurricanes, Japanese typhoons and European windstorms alone could increase by two-thirds to $27bn (£14.8bn). This equates to an increase in average annual damages of $10.5bn on a baseline of $16.5bn today. Such an increase in losses would also most likely raise the cost of capital required by insurers and heighten the volatility of insurance markets. Under a high emissions scenario, for example, where carbon dioxide levels double, insurers' capital requirements could increase by more than 90% for hurricanes and 80% for typhoons.

This is the stark reality of the financial costs of climate change, presented yesterday by the Association of British Insurers to policymakers from around the world.

With the intention of putting climate change into a financial framework, research companies Climate Risk Management and Metroeconomica were commissioned by the ABI to identify the costs of climate change for the insurance industry and thus focused on these three major storm types as the ones most likely to shake up the capital markets.

Scenarios about the danger of increasing severity, based on emerging scientific consensus, were then given to catastrophe modelling company AIR Worldwide. The result has been to attach some hard figures and financial ramifications on the predicted changes in extreme weather conditions.

This is believed to be the first time such a study, combining industry catastrophe modelling with the best scientific data available, has been produced. "The idea of the study was to start to look at the financial costs of climate change on a global scale, as the insurance industry is a global business," explains Dr Sebastian Catovsky, policy adviser on natural perils at the ABI. "And also to work with the government's agenda this year on climate change as a key international issue."

Moreover, these figures are deliberately 'frozen', taking no account of the likely increase in society's exposure to extreme storms. They are based on current population, wealth and asset distribution. Therefore - due to the trend in increasing population and wealth, combined with asset concentration - the financial costs would in all likelihood be considerably higher. "It is clear that socio-economic factors have a massive impact in terms of exacerbating losses," says Dr Catovsky. "Equally, policymakers could use those socio-economic trends to mitigate losses."

Jane Milne, head of property at the ABI, illustrates just how significant socio-economic factors can be in exacerbating insured losses, by using the example of Hurricane Andrew - still the most costly natural catastrophe in history. "US studies on Hurricane Andrew have revealed that if it had happened in 2002, rather than 1992, the costs in real terms would be double because of the rising asset costs, and a higher number of people in the same area."

The ABI believes that with this research policymakers should now be able to make more informed choices about the future consequences of climate change and any action they may take to mitigate those consequences.

Capital requirements

In the do-nothing scenario, wind-related annual insured losses from extreme US hurricanes would increase by around three-quarters from the current level to the end of the century, to between $100bn and $150bn. To put this in perspective, that is the equivalent of being hit by two to three Hurricane Andrews in a single season.

When it comes to extreme Japanese typhoons, wind-related annual insured losses are predicted to rise by around two-thirds to between $25bn and $34bn. This increase alone is more than twice the cost of last year's typhoon season - the costliest in 100 years.

Finally, wind-related insured losses arising from extreme European windstorms would increase by at least 5% to between $32bn and $38bn. Although this may not seem a great change, Dr Catovsky explains: "The science about windstorms in Europe is less clear, although we are expected to have more deep, heavy storms across the UK and other countries. The models showed an increase in the deepest storms by 20% in terms of frequency."

This research deliberately focused on the financial implications of catastrophic storms due to the fact that insurers' capital requirements must reflect the worst-case scenarios, rather than average ones. They must be ready and prepared to pay out on an extreme event occurring at any time.

As the report states: "Analysis of different policy responses to climate change rarely includes consideration of the financial consequences of very extreme weather events and knock-on effects through capital markets.

Policymakers should incorporate the potential direct and indirect impacts of climate change on extreme weather within their cost-benefit analyses, given the scale of the potential risks."

Dr Catovsky reiterates this by saying: "Policymakers tend to look at average increases but have got to look at the volatility aspect too." Ms Milne adds: "They can then assess how much it is worth spending now to avoid damage and accrue benefits. They can have proper cost-effective policies in place rather than just continue with the debate at the moment, which is stuck in emotional appeals and taking a moral stance. Not that these aspects aren't important - but now governments have the hard-nosed business risk issues too."

As indicated above, under a high-emissions scenario, capital requirements could increase by more than 90% for hurricanes and by 80% for typhoons.

However, in total, an additional $76bn could be needed to cover the gap between extreme and average losses resulting from tropical cyclones in the US and Japan. The higher capital costs, combined with greater annual losses for windstorm alone, could result in premium increases of around 60% in these markets.

"This could also mean capital becomes more costly," says Ms Milne, "fuelled not only by increased demand for a finite resource but also because the risks increase, meaning providers will be looking for a better rate of return before they are willing to make it available."

There would undoubtedly be an opportunity cost if increased capital were to be channelled into the insurance industry and away from other markets.

These are the types of financial implications the ABI is keen for international governments to take on board before deciding to reject or pursue any adaptation measures to combat climate change.

However, all these figures are obviously based on a do-nothing scenario.

The research also examined two ways in which these cost increases can be avoided or offset: by reducing carbon dioxide emissions and by reducing society's vulnerability to the impacts of climate change. Consequently, policymakers around the world now have the data in hand to take positive action to mitigate these predicted losses and capital consequences of climate change. "By taking this twin-track approach, we produced some good levels of potential savings," comments Dr Catovsky.

For example, the research identified how reducing carbon dioxide emissions from a high to a low scenario would impact on losses and insurers' capital requirements for extreme windstorms. "If we go down the emissions stabilisation route, we could be saving around 80% of the increase in losses," says Dr Catovsky. "It would bring down the extra costs by between $35bn and $50bn, roughly equivalent to avoiding two Hurricane Andrews in one season."

Furthermore, flood risk across northern Europe may only increase to four times current levels under a low emissions scenario, saving $120bn each year by the 2080s - as opposed to a tenfold or twentyfold increase under the do-nothing scenario. Action to reduce society's vulnerability to some of these inevitable impacts of climate change could include the construction of more resilient buildings and improved flood defences, which could result in significant but targeted savings.

Although the financial benefits of adaptation were not modelled in this study, the ABI claims considerable cost savings could be achieved. "Strong and properly enforced building codes have been shown to prevent and reduce losses from windstorms," states the report. "If all properties in south Florida were built to meet the strongest building code requirements, damages from a repeat of Hurricane Andrew would fall by nearly 45%."

Messenger for change

"The spirit of this report is to demonstrate that the insurance industry is both a communicator of risk and a messenger for change," says Dr Catovsky.

"Many people look to the insurance industry to be engaged in the climate change debate - they see us as a driver for change. Yes, insurance is about spreading and sharing the risk but it can't fundamentally reduce it. So people should also recognise that we can't remove the risk of climate change, except through incentivising action - in offering reduced premiums for properly managed risks - and offering the expertise on how to go about that action."

Both Dr Catovsky and Ms Milne stress this report is merely the first step towards what they hope is a more systematic assessment of the impacts of climate change on the costs of extreme weather and their financial implications. Indeed, another benefit of conducting this research was its ability to flag up areas where future work is necessary to build on the framework set out.

The four key future work streams are: to develop more sophisticated analysis of the impacts of climate change on flood risk at regional level; to refine understanding of its impact on European windstorms, where the frequency of less severe storms could also increase; to establish integrated models that couple outputs from climate change models with insurance industry catastrophe models; and to examine how socio-economic factors could exacerbate or alleviate the effects of climate change on the costs of extreme weather.

For this piece of research, the ABI and its partners had to start with a blank sheet of paper. "There was nothing on the shelf for us to pull off and use; we had to invent the methodology," explains Ms Milne. "Inevitably there is more work to be done. We have only looked at these three specific storm types that were identified as the 'big ones', the ones that have the ability to rock the capital markets now."

So does the ABI have any specific recommendations for the UK government on the back of these findings? Stressing that the idea was merely to provide a sound context for future discussions, Ms Milne says: "We did not want to get drawn into politics. Instead we wanted to offer policymakers some hard, factual parameters for them to go away and consider. This research could have a huge impact on getting mitigation strategies right."

Dr Catovsky is certainly confident that this report will be given firm and frank consideration: "I feel this research will resonate strongly with policymakers - the fact a global industry is thinking seriously about the cost ramifications of climate change."

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