Insurers’ inability to foresee the impact of extreme weather on long-term investments is hindering asset selection processes, but a new modelling tool that more accurately forecasts future climate risks may prove to be a boon to carriers and other asset owners.
Like most other sectors, the insurance industry has experienced severe disruption since the onset of the Covid-19 pandemic. From staff being made to work from home, to traditional in-person distribution channels going entirely virtual, to yet more uncertainty around potential claims for business interruption insurance, the modus operandi across the industry has been upended.
That said, there are silver linings. From an investment perspective, the frequency of discussions with asset managers, request for project work and the funding of new mandates have significantly increased over the past year. The pandemic also reprioritised efforts to further digitise policyholder experiences, making these easier to access online and more self-serving. This added spend should pay dividends for providers in the coming years.
A more pressing, longer-term challenge for the insurance industry looms, however. While Covid-19 has caused vast disruption for carriers, climate change will likely prove more problematic in the coming decades. Higher temperatures, longer droughts, extreme precipitation and other physical climate risks could significantly disrupt daily life as we know it. Widespread flooding will lead to an increase in vector-borne diseases such as Covid-19, and rising sea levels will threaten businesses, investments and homes that are located in coastal areas. Everything from food and water supplies to human health, infrastructure and energy systems will be impacted.
New climate risks will add much strain on companies and insurers operating in these sectors, as well as the livelihoods of individuals. By 2050, up to 13% of emerging Asia GDP could be at risk from climate change, according to a 2020 study by McKinsey.
Today’s reward, tomorrow’s risk?
Foreseeing change across all risks is crucial for the insurance industry. Given the long-term liabilities that carriers typically face, they must make investments in assets that consistently perform over the longer term. Life insurance and annuity policies typically have long durations and various product options for holders, which can increase the challenge of earning a spread versus what is owed.
Investment horizons commonly exceed ten years, with some spanning multiple decades. Such products are usually backed by fixed income credit; illiquid assets that produce reliable income streams, such as private credit, mortgage loans and real estate; and on occasion, they may utilise long-term holdings of equities.
So, what happens when a low-risk asset today becomes high-risk in 20 years’ time?
Take water utilities, for instance. Utilities are generally considered to be fairly low-risk, with stable revenue streams and rates that are often indexed to inflation. But even though Delhi, for example, has built four new municipal water-processing facilities, water stress could worsen due to a combination of more frequent droughts in India and the inability to capture extreme precipitation during the monsoon season. Against the backdrop of a rapidly growing population, water resources could become severely strained and force utilities to make costly upgrades. Since it seems unlikely that higher costs will be willingly absorbed by water customers, utilities may be unable to repay their debts and deliver returns to investors.
Other traditional ‘safe’ assets may also become riskier in the face of climate change. Municipal bonds issued to fund ports and industrial complexes in the Gulf of Mexico, for instance, could come under pressure because that region is projected to experience more Category 5 hurricanes. Corporate debt issued by companies in that region could also experience ratings downgrades, and equities from these same issuers may come under price pressure.
How can insurers and asset owners as a whole obtain long-term visibility over their investments?
Bridging the divide
While there is enthusiasm among the insurance industry to gain greater foresight of future climate risks, tools that marry climate modelling with financial assets are limited in number. A core challenge is that there is no universal taxonomy or dataset that establishes what these risks might be. And among the various approaches that constitute sustainable investing, there are few universal standards. In addition, typically these strategies tend to focus on backward-looking metrics rather than forward-focused data.
With these restraints in mind, a new tool being developed by the Woodwell Climate Research Center and Wellington Management can help insurers identify potential future climate risks. Named Climate Exposure Risk Analysis, or CERA, the tool is designed to help investors better understand the risk profile of a specific building, facility or location across seven key climate physical risk factors: heat, drought, wildfire, hurricanes, flooding, water scarcity and air quality.
As one of the world’s top climate science research organisations, Woodwell has access to volumes of climate data and is renowned for its pioneering work in the field of scenario analysis[i]. Information from CERA could also be a useful input for insurers to incorporate into overall risk analysis, helping to determine appropriate pricing.
Potentially, insurers could lessen the likelihood of future financial losses and channel their capital into projects that are more environmentally sustainable over the longer term.
‘Crisis is opportunity’
CERA was used to provide a more accurate representation of flood risk in the US than models generated by the Federal Emergency Management Agency. Wellington’s bond team found overlooked flood risks in numerous locations, including a multi-billion-dollar chemicals plant in Louisiana. CERA has also identified future drought risks in the Mediterranean region, helping investors to scrutinise the sustainability of local hydropower facilities.
As the Chinese saying goes, “crisis is opportunity (危机即转机)”. In Europe, the tool projects wind power potential to rise by more than 5% between 2014 and 2060, greatly enhancing the continent’s green power capabilities.
The use of CERA is being extended to other institutional investors and investment managers.
As climate change rapidly progresses, the need to deploy future-proofing tools to unearth future threats and opportunities will become a necessity — not just for Asian insurers, but for the wider investment community.
Tim Antonelli is a global multi-asset insurance strategist at Wellington Management
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