Climate Change Is Forcing the Insurance Industry To Recalculate

The only question the insurance industry is asking about climate change is not whether it's real, but what the cost will be. JL

Bradley Hope and Nicole Friedman report in the Wall Street Journal:

Catastrophe models' secret sauce was building databases of weather events going back decades. Climate change upends that strategy because scientists broadly believe the future is likely to be very different from the prior decades that are the basis for these models. The climate has grown about 1.8 degrees Fahrenheit warmer since the late 19th century. A consensus of scientists puts blame substantially on emissions of greenhouse gases from cars, farms and factories.“It takes a lot of premium, a lot of margin, to account for this increased uncertainty."

When a wildfire engulfed the Canadian oil-sands boomtown of Fort McMurray two years ago, it hit insurance company Aviva PLC out of nowhere.

The British firm had been active in Canada since 1835. Its actuaries long believed wildfire risk to homes in the area was almost nonexistent, it says. Yet flames on the town’s outskirts roared across an area larger than Delaware, forcing 100,000 people to evacuate and leaving insurers with $3 billion in damages to cover.

“That is not a type of loss we have experienced in that part of the world, ever,” says Maurice Tulloch, the Toronto-based chief executive of Aviva’s international insurance division. “The previous models wouldn’t have envisioned it.”

Aviva studied the incident and concluded the wildfire was an example of how the earth’s gradually warming temperature is changing the behavior of natural catastrophes. Aviva increased premiums in Canada as a result.

The effects of the planet’s slow heating are diffuse. Predictions of the fallout are imprecise, and the drivers are debated. But faced with the prospect of a warming planet, the world of business and finance is starting to put a price on climate change.

The price of homes on the U.S.’s eastern seaboard battered by fiercer storms and higher seas is lagging behind those inland. The price of farmland is rising in North America’s once-frigid reaches, partly because of bets it will become more temperate. Investors are turning fresh water into an asset, a wager in part that climate change will make it scarcer.

Insurers are at the forefront of calculating the impact. “We don’t discuss the question anymore of, ‘Is there climate change,’” says Torsten Jeworrek, chief executive for reinsurance at Munich Re, the world’s largest seller of reinsurance—insurance for insurers. “For us, it’s a question now for our own underwriting.”For the most part, insurers are acting on climate change by building models that aim to better estimate the impact. That leaves the industry with the tough question of how to reflect in premiums the new understandings of the underlying risk.

“It takes a lot of premium, a lot of margin, to account for this increased uncertainty, and I’m not sure we’re doing a good job of reflecting this and charging appropriately for it,” said Marc Grandisson, chief executive of insurer Arch Capital Group Ltd., at an industry conference Thursday. “We need to incorporate a greater range of possible outcomes into our pricing.”

Arch has written less property-catastrophe reinsurance in recent years as prices have dropped and as industry results have been volatile, in part due to losses attributed to climate change, Arch spokesman Donald Watson says.

After the Canadian wildfire, Aviva’s changes to its risk models filtered into its home-insurance premiums in Canada, which increased by roughly 6% since 2016, partly because of its research into catastrophe risks.

For most insurers, rates aren’t rising—yet. A flood of capital into the industry from pension and hedge-fund investors, driven by low interest rates, has increased competition and pushed down property-catastrophe reinsurance prices in the past decade.

And property insurance and reinsurance contracts typically last one year, so an insurer can recalibrate yearly as risks change. “Global warming may be occurring. Probably is,” says Warren Buffett, chief executive of Berkshire Hathaway Inc., which has a major reinsurance business. “But it hasn’t hurt the reinsurance industry. And people are pricing still as if it won’t, on a one-year basis.”

If reinsurance contracts covered 30 years, he says, “I’d be crazy not to” include the risks.

Understanding how weather is changing is laborious and plagued by the same uncertainty that prevents weekly forecasts from being precise. The genesis of a major hurricane, say, depends on factors such as wind shear—the wind pattern that gives hurricanes a whirling shape—not just the warming surface temperature that fuels it. One changing factor may make a storm more likely to be dangerous, but another could shift it on a path away from land or cities.

Big insurers are expanding teams of in-house climatologists, computer scientists and statisticians to redesign models to incorporate the effect of the warming earth on hailstorms, hurricanes, flooding and wildfires. Insurers such as Swiss Re Group say hurricanes like Harvey and Florence, which caused widespread flooding, could represent a more common occurrence in the coming decades.

Climate change may be gradual, but the effects are volatile, meaning a company could become exposed to a large, unexpected hit if it doesn’t understand the changing risks, says Junaid Seria, head of catastrophe-model research and development and governance at Paris-based reinsurer Scor SE.

“We’re in the camp that believes you can have an increased potential for an outsized loss in a single year,” he says. “There’s a cost for inaction.”

The insurance industry has historically changed after big disasters. Natural-catastrophe modeling took off after Hurricane Andrew struck Florida on Aug. 24, 1992, causing an estimated $15.5 billion of insured losses. Thirteen insurance companies were ordered liquidated, according to ratings firm A.M. Best Co.

Catastrophe models—computer algorithms that analyze disasters and property data to predict losses—grew more sophisticated over time. Their secret sauce was building databases of weather events going back decades.

Climate change upends that strategy because scientists broadly believe the future is likely to be very different from the prior decades that are the basis for these models. The climate has grown about 1.8 degrees Fahrenheit warmer since the late 19th century. A consensus of scientists puts blame substantially on emissions of greenhouse gases from cars, farms and factories.

The team of 35 scientists and engineers at Swiss Re who test and update its internal catastrophe models found that the decades of torrential rainfall that had long been a part of the model were no longer useful for predicting risks in some regions, because rain now falls so much more heavily and frequently there. They now use just the past 25 years, Swiss Re says.

Using a shorter observation period has shown a higher rate of torrential downpours resulting in property damage in many parts of the world. That has made rainfall a higher-priority peril for Swiss Re, the company says.

AIR Worldwide, a unit of Verisk Analytics Inc. that sells catastrophe models to insurers, since about 2010 has limited many of its models to the most recent 30 to 35 years of data, says director of meteorology Peter Sousounis. It previously used data going back to as early as 1951. For capturing both longer-term and shorter-term trends, he says, “we feel that that’s a good compromise.”

Insurers such as Munich Re are analyzing those studies and conducting research to focus on the potential for increased losses to the insurer that could reduce its profits. “We can only accept risk and put risks on our books if we understand them properly,” says Ernst Rauch, Munich Re’s global head of climate and public-sector business development. That, he says, is “why we are so interested in climate change.”

Munich Re researchers found a significant increase in storms with hailstones larger than a penny in diameter between 1979 and 2016 in central and southern Europe, causing higher losses during that period. Munich Re concluded such storms will get worse, something previous models didn’t show.

“We believe there is a strong indication that climate change is a driver of this trend,” Mr. Rauch says. Those conclusions, he says, led Munich Re to order a redesign of the risk model for hailstorm-insurance losses that helps set the price of its premiums. “This might entail many things,” he says, “in some regions also an adjustment in price.”

A 2015 study from professors at Princeton University and the Massachusetts Institute of Technology found the warming planet is increasing the chance that a major hurricane could enter the Persian Gulf, home to hundreds of billions of dollars of petroleum equipment and assets.

Such cyclones periodically hit Oman and Yemen but have never been observed in the Persian Gulf, climate researchers say. The researchers found that, with new conditions due to warming, some cyclones could enter the Gulf in the future and could also form in the Gulf itself.

“Climate change makes the historical record of extreme weather an unreliable indicator of the current risk,” says Stephen Pacala, a board member at Hamilton Insurance Group Ltd. and a Princeton professor, who wasn’t involved in the study. “So, what’s the insurance industry to do? No hurricane has ever threatened the massive unarmored oil and gas infrastructure in the Persian Gulf.” Markus Stowasser, head of catastrophe research and development at Allianz SE’s reinsurance unit, says computer simulations show an increase in the probability of “extreme gray swan events,” expected but rare phenomena such as hurricanes, forming in the Persian Gulf. (“Black swan” events are both unexpected and rare.) The simulations show such events still don’t seem likely near-term. Insurers’ most immediate climate peril is water. More heat means more moisture held in the atmosphere and greater precipitation. Melting ice is pushing up sea levels. A 2013 study in the journal Nature projected average flood losses for the world’s 136 biggest coastal cities could rise from $6 billion a year in 2005 to $52 billion a year by 2050 due to increased population and development. When taking climate change and a sea-level rise into account, flood losses could exceed $1 trillion a year by 2050, the study concluded, unless the cities invested about $50 billion annually in adapting.

Hurricanes historically caused wind damage. But Hurricane Harvey, which hit Texas in August 2017, spent weeks absorbing 33 trillion gallons of water, according to the National Oceanic and Atmospheric Administration. It dumped more than 60 inches of rain and caused tens of billions of dollars in flood damage.

The probability of a Texas storm dropping about 20 inches of rain was about 1% a year between 1981 and 2000, but will likely increase to 18% a year by 2100, according to a 2017 study by Kerry Emanuel, an MIT professor of atmospheric science who says changing climate conditions are driving the trend.

“As the atmosphere warms, we see great rainfall rates,” says Marla Schwartz, atmospheric-perils specialist at Swiss Re. Referring to Harvey, she says: “We might expect to see something more often like that in the future.”

Hurricane Florence, which hit North Carolina last month, behaved similarly to Harvey and dropped more than 30 inches of rain on parts of the state.

Increased flood damage also presents an opportunity to insurers. As more regions become exposed to flooding, insurers expect the market for flood insurance to grow. Much of Harvey’s flood damage wasn’t covered, insurers say, because the industry has historically excluded floods from residential policies.

$55B

“What we call the protection gap is still huge,” says Edouard Schmid, group chief underwriting officer at Swiss Re. “We of course want to offer solutions around risks, including climate risks.”

Changing risk probabilities may make some areas uninsurable altogether, or at least so risky the cost would be prohibitively expensive for insurance buyers, executives say.

Allianz, one of the world’s largest insurers, says it sold the retail business of U.S. insurer Fireman’s Fund Insurance Co. in 2015 in part because climate change is increasing the risk of losses to coastal homes in California and Florida.

“Coastal flooding will clearly become a bigger issue in the long term,” Swiss Re’s Mr. Schmid says. “We can offer protection for hurricane losses or flood losses or other perils, but if certain coastal areas are so exposed, insurance becomes no longer viable. It becomes even uninsurable.”