Are the current climate change scenarios used by insurers still fit for purpose? It’s a question under constant scrutiny at the WTW Research Network as it looks to improve understanding of risk across its broad client base comprising insurers, reinsurers and corporates.
For Cameron Rye (pictured), head of modelling research and innovation at the network, addressing this concern means assessing the third-party models that insurers licence to price policies – and determining whether they still reflect current climate conditions. It’s a complex question, he said, which is further complicated by the multifaceted nature of climate risk.
Examining what’s happening, he noted that for some perils such as wildfires and extreme precipitation, there is observational evidence that climate change has already increased the risk in many parts of the world. However, when it comes to other perils - such as severe convective storms - from a statistical significance perspective, the small number of events is making it very difficult to accurately assess the viability of current models and detect trends.
A key area of concern for Rye and the team at the WTW Research Network is that future climate change scenarios currently used by insurers may not be adequate because they don’t include tipping points. Climate tipping points are the crossing of a ‘climate threshold’, he said. This could be the gradual increase of global temperate to a tipping point which leads to a sudden change in a part of the climate system - for example, the collapse of an ice sheet in West Antarctica leading to large increases in sea level, which has implications for coastal insurance.
Trends, as discussed above, examine present-day risks and the adequacy of catastrophe models in capturing these trends, he said. This has significant implications for present-day pricing and capital. In contrast, tipping points focus on the future (e.g. a 2 or 3 degree world), and the issue is around the climate change stress tests that regulators require insurers to conduct. Recently, there has been considerable discussion about the limitations of current scenarios, especially regarding the absence of tipping points, which means insurers are likely underestimating the future physical risks they could be exposed to.
With that in mind, the WTW Research Network is looking to sound the alarm on the impact of rate-induced tipping.
“That’s where the climate system changes too quickly and you end up in a situation where you reach a tipping point before the ‘traditional’ tipping point is reached,” Rye said. “A way to think about this is in terms of interest rates. A recent example is how the central banks have been increasing interest rates very slowly over time to counter inflation.
“If, when inflation spiked so high about 18 months ago, the central bank had suddenly increased to 5% interest rates on day one, you’d have ended up with chaos in the mortgage and financial markets. When we think about rate-induced tipping points, we can think about it in the same way as the climate system needs to rebalance slowly over time as climate change happens. If we end up moving too quickly, we’ll end up with all kinds of chaos happening in the climate system.”
Rye pointed to a paper published by Leeds University which made the argument that when climate tipping points are being examined, the rate of change is a much more important consideration than the kind of change occurring. People often look to different degrees of warming as trigger points for events such as the collapse of ice sheets, he said, but actually, if the rate of change is too quick, you can get to these tipping points without reaching a specific degree of warming.
“The next step is really thinking about this in relation to the insurance market,” he said. “And the same kind of thinking can be applied there. At the moment, most homeowners or business owners have their premiums, and those premiums will often increase with inflation year-on-year, at a gradual pace that people can manage.
“It’s the same with reinsurance. When insurers are trying to get cover for the riskier stuff in the tail, they’re purchasing their reinsurance, which again, is traditionally increasing year-on-year, with only small changes. But if insurers are seeing a large increase in claims because of climate change, and that rate of change is really fast, we could end up in a situation where we’re seeing companies pull out of insurance markets. And we’ve already seen that happen in certain states in the US, like Florida and California.”
If insurers start to become increasingly concerned about climate change, resulting in them making drastic changes to their pricing models, it could result in chaos in the insurance markets, he said. With insurers unable to get the right reinsurance, some policyholders may be unable to afford the massive resulting increase in their premiums and in that scenario, it may fall to governments to step in.
“So, there is this risk that the whole traditional way in which this industry has worked could just break down,” he said. “We’re flagging to the market that insurers need to think about building scenarios that are rate-based. For instance, in the UK, the largest insurers undertook the Bank of England stress test – CBES – in 2021 which was looking at the impact of a sudden shift in the climate.
“That explored the impact of a static, traditional scenario. Whereas, what we’re saying is that we need insurers to also look at the rate of change. What if, all of a sudden, the rate of reinsurance got too high, or the rate of claims became too rapid? What are they going to do in those situations? Do they know what it would mean to their business if they couldn’t get reinsurance cover?”
From looking across the market, Rye noted that market regulators, including Lloyd’s, are asking insurers to make sure that their capital calculations account for present-day climate conditions. However, he said, when it comes to the rate of change, it’s not a conversation that’s being widely discussed in the market and that needs to change if the market is going to be adequately prepared for all risk scenarios.
“It is interesting to see how conversations are evolving,” he said. “I’ve been in the industry for 10 years and it’s certainly changed a lot. When I joined, people in the cat modelling world were talking about some elements of climate change and its ‘what ifs’. But it has become much more mainstream in the past 10 years, in part driven by the regulators and the pushing of climate change scenarios, and the need to account for climate in capital being higher on the agenda.
“It’s an interesting time because we’re getting much more engagement from different levels within insurance companies on these kinds of topics. So, I’m excited to see where these go next.”
