How insurance concepts can help build support for managing risk

Date14th January 2020

Climate Risk Update

Welcome to the seventh edition of the Finity Climate Risk Blog and the first of the decade, which focuses on insight into why countries struggle with acting on decarbonization and how thinking of the problem in an insurance context may be helpful.

Different types of science

Many wonders why it seems so difficult to get a consensus on climate action given the nearly unanimous opinion of the scientific community on the general causes and effects of emissions on the climate. Part of the answer lies in the type of science one focuses on. While climate science may be clear, economic and political science is more complicated. When considering how different types of science look at climate risk, it helps to think about it in terms of timing and uncertainty, two issues the insurance community is well versed in.

The TCFD framework

The Task Force on Climate-related Financial Disclosures (TCFD) groups climate risk into three broad categories, physical, transition, and litigation.

  • Physical risk refers to the consequences of changes in either weather events or longer-term climate patterns, such as damage to assets or supply chain disruption.

  • Transition risk refers to the consequences of changes to the economic, legal, or technological environment of policies required to achieve decarbonisation.

  • Litigation risk refers to an entity receiving a lawsuit as a result of either direct action, or inaction, relating to climate risk.

Generally, there is a trade-off between physical and transition risk. Taking strong action to reduce carbon emissions reduces physical risk from things like rising sea levels but increases transition risk from things like mandating electric vehicles. Conversely, taking minimal action on emissions reduces transition risk but increases physical risk. This is illustrated in the chart below.
The chart accurately reflects the trade-off over a long time period. What it fails to communicate is when the risks materialize and how relatively uncertain they are.

Setting aside for the moment whether the current Australian bushfire crisis has been triggered by climate change, periodic climate cycles like ENSO or the Indian Ocean Dipole, or both, the physical risk from climate change is expected to emerge gradually over many decades as seas rise, temperatures warm, and rainfall patterns shift. Further, much of the physical risk is already “baked in”, as carbon released into the atmosphere over recent decades will take a long time to disperse. Thus, changes in emissions will have effects, either positive or negative, over a long time horizon and involve significant uncertainty.

Transition risk, on the other hand, can arise almost immediately with high certainty, as decarbonisation will affect things like the cost of energy or the type of cars we drive in the near term. For example, a carbon tax could be enacted in 2020 and raise electricity prices in 2021.

This is an example of the timing and uncertainty problem with climate risk. Action to reduce uncertain physical risk in the long term is likely to trigger disruptive transition issues in the near term.

It follows from this analysis that climate change should be thought about in a probabilistic way. The issue is not a black and white one where there is certainty about what will happen fifty years hence. Instead, there are a range of possible future states, some of which involve dire economic consequences in terms of physical risk. By framing the issue this way the discussion can encompass a wider range of views and move beyond the right/wrong mindset that makes compromise difficult.

The insurance system has faced similar issues

These are problems the insurance system has overcome. Insurers are able to sell products which trade a certain cost today for an uncertain benefit far in the future (consider life or long term care insurance). Insurers also sell products which may never yield a benefit (consider paying a home premium to protect against a fire that may never happen). The fact that the insurance system has prospered over time is evidence that people can be convinced to trade current cost for an uncertain future benefit.

At a societal level countries across the globe have implemented pension systems which collect funds today to provide benefits to retirees decades in the future. Countries also justify large investments in infrastructure, say for transportation or water systems, which involve spending billions today for benefits far in the future. Thus, it is clearly possible for governments to adopt a multi-decadal view of cost and benefit.

Similarly, individuals, businesses, and governments routinely protect themselves against risks they do not believe will ever materialize. People buying motor insurance do not expect to get into an accident and governments fund the military without being sure it will be needed to fight a war. Such actions are economically rational because the risk of not buying insurance or not having an army is great enough that even without the certainty of something bad happening it is deemed prudent to invest in protection.

Addressing the climate risk problem will involve many things, including emphasizing the economic benefits of decarbonisation and the two discussed here:

  • Costs and benefits must be considered over a multi-decadal time horizon.

  • Climate risk must be viewed as a distribution of many possible outcomes, some of which are very bad, meaning that even if one is a “climate denier” one should be willing to pay a “premium” to protect against that risk.

Thinking about the climate problem from an insurance perspective may be helpful in finding ways to solve the challenges in the economic and political sciences.

Further reading

"The better way to look at climate effects is by examining the underlying weather data directly, as we do in the Actuaries Climate Index." Rade Musulin in the The Australian Financial Review on insurers bearing the cost of bushfires and the long term trends in insured catastrophe losses and climate change.

Rade Musulin, Shirley Chau and Stephen Lau from our Climate Risk Team
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