Taking the long view: the wider role for modelling in tackling climate risks: RMS

Few could accuse re/insurers of ignoring climate change. In renewal discussions, and at Baden-Baden and the Monte Carlo Rendez-Vous, it’s been perhaps the key topic. The extent to which increasing and increasingly diverse risks from climate change are reflected in cat models is among the central concerns.

As November 2021’s COP26 conference in Glasgow showed, however, the wider discussion is focused on achieving net zero carbon emissions by mid-century. According to Robert Muir-Wood, chief research officer at cat modeller RMS, it’s a discussion in which insurers have played a lesser role.

But that may be about to change. “The insurance sector tends to write one-year contracts and thus may have a limited perspective on the future, but it’s going to be challenged by regulators to look longer term,” Muir-Wood told the Re/insurance Lounge, Intelligent Insurer’s online platform for discussing the most significant issues facing the industry.

“The industry is starting to be asked some quite deep questions about what they expect around the future hazard,” he added.

There will be increasing pressure to look beyond a passive response of evaluating risk to ensure profitable short-term contracts to actively drive adaption. As the industry moves from simply asking “what’s the worst that can happen?” to considering how can it support solutions for a better future, modelling will be essential. According to Muir-Wood, there are at least five ways it’s likely to help.

Expanding understanding

The most well-developed of these it is doing already: enhancing understanding of future catastrophe risk and the associated uncertainty. Re/insurers are under increasing pressure to look beyond contract periods to how risks will evolve in the longer term.

“Boards of insurance companies need to be asking some penetrating questions about what to expect here in 10 or 15 years,” Muir-Wood said.

Traditional models already take account of the effects of climate change on current levels of risk but are not forward-looking. Earlier in 2021, RMS launched a range of new “probabilistic models” to enable insurers to model the future impact of climate change according to different scenarios mapped out by the Intergovernmental Panel on Climate Change (IPCC) and across different time horizons.

The knowledge developed from these will have broader applicability.

“Whether we’re looking at different realistic pathways of how the carbon dioxide in the atmosphere will develop with the industrial activity or at the uncertainty of our projections, it is all going to be valuable information,” said Muir-Wood.

Inspiring and incentivising adaption

Once the risks are better understood, there’s also the prospect of doing something about it.

That suggests a role for modelling outside its traditional uses in re/insurance. It may include informing municipalities thinking about new flood defences or building better drainage systems, or considering the concept of “sponge cities” in China, for example.

“In all these areas, there are big questions about what to expect in the future, and for all these projects, a benefit:cost analysis will be needed,” explained Muir-Wood. Models can provide the benefit side of the equation. A probabilistic flood hazard and loss model, for instance, can calculate flood losses with or without a flood wall.

This could also help avoid ineffective spending that has occurred in the past, such as inadequately upgraded flood defences in Carlisle in the UK, which failed to prevent repeated flooding only a few years later. It was a failure to realise that extreme rainfall events were going to become more common.

“If you’re thinking of your future investments, you need to be concerned with future climate,” warned Muir-Wood.

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Modelling new perils

While cat modelling has been driven by the re/insurance industry, the symbiotic relationship has also limited it in some respects.

“There are a number of perils that we don’t currently model because they’re not very insurable,” explained Muir-Wood. Drought, for example, has a long lead time and can persist for more than a year, longer than most policies’ terms.

“It doesn’t arrive in the form which is naturally insurable,” he said.

Nevertheless, such perils, as well as heatwaves and water shortages, are likely to be exacerbated by climate change. As they become more severe, there will be an increasing desire for coverage of the financial impacts, whether or not insurers ultimately pick these up. It might be mortgage providers concerned about loans to farms dependent on water supplies who look for solutions, for example.

“All these areas may not be insured right now, but there’s a risk, and it will fall on someone to cover it,” said Muir-Wood. “There’s an expanded role for modelling expanded hazards.”

Supporting sustainable energy generation

The ambitions outlined at COP26 make it clear that renewable production will be a rapidly increasing part of the energy mix. For re/insurers, it promises to be a growth business.

“There is going to be an enormous value of installation happening in many regions onshore and, for wind, offshore, too, and the modelling needs to be there to support it,” said Muir-Wood.

“Whether it’s wind turbines in the North Sea or solar panels in the Sahara, there are catastrophic perils that can impact firms,” he said. Geothermal energy sources that are largely volcanic present potentially even greater challenges, he added.

“There’s going to be insurance for these, but they may be in domains that catastrophe models don’t currently cover,” said Muir-Wood. “If we’re not modelling wind speeds in the middle of the North Sea or hailstorms for the Sahara desert, we may need to include those to support the expansion of insurance.”

There’s a role, too, in the secondary market of electricity generation—as Muir-Wood puts it: “What happens if the sun doesn’t shine or the wind doesn’t blow.”

Again, whether insurance or the wider financial sector picks up the role of mitigating the impacts on the profitability of such eventualities is open to question. The role of modelling in evaluating such risks is not.

Covering solutions

Along with renewable sources, the future will bring a significant increase in carbon sequestration and storage.

“There are going to be more attempts to find ways of incentivising taking carbon out of the system,” said Muir-Wood. “There will be large scale facilities to accomplish this and significant rewards if you can get rid of carbon out of the atmosphere.”

That may be via underground reservoirs in former gas fields or expanded forests. Insurance’s role may well be to support the carbon credits required to incentivise these. While sequestration must necessarily be for the long term, insurance could offer coverage over perhaps renewable five-year periods.

“We can expect this to become a big market,” he added.

Modelling, meanwhile, will be needed to evaluate the risks: how likely is an earthquake that could damage a reservoir, allowing the carbon dioxide to escape, or a wildfire that would destroy the forest?

“Insurance will have a role in the solutions to the current crisis, just as it does in mitigating its effects. We’re going to have insurance products of some kind to cover the potential for something going wrong,” he concluded.

To view the full Re/insurance Lounge interview click here