Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients.
Global temperatures have been rising for decades and now appear to be accelerating — with no sign of mean reversion (Figure 1). A hotter world has innumerable potential consequences for humankind and the economy. Climate researchers have warned of catastrophic scenarios, including rising sea levels that inundate coastal cities, large-scale crop failures that can cause famine, waves of climate refugees migrating to temperate regions, unsustainable pressure on aging infrastructure and power grids, and the mass extinction of many plants and animals, which would further alter our ecosystem. In our opinion, investors who continue to underestimate or ignore climate risks may do so at their own financial peril — and that of their clients.
Figure 1: Climate change is a trend with no sign of mean reversion
As of 31 December 2016 | Source: National Aeronautics and Space Administration
Exacerbating the economic and physical risk of climate change is the shift of urban population centers to low-lying coastal regions. According to the National Oceanic and Atmospheric Administration (NOAA), US coastal areas have become much more crowded than the rest of the country. In 2010, the US Census Bureau reported that from 1960 to 2008, the US coastal population grew by 40 million people, an 83% increase. Housing units along the US coast rose by 100% during that same period, from 16 million to over 33 million.1 The global picture is the same. One study found that population density for low-elevation coastal zones is five times higher than the global density average — and is expected to quadruple by 2030.2
More population density means more economically valuable, physical capital stock is at risk of flooding from potential weather events or sea-level rise. Urbanization has exacerbated flooding concerns by hampering coastal cities’ ability to withstand natural disasters. Heavy rainfall and storm surges from hurricanes create drainage challenges in heavily developed areas, as asphalt and concrete aren’t porous enough to absorb water. And it is not just infrastructure or personal property that is at risk. For example, according to NOAA, each year US coastal communities “produce more than US $7.9 trillion in goods and services, employ 54.6 million people, and pay US $3.2 trillion in wages.”3 Again, the threat of disruption to economic activity is enormous and is by no means unique to the US. The OECD estimates coastal flooding in large port cities including Shanghai and Mumbai could put up to US $35 trillion in property and infrastructure at risk by 2070.4
How The Insurance Industry Is Coping
With liabilities that are often measured in decades, property and casualty (P&C) insurers are effectively long climate risk. P&C insurance companies generally accept climate science, while having a vested economic interest in managing and hedging climate risk. As a result, we believe P&C companies will likely be critical change agents in climate-risk repricing through the facilitation of climate mitigation and adaptation.
Insurance in general and the P&C industry in particular have historically served valuable societal benefits. By pooling and managing risk, insurance enables companies and individuals to innovate and test new business models. By supporting entrepreneurship and promoting trade, the insurance industry is a key economic driver. Insurance also prices — and reprices — risks over time, helping to ensure the efficient allocation of capital.
Shortcomings of current risk-management tools
Today the industry attempts to manage climate risks by focusing on one of four major approaches: risk transfer, risk avoidance, raising premiums, or investing in private infrastructure (Figure 2). We think each of these approaches is limited in its ability to address the systemic, long-term threat of climate change.
Figure 2: Existing climate risk-management tools have some limitations
Source: Wellington Management
• Risk transfer through the use of weather derivatives or catastrophe bonds is a short-term solution that tends to ignore longer-term risks. Pricing assumes historical data, which will likely prove unreliable in the face of accelerating climate change.
• Risk avoidance may mitigate risks for the insurer, but sends insufficient pricing signals to the marketplace, perpetuating the mispricing of climate risk. Additionally, avoidance nearly always implies eventual dependence on a state or government agency that may be ill equipped to underwrite risk.
• Raising premiums has two potential drawbacks. First, it may limit underwriting opportunities. Second, premiums are still mostly based on backward-looking models that do not reflect future weather and climate risks. Both of these issues imply that current premiums may be too low.
• Private-infrastructure investing can help underwrite the creation of necessary climate-resilient assets, but this approach can be difficult to scale and can present liquidity, reinvestment, and inflation-hedging risks.
The problems of correlation
In addition to these challenges, a correlation risk between insurance assets and liabilities poses a tricky dilemma. Insurance companies must ensure that their assets (in this case, their investments) do not lose value concurrent with increases in their liabilities (claims they have underwritten). Unless an insurer’s liabilities on physical property perfectly price in climate change, those obligations can become more onerous over time. At the same time, if an insurer’s investment portfolio is heavily exposed to assets bearing climate risk, they may face classic asset-liability mismatch.
Helping insurers manage climate risk
In our view, it seems clear that the insurance industry should provide leadership on climate-risk repricing. No amount of insurance makes a bad risk a good risk, so in the face of accelerating climate change, we think insurers must consider more expansive, multi-decadal approaches to climate-risk management. We believe that a public equity investment strategy that offers exposure to companies engaged in climate mitigation and adaptation can complement existing hedging strategies.
Decoupling investment risk from the rising climate-related liability risks that insurers are facing may be a more sustainable long-term approach. Should carbon trading or carbon taxation be more widely used, inflationary pressures on claims and other liabilities may intensify, making a liquid equity-based approach potentially additive to a broader investment portfolio.
Those costs are not currently captured in most insurers’ asset bases, which are still dominated by fixed income investments. In the US, for example, insurers still allocate over 60% of their portfolios to bonds.5
Some portfolio allocators are beginning to recommend equity investment- based approaches to their insurance clients as well, advocating a combination of asset reallocation (including divestment and environmental, social, and corporate governance [ESG] awareness), hedges using low-carbon indexes or derivative overlays, and engagement on policy and physical-risk disclosures.
Wellington & Woods Hole Research Center (WHRC), one of the world’s leading independent climate research organizations, recently announced a collaborative initiative to integrate climate science and asset management. This new alliance will focus on creating quantitative models to help analyze and better understand how and where climate change may impact global capital markets. We will collaborate with WHRC on a broad range of projects, including developing investor tools and innovative analytical methods seeking to improve climate risk assessment and investment outcomes. With insurers on the front lines of this critical issue, we hope these new research efforts will help our insurance clients better manage, assess, and price climate risks.
By Wellington Management
Alan Hsu, Global Industry Analyst & Portfolio Manager
Alan conducts fundamental analysis and research on utilities and energy, including sustainable energy and clean technology. He is also a portfolio manager of our Climate Strategy approach, a dedicated climate-focused impact strategy. Alan works in our Boston office.
For a more comprehensive look at this critical issue, please see Alan Hsu’s white paper, “Brewing storm: Are investors discounting climate risks and opportunities?”
2Neumann, B., et al. “Future Coastal Population Growth and Exposure to Sea-Level Rise and Coastal Flooding: A Global Assessment,” PLOS, March 2015.
3Total Economy of Coastal Areas, NOAA, 2017.
4“Climate change could triple population at risk from coastal flooding by 2070,” OECD, April 2007. This data has not been updated by OECD in recent years; however, we believe the estimate presented is still accurate.
5“A firm foundation: How insurance supports the economy,” Insurance Information Institute, 2017 (data supplied by NAIC and sourced from S&P Global Market Intelligence).
This article contains estimates and forecasts. Actual results may differ, perhaps significantly, from the estimated and forecasted data shown.
Certain data provided is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness.
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