Climate Change and Resource Depletion: The Challenges for Actuaries
Review of Literature
By S.D. Baxter, O.D. Bettis, S.J.R. Brimblecombe, C.A. Fitzgerald, Dr. S. Harrison, V.J. Hodge, B.P. Maher, P.G. Meins, A. Mookerjee. L. Perroy and N.G. Silver
[Discussed at the Institute and Faculty of Actuaries, 4 November 2010]
Climate change and resource depletion are likely to result in unprecedented changes to the economic and social environment in which actuaries work. Whilst there is a mass of scientific and more general literature, the financial implications have received less attention. This Review - hopefully the first in an ongoing series – aims to provide actuaries with summaries of papers relevant to their work and the significant risk management challenges they pose. The Review considers a series of risks that could affect the assets, liabilities and solvency of the world’s financial institutions. Not only are there challenges; there are opportunities for actuaries. Our training in model building, interpreting stochastic model output, managing uncertainty and risk, in understanding the long-term nature of assets and liabilities, the inter-generational transfer of wealth through the discount rate mechanism and deep understanding of insurance put us in an ideal position to contribute to the global policy debate. Yet this initial Literature Review shows that the actuarial Profession’s contribution to this important debate appears so far to have been relatively minimal even in the financial sector.
Climate, economics, insurance, resource depletion, risk, sustainability
O.D. Bettis, Great Lakes Reinsurance (UK) PLC, Plantation Place, 30 Fenchurch Street, LONDON EC3M 3AJ; : +44(0) 20 3003 7264; : email@example.com
2 Executive Summary 3
3 Introduction 7
4 What do we mean by climate change and Sustainability? 10
5 Are Sustainability issues Relevant to actuaries? 11
6 Review of salient literature 14
A Background Science 17
B Enterprise Risk Management 20
C Economics, Finance and Investment 33
D Pensions 51
E General and Life Insurance 54
F Health and Mortality 62
7 Public Interest Role 69
8 Activities of Other International Actuarial Bodies 70
9 Gap Analysis 73
10 Observations and Questions to Think About 74
11 Acknowledgements 76
12 Appendix 1 – Further Interesting Papers 77
1.1This is the first of what is expected to be a regular series of literature reviews on sustainability issues. There are three main objectives:-
To review research into the impact of climate change and the opportunities for actuaries to deal with the financial and economic consequences thereof, with a particular emphasis on the quantification of risk.
To foster a dialogue between senior members of the Profession, the academic world and relevant organisations on the significant challenges presented by the issues.
1.2Out of the many thousands of reports and papers that have been written on climate science, energy and sustainability, the authors have selected around 30 for review. These have been chosen for their particular application to the actuarial profession and, in the main, we have restricted ourselves to those published in recent years. Papers have been reviewed in groups according to their most natural actuarial discipline: Enterprise Risk Management, Finance and Investment, General Insurance, Health and Care, Life Insurance and Pensions, plus a section on climate science. Below is a selection of some key points from the reviews:
A Background Science
The first review summarises conclusions from the Intergovernmental Panel on Climate Change’s 4th Assessment Report (AR4), which was published in 2007, as this provides the context for other papers and is the foundation for international government actions. It stated that warming of the climate system is unequivocal, and can be seen from observations of increases in global average air and ocean temperatures, widespread melting of snow and ice and rising global average sea levels.
In work published since AR4, some scientists have estimated that the sensitivity of the climate to greenhouse gas is higher than the central estimate used in AR4. If this new estimate is correct, then they conclude that atmospheric CO2 will need to be reduced from its current c.385ppm to at most 350ppm, otherwise very large changes will occur. This is set out in Paper 2.
B Enterprise Risk Management
Uncertainty in climate change damage
Reviews 3, 4 and 7 cover papers which explore the consequences of the uncertainty in the sensitivity of the climate to the warming effect of greenhouse gas, and uncertainty in the damage caused by climate change. They find that the probability distribution for the sensitivity of the climate to greenhouse gas has a fat tail. But models used to date to estimate damages from climate change have tended to ignore this fat tail. Actuaries’ core skills in areas such as modelling long-term risks and in catastrophe insurance might be usefully deployed in investigating these issues.
Review 5 covers an early (from 2005) attempt to explore the impact of climate change in general terms upon asset-liability modelling in financial institutions.
Reviews 6a and 6b assess papers which look at how natural disasters affect property owners and small businesses. They describe how the insurance industry, in collaboration with governments, can play a leading role in managing these risks.
Review 9, from the ABI, estimates the direct financial impact of climate change on the insurance industry, both on an expected loss basis, and on the capital requirement, which is driven by the severity of extreme losses. It may be the first attempt to link climate models with insurance risk models. However, it covers only the impact on insurance claims cost, not the impact on the wider global economy (for example by forced migration caused by changes in zones of vegetation), which could effect the whole economy including insurance.
Review 8 is of a June 2010 report published jointly by Lloyd’s of London and Chatham House. It covers energy security, particularly regarding what it describes as the forthcoming “energy crunch” caused by a restricted oil supply. The review considers that the possible consequences of restrictions in energy supply identified in the report, might be a recession and/or high inflation, revaluation of asset prices and difficulties in the payment of debt. In the foreward to the report, Lloyd’s CEO Dr Richard Ward comments on the current situation, whereby the effects of the energy crunch have not yet been felt but are coming in the relatively near future. He states that “At this precise point in time we are in a period akin to a phoney war …”.
C Economics, Finance and Investment
The economic effect of climate change
Review 17 covers the Stern Review, the seminal report from 2006 commissioned by HM Treasury, which evaluated the economics of climate change. The Stern Review argued that strong early action against climate change was justified. It was a pioneering work, one of the first pieces of integrated research to bridge the science of climate change and policy formulation. It had great influence on global climate change policies. Our review - and other papers - draws attention to issues regarding the treatment of the probability distribution for future temperature rises, one of the areas of modelling expertise where an actuarial approach might add value.
Review 10 is of another paper which evaluates the Stern Review. Issues of intergenerational equity are pointed out which again are very familiar to the actuaries.
Reviews 11, 12, 14 and 15 cover papers and reports which point out the financial implications of the coming stricter regulation of greenhouse gases. Paper 11 (by Goldman Sachs) is a good introduction to the ways that business will be affected by having to reduce emissions. Review 12 takes as its starting point that the International Energy Agency has estimated that the world needs to invest around $1 trillion per annum in the low carbon economy, in order to avoid dangerous climate change. This scale of investment would clearly significantly change the landscape for pension fund investment. Review 14 covers an 88 page report from the US, which is a detailed guide to adopting a sustainable business strategy, in order to maximise long-term shareholder value. It provides 200 real world examples across 20 industry sectors.
Review 16 covers a paper which examines the effect of climate change upon the UK financial sector. Impacts on asset values are split into primary (direct climate impact), secondary (indirect climate impact) and tertiary (the resultant impact on economic variables). While some previous studies have found that the effects of climate change on asset portfolios are likely to be modest, this report finds that these studies have concentrated on primary impacts where exposure is limited. Secondary and tertiary impacts are likely to be much more important. The report also finds that the UK’s financial sector has opportunities, for example, as a leader in carbon finance and as a centre for the world’s insurance industry, which is taking a lead in risk management of climate risks.
Review 13 covers a recent paper published by the wholesale broker Tullett Prebon, called “Dangerous Exponentials: a radical take on the future”, plus 5 other items which cover similar issues. The other items include the original “Limits to Growth” study which was published in 1972, and the report “Qualitative Growth” by the ICAEW. The core thesis of Tullet Prebon’s report is that the global economy is in the grip of a “forest of exponentials”. Key indicators, including population growth, energy consumption, cumulative inflation and money supply have turned into exponential “hockey-stick” curves. This forest of exponentials is highly dangerous, because it is not properly understood or managed.
The review identifies the issue that if money supply grows at a time when the supply of goods and services is limited due to constraints on energy supply and other resources, then this could lead to problems with inflation and currency stability. Other potential non-financial effects are not covered in this report.
Reviews 18 and 19 cover reports which look at the extent to which asset managers and pension fund trustees have taken climate change into consideration in their decision-making processes. The general conclusion was that the level of awareness of the impact of climate change is not high. The implication is that in general, both investment managers and advisors could do more to draw the attention of trustees towards these issues.
E General and Life Insurance
Reviews 20 and 22 cover reports which detail the impact upon and opportunities for the insurance industry, arising from climate change. Report 20 was published by the Chartered Insurance Institute in 2009 and looks at the implications of climate change under two broad headings: mitigation and adaptation. Review 22 covers a paper published in Science in 2005 which deals with the insurance industry’s role in tackling climate change.
Review 21 covers the area of micro-insurance, which could be an adaptation mechanism for the populations of developing countries, helping them to recover from adverse events such as droughts. This paper was the product of the Profession’s micro-insurance working party.
Review 24 covers the report from the climate change working party, which reported to the 2007 GIRO conference. Work from the climate change working party remains available on the wiki (ongoing work in this area has transferred to the Resource and Environment Group, which has its own wiki). The report summarises the threats and opportunities for non-life companies. Threats include not only increased liabilities from claims across many lines of business, but also damage to asset values, plus increased uncertainty relating to assets and liabilities requiring an increase in capital requirement. Additionally, there is a reputational risk for the industry.
F Health and Mortality
Review 25 focuses on the health effect of climate change in the UK. The conclusion from the papers reviewed in this section is that in the UK, climate change is likely to exert, over the short to medium term, some downward pressure on mortality rates. Over the longer term, increased heat related mortality may put upward pressure on mortality. However, it is recognised that the impacts of climate change on mortality and morbidity are subject to considerable uncertainty. The Profession would benefit from closer links with researchers in this area.
Review 26 is of a report which uses citations from 175 different papers on the health impacts of climate change. It provides a global perspective on the implications of climate change, which it considers to be the biggest global health threat of the 21st century. The main health effects are viewed to be the indirect effects, such as food security, water and sanitation, extreme events and population migration.
We have undertaken a brief initial survey of our fellow actuarial organisations around the world in regard to their work on climate change and resource depletion. There are some significant activities, for example in the USA and Australia, but it seems clear that all of us are still at the early stages in tackling the challenges. Given the global nature of the problem, the authors hope that our profession will increasingly work together.
Towards the end of this Literature Review we try to identify areas for further research. We also pose a number of questions for discussion, including:
Will climate change affect the way in which clients manage and value their liabilities?
How will it impact on the asset-side of the balance sheet?
How will the changes alter our valuation methodologies, assumptions and solvency levels?
Will new business opportunities appear?
Are actuarial risk models sufficiently robust to incorporate the new and changing environment?
The authors also believe that there is a potentially important role for actuaries in contributing to the policy response to climate change and other sustainability issues, and understanding the potential risks and uncertainties. The actuarial profession’s core skills in statistics, modelling and risk are needed in these areas.
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