A Century Unsafe for Business

The insurance industry is the largest industry in the world, earning revenues of $4.3 trillion in 2008. It’s size is testament to its importance to a stable business environment. Essentially, economic growth is impossible without some mechanism to smooth out the dips in the road and insurance provides that mechanism.

But as the world has warmed incrementally over the past half-century, the insurance industry has begun to witness growing losses as storm frequency and power have increased, portending a future where insurance services may no longer be affordable, leaving businesses exposed to ruinous losses.

The threat posed by climate change for the insurance industry was summed up in a 2009 paper, The Climate Change Challenge, by Andrew Dlugolecki of the Geneva Association, an insurance industry think tank:

Climate change brings several dangers to insurers. Firstly, it increases the risk of extreme events in an insidious way by generating conditions that are more conducive to their appearance. Next, it increases the possibility that the severity of such events will reach unmanageable levels. Thirdly, it creates the possibility of widespread social and economic stresses which would undermine insurability.

But these dangers are hardly just dangers of the future. They have already impacted the bottom-line of the insurance industry. Evan Mills of the Lawrence Berkeley National Laboratory, another insurance industry expert, has warned as much (Evans, 2005):

Global weather-related losses in recent years have been trending upward much faster than population, inflation, or insurance penetration, and faster than non–weather-related events. By some estimates, losses have increased by a factor of 2, after accounting for these factors plus increased density of insured values. The Association of British Insurers states that changes in weather could already be driving UK property losses up 2 to 4% per year owing to increasing extreme weather events. Specific event types have increased far more quickly than the averages. For example, damages from U.S. storms grew 60-fold to US$6 billion/year between the 1950s and the 1990s.

An analysis by the reinsurer Munich Re concurs. In the 1950s, there were fewer than 200 weather-related disasters in the world and their costs to the industry were negligible. By the 1990s, however, that number had ballooned to over 1,600. And by 2004, the costs to the industry mushroomed to $340 billion.

Then Hurricane Katrina smashed into the Gulf Coast of the United States in 2005, driving costs to an all-time high.

Though no single weather event can be directly attributed to climate change, the forecasts do see Katrina-like events increasing in number as the world warms. This is because warmer temperatures add energy to the atmosphere, which in turn, will lead to an increase in the power and likelihood of catastrophic weather events, like Katrina. The Global Humanitarian Forum has calculated that storm disasters will be three times as common in 2030 as they were between 1978-2007. And Dlugolecki notes, disasters once classified as once in ten-year events are now once in three-year events. Once in one hundred-year events are now occurring every 12.5 years. And once in a thousand-year events are now once in 83-year events.

That last number should give us all pause. Traditionally, these kinds of once in a millennia, super-catastrophes were so rare that they did not factor into insurance planning, but now such costs must be anticipated and planned for. To put this into perspective, the Geneva Association has warned its members that they should plan for an especially bad “peak” year sometime before 2040, where losses will reach $1 trillion.

But it gets worse. If current trends hold up, by the year 2065 losses will equal global GDP (Flannery, 2006). And these are just the storm-related costs.

Aside from just more numerous and more powerful storms, climate change is also expected to introduce other hazards that will add to insurance losses. These range from increases in disease to increases in pests, but also losses caused by political instability and climate crisis-spawned litigation. But the list of contributing impacts is too long to discuss in detail here. The point is that the insurance industry will be under assault from many different directions, until, its services are too costly for the economy to bear.

Given its size alone, the failure of the insurance industry would be a powerful blow to the economy. But the industry is actually deeply integrated into the financial system, so that when an insurer fails, there can be dire repercussions across the financial system. The recent experience of insurance giant AIG’s troubles, which nearly brought down the global economy, make this point clear.

Indeed, we may witness a series of AIGs down the road. This is because as climate change drives up losses, and many insurers begin to fail, they will turn to liquidating assets, usually blocks of securities, in order to cover those losses. This kind of response was well documented in the 1990s when European insurers sold off assets in order to cover extraordinary losses after severe wind storms hit the Continent.

This kind of asset dumping is bad enough for the stock market in any given year. But imagine that the trend of ever-increasing losses continues and the number of loss years rises. Suddenly, it is easy to see how the failure of the insurance industry can take down the entire financial world. And based on what we can see in the trendlines, we may see such an insurance industry collapse before 2040, resulting in an economic meltdown immediately afterward.

That is, if the confluence of commercial catastrophes highlighted in the previous weeks’ posts do not conspire to undermine the economy much earlier. For if we add in those variables of shortages of oil, water and food to the crisis of insurance, we see that disaster for the world financial system may come far sooner than 2040.

Such will be the topic in next week’s blog.