ESG Special: How climate conditions impact both insurers’ present day and future risk

(Re)Thinking Insurance Podcast Season 3, Episode 6: Physical risk

DAVID SINGH: But the ultimate aspects really comes now, and it's a challenge that's been bestowed upon us, which is around climate change and how that's impacting insurance firms. And ultimately, what does that mean for portfolios and thinking about sustainability in terms of underwriting going forward?

NARRATOR: You're listening to Rethinking Insurance, a podcast series from WTW, where we discuss the issues facing P&C, life, and composite insurers around the globe, as well as exploring the latest tools, techniques, and innovations that will help you rethink insurance.

SINA THIEME: Hello, and welcome to Rethinking Insurance. I'm your host, Sina Thieme, and today, I am delighted to be joined by my guest David Singh. Welcome David.

DAVID SINGH: Hi, Sina. Really excited to be here, and thanks for having me.

SINA THIEME: So today's discussion is one of our ESG specials, and the key theme of the specials is how insurers as key asset owners and as key risk takers and risk managers can and have to play a vital role at moving to a more sustainable future. The key questions for us in WTW are how insurers can design a top level ESG strategy and how that can be embedded into functional strategies and then translated into a more specific ESG program. We're working on how insurers can incorporate ESG factors into their strategies and target portfolios, both on the underwriting side and the investment side.

We're looking at how insurers can identify growth opportunities that are arising from the transition to a low carbon economy. We're looking at how insurers can identify climate-change-related risks, assess their materiality, assess their potential impact for different time horizons, adjust modeling approaches, assumptions, parameters where required and also include climate-change related risks and just wider risk monitoring and risk management frameworks.

David, you're the head of climate analytics and exposure management for WTW's Insurance Consulting and Technology business. Basically, assisting insurers and reinsurers in managing property and non-property exposures and financial risks from climate change. Prior to WTW, you served as the group head of exposure and portfolio management at global insurer MS Amlin and prior to that you were at Lloyd's of London. At the end of 2022, you received a Lifetime Achievement-- an important contribution award-- at the London Catastrophe Modeling Awards ceremony, recognizing your contributions to the exposure management and catastrophe modeling in the insurance industry, right? Congratulations again.

DAVID SINGH: Thanks very much, Sina.

SINA THIEME: So there's been a real push in the insurance industry and from related stakeholders to regulators, CAT modeling firms, climate scientists, consultants, investors, and insurance risks to better understand to which extent present day climate conditions are reflected in CAT models and current insurance and reinsurance premiums and also how climate change can impact prices and risk profiles more medium term.

And so David, from your perspective, why has there been such a great emphasis on the topic in recent years, and why do you think it's important to really take a closer look at how models are capturing climate change?

DAVID SINGH: From my perspective, just given that the fact that I've been in the industry now for well over 20 years, managing catastrophe risks has really been a challenge that's been bestowed upon the insurance industry. And we've been very well positioned to manage these types of risks.

Now, ultimately, when we look at risks that have been posed, typically by certain types of natural catastrophe perils to insurance firms, we've made a lot of progress in terms of how to manage and capture those, especially with the use of catastrophe models that we so widely use across the market.

Now, it's not to say that catastrophe models have the answer, but it's almost they give a really good guide and an opinion based on projected potential events that could happen and the likely damage that could come from it. But the ultimate aspect really comes now, and it's a challenge that's been bestowed upon us, which is around climate change and how that's impacting insurance firms. And ultimately, what does that mean for portfolios and thinking about sustainability in terms of underwriting going forward?

Now, the key aspect is that we've made lots of changes in terms of how we capture and how we start to record NAT CAT events, typically with the use of better data and more informative insights around the actual events happening.

But the underlying key aspects of that is how does that impact the underwriting? What about the exposure management function and the capital amongst other areas of portfolio management? So when we talk about climate change, we're talking about the changes to obviously the climate and the temperature, but as a result of that, the global warming that is already quite evident and shaking up our risk landscape.

What we are seeing is that there's been warmer than average temperatures. We've seen rising sea levels and the melting of ice caps, and we've seen longer and more frequent heatwaves as well as erratic rainfall patterns and more extreme weathers.

So, as a result of that, it's not just a case of now looking back into the past about some of the events that have occurred, but we now need to start thinking about the prediction aspects of the impact of warming temperatures on those insured losses over a portfolio. So we use CAT models to construct sensible pathways for temperatures and extreme event frequencies and severities.

But our distributions at this moment in time are quite limited, and now, it's a case of how do we then project those out and how do we alter those for near-term climate trends as well as the long-term as well? But that said, we're not in an industry that shies away from uncertainty. We know that this exposure continues to grow and especially as people starts to migrate to cities and the changes in social demographics-- it's having a big impact on this as well at the same time.

We also know that we see lots of billion dollar weather losses that come through, loss of industry, erosion in terms of earnings, but also at the same time, the transformation has to be quite clear and transparent by way of capturing complex environmental issues and ensuring that our industry experts-- either portfolio managers, the catastrophe modelers, the exposure managers, the underwriters-- are effectively working together to understand how these extreme events are evolving.

So as a result of that, we do get to see better data now coming forward, and the link between scientific and academia has been stronger than ever, and it's something that we must really promote in our industry as well at the same time.

Just to finish off that last point around uncertainty, whilst we look at new types of methods and solutions to measure and assess the uncertainty associated with climate change, we got to keep thinking about our capabilities and thinking about the gaps around our knowledge, as well as thinking about future climate-related losses that could occur.

So as a result of that, we know that the regulators themselves are really looking into forming judgments on whether uncertainty or quantification of risk is possible and ultimately against what time horizons and what kind of impact this is going to have on portfolios that we are considering writing for the following year and beyond.

SINA THIEME: So are there any specific regions of perils that are of particular concern?

DAVID SINGH: Good question. We do see a lot of impacts as a result of climate change and those rising sea levels as we mentioned beforehand. The CAT models themselves are typically used to construct sensible pathways between different factors and different characteristics of events.

However, typically we do see a lot of emphasis being put onto hurricanes as they seem to be getting stronger and more frequent, but there's also a propensity for them to alter in path as well. So typically not to take the past that as we've seen before in terms of paths, et cetera.

In addition to that, the warm sea surface temperatures and winds that facilitate the hurricanes could mean that there's more powerful flooding events that could occur, and instead of them just sort of affecting known catchment areas, we could also see them changing in terms of severity and region in terms of the impacts that we've traditionally seen before. So I think the key point here is that the models themselves do rely on historical data. However, we shouldn't be blinded, or we shouldn't be taking too much of that as a way to manage our risks for forward looking views because of the uncertainties associated with climate change and the impact that it can have on these types of events.

Just the other point to add there is when we're looking at these types of events, we tend to focus significantly around the primary peril in itself but not so much the secondary peril, and it's only over the last three to five years where the secondary perils have really been quite damaging to the industry. And the emphasis is now-- and rightly so talks about secondary perils. But really there's got to be another approach to this, I think. That's in my personal view.

Which is, how do we look at events holistically and not to categorize them in terms of wind and flood? And we know obviously that has implications in terms of coverages, et cetera. But in terms of understanding the loss potential from these types of events, it's really important that we start to look at these as holistic events and start to check the sensitivities and understand some of the impact that this could have in terms of modeling going forward.

SINA THIEME: Yeah. And you touched upon it earlier. I guess apart from catastrophe risk itself, there are a number of knock on effects that climate change can have as well. So just thinking about long CAT premium risk for property insurance, for example. More high frequency, low severity type weather related events could increase attritional loss amounts. Thinking about reserve risk for property.

For example, severe flooding can cause supply chain disruptions, which in turn can cause delays in claim settlements. Thinking about the risk reinsurers may struggle to actually pay out claims as a result of more severe catastrophes.

And on the market risk side as well, so real estate investment, et cetera, values are impacted by physical risks, or they could change because of non-compliance with particular building codes. And of course, on the operational risk side, as an example, I guess, there could be a risk of physical damage to insurers or reinsurance offices and the impact on operations.

So looking at this holistically and then all of the various impacts that climate change has on the insurer's business model, what would be your recommendations as to what companies should be doing?

DAVID SINGH: It's a great question. Only on the basis-- it's quite wide ranging. And when we look at climate change, the climate change really does form part of the ESG aspects of managing those types of factors. The environmental piece as we know is where climate sits, but then climate can be broken down into the physical piece, the transition piece, and also the liability aspects of that.

So how this then incorporates up into the build-- into the strategy of the company is really important. So not only do you get the strategy from ESG and the company vision and other underwriting strategies that can actually cascade down into various elements of managing portfolios.

There's got to be this drive up from the bottom, where you're working with the claims team, and they have a direct feed up into the strategy as well. But also from the exposure management function and the underwriters, who are very close to the exposures-- how does this then feed up into managing the environmental piece of ESG?

So the physical piece has been very-- I say it's quite embedded at this moment in time because we have some really good models that we use, especially for risk transfer purposes but also at the same time for assessing these types of risks.

However, thinking about the other aspects of where climate is going, there seems to be quite a disconnect, I think, in terms of how we can build out or close down the cone of uncertainty that we're seeing and get some real confidence around these levels. Notwithstanding, it's-- the models that we have in place at the moment and the methodologies we're using, they are tried and tested.

However, given the uncertainty, it makes it so much more difficult to do so, so where we're relying on historical data, one aspect is to start to think about getting some more scientific and academic data to help with the future and the uncertainties associated with climate change.

Also start to think about socioeconomic and demographic factors as well as these remain some of the rapid increases in assets in some exposed areas, especially through urbanization. And the other way to think about this is to turn to professionals in terms of getting some expert advice and thinking about how well and how better you can actually manage your portfolio based on certain types of risk appetites, certain types of underwriting strategies, and even thinking about it against the backdrop of the current economic environment that we're in at the moment.

So taking that forward looking view is going to be important but also at the same time, one key thing is to use different types of tools. So we do have, obviously, catastrophe models as I mentioned that take an approach around stress and scenario testing or counterfactual what-if type analysis. It's also been really key for some of those who have been much more advanced in thinking about climate modeling, and that certainly helps with the better evaluation of tail risks in particular.

SINA THIEME: Yeah, and maybe you can expand a bit on the as-if analysis and on how stress and scenario testing generally can help with the analysis.

DAVID SINGH: Certainly. As we know, the scenario analysis is, again, widely used across our industry, and it's so valuable. My key takeaway, just from using scenarios and having designed scenarios over my many years in the insurance industry is almost start to think about why use them in the first place.

They tend to be forward looking scenarios and even backward looking scenarios that combines historical experience with the future. But ultimately, understanding whether this is an aggregation type scenario, or thinking about it from an emerging risk type scenario, or is it meant to be a capital stress testing scenario is a really key aspect to scenario design.

So ultimately, when we start to think about primary perils and secondary perils, we've got to start to incorporate those into our scenarios and also consider other types of reporting or clash reporting that could come from different classes of business that historically haven't really had an impact from certain types of events. So we've seen a lot more of those, so having that open mindedness in terms of how to look at scenarios is really key. But also at the same time, thinking about how to pitch those scenarios, and the education associated with those is really important.

So we know that, for example, for catastrophe models, they vary and in some cases, for certain perils they've converged, but as exposure management, it's very much-- the focus is on the data, the validation piece, the processes, and the methods, and ultimately, the outcomes or the insights that can come from it.

So really validation is going to be key, and stress and scenario testing can really help with that aspect of thinking about the models and thinking about the future, and ultimately using what-if sensitivity type analysis, especially with regards to things like falsification, where it's challenging your own view of risk with events that have happened is going to be key going forward.

And I think that just shows a really good governance process and touches upon the GP-- so the ESG ultimately as well going forward. So when I often speak about stress and scenario testing, I almost think about it what-- like I said, what is it therefore? How should people use them? But also at the same time, are there uncertainties associated with those as well?

So it's really important that you identify the uncertainties associated with stress and scenario testing, but ultimately, by bringing in sensitivities, you can really explore a range of plausible futures but without the requirement to actually forecast properly, and it makes it much more easier.

So with a focus on SSTs, it's about the learning of the peril or in this instance about climate change. It certainly helps with the awareness and developing out the assessment of plausible outcomes. Now, in a-- and sorry if it's taken too much time on this, but it's really important that there's two types of different scenarios that we can approach this with. When we look at climate change, we have exploratory, which really asks about what if and the sensitivity analysis. It's back to your question. And that really helps to create a future memory aspect of what it is that is being considered.

So the exploratory approach explores a wide range of contrasting range of plausible futures as a function of diverging assumptions. And the point of that is to widen the scope of options considered by users and stimulate the imagination and the creative thinking about the future as well as the exploratory scenarios. You can have a normative type of approach, which then uses scenarios that are basically formulated on the technical quantitative aspects. So that paths to desirable or undesirable futures can be analyzed.

And so you utilize such a scenario for decision making and a more narrowly defined set of criteria. The objectives must be really explicitly defined, and then you work backwards from there. So that's the key aspect of how you could use what-ifs.

SINA THIEME: Thanks, David. So what are the key points that you think people should take away from our discussion?

DAVID SINGH: I mean, there's so many, but really the key point I would say is as an industry, this is an industry problem. This is not so much-- and a global problem as well. So we've got to work together if that's-- one of the takeaways I would definitely recommend is the collaboration piece.

We've built some really strong links with academics and scientific communities, and ultimately, there is no need for us to keep repeating the same process and exercises over again multiple ways. Because we're different insurance companies, we should be able to share some of that information and ultimately take that forward as part of our baseline or foundation level to then think about establishing a view of risk on top of that.

So collaboration is a really key aspect of this, but also at the same time to work closely with the regulators and the legislators around this as well. We've seen the regulatory side of it. It's been quite extensive at the moment. I think there will be a spotlight on that for the next few years, especially as certain initiatives come to fruition and as insurers starts to think about transition risk and the physical aspects.

These are not independent from each other. They're closely correlated, and this is going to be something that exposure managers and underwriting managers will really be wanting to get right. Not least because there's stakeholder management associated with that, and ultimately, the implications of not doing it right or following the right process can have significant ramifications, I would say.

And the last piece I would say is really around decent research, and don't be afraid to think about different methods and challenge existing approaches because it's really-- it's with-- that is how we get to where we are in terms of being an innovative solution industry.

And we are really-- we've got some very good people generally in terms of providing scientific and academic research as well as mathematicians and meteorologists, et cetera. So we really-- we should be using everyone's skill in the right way, and we can all benefit from that as an industry going forward.

SINA THIEME: Thank you so much for your time and your thoughts, David. I really look forward to continuing our discussion on ESG.

DAVID SINGH: Thank you very much, Sina.

SINA THIEME: Well, thank you for listening to this episode, and if you found this interesting then join us on future episodes of Rethinking Insurance.

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