Why we can expect greater volatility in the price of risk capital.

It was impossible to watch the news in 2019 without noticing the increasing attention paid to climate change. From Extinction Rebellion protests in London to record-breaking Japanese typhoons, society’s eyes are being drawn to a complex and systemic risk. Although climate risk is not new, the growing alarm raises questions for insurers and real estate investors.

In October 2018, the United Nations’ Intergovernmental Panel on Climate Change (IPCC) released a groundbreaking report on the difference between a world that warms 1.5 degrees Celsius from the pre-industrial average and a 2-degree increase in warming, which is what scientists previously assumed was safe. The cumulative economic impact from a 1.5-degree scenario would be $54 trillion by 2100, whereas a 2-degree scenario would lead to $69 trillion in economic impact, a staggering $15 trillion difference. The sense of urgency has continued apace as scientists say the world has until 2030 to get back on track to a scenario in which warming is “well below 2 degrees,” as committed to in the U.N.’s Paris Climate Agreement. In the meantime, the world remains on a 3- to 4-degree pathway.

The G-20’s Financial Stability Board (the Group of 20 represents finance ministers and central bank governors from 19 nations and the European Union) gave its recommendations on disclosing the financial impacts of climate change through the task force on climate-related financial disclosures framework more than two years ago. Yet few businesses are still disclosing these impacts publicly. Despite this lack of transparency, many financial institutions are carefully looking at the climate risks they carry on their balance sheets, both from physical impacts and from the transition away from fossil fuels. In global professional services firm Aon’s experience, firms that are heavy on real assets are receiving disproportionate attention.

Quantifying Climate Risk

With climate change increasingly accepted as a legitimate peril, real estate values are exposed to both transition and physical risks. Buildings, for instance, are estimated to account for roughly 40 percent of global greenhouse gas emissions. Should policy-makers seek to move to a 1.5-degree world, there will be massive changes in the world’s energy system and in energy efficiency requirements, which would necessarily be reflected in increased building operating costs.

It is the looming prospect of physical risk, however, that is receiving more attention. In general, modern buildings are expected to last several decades, and in some cases close to a century. But the business model commonly used by the insurance industry and real estate sector still assumes a stationary and stable climate, which we now know is no longer the case. While the consequences of extreme weather events, including floods and wildfires, are to some extent a known quantity, it is the chronic nature of climate risk that poses the bigger challenge, particularly in relation to sea-level rise. In Shanghai, for example, 15 million to 20 million people are expected to be displaced under a 3-degree-increase scenario by 2070. The question is: how does this change real estate fundamentals in that market? Or, for that matter, how does it change fundamentals in Osaka for its $1 trillion in assets believed to be at risk by 2070, according to the IPCC, under that same temperature scenario? These unfathomable numbers go far beyond the ability of the insurance markets to absorb risk and smooth volatility.

Areas that were considered historically to have low exposure to climate change or natural catastrophe risk also are increasingly of concern for risk practitioners and investors. From deforestation in Thailand that exacerbates flood risk to the intensity of recent forest fires in Australia following a particularly dry spell, these changes are manmade or were naturally occurring risks intensified by climate change.

To help investors and developers better quantify the evolving nature of climate change exposure they face, new scenario-based climate models are being developed to understand the potential intensity and geographic impact of adverse weather events. Aon’s partnerships with these emerging modeling startups have revealed the different approaches being offered. Some are focused on a climate “value at risk”; some are looking at detailed mapping data; and others are doing portfolio-based risk ratings. Each is suited for different use cases and different questions; this is not a one-size-fits-all exercise.

Modeling alone is not enough, however. Assessing what the model outputs mean for the total cost of risk and for the deployment of the correct risk-management strategies is critical. There is a balance to be found among retaining, mitigating, and transferring risk. Risk appetites vary, so approaches and strategies should be tailored accordingly. What underpins all these approaches is a focus on the trends and the need to outline critical decision pathways.

Managing Climate Risk

Resilience is triangular, with institutional resilience—how communities and governments respond—at the top, and financial and physical resilience supporting it. While we do not know how climate change will specifically affect the insurance industry from a capital perspective, we can expect greater volatility in the price of risk capital given the increasingly volatile market environment.

This pricing volatility can be hedged through mitigating the underlying risks to the physical assets, which could include flood defenses, right-sizing heating and cooling systems for a hotter climate, and ensuring that glazing is resistant to stronger winds and hailstorms.

Engaging communities and policymakers is critical, however, because no matter how much is invested in physical resilience, asset values are still affected by the overall resilience of the city where the asset is located. When these issues are properly considered, it becomes time to think about the role of risk transfer.

Transferring Climate Risk

The insurance market globally is hardening at a significant pace, with insurance capital being withdrawn from certain product classes and territories. This is driven by years of falling prices, coupled with significant losses that are making some insurers’ books unprofitable. Climate change and natural catastrophes are playing significant parts in this, with the 2018 hurricanes Harvey, Irma, and Maria constituting significant market events. In the Asia Pacific region, meanwhile, Typhoon Hagibis had a devastating impact as it made landfall in Japan in October 2019, causing significant insured losses and even larger economic (i.e., true financial) losses. As a result, the hardening market environment and subsequent insurance rate increases have been exacerbated in regions prone to natural catastrophes.

In addition to the intensifying nature of climate-related risks, the real estate sector is increasingly subject to broader “nondamage” revenue losses that result from extreme weather. Such losses result from the widespread disruption that often follows a specific climatic or natural catastrophe.

In the real estate sector, hospitality and retail assets are particularly exposed to this type of loss, which can be substantial even though not covered by traditional insurance policies if not involving first-party property damage. Examples of adverse events include closure of airports, seaports, or other major transport hubs due to bad weather, widespread flooding, typhoon damage, or extreme temperatures.

The combined impact of these different market forces has made climate change a hot topic in the insurance industry, with several significant developments over the past few years:

  • Some major international insurers are pulling or reducing support for industries such as thermal coal power generation or mining in order to reduce these industries’ enablement of the drivers of climate change. This potentially creates a significant challenge for investors in these sectors as insurance coverage becomes increasingly expensive and difficult to procure. It also creates a knock-on effect for the financing of the purchase and construction of these types of assets.
  • Insurers are offering specific extensions to real estate owners that cover some of the additional sustainability costs that organizations face following a loss, such as hiring green-accredited professionals, green disposal of debris, and costs related to regaining green or climate-friendly certification for repaired or reinstated properties.
  • New products are being developed to offer coverage against revenue losses from adverse weather events even if the insured party’s assets are not directly damaged.
  • “Parametric” trigger insurance products have been developed to transfer weather risk. These typically pay out following a qualifying event within a matter of days or weeks, providing affected parties needed liquidity. These could become particularly relevant given the growing threat of chronic climate risks or where traditional insurance coverage becomes difficult to procure.

Bringing It All Together

Climate change is a systemic challenge that requires a strategic response. Material risks need to be identified and managed through scenario analysis, and governance is critical to getting the strategy right. However, with the proliferation of new modeling approaches, it is now possible to analyze these risks to inform a climate-risk strategy. The right balance of risk retention, mitigation, and transfer creates a decision-making roadmap that not only helps manage risk, but also highlights opportunities.

Ultimately, insurance is just one tool among many to manage the impacts of climate-related events. But as investors and regulators increasingly demand more transparency regarding the financial risks of climate change, the tools and approaches that insurers use to assess risk are more important than ever for real asset owners.

RUPERT ROBERTS is director of Specialty Growth, Asia, supporting Asian organizations with managing and transferring complex risk exposure.