Documente Academic
Documente Profesional
Documente Cultură
By Louis Perroy
Presented to
The Staple Inn Actuarial Society
14 June 2005 at 6pm
Acknowledgements
This report was initially written in partial fulfilment of a MSc degree at the Department
of Environmental Science and Technology, Faculty of Life Sciences, Imperial College
London. I would like to thank Professor Dennis Anderson of the faculty for his support
and his suggestions.
I would also like to thank the Institute of Actuaries Environmental Research Group, in
particular Dr Andrew Dlugolecki, and the team at Climate Change Capital for their
contribution and for introducing me to various people from institutional investors and
consultancies specialised in reinsurance and pensions.
My heartfelt appreciation goes to the following people whom I have met in a series of
interviews and who were able to provide me with a useful and up-to-date understanding
of the views of financial institutions on climate change:
Andrew Bisset (AXIS Re Europe),
Claudia Kruse (ISIS),
David Russell (USS),
Francis Fernandes (LCP),
Mark Azzopardi (BNP Paribas),
Mark Cockroft (LCP),
Markus Aichinger and Antje Terrahe (Allianz Group),
Michel Dacorogna and Dr Erik Ruttener (Converium),
Nick Robins (Henderson),
Paul McNamara (PRUDENTIAL PIM),
Sebastian Catovsky (ABI),
Simon Pilcher (PRUDENTIAL M&G),
Thomas Loster & Claudia Wippich (Munich Re Group)
Dr Thomas Streiff (Swiss Re) and
Warren Diogo (MARSH).
Finally I would like to thank Li Choo Kwek for her help in editing this report.
i
Table of contents
Acknowledgements i
Table of contents iii
List of Figures v
List of Tables vi
Abstract vii
Introduction 1
Part I ALM for financial institutions, a general description 4
Part I.1 Introduction .................................................................................................................4
Part I.2 ALM for capital needs requirements ...........................................................................5
Part I.3 Asset and Liability modelling......................................................................................5
Part I.4 Asset Allocation ..........................................................................................................6
Part I.5 Examples of assets strategies.......................................................................................6
Part I.6 The case of Pensions ...................................................................................................7
Part I.6.1 Definition ............................................................................................................7
Part I.6.2 Investment practices for pension assets across Europe......................................9
Part I.6.3 Defined Benefit and Defined Contribution Schemes.........................................10
Part I.6.4 Risk management and the use of derivatives ....................................................10
Part I.6.5 Asset allocation and relevance of ALM ............................................................10
Part I.7 The case of Life Insurance.........................................................................................11
Part I.7.1 ALM in Life insurance ......................................................................................12
Part I.8 The case of General Insurance (GI)...........................................................................13
Part I.8.1 GI ALM definition.............................................................................................13
Part I.8.2 GI ALM modelling ............................................................................................14
Part I.8.3 Liabilities ..........................................................................................................15
Part I.9 The case of Banking ..................................................................................................15
Part I.9.1 Types of banking risks.......................................................................................16
Part I.10 Conclusion.................................................................................................................17
Part II Climate Change and its direct physical impact 18
Part II.1 Introduction ...............................................................................................................18
Part II.2 Climate disruption and natural catastrophes caused by CC.......................................20
Part II.2.1 A factual increase in catastrophe claims ..........................................................20
Part II.2.2 Relevance to ALM .............................................................................................25
Part II.2.3 The case of Europe and the UK ........................................................................28
Part II.2.4 Potential abrupt climate shifts, Gulf Stream disappearance ............................32
Part II.2.5 Conclusion ........................................................................................................34
Part II.3 Impact on the reinsurance industry............................................................................35
Part II.4 Impact on property insurance ....................................................................................36
Part II.5 Motor insurance.........................................................................................................38
Part II.6 Travel insurance ........................................................................................................39
Part II.7 Agricultural and forestry insurance ...........................................................................40
Part II.8 Construction insurance ..............................................................................................41
Part II.9 Directors’ and officers’ duty of care..........................................................................41
Part II.10 Health insurance ........................................................................................................42
Part II.10.1 Mosquito-related diseases ................................................................................43
Part II.10.2 Emerging infectious diseases and globalisation...............................................46
Part II.10.3 Allergic and pulmonary diseases ......................................................................46
Part II.10.4 Cardio-respiratory disease and air quality ......................................................46
Part II.10.5 Poor quality water ............................................................................................47
Part II.10.6 CC and children health.....................................................................................47
Part II.10.7 Conclusion ........................................................................................................48
Part II.11 Life and morbidity insurance.....................................................................................49
Part II.11.1 Death from natural catastrophes ......................................................................49
ii
Part II.11.2 Death from aggravated health hazards............................................................ 49
Part II.11.3 Conclusion........................................................................................................ 50
Part III Climate Change and its impact on assets 52
Part III.1 Climate Change and its direct impact on assets ........................................................ 52
Part III.1.1 Introduction ...................................................................................................... 52
Part III.1.2 Property sector ................................................................................................. 53
Part III.1.3 Agriculture and forestry ................................................................................... 54
Part III.1.4 Tourism sector.................................................................................................. 57
Part III.1.5 Health industry ................................................................................................. 57
Part III.1.6 Insurance, reinsurance, and financial services................................................ 58
Part III.1.7 Location of operations...................................................................................... 58
Part III.1.8 Conclusion........................................................................................................ 58
Part III.2 Climate Change and its regulatory impact on assets................................................. 59
Part III.2.1 Introduction ...................................................................................................... 59
Part III.2.2 The EU scheme................................................................................................. 61
Part III.2.3 Renewable Obligations Certificates (ROCs).................................................... 62
Part III.2.4 The Climate Change Levy ................................................................................ 62
Part III.2.5 UK emission trading scheme ............................................................................ 63
Part III.2.6 An uneven impact of CC regulations................................................................ 64
Part III.3 Climate Change and macro-economic impact (with a time horizon to 2035).......... 70
Part III.3.1 Introduction ...................................................................................................... 70
Part III.3.2 Potential macro economic impact of climate change in developed countries.. 70
Part III.3.3 Potential macro economic impact of climate change in under developed and
emerging countries ........................................................................................... 73
Part III.3.4 Other concurring factors.................................................................................. 74
Part III.3.5 Likely Consequences ........................................................................................ 78
Part IV Adaptation to and mitigation of CC 82
Part IV.1 Introduction............................................................................................................... 82
Part IV.2 Adaptation and mitigation......................................................................................... 82
Part IV.3 Justification of mitigation ......................................................................................... 84
Part IV.4 Mitigation and macroeconomic issues ...................................................................... 86
Part IV.4.1 Precautionary principle and mitigation ........................................................... 87
Part IV.4.2 Mitigation - A long term investment trend ....................................................... 87
Part IV.4.3 The leverage of pension funds and insurance companies on capital markets.. 88
Part IV.5 Mitigation initiative within institutional investors companies .................................. 91
Part IV.6 Mitigation initiative from institutional investors ...................................................... 91
Part IV.6.1 The Carbon Disclosure Project........................................................................ 92
Part IV.6.2 The Institutional Investors Group on Climate Change .................................... 92
Part IV.6.3 The Investor Network on Climate Risk............................................................. 92
Part IV.6.4 The Equator Principle ...................................................................................... 93
Part IV.7 Conclusion adaptation, mitigation in an ALM context ............................................. 93
Part V Recommendations 95
Part V.1 Recommendations for further research ..................................................................... 95
Part V.2 Recommendations to conduct ALM differently ....................................................... 96
Part VI Conclusion 99
References 102
iii
List of Figures
Figure 1: Fossil fuel emissions and the rate of increase of CO2 concentration in the
atmosphere 1
Figure 3: Great Natural Disasters and economic and insured losses trends. (1952 –2002) 23
Figure 12: The current trajectory of the conveyor belt conveying heat around the planet. 33
Figure 13: Health consequences of burning of fossil fuels and associated pollution. 42
iv
List of Tables
Table 1: Examples of impacts resulting from projected changes in extreme climate events
(IPCC TAR2001). 18
Table 2: Extreme climate-related phenomena and their effects on the insurance industry:
observed changes and projected changes (IPCC TAR2001). 19
Table 5: Estimates of flood exposure and incidence for Europe’s coasts in 1990 and the
2080s (IPCC). 29
v
Abstract
Asset and liability management (ALM) is extremely important for the management of
financial institutions. Institutional investors typically have medium to long-term
liabilities (e.g. pensions are timed for future retirement), and the duration and return of
assets held will have to match these. This exercise typically involves the use of
projection models and assumptions.
Climate change (CC) has an impact on world climate today. This impact grows with
the continual emission of greenhouse gas (GHG) in the atmosphere. The frequency and
intensity of weather extremes may increase with CC, and this will affect most sectors of
the economy. This report focuses on analysing the impacts that CC may have on
assets, liabilities and the ALM of financial institutions.
CC will cause direct physical impacts which include worsened insurance claims to
reinsurance, property, business interruptions, motor, travel, directors’ liability,
construction, agriculture and forestry, health and life insurances. In parallel, direct
physical impacts will also be felt on asset investments, such as property, agriculture and
forestry, travel sectors and also on financial institutions themselves.
Europe, and especially the UK, have implemented legislations to progressively mitigate
CC, despite the delayed ratification of the Kyoto protocol. These legislations to date
focus on GHG emitting sectors such as energy, oil and gas, manufacturing, amongst
others. These regulations would have other impacts on the assets of financial
institutions.
The report concludes with a set of recommendations to ALM experts (mostly actuaries)
on how to incorporate CC in their ALM projections.
vi
Introduction
Introduction
Large amounts of carbon dioxide (CO2) and other greenhouse gases (GHG) have been
released into the earth’s atmosphere for the past 150 years. This can be seen by
analysing the current composition of gases in the air. (See figure below.).
Figure 1: Fossil fuel emissions and the rate of increase of CO2 concentration in the atmosphere
The various models of the world scientific community are quasi-unanimously showing
that the changing composition of gases in the air is causing a rise in temperature of the
earth’s surface, known as global warming (GW), and is causing as well profound
climate disturbance. Disturbances to the climate in turn are known to modify weather
patterns.
As a matter of evidence, and independently from climate change (CC), other climate
disruptions have been observed recently. For instance, a temporary global cooling
1
Introduction
Because the world climate mechanism is so complex, no one today is able to determine
precisely the relationship between the future rise in temperature with actual change in
weather pattern. However, as will be discussed in this report, a trend of modification to
the weather seems perceivable in terms of the frequency and intensity of extreme
catastrophes. In addition, a positive correlation between the rise in temperature and sea
levels has been demonstrated. The Intergovernmental Panel on Climate Change
(IPCC) (Third Assessment Report - TAR 2001) states that “global average sea levels
rose between 0.1 and 0.2 metres during the 20th century”. This corresponds to a
“global average surface temperature increase over the 20th century by about 0.6°C”
(IPCC TAR 2001).
This report investigates what should be expected from these financial institutions in
response to the impact of CC on their assets and liability management (ALM).
All businesses around the world, from the smallest grocery shop in India to the largest
multinationals in the United States, have or will face asset and liability mismatch issues
and will have to manage their assets and liabilities. ALM involves “investigating part
or all of the future financial outcomes of a company under conditions where the assets,
liabilities or both may vary” (Lang J. 1998). An efficient management of assets in
2
Introduction
respect of the liabilities may differentiate a fast growing business from a growing
business. An efficient management of liabilities will enable the company to understand
where business risks lie and therefore what amount of assets should be safely invested
and what amount could be put in riskier and potentially more rewarding investments so
that the company is not under the threat of bankruptcy. Today, almost all large
companies fuel their growth through borrowings to invest in new productive assets.
These new assets may be in the form of new production machinery, a newly acquired
company, property in the form of new offices or pure investments (e.g. financial
markets and venture capital).
The optimisation of the return and duration of assets in respect of liability commitments
is an exercise that all chief executive officers (CEOs) and chief financial officers
(CFOs) will have to deal with to determine conditions for a well-managed and
enlighten growth. Business plans and cash flow projections are tools used to perform
an efficient ALM.
This report is structured in four main parts. It aims first to take the reader through a
brief introduction to ALM and how it is conducted in today’s financial institutions.
The second part of the report discusses the physical impacts of CC which may affect
assets or liabilities of such institutions in a way that it may modify ALM projections.
The consequences of new regulations aimed at mitigating GHG emissions in the
atmosphere are then analysed to understand their potential impact on assets and liability
projections. Finally the report analyses the role of financial institutions in respect of
adaptation and mitigation of CC and the consequences of decisions taken in this area on
ALM.
This report gives some reasons for actuaries and other ALM experts to take CC into
consideration in their ALM work. It does not, as it is, provide an answer or a
quantitative indication on how CC should be taken into account.
3
ALM for financial institutions, a general description
In the case of financial institutions i.e. insurance companies, pension funds and banks,
ALM is particularly crucial to the business as most of the assets and liabilities translate
into medium to long term cash flow projections. Typically, a bank will lend funds over
a period of 20 years. A life insurance company will receive regular premiums for
periods of often higher than 30 years to guarantee over the mortality or the morbidity
(invalidity) of an individual. A pension fund will receive contributions from
individuals aged 18 to 65 and will invest these contributions into assets so that it is able
to provide adequate retirement for these individuals at retirement age.
The key to the success of these financial institutions lies in their being able to estimate
the inter-relationship between their assets and their liability, and understanding how
these two groups will evolve over time. “The possible financial outcomes of the
company (e.g. solvency, profitability or some other measures) can be investigated
under a variety of scenarios relating to the projected value of assets and/or liabilities”
(Lang J. 1998).
To conduct an appropriate ALM exercise, risk managers will have to use models which
project both assets and liabilities, and understand the interactions between these two
accounting blocks. This should include, for instance, the potential impact that new
economic conditions may have on assets and on liabilities. This would also include
rules on how the assets would be reviewed following a change in liability conditions
4
ALM for financial institutions, a general description
and vice-versa. As it is all a matter of projections and models, extremely different asset
strategies could be decided upon for very similar sets of liabilities and may lead to very
close or very different outcomes.
“A capital needs investigation usually focuses on a particular undesirable event.” (Lang
J. 1998). This undesirable event may cause an insurance company to breach minimum
solvency requirements or force a company into bankruptcy. In Japan, a number of life
insurance companies selling products with high interest rate guarantees were forced
into bankruptcy when market returns dropped significantly below expectations. This
report will demonstrate that CC could have a similar effect in proving reserves to be
insufficient when faced with drastic events caused by GW.
The models will estimate “future financial outcomes of the company under a range of
scenarios” (Lang J. 1998). The range of scenarios is usually a variation of asset mix
and corresponding asset returns, with the company’s liabilities varying independently
or with various degrees of correlation.
The various ALM techniques available can be broadly classified as either deterministic
or stochastic. Stochastic scenarios involve numerous random generation variation of
parameters with corresponding probability of occurrence. Deterministic scenarios
involve specific variations corresponding to actual potential situations and
investigations. The results of such investigations will “help the company to understand
the adequacy of its reserves and the capital currently held in the company”. “If the
scenarios are stochastic, the probability of the undesirable event occurring can be
5
ALM for financial institutions, a general description
measured. ” (Lang J. 1998). Because we expect the effects of CC to be felt in the long
term, it would have a relevance in the assessment of the future financial outcomes.
The assets will be allocated within the various scenarios depending on the levels of
trade-off between return and risk acceptable to the company.
Often the only source of variability introduced is the variation of asset returns and
liabilities due to changes in economic conditions.
The expected return on the assets will be dependent on the asset mix. A variety of asset
mix strategies can be used, using a combination of equities, government and corporate
bonds, or through the use of derivatives or the purchase of structured assets. Different
asset mixes will invariably mean different levels of risks. Risk is defined as variance in
asset returns or the probability of lower return or probability of the need to raise more
capital.
For illustrative purposes, examples of typical assets allocations are listed below:
x A Spanish general insurer has significant long-tail liabilities and invests 80% of
its asset portfolio in government floating rate bonds and splits the rest of the
20% equally in cash and equities.
x A UK pension fund with both active and pensioner liabilities invests primarily
in equities and marginally in UK government bonds. No clear match is
established between the government bonds portfolio and pensioner liabilities.
x A German pension fund with similar liabilities invests exclusively in
government bonds.
x A UK life insurer with a broad range of life insurance liabilities matches its
portfolio by investing entirely in equities.
x A French life insurer with a similar liability portfolio profile invests 25% in
equities, 15% in properties and the remaining 60% in government bonds.
6
ALM for financial institutions, a general description
These real life cases clearly show the diverse asset strategies which exist depending on
the experts’ views and their country of origin.
“Companies have widely differing investment strategies to back often very similar
liability profiles.”(Jagger S., & Metha S. 1999). However more than one asset strategy
might be right “since in a broadly efficient market there is an association of risk and
return, and shareholder value is often largely unaffected by choice of asset class.”.
The current UK pensions system is built around two types of schemes, Defined Benefit
and Defined Contribution schemes (further explained below).
7
ALM for financial institutions, a general description
A large UK pension fund when interviewed sees pension funds possibly extending the
definition of the fiduciary duties of the trustees such that issues of CC are taken into
account. Trustees have to strike a balance between ensuring an equivalent future
standard of living and deciding whether CC should be taken into account in the best
interest of members.
“Various asset mixes would then be analysed in detail to assess the risks (relative to
liabilities) and the rewards of each alternative under consideration.” (Kemp M. 1996).
This will for instance lead to an investment strategy preferring investments in UK
rather than in overseas equities, properties or bonds.
8
ALM for financial institutions, a general description
There is a fundamental obligation for trustees and more generally funds administrators
to invest prudently in pension funds. However the term “prudent” may be interpreted
differently amongst various investors in Europe.
Continental Europe has generally fairly specific quantitative rules for the investment of
pension assets. For instance,
x German pension money should have a maximum of 30% in EU equity, 25% in
EU property, 6% in non EU shares, 6% non EU bonds, 20% overall foreign
assets and a 10% self-investment limit.
x Denmark, has a maximum investment limit of 40% for “high risk assets” (incl.
domestic and foreign equities), 80% currency matching is required. No self
investment limits are allowed.
Prudence is then synonymous with safety. The idea of prudence focuses on judging the
investments themselves and restricting them through a test on the asset categories, the
investment themselves and the outcomes of making the investments.
The alternative approach is the concept of the “prudent person” (Goldman R. 2000) as
applied in the UK or the US. The prudent process of making the investment decision is
more important than the investment itself. This prudent person, has the responsibility
to make proper investigations.
The EU Commission approach looks mostly at prudence from a third party’s point of
view with respect to consumers’ protection. “Prudence becomes about proper
management and supervision, not about restrictive investment. This takes a qualitative
approach more restrictive than the “prudent person”
approach. (Goldman R. 2000)
9
ALM for financial institutions, a general description
Within the funded schemes there are two main types of pension schemes:
Defined benefit (DB). These schemes are designed to deliver, at retirement, a level of
pension defined at the outset of the plan. The pension benefit level is typically related
to the salary near retirement. ALM is crucial to these funds as it assists in the
calculation of the required contribution level. These schemes have the major
disadvantage of being attached to contributing employer companies and therefore
penalising employees who switch jobs. These schemes are progressively disappearing.
Defined contribution (DC). These schemes are more common and have the advantage
of easier transportability of funds when switching jobs. The management of DC
schemes essentially involves decisions on the level of risk acceptance of the member.
Personal DC schemes are traditionally offered by financial institutions such as
insurance companies, banks, building society, mutual funds.
Since the 1980s, there has been an increasing use of derivatives as risk management
tools to hedge risk (i.e. forwards and options). In the UK, it has been an arduous task
for fund managers to convince regulators and trustees that derivatives are appropriate
hedging vehicles despite their highly speculative element. Forward currencies are
commonly used to hedge against short-term exposures in foreign bond markets.
Weather derivatives could soon be used to protect assets against risks caused by a
change of climate.
For the asset allocation within UK funds, equities prevail (with investment proportions
usually around 75%), indexed bonds 5%, property 5%, and the rest being in cash and
other bonds.
10
ALM for financial institutions, a general description
A study done by Blake and Timmermann (1997) shows that the total return generated
by fund managers can be dependant to the following factors to the following extent:
This shows the importance of the strategic asset allocation, that is, “the long-run asset
allocation specified by pension scheme sponsors on the advice of their actuaries in the
light of the structure and maturity of their liabilities”, resulting from ALM exercises.
This is often described as the passive component of the funds performance when the
active components only represent a limited share of the performance and may even
have a negative performance. This corroborates the general understanding that pension
fund managers are not usually very successful at active fund management.
Life insurance traditionally covers two main risks, death and morbidity (different
degrees of invalidity) with often the inclusion of an important investment element.
Health insurance is sometimes categorised as life insurance. For the purpose of this
report, it is considered as general insurance (GI).
Premium terms can vary, from single premium to regular paying premiums. Duration
of insurance coverage may also vary, e.g. whole of life or term insurance.
Life insurance products can be “participating” in the investment return of the reserves
or “non-participating”.
11
ALM for financial institutions, a general description
The two major sources of profit variation for life insurance are:
x Investment return, and
x The match or mismatch of assets and liabilities.
Other less important sources of profit include the company’s expenses, claims costs and
surrenders or lapses. Modelling lapse rates behaviour can be very relevant to the
timing on which the company decides to credit investment return.
Claims behaviour in life insurance usually do not vary with companies and assumptions
are consistent across markets operating in the same country (e.g. use of same mortality
table for one country).
Traditionally, extensive modelling has been important in life insurance in order to meet
capital adequacy requirements. This however becomes less so with insurance
companies limiting their exposure to risk and to insurance companies becoming more
investment-orientated.
Listed companies have difficulties justifying variable profits to financial markets and
therefore want to avoid as much as possible such exposure. Insurance companies may
transfer investment risks back to the policyholders through unit linked products and
avoid as much as possible guaranteeing a rate of return on traditional life insurance
products. The assets which an insurance company must hold to cover future payments
consist of four components:
x Statutory minimum reserves,
x Minimum solvency margin,
x Resilience or mismatching reserve, and
x Free assets or shareholders reserves.
The solvency margin requirement is often a percentage of statutory reserves and capital
at risks.
12
ALM for financial institutions, a general description
Conditions which could make this additional resilience reserve useful include a
mismatch of cash flows of assets and liabilities, and a change in market conditions such
that assets and liabilities do not move as expected. As will be described in later
chapters, this could be applied in a similar case when CC could have an unexpected
impact on assets or liabilities of insurance companies.
GI comprises all the non-life insurance coverage, including property insurance, motor
insurance, heath insurance and third-party liability insurance. It also includes insurance
involving companies such as business interruption and farmers insurance. Finally, it
includes large risk insurance such as rockets insurance and large national projects.
There are two major sources of profit for GI companies. They are technical profit,
coming from premium levels compared with claims level (or expected claims levels
compared with actual claims level), and investment return from shareholder’s fund and
reserves.
A GI company has short-tail businesses, which usually do not stay on the books for
more than a year (e.g. motor insurance), and long-tail businesses, which may carry
claims over 10 years or more (e.g. asbestos liabilities).
Due to the nature of its business, reserves will be mostly short term so a GI company
will inherently not carry a lot of assets under management. Instead, it will accumulate
assets over the years of successful operations. As a consequence, a young or small
company will hold most of its assets in cash to back short-term liabilities and hold
assets for unearned premium on long-tail business. Assets on long-tail liabilities are
usually invested in fixed interest vehicles with duration matching exactly the duration
13
ALM for financial institutions, a general description
of liabilities. Unlike in the cases of life insurance and pension, a GI company is not
expected to re-distribute any of its investment return on the reserves backing the
customers’ liabilities. It therefore will invest only spare net assets in equities or when
reserves are so large that investing a proportion of these in equities presents little risk as
any potential fall in stock markets would not have a major impact.
Some of the key issues with ALM work in GI lies in modelling the underlying cash
flows, in particular benefit payments. It was found that the best conceptual approach is
divided into three parts. The first part which might be called additional claims is
measured on a loss-ratio approach and uses variability in the loss ratio (ratio of claims
over premiums). The second part, large individual claims, is particularly worth
modelling for smaller portfolios. The third part consists of catastrophe claims, which is
important for reinsurance arrangements and is also important for risk of ruin,
particularly where insurance limits are a major issue. The interactions between the
three parts are important.
An appropriate ALM exercise would include modelling of market cycles especially for
catastrophe insurance and reinsurance. It is today a more and more accepted fact that
CC has a noticeable impact on natural catastrophic claims cycle and therefore will have
an impact on reinsurance cycles.
14
ALM for financial institutions, a general description
Often claims volatility is so large that it overshadows variability in all other accounting
items.
Traditional short or long-tailed reserves are usually set up by actuaries and statistical
experts and are fairly well estimated nowadays. However catastrophe and other
unexpected risks tend to be based on fairly subjective approaches. In particular, an
assessor or claims specialist will use his experience and expertise to estimate the likely
size of a large claim.
Moreover, catastrophe and equalisation reserves are not permitted in many countries.
This could become more prevalent as there is an increasing trend of accounting
systems, for example in the USA, not recognising these reserves. This is treading on
dangerous grounds as catastrophe claims, despite being infrequent, when they do
happen, could be damageable to companies’ accounts.
Banks typically understand ALM as a process to ensure that at no time the mismatch
between assets and liabilities is so great that it over-exposes the bank, in the case of a
sudden important financial market drop.
15
ALM for financial institutions, a general description
Amongst the financial sectors mentioned in Part I.1 above, the banking industry might
be the most “short termist” of all four. Results are usually analysed on a quarterly basis
and based on accounting earnings.
The risk which is most likely the cause of a bank’s failure is the effect of significant
credit losses. This in turn causes a loss of liquidity when the market has realised the
conjunction of these two risks and therefore discount the market value of assets to a
level where the bank cannot face the liabilities. Liquidity risk becomes a real issue
only when it is coupled with a loss of confidence in the bank’s stability.
Although this may be arguable, banks traditionally take a “short termist” view in
conducting ALM exercises. Therefore this report will mostly focus on pension funds,
general insurance and life insurance.
16
ALM for financial institutions, a general description
However banks could have a larger exposure to the risk of default from CC. This
would come mainly from uninsured customers. Already today, insurance is not readily
available for some risks, e.g. floods, agriculture.
ALM is a crucial exercise for financial institutions as it acts as a warning signal to the
future financial soundness of companies. The scenarios studies done test the potential
issues that financial institutions may meet in the future. As mentioned before, these
projections are carried out using a range of assumptions and models.
17
Climate Change and its direct physical impact
This warns us that higher maximum temperatures and intense precipitation are “very
likely” events which render drought, storms, cyclones, floods “likely” in numerous
areas of the globe.
18
Climate Change and its direct physical impact
The following pages analyse the damages that CC seems to already be causing and how
it affects the liability position of financial institutions. It analyses also what seems to
be the current level of knowledge in terms of prediction of the potential impact of CC.
The report will specifically focus on Europe and the UK, but will try to develop an
understanding for the rest of the world.
This report will then analyse separately the impacts of CC on catastrophe insurance,
property insurance, car insurance, health insurance, life and morbidity insurance, and
pension funds.
19
Climate Change and its direct physical impact
Berz G. (2004 Munich Re) remarks that prior to 1987, only one event caused an
aggregate insured loss of at least US$ 1 billion. Since that year, 46 such events have
occurred and 44 since 1990 (see table below). Of these 46 events, only two are
earthquakes.
20
Climate Change and its direct physical impact
Ins.Losse Econ.Losse
Year Event Area s s
(millions US$)
1983 Hurricane "Alicia" USA 1,500 3,000
1987 Winter storm West Europe 3,100 3,700
1989 Hurricane "Hugo" Caribbean. USA 4,500 9,000
1990 Winter storm "Daria" Europe 5,100 6,800
1990 Winter storm "Herta" Europe 1,300 1,950
1990 Winterstorm "Vivian" Europe 2,100 3,200
1990 Winter storm "Wiebke" Europe 1,300 2,250
1991 Typhoon "Mireille" Japan 5,400 10,000
1991 Wildfire "Oakland fire„ USA 1,750 2,500
1992 Hurricane "Andrew" USA 17,000 30,000
1992 Hurricane "Iniki" USA, Hawaii 1,600 3,000
1993 Blizzard USA 1,750 5,000
1993 Floods USA 1,270 21,000
1994 Earthquake USA 15,300 44,000
1995 Earthquake Japan 3,000 100,000
1995 Hailstorm USA 1,135 2,000
1995 Hurricane "Luis" Caribbean 1,500 2,500
1995 Hurricane "Opal" USA 2,100 3,000
1996 Hurricane "Fran" USA 1,800 5,200
1997 Ice storm Canada. USA 1,200 2,500
1998 Floods China 1,000 30,000
1998 Typhoon „Vicki“ and „Waldo“ Japan 1,600 3,000
1998 Hailstorm, severe storm USA 1,350 1,800
1998 Hurricane "Georges" Caribbean. USA 4,000 10,000
1999 Hailstorm Australia 1,100 1,500
1999 Tornadoes USA 1,485 2,800
1999 Hurricane "Floyd" USA 2,200 4,500
1999 Typhoon "Bart" Japan 3,500 5,000
1999 Winter storm "Anatol" Europe 2,350 2,900
1999 Winter storm "Lothar" Europe 5,900 11,500
1999 Winter storm "Martin" Europe 2,500 4,100
2000 Typhoon "Saomai" Japan 1,050 1,500
2000 Floods United Kingdom 1,100 1,500
2000 Hailstorm, severe storm USA 1,900 2,500
2001 Tropical Storm „Allison“ USA 3,500 6,000
2002 Tornadoes USA 1,675 2,200
2002 Floods Europe 3,400 16,000
2002 Winter storm „Jeanett“ Europe 1,500 2,300
2003 Hailstorm, Tornadoes USA 1,600 2,100
2003 Tornadoes USA 3,200 4,000
2003 Hurricane „Isabell“ USA 1,685 5,000
2003 Wildfires USA 2,200 3,500
2004 Hurricane „Charley“ Caribbean. USA 8,000 18,000
2004 Hurricane „Frances“ Caribbean. USA 6,000 12,000
2004 Typhoon „Songda“ Japan 3,000 6,000
2004 Hurricane „Ivan“ Caribbean. USA 11,500 23,000
2004 Hurricane „Jeanne“ Caribbean. USA 5,000 9,000
2004 Typhoon „Tokage“ Japan 1,300 2,300
21
Climate Change and its direct physical impact
The same report from Munich Re produces the table below which has been crudely
adjusted by subtracting losses from earthquakes over US$ 1 billion during the decade
“1990-99” (i.e 1994 USA earthquake insured losses of US$ 15300 million and 1995
Japan earthquake insured losses of US$ 3 000 million). It is assumed that all other
earthquakes are uniformly distributed over the years. It is assumed also that
earthquakes by nature are completely uncorrelated to CC events.
Economic losses 44.9 80.5 147.6 228 703.6 566.8 2.8 8.7
The table above clearly shows an increase in the number of natural disasters. It could
be seen that increase in total economic losses can be attributed more to an increase in
number of events than to an increase in case sizes, i.e. size of economic losses due to
modern economic factors.
The following two figures (Berz G., 2004 Munich Re) illustrate a derailment of trends.
22
Climate Change and its direct physical impact
Figure 3: Great Natural Disasters and economic and insured losses trends. (1952 –2002)
(Topics Geo – Annual review: Natural catastrophes 2004)
Number of events
16
Other
Others
events
(Drought,
(Drought,
heatwave,
heat wave,
coldwave)
cold wave)
Flood
Flood
14
Storm
Storm
Earthquake/Tsunami,
Earthquake/tsunami,Volcanic
volcanic
eruption
eruption
12
10
Number
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
60
40
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
The elements above show some repeated weather abnormalities without necessarily
showing any climate disruption. This increase in the number of claims could be due to
climatic cycles.
23
Climate Change and its direct physical impact
Number Number
Linear Trend Linear Trend
These worsened natural catastrophes may be such that the financial soundness of
insurance companies and reinsurance companies could become vulnerable. There is
therefore a need to understand the causes of such changes and a need to remediate the
problem to preserve the survival of these insurers and re-insurers. As a matter of fact,
eleven insurance companies went insolvent in 1992 following Hurricane Andrew and
many large carriers required recapitalisation.
In the same report (TOPICS geo 2004 Munich Re), Munich Re states that “Recent
disasters have highlighted the disproportionately heavy burden shouldered by reinsurers
in compensating extreme disasters losses and underscored the need to be better
prepared for the risks of the future if the insurance industry is to fulfil its obligations in
an increasingly hostile environment”.
The IPCC describes that the likely changes from current climate is a progressive
change in the seasons towards warmer temperatures (hotter summers, milder winters),
more frequent and intense natural hazards (storms, precipitations) and progressive long
term changes (sea level rise).
24
Climate Change and its direct physical impact
The above demonstrates the close relevance of CC to any long term projections
potentially affected by natural catastrophes. This is especially so as insurance and
reinsurance businesses are in the direct line of fire of such deteriorations of
catastrophes. As Munich Re states (Berz G., 2004 Munich Re) “Changes in many
atmospheric processes will significantly increase the frequency and severity of heat
waves, droughts, bush fires, tropical and extra tropical cyclones, tornadoes, hailstorms,
floods and storm surges in many parts of the world.”
Climatic models are too imprecise in terms of the amplitude of the impact of CC or its
timing and location. At this stage, only one certainty seems to prevail, a serious
derailment of climatic events. For instance, at this stage, no direct correlation can be
established between temperature increases and increase in the occurrence of natural
catastrophes.
As shown below, the IPCC (TAR 2001) suggests a shift in the climatic events
distribution curve which will mean less cold weather events. At the same time, the
distribution curve flattens, reflecting an increasing number of extreme climatic events
due to hot weather.
However quantifying this shift more precisely, on a time and geographical basis, would
be crucial to projections of liabilities or even prospective pricing of insurance and
financial products.
25
Climate Change and its direct physical impact
Work is already being actively carried out today by academics and within large
reinsurance and insurance companies to start quantifying the effect of global warming
so that this can eventually be factored in premium calculations.
26
Climate Change and its direct physical impact
The West LB (2004) report which reproduces the Munich Re graph below states that
“Potential climate disasters are generally projected using the willingness to pay (WTP)
method, necessitating assumptions about risk aversion and the shape of the probability
distribution. The Nordhaus/Boyer model arrived at cost increases of between 0.4% to
2.3% given an average increase in temperature of 2.5oC, and increased costs of between
3%-15.4% given an average increase in temperature of 6oC”.
A large reinsurance consulting firm agrees that a trend in natural catastrophes is starting
to be felt. No company however seems to be including such trends in their pricing at
this stage and this reluctance may be due to current competitive market pressures.
Moreover the events of September 11 in New York have increased insurance rates and
caused a sharp rise in capacity (overall financial ability to pay reinsurance claims)
within the reinsurance market which should avoid any capacity issues for the next 5 to
10 years. The alternation of large claims followed by increase in capacity are until now
in cycles of around 5 to 10 years.
27
Climate Change and its direct physical impact
The same firm notes that this period of capacity would potentially be better used to
raise the awareness of the impacts of CC and to adapt reserving and pricing to future
conditions.
Extreme climatic events have also increased significantly, although unevenly, across
Europe. The number of storms and sudden torrential rains have increased causing an
increase in flash floods.
The IPCC describes the likely changes from current climate as follows:
x “Extreme seasons
o Exceptionally hot and dry summers (we may refer to summers of 1995
and 2003),
o Mild winters.
x Short-duration hazards
o Windstorm (possibly associated with tidal surges),
o Heavy rain leading to river valley flooding and flash floods
28
Climate Change and its direct physical impact
Hot and dry summers can be disastrous for agriculture and water supply. It will also
reduce the growth of vegetation and make it more vulnerable to pathogens and pests,
especially for trees, and cause wildfires. The IPCC (TAR 2001) claims that each
summer becomes hotter than the previous 1 in 10 summers.
Mild winters will also cause pest problems as frost will not kill undesirable insects and
may de-regulate vegetations.
Extreme short-duration hazard events have also occurred with a higher frequency in the
past decades mostly in the form of major windstorms or tidal surges which can be lethal
for the vegetation (especially for trees), housing or even people. (In 1953, a windstorm
associated with a tidal surge killed more than 2000 people on the coast of the
Netherlands and East Anglia.).
Several floods have also affected Europe in the past 15 years. In 2003 alone, Munich
Re (TOPICS geo 2004) reported floods in early January in Germany, Switzerland and
France (amounting to economic losses of over US$1 billion), and at the end of January
in Italy, February in Greece, April in Russia, and December in France (amounting to
economic losses of over US$1.5 billion).
The scenarios modelled by the IPCC (TAR 2001), give an indication of the potential
consequences of flooding.
Table 5: Estimates of flood exposure and incidence for Europe’s coasts in 1990 and the 2080s
(IPCC).
In the UK, heavy precipitations in winter seem inversely correlated with a lower
frequency of cold days during the season.
29
Climate Change and its direct physical impact
Also, “coastal squeeze” which happens when habitats are squeezed between rising sea
and coastal hard defences is becoming a real issue in Northern Europe.
The following four graphs were produced by various scientists in their respective
European countries and demonstrate that trends of extreme events caused by CC are
starting to be better understood and to be quantified to a point where it may be possible
to make reasonable CC related assumptions to be included in medium to long term
projections.
1961-90 2050s
T = 15.3°C T = 16.9°C T = 1.6°C
p = 33.3%
factor 25
p = 1.3%
1975
1983
1995
1826
1976
30
Climate Change and its direct physical impact
140 +44%
120
+22%
100 mm threshold
100
+4°C
80 factor 3
+2°C
60 factor 8
40
Source: A. Reuvekamp, A. Klein Tank, KNMI,
Change 30, p. 8-10, June 1996
20
50 20 10 5 3 2 (% p.a.)
Probability
Normal winter
Warm winter
(snow cover reduced)
Sa/El 04.93 - Source: Dronia, 1991
31
Climate Change and its direct physical impact
60 5,0
Source: U. Otte, German Weather Service, 2000
4,5
Mean Wind Speed
50
4,0
3,5
3,0
with Bft 8 and above
30 2,5
2,0
20
1,5
1,0
10
0,5
0 0,0
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
Part II.2.4 Potential abrupt climate shifts, Gulf Stream disappearance
The IPCC and other scientists are warning us of potential abrupt climate shifts. One
such instance is the shift of the Gulf Stream which could mean a local cooling. Such
shifts have happened over decades in the past, installing a new equilibrium for
centuries.
The “Ocean and Climate Change Institute” specifies that “these climate shifts do not
necessarily have universal, global effects. They can generate a counter-intuitive
scenario. Even as the earth as a whole continues to warm gradually, large regions may
experience a precipitous and disruptive shift into colder climates.”
If the salinity level of ocean waters was to change drastically, waters in the North
Atlantic could stop sinking, then the conveyor would cease and the Gulf Stream would
not reach the North Atlantic. This would bring harsher European and North American
winters.
32
Climate Change and its direct physical impact
Figure 12: The current trajectory of the conveyor belt conveying heat around the planet.
White sections represent warm surface currents. Purple sections represent deep cold currents.
(Illustration Jayne Doucette, WHOI Graphic Services).
This could mean a global warming with local zones of extreme cooling. This would
likewise bring drastic modifications to today’s ecosystems and to human societies.
There is an undeniable decrease in salinity in the waters of the Northern Atlantic Ocean
which may cause the Gulf Stream to shift. However, the BBC reports “that current
33
Climate Change and its direct physical impact
climate model predictions are confident that the increase in temperatures resulting from
an increase in greenhouse gas emissions is much greater than the potential cooling
effect, so a cooling of the UK climate is unlikely this century.”.
Due to the projected timing of the occurrence of such events, it will not be considered
in this report. What happens in a hundred years is of prime relevance to humanity,
however less so to the assets and liability position of financial institutions today.
The movie “The Day After Tomorrow” (Emmerich R. 2004) focussed on possible
effects caused by the progressive desalinisation of the world oceans, which has a low
probability of occurrence.
Drawing a list of all potential impacts leads us to consider the financial consequences
of such damages and a potential compensation mechanism for additional financial
losses. This is already today a major concern to reinsurers in their cover of catastrophic
events. Such direct impacts may also be of concern to property insurance, business
interruption insurance, car insurance, health and life insurance.
A large reinsurer, when spoke to, emphasised the problem of countries not having the
right infrastructure to adapt to changes brought by CC. For instance the drought of
summer 1995 cost GBP 1 billion mainly due to inadequate infrastructure. The bending
of rails because of extreme heat could cause accidents, resulting in a much heavier bill.
34
Climate Change and its direct physical impact
Reinsurance cover is essential to the insurance business and in the current state of
things, CC could be catastrophic to reinsurance companies. Reinsurers therefore are
faced with the following alternatives;
x Either exclude risks which are too exposed to CC, or placing a maximum cap on
the concentration of claims. An exclusion of risk from reinsurers would most
likely mean the exclusion of such risk from the direct insurer leaving the
individual fully exposed. This may not be acceptable to governments especially
when such insurance are compulsory (e.g. property or car insurance).
x Increase premiums to a level which might render insurance impractical.
x A third solution would be a securitisation of the risk through the use of weather
derivatives or catastrophe bonds. However even this solution of in effect
reinsuring risk by the public may become commercially unattractive if natural
catastrophes worsen too dramatically.
35
Climate Change and its direct physical impact
During one of the interviews, a large reinsurance company expressed that they have not
increased premiums in response to CC trends because such trends cannot be clearly
determined from local data. There is an issue of cedantes (insurance companies
seeking reinsurance) not communicating enough data.
CC is increasing the frequency and the severity of extreme catastrophic events such as
floods, wind storms, droughts and coastal squeezes.
All these events will have a direct impact on private and commercial properties and
therefore will affect property insurance directly.
The ABI (Dlugolecki A., 2004) stated that CC has already had a noticeable impact on
the UK property market.
ABI reports that “the UK storm and flood losses during the period 1998-2003 have
totalled GBP 6.2 billion, twice that of previous period.” Also “underwriting risk has
changed. Small changes in the severity of extreme events can result in increases in
damages of 4 to 5 times greater.” The ABI estimates that weather catastrophes risk rate
might already be rising at an “unseen” rate of 2 – 4% per year.
36
Climate Change and its direct physical impact
The major various events which will have a definite impact on properties in the UK
include floods, windstorms, subsidence and coastal squeezes. These risks would be
similar in the rest of Europe and other developed countries. However it may vary
depending on physical specificities of countries (i.e. mountainous, low rise, long coast
line land, etc).
In the same report, the ABI produces a prospective table of likely costs of damage to
properties due to extreme events. The table shows an increase of claims by 2050 by
two to three times.
This assumes that no adaptations are taken by the property market which is probably
pessimistic.
37
Climate Change and its direct physical impact
It is likely that CC will reshape the property market as the property market and the
insurance market will respond to increasingly obvious signs of CC impacts. A
“red lining” system which excludes the most exposed properties is already put in place
on a limited scale in the UK and in Germany. Unless adaptation efforts of developed
countries reduce the impacts of a worsening trend in natural catastrophes, such red
lining or insurance exclusion seems unavoidable.
This re-shaping, combined with direct impacts of CC, will necessitate close monitoring
of the pricing of property insurance in the future. Using past statistics as a main basis
for pricing may not be appropriate anymore.
Such risks will render a proper ALM exercise even more useful.
Driving in bad weather conditions would inevitably increase accident rates. Damages
to cars should also increase with higher incidences of storms and hails, and so on.
38
Climate Change and its direct physical impact
Finally as transportation today accounts for roughly 26% of the UK total GHG
emissions, it is likely that government measures will tend to encourage drivers to limit
the use of their cars and use public transport more; and this is suggested in the UK
Transport Ten Year Plan 2000. This would therefore hopefully reduce incidents of car
accidents.
All in all, CC should have some impact on drivers and their cars. However, it is hard to
predict what this impact would be. Therefore, it is not foreseen that such impact would
be major. Nonetheless it cannot be ignored and further studies should be encouraged.
A reinsurance company when interviewed notes that the number of accidents which
may increase as result of changed road conditions caused by CC, is today negligible.
People may travel less away from the UK since the weather has become warmer and
usual destinations have become too warm to be pleasant. On the other hand, some
scenarios show an increase in precipitations in the UK due to CC, which may not make
the UK more hospitable for holidays.
39
Climate Change and its direct physical impact
time. It is thus extremely likely that measures to reduce the flights traffic in the future
will be taken. A drastic increase in flight prices would most likely result from this.
The farming sector is likely to be badly affected by an increase in the density and
severity of natural catastrophes. At the same time, it is interesting to note that
according to the IPCC (TAR 2001) and other experts, “Cereals of different species and
varieties are grown throughout Europe. Climatic warming will expand the area of
cereals cultivation (e.g., wheat and maize) northward (Kenny et al., 1993; Harrison and
Butterfield, 1996; Carter et al., 1996a). For wheat, a rise in temperature will lead to a
small yield reduction, whereas an increase in CO2 will cause a large yield increase; the
net effect of both for a moderate climate change is a large yield increase.”
Insurance covers specifically cover for fire, lightning, wind, hail, and third-party
damage as a result of pollution.
x Crop insurance can also be provided by the private or public sector, and is
currently based on the “Actual Production History” (e.g. claims are only paid if
there is a loss of 25% or more of historical production).
40
Climate Change and its direct physical impact
According to the IPCC, CC would substantially increase the risk of fire and extend this
risk to latitudes where it is today non-existent. CC would also increase the risk of
damages due to wind storms and pests brought by less cold weather (winter frost kills
pest larvae.).
Incidences of windstorms in continental Europe over the last few years have revised
insurance conditions and tariffs substantially. As a consequence, forestry insurance is
more restrictive today.
Following what has happened in the case of other environmental damages (Asbestos);
CC could potentially give way to directors and top management liability.
Although it may appear impractical that large CO2 emitters are held liable for climate
change, actions could nonetheless be attempted towards emitters in certain
circumstances where these companies may have deliberately ignored warnings of
obvious damages it has caused. This has happened previously for tobacco companies
and asbestos companies in the US. West LB (2004) remarks that “An international
grouping of lawyers, scientists and public interest groups intention is to look into how
41
Climate Change and its direct physical impact
far existing statutory requirements can be used to act against causes of climate change.
In the future we expect that companies will also come under increasing pressure to take
concrete measures to react to climate change.”.
It is difficult to predict the likelihood of such duty of care risks. They have the
potential of representing very large amounts and therefore should not be under-
estimated.
The Harvard report, (Epstein P., & Rogers C., 2004) summarises the potential health
consequences of burning of fossil fuels and associated pollution as follows:
Figure 13: Health consequences of burning of fossil fuels and associated pollution.
Climate Change
Global heating of the atmosphere can have numerous direct and indirect impacts.
x It will increase the number of heat-waves tremendously and, in particular,
increase night time temperatures. It is predicted that by 2020, the number of
deaths through heat-waves will double. Also the production of smog and the
dispersal of particles in the atmosphere will increase the number of respiratory
problems.
42
Climate Change and its direct physical impact
GW may also threaten food supply in certain regions of the world and therefore give
rise to problems of malnutrition. This may lead to displacement of population and
overcrowding, which in turn may mean appearance of serious diseases such as
tuberculosis.
The maps below is a scenario for potential malaria risk areas in 1990 and 2100
(Epstein P., & Diaz H., et al 1998) based on the climate patterns generated by the U.K.
Meteorological Office-General Circulation Model with the accelerated policies and
business-as-usual greenhouse gas emission scenarios (Martens et al. 1995). It shows
that although current zones of high malaria exposure do not change drastically, the
disease becomes more important in Northern America and across Europe.
43
Climate Change and its direct physical impact
AP Scenario 2100
Three phenomena would be aggravated by GW, and will cause the proliferations of
diseases through mosquitoes.
1. Mosquito related diseases are currently nearly non-existent in northern countries
and high elevated lands of southern countries because mosquitoes carrying the
disease cannot reproduce in cold weather (freezing conditions kill eggs and
larvae). Malaria is only seen in places where temperature routinely exceeds
15.6 o C, and dengue fever and yellow fever needs temperature not falling under
10oC to be communicable. With an increase in temperature due to GW, ideal
44
Climate Change and its direct physical impact
conditions for such diseases will be extended to 60% of the world population in
the 21st century instead of the current 45%.
2. Mosquitoes need stagnant waters to breed. CC will increase the risk of
precipitation and therefore spread the risk of uncontrollable and frequent
patches of stagnant waters. This may be further aggravated by a deliberate
policy of increasing the number of water reservoirs to face severe drought.
3. Mosquitoes acquire diseases from feeding on the blood of infected animals or
human-beings. The disease gets amplified “pathogens increase and mature”
(Epstein P.,2000) in the mosquito organism and this amplification factor will
increase with the surrounding temperatures, such that “at 68 degrees F (20oC),
the immature malaria parasite takes 26 days to develop fully, but at 77 degree F
(25oC), it takes only 13 days. The Anopheles mosquitoes that spread the
malaria parasite live only several weeks; warmer temperatures raise the odds
that the parasites will mature in time for the mosquitoes to transfer the
infection.” (Epstein P.,2000). Finally, at higher temperatures, mosquitoes
proliferate faster and are more active than at lower temperatures.
This phenomenon is already observed in many areas of the world. For instance,
malaria has appeared in the highlands of Papua New Guinea and in the mountains in
Tanzania. Dengue fever is now present in Taxco in Mexico, and the northern highlands
of India. Malaria has also returned to South Korea, South Africa, and former USSR. It
has also been seen in Texas, New Jersey, New York, Toronto (Bunyavanich, S., &
Landrigan, C., et Al 2003), mainly affecting children between 3 and 5 years old.
This represents definitely a serious threat for western countries which are currently
unprepared for outbreaks of such diseases. However, it has been shown that certain
developed countries such Singapore or Malaysia, situated at a latitude prone to such
diseases and surrounded by countries such as Indonesia where little is done to contain
the disease, have contained or eradicated these diseases through a disciplined approach.
In New York, in response to the West Nile virus, people have been asked to clear
stagnant waters.
45
Climate Change and its direct physical impact
Epstein P., & Rogers C.,(2004) notes that “Since 1976, the World Health Organization
reports there are 30 infectious diseases that are new to medicine. In addition, there is a
resurgence of some old diseases (malaria, dengue fever, cholera), and a re-distribution
of others (e.g., West Nile virus) occurring on a global scale.” Although none of these
emerging diseases can be solely attributed to GW, a great number of them are zoo
noses, animal diseases which spill over to humans through mosquitoes and rodents. An
explosion of the rodent population in New Mexico occurred in 1993 following severe
droughts which depleted rodent predators. This was further aggravated by heavy
precipitations which helps provided food to rodents.
Climate change has a certain effect on pollen production. Spring has consistently been
occurring earlier than usual and therefore causes an advancement of bud burst.
Moreover, quantity of pollen production has increased due to a higher concentration of
CO2. Another cause of allergic diseases and respiratory problems is mould or fungi,
which develops particularly in wet interiors. Wet conditions are likely to be helped by
heavy precipitations, flooding, lack of ventilations in modern buildings, or even by the
over-use of air-conditioning.
The high level of CO2 coupled with high temperatures increases the potential for pollen
production and therefore causes an increase in respiratory problems such as asthma.
Diseases of this kind may also result from direct pollution such as petrochemical smog
and ground level ozone. Diesel exhaust particles can also be particularly vicious as
they bypass lungs defences and can
“1) clog airways and cause cardiovascular and respiratory illness,
2) help deliver pollen grains and moulds deep into the lungs and
46
Climate Change and its direct physical impact
Risk of poor quality drinking water due to severe flooding can also be a potential issue.
For instance, the torrential rains in 1993 in Milwaukee and Wisconsin contaminated
drinking water with a protozoan contained in animal farm stools. According to Epstein
P., & Rogers C., 2004, 52% of the people who used this water had different forms of
gastrointestinal infection. Food supply can also be affected, especially seafood.
However this impact may only be marginal in northern countries.
The table below (Bunyavanich, S., & Landrigan, C., et Al 2003) shows areas where the
health risk is increased for children compared to adults.
Health concerns due to GW is particularly acute for children as they are vulnerable to
respiratory diseases and pollution.
47
Climate Change and its direct physical impact
It is speculative at this stage on how modern medicine will cope with these new threats.
It may not be unrealistic to think that the developed world medical system will be able
to adapt reasonably well to these new attacks. But this will be at an adjustment cost
which will probably be partially born by the insurance sector. Nonetheless it is
possible that if CC was to cause too many health problems, all at the same time,
medical systems might be overwhelmed and catastrophic consequences could be
feared.
It is therefore reasonable to conclude that in conducting ALM for long term health
insurance liabilities projections, CC should be factored in as an important volatility
factor of these liabilities. An awareness of the threat coupled with a close monitoring
of it may be the right approach to such an uncertain future. This may imply specific
pricing of certain health insurance products.
The ABI (Dlugolecki A., 2004) in their report states that the net effect of CC on health
is currently “unclear”. Some aspects will have negative consequences, at the same time
GW may have “beneficial effects on health policy claims”.
It concludes by saying that “over the longer term, increased life expectancies may be
combined with poorer health” which would fall on healthcare providers.
48
Climate Change and its direct physical impact
In the summer 2003, a heat wave with temperatures reaching up to 65oC in southern
Europe had terrible consequences in Europe killing nearly 15,000 people in France (up
to 4 times the fatality rate of the important heat wave in Chicago in 1995), and over
12,000 in other European countries (TOPICS geo 2004 Munich Re). This may seem
worrying for in terms of the future impact of heat waves caused by CC. However when
one analyses the event carefully, one will notice that most of the victims of this heat
wave were the elderly who would have probably died within 6 months independently
from the heat wave anyway. The high fatality rate was mainly due to the fact that
infrastructure in the countries was not prepared for such extreme temperatures. If high
temperatures like this become a frequent occurrence, it is likely that the infrastructure
will be adapted to deal with it. Other extreme events such as windstorms or floods can
also be fatal. This was especially so in the case of a winter storm in western Europe in
March 1990 which claimed 230 lives.
This could be illustrated using the example of Hurricane Andrew in 1992 which caused
30 billion dollars in damage, but comparatively only claimed the lives of 38 people.
(Swiss Re 2003)
Health hazards may increase with CC, with increased risks of malaria and other
epidemics. The potential for future epidemics is only a hypothetical fact. For instance,
recent examples of SARS or AIDS for which no vaccine have been discovered, have
shown that such potentially catastrophic diseases were minimized in Asia, North
America and Europe through precautionary and isolation measures. SARS in particular
49
Climate Change and its direct physical impact
showed how fast and responsive the international community could react to such
threats.
In terms of deaths caused by severe droughts, the ABI estimates that “warmer winters
could reduce cold-related deaths in the UK by 20,000 per year. This reduction would
only be marginally offset by an increase in summer heat-related deaths of 2800 per
year.”.
On the other hand, Munich Re (TOPICS geo 2004) analyses that in New York and
Shanghai, as much as 3 times more people die on extremely hot days as on normal
days. There is a definite “harvesting effect” caused by heat waves which advances
death by a few days. Moreover, extreme heat waves weaken people to a point where it
may increase mortality significantly over a period of a few weeks.
The above incidences of AIDS and SARS, however dramatic they may have been for
the victims, and despite the lack of treatment for people from developing countries,
have not at this stage had any significant impact on overall probabilities of mortality or
morbidity in the developed world. We can therefore conclude that, to the best of our
current knowledge, there is a fairly low risk that CC will have a very noticeable impact
in the foreseeable future on the probabilities of mortality and morbidity of individuals
living in the developed world.
50
Climate Change and its direct physical impact
Ranking (Rk*)
5- Can be extremely detrimental, should definitely be considered for ALM projections.
4 – Important impact on assets and liabilities. May be considered for ALM projections.
3 – Medium level of importance, may be ignored in ALM projections
2 – Potentially important, however mild at this stage of knowledge. It can be ignored in ALM
(projections unless further research shows otherwise).
1 – Very mild impact on assets or liability. It does not need to be considered for ALM.
51
Climate Change and its impact on assets
Numerous sectors of the economy, if not all sectors, will be affected one way or the
other by harsher natural catastrophes caused by CC. However the purpose of this
report is to try to understand whether it would make reasonable sense for a financial
institution, such as an insurance company or a pension fund, to make investment
decisions which would take these aspects into account, in particular for ALM.
The main sectors of the economy which may directly suffer from impacts of CC
include, property, agriculture, forestry, fishery, food and beverage distribution,
infrastructure & utilities, transportation (water, trains, highways), health and
insurance/reinsurance sectors.
52
Climate Change and its impact on assets
An increase in the number of storms, floods, droughts and a progressive rise in sea
levels will irremediably have an impact on the property markets.
The risk will not be spread evenly throughout the property market. It will depend on
the exposure of the location of the property to the increased risk of natural catastrophes
and the adaptation measures which are already in existence to protect such properties.
It is relatively easy to identify areas prone to flooding by looking at historical data and
seeing whether potential dykes and reservoirs have been built to minimise such risks.
The ABI (2003) states that “Of the approximately 21 million properties in England and
Wales, around 1.8 million homes and 130 000 commercial properties are at risk from
inland or coastal flooding.” It also cites the autumn of 2000 as the wettest for nearly
300 years, when 10,000 properties were damaged in that period alone.
The same report mentions that “winter rainfall could increase by 15% to 30%,
increasing peak river flows by about 20%.” In addition, the risk of urban flooding may
double mainly due to inadequate sewage systems. Finally it says that there is a
“potential to increase coastal flooding risk by up to 30-fold”.
53
Climate Change and its impact on assets
Droughts in the UK increase the risk of subsidence which causes clay soils to dry out
and shrink, undermining the foundations of buildings. This became a real problem
during the hot and dry summers of 1990 and 1991. This phenomenon recurred every
year between 1995 and 2001 and amplified itself further in 2003. An investment
selection could be done based on the soil and construction conditions to minimise
exposure to this subsidence risk.
All these amplified risks due to CC may have a major impact on large property
portfolios of financial institutions.
However, a selection of properties less prone to such risks is possible. This may mean
that market prices will naturally incorporate the factors mentioned above. It may also
mean that big cities, where adaptation efforts to these types of risks precede smaller
cities, may become relatively more attractive. These adaptation efforts should also
consider additional risk exposure due to a rise in sea levels.
The risk induced by CC on properties is very important for liabilities and will trigger
additional reserving or re-pricing of insurance products. In the case of assets, it may be
partially avoided through appropriate selection.
Financial institutions do not traditionally invest heavily in the agriculture and forestry
business. However under different market and economic circumstances, these sectors
may become favoured sectors again, as they used to be until the mid 19th century.
54
Climate Change and its impact on assets
Although the 20th century has seen a very rapid increase in world population, the rate of
increase in food supply and production was even higher. This has led to a decrease in
the monetary value of arable land. Could CC reverse this trend?
The IPCC (TAR 2001) expresses some real concerns over the agricultural production of
some developing nations, but does not seem too pessimistic when looking at things
from a global perspective. Some land may become hospitable to new types of plants
because of milder temperature. At the same time, irrigation may be employed in
southern European countries as long as sources of water are at within reach.
The IPCC (TAR 2001) states that “Relatively few studies have attempted to predict
likely paths for food demand and supply beyond 2020. There are reasons for optimism
that growth in food supply is likely to continue to keep apace with demand beyond
2020. For example, population growth rates are projected to continue to decline into
the 21st century (Bos et al., 1994; Lutz et al., 1996; United Nations, 1996), and multiple
lines of evidence suggest that agricultural productivity potential is likely to continue to
increase. Rosegrant and Ringler (1997) project that current and future expected yields
will remain below theoretical maximums for the foreseeable future, implying
opportunities for further productivity growth.”.
The IPCC (TAR 2001) also projects that, in terms of water supply, the UK would
probably be wetter due to CC, despite the fact that the water table may enter into
different cycles with drier summers and wetter winters. It therefore seems that
agriculture, which may become an issue in other parts of the world, may on the
contrary become more profitable in the UK and across most of Europe. This however
could potentially be less of the case in southern European countries.
Forestry is an interesting sector to look at, as it has numerous interactions with CC.
x Forests act as carbon sinks and are one of the main natural ways to reduce the
level of CO2 in the atmosphere.
55
Climate Change and its impact on assets
x Forests are under considerable strain due to a shortage of arable land in some
countries where land is not managed to its best potential. In more developed
countries, forests are losing ground to business developments and new
buildings.
x Finally, forests are under increasing strain due to forest fires resulting from
dryer weather, and
x are exposed to an increased frequency of storms and pests due to higher
temperatures (especially milder winter which may not kill pest larvae) .
However, because of
x its relative scarcity,
x its sequestration power (especially when wood is used to manufacture products
with long life spans such as furniture, building structure, etc),
x a potential progressive but less intensive use of fossil fuel derivative materials
such as plastics and finally,
x a potential improved growth due to higher CO2 atmospheric concentration
(although ground ozone has the exact opposite effect) ),
well managed forests may start having higher values, bring in higher returns to
investments and become more interesting long term investment alternatives for
financial institutions. This is especially so for institutions in need of long term
investment durations of this nature.
With CC, the situation looks bleak for forests for now. There may however be a silver
lining in the future for the forestry business. Forestry could become a significant
investment vehicle for financial institutions. In countries such as Malaysia, proper
management of forests through the company “TropBio Carbon Exchange Sdn Bhd” has
allowed the company to obtain rights to market the carbon sequestration potential from
other forest concessionaires in the country and abroad. TropBio Carbon Exchange can
offer over one million hectares of forest land in Malaysia for carbon credits, subject to
the approval of Malaysian government.
A large UK pension consulting firm, when interviewed, noted that there seem to be an
increase in interest for forest land investment recently.
56
Climate Change and its impact on assets
Investing in tourism has not traditionally been favoured by financial institutions. This
is mostly because of fragmentation of the industry, with the exception of a handful of
large international players.
Nonetheless, the tourism industry has been a growing sector in developed countries due
to greater affluence, increase in leisure time, a growing retired population and cheaper
transportation means.
This sector may face a complete re-shuffle in the decades to come due to CC.
These potential changes could bring a certain amount of uncertainty to the tourism
business and therefore increase the volatility of the value of tourism companies.
However this is unlikely to have a great impact on financial institutions today
considering the low level of investment of financial institutions in the sector.
57
Climate Change and its impact on assets
As the Carbon Disclosure Project (Dickinson, P., & Whittaker, M. 2004) report points
out, “CC has the potential to cause major disruption to a range of sectors” and therefore
may affect, especially, institutional investors and financial organisations such as
insurance companies and banks taking risks across a wide range of sectors.
This report demonstrates that financial institutions who do not take CC into account for
their liability management as well as their assets investment may be faced with
tumultuous times ahead and make unwise investments.
These catastrophes will be location specific, i.e. they will affect specific geographical
areas. Therefore, it will be important to analyse the geographical concentration of
businesses and assets such as property.
58
Climate Change and its impact on assets
should not ignore the increased volatility in prices and returns consecutive to CC. The
following table provides a summary of findings.
The GHG effect has been identified for over a century as having a potential negative
effect on the world sea level and climate. This is a result of an increase in carbon gases
in the atmosphere from industrial activities. However it is only in 1992 that the United
Nation Framework Convention on Climate Change (UNFCCC) was put in place at the
Earth Summit in Rio de Janeiro. Under the convention, 184 countries agreed to work
towards returning their carbon emission to 1990 levels by 2000.
The Convention was followed by a more concrete agreement, the Kyoto Protocol, in
1997, which gave all industrial countries legally binding targets to reduce their
emissions of six GHG by 5.2% below 1990 levels between the years 2008 and 2012.
Under the Kyoto Protocol, each country has a fixed target (the US -7%, Japan -6% and
the EU collectively -8% within a “bubble” arrangement). To be fully ratified the
Protocol had to be ratified by countries accounting for at least 55% of the emissions of
all signatory countries. After a long period of uncertainty, the protocol entered into
59
Climate Change and its impact on assets
force in February 2005 due to the ratification from Russia. As the ratification of the
protocol took longer than was planned, the EU had decided to go ahead and respect
their commitments under the Kyoto Protocol, anyway, as follows.
A number of current regulations already exist with the aim of reducing carbon
equivalent emissions. These include the EU scheme, the climate change levy and the
UK emission trading scheme, and will impact numerous sectors of the economy.
60
Climate Change and its impact on assets
Despite Russia’s initial refusal to ratify the Protocol and Australia and the US refusing
to participate, the Kyoto Protocol had an early implementation in the EU in 2005.
The EU implementation includes important aspects of the Kyoto protocol, notably the
use of Clean Development Mechanism (CDM), Joint Implementation (JI), and the set
up of an Emission Trading Scheme (ETS). CDM gives flexibility to European carbon
emitting firms and countries to fulfil their obligations using emission savings in
non-Annex I countries (in Kyoto terms, Annex I countries refer mostly to OECD
countries), mostly developing countries, while JI applies the same principle to Annex I
countries however to date mostly Eastern European countries are benefitting from this
mechanism.
The ETS, was agreed in 2003 and has come into force in January 2005. This is a
scheme whereby carbon credits can be exchanged amongst the various European
countries to meet their obligations. The ETS has two phases. The first phase will
operate in 2005 for electricity generation, oil refinery and other heavy industries. A
second phase, to be implemented in 2008, extends the scheme to other industrial sectors
as required by the European Directive on Climate Change.
The UK's climate change programme (DTR 2000) details how the UK will meet its
Kyoto target to cut its greenhouse gas emissions by 12.5%, and specifies how it will
move towards its domestic goal to cut CO2 emissions 20% below 1990 levels by the
year 2010.
61
Climate Change and its impact on assets
Finally the UK is looking beyond Kyoto, towards achieving an emission target in line
with what the scientists see as an acceptable level of GHG concentration in the
atmosphere to preserve the world climate (550 ppm of CO2). Referring to the “Energy
White Paper” published in February 2003, Tony Blair says that “We are showing
leadership by putting the UK on a path to a 60% reduction in its carbon dioxide
emissions by 2050.”
Separate initiatives are also in place to tackle current domestic and transport emissions
levels across the UK.
Since 2002, electricity suppliers have the legal obligation to demonstrate that they have
sold a certain proportion of renewable energy. This is evidenced via the production of
Renewable Obligations Certificates (ROCs) which are fully tradable. A ROC is one
megawatt hour (1,000,000 units) of electricity generated from eligible sources. These
sources include landfill gas, co-firing of biomass with fossil fuels, biomass, sewage
gas, wind and some hydro facilities.
The Energy White Paper shows a target of generating 10% of energy in the UK from
renewable energy by the year 2010.
In 2001, the UK government introduced the “climate change levy” which acts as a tax
on CO2 emitting energy sources. It is aimed at encouraging industrial energy users to
using less fossil fuel energy which produces CO2. This levy adds between 8% and 15%
to the average energy bill, but is made neutral to companies through a 0.3% cut in
Employers’ National Insurance Contributions. It also used to contribute towards
setting up an £150m energy efficiency fund (including The Carbon Trust). A
discounted levy is applicable to some energy intensive businesses and an exemption
exists for “new” renewable energy businesses.
62
Climate Change and its impact on assets
A large UK investment fund manager indicates that the effect of the climate change
levy is not transparent and therefore it is difficult to understand its impact on large
companies. Also measures such as the ROCs are too recent to yet have an impact.
In 2002, the UK developed its own emission trading scheme for the local market. This
will become part of the EU scheme in 2007. Until 2007, emission reductions operated
by UK firms will be either accounted for under the EU system or the UK system.
Such initiatives will invariably put some strain on the UK carbon-emitting industries
unless they manage to change their process in such a way that it gives them a
competitive advantage over the long run.
The report “Climate Change – the UK programme” (DTR 2000) provides the following
split of emissions and its targets:
The UK programme sets targets of reduction in the six sectors above with specific
actions to be taken in each of these sectors. The programme includes sectors which are
not currently covered by the EU ETS, such as transportation.
In parallel under the EU scheme, the UK National Allocation Plan (NAP) gives further
details on reduction target position by sector and by company. This is important
information for potential investors in these companies.
NAPs are available for all the European countries part of the ETS and therefore provide
similar valuable investment information by sector and installation.
63
Climate Change and its impact on assets
People responsible for investments and ALM in financial institutions will have to form
an opinion on how to take CC remediation regulations, which are either in place or
planned, into account. Regulations will affect numerous sectors including the energy
sector, refineries, oil & gas, transport, cement, ceramics, pulp and paper companies,
and food and beverages companies.
64
Climate Change and its impact on assets
Information about carbon emission constrains and targets can be obtained in the UK
from official documents such as the NAP or the UK programme. Such documents will
in particular provide data on installations which should deliver these targets. Other
documents and studies such as the “Carbon Disclosure Project” provide an industry
sentiment:
x “Given the exposure of the sector to emissions restrictions and the length of the
planning cycle in the power business, management strategy remains critical.
x Asset pricing calculations increasingly incorporate a “carbon risk” premium.
x Coal-dependent utilities face the greatest risk.
x To balance increasing market and environmental regulatory forces, utilities are
investing more in combined-cycle gas turbine (CCGT) technology plants.
x Distributed power generation market continues to mature on the back of
reliability concerns and demand for better energy/transmission efficiency.
x Emission trading is a key part of the near-term risk management armoury.
x Meanwhile, firms seek out long-term technological solutions to carbon capture
and storage.
x Renewable energy growth continues apace as the dynamics of the energy
marketplace evolve.”
65
Climate Change and its impact on assets
These clearly indicates a high level of uncertainty on the future of the traditional energy
business, and gives a first indication for investment analysts on uncertainties
concerning energy companies and plants.
There is further uncertainty if it is considered that the easier emission reduction (such
as converting petrol generator to gas), i.e. “low level fruits” have been picked up, and
that future reduction in emissions in this sector will be difficult, and more costly.
This suggests a high level of uncertainty in the traditional energy (fossil fuel based)
sector. Large energy companies will have to be able to adapt and progressively phase
out of their core products (traditional electricity generation). They will probably have
to move towards products which are only at an experimental stage today and which
may be better delivered by newly formed companies (smaller renewable energy
companies) which may be able to cope better with the challenge. This will, in any case,
generate a high level of volatility for decades to come in the energy sector, which
traditionally has been very stable.
The CDP report analyses that “two-thirds of the EU utility companies can expect
wholesale power prices to rise by up to 20% (a fifth expects increases of 20-40%) due
to the ETS. A dislocation of the European utility sector is expected by numerous
famous utility analysts such as Citigroup, Deutsche Bank and others.
As the CDP points out, the ETS will also develop opportunities for new energies. The
income generated from carbon credit could add up to 15% increase in the internal rate
of return (IRR) of projects. In addition, ROCs will create substantial additional
revenues for renewable energy companies.
Institutional investors are starting to commit to “clean energies”. For example, two
Californian pension funds, CalPERS and CalSTRS, will together invest US$1.5 billion
to clean technology companies.
However such new trends will take time to stabilise, especially as clean technologies
are still under development. This will, if anything, add to the volatility of energy
markets in the 21st century. The IIGCC, in their brochure “Climate change + power
generation” (Borremans, E., 2003), conclude that “utilities have long been regarded by
investors as a stable, defensive sector. Market de-regulation and carbon constraints are
66
Climate Change and its impact on assets
bringing a new set of value drivers, not only for long-term responsible investors, but for
financial markets at large.”.
Likewise, the oil and gas sector will face numerous challenges in the coming decades.
They are at the centre of the CC threat. Already large companies such as BP or Shell
invest in renewable energy technology, knowing that their core products might be
under threat in fifty to a hundred years.
Oil and gas companies are coming under increasing pressure from various stakeholders
including their shareholders on both side of the Atlantic.
In the US, the oil and gas sector received, in early 2004, a record number of global
warming shareholder resolutions from shareholders. This included pension funds,
representing over $250 billion in assets. A representative of the New York City
pension funds stated “This is the first climate change related resolution we have filed,
and I believe it's going to become a major issue for institutional investors.”
Meanwhile the CDP reports that large oil firms such Exxon Mobil are investing into the
research of new combustion technologies. While others such as Shell are looking
favourably at natural gas as a transition fuel.
The oil and gas business is seen as being extremely vulnerable to how the international
community will deal with the CC issue in the future.
BP is the first company to have calculated the total number of CO2 emission that they
are responsible for in 2003, nearly 1,300 million tones to be compared with the UK’s
emission of roughly 600 million tones CO2 in the year 1990 (Defra www.defra.gov.uk
(2004)UK NAP).
Even more so than for the energy sector, and although companies such as BP or
Chevron Texaco are looking at sequestration solutions either naturally through
chlorophyll or through capture to be injected into the ground, the oil and gas sector is
set for an uncertain future. There is an uncertainty in finding new reserves combined
67
Climate Change and its impact on assets
with a potential political instability in the Middle East (which supplies nearly half of
the world’s oil consumption).
The transport sector including airlines, freight, car, ship and planes manufacturers are
also under heavy regulatory threat due to the CO2 emitted by engines.
Here again some of such firms may compensate for the emission through CO2
sequestration projects. As an example, Mitsui maintains about 40,000 hectares of
forest land in Japan to sink 172,000 tCO2e/year (Carbon Disclosure Project 2004).
Despite these efforts and the development of nascent new transport technologies such
as hybrid vehicles or hydrogen engines, no large scale solution is yet available and
therefore regulations may again mean high volatility for the sector. At this stage
regulations are not stringent mainly because emission reductions are less accessible
than in energy. Nonetheless, regulations are expected to become stricter in the future.
All the above sectors are large emitters of GHG, either due to the significant amount of
electricity that their processes require (referring for example to the aluminium industry)
or because processes themselves emit CO2 such as the cement industry.
These sectors come invariably under the scrutiny of the NAP of various European
countries which sets targets reductions for the main players.
Stock prices for these companies will be highly volatile depending on how they
respond to the restrictions imposed by different regulations.
The agriculture and forestry businesses are two large emitters of GHG and are targets
of some GHG emission reduction measures. However agriculture is seldom favoured
68
Climate Change and its impact on assets
European CC regulations implemented through the countries’ NAP and other countries’
initiatives will have a definite impact on the various GHG emitting sectors of the
economy.
Long term investments in these sectors have often been favoured by financial
institutions for their stability. The concentration of investments in these sectors within
the hands of large players together with the possible high volatility of stock price in the
future presents great threats to financial institutions’ investments.
Any long term projection of assets behaviour should make important references to CC
issues. These should take into account regulations that countries are already
implementing today and will implement in the future until a satisfactory mitigation
effort has been made. People in charge of such projections (ALM specialists) will have
to clearly understand current and future regulations and assess upcoming changes as a
result of such regulations.
69
Climate Change and its impact on assets
This report has demonstrated so far that CC may have major impact on numerous areas
of financial institutions and to numerous parts of the world economies. CC climatic
consequences will make the world weather harsher, more unpredictable and may
increase the number and intensity of natural catastrophes; and is expected to worsen
over the years. Regulations aiming at mitigating CC will affect directly all industries
emitting GHG today. These emitting industries are basic need industries such as
energy generation, transportation or agriculture industries. At the same time, CC will
have a direct negative impact on crucial industries such as financial services, properties
etc.
All these disturbances to numerous sectors of the economy prompts one to ask what the
overall consequence of such disruptions at a world macro economic level could be.
Part III.3.2.1 Expected severe climatic extremes, a harsh burden on the economy
and society
There is today a strong consensus among experts and scientists that CC will bring great
disturbance in the form of extreme weather events.
70
Climate Change and its impact on assets
As expressed earlier in the report if the frequency and the amplitude of damages caused
by natural catastrophes were to rise further, insurance and reinsurance companies may
find these risks uninsurable or the amount of premium which they would have to
charge to cover these risks would not justify contracting an insurance. In these cases,
insurance and reinsurance companies are likely to exclude uninsurable risks.
This would transfer these risks back to either the government or the public. If such
costs represent a significant proportion of GDP, this may put countries in serious
difficulties during bad years.
71
Climate Change and its impact on assets
If natural catastrophes were to become significantly more frequent and severe in the
future this could mean a heavy financial burden on societies and citizens of developed
countries.
The impacts of natural catastrophes will coincide with a potential difficulty in adapting
the agriculture sector to temperature changes and water availability, especially in
southern Europe, Australia and southern or mid west States of the US.
The IPCC (TAR 2001) states: “a lack of water resulting from climate change might
mean that increased irrigation demands cannot be met, and that changes in the water
sector therefore are impacting directly on agricultural response to climate change. In
addition, changes in agricultural land-use resulting directly or indirectly from climate
change may affect catchments water balance and water quality. These effects may be
more substantial than the direct effects of climate change on hydrology.”
As seen earlier, regulatory efforts are targeted mostly at large emitting sectors such as
fossil fuel-related economic sectors, the energy generation sector, the oil and gas
sectors, large energy user sectors, and transportation sectors (aviation, maritime and
ground).
Unless means to replace fossil fuels as a main source of energy are found within the
next twenty to thirty years, it may be reasonable to assume that cost of producing
energy using fossil fuels will increase significantly.
72
Climate Change and its impact on assets
As experienced in 1974 and 1983, or even more recently, an increase in the price of
crude oil, which directly increases the cost of energy, can be extremely detrimental to
the world economy and even causes recessions.
Referring to the IPCC scenarios and other scientific studies, the African continent will
be badly affected by CC.
Africa will experience harsher and longer lasting droughts which will affect almost all
countries except those situated at latitude around the Equator. These droughts would
become an important issue for water and agriculture in the Northern African and
Middle Eastern countries. The same problems will be faced in regions at higher
altitudes in the north of South Africa, which have up to now far milder climate areas.
These droughts will be combined with occasional flash floods which will progressively
replace current rain patterns and which will make water shortage issues even more
acute. This may already to be the case. Munich Re (TOPICgeo 2004) reported a total
number of 41 flash floods in Africa, including two important ones in
Kenya/Ethiopia/Somalia and in Sudan/Eritrea which made hundred of thousands people
homeless and caused large agricultural and livestock losses.
Latin America will also suffer from an increase in temperature, and a drastic increase in
frequency and severity of high precipitations and droughts. More frequent El Nino
effect will add to the climatic issues.
73
Climate Change and its impact on assets
The populations and economies of Latin America will suffer to a great extent from the
effects of CC, especially due to their dependence on agriculture and fisheries. Health
hazards may also become serious in the continent’s least developed countries due to
inadequate medical facilities.
Asian countries such as Bangladesh, Vietnam, India and China may be under
increasing extreme climatic strain mostly due to frequent flooding. This has already
been experienced at a catastrophic level in Bangladesh , China and India in 2003 and
2004. It is difficult to imagine how these countries will cope with an increased severity
and frequency of such events. In the case of low rise lands such as Bangladesh and
Vietnam, the inundations may even become permanent. Projected scenarios of the
IPCC (TAR 2001) forecast that 20% of Bangladesh and 12% of Vietnam may be
permanently inundated in a hundred years. At the same time, countries situated at the
latitude of the Middle East and the Gobi Desert will become even dryer and
inhospitable to human living.
Although the economies of some of the more developed countries such as Southeast
Asian countries, “tiger economies” countries, or even regions of China may cope better
than Africa or South America because of lesser dependence on agriculture and fishery,
and being more developed economics. CC will still pose very serious threats to Asian
countries. In particular, health related issues could also become important due to the
overpopulation of these regions.
Economies are, today, largely fuelled by fossil fuels and more precisely, oil and natural
gas. According to some experts (Rifkin, J., 2003), projections of the current planned
gas-fired power stations in the developing world and the current rate of economic
development of countries such as China and India will put heavy strains on world oil
and natural gas reserves. This should increase the dependence of the world to the
largest oil and natural gas reserves, i.e. Middle Eastern countries and in particular Saudi
Arabia. The same publication (Rifkin, J., 2003) predicts that at the current rate of
74
Climate Change and its impact on assets
utilisation, such reserves should peak around 2020 unless other sources of energy are
found quickly or the world starts using dirtier fossil fuel reserves such as coal, tar,
heavy oil and oil shale. These fossil fuel sources emit higher quantities of CO2 when
refined or burned compared to traditional oil and gas. Having oil reserves peak means
that although there may be enough oil for a number of years after the 2020 deadline, the
world oil reserves will decrease from this date onward. Based on the Energy
International Agency analysis, the “Energy Information Administration / International
Energy Outlook 2004” notes that they “expect conventional oil to peak closer to the
middle than to the beginning of the 21st century.” The same analysis projects that
OPEC countries would by then produce half of the world oil compared to around 38%
today. As the report states “No one doubts that fossil fuels are subject to depletion, and
that depletion leads to scarcity, which in turn leads to higher prices.”. The recent rise in
petrol prices definitely confirms this view.
The peak in fossil fuel reserves, which we should expect in the not too distant future,
may happen with simultaneous political instability in the Middle-East. It is uncertain
that the political situation in the Middle-East would improve in the future. A
combination of these two factors hence gives a strong basis to believe that prices of
energy would become highly volatile.
CC will have an important bearing on the environment, in particular with respect to the
loss of biodiversity.
75
Climate Change and its impact on assets
CC will affect the various fauna and flora species to differing extend and unevenly
geographically. As a solution, some species may migrate. Their natural habitat,
however, will not be able to migrate or adapt to abrupt changes in temperature as
easily. The increase in human population and its economical development will
continue to cause an unbearable strain on the world biodiversity. The loss impact on
biodiversity is already evident in fisheries around the world, and in tropical and
equatorial forests.
Loss of biodiversity is not yet recognised today as an issue by the vast majority of
people because the proportion of the world biodiversity which has been lost is still
minimal. However current trends are very significant as it is estimated that a hundred
species disappear every day according to the European Non Gouvernmental
Organisation (NGO) FERN. The NGO, WWF monitors an index “living planet index”
which is derived from trends over the past thirty years in populations of hundreds of
species of birds, mammals, reptiles, amphibians and fishes.
The above WWF analysis shows the stark trends indicated by the “Living Planet
Index”. This is a quantitative confirmation that the world undergoes currently a very
rapid loss of biodiversity comparable with the great mass extinction events that have
previously occurred only five or six times in the Earth's history.
76
Climate Change and its impact on assets
If the pace of species extinction remains at the current level, or worse increases due to
CC, this will seriously hinder the potential for adaptation to new situations and
potentially delay world reaction to medical or food issues. WWF states that “Many
plant and animal species are unlikely to survive predicted climate change. 15–37% of a
sample of 1,103 land plants and animals would eventually become extinct as a result of
climate changes expected by 2050. For some of these species, there will no longer be a
suitable place to live on the face of the earth. Other species would not be able to reach
places where the climate is suitable for survival. A rapid shift to technologies that do
not produce greenhouse gases, combined with carbon sequestration, could save 15–
20% of these species from extinction.”
Also, according to some experts, the future use of Genetically Modified Organism as a
quick fix for some of the current agricultural supply problems will intensify the loss of
biodiversity and make the biodiversity shortage problem even more acute.
As explained by the IPCC (TAR 2001), water shortage may not only become an acute
problem for many under-developed countries, but for developed countries around the
Mediterranean basin such as Spain, Italy and Greece as well.
Some experts speculate that the problem of water shortage may become so extreme in
some areas of the world that it could lead to human mass migration and potentially
cause international conflicts.
In this respect, the IPCC (TAR 2001) writes “where there are disputes, the threat of
climate change is likely to exacerbate, rather than ameliorate, matters because of the
uncertainty about the amount of future resources that it engenders”.
According to the IPCC (TAR 2001), migrations could also have other sources such as
soil degradation which is a very important issue in the southern Mediterranean region, .
IPCC (TAR 2001) stresses that “with perhaps 24% of total dry lands in Africa in the
process of desertification and 0.3% of the African population permanently displaced
77
Climate Change and its impact on assets
A large reinsurance company sees water as a potential source of real conflicts, for
instance in places like middle eastern countries being downstream of Turkey or South
East Asian countries downstream from China. Australia also could face real issues due
shortage of water for agriculture.
Such health issues may be magnified by impacts of CC and undoubtedly. add serious
uncertainties to the future of the world. As a matter of example, the SARS epidemic
had serious negative economic impacts on countries like Hong Kong and Singapore.
78
Climate Change and its impact on assets
despite emitting large quantities of GHG. Such countries have based their economic
development over the previous century on such guilty emissions.
This political instability may mean an increased migration to developed countries who
are less affected by CC, and have more means to cope with changes.
It is possible that the change in climate and the lack of food supply may become so
critical in some countries that large populations might migrate to more hospitable
neighbouring regions at the risk of causing open conflicts. Imagine how Northern
African countries might react if they loose a large proportion of their arable land while
Europe carries on life as usual.
Risk experts of a large reinsurance company were of the opinion during an interview
that within a five to ten-year horizon, natural catastrophes may start having an impact
on countries economies. A large proportion of destroyed or damaged infrastructure
could have recessionary consequences. However this does not seem to be happening
yet. As of today, there seems to be very little indication that countries like Taiwan
which has experienced a large number of subsequent catastrophes (earthquakes,
typhoons) have or could be facing a recession due to natural disasters.
Based on all the above issues due to CC, it would not be unrealistic to assume that the
developed world will experience, before 2050, a crisis of confidence. Various factors
may affect deeply the economy and the confidence that people and businesses place in
the world economy:
x Unless a clean replacement source of energy is found for fossil fuels, this period
may see a deep energy crisis whereby reserves of good quality oil and gas will
be known as sure to deplete whilst no serious replacement energy source is
known. Hydrogen is often presented as having the potential to replace fossil
fuel especially when coupled with fuel cells. “Fuel cells powered by hydrogen
could potentially produce enough electricity to serve the needs of the human
race far into the future.” (Rifkin, J., 2003). However, at the current pace of
79
Climate Change and its impact on assets
In light of the above, a somehow bleak scenario may be drawn of the world economy as
a result of CC.
80
Climate Change and its impact on assets
Lending rate, and in particular corporate bonds rate, might be continuously higher than
equity return as long as it is felt that a complete reshape of the world economy is
necessary for a real sustainable future.
This pessimistic future scenario may not be unrealistic by any means and in addition to
the cost of eradicating the source of the problem, CC would inevitably mean difficult
adjustments for numerous people and countries of the world. People involved in long
term projections and ALM definitely have enough material with CC for making
assumptions of a few catastrophic economic scenarios in the 30 to 50 years to come.
The same person also thinks that un-modelled catastrophic scenarios deserve
consideration, such as disappearance of the Gulf Stream or mass migration due to water
or food shortage.
At another interview, a large reinsurance company suggests that it would take three
almost simultaneous, very important events caused by CC to destabilise financial
market and really wake the whole world up to the problems of CC.
81
Adaptation to and mitigation of CC
A complete ALM exercise includes projection of assets and of liabilities in a way that
replicates as much as possible the expected trends of these two items. However
measures that companies might consider on assets or on liabilities should be reflected
in the ALM exercises and be tested.
This is often the case with liabilities, where ALM can be used to monitor prospective
behaviours of portfolios. For instance, if a life insurance product has been under-
priced, it is logical to expect this product to be phased out and replaced by a better
priced one. This is reflected in ALM scenarios.
In the exact same way, if it is known that CC will have a significant impact on the
profitability of the financial company in future years, measures of adaptation (adapting
the insured element to the likely impact of CC so that it endures less damages and incur
less loss) will be strongly encouraged by the company and may become a condition of
insurability. When it is possible, the company may apply measures of mitigation (i.e.
an attempt to modify the original cause of CC so that it occurs less).
Although the two measures of adaptation and mitigation may have the same aim,
avoiding floods in a particular area through adaptation measures such as building dykes
appears to lead to more definite results, i.e. a known result and a known timing for
achieving results, and enables a better estimate of the real costs of doing so.
The alternative approach of using mitigation measures may have a result which
encompasses largely the particular flooding problem in the particular area but would
take decades, to put in place. It could cost enormous amounts of money even if in this
case the cost would be shared with other investors with similar concerns. Even when
emissions are reduced, there is no guarantee whatsoever of how long it may take before
the weather pattern resumes to what it was initially, this would be at least a matter of
decades. Hence, the end result is so far from being guaranteed that the dykes would
probably have to be built anyway.
In analysing the costs of these two alternatives, it is necessary to bear in mind that
mitigation measures will generate carbon credits which may compensate partially the
83
Adaptation to and mitigation of CC
blind mitigation costs (it is often difficult if not impossible to estimate costs of
mitigation).
Whilst adaptation is, for now, the recommended option for companies, it is a quick fix
to a problem. It can only be temporary and cannot replace going to the source of the
problem. When an old roof is leaking, one can only move tiles around or place basins
in the attic for a limited period of time. After some time the roof has to be redone or
the house starts deteriorating and eventually crumbles down.
In the case of flooding the maximum level of flood in a particular area can probably be
accurately estimated, but it does not sound sensible to build dykes around the country
without taking in consideration the real cause of a problem. Moreover the construction
of dykes would probably use a large amount of cement which emits a large amount of
GHG in its process and therefore contribute to CC in their own way.
Along these lines, the ABI (Dlugolecki, A., 2004) writes: “If society takes no action to
prepare for the impacts of climate change, weather-related damage costs will continue
84
Adaptation to and mitigation of CC
From a societal and ethical point of view it seems that the insurance industry as a whole
cannot just be reactive to CC and needs to be proactive.
Costs related to natural catastrophe to reinsurers has increased considerably in the past
decades. Whether it is a cost to insurers and reinsurers or to the society this cost still
has to be born by someone and the developed world cannot afford such increasing costs
without trying to fix up what causes this trend. The overall problem becomes
comparing the cost of reducing CO2 now or bearing the future global cost of CC
consequences or expressed otherwise, comparing a relatively certain cost now against
an uncertain future cost.
The issue is a global issue which cannot be sensibly addressed by one individual
company and which cannot be scrutinised at the level of one economic player, however
big that player is. Moreover all companies are part of the global world and cannot
dissociate themselves from the world and therefore have to address the problem in the
best way they can.
Because this is a global issue, mitigation actions start to make sense when numerous
multinationals, especially emitting companies, decide to get together to do something
about the issue.
This is also the case when institutional investors use their right as shareholders of
companies to put pressure on them to change the way they operate. A similar pressure
can be applied if major investors voice their concerns strongly to the management team
in place or threaten the emitting companies to disinvest massively, this could send
stock prices plummeting and discredit the company and eventually bring it to
bankruptcy. Financial institutions such as insurance companies, pension funds or banks
85
Adaptation to and mitigation of CC
have an enormous leverage through the stake they have in multinational companies. In
the October 2003 issue of the “Environmental Finance”, it was reported that the UK
insurance industry alone has investments totalling more than GBP 1,000 billion, which
accounts for 20% of the UK stock market.
During the interviews, a large UK pension fund indicated that UK pension funds
represent roughly 17% to 20% of the UK stock market, while another 30% is foreign
investment mostly from foreign financial institutions.
Other ways of raising awareness were also expressed. For instance, a large insurance
company is raising the awareness of CC through sending a CC exposure software
model to their entities so that they can assess their exposure to CC risks individually. A
team of specialists in this company has been set up to assess CC risks on liabilities.
However, the issue is currently not considered important enough for the team to assess
risks on assets as well.
86
Adaptation to and mitigation of CC
In the spirit of the precautionary principle, if the full impact of an anthropogenic action
is potentially bad to the world and the environment, it is better not to take the risk until
more is known about the consequences even if this means delaying the profits that may
be made immediately. This is the case in Europe for genetically modified organism
(GMO) where there is a general refusal to grow them until there is a wider and deeper
knowledge about them. This is a fundamental principle generally applied in life
insurance where insurers usually prefer to stay away from a risk until it is fully
assessed.
In terms of CC, this means to minimize or eradicate a risk as much as possible until it is
understood.
Due to the nature of their liabilities pension funds and life insurance companies,have
long term views and therefore have a very stable and conservative approach to their
investment policy.
From a pure investment point of view, CC has been identified by most countries around
the world as a likely long term occurrence. Because of the enormous threat that this
phenomenon represents for economies and people around the world, initial global and
local laws and regulations have been put in place (not only in the EU, but also in some
US states, and countries such as Canada and Japan). As more and more signs of CC
surface, the response from the world community will intensify. It is therefore logical
for long term investors to recognise the trends associated with CC, analyse them and
invest coherently with these trends. Risk Management of this nature should invariably
lead to profits in the long run.
87
Adaptation to and mitigation of CC
Part IV.4.3 The leverage of pension funds and insurance companies on capital
markets
Because of their size, pension fund have an enormous influence on capital markets and
more generally on the economy as a whole. These influences can be positive or
negative.
Finally the presence of large investors will contribute to the development of financial
intermediaries who will provide services of market making, research, and so on and
more generally respond to the investors’ needs for new CC mitigation products.
A problem which exists today is that institutional investors seldom turn up at annual
general meetings. Only about 30% attendance at AGM is from these institutional
shareholders. The issue is that there is an often too big gap between ownership and
88
Adaptation to and mitigation of CC
control. Shareholders own the company but are not involved in the day-to-day
management of the company. However institutional investors are starting to use their
ownership power to override the company’s management decisions, when necessary.
Part IV.4.3.2 Providing a large, loyal shareholder base for financing real
investment
Insurance companies own 20% of the UK stock market while pension funds own over
30%.
“If the pension fund holdings are held on a long-term basis, the effect both on the
companies and the economy can be beneficial. Companies will have a large, loyal
shareholder base and this will allow companies to plan and undertake long-term
investment projects that increase their long-term profitability and have long term
benefit to their shareholders. In this way, a virtuous circle is created.”(Blake, D.,
1997). This long term commitment will give time to emitting companies to operate
necessary changes by introducing mitigation actions such as renewable energy
initiatives within oil and gas companies. However if the holding becomes too stable
then it may contribute to render the market inefficient.
For over 25 years now, the UK pension industry has been accused of “short-termism”
in their investment strategies and showing insufficient concern about the long term
future of the British economy.
Also pension funds are found not to invest sufficiently in small and medium
enterprises, and therefore are not contributing towards raising capital for firms who
may represent the future of the economy. This applies, in particular, to investing in CC
mitigation companies.
One of the main reasons for not investing in small to medium sized firms is the absence
of liquidity of such firms. In addition, investment research is too costly for SME
companies (compared with the amount available for investment). This is unfortunate
for the SME specialising in mitigation companies.
89
Adaptation to and mitigation of CC
Pension firms prefer to invest in large funds and also in sectors dominated by large
firms (such as the oil sector for instance). The role of Venture Capitalist is undesirable
for most of the pension funds for all reasons mentioned in the previous paragraphs.
This is unfortunate as venture capital, in this case will assist new initiatives for climate
mitigation and therefore will actually act for the long term benefit of CC mitigation.
The return from EU funds is mostly being generated through investment outside of the
EU. This may present a major issue as it, in turn has the negative consequence of
reducing the capital per worker in the EU and therefore damages labour productivity in
the EU. The immediate consequence of this phenomenon is, either an increase in
unemployment or a fall in wages. Fortunately numerous CC mitigation initiatives
today are European and can therefore provide a vehicle for pension funds and insurance
investments.
However, the Kyoto protocol may act as an incentive to investment abroad through
Clean Development Mechanism (CDM) as GW is a global issue and reducing GHG
emission in London is as good as doing it in Beijing (China). CDM is the Kyoto
protocol mechanism through which a government from a developed country, or
companies originated from such developed countries, can create carbon credits in
developing countries through investing in GHG emission reduction projects in these
developing countries.
Part IV.4.3.5 Relationship between trustees and investment managers - The case
of pension funds
Trustees of a pension fund have the legal responsibility to ensure that pension money is
soundly invested. In practice, the trustees’ lack good understanding of investment
matters and leave this role to professional investment managers. The trustees in
practice only provide general guidelines for the investments and subsequently assess
the performance of fund managers. As an example, consulting actuaries typically will
recommend allocation indications between types of assets, such as equities and bonds
90
Adaptation to and mitigation of CC
and the location of assets, i.e. either domestic or overseas. The asset allocation is a
critical decision in respect of the future performance of the pension fund.
The attitude towards risk of the trustees will determine the allocation (i.e. equities
versus bonds, local versus foreign) and subsequently influence the future performance
of the fund. It is often the case that trustees are risk-adverse but however critical of the
fund managers’ role when the performances of the funds are assessed, as it may show
an underperformance to the market. This attitude of trustees, coupled with the
quarterly assessment of funds performance, forces pension funds managers to adopt a
short-termist attitude.
Individual companies not included in the EU scheme (i.e. who do not have emission
target) may implement their own mitigation actions. This is not uncommon with
financial services companies as some financial institution may modify their office
buildings or implement transportation policies in the aim of emission reductions.
During an interview, the property arm of a large insurance company indicated that
mitigation efforts have a maximum leverage within their own organisation. However
they expressed that similar measures have much less leverage to tenants for instance in
reducing their electricity use. In the same way, it is usually difficult to justify green
measures in terms of return on investment.
A large insurance company has also implemented policy incentives to use public
transport and limit the number of flights of their employees as much as possible.
A number of groups of institutional investors have understood the risk of CC and are
already working on mitigation measures. The main initiatives which are starting to
have an impact are described below.
91
Adaptation to and mitigation of CC
Among others, the IIGCC focuses on CC issues within the energy and the property
sectors.
Nick Robins of Henderson Global Investors states in the May 2003 issue of
Environmental Finance that “IIGCC members believe it is part of their fiduciary duty
… to engage on climate change policy”.
A US initiative was launched with the assistance of the UN, the Investor Network on
Climate Risk (INCR).
92
Adaptation to and mitigation of CC
“The purpose of the INCR is to promote better understanding of the risks of climate
change among institutional investors. INCR encourages companies in which its
members invest to address any material risks and opportunities to their businesses
associated with climate change and a shift to a lower carbon economy. Climate risk
includes financial, fiduciary and liability risk ensuing from climate change.” (INCR
website). In July 2004, INCR produced an investor’s guide to advise investors on
addressing the financial risks and investment opportunities posed by climate risk.
The banking industry also recently took a similar initiative with the “Equator
Principle”. As of August 2004, twenty-seven global banks “have taken a bold step
toward ensuring projects they finance around the world meet strict environmental and
social criteria.”. This initiative includes banks such as Citigroup, HSBC group and the
ING group. At this stage, the principles are not specific to CC.
Today, none of these initiatives go into active mitigation efforts. However these have
to be seen as initial steps.
Mitigation has a much wider reach. It may have an impact on the perception that people
have of CC and therefore may affect financial markets and have a macroeconomic
impact. Therefore mitigation is particularly important in its impact on assets.
93
Adaptation to and mitigation of CC
94
Recommendations
Part V Recommendations
This report has drawn a list of various effects from CC which may have an impact on
the assets and liabilities of financial institutions, and on the financial viability of such
institutions. The report is also an attempt to understand the extent that CC damages
may cause to assets and liabilities of financial institutions.
However it is important to emphasise that this report is very much qualitative, and asks
more questions than it provides solutions. One of its purposes is to invoke reflection
and further research on the topic.
A set of recommendations is provided below for future research and works, which
would hopefully complement this report, and provide practical assistance to the day to
day work of actuaries and ALM specialists.
Natural catastrophes
Life insurance
95
Recommendations
Heath insurance
ALM scenarios
x Based on this report, draw a set of potential scenarios for various asset classes
and types of liability. This should be based on today’s knowledge of
occurrences of events caused by CC. The scenarios would consider the
importance of the consequences and timing of CC.
Insurance industry
96
Recommendations
x Asset managers should have to report the exposure of their investment decisions
to impacts of CC to trustees for pension investments, and to top management
and actuaries for insurance assets. This should be done in respect of negative
impact, physical impact or regulatory impact and in terms of mitigation aspects
of such investments.
97
Recommendations
98
Conclusion
Part VI Conclusion
In light of this report, CC appears to be a definite concern to the asset and liability
management of financial institutions. This is in respect of the timing of CC issues and
increased value volatility of assets and of liabilities.
Many reports and documents have been produced from industry bodies, reinsurance
and insurance companies or even NGOs about the impact of CC on the insurance
industry. As analysed in the Part II of this document, there is no doubt that CC is a
serious threat to the sector. However the analysis looked at the impact of CC from an
ALM perspective and therefore investigated the asset similarly and found that the
impact on assets may even be greater than the cost of frequent large natural
catastrophes or threat to human health such as new epidemics. CC may cause a high
equity and property investment volatility due to physical and regulatory impact and
more importantly potential macro economic issues.
Finally this report looked at the relevance of adaptation and mitigation efforts to ALM.
It analysed that ALM projections should include adaptation and mitigation initiatives
made by financial institutions.
However, financial institutions have yet to fully realise the likely impacts of CC on
their businesses. The “Environmental Finance” magazine of October 2003 notes: “we
therefore have a situation where CC, to take but one concern, appears to be creating
enormous future liabilities for the insurance industry, but on the evidence of the
sector’s reports (GRI report), market-based measures to help prevent or mitigate the
impacts are not being taken by an industry which has the assets and influence to make a
significant contribution.”
99
Conclusion
Although it is difficult to ignore the negative impact of CC, mitigation and even
adaptation actions, are likely to provide world economies with new areas of initiative
and developments, for instance with the emergence of renewable energies.
Furthermore, CC could have a long run positive impact on the interaction between
humanity, its industrial developments and the world environment. Impacts of CC will
overall be extremely detrimental and in some cases catastrophic. However, one can
hope that it will provide to the world the big shake-up that it needs to finally realise
how the concept of “sustainable development” should be applied to economic
development and that any unnatural large modification or rejection into the
environment from human industrial processes should never be overlooked again.
100
The Author
Louis Perroy is a Fellow of the Institute of Actuaries and a qualified member of the
“Institut des Actuaires” in France.
In 2001, Louis decided on a complete change of career towards the field of the
environment with a specific focus on the issue of Climate Change. He had the
opportunity of working in Australia on projects related to renewable energies and went
on later to become a Partner of Deloitte France, heading the environmental team in his
home country.
To further his knowledge in his new field of adoption, Louis went back to school last
year and completed a postgraduate degree in Environmental Technology at the Imperial
College, London.
Louis has a passion for the Chinese culture and has taken time, both a year off work in
1993 and regularly up to today, to study the Chinese language.
These days, Louis works with a young investment bank, Climate Change Capital,
which specialises in climate change risks and in financing adaptation and mitigation to
Climate Change. Louis works with Climate Change Capital on its interaction with
financial institutions and is responsible for starting up its presence in France and
Belgium.
101
References
BBC (http://www.bbc.co.uk/climate/impact/gulf_stream.shtml)
Berz G., (2004) Natural Disasters and Climate Change: Concerns and Possible
Counter-Measures from the Viewpoint of an International Reinsurer. Geo Risk
Research Dept at Munich Re.
Blake, D., (1997) Pension Funds and Capital Markets. The Pensions Institute
Brauner C., (2002) Opportunities and Risks of climate change – Risk Perception. Swiss
Re
Bunyavanich, S., & Landrigan, C., et Al (2003) The Impact of Climate Change on
Child Health. Ambulatory Pediatrics.
Carbon Disclosure Project (2004) Climate Change and Shareholder Value in 2004.
Dlugolecki, A., (2004) A Changing Climate for Insurance – A Summary Report for
Chief Executives and Policymakers. Association of British Insurers
E/The Environmental Magazine (2002) Global climate change threatens the insurance
industry
Epstein P., (2000) The WTO, globalisation and a new world order. Center for Health
and the Global Environment - Harvard Medical School
102
Epstein P., & Defilippo C.,(2002) West Nile virus and drought. Center for Health and
the Global Environment. Harvard Medical School
Epstein P.,(2002) Climate Change and Infectious Disease: Stormy Weather Ahead?
Lippincott Williams & Wilkins, Inc.
Epstein P., & Diaz H., et al (1998)Biological and Physical Signs of Climate Change:
Focus on Mosquito-borne Diseases. Bulletin of the American Meteorological Society
FERN (http://www.fern.org/pages/cbd/bioloss.html)
Goldman R. (2000) The development of the ‘prudent man’ concept in relation to pension
schemes. Journal of Pension Management.
Hickling, M., & Grace, E., (2004) How climate change is impacting financial services.
The Institute of Actuaries of Australia 2004 Financial Services Forum
Higgs, D., & Warburg, S. (1996) Environmental Issues – The Investment Risk. National
Association of Pension Funds
Holdren J., & Heinz T. & J. (2003) Risks from Global Climate Change: What Do We
Know? What Should We Do? Institutional Investors’ Summit on Climate Risk
INCR (http://www.incr.com)
IPCC (TAR2001) Third Assessment Report – Climate Change 2001 [Online] Available
from http://www.ipcc.ch
Jagger S., & Metha S. (1999) Asset/Liability Management of a Fixed Interest Portfolio.
The Institute of Actuaries
Kelly, M., & Kleffner, A., (2003) Optimal Loss Mitigation and Contract Design. The
journal of Risk and Insurance.
Labatt, S., & White, R. (2002) Environmental Finance. John Wiley & Sons, Inc.
Lang, J., (1998) Asset Liability Modelling for Life and General Insurance Companies.
The Institute of Actuaries of Australia
103
Mansley, M., & Dlugolecki, A. (2001) Climate Change – A Risk Management
Challenge for Institutional Investors. Universities Superannuation Scheme
Munich Re Group (2004) TOPICS geo – Annual Review: Natural Catastrophes 2003.
Munich Re Group (2000) Winter Storms in Europe (II) – Analysis of 1999 losses and
Loss Potentials
NAO (2004)The UK Emissions Trading Scheme A New Way to Combat Climate Change.
Palutikoff, J.P., & Hanson C., & Holt T., (2004) An Integrated Assessment of the
Potential for Change in Storm Activity over Europe: Implications for Insurance and
Forestry in the UK. Tyndall Centre for Climate Change Research
Peara, A., & Mills, E., (1999) Climate for Change – An Actuarial Perspective on
Global Warming and its Potential Impact on Insurers. Contingencies: Journal of the
American Academy of Actuaries
Rifkin, J., (2003) The Hydrogen Economy – The Next Great Economic Revolution.
Polity
Swiss Re (1996) Climatic change and the insurance industry: still a critical issue
Uyemura, D., & Van Deventer, D. (1993) Financial Risk Management in Banking –
The Theory & Application of Asset & Liability Management. McGraw-Hill
Walsh, D., & Booth, Ph. (2000) An Actuarial Approach to the PRICING OF Banking
Risk
West LB, Pan European Equity (2004) Insurance & Sustainability Playing with fire
Equity Markets
WHO (http://www.who.int/en/)
WWF (http://www.wwf.org/)
104