The insurance sector on the climate frontlines
A conversation with J. Eric Smith (KSM ‘01), President and CEO of Swiss Re Americas
By Tom Linquist
Just one week after Hurricane Harvey devastated the Houston area, insured losses to homeowners were estimated to be in excess of $12 billion. Yet even with such large losses, the insurance industry rating agency A.M. Best reported that “Texas insurers [are] expected to withstand losses from Hurricane Harvey.” The ability to weather liabilities of that magnitude is a testament to the criticality and efficacy of the insurance sector. In an increasingly risk-prone world, the industry is pursuing its own practical answers to difficult, politically-charged questions through established insurance tools and product services innovation.
“Swiss Re has been studying climate change for more than 30 years and has become increasingly concerned with its effects over that time span,” says J. Eric Smith (KSM ’01), president and CEO of Swiss Re Americas. “The frequency and severity of more extreme weather impacts the company and its clients, resulting in higher claims. A central concern with climate change is the risk to entire geographic areas impacted by rising sea levels and increased flooding. The worst-case scenario is one in which sea-level refugees have to flee coastal areas that flood too often, or are submerged completely.”
At its core, insurance is simply a form of risk protection. Reinsurance allows a third-party insurer to further transfer or distribute risk to others without modifying the risk itself. Transfer of a primary insurer’s risk portfolio to another party through reinsurance has several benefits for the primary insurer, not the least of which is reducing the likelihood of having to pay a solvency-threatening large obligation resulting from one or more insurance claims. The benefits of reinsurance extend to overall public welfare by allowing the primary insurer the ability to underwrite policies covering a larger volume of risks without excessively raising premiums. Reinsurance also provides liquidity for primary insurers to cover exceptional losses, especially during times of critical need. “Throughout history, a key requirement for successful commercial endeavors has been capital. Capital providers were unwilling to commit long-term dollars to large commercial projects without insurance coverage, and that continues today,” Smith says.
Precaution and Prevention
Although transfer of risk is the defining service of the industry, reinsurance also plays a crucial role in ensuring sustainable capital flow by influencing other forms of risk protection, including prevention and precaution. For the reinsurance industry today, prevention continues to be a first order focus. “Everyone assumes that as the reinsurance folks, we partner with other reinsurance companies or the big insurance companies, and we just try to create policies that are going to cover a loss. But, what really happens first is risk mitigation through prevention,” Smith says. Prevention involves acting directly on the risk before the event by altering either the probability of the event’s occurrence or its consequences.
There is an entire field of risk and insurance economics devoted to prevention, and the reinsurance industry is on the leading edge. “After Superstorm Sandy and the significant flooding damage it caused in New York City, especially in Manhattan, Mayor Bloomberg commissioned McKinsey and some other firms to do a study around risk mitigation. Swiss Re was one of the participants because we’ve built models that can predict different types of flooding in different scenarios. We can design mitigation actions to strengthen the infrastructure so that the next time the flooding comes, the damage is minimized. This could include installing certain types of doors in subway tunnels or building up levies around Manhattan.
With risk minimized, applying a financial tool to what’s left is more manageable, whether it’s a reinsurance agreement or some sort of core insurance agreement. It’s much less costly for the consumer, and enables the deployment of risk-transfer financial solutions that are highly levered. You want to pay a very small premium, but should something terrible happen, you want plenty of funds to build things back,” Smith says.
Precaution is another form of risk protection. It is controversial and a source of friction in ongoing climate policy debates. Whereas prevention relates to the idea of acting on the ‘known risk’ before the event, precaution involves the dynamic posture of being vigilant and watching out for more evidence on a potential risk, and then making adjustments as more information is gathered. Precaution recognizes that more information will be known in the future — for example, through scientific progress. For capital and risk protection providers, the stakes around precautionary measures in the face of new scientific progress are very high. Precaution entered the limelight as a climate change rub when it was formalized as a new standard of risk management. In 1992 the ‘Precautionary Principle’ was captured in Article 3, Provision 3 of the UN’s framework convention on climate change. It states, “The Parties should take precautionary measures to anticipate, prevent or minimize the causes of climate change and mitigate its adverse effects. Where there are threats of serious or irreversible damage, lack of full scientific certainty should not be used as a reason for postponing such measures…”
Assessing Climate Risk
Whether dealing with causes or mitigating adverse effects, the reinsurance sector is pursuing a fitting and natural course in precautionary measures, and seeking to assess risk and economic consequences of climate change — regardless of political views. “The US withdrawal from the Paris climate accord was extremely disappointing to Swiss Re because we view the accord as preemptive action to deal with the threat of climate change. We have conducted more than twenty Economics of Climate Adaptation studies, which show that existing climate change risk will cause economic losses equal to 1 percent to 12 percent of GDP in the countries studied,” Smith says. “Climate change does not conform to national borders as the action in one country impacts the rest of the world. The melting of the arctic ice pack is one example. That will result in rising sea levels and will impact every coastal country. We feel that it is important to bring all nations together to understand what is happening so we can work on common solutions that benefit everyone.”
Yet, some companies want to throw precaution to the wind. There are disincentives for companies to pursue more certainty around potential risks. Smith explains, “It’s very hard for companies to quantify the impacts of climate change on their business because so much is unpredictable. If they could quantify the impact, they would have to account for it, which could penalize them against their competitors who choose not to quantify the impacts.”
Investing at Home
Swiss Re’s commitment to corporate social responsibility spans both sides of its balance sheet. The firm’s approach further emphasizes company values. Smith elaborates, “We want to show that it’s reasonable for a large corporation to gather their electrical needs from renewable sources: water, sun, wind. We are a part of a group of international companies that made a commitment several years ago, with RE100. Officially launched at Climate Week NYC in September 2014, RE100 unites 100 of the world’s largest companies in a shared commitment to use 100 percent renewable power by 2020. In addition, earlier in 2017 we invested about $7 million into a two-megawatt solar power plant to power Swiss Re headquarters here in Armonk, NY. The project has an attractive payback of less than seven years.”
Swiss Re has gone even further at the employee level. “We’ve encouraged our employees to make their own investments for the last eight or nine years in a program that encourages ditching their gasoline cars and buying electric cars, or in some cities buying a bicycle so they can ride to work and not drive. The program also encourages employees to put solar panels on their homes, buy more efficient appliances, and gives them substantial cash back to make those kinds of investments in their personal lives. We’ve invested millions of dollars through our employees to help reduce their carbon footprint.”
Product Innovation
Swiss Re is also making bold strides with investments related to their business as well. Amidst the US announcement to withdraw from the Paris climate accord earlier this year, the company made the decision to implement environmental, social, and government (ESG) benchmarks across its entire $130 billion investment portfolio. The firm has also been pushing regulators to expand their permitted investments to allow for a class of investment in infrastructure. It is still a work-in-progress. “We’ve made a pledge now to reposition our investments away from basically anything that’s carbon. The repositioning is influenced by our commitment to renewable energy and our concerns around climate change. It also defines our values as a company. We do believe, it’s less about a social statement and more about long-term prudent investment management. Our investments belong in these types of assets.”
Swiss Re also continues to invest in developing and evolving its product offerings. Parametric coverage is a more recent innovation. “Parametric coverage enables a different way of approaching exposures to flooding, lack of sunlight, or lack of rainfall, and what that can mean to a project or to society,” notes Smith. This is yet another risk protection mechanism for capital providers that can render a project financeable. It is designed to trigger off of a specific event, and follows with a payout mechanism. This trigger is typically based on parameters directly related to the risk that the protection buyer seeks to acquire coverage against, such as hurricane wind speed, hurricane minimum central pressure, temperature, rainfall total, or geographic location of a storm. The contingent nature of a parametric insurance contract, that it pays out only when defined parameters are recorded or experienced, makes the payout mechanism predictable and rapid. There are a multitude of ways to design a parametric trigger for an insurance, reinsurance, or risk transfer contract. This type of coverage has been enabling for investment in a broad range of applications, including intermittent sources of renewable energy like solar, wind, and hydropower resources. Smith elaborates, “For someone who is making major investments in solar power generation for example, they need a parametric cover by which they know each year that we will guarantee the amount of sunlight that will come down and hit those panels, so they can hit their electrical generation goals.”
Mind the (Protection) Gap
Despite progress with products financially engineered to provide risk protection against Mother Nature’s volatility, the increased frequency and severity of extreme weather events has exacerbated another encompassing policy problem for the industry and society — the protection gap, The protection gap, the difference between economic losses and insured losses, exists for several reasons. The first is affordability. Coverage may carry expensive premiums and will often not have priority over other expenditures. The second is lack of awareness. “There is a human tendency to minimize the projected impact of longer-term risks. We tend to think much shorter term,” Smith explains (see Empower Fall 2017 article “Myth and the Media: Understanding public skepticism of climate change”). Finally, as was recently demonstrated in Houston, there is a lack of requirement for protection against less probable events. Generally speaking, in order to finance a home in Houston, flood insurance is only required if the home is within the 100-year floodplain. There is no flood insurance requirement for areas beyond the 100-year floodplain. As a result, a 500-year flood event, like that produced by the rainfall from Hurricane Harvey, leaves a very wide protection gap.
The unmitigated effects of climate change have markedly widened the protection gap impact on all of us. “The greater this gap, the longer it takes for communities to rebuild and rebound after a natural catastrophe. We have been working with our clients to close this gap. One area we are focused on is the National Flood Insurance Program. The program cannot be sustained at the current pricing, and the federal government will be on the hook for larger and larger deficits caused by the program. This is the first year the government is buying reinsurance for the program, and Swiss Re is proud to be a reinsurer,” notes Smith.
A Need for Talent
As Smith and Swiss Re look forward over the next ten years at the need for talent to address the complexities of current and emerging risks, they will continue to seek actuaries from the best schools with strong financial modeling discipline. Swiss Re uses resiliency as a recruitment platform. “We tend to attract people that are more geared towards doing good for society,” Smith adds. “So, the idea is that we help make the world more resilient — that is what we do. We’re very proud of that,” Smith says. “We look for those with a certain emotional connection to society that really want to do something special. ISEN’s interdisciplinary approach to educating students on solving complex, global challenges is so important. We need our next generation of leaders to understand the challenges society faces, what the true solutions are, and what we need to do both as corporate and private citizens to help bring about a change of mind and heart in so many people across the globe. That’s when we will start to solve some of these problems in society.”
