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The Actuary The magazine of the Institute & Faculty of Actuaries

Asset meltdown

On a very sunny day at the Staple Inn Actuarial
Society meeting in June, just prior to our first
(and last) heatwave of the summer, actuaries and other professionals discussed just how much the change in climate has affected the values of both assets and liabilities, with the emphasis on assets. All of us naturally associate climate change with loss events, insurance claims, and liabilities, but there is actually far more at stake on the asset side. Although substantial future changes have yet to occur, current share prices clearly do not even reflect past climate changes accurately.
The paper under discussion emerges from the Environmental Research Group of the Social Policy Board. The author, Louis Perroy, already works in the field of assessing the effects of climate change, and he presented his introduction to the subject at the meeting.

Hurricane Katrina
Although the meeting was held prior to hurricane Katrina, the paper was particularly topical given the current climate-related coverage in the media, and also the stuttering stance of so many important governments, but not including the UK! Given low priority by so many, the Kyoto protocol comes in effect in 2008. However, although FT Global 500 companies are requested to produce details of their carbon emissions unit holdings, many do not do so. Those involved in EU emissions trading must legally comply.
Climate change can have a significant effect on the values of companies, but share prices tend to reflect the short-term earnings and dividend streams rather than the longer-term potential for climate problems or benefits. Whereas there is considerable interest in climate change at the macro level, this has not so far translated into the business areas of companies. There is insufficient research performed by large companies in this area, as they tend to duck the issue. In their assessment of investments, such issues are important for pension fund trustees as well as pension fund managers.
Before actuaries and others can address this fully, a deeper understanding of the facts is needed. There is clearly a desperate need to translate the results of the work performed so far into quantifiable amounts for the financial decision-makers. What is needed is a profession that understands the effects of current and deferred consumption, and that can quantify the present value of the cost of future events, allowing for uncertainty and the probability of occurrences. One profession clearly springs to mind, and indeed many outside of our profession believe that our involvement will assist in the general understanding of the effects on financial institutions of climate change.

Carbon disclosure and emission trading
We cannot just look at current day rates of return in the valuation of the worth of companies; we must allow for the effects of climate change based on a sound understanding of the results (and potential future results) of such changes. To fulfil that role, we must perform the necessary research now in areas such as carbon disclosure, emission trading, and other issues that increasingly have an impact on balance sheets relating to our change in climate.
Leaving the subject of pension fund assets, the meeting then considered liabilities. Although these intuitively come to mind first as being more important than assets, they are potentially less important when thinking of climate change from the whole perspective of financial institutions.
Nevertheless, catastrophe return periods, more additional flood damage and other weather-prone losses have to be priced by insurers and especially reinsurers. Further, the capital needed to write such property catastrophe business (and capital is now correctly given a very high profile) depends significantly on the assumptions based on such loss event occurrences. As insurance margins have been so drastically reduced in recent times, there is no scope for the present market to absorb such changes without a full allowance and accurate assessment of the risk involved, and that needs much more research and understanding.

Although redlining (that is, excluding types of insurance cover in certain places) is a practice not to be encouraged, it is an easier solution for insurers to the problem of rating difficult types of risks in certain geographical areas. If uncertainty increases owing to climate change without proper research, the serious problem of redlining will worsen. The Social Policy Board is already considering such issues. To do without redlining would require unjustifiable generosity by certain insurers for specific insureds, or alternatively government intervention. It is a difficult problem, and it will become more so. Looking internationally, as developing world countries require more insurance, this issue becomes very important indeed. Future insurance for factors such as Bangladesh’s flood plain may be totally impossible, thus exacerbating poverty there. This will increase the need for OECD intervention and assistance.

Colder, warmer, wetter, or drier?
With the rapid development of Asia, the problems caused by climate change will increase exponentially. China builds more power stations each year than currently exist in the UK. Other Asian countries will develop further. Some western countries, most notably the US, are taking insufficient action and so problems are not years away, but imminent.
Some areas of the world will become colder, most much warmer, others wetter or drier. As actuaries, we need to understand the issues. We need to be able to quantify the issues, and more importantly, we need to be able to interpret and explain them. This subject is the future opportunity for actuaries!