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The Actuary The magazine of the Institute & Faculty of Actuaries

False accounting

As I write this, the 16th annual round of negotiations of the United Nations Framework Convention on Climate Change (COP 16) has just ended. After the disappointment of the previous round in Copenhagen in December 2009, the agreement reached has been greeted with some optimism. But what was agreed? On the positive side, the goal of limiting the global average temperature rise to less than 2°C was reaffirmed. It was also acknowledged that this target might need to be lowered to <1.5°C if future science demands. In addition, voluntary cuts that were offered during the last round of negotiations were written into the agreement.

On the other hand, there was no major progress on how to extend the Kyoto protocol, which obliges rich nations to cut greenhouse gas emissions 1. The CancÚn agreement is not legally binding. And worst of all, the cuts agreed are almost certainly insufficient to achieve the stated aim of holding warming below 2°C 2.

Climate change is not the only problem facing the world today. There is also a risk of an energy crunch in the near future 3, among other resource constraints. Why is there not more urgent action on these issues?

An analogy: the world as an insurance company
Reserving for a non-life insurance company is tricky, because the true best estimate is always uncertain. The delay between receipt of premium and payment of claims means that it takes a while for the company’s true liability to emerge. Booked reserve movements, on the other hand, flow through immediately to the bottom line. This means that when premium rates are down, the ‘soft market’, releasing reserves is an easy way to bolster short-term profits. However, if reserves are insufficient to pay claims arising from all written premiums, the company is under-reserved.

In the analogy between the global economy and an insurance company, insurance company managers represent politicians, the company’s shareholders represent the general population, the company profits represent the wealth of the population and the insurance company’s actuaries represent climate scientists.

If the soft market continues, then the insurer’s loss experience will worsen. It is perfectly legitimate to book reserves within a range of the best estimate. However, management has an incentive to choose a reserve estimate at the lower end of the range, in order to meet profit targets. Also, there is a natural tendency for anchoring, whereby new estimates are pulled back towards the previous versions. Eventually, reserves may get so out of line with real liabilities that rating agencies get interested. For example, when Swiss Re took over Employers Re in 2006, it found that the reserves needed to be strengthened by $3.4bn 4.

When an insurance company under-reserves, it does not recognise all its liabilities. This allows it to maintain short-term reported profits for shareholders. Currently, politicians are holding back from recognising the full costs of fixing environmental and resource problems. This lack of recognition allows them to maintain our standard of living in the short term. However, in both cases the profit or wealth is illusory. It is based on an accounting trick that trades the future for the present. In the world, the false accounting arises from consuming natural capital and accounting for it as income. Natural capital refers both to irreplaceable natural resources such as oil, and to the ability of the environment to soak up pollution 5.

Given that the Kyoto Protocol expires in 2012 and there is still no agreement on its successor, we might be forgiven for thinking that politicians have given up on climate change. Also, the lack of preparation for the coming energy crunch is puzzling. Maybe politicians are like the insurance company manager who decides that under-reserving is too large to tell shareholders about?

Perhaps the actuarial profession, alongside other professions, could help to create the political space for real solutions to develop? As an example, in order to clean up pollution we will need to pay more for our energy in future 6, but this will not be a popular message. Our profession could communicate to the public that they will have to pay more for their security. Before we can do this, we need to have a debate within our profession about what we think are reasonable responses to climate change and the resource crunch. If you would like to contribute to this debate, please get in touch with the Resource & Environment Member Interest Group (REG). You can find more information about the impact of climate change and resource depletion on the actuarial profession in the recent Literature Review carried out by the REG at http://tinyurl.com/32p68c3


1 http://in.reuters.com/article/idINIndia-53501020101211?pageNumber=2

2 www.newscientist.com/article/dn19826-climate-pledges-are-9-gigatonnes-short.html?DCMP=OTC-rss&nsref=climate-change

3 www.lloyds.com/News-and-Insight/360-Risk-Insight/Research-and-Reports/Energy-Security/Energy-Security

4 www.thefreelibrary.com/A.M.+Best+Comments+on+Swiss+Re’s

5 See Andrew Simms’ book Ecological Debt and www.neweconomics.org/press-releases/worldentersecological-debt-on-saturday-21-august-2010

6 www.economist.com/node/17679633?story_id=17679633&fsrc=rss


Oliver Bettis is chair of the Resource & Environmental Member Interest Group