[Skip to content]

Sign up for our daily newsletter
The Actuary The magazine of the Institute & Faculty of Actuaries

Why we must learn to waterski

Like many of my fellow professionals, every winter I enjoy the somewhat irrational pursuit of throwing myself off mountains on a pair of metal
planks. However, when I arrived in Switzerland last February in pursuit of my hobby, I found the mountains covered only in rocks. Zermatt was enjoying its hottest winter on record. There was not so much as a flake of snow. You can imagine my disappointment.
I am sure that any of my fellow professionals who happen to live in Prague, Dresden, or various parts of southern England were a little bit more than disappointed to find their homes had disappeared in floods at some point over the last year. In turn, our problems in the ‘developed’ world pale into insignificance compared to the rest of the world. For example, according to the UN World Food Programme, millions of Africans face famine this year caused by drought.
The lack of snow in the Alps, flooding in Europe, and drought in Africa are all dramatic manifestations of climate change. According to the Red Cross, 2000 and 2001 were the worst two years for natural disasters ever recorded. The Intergovernmental Panel on Climate Change (IPCC) has shown the 1990s was the warmest decade in the millennium, and that the rate of warming in the 20th century has been greater than in any of the last 900 years. 2003 is predicted to be the warmest year since records began.
‘What does this have to do with actuaries?’ I hear you ask. Quite a lot, actually. In this article and its sequel, I will look at how climate change will affect traditional actuarial areas of work, and how it could also lead to potentially interesting and challenging new areas.
Scientific background
Burning fossil fuels releases carbon dioxide and other greenhouse gases into the atmosphere. Accumulating more rapidly than can be absorbed by natural sinks, these gases trap heat, affecting the climate in a number of complex ways.
Figure 1 shows a 150,000-year correlation between carbon dioxide density in the atmosphere, measured in parts per million (ppm) and temperature change. The pre-industrial concentration of around 280ppm has risen to our current level of 386ppm.
The IPCC emissions scenarios project carbon dioxide concentrations in the year 2100 ranging from 540 to 970ppm. This is expected to lead to an increase in temperature of between 1.4?C and 5.8?C. This rise in temperature will in turn lead to an increase in sea levels of between 0.09 and 0.88 metres, due to thermal expansion and loss of mass from glaciers and ice caps. The higher temperatures are also likely to upset the finely balanced mechanism that is the global climate system, leading to ever-increasing numbers of extreme weather events, such as storms, droughts, and floods.
The impact on human activity and ecosystems will be vast. The effect can be lessened or exaggerated by human, economic, and social activities. For example, insurance losses caused by floods in Sussex last year were magnified as the floods coincided with high property values. The drought in Africa has been exacerbated by political instability, inefficient land use, and deforestation.
Climate change is happening, and it will increase over this century. Can it be averted? Carbon dioxide in the atmosphere has been building up unabated over the last 250 years. Human carbon emissions are continuing to increase as the world develops and economies grow. To mitigate the damage, a massive immediate reduction would be required. However, as even the modest reductions proposed in the Kyoto Protocol could not be agreed, it seems unlikely the required reduction will ever occur. Climate change is here to stay.

Life insurance and pensions
Climate change is likely to affect both demographic and financial variables. Since little research has been carried out in these areas, and what has been done is often contradictory, the suggested effects are highly speculative. However, I will highlight some questions that need to be asked and the areas where research is required, using the UK as an example.

Demographic factors
Mortality and morbidity are likely to be affected by three factors.
n Milder winters are likely to lead to increased life expectancy for the elderly. However, it is by no means certain that the UK will experience milder winters. Under some scenarios, ocean thermohaline circulation will be reduced or even curtailed, leading to lower winter temperatures and increased mortality.
– Increased temperatures could introduce tropical diseases and pests previously unknown in the UK.
– A higher occurrence of extreme weather events will increase the incidence of death and injury from these events.

Financial factors
Actuaries base long-term financial assumptions on the links between economic variables, such as investment return, interest rates, inflation, and salary increases, which have historically been stable. Over the latter half of the 20th century, we have lived in a time of prosperity, free from wars, and with steady economic growth. It is possible climate change will ‘unbundle’ these variables, leading to greater unpredictability of pension and insurance costs.
The UK Chartered Institute of Insurers predicts that weather-related damage will be larger than economic growth by the year 2065. A possible macroeconomic framework brought about by a large increase in extreme weather events is as follows.
The insurance industry will be the first to bear the cost of any increase in extreme weather events. It is likely to react by increasing premiums and expanding exclusions. Government spending will increase, both to repair damage and to implement prevention strategies against future damage, hence taxes and public sector borrowing will increase. Possibly most crucially, uncertainty will increase, so consumers and companies will want to hold more cash and will be less willing to invest and spend. Prices will increase as transport and production costs rise. Globalisation means an increasing amount of production is being farmed out to countries where production costs are lower. These are the very areas that will be hit most by climate change. They are also the least able to cope, leading to further increased instability.
The most important macroeconomic relationship affecting the cost of pensions and insurance products is the relationship between investment returns, salary inflation and consumer price inflation. The major component of the investment return/inflation gap is real economic growth. If the economy grows faster over the long term, this is translated into high real investment returns through the stock market and property prices.

Reduction in long-term growth
The question ‘what are the causes of long-term growth?’ is probably the most controversial topic in economics. However, the following are the most likely causes.
– Technological progress Technology influences the output from capital and labour at any time. All other things being equal, climate change will have a negative impact on technological progress, as the likely increase in taxes and the costs of insurance and raw materials, as well as direct weather damage, will reduce the output from a given quantity of capital and labour.
– Population growth In this context, population growth refers to working population. At least in developed countries, this is unlikely to be significantly affected by weather-related events. However, because of the ageing population, the working population will actually decline until 2035 and then level out (in the absence of large-scale immigration).
– Capital accumulation Weather-related damage is likely to lead to an increase in ‘depreciation’ of capital, both directly and indirectly (for example, through reduced willingness of people to invest, due to higher cost of damage).
– Savings rate With the increased uncertainty and greater expenditure requirements brought about by climate change, we are likely to see a reduction in the savings rate. This will initially be exacerbated by retiring pensioners cashing-in their pensions. According to the endogenous growth theory, this will lead to a reduction of long-term growth.
Taken together, the above factors will lead to a reduction in long-term growth, especially when the effects of climate change are combined with the effects of the ageing population. This means that real asset returns are likely to be lower in the future, and hence pension and insurance policies will be more expensive.
I have hypothesised one scenario. I may be quite wrong. For example, another situation would be a war, where GDP can rise due to increased demand and a general re-ordering of society on more efficient lines in the face of an outside threat. Under this scenario, growth and investment return could increase with GDP, although inflation and interest rates would also increase. The only certainty is that uncertainty will increase.
The conclusion is that I do not know the answer, but neither does anyone else. The senior IPCC economist, William D Nordhaus, states: ‘It must be emphasised that attempts to estimate the impacts of climate change continue to be highly speculative the number of scholarly studies of the economic impacts of climate change remains vanishingly small.’

Tip of the thawing iceberg
I hope I have raised a number of pertinent questions that require answers in the not too distant future. There is a huge need for further research, particularly into the financial and economic impacts of climate change. There will also be large commercial opportunities, should we choose to take a lead in this field these will be discussed in the next article
Finally, back to the really important question. What am I going to do for my winter holidays? I guess I’ll have to learn to waterski.

The Environmental Research Group seeks to identify and research areas in which actuaries can become, or will need to become, involved in environmental issues. The group seeks to work with non-actuarial academics and professional experts in environmental matters, acting as a catalyst to ensure effective action within and outside the profession.
Members who would like to join the group should contact Maria Singleton (tel 020-7632 2173, email marias@actuaries.org.uk).