At a crossroads

Neil Cantle, Nancy Watkins and Peter Kingsley sat down with Chris Seekings to discuss the role actuaries  and insurers can play in tackling climate change, following the coronavirus crisis.
 

Climate change is one of a number of interconnected risks threatening the stability of the global financial system. This year, for the first time, the World Economic Forum (WEF) ranked it as the top challenge facing humanity.

The issue has not gone away amid COVID-19, which has exposed how actions in one country can have direct consequences for the whole world. The WEF has called the pandemic ‘The Great Reset’, arguing that “leaders find themselves at a historic crossroads, managing short-term pressures against medium and long-term uncertainties”.

The choices we make as we recover will have serious implications for the efforts being made to tackle climate change. If polls are to be believed, reverting back to business-as-usual is not acceptable to most people.

I sat down with three risk experts to discuss the lessons that COVID-19 can teach us about tackling climate change and its associated financial and societal threats.
 

How things stand

Last year, the Bank of England challenged UK lenders and insurers to assess their exposure to climate change through its first ever ‘climate stress test’. The results are expected in 2021 and it seems that firms have a good grasp of the immediate risks. “In terms of the modelling, we are at a really good stage of understanding current-level risks, such as asset holdings becoming less valuable,” explains Nancy Watkins, principal and consulting actuary at actuarial consultancy firm Milliman. “But there are risks that have not been fully explored – what you might call secondary or tertiary risks.”

She points to the pandemic as an example of an issue presenting unforeseen challenges. “A lot of the effects are not only from people getting sick, they’re from mitigation measures intended to prevent people from getting sick. It should have been expected that sections of the world would shut down, and those risks could have been modelled. That’s the thing we’re trying to get ahead of when it comes to climate change.”

The impact of extreme weather on insurance prices is relatively well known, but there are numerous transitional risks that remain unclear. “We can understand the shape of some physical risks and what those might look like,” explains Neil Cantle, Milliman principal and consulting actuary. “The transition ones are much softer, and are often triggered by people’s perceptions of what a future physical risk might be. I think actuaries have been struggling to get their heads around that as part of the scenario analysis, because to a lot of people it still feels as though the risk is a long way away.”
 

Time for storytelling

Peter Kingsley is chairman of The Oracle Partnership, which aims to identify the earliest signs of global strategic risk and fundamental structural change. Oracle’s scenarios look ahead to 2050, exploring the complex interplay of everything from climate change to geopolitics and radical innovation. This involves a lot of ‘thinking outside the box’. “We look at the whole system and interdependencies,” he explains. “It’s about storytelling and human interactions, and you need to be imaginative.” He takes a long-term view, arguing that backward-looking measures and data analysis – frequently used by disaster planners – are not enough. “I think that’s illustrated by just about every disaster, from 9/11 to recent events. We classified the pandemic as a wildcard event, but it was foreseen. It wasn’t a black swan, it was a failure of mental models.”

The danger is that decision-makers may focus on the risks that are modelled and ignore significant risks that the models do not consider.  “The expression ‘the map is not the territory’ was coined by a Polish mathematician in the 1930s and means that the description of the thing is not the thing itself,” Watkins says. “A model is just a synthetic depiction of reality. It’s difficult to translate abstract concepts, such as sea levels rising, into something that people care about.”

The evolution to a holistic approach may pose challenges for actuaries, whose methodologies tend to based on modelling one issue at a time and then joining them together.  “Actuarial models historically haven’t embraced a fully complex problem and modelled it head-on, because it’s difficult,” says Cantle. “The way we’ve been approaching it is to just embrace that complexity.”
 

The great realisation

Kingsley argues that insurers and actuaries need to imagine the worst impacts of climate change as if they are happening today. “People can’t start taking notice when and if Miami goes underwater in 2050 – they are starting to make decisions as if it were a fact now,” he says. “There are all sorts of variables around sea defences and mitigation, but it is the imagined future that creates shocks in the real world.”

Companies such as BP and Shell have suffered a large asset squeeze in recent years, with shareholders and investors realising the fossil fuel industry is facing an existential crisis. “But the best hedge funds started acting five years ago,” Kingsley says. “You’ve got to take the imagined future as a present-day reality.”

The Oracle Partnership surveys and monitoring of corporate leadership sentiment show that environmental, social and governance issues are now perceived as urgent – so could the investment landscape look vastly different in the coming decades? “I think radically different in two years, actually,” Kingsley says. “If you look at the current pandemic, industries have to ask if they can rely on political leaders to look after the public interest.Plainly, in some countries, the answer is no. If you then say climate risk is many times more serious, you have an entirely different investment and risk environment.”

It is agreed that the insurance industry’s ability to be flexible when entering and exiting new markets may act as a barrier to climate action. The sector can also change the terms of its coverage from year to year and revise its underwriting rules whenever it wants. “Short-term thinking is not penalised if you’re an insurance company,” Watkins explains. “Reinsurance firms tend to have a longer-term view of the world and a greater leadership role right now on climate change.”

“Early intervention is better than waiting until we don’t have any good choices”

Leading the way

Some insurers are increasing their activities around climate change, but there is a need for greater leadership within the industry. Environmentally unfriendly projects such as coal mines cannot operate without insurance coverage, and insurers are also often large investors in fossil fuels. AXA was one the first firms to stop supporting the industry, with many other European firms following suit. “They’re addressing legal risks,” Kingsley says. “They’re worried about reputational risk and, at the extreme, existential risk. They can see mass consumer defections.”

There is a perceived disadvantage to being a first mover, as companies worry about taking a hit on their underwriting and investment revenues, but COVID-19 has shown that early action can save money in the long term. “That’s what I would like the lesson to be,” Watkins says. “Even though we don’t know exactly how things are going to happen, we should be able to agree that early intervention is better than waiting until we don’t have any good choices. Early intervention can pay for itself many times over.”

BlackRock’s Larry Fink has positioned himself as a leader on climate change, while activist groups such as Extinction Rebellion have put pressure on financial firms to end support for fossil fuels. “I think they’re changing how customers think, which changes how some staff think,” Cantle suggests. “But it wasn’t until the Bank of England governor Mark Carney slapped insurers with a scenario exercise that they committed to it. Some actuaries who care deeply about climate change, such as the IFoA’s future president Louise Pryor, are very passionate and are showing leadership.”
 

Direct intervention

Kingsley believes there is an opportunity for insurers to reimagine their role in society, and explains how revolutionary technologies such as sensors and drones could help the sector to directly intervene in the underlying risks of climate change. “There is a gap between the perception of the industry and its real potential,” he continues. “Sensor-based, drone-based new technologies can streamline everything, make it easier for everyone, improve customer service and reduce risk. A direct reduction of risk turns the insurance industry upside down, if it can move into the mainstream.”

Insurers have been under intense pressure to ensure that businesses continue to operate during the pandemic, and the prospect of rising claims in an increasingly volatile climate may make direct intervention even more attractive. “Altruism is a wonderful force, but self-interest has more direct power,” Watkins says. “With claims from COVID-19, insurers are fighting an event that could potentially cause the whole industry to become insolvent. If they apply that to climate change, they might one day be called upon to insure the value of everyone’s property in the world. It might spur them on to act in ways they haven’t in previous years – not just pointing out risks, but helping to reduce them.”

This is just one way the industry could reinvent itself, and there is agreement that actuaries could play a more prominent role in government decision-making. “We are part of the team of superheroes that is needed,” Watkins says. “We will also need climate scientists, engineers and corporate finance people, but what I like about our role is the ability and independence to work in spaces between other specialities, translating from one side to the other so that people are working with the same set of facts.”
 

The new normal

COVID-19 has shone a spotlight on the fragile state of the world’s financial system and the need for greater operational resilience. “It’s easy to ignore it and go back to what you think of normal, but operational resilience requires a more agile way of looking at risk,” Cantle says. “Most firms do quarterly or annual reviews, and it’s not good enough. The situation is changing on a day-by-day basis, so this pandemic has been a big wake-up call for actuarial teams.”

Another lesson from the crisis is that we must be more imaginative when it comes to modelling, and Watkins believes that forecasts need to consider more “downstream outcomes” so that the world is prepared for low-probability events. “One thing I’ve seen is too many black swans,” she continues. “We need to turn on the lights, and maybe they won’t look like black swans any more. We all feel more fragile than we did in February, and I think people are rethinking what is possible and what’s not, what’s important and what’s not. Insurers need to show more leadership and be more proactive if they are to have a market or company in 10 years or 20 years.”

For Kingsley, the pandemic has highlighted the need for firms to spot signs of major disruption early. “We look for surprises even if they are tiny, almost vague and completely ambiguous – that’s where you find the answer to the ‘unknown unknowns’ that Donald Rumsfeld talked about. That means near real-time monitoring of a lot of variables. Nancy and Neil’s actuarial work is fascinating because it translates the mental model problems, cultural blind spots and potential shocks that we identify into another form which can quantify the complex risks and serve as a framework for decision-makers.”

Direct intervention, reimagining risk, greater leadership and vastly different investment and underwriting landscapes are just some of the seismic shifts that actuaries and insurers will face during the coming years. Although COVID-19 has brought suffering to millions, it may have added an element of urgency to the climate debate. “I think a lot of people have assumed that when things go wrong, they will go back to normal,” Cantle says. “Hopefully they now realise that that hasn’t been true for a long time, and it’s certainly not going to be true now.”

 

Nancy Watkins is a principal and consulting actuary with Milliman. She manages a consulting practice in San Francisco that focuses on climate change, insurtech and property insurance analytics. She is a thought leader in the area of property insurance availability and affordability and an expert in the US flood market.

Neil Cantle is a principal at Milliman and one of the leaders of their London office.He is Milliman’s global thought leader on risk management and is past chair of the IFoA Risk Management Board, Risk Management Research & Thought Leadership Committee, and a member of the Financial Systems Thinking Innovation Centre.

Peter Kingsley is chairman of The Oracle Partnership, which specialises in agenda-setting foresight. He has delivered strategic advice and thought leadership to major financial institutions, corporate boards and wealth managers for more than 20 years. He co-founded Oracle with Thierry Malleret, who ran the World Economic Forum events in Davos.

Image credit | Getty