Insurance industry's climate risk assessment models: Effectiveness in question?
In the ever-evolving landscape of climate change, insurers are grappling with significant limitations and potential inaccuracies in their risk models, according to industry experts. These models, designed to predict the physical impacts of climate change, are under scrutiny for oversimplifying complex climate processes and omitting dynamic mitigation and resilience factors.
Last year, Carbon Tracker, a leading climate analysis organisation, criticised the climate economic models sold by consultants to pension fund clients, labelling them as "inadequate" and "not fit for purpose." The criticisms centred around the models' inability to accurately predict the physical impacts of climate change, particularly regarding tipping points and oversimplification.
One of the key limitations of these models is their narrow focus on annual policies, capturing only a limited, short-term view of risk. This approach fails to reflect the accelerating and compounding nature of climate change impacts over longer horizons.
Another concern is the exclusion of risk reduction measures at household or community levels. Many current models do not integrate timely updates or comprehensive data on mitigation efforts, leading to less accurate risk quantification.
Climate risk is inherently multi-dimensional and involves feedback loops and thresholds. Models often simplify these complexities to statistical or actuarial estimations, potentially missing nonlinear or sudden changes in risk, resulting in underestimation or mispricing of extreme events.
Physical climate risks such as wildfires or hurricanes can cause highly correlated losses across many policies simultaneously, reducing diversification benefits and increasing difficulty in risk pooling and transfer. Additionally, data quality and availability constraints limit model precision and potentially bias risk projections.
Some climate-related risks are becoming too frequent, predictable, or large to be insurable under traditional market mechanisms, a challenge that models may not fully represent.
Mark Campanale, founder and director of Carbon Tracker, agreed with the critique, highlighting the lack of regulatory oversight of climate scenario analysis and climate risk assessment. He also noted that those who create the climate risk models may not be held accountable if the models prove to be inaccurate.
Insurers may feel compelled to purchase climate risk management tools due to regulatory, shareholder, and public pressure. However, tools built from data like CMIP6 may oversimplify complex climate scenarios, leading to potential inaccuracies. Much of the climate data available is qualitative and difficult to translate into business terms for insurers.
Amidst these challenges, MunichRe offers a modular SaaS solution to help understand exposure to current physical risks and assess physical risks associated with climate change in different future scenarios. The tool provides risk scores for physical impacts such as sea level rise, tropical cyclones, and storm surges based on the latest scientific framework and modelling approach.
The insurance sector is facing questions about whether it can withstand the stress of climate change, with the insurance crisis in Florida leading to new laws aimed at making home insurance more affordable while ensuring enough reserve funds for catastrophic losses. Premiums for home insurance in Florida have reached an all-time high due to extreme weather events.
Experts have expressed concern that inaccuracies in climate risk models used by insurers could lead to a "black swan" event similar to the 2008 financial crisis. Insurers are focusing on the physical impacts of climate change due to concerns about regulatory pressures and shareholder expectations. Improving these models requires better data integration of mitigation outcomes, real-time updates, and enhanced modeling frameworks that capture nonlinear climate dynamics and correlated loss patterns.
- The insurance sector is grappling with the criticism from environmental science experts that insurers' climate risk models, under scrutiny for oversimplifying complex climate processes and omitting dynamic mitigation and resilience factors, are inadequate and not fit for purpose, as pointed out by organizations like Carbon Tracker.
- These climate models, designed to predict physical impacts of climate change, are deemed as unsuitable for long-term risk assessments due to their narrow focus on annual policies, capturing only a limited, short-term view of risk, and their exclusion of risk reduction measures at household or community levels.
- Climate-related risks, involving complexities like feedback loops, thresholds, nonlinear changes, and correlated losses, are often simplified by these models to statistical or actuarial estimations, potentially leading to underestimation or mispricing of extreme events and exacerbating the potential for a "black swan" event similar to the 2008 financial crisis, as warned by experts.
