Climate change is no longer a distant threat. Businesses and investors are already experiencing increased financial losses from catastrophic weather events. To help understand and mitigate these losses, the insurance industry has depended on sophisticated catastrophe risk models, but these do not currently take into account the threats from a changing climate. Meanwhile, climate risk models have emerged to estimate how temperatures will evolve in the future. Combining the results from both catastrophe and climate risk models will enhance risk management and mitigation strategies by taking a holistic view and providing clarity on the impact adaptation investments, portfolio risk profiles, real estate values and insurability.
The financial industry is going through a period of disruption as it starts to put a price on the changing climate. The world is already one degree Celsius hotter than it was in the nineteenth century and scientists believe heat stored in the oceans has locked at least another 0.5 degrees of warming. Businesses are grappling with the physical risks from climate change, including extreme temperatures, sea level rise, riverine flooding, increased frequency and severity of wildfires and catastrophic events. They are also navigating the transition to a low carbon economy and the resultant legal, market, technology and reputational risks – plus the new opportunities.
To some, the physical risks from a changing climate look familiar. The insurance industry has been using catastrophe risk models for decades to assess the frequency and severity of natural disasters across the world, coupled with the resiliency of assets such as houses or infrastructure, to estimate the financial impact. The modelled results enable insurers to shape their underwriting risk appetite, reinsurance purchase and exposure management.
Climate risk models are complementary to, not substitutes for, catastrophe models
Catastrophe models use historical climate data from past natural disaster events. However, climate change has likely already changed the probability and intensity of meteorologically-linked physical perils. As the consequences of climate change become increasingly evident, businesses and insurers are also turning to a new set of tools: climate risk models.
Rather than rely on historical, backward-looking data, climate models provide forward-looking simulations of the interaction between energy and matter in the ocean, atmosphere and land based on levels of greenhouse gases emissions. While the future is uncertain, climate models enable the projection of temperature, precipitation, and other weather-related conditions and events over the next several decades.
Refining the approach to climate modelling
The process of modeling climate risk involves coupling climate model data with a vulnerability assessment of assets to produce a quantified estimate of financial loss for any asset at any location on the planet. By aggregating dozens of climate models, forward-looking hazard data is estimated, interpreted and managed by climatologists, expert data scientists, engineers, and financial analysts.
What the climate looks like in the future depends on expected levels of greenhouse gas (GHG) emissions. Intergovernmental Panel on Climate Change (IPCC) scientists developed four Representative Concentration Pathways (RCP), which model the projected temperature increases and atmospheric warming expected by the end of the century. The below chart shows how the high emissions scenario, RCP8.5, might lead to an increase in temperature of more than five degrees Celsius.
Source: Fuss et al 2014; CDIAC; Global Carbon Budget 2014
Using these RCP scenarios, climate risk analytics providers like The Climate Service model the financial impact of physical hazards including extreme temperature, wildfire, drought, water stress, riverine flooding, coastal flooding and tropical cyclones, given the uncertainty and assumptions that climate change presents.
Catastrophe modeling remains essential for good risk management
It is clear that catastrophe and climate models both have unique and valuable attributes. Combining climate risk analysis with catastrophe modelling and risk management can yield a more robust understanding of the financial implications of climate-related hazards in the future, under different climate scenarios. In turn, this enables more holistic preparation for the threats and opportunities that the future may present.
Comprehensive insight into climate risk
Blending catastrophe risk and climate risk outputs can unlock a range of analytical opportunities:
- Empower strategic investments in adaptation measures such as green roofs to mitigate building-level extreme temperature impacts, or stormwater best management practices to mitigate riverine flooding, via cost benefit analysis.
- Enable corporations to identify locations with lower climate risk profiles for the future placement of key facilities or personnel.
- Expand investor understanding of risk over a longer time horizon. Catastrophe risk models typically provide a sophisticated understanding of potential insured loss over the next 12 months, while climate risk models can project economic losses decades into the future.
- Hone a longer-term return on investment perspective. With a better understanding of the ultimate terminal or sale value of real estate assets, investors can model the expected return on investment and incorporate climate risk into investment decision making.
- Identify the broader impact of climate change on markets. For instance, the availability and price of insurance for physical perils, the implications for credit and the cost of capital, and how to best navigate the regulatory journey toward mandatory climate risk disclosures.
In a world rocked by turmoil and disruption, climate change remains one of the biggest challenges facing humanity and is already reshaping industries and markets. Combining the perspectives of catastrophe and climate risk models can help in identifying actionable approaches and solutions to navigate this uncertainty. The sooner businesses and investors understand their climate related financial risks, the better placed they will be to weather the gathering storm and seize opportunities as they emerge.
About the Authors:
Aon’s Stefan Wolf Stärtzel helps to coordinate Aon’s climate strategy and develop new solutions for clients. Stefan is also pursuing a PhD at the University College London in the Department of Science, Technology, Engineering and Public Policy.
Formerly managing director for climate risk at The Economist, Joseph Lake is Chief Operating Officer at The Climate Service (TCS)
Tory Grieves, completed dual MEM/MBA degrees at Yale University before joining TCS to lead analytics initiatives. The TCS Climanomics® platform puts a price on climate risk for investors and businesses and was recently named a leader in climate risk solutions by Forrester Research.