We wrote yesterday to introduce Ceres’ report on the disclosure of climate risks by insurers and considered its first Recommendation to Regulators concerning mandatory and public disclosures. We address today the second recommendation in Climate Risk Disclosures by Insurers: Evaluating Insurer Responses to the NAIC Climate Disclosure Survey. Ceres’ second recommendation is to "[c]reate shared resources around the implications of climate trends on enterprise risk management." Id. at 51. In other words, more research should be made available concerning investment risks and opportunities, correlated risks, loss modeling, the potential for loss of health and life, and customer resilience (ability to resist extreme events). Id.
Taking modeling by way of example, Ceres discusses modeling thoroughly in Part 2 and the discussion is thought-provoking. Several insurers are conducting climate change modeling internally. For the rest, they rely on third-party vendors, which invokes much criticism from Ceres. "The majority of insurers that report using catastrophe models describe them in terms that suggest their company does not have a clear understanding of how the models can or cannot be used to anticipate changing risk. Most of the industry relies on third-party catastrophe risk models that only marginally integrate changing extreme weather." Id. at 6. "[I]nsurers relying entirely on third-party models may be severely unequipped to adjust pricing to incorporate emerging climate risks." Id. at 31. "Insurers' disclosures suggest that the majority of insurers may be setting pricing based on flawed assumptions of how the industry's loss models incorporate changing climate trends." Id. at 32.
Ceres lauds those companies that can do it in-house. But specialization and economies of scale are fundamental drivers of the market. Were every insurer to bring modeling inside, undoubtedly there would be some new insights not presently uncovered. But there would also be insurers who got the models grievously wrong and, in most cases, the resources spent on modeling would be more cost-effectively spent on other items necessary to delivering products or services.
To be sure, reliance on EQECAT, AIR Worldwide and RMS as the sources for all climate change modeling has its flaws. One need only think back a few years to where another triumvirate dispensing financial ratings (allegedly) misled sophisticated investors around the globe. But in a world of constrained resources, or even an unconstrained one, third-party modelers are necessary and beneficial.
Further, a disadvantage to society from in-house modeling is that the insights developed from proprietary work may remain just that: proprietary. Ceres acknowledges "it is ... possible that asymmetrical information can be used by individual companies to secure a competitive edge against their peers." Id. at 38. Indeed, "larger insurers more readily recognize the inherent limitations of current catastrophe models in light of changing climate than do their smaller competitors or clients. These players have a clear competitive advantage in deploying resources to build the latest climate science into their pricing models." Id. at 37. Third-party vendors, on the other hand, spread their best products across many insurers, in effect sharing their best research (but only to those willing to pay for it).
We wrote yesterday of the need to recognize that intellectual capital is a business asset and criticizing a goal of making climate change disclosures public available. We think those comments apply likewise to the sharing of resources.
Nevertheless, Ceres does great work in raising the bar for third-party vendors. By pointing out to insurer-users that they may not be getting what they really need from the modeling firms, we expect the modelers will have to go out and address Ceres’ criticisms. For example, insurers are exposed if (as Ceres asserts) "few insured perils are modeled by insurers, leaving the possibility for climate-affected perils to be underpriced." Id. at 35. More specifically, "recent years have demonstrated that climate change may be driving up aggregated losses from smaller events, including perils such as floods, snowstorms and hailstorms, in ways that erode insurer profitability." Id.
Tomorrow we conclude our review with a look at Ceres’ third recommendation as well as sharing some concerns about research.