Insurance solutions for environmental risks ?

Insurance solutions for environmental risks ? Philippe TRAINAR Chief Economist Officer SCOR 35th OAA Conference and General Assembly 24th – 29th May 2008

Specificities of environmental risks ? • Whither insurance solutions ? • Role of government vs insurance ?

Specificities of environmental risks ? • Environmental risks : six key facts • Environmental risks and climate change

1. Environmental risks : six key facts • Human being is fighting against natural catastrophes at the same time when it is “cooperating” with nature ;human organizations have been built for protecting their members against these perils which • Nature is destroying human productions and human beings : losses (financial costs as well as deaths etc.) due to natural catastrophes make three fourth of all the losses due to catastrophes, either natural or technological and human • Nature is killing less than in the past : it’s a consequence of rising efforts of protection and prevention, • But, catastrophes are occurring more often and affecting a rising number of people as a consequence of : • rising world population • Concentration of world population on the most risky areas around the world • The share of climatic catastrophes increases rapidly, in term of nulbers as well as of costs • Floods dominate in term of frequency and Storms in term of costsamong climatic catastrophes

Graph :Importance of environmental catastrophes US$billions Source : EM-DAT, University of Louvain

Graphique 4 :La population se concentre dans les zones à haut risque Source: United Nations Population Fund: State of World Population 2007 www.unfpa.org

Graph :Number of natural catastrophes around the world (milliers) Source : EM-DAT, University of Louvain

Graph :Number of natural catastrophes around the world milliers Source : EM-DAT, University of Louvain

Graph :Number of natural catastrophes around the world US$billions Source : EM-DAT, University of Louvain

2. Environmental risks and climate change • Available (re)insurance data don’t give us a good idea of the climate change that is taking place, for two main reasons : • Consequences of climate change are ambiguous : for ex., hurricanes will decrease in number, increase in average intensity, remain stable in maximal intensity • The most significant consequences of climate change are coming but not yet observable : temperature has not sufficiently increased for significant consequences • For a good climate strategy, it is as much important, to implement active prevention policies aimed at reducing the exposure of the world population to climatic catastrophes than to reduce carbon use : • Even if the world is reducing quickly carbon use, it will be confronted with increasing climatic catastrophes in the coming years because trends are difficult to alter • Moreover, one main source of increasing carbon use, i.e. population and economic growth, will not come to a standstill in the coming years • If the trend toward increasing concentration of world population in the most dangerous areas is not reversed, major catastrophes can be anticipated • These risks would be all the more serious because they would induce pandemics and migrations that may degenerate in armed conflicts for water, foods etc.

Graph :Hurricanes and climate change Maximum speed of hurricane (m/s) Number of violent hurricanes

Graph :Increase of temperature and climate risks Source : Rapport Stern

Whither insurance solutions ? • Pb : ambiguous & potentially systemic risks • An active & rapidly developing market offer

1. Pb : ambiguous & potentially systemic risks • Economic nature of environmental risks • Extreme and progressive risks • Extreme risks : combination of low probability and high severity • Progressive risks : climate change risks are emerging over the long term • Risks for which it is difficult to find willing counterparties • Uncertain definition and frontiers of environmental risks : risk of ambiguity • In most extreme cases, everyone is affected : uninsurability of systemic risk • Risk for which capacities are limited • Underestimation of extreme risks by insured => non willingness to pay • Limited available capacities for potentially unlimited risks => fluctuating price • Concerned insurance Lines of Business • Mostly property insurance : material destructions by flooding and wind : • Houses and cars • Professional buildings and equipments • Threatening liability insurance : legal actions against : • Negligent executives, directors and authorities • Responsibility of carbon producer (climate change) • Emerging life insurance : human destruction by flooding and wind • Mortality risks • Disability risks

Graph :Uninsurability of climate change Source : Stern report

1. Risks that are potentially ambiguous & systemic • Economic nature of environmental risks • Extreme and progressive risks • Extreme risks : combination of low probability and high severity • Progressive risks : climate change risks are emerging over the long term • Risks for which it is difficult to find willing counterparties • Uncertain definition and frontiers of environmental risks : risk of ambiguity • In most extreme cases, everyone potentially affected : systemic risk • Risk for which capacities are limited • Underestimation of extreme risks by insured => non willingness to pay • Limited available capacities for potentially unlimited risks => fluctuating price • Concerned insurance Lines of Business • Mostly property insurance : material destructions by flooding and wind : • Houses and cars • Professional buildings and equipments • Threatening liability insurance : legal actions against : • Negligent executives, directors and authorities • Responsibility of carbon producer (climate change) • Emerging life insurance : human destruction by flooding and wind • Mortality risks • Disability risks

Graph :Detrended Cat insurance premiums Katrina Andrew WTC Source : Lane Financial LLC

1. Risks that are potentially ambiguous & systemic • Economic nature of environmental risks • Extreme and progressive risks • Extreme risks : combination of low probability and high severity • Progressive risks : climate change risks are emerging over the long term • Risks for which it is difficult to find willing counterparties • Uncertain definition and frontiers of environmental risks : risk of ambiguity • In most extreme cases, everyone potentially affected : systemic risk • Risk for which capacities are limited • Underestimation of extreme risks by insured => non willingness to pay • Limited available capacities facing potentially unlimited risks => fluctuating price • Concerned insurance Lines of Business • Mostly property insurance : material destructions by flooding and wind : • Houses and cars • Professional buildings and equipments • Threatening liability insurance : legal actions against : • Negligent executives, directors and authorities • Responsibility of carbon producer (climate change) • Emerging life insurance : human destruction by flooding and wind • Mortality risks • Disability risks

Graph :Number of victims of natural catastrophes Source : SwissRe, Sigma 2/2007

2. An active and rapidly developing market offer • Components of insurance contracts covering environmental risks • Three classical available instruments : • Explicit limits to indemnities : they make all environmental risks insurable • Explicit excesses : they limit the huge moral hazard of environmental risks • Explicit modulation of premiums with regard to the risk exposure : it limits anti-selection, which is prevalent with environmental risks • Necessity to combine the three instruments in a sophisticated manner • Insurance to be complemented by reinsurance • The value added by reinsurance to insurance of environmental risks : • Complementary capacities from more risk tolerant shareholders • Enlarged international pooling for risks whose national pooling is limited • Top expertise on environmental risks (cf. reinsurance models) • A structuring actor for insurance pricing • (Re)insurance to be complemented by securitization • The value added by securitization : • Revelation of pooling dimension not available on the (re)insurance market • Correction of the (re)insurance coverage biases against extreme risks • A complement of reinsurance more than insurance • Optimal pooling of reinsured risks vs insured risks • Because of structuration costs, direct securitization reserved to big insurers

Graph :ILS issued and outstanding Source : SwissRe, Sigma 2/2007

Role of government vs insurance ? • Role of governments around the world • Bad and good reasons to intervene

1. Role of governments around the world • In most countries, natural catastrophes are insured by market insurance (storms, floods, volcanoes, earthquakes, droughts) • Nevertheless, in some countries, government are used to intervene : • In most cases, for organizing the guarantee of a specific national risk : • Floods in USA • Earthquakes in California, Japan, New Zeeland, Taiwan, Turkey • Storms in Florida • More seldom, for organizing the guarantee of all natural catastrophes : • Iceland, Norwegian, Spain, Switzerland, France • Except in France (for households and companies) and in Japan (for households only), the guarantee is supplied by the (re)insurance market (often in the framework of a pool) • France is the only industrialized country where the government intervene directly, by mean of a dedicated public reinsurance company, despite no specific national risk ; characteristics of this public regime are : • An unlimited government guarantee for households and companies • Conditioned by a 50% quota-share with the public reinsurance company • Inducing a huge moral hazard : most houses are now built in flooding areas • Organizing a huge transfer and subsidy system in favor of small subset of insured

Graph :Concentrated and recurring compensations in France 1988 – 2006 Probability of compensation by administrative area (in ‰) Lecture : 75 % of the areas have a probability of compensation lower than the average 1,3 ‰ when 4 % of the areas have a probability larger than 4 times this average Source : FFSA, 2007

2. Bad and good reasons to intervene • Three bad reasons for public intervention • Uninsurability of cat risks • Of course, most dangerous environmental risks are cat risks • Nevertheless, for most cat risk capacities are available and increasing • Equality between inured, independently from their risk exposure • Of course, risk exposures are not always chosen • Nevertheless, not penalizing risky choices increases risk taking (moral hazard) • Short term concerns of market forces • Market does not give the right incentive for long term prevention (cf. carbon use) • In fact, government is more short term oriented than market forces • Why and whither public intervention ? • Three good reasons for public intervention • Blindness of consumers, who underestimate extreme risks, esp. at long term • Limitations and fluctuations of (re)insurance capacities • Systemic dimension included in all the environmental risks • Need for governments to have an incentive to invest in public equipment • Need for a public / private partnership based on : • GAREAT and TRIA philosophy : market is in charge of non systemic losses • Public guarantee given at market price for loans issued for covering excess loss • Objective assessment of risk exposures and losses

Graph :Increasing reinsurance capacities

2. Good and bad reasons to intervene • Three bad reasons for public intervention • Uninsurability of cat risks • Of course, most dangerous environmental risks are cat risks • Nevertheless, for most cat risk capacities are available and increasing • Equality between inured independently from their risk exposure • Of course, risk exposures are not always chosen (cf. inherited house etc.) • Nevertheless, not penalizing risky choices increases risk taking (moral hazard) • Short term concerns of market forces • Market does not give the right incentive for long term prevention (cf. carbon use) • In fact, government is more short term oriented than market forces • Why and whither public intervention ? • Three good reasons for public intervention • Blindness of consumers, who underestimate extreme risks, esp. at long term • Systemic dimension included in all the environmental risks • Limitations and fluctuations of (re)insurance capacities • Need for governments to have an incentive to invest in public equipment • Need for a public / private partnership based on : • GAREAT and TRIA philosophy : market is in charge of non systemic losses • Public guarantee given at market price for loans issued for covering excess loss • Objective assessment of risk exposures and losses

Graph :A pool mode of senior and junior slices Losses Slice financed by issuing a corporate bond guaranteed by the government Slice financed by reinsurance Slice financed by reinsurance and by big insurers Slice financed by insurers Losses’ frequency

CONCLUSION Environmental risks are more and more affecting the daily life of the world currently and this trend will not reverse in the coming years Environmental risks have the potential to become catastrophic and climate change presents a threat for the world from this point of view Insurance markets is able to cover the environmental risks, even when extrem, except when they become systemic at national level Reinsurance and securitization markets are able to offer a complementary cover for environmental risks, even when extrem, except when they become systemic at international level Government intervention should concentrate on systemic risks and avoid to induce too much moral hazard or anti-selection This handling of such a situation requires a public / private partnership based on the complementarities between the different actors : insurance  reinsurance  securitization  government intervention 34

ANNEXE Cercle “La part de risque” 2 avril 2008

Insurance solutions for environmental risks ?