At the mercy of the elements?

It is hard to break the habit of a lifetime and when your life has been spent looking backwards, analysing the past and dealing in quantifiable events, it is no easy task to suddenly have to make strategic decisions based on an uncertain future with no guarantee that current predictions will become reality. But this is the very challenge that the insurance industry faces in trying to prepare for climate change.

How useful are the industry's trusted claims histories on natural catastrophes if future weather patterns are likely to bear little resemblance? Change would not be so hard to factor in if insurers knew exactly what to expect.

But there are no guarantees. Yet, without action now, and without some sort of provision, the impact could be disastrous. UK insurers can take little comfort from some of the future scenarios being painted for our island: a month's rainfall in 24 hours; flood levels that currently occur once a century set to inundate the land once every three years by 2080; and a multi-billion-pound property damage bill hitting the industry's doormat every year.

So should the industry employ the wait-and-see approach, or should it take immediate action? Peter Staddon, head of technical services at the British Insurance Brokers' Association, is a supporter of fundamental change: "It is, in my simple opinion, essential that insurers should work with researchers to establish potential problems and seek to construct some sort of central fund to build up reserves."

A pooling arrangement is, of course, a fairly drastic measure usually reserved for the type of losses that are so unpredictable and potentially catastrophic that the ability to rate risks normally has ceased to exist.

Terrorism is the obvious example. Many may find it hard to believe that the threat of climate change is so immense. But then again, it was the government's own chief scientific adviser Sir David King, who earlier this month declared climate change a more serious threat to the world than terrorism. If this view is widely held, perhaps a central fund is the appropriate solution and should be given due consideration?

Flood-impaired risks market

Insurers, however, are not rallying to Mr Staddon's call. "I would not support such a fund at this stage - we are nowhere near that situation," says Paul Chaplain, underwriting director at Fortis. "There even remains a market for flood-impaired risks. My feeling is that the free market will prevail and be able to provide solutions in most cases."

He adds that establishing any kind of pooling arrangement also introduces a moral hazard, which would undermine insurer efforts to dissuade development in high-risk flood areas, for example. "It could encourage a mentality that people are free to build anywhere they like because they will be able to get cover, which is not helpful."

Not only do insurers believe that a competitive market still exists for weather-related covers but they point to their current ability to still secure reinsurance protection. "If reinsurance ever reacted to global warming and climate change in the same way it has reacted to terrorism - that is, taking cover away, saying it can't price the risks - then that would be the time to start talking about a central fund or pool," says Steve Wilcox, household and travel manager at Axa.

It is not just insurers that seem unconvinced about the value a central fund would bring. "Wouldn't that stifle innovation from individual insurers?" asks Steve Dorling, senior lecturer at the University of East Anglia's School of Environmental Sciences. "I think it would penalise those insurers putting sensible measures in place. What incentive would there be for insurers to go forward with their research and risk evaluation work if everyone's going to get bailed out through a central fund?"

Although a pooling arrangement does not appeal, UK insurers are suitably concerned by climate change and the impact it will have on frequency and scale of flooding, storm and subsidence claims. The general consensus that the future will bring milder wetter winters and longer drier summers, caused by global warming from greenhouse gas emissions, is now taken as fact rather than scaremongering.

Does this mean UK insurers are already making amendments to their rating structures, enabling them to put aside more money and bolster reserves? "We have seen a greater variation in weather events that are out of step with recent history," confirms Steven Ward, household manager at Allianz Cornhill. "As an insurer, we try to take this into account when setting rates to ensure we collect sufficient premium to meet the cost in poor years."

But he explains that this does not mean significant alterations are currently being made to the balance between funding for predicted annual claims and those that are event-driven, which produce a greater impact. Mr Ward refers to a 90:10 ratio, the smaller portion typically set aside to fund any significant weather-event claims. However, he adds that this is under constant review and could move to an 80:20 split if the 'bad' years began to grow significantly in proportion.

"It is too early to say we are revising our rating structure because of global warming effects and, to be fair, I don't think we will get there until after 2010," agrees Mr Wilcox.

Restraining factors

Even if UK insurers were all intent on re-pricing property insurance cover immediately to bolster reserves, Arthur Philp, underwriting policy manager at Norwich Union, identifies two restraining factors on taking such steps. "Not only are we constrained by having to operate in such a competitive market, but we can't even establish larger reserves for tax reasons." Equalisation reserves, he explains, are limited because tax is not paid on such reserves until they are brought out of equalisation.

Mr Philp believes insurers will only react in terms of pricing when claims associated to climate change begin to bite. He compares it to the rating reactions following the devastating storm of October 1987 and a series of severe storms in the early 1990s. After the 1987 storm, he said rates rose from 16p for every £100 insured to 18p. This further increased to 20p and 22p after the storms of the early 1990s. "Competition since then has forced rates down again, back to around 16p-18p."

But it is this continuing price competition that climate experts are warning against. "The threats posed by climate change are consistent with the general need for rises in premiums and it would seem increasingly irresponsible for insurers to consider continuing to undercut each other," says Mr Dorling.

UK insurers are busy conducting research to enhance their own understanding of realistic future climate scenarios, impact on claims and potential mitigation measures. Halifax General Insurance has sponsored several research projects including one with Cambridge University into coastal settlements at risk of flooding and one with Dundee University into the susceptibility of different property types to flood damage.

Internally-focused strategies

Others, including Axa and Zurich, are looking within their own company groups for ideas and experience-sharing at home and overseas. For example, Zurich has pursued an internally-focused strategy to better identify and manage exposures across the board, according to Larry Stokes, underwriting manager of its public sector arm Zurich Municipal: "There has been a lot of research this year on bringing together data from each part of the group to create a global information system."

Of course, global warming is not all about negative effects. In terms of the insurance industry, milder winters could reduce the number of freeze claims such as burst pipes. But it is here that some of the consensus stops. There are emerging indications that the UK may lose the warming effects of the Gulf Stream, as the Arctic ice caps melt, resulting in rapid cooling of the UK and north-west Europe.

This issue was flagged up in Benfield Hazard Research Centre's latest newsletter Alert. Recent findings have revealed a dramatic fall in salinity in the North Atlantic, with the worry that the drop in density would hinder or prevent the return of cold, dense water and slow down or shut off circulation.

According to BHRC, for some years, global climate models have predicted a weakening of the Gulf Stream as a consequence of global warming and the whole process may have already started.

Without the warming effect of the Gulf Stream, scientists believe the temperature in the UK and north-west Europe would be 5 deg C cooler with bitter winters. Although it remains impossible to say when we may lose the warming effects, BHRC states that it is "likely to be very rapid - possibly taking just five to 10 years" and that the effect could be "devastating". However, as yet, there is no consensus on this.

Perhaps even more worrying is the significant degree of uncertainty surrounding future changes to the windstorm pattern. In the last 50 years, three-quarters of the UK's insured losses due to natural catastrophes have been caused by windstorms. Predictions are that future wind speeds will increase by up to 6% for most parts of the UK, with southern England bearing the brunt and design standards for new properties, therefore, being essential.

So what lies behind these predictions? "The key driver appears to be movements in the position of blocking high-pressure areas," explains Jane Milne, head of property at the Association of British Insurers. "Currently, typical winters see a large blocking high over the Alps, diverting storm tracks to the south of Spain and north of Scotland. Some scenarios see a shift in this, so that storms may come over south England more often. Whereas buildings in areas traditionally affected by these storms are built to resist them, our buildings are not."

The ABI has long been lobbying for improved building standards that would mitigate the increased damage threats from windstorm and flood. Ms Milne explains that the trade body's windstorm research, carried out by the Building Research Establishment, has already been put to the government.

"A review of building standards is due this year and we see this work as very much part of the evidence of our contribution to that process." However, she warns that the process will be slow - taking a year or longer.

"The government has certainly taken on board the need to look at flood resilience, but wind has never been on the horizon before." She explains that although windstorm damage may cause the greatest insurance losses of all natural catastrophes, this is obviously not a card that can be played when trying to persuade government to change policies. "If we did articulate in terms of insurance profit or loss, we could not expect much sympathy - we must always approach things from the perspective of the consumer."

Professor David Crichton, research consultant and visiting professor at BHRC, believes that a claims database on windstorm damage would provide much-needed support for the industry's campaign (see p25). "This would be very good ammunition to lobby government over improving building standards. I have had talks with one university that is very good on building standards and is quite interested in taking such a project on - providing there is a readiness on the part of the insurance industry."

Building strategies

Faced with the current long, slow process of government review of building standards, he also suggests stealing a leaf out of Australia's 'blue book' and taking the matter into the industry's own hands. "Insurers and banks there have agreed on a set of building standards for certain properties and owners can't get a mortgage unless construction meets these standards," explains Professor Crichton. "They are much higher than the government's own, which are ignored by builders, who use the insurer/bank guidelines instead."

But Ms Milne believes such an initiative would be impossible in the UK. "The advantage Australia has is that it is not subject to European Union competition laws or block exemption rules," she explains. "It is actually quite prescribed what UK insurers can do in terms of acting together to 'force' things to happen. We can, however, do a lot to 'encourage' change."

The ABI and the wider industry continue to lobby on various flood issues such as resilient building techniques and informed planning decisions, with the Thames Gateway development continuing to be a major concern.

There has been some noticeable improvement in the planning policies of local authorities, with many now accepting the serious consequences of building on inappropriate sites - although some are better than others, according to Ms Milne. "We do not want to usurp democratic processes, but do consider that whether a building is insurable or not should be a material factor in considering a development consent." After all, it is no good increasing the housing stock to meet demand if the owners of resulting properties cannot secure mortgages on them because they are effectively uninsurable.

But some insurers are still unhappy about the flow of information from the Environment Agency. "A lot of defence projects are under way, but it is very difficult for insurers to find out about the progress and specifications of these defences," says Adrian Webb, head of communications at Esure.

"We turned down one man from Melton on the basis of maps available, which still showed the area as highly vulnerable. He then produced a local press cutting showing that the nearby dam had been opened. Therefore, we were able to re-rate the whole area on the basis of this information."

As a result of numerous examples of similarly out-of-date information, Esure is calling for the website to be updated continually, with details of defences completed; projected dates of completion for those under way; details of demountable defences, as well as permanent structures; and what the resultant return period is for the surrounding area.

But Ms Milne believes the EA has made great progress in terms of important information supply to insurers: "The Environment Agency is now publishing monthly updates of where it has objected to development applications on flood-risk grounds and we see this greater transparency as enabling insurers and members of the public to give their views during the planning process." For example, 92 objections are logged on the first such bulletin for applications between 1 and 30 November 2003.

Of course, all the policies and campaigns detailed above suggest insurers can only ever be reactive when it comes to climate change impact and issues. This is far from the truth. There is now a golden opportunity for the industry to take a fundamentally proactive stance - and actually help reduce the long-term impact of global warming. "We believe that in order to mitigate real climate change risk, insurers could do more to support renewable energy technology and the risks associated with the emissions trading market," says Tom Sexton, vice president of Marsh's marine & energy practice. "Not only could this hopefully reduce the effects of climate change, but it would bring more premium into the market." The global broker is currently developing insurance products to support both the renewable energy industry - such as offshore wind farms - and the emissions trading market, due to take off over the next year.

The EU's emissions trading scheme (see p25) becomes operational in 2005 and Marsh is working on developing products that could support this. Only last week, the government revealed plans to cut Britain's carbon dioxide emissions by 20% by 2010 - a reduction nearly double that required under the Kyoto protocol.

All installations within the scope of the scheme are required to have a permit by 31 March, having submitted their application by the end of this month. Tough targets indeed, but emissions trading gives companies the flexibility to meet targets according to their own strategy. By allowing participants to trade in allowances, overall emissions reductions are achieved - cutting pollution from greenhouse gases - in the most cost-effective way.

Credit in the future

Such trading involves a lot of contracts, explains Warren Diogo, climate change specialist at Marsh, about delivering a certain amount of credit in the future and there are risks inherent in being able to deliver at specified dates that need to be managed.

At the end of the day, it is the continuing unpredictability of what could happen and when, regarding climate change, that is of most concern to UK insurers. But two major projects are under way that could provide some much needed clarity that insurers must keep an eye on. Stardex began in February 2002 and will run until the end of July 2005. Funded by the European Union, Stardex is a collaboration between several different European research groups, focusing on the extremes of climate and how they are changing in frequency. As such, the project's work and findings will be highly relevant to the insurance industry.

It is primarily responding to the growing demand for scenarios with higher and higher spatial and temporal resolutions and a need to reduce the uncertainties associated with climate change scenarios. The challenge in climate modelling has always been to build a model reliable enough in terms of predictions about important weather perils changing in frequency and intensity. The project will test both the robustness and predictive quality of various models. Secondly, there is the UK's own Foresight project, which is taking a long-term look at the issue of flood and coastal defences (see box). Feedback is due in April.

Referring to the Foresight project, Professor Crichton says: "It is very refreshing to see the government looking so far ahead, but that does not negate the need to take action now regarding planning and building standards."

This warning is echoed by Mr Dorling's own, which is directed at all stakeholders: "If people don't keep on top of climate change and make plans, the pace may be enough for all concerned to fall behind in their response."