Climate change main risk to the industry

By Hubert Roy | June 27 2008 02:49PM

Climate change is the biggest threat looming over the insurance industry, putting both life insurance and property and casualty insurance at risk. These sectors must also adapt to emerging demographic shifts.

These findings come from a study conducted by the firm Ernst & Young in cooperation with Oxford Analytica. Ernst & Young produced a list of the ten main threats that insurers will have to face, after having surveyed over twenty industry executives around the world.

The firm’s report finds that climate change poses the most serious strategic threat to the industry because global warming is altering the climate, which increases the probability of losses linked to floods, hurricanes and other natural phenomena.

“I’m not sure that the industry is ready to face climate change,” warns Tom Kornya, associate at Ernst & Young, interviewed by The Insurance Journal. “Five years ago, this risk wasn’t even on the list.”

Mr. Kornya adds that property and casualty (P&C) insurance is not the only sector that will be affected by climate change. Life insurance will also have to factor in this risk sooner or later.

“In P&C insurance, climate change will trigger wind storms and floods. In life insurance, the consequences will be gradual. The risk of changing temperatures will create new health and mortality problems in life insurance. This may lead to different types of losses.”

“Risk selection for these products is evolving significantly, and no one has calculated the effects climate change might have. The success of the industry will hinge on development of innovative products, as the industry faces greater uncertainties over factors such as striking speed and the severity of climate change,” he continues.

The second risk the industry must face is demographic change, given the imminent retirement of the baby boomers, which will create new needs. Insurers may experience strong pressure to step into a role previously played by the government.

“It’s a risk for insurers but also a formidable opportunity,” Mr. Kornya points out. “Demand for retirement products will grow. The baby boomers will seek low cost, income generating products. However, the debate over the role of the government in pension plans is practically in its infancy. Insurers will be asked to take over, and this is a new risk that they are not used to.”

In addition to pressure generated by this new role, insurers must also deal with competitors. “Banks, mutual fund companies and all the financial institutions will be battling it out for the same dollar. There’s a risk there as well. Insurance companies must keep their products innovative if they want to maintain their edge,” Mr. Kornya adds.

Insurers must also contend with the increase in costs related to catastrophic events, which may influence their net result and capital. Burgeoning emerging markets could also be a double-edged sword. Although these markets represent a business opportunity for established players, they might also unleash a horde of new players in the industry.

Regulation and technology

Ernst & Young believes that new regulations and tighter monitoring may trigger changes in pricing practices. Increased pressure from securities markets may also have serious repercussions if these markets are not watched closely.

The Internet is another risk to insurers. Companies with multichannel access to sales and information could enjoy a competitive advantage. Ernst & Young points out the risk of failure to integrate technology, operating activities and strategy.

“Insurers’ environment is constantly and rapidly changing,” Mr. Kornya says. “Some consumers are seeking simple, low cost products, while others want complex products that also cost more. A company without multichannel access may fall behind if it does not use the Internet, the media and telephone.”

The last two threats that make Ernst &Young’s list of the ten main risks are legal uncertainties and the potential for geopolitical or macroeconomic shocks. In legal terms, liability and tort reform could cause financial losses. As for shocks, the firm mentions that the threat of a serious financial crisis sparked by derivatives and hedge funds could hamper the industry.

Five other risks

Ernst &Young adds five risks that could emerge within the next five years. The first is over-reliance on model-based risk management, whose validity erodes over time. The second risk is to the industry’s reputation. Ernst &Young cannot rule out the possibility of an Enron-type scandal. This is why the industry must adopt good governance and internal controls, because public scrutiny of the industry should grow in the coming years.

The industry must not lose the war for talent, the firm says. “As the environment becomes more complex, the industry is struggling to attract personnel of the necessary calibre and, in many markets, has low levels of technical skill and managerial competence and probity,” the Ernst &Young report explains.

The entry of insurers onto new markets may also pose a challenge related to regulation. “What happens when a firm has significant markets in 30 or 40 countries at varying levels of development and with very different regulatory traditions?” the report continues.

On top of that, entirely new risks might emerge. “It is inevitable that new risks will emerge that insurers have failed to predict or price accurately. These may be risks affecting human life or health… pandemics or, possibly, risks that will affect property insurance portfolios,” the report says.

All the same, Mr. Kornya says he thinks insurers are well positioned to face all the risks stated on the list, both in Canada and in the rest of the world.

“The Canadian industry must face the same risks as the global industry. It can also capitalize on the same opportunities. The Canadian industry has always been strong and competitive. In addition, many Canadian players operate very well on the global arena, which is already an advantage for them.”

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