Is Lloyd’s of London Protecting itself from Climate Change?

Lloyds needs to re-evaluate premium pricing and capital requirements.

Who is Lloyd’s?

Lloyd’s of London is the world’s oldest insurance market. It is not an insurance company, rather members can form syndicates, which write insurance business. Syndicates interface with a broker, which place the insurance to the end client. Lloyd’s requires syndicates to hold a certain amount of capital (usually about 40-50%[1], though higher for less diversified syndicates) against the insurance risk they write. In addition, syndicates must contribute to the central fund, which is a mutual pool to cover losses at Lloyd’s after the syndicates exhaust their capital.

Threat to business model

The syndicates at Lloyd’s write all types of insurance, much of which could be affected by climate change. The most obvious one affected is property risk, specifically in areas like Florida which have increased risk of wind and flooding damage. Insurers rely heavily on catastrophe models to price insurance; the largest two providers of such models are RMS and AIR. The models are based on historical data and while they do contain some trend information from recent years, they generally do not project those trends into the future. Furthermore, these models are only highly accurate for more developed parts of the world.

Another threat is due to Lloyd’s’ unique mutual structure. If a few syndicates are not careful in underwriting – of any risk, inclusive of climate change – the mutual pool can be wiped out to fund payouts to policy holders. The remaining syndicates will then need to pay to re-build the mutual pool [2].

Current action

Lloyd’s carefully monitors the risk of its syndicates. Lloyd’s uses Realistic Disaster Scenarios (RDS) to quantify all risks and to help determine how much capital each syndicate must keep on hand. While there are not RDS for climate change in general, Lloyd’s does evaluate windstorms in Florida and Mexico in which it considers recent research on effects of warmer ocean temperatures [3].

Lloyd’s has also been fostering conversations to improve the catastrophe models its syndicates and other insurers rely on. It has backed Oasis, a not-for-profit building an open platform for catastrophe models. Each modeling company is seeking to create the best possible models individually. Proponents of an open platform instead argue that if the best information is shared from each catastrophe model, everybody has access to multiple view-points of risk, and the reliance on the model lessens, allowing for better underwriting of insurance risk. Lloyd’s has actively sought to add more providers to the platform [4]. Separately, RMS partnered with the Risky Business Initiative in an attempt to bring scientific research on expected climate change into its catastrophe model, rather than to rely solely on historical data. [5]

Lloyd’s is also particularly careful with reinsurance. After a scandal in the 1990s, syndicates are limited on how  much reinsurance they provide to other syndicates – generally syndicates are required to go outside of Lloyd’s for reinsurance. While not specific to climate change, this does limit the risk of Lloyd’s to that which is not reinsured or is reinsured within Lloyd’s. However, reinsuring outside of Lloyd’s simply offlays the risk to other parts of the industry, rather than eliminating the risks entirely.

Recommendation

To date, Lloyd’s actions have focused primarily on property and catastrophe risk, which are the most obvious insurance lines to be affected. However, Lloyd’s is a specialty insurer and its syndicates write quite a bit of risk in other areas which are likely to be affected, such as agriculture – which is likely to be affected by changing precipitation patterns – and animal husbandry – which could be affected by regulation as meat production is a large producer of greenhouse gases. Lloyd’s should investigate potential impacts to these areas and determine how to write policies to mitigate some of the risks of climate change as well as appropriate prices to charge as premiums as the risks change.

Lloyd’s should also reevaluate the amount of capital it requires its members to hold against premiums written. Infrequent catastrophes are becoming more frequent, and climate change has the potential to increase rapidly. Given the heightened level of risk, Lloyd’s should increase the amount of capital required in order to ensure it will be able to continue to pay its liabilities. Lloyd’s currently adds an “uplift” to the capital requirement determined through the RDS process. It should start simply by increasing the uplift. At the same time, it can evaluate how climate change will impact its RDS, as it would be better in the long run to include the capital requirement of writing business affected by climate change main evaluation process rather than simply through an uplift.

Word count: 771

 

[1] Lloyd’s of London Corporate Website

[2] Ibid

[3] Ibid, see “2016 Scenario Specifications.”

[4] Insurance Business Mag: http://www.insurancebusinessmag.com/uk/news/breaking-news/lloyds-and-lma-announce-groundbreaking-deal-37958.aspx

[5] RMS press release: http://www.rms.com/blog/2014/06/24/rms-and-risky-business-modeling-climate-change-risk/

 

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2 thoughts on “Is Lloyd’s of London Protecting itself from Climate Change?

  1. Margaret – I agree that insurance companies such as Lloyd’s need to think more defensively to adapt to the broad-sweeping impact of climate change on many of their offerings. Said another way, I see three areas of the value chain that are at risk for insurance companies: products and services, liquidity and capital management, and investments. You very astutely pointed out how Lloyd’s should reevaluate its capital requirements for such its products and how Lloyd’s has invested in updating and optimizing their catastrophe models to take climate control into account.

    However, one area that I think Lloyd’s can do better in is expansion of its products and services to adapt to climate change needs. For example, in this 2012 Science paper, “The Greening of Insurance” (http://evanmills.lbl.gov/pubs/pdf/science-2012-mills-1424-5.pdf), we can see potential for insurers to underwrite climate change mitigation technologies to align policyholders to lower-risk behavior, which is another approach to reduce the risk exposure that Lloyd’s is subject to through its P&C insurance business line. Granted, there is limited operational history to properly quantify, for example, the impacts of pay-as-you-go insurance backed by telematics technology, but insurance companies of Lloyd’s size and clout can have major power to influence public policy by accepting these innovative climate change mitigation strategies into its product line.

  2. Considering the insurance industry is well accomplished to assess all the risks impacting an asset prior to issuing insurance, I would think that the market be pricing in climate change risk. For those who may think that the threat is too new or too uncertain for insurers to act, there are plenty of climate models that capture the essence of the perceived climate risks the world is facing — enough, at least, to regulate global policy. I would offer that with this information in hand, the insurance companies are already pricing in the risks of climate change and that the market has deemed that risk to be low in the near term.

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