Who Insures the Insurers? Hopefully, Themselves.
How is AIG, one of the world's most famous insurers, insuring its own exposure to the severe weather events that accompany global warming?
What does climate change have to do with insurance?
American International Group, better known by its acronym AIG, is infamous for its 2008 government bail-out that eventually reached a tax-payer price tag of $185 billion [1]. But having recovered from its questionable underwriting practices in the mortgage backed securities industry, AIG’s next challenge comes from an altogether different realm – global climate change.
As early as 2011, AIG recognized climate change as a threat to the broader insurance industry – citing a fifteen times increase in insurance payments related to climactic weather events, including hurricanes, tornadoes, floods, and severe storms [2]. According to the United States’ Environmental Protection Agency, climate change in the form of global warming has caused ocean temperatures to rise, leading to increased rates of evaporation. As a result, the warmer, more humid air increases the likelihood of severe weather events occurring [3]. North America, where AIG is based and derives 76% of its insurance premium revenue, is considered to be of particularly high risk for increased severe weather activity [4]. The Gulf of Mexico’s warm waters incubate convection events, and because North America lacks an east-west mountain range, there is nothing to block humid air from the Gulf of Mexico from clashing with cold, dry air from Canada [5].
Surely AIG has thought of this!
AIG has taken a number of steps to mitigate the risks climate change poses to its insurance business. In general, they fall into two distinct categories. In the first category, the company has taken steps to better price climate change into its risk premiums. AIG is working with climate scientists to develop forward-looking projections of the ways in which climate change may affect weather patterns in the future [6]. Using these models, AIG hopes to more accurately account for its insurance risks than if it continued to use models based on historical weather patterns. Similarly, AIG is beginning to change its underwriting policies to incentivize critically exposed markets to build resiliency against severe weather events, such as storm-proofing buildings in coastal areas [7]. And finally, and perhaps most inefficiently, AIG has simply had to raise premiums in high-risk areas and hold larger capital reserves against those policies [8].
The second category of mitigation steps AIG has taken generally take a longer-term perspective in reducing or mitigating the rate of climate change itself, rather than attempting to minimize its impact on AIG’s primary businesses. For example, AIG has subsidized insurance premiums to companies that promote clean and efficient energy practices in an attempt to reduce the burden these business place on the environment. AIG has also supported research on climate change and weather patterns, both to better understand the mechanisms of climate change and to better anticipate the continued effects it will have. Finally, AIG and its many subsidiaries have taken steps to reduce its own contributions to global climate change. Both AIG’s Hong Kong and Zurich office complexes were redesigned to be more “green” by establishing a reduced carbon footprint, and AIG has invested in numerous climate-related projects such as forestry assets, renewable energy sources, greenhouse gas mitigation technologies, and energy-efficient real estate practices [9].
On the other hand…
Thus far, AIG has done its homework to come to terms with the likely impacts of climate change. It has even begun taking some preliminary steps to isolate itself from the new risks that climate change may one day pose to its business model. But to truly prepare itself for the future, AIG needs to go further. For one thing, it needs to further diverse its business geographically. As mentioned, 76% of AIG’s revenues are derived from the United States. One of AIG’s key advantages is that it is the largest US property and casualty insurer in both Europe and Asia [10]. The company needs to leverage that advantage and focus its growth on those continents in the coming years. Because countries in these regions are less susceptible to severe weather events, and because of the geographical separation, expanding into these areas will provide diversification to AIG’s policy assets. Equally important, AIG needs to diversify geographically within the United States itself. In 2015, 11.4% of AIG’s property insurance premiums came from businesses located in the states of California and New York – both coastal and susceptible to extreme weather events [11]. Though this concentration of premiums in those two states is likely dictated by the sheer number of businesses operating in those states, AIG needs to take steps to either diversify that risk by expanding into other states or hedging its exposure to those particular states through financial derivatives. By diversifying the geographic risks AIG faces, it will help insulate itself from the damages of climate change – perhaps this time without the need for capital injections from the US Treasury.
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References:
[1] Scism, Leslie. “Former AIG Chief Hank Greenberg Wins Moral Victory in Bailout Trail.” June 15, 2015 http://www.wsj.com/articles/judge-rules-in-former-aig-chief-greenbergs-favor-in-bailout-trial-1434384756. Accessed November 1, 2016.
[2] American International Group. http://www.aig.com/content/dam/aig/america-canada/us/documents/business/industry/ipg-real-estate-climate-change-paper-brochure.pdf. Accessed November 1, 2016.
[3] Environmental Protection Agency. “Understanding the Link Between Climate Change and Extreme Weather.” https://www.epa.gov/climate-change-science/understanding-link-between-climate-change-and-extreme-weather Accessed November 1, 2016.
[4] AIG 10-K p8 http://www.aig.com/content/dam/aig/america-canada/us/documents/investor-relations/december-31-2015-10k-final.pdf
[5] Hedde, Carl. “US Natural Catastrophe Update.” January 4, 2012. https://www.munichre.com/site/mram/get/documents_E1746699606/mram/assetpool.mr_america/PDFs/4_Events/munichre_iii_2011natcatreview.pdf. Accessed November 1, 2016.
[6] American International Group. http://www.aig.com/content/dam/aig/america-canada/us/documents/business/industry/ipg-real-estate-climate-change-paper-brochure.pdf. Accessed November 1, 2016.
[7] American International Group. http://www.aig.com/content/dam/aig/america-canada/us/documents/business/industry/ipg-real-estate-climate-change-paper-brochure.pdf. Accessed November 1, 2016.
[8] American International Group. http://www.aig.com/content/dam/aig/america-canada/us/documents/business/industry/ipg-real-estate-climate-change-paper-brochure.pdf. Accessed November 1, 2016.
[9] American International Group. http://www.aig.com/content/dam/aig/america-canada/us/documents/business/industry/ipg-real-estate-climate-change-paper-brochure.pdf. Accessed November 1, 2016.
[10] Securities and Exchange Commission. “Form 10-K, American International Group, Inc. for the Year Ended December 31, 2015” http://www.aig.com/content/dam/aig/america-canada/us/documents/investor-relations/december-31-2015-10k-final.pdf. Accessed November 1, 2016.
[11] Securities and Exchange Commission. “Form 10-K, American International Group, Inc. for the Year Ended December 31, 2015” http://www.aig.com/content/dam/aig/america-canada/us/documents/investor-relations/december-31-2015-10k-final.pdf. Accessed November 1, 2016.
Very thoughtful post. I agree that AIG is adding systemic risk (again) by concentrating its portfolio in the US. It’s possible that AIG is reinsuring some of this risk and perhaps that reinsurer is helping spread risk in the system, but nonetheless, AIG can take some steps itself.
AIG’s mitigation against climate risk falls squarely in the “maximize profit” framework – improving pricing methodology, incentivizing insured to build resiliency, and increasing premiums all improve AIG’s bottom line. Given this approach, AIG also has room to expand into the carbon credits business to support some of the cap-and-trade rules in Europe. For example, AIG could potentially insure against the failure of a project to generate carbon reductions. AIG could also provide brokerage services to AIG’s clients that have compliance obligations. Perhaps this will not only impact AIG’s bottom line, but will also help them diversify away from geographic concentration risk in the US while still taking a stand to mitigate the risks of climate change.
Very informative! I agree with you that simply raising insurance premiums is not going to help combat the future risks. I’m interested to learn more about how AIG is helping the exposed areas -such as those in the Gulf Coast – build more resiliency and protection against severe weather events. Should it be the AIG’s or the government’s responsibility to help these areas that are at “high risk”? Or both? Also, I agree with you that investing in derivatives is a great way for insurance companies to hedge its underwriting risks [1]. One thing that is no mentioned here is AIG’s potential financial exposure to companies that are at high-risk of climate change, such as Oil and Gas industries or large producers of industrial carbon emissions. As most insurances companies invest their premiums from clients back into the market, one way for AIG to diversify its risk is to reallocate its investments into green-tech or alternative energy companies.
[1] http://www.naic.org/capital_markets_archive/110715.htm
Great post. I also wrote about the effects of climate change on the insurance industry and it seems like AIG is well positioned to tackle the risks associated with climate change. From the articles I’ve read, it seems that the big insurance players are applying the same strategies to address climate change: 1) improve pricing of risk premiums 2) offer products that help mitigate the effects of climate change.
I like your suggestion of diversifying the business geographically (away from US coastal regions and more in Europe and Asia). In fact, according to Swiss Re sigma, 6 of the 10 most costly weather-related catastrophes for the insurance industry occurred over the past two decades. And 5 out of 6 of these events occurred in the US– Hurricanes Katrina, Andrew, Ike and Ivan, and Superstorm Sandy flood – and resulted in $200 billion in insured losses. [1] Diversification of geography is a great way to mitigate these risks!
[1] Ace Group. 2015. ACE Group Environment Report 2015. [ONLINE] Available at: http://www.acegroup.com/assets/attachments/ace-group-2015-environmental-report.pdf. [Accessed 2 November 2016].