Rate-induced climate tipping points pose new threat to exposed insurance markets
It is often argued that insurers can manage climate change risk simply by using the annual policy cycle to reprice and rebalance portfolios. WTW’s Cameron Rye considers what happens if the rate of change is too fast…
The Intergovernmental Panel on Climate Change defines a tipping point as “a critical threshold beyond which a system re-organises, often abruptly and/or irreversibly”.
Scientists have identified at least 15 potential climate tipping points, including rainforest dieback, ice sheet melting and the thawing of permafrost. Climate tipping points increase economic risk globally and there have been recent warnings that if insurers do not account for these thresholds in their scenarios, they will be underestimating their exposure to climate change.
Scientific research tells us that when it comes to generating tipping points, the rate of change in external forcing can often be more important than the absolute change. This is because when an external forcing is applied to a system, it usually responds by adjusting to find a new equilibrium.
But if the rate of change of the forcing is too rapid, the normal balancing forces that keep a system in check cannot keep up. This is known as rate-induced tipping.
As the global mean temperature increases, the Earth’s system adjusts to achieve a new equilibrium. However, if the temperature changes too quickly and causes the system to deviate significantly from the equilibrium, rate-induced tipping can occur. In other words, increasing temperatures too quickly can cause climate instability.
An example from the climate system is the Atlantic Meridional Overturning Circulation (AMOC), which plays a crucial role in redistributing heat and salinity across the Atlantic Ocean.
Paleo records have long indicated that an increase in the amount of freshwater flowing into the North Atlantic – such as from melting glaciers – can lead to a threshold being crossed that causes an abrupt slowdown of the AMOC. This would have significant consequences for regional temperature, wind and precipitation patterns. However, recent research suggests that the rate of freshwater increase also matters; if it's too fast, the AMOC could destabilise and collapse even before this threshold is reached.
Market tipping points
Insurance markets are particularly vulnerable to rate-induced tipping because they are at the forefront of dealing with the impacts and uncertainty of climate change. If the costs of extreme weather claims increase, it will often not take long for these expenses to be reflected in the price and availability of insurance. If the change is gradual, then insurers and consumers can easily adjust over time. But if the change is too fast, there is a risk of market dislocation.
Despite this risk, most insurers are not yet considering rate-induced market tipping in their climate change scenarios. This oversight could be because it is frequently assumed that the annual policy cycle can be used to gradually reprice and rebalance portfolios over time as climate change progresses.
The problem with this strategy is that it implicitly assumes that the rate of change will be manageable and that traditional strategies used to adjust exposures – such as limiting risk, increasing premiums and transferring risk – will be available and sufficient to restore balance.
But some warning signs are already starting to emerge. Insurance costs have been increasing rapidly in recent years due to a number of expensive disasters, growing concerns about climate change and above-average reconstruction inflation.
This has created a particularly challenging market for primary insurers, which have been struggling to secure sufficient reinsurance for their riskiest exposures.
This scenario is made all the more challenging by uncertainty. Where there is ambiguity in the magnitude of the contribution of climate change to increasing claims, for example due to the lack of enough historical data to detect a statistically significant trend, insurance markets are susceptible to contagion.
Small behavioural changes could accumulate until there is a moment of critical mass. In other words, if the concerns about the future impacts of climate change grow large enough, rapid changes in insurance markets could happen over a short period of time, inducing tipping points before the actual impacts are fully realised.
Trend risk scenarios
The real question for insurance companies is how to assess the risks from rate-induced tipping points. One option is to use trend risk scenarios. Trend scenarios were first pioneered in the 1970s by Pierre Wack, who led the scenario analysis team at Royal Dutch Shell to analyse how the rate of change in a variable, such as market volatility, influences business outcomes.
The same approach could be used by insurers to explore the implications of rate-based changes in weather-related claims and potential thresholds at which market dislocation could occur.
To be useful for decision-making, these scenarios should focus on individual insurers’ exposures, business models and objectives. One way to conduct such an exercise is via a normative (or reverse stress test) approach, which would allow an insurer to first specify an undesirable rate of change that is relevant for their business, before then exploring the different ways in which that change may materialise.
Incorporating rates of change into insurance decision-making has the potential to revolutionise the way that many firms think about, analyse and manage climate change risks. As a result, it is vital that insurers begin to explore the potential risks posed by rate-induced tipping in both physical systems and insurance markets.
Cameron Rye is head of modelling research and innovation at WTW Research Network