More frequent or severe extreme weather events and/or a late and abrupt transition to a low-carbon economy could have significant impacts on the financial system, with potential systemic consequences. Extreme weather events could lead to damage of physical assets, including real estate, productive capital and infrastructure, and loss of life with consequent property and casualty insurance losses, damage to balance sheets of households and firms, increases in defaults, and potential financial sector distress. A late and abrupt transition to a low-carbon economy could lead to a sudden repricing of climate-related risks and stranded assets, which could negatively impact the balance sheets of financial institutions....
Real estate and agriculture suggest themselves as sectors that are both particularly important and more immediately exposed to physical impacts of climate change, which could affect banks and insurers exposed to these sectors on both the asset and liability sides of their balance sheet. Furthermore, as physical risks rise or become more unpredictable, insurers will most likely increase premiums or stop insuring some risks. The implied decrease in coverage leads to increased uninsured losses (‘protection gap’) in case of a catastrophic event which could negatively impact the collateral value of properties, leaving banks exposed to credit risk. Understanding the trends in insurability, the cost of insurance, the protection gap, and their spillovers to the banking sector and the economy more broadly is an important direction of research. This requires an analysis of insurers’ role and behaviour, including the effectiveness of the catastrophic risk market. (p. 4) "The Macroeconomic and Financial Stability Impacts of Climate Change Research Priorities," June 2020 NGFS: Central Banks and Supervisors Network for Greening the Financial System[HT Anne Kervers]
The "NGFS Technical document" quoted above is worth reading because, while it names no names, it is a forthright exploration of the limitations of existing scientific approaches to understanding the impact of climate change on the financial system and it contains several calls for more research in lots of areas that have become politically and morally salient. Here I am interested in using it as a granular, but useful window into what we may call the central bankers' consensus view about how to think about the significance of climate change to their jobs. So, before I get to insurance and reinsurance, let me just provide a two paragraph summary of that.
What is immediately noticeable is that the central bankers view their job as handling, that is anticipating and mitigating, the impact of "shocks" to the economy. And it is quite clear that they view the economy as a kind of autonomous system with a trendline, and their role is to mitigate and ameliorate the deviations to that trend line caused by shocks external to the trend line. Behind the fancy language we can still discern the idea that ordinary "fluctuations in economic activity are seen as the result of small, white noise shocks-impulses-that affect the economy through a complex dynamic propagation system," (127) and that major fluctuations have to be understood in terms of large demand or supply shocks.*
Crucially, in the central bankers' perspective, "demand shocks are typically manageable from a monetary policy perspective, [while] supply shocks are generally more challenging as they generate a trade-off for central banks between stabilising inflation and stabilising output fluctuations." (6) The significance of climate change is viewed through the lense of a destabilising series of supply shocks that potentially overwhelm monetary policy. Strikingly, in the report this is viewed as a danger to the central banks' ability to fight inflation (6-9). Somehow, and this is remarkable in light of recent experience, the risks to deflation are apparently not worth noting at all.**
There is, of course, plenty be said about the utility and normative significance of treating the economy in terms of deviations from a trendline, but let's turn to quoted passage(s). The first thing to notice is that the 2020 report highlights insurance and reinsurance. I noticed it before looking at last year's report, which is longer (and more detailed engagement with scientific literature); there insurance and reinsurance are entirely absent. Second, central bankers admit that from their perspective, at the moment, some of the best research on the effects of climate change on the economy is taking place in the insurance world, especially, I gather, integrating climate modelling with economic and geographic analysis. ("To this end macroeconomic modellers could borrow well-advanced methodologies used by (re-)insurance firms to quantify the economic impact of physical risks from extreme weather events, including spatial analysis.") I know nothing of this research, but will try to learn about it before long.
Third, the central bankers explicitly worry that in light of climate change insurance and reinsurance (henceforth when I use 'insurance' and its cognates I mean both insurance and reinsurance) will become more expensive and, subsequently, cover less of economic activity. I think they are identifying a number of distinct concerns. And it may be useful to list them. [I] If insurers misjudge the underwriting risks because they are now in the realm of true uncertainty ["unpredictable"], they may go bankrupt. Since historical data are becoming less useful, underwriting is becoming more art than science reliant on the sensitivity to assumptions in complex modeling. If major insurers cannot pay out, or are perceived not to be able to pay out, then significant bits of the financial and real economy are exposed to serious damage [" financial sector distress."], if not collapse. Since AIG this is not just science fictions.
In fact, [II] the central bankers are worried about the future of insurance as a profitable enterprise ["longer-term climate change implications for the profitability/viability" (6)] What they do not say is that most risk modeling and portfolio management in finance presupposes that profitable insurance is possible. So, the significance of this concern is much wider.
[III] As premiums increase the central bankers assume that ordinary firms and individuals will be exposed to inflationary pressures and the decision to forego coverage. Strikingly the central bankers do not assume (a) that these will stop economic activity in the exposed areas; or (b) that governments will step in to provide insurance or to mandate/subsidize insurance. On (a) this means the central bankers assume that say due to path dependencies economic agents will persist in their activity without insurance and will tolerate considerable more uncertainty in their lives. And this will percolate through the system because a lack of insurance in one sector will impact its interactions with others. On (b) this strikes me as unrealistic. Governments will be lobbied extensively. Of course, at some point governments will have to make tough decisions about which parts of the economy to cover or not.
[IV] Central bankers are still very worried about bank balance sheets. Here the main concern is that the collateral that itself becomes worthless and is under-uninsured. It's one thing if the waves topple a hotel tower in Southern Florida and makes a loan non-performing; another if there is no insurance to pay back the principle of the underwriter. That leads to write-downs and deleveraging, etc. ["the collateral value of properties, leaving banks exposed to credit risk. Understanding the trends in insurability, the cost of insurance, the protection gap, and their spillovers to the banking sector and the economy more broadly "]
[V] The central bankers assume that the effects of climate change are not felt uniformly ["climate change could impact geographical/economic areas differently within a country or currency area." (7)] In particular, throughout the document they show awareness of the significance of (what is known as) spatial economics; and that their existing models and policy instruments sit uneasily with a spatial or geographic approach to the financial system.
Finally, [VI] it is noticeable that whole areas of insurance that impact the vast majority of consumers and citizens directly (medical, car, travel, home-owner/renters, etc.) are either discussed obliquely or not mentioned at all. And while in many cases this will not matter much, it is important that somebody alerts the central bankers to the risks of cognitive capture by various industries. In the end they must be servants of the wider public, too.
To sum up. Catastrophic risk insurance is a part of the financial system that generally is ignored by the public. Given the centrality of insurance in modern political economy, it is a good thing that central bankers are starting to reflect on what happens when agents start to wonder if they cannot count on insurance in a crisis. The danger is, of course, this will very thought accelerates the possibility.
*I am quoting Oliver J. Blanchard, Mark W. Watson (1986) Are Business Cycles All Alike? National Bureau of Economic Research. An influential paper in its time.
**Here's a thought: while indeed the initial effect of great supply shocks are inflationary; when they undermine the functioning of the financial system -- bring it to a halt --deflation is the much greater risk.
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