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Convention on Climate Change Conference of Parties
in Paris in December. In this context, there is a growing
recognition that the insurance industry’s experience may
provide essential ingredients for dealing with the overall
challenges of natural disaster and climate risk, and also
shed light on how we confront other risks of resilience and
sustainable growth.
Under the auspices of the UN Secretary General’s Office,
a consortium including scientists, regulators, human rights
experts, credit rating agencies and financial institutions have
propelled an initiative that will integrate natural disaster risk
and resilience into the financial system. What was once an
existential risk to the insurance sector has now become a
material risk across the wider economy, and should now be
appropriately encoded into decision making. The outcome
will influence how we build and operate our cities, arrange
our companies and protect our populations. In the coming
decades, millions of lives and livelihoods and billions of
dollars of assets are at stake.
The initiative proposes that securities (including listed
equities and bonds) and bank debt (including mortgage
portfolios) should be exposed to the following stress tests
to assess their exposure to natural disaster risk:
• 1-in-100 year maximum probable annual loss to natural
disaster risk (as a survivability/solvency test).
• 1-in-20 year maximum probable annual loss to natural
disaster risk (as an operational risk / profits test).
• The Annual Average Loss (AAL) to natural disaster risk.
The application of these metrics by insurance companies
has been instrumental in the effective transformation of the
industry’s performance. In essence, risk discounts the value
of assets and resilience increases the value of assets in the
eyes of buyers and investors.
There is a growing recognition that many of the systemic
changes that are necessary to confront our major challenges
cannot be progressed until the costs of ‘business as usual’
are accounted for proportionately. Current levels of natural
disaster risk seem to be a good place to start. Once
properly informed, the invisible hand of the market has the
power to transform urban landscapes, corporate operations
and public policy to underpin resilience and sustainable
growth.
This all rests on improvements in science that have
enabled natural hazards to be understood as foreseeable,
quantifiable and (in non-seismic risks) often forecasted
events. But this scientific knowledge must be transformed
by financial and legal mechanisms to have optimum
impact on systemic risk-management and the protection
of populations. This requires a common language and
modelling framework to enable the communication and
interoperability needed to manage risk.
This recent statement by the UN Office of the High
Commissioner for Human Rights illustrates how the
language of science, engineering and risk management is
now informing the development and operation of social
protections against excess losses:
“All states have positive human rights obligations to
protect human rights. Natural hazards are not disasters, in
and of themselves. They become disasters depending on the
elements of exposure, vulnerability and resilience, all factors
that can be addressed by human (including state) action.
A failure (by governments and others) to take reasonable
preventive action to reduce exposure and vulnerability
and to enhance resilience, as well as to provide effective
mitigation, is therefore a human rights question.”
THE INSURANCE MARKET’S
PERSPECTIVE
Trevor Maynard (Head of Exposure Management and
Reinsurance, Lloyd’s of London)
Lloyd’s of London is a specialist insurance and
reinsurance marketplace consisting of multiple
competing entities (known as syndicates) with a
mutualized central fund at its heart. To ensure that the
fund is as safe as possible, the Corporation of Lloyd’s sets
capital requirements for these syndicates and has a suite of
minimum standards covering every aspect of doing business,
from claims management to catastrophe modelling. As such,
the Corporation regulates the Lloyd’s market with a small
‘r’; the true financial regulator is the Prudential Regulation
Authority, as it is for all other insurers in the United
Kingdom.
Natural disasters are an important issue for Lloyd’s; it
actively seeks to take catastrophe risks from businesses, and
also other insurers (called reinsurance). When disasters
strike, the Lloyd’s market will often pay a significant
proportion of the insurance claims and so the risks need to
be well understood and managed. This short case study will
consider the management of natural disasters before, during,
after and long after they occur.
Before the disaster, the Lloyd’s market must estimate
how much risk it has taken onto its balance sheet in order
to ensure that premium rates and additional capital are
sufficient to pay the claims that might arise. Policyholder
security is paramount and we seek to hold assets well
in excess of regulatory minima. However, no insurer’s
resources are infinite and some events could exhaust our
funds. There is a trade off, though: the more funds that
are held, the more expensive the insurance becomes,
because shareholders need rewarding for the capital they
make available to support the business. This is the first
key regulatory decision that must be made in the face of
uncertainty: what level of confidence should policyholders
have a right to expect?
The Lloyd’s approach largely follows the current
regulatory approach in the United Kingdom. In simple terms,
we estimate the size of claims that could only be exceeded
with 0.5% probability over the coming year, and then deduct