12 September 2011

Risk and Reinsurance

Bloomberg Businessweek has an article on the global reinsurance industry, tied to the 9/11 anniversary.  It has this interesting passage:
In 1888 the city of Sundsvall in Sweden, built of wood, burned to the ground. A group of reinsurers, Swiss Re among them, let Sweden’s insurers know there was going to be a limit in the future on losses from wooden houses, and it was going to be low. Sweden began building with stone. Reinsurance is a product, but also a carrot in the negotiation between culture and reality; it lets societies know what habits are unsustainable.

More recently, the company has been working with McKinsey & Co., the European Commission, and several environmental groups to develop a methodology it calls the “economics of climate adaptation,” a way to encourage city planners to build in a way that will be insurable in the future. A study of the U.K. port of Hull looks at potential losses by 2030 under several different climate scenarios. Even under the most extreme, losses were expected to grow by $17 million due to climate change and by $23 million due to economic growth. How Hull builds in the next two decades matters more to it than the levels of carbon dioxide in the air. A similar study for Entergy (ETR), a New Orleans-based utility, concluded that adaptations on the Gulf Coast—such as tightening building codes, restoring wetlands and barrier islands, building levees around chemical plants, and requiring that new homes in high-risk areas be elevated—could almost completely offset the predicted cost of 100-year storms happening every 40 years.

As with Sweden’s stone houses, all of these adaptations cost more money in the short run, but reinsurers must take the long view, and they can drag development along with them. The public, whom the reinsurers refer to as “the original insured,” should be concerned by these hints. Even when they are forced to sign all-perils covers, reinsurers are writing more known risks out of their treaties. Swiss Re publishes an annual report on catastrophe losses; since the 1970s losses have been increasing exponentially. It’s this graph that gives reinsurers pause. The God clause includes less each year because every loss event—every catastrophe—reminds them of the hubris of thinking God doesn’t have any surprises left.
The fact that projected societal changes increase projected losses by more than projected changes in climate is not going to be surprising to readers here.  I was unaware of the Hull and Gulf case studies, which add to a now overwhelming literature on this topic.

The article also suggests that reinsurers would have a hard time in trying to exaggerate or underplay perceived risks:
Reinsurers, however, have no incentive to mislead. Their choices on risk, with billions of dollars at stake, are necessarily aligned with the pursuit of truth. If a reinsurer is more scared of a risk than it should be, its shareholders will punish it. If it is less scared than it should be, the world, eventually, will break it. There are rewards for politicians, corporations, think tanks, and activists who dissemble about risk. There are none for reinsurers.
While I think that in the abstract this claim is right, I don't think that it recognizes the challenges associated with a diversity of knowledge about risk.  On many topics of risk there are a wide range of legitimate points of view which collectively span a large range, and there is benefit for companies to selectively interpreting such risks in a way that is beneficial to their bottom line. It would only be surprising if it were otherwise. On the other hand, there are other players in the re/insurance market place for whom incentives line up a bit differently.