Insurance is Dead! Climate Change killed it
How much money does it take to buy insurance for the whole world?
Insurance is dead! Well, it's not really dead right now. But it's dying. I am speaking from the future. I am in 2040 and 2050 thereabout. The insurance industry will not survive another +20 years of climate change.
Retrospectively, it all seems obvious that this was one of the first pieces of our life to be wiped away by climate change. Coming from the past, in AD2022, it’s not that obvious to everyone that climate change will destroy the concept of insurance way earlier than its impact on the habitability of the earth.
The title is melodramatic because most of you are addicted to catchy headlines. Over and over again you give in to click-bait because you want something juicy. Well, this one is actually juicy and factual with the only exaggeration being that of suggesting that insurance is already dead right now.
Insurance is dying. It's headed for a total collapse. It's death and destruction for the industry. There are no solutions besides tackling climate change itself. Overpaid consultants at Deloitte and McKinsey have no solution for this one. The advisory stuff they can come up with will not save the insurance industry. No one can save this industry unless we save the earth itself, which is highly unlikely for now.
The focus on sustainability which is currently en vogue is great, but it doesn't help much because it doesn't really address the elephant in the room. Late-Stage Capitalism riveted around planned obsolescence is the ultimately unsustainable monster, whether you look at it from an inequality point of view or from a climate change point of view.
There are several things to ponder for the insurance industry vis-a-vis climate change.
- Pooling — Insurance is premised on the pooling of risks. How do climate change-induced events affect this pooling thing?
- Balance Sheet Capacity — Liabilities versus Assets — Climate change obviously increases Insurance company liabilities. How does it affect the asset side of the balance sheet?
The above questions reveal the precarious existence of the concept of insurance itself with regards to climate change. When we think of climate change, we often think of the various aspects of life that will be changed. Insurance is typically at the back of the line. We tend to think we can insure our way out of these catastrophes. We often don't stop to think if the insurance industry will remain viable. The insurance industry is on the frontline. It will get affected first.
Pooling is premised on the assumption that not all insured risks will materialize at once, hence payouts from the pool are assumed to happen gradually over time. Climate change-induced catastrophes violate these assumptions. Large, outsized payouts occur suddenly instead of gradually. A troublesome fire guts the entire neighborhood as opposed to one house in the hood.
Large payouts deplete the pool faster and inhibit the growth of the assets in the pool meant to protect us in the future. The frequency and severity of catastrophes and the diminishing pool of assets push insurers to raise premiums because the risk profile has changed. This in turn prices out many. Where an insurance company had 100,000 clients, a 40% hike in premiums displaces for example 60,000 clients leaving the pool smaller. A smaller pool needs even more contributions thus necessitating another hike, which in turn displaces even more demand. It's a cycle of death, and it's self-reinforcing. Premium hikes trigger demand displacement, and demand displacement triggers a new round of premium hikes. The very concept of pooling risks dies, and the insurance industry dies along with it.
Balance Sheet Capacity is related to pooling but needs special emphasis. Insurance companies collect premiums from clients and invest these premiums into various assets. This forms the asset side of their balance sheets. At the same time, they create future liabilities with each policy they write. They have to meet these liabilities as they become due, that is, when the insured loss occurs. Under normal circumstances, the asset side is not too interconnected with the liability side in terms of the risk event. Climate change-induced events change that. These catastrophes affect both the assets side and the liability side, at the same time. Insurance companies are not investing in Mars, their assets are deployed here on earth. They are in equities, bonds, real estate money market instruments, etc. These are affected by climate-induced events too. The asset side of the balance sheet can witness large declines at the very same time that liabilities are materializing.
A prudent asset mix and global geographic diversification of assets can help spread the risk around. However, climate change-induced events are also globally diversified well enough to affect many areas at once. So, sorry, diversification might not get you that far. There is nowhere to hide.
When a large climate-change-induced event occurs, the asset side of an insurer declines twice (i.e., declines from two things):
- From assets held suffering directly from the disaster
- From withdrawals and selloffs needed to meet the large claims
One big event depletes the assets faster than previously understood. As liabilities suddenly materialize all at once, some assets have to be disposed of in a fire-sale manner, at a time when market values are depressed. After facing a couple of big events in succession, the balance sheet becomes incapacitated. It won't have the capacity to withstand future calamities.
In past regimes, insurers have been able to build the balance sheet back again as they collect premiums over the years since these catastrophes were spaced nicely across time. The difference now is that there is no time to build capacity again. This is why it is obvious to see that insurers will not be able to survive two decades of climate change-induced catastrophes. Just an extension of the current trends is enough to kill insurance. But things are not getting better, they are getting worse. If what we have currently is a baby, then what we will experience 15 years from now will be quite serious, enough to put a nail in the insurance coffin.
The world is a Complex Adaptive System. It gets so complex that in the end, nothing will be insurable at all. In the meantime, insurers are faced with Model Risk. There is a regime change in data, and their models are backward-looking (historical data) and slow to adapt. The slowness will lead to huge insurance losses in these early years leading to a quicker death. Several insurers could fall within a decade, leaving a few giants inkling along in the decade thereafter.
Looking into Models might complicate things unnecessarily. Let's rather ask a very basic question.
How much does it cost to insure the Earth?
The answer is another earth, or two, or a fraction of this earth. Maybe our insurance is establishing a parallel human existence on Mars, as Elon Musk suggests. Outside of that, it is simply not possible to insure the world.
It is folly to expect insurers to save the world from climate change. This is not the type of risk that can be insured, at the global level, and at micro levels. When a fire ravages through the city due to heatwaves, burning out 20% of the cars in the city, insurers will not be able to meet all the claims because they fall due all at once.
When one climate change-induced disaster occurs in one region, reinsures can cope but when these events happen in multiple regions in the same year, reinsurers struggle. We will never have enough resources to “insure” the earth. That's the big picture. From there, you can zoom into the small picture.
Frequency and Severity = Too Large to be Insured
These are the key details to pay attention to. Currently, models predict only so many floods to happen within a set period of time, for example, 2 in 20 years. The entire model collapses when you have 4 floods in a decade. The frequency of the event kills the insurer.
Moreover, climate change brings a new dynamic into this. It brings the multi-dimensionality and interconnectedness of these natural disasters. It is now very much possible to have a flood this year followed by a drought next year. This is because climate change brings erratic patterns. Instead of receiving even rainfall throughout a season, that rainfall comes in droves at once and then goes missing for the next season. The client (eg., a farmer), having insured against both risks, claims for two consecutive years. At times, one province within a country experiences a flood while the other experiences a drought. The same country, one insurer, and different regions are experiencing different natural disaster claims. The balance sheet of the insurer won’t survive. China had floods in 2021 and droughts in 2022.
Small insurers can say, “Well, we will just buy reinsurance”. Reinsurance won't help much because it will be suffering from the same phenomenon. Reinsurers are global giants, and all will be the first ones to fall. The cost of reinsurance will be the first one to spike, and small insurers will be the first ones to not afford the cost of reinsurance, so they will self-insure and absorb some risks themselves, starving the reinsurers of cash inflows into their big pools.
A giant reinsurance company could face claims from a flood in Southeast Asia, a drought in East Africa, and heatwave damages in Europe, all at the same time. The lesson they will learn is that it is impossible to “insure” the world using these financial numbers we call money.
The only sustainable insurance is reversing climate change.
A centenarian living in a Martian human enclave in 2105 will tell our grandkids how we used to have a thing called insurance back on planet earth, and how that thing (insurance) suffered from sudden death. Insurance died too soon, 5 decades before the earth became inhabitable.