Insurance Uncovered

Merchants in ancient Bablyon arranged special agreements to protect interests in cargo placed on ships running between Mediterranean ports.   Called ‘bottomry’ contracts, these early entrepreneurs did not have to pay back loans if a shipment was lost at sea.  Interest on the loan paid the insurance premium.  The Hindus, Greeks and Romans all used variations of the bottomry contract.  By the 15^th Century marine insurance was well developed and in widespread use.  The idea of protection against adverse outcomes had been extended to fire and other property risks.  Indeed Lloyd’s of London had its origins in the 17^th Century.

 The 21^st Century may become known at the time of death for the ancient practice of property insurance.  What is sounding the death knell for insurers?  Climate change!

Scientists have told us repeatedly that extreme events are going to become the norm in the decades ahead.  Our future in a world with a rapidly warming ocean:  wilder tropical storms, rogue tornadoes, extended and deepened droughts, exceptional rainfall and floods.  This future will unfold for all peoples, including climate deniers.

The ramifications for investors could be enormous if property insurance is no longer available for becomes so expensive public companies can no longer afford the premiums.  Swiss Re estimates that in 2018 property and casualty insurance worldwide reached $2.4 trillion.  This compares to the global gross domestic product of $84.8 trillion.  With insurance accounting for 2.8% of the world economy, it is imprudent to ignore the impact of climate change on the property and casualty insurance industry.

In a perfect world, the actuaries of the insurance industry will simply recalibrate their formulae as the climate crisis unfolds.  Revised premiums will support greater payouts and insurance enterprises will easily manage the shifts in the risks.  Or not!

It is also quite possible that the insurance industry will not be able to fully grasp and address the changing environmental risk.  This means that some or perhaps even all property and casualty insurers will go out of business.  Such a dire outcome would leave property owners in a lurch, facing loss all on their own.  The extent to which stock values reflect the latter outcome is not clear.  Virtually no public companies reflect any contingent liability related to climate change on the balance sheet.

Most investors would like to remain in the camp of Donald Trump who claims the climate crisis is just a hoax cooked up by the Chinese to gain economic advantage.   This is certainly the easy route.  No changes in valuation required in the Trumpian world!

Unfortunately, the inconvenient truth is populated with numerous examples of extreme events related to climate change. In just the last twelve months there have been several:  Hurricane Barry in set destruction records in July, Hurricane Dorian hit new rainfall records in August, wildfires in California have left hundreds homeless, and three out of four cyclones in the Indian Ocean were classified as very severe. 

Swiss Re indicates that between 1980 and 2015, the U.S. experienced an average of five climate-related events each year causing more than $1 billion in damage. The average spiked to fifteen annual events in the three years from 2016 to 2018.  Denial is becoming more and more difficult with each passing storm.

Investors have become accustomed to full coverage of property loss by insurance.  It has meant there has been no need for any discount on valuation for property risk.  It is possible in our rapidly changing environment that insurance can no longer be considered a sure thing.  Property loss will need to be considered in affixing stock value.

The values that we must consider are consequential.  Swiss Re estimates the annual insured losses from catastrophic events have increased by twenty times since 1970 to as much as $85 billion in 2018.  This does not include business interruption coverage.  The McKinsey business consulting firm reports that insurers have begun preparing for larger, more frequent payouts due to climate change by increasing capital reserves by more than double over the last few years.

Companies have long argued against recording contingent liabilities related to environmental responsibility.  The inability to estimate value is often cited as the primary impediment to a formal accounting.  However, with the insurance industry on it heals it would appear this excuse is no longer valid.  The industry is quickly totting up the value and it will be displayed for all to see in premiums and bankruptcy proceedings.  It appears that the quiet and unassuming actuary may end of being the hero of the environmental movement by uncovering the costs of climate change.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.