“There is one thing which is absolutely clear: if the warming goes beyond 2 degrees, it’s going to become tougher and tougher and probably impossible for insurers to cope with damage to the environment” – Henri de Castries, CEO of AXA (second largest insurance company in the world) (1)
The cost of climate change
There’s no doubt that climate change is causing serious damage. Scientific research has shown that the current increase in global temperatures leads to more frequent and intense natural disasters (hurricanes, droughts, floods), rising sea levels and disruptions of the food chain(2). All these events turn into financial cost when infrastructure is destroyed, people are injured, tourism is diminished, agriculture is less productive and mass migrations are happening(3). In the US alone, it is estimated that this cost could reach at least $1.9 trillion annually by 2100, as shown in the table below(4).
With that being said, a question remains: who is paying for this?
The “insurance” business model
Insurance companies have built their business model around paying these costs on behalf of others. Their business model is very simple:
- The insurance company collects premiums from a large number of clients
- These premiums are gathered together to create a “buffer”
- The “buffer” does not sit idle: it is invested in the financial markets to generate returns
- Every time a customer experiences an accident, part of the buffer is used to compensate him from the damage he suffered. Premiums are sized accordingly so that the buffer is always sufficient to face the cash-out needed to compensate customers.
This model works because accidents are fairly rare and having a large customer pool enables risk diversification. It works so well that insurers are often very profitable businesses: AXA alone generates €6 billion profit per year! (7)
So, what is AXA complaining about?
Why insurers don’t like climate change
Climate change invalidates two very strong assumptions that make the “insurance” business model work. First, accidents are not rare anymore: natural disasters are more common and rising sea level is accelerating. This leads to an increased rate of accidents and with much larger financial impact. Second, there is much less diversification because accidents happen on a very large scale nowadays. A natural disaster could affect millions of people at once, and a single insurance company will certainly not have a big enough “buffer” to compensate all these people at the same time.
So what can insurance companies do?
How AXA is fighting climate change
AXA is fighting the threats to its business model through a number of initiatives announced in late 2015: (5)
- Prevention: AXA is investing €3bn by 2020 in “green” companies that are environmentally friendly. This investment is aimed at fostering responsible behavior from other players and hence diminish the impact of climate change in the future. Likewise, AXA also participates in shareholder-backed initiatives such as “Carbon Action” that promote good environmental behavior from other companies.
- Resilience: AXA is also working with public and private partners to improve the resilience of infrastructure and people (e.g. AXA joined the African Risk Capacity to promote food safety and is working with the World Bank to help finance better infrastructure)
- Reaction: AXA is divesting €500m from coal-related companies. By doing so, their “buffer” is not invested in risky fossil-fuel assets anymore. AXA believes that the coal industry is declining, and the buffer needs to be invested in growing markets in order to generate returns and grow.
Despite these efforts, AXA is still suffering heavily from climate change and has been sanctioned by shareholders and analysts. Since announcing this plan, AXA share price has dropped 25%(6).
What else could AXA do to please its shareholders?
Potential next steps
I believe AXA should revisit the core principles of its business model:
- Use more re-insurance. One way to minimize the impact of the large-scale natural disasters who are hitting AXA is the use of re-insurance companies. Simply put, AXA can itself subscribe to an insurance that can cover the exceptional cost of large-scale events such as natural disasters.
- Revisit prediction models. The premiums charged by AXA to its customers are calibrated according to models that predict how often customers will be hit by accidents. Today, these models need to be revisited to include the impacts of climate change. It is particularly challenging to stay up-to-date when new models and research is published daily. Hence, I believe AXA should partner with universities and research centers to help build new models and use them in their predictions.
- Revisit the “buffer size”. Not all the buffer owned by AXA is available at all time. AXA indeed invests its buffer in different financial assets, and some of them are not liquid. Given the strong variability that has been introduced in the system because of climate change, AXA should consider increase its buffer size, i.e. have a more liquid balance sheet so that the buffer available is always big enough to compensate customers.