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Modeling the business impacts     |     Uncovering gaps     |     New solutions     |     Systemic questions 

With climate change creating new risks and societal needs, financial services organizations must ensure their services are adapting to the shifting landscape.

At the time of publication, countries throughout the world are coping with the health crisis caused by COVID-19 along with its wide-ranging societal and economic impact. There still are a lot of unknowns, but one thing is clear — the virus will have profound and lasting implications for all of our lives as well as every business and industry.

In the insurance space, cover is well-established for damage to physical assets — but do climate risks mean that new hybrid products are needed for severe events and other longer term impacts, or that organisations outside of insurance need to have deeper understanding of their exposure to weather events to adapt?

The work that KPMG Australia have been conducting for Transurban, a major Australian toll road operator, suggests this might be the case.

Admittedly, Australia is an extreme example. The news reports that have been beamed around the world of the bushfires and soaring temperatures sadly testify to that. But even if it is an outlier, the situation in the country may show the direction of travel that many other parts of the world are heading in.

It was a growing awareness of climate shifts that led our client to want to model the possible impact of future climate change on its business.

Our analysis so far, is revealing that climate changes are likely to have impacts on the client’s business that are not currently insurable.

Modeling the business impacts

What makes this work a bit different is that Transurban wasn’t only concerned with the direct costs of weather events to its assets — but wanted to take a wider view and model the potential impacts of climate risks on revenue and operations. Importantly, this work highlighted interdependencies between the client’s roads and the surrounding network.

This involved taking extreme weather events such as excessive rainfall or prolonged extreme heat and assessing what impact they could have on the Hills M2 Motorway in Sydney, one of Transurban’s busiest assets, across four key indicators: traffic volumes, average speeds, traffic incidents/accidents, and toll revenues.

Traffic volumes and toll revenues are directly linked of course, and their importance to a toll road operator needs no explanation. Average speeds are also important because if travellers suffer slow moving traffic and congestion, they may seek alternative routes or modes of transport in the future. Congestion can also impact road user safety and affect the number of incidents on the roads.

Working with the client in a team with a wide range of analytical, data and catastrophe modelling skills, we have been able to assess historical traffic, incident and revenue data from the client and from other sources, such as the wider road network and the department of meteorology. Linking these data sets together, we then looked for evidence of the impact of weather events on the client’s key indicators, across its own asset and the surrounding network.

From this, KPMG professionals then also modelled the likely impacts of climate change under different warming scenarios using a collection of catastrophe and climate risk models. For example, assuming 4°C warming above pre-industrial averages by 2100. This 4°C rise, however, is only the average — at its extremes it could be perhaps 10°C — meaning temperatures conceivably hitting 60°C in Australia.

KPMG Australia specialists are currently compiling our findings and creating visualizations of the impacts on the client’s KPIs over a geo-spatial map.

The three figures below demonstrate the traditional view of climate risk by geospatial location and how we may translate this approach to apply to the profit and loss (P&L) over a long-term projection.

  

Natural hazard map
P&L distribution
Simulated P&L results

Uncovering gaps in insurance

Our analysis so far, is revealing that climate changes could have impacts on the client’s business that are not currently insurable. 

For example, consider an extreme heat event where temperatures reached 60°C. Authorities might order schools to close; companies may tell employees to stay at home; sporting and other events may be cancelled. The result would be a marked reduction in traffic on the operator’s roads — and therefore a marked reduction in revenues. This business impact is not currently insurable because it doesn’t relate to a physical impact, and currently insurance products don’t cover this type of impact.

The same could apply if there was torrential rainfall, deterring people from travelling. This rainfall could also cause bottlenecks and slow-moving traffic across the network and deter people from driving in the future — a more subtle loss of business over time.

New solutions needed?

Current insurance products are geared around highly visible effects of one-time events: flooding to a property, lightning damage to a roof, a hurricane rolling through. But how will we deal with the longer term effects of climate changes? Is this simply something that businesses must endure — or is there in fact an opportunity for insurers to create new products that meet these needs and so create new income streams?

After all, there are many different kinds of business that would welcome such cover: power and utility companies with highly expensive and complex generating machinery, manufacturing sites, infrastructure owners and operators, supply chain and logistics businesses, property portfolio owners and managers — the list goes on.

The whole topic of insurability under climate change scenarios is an issue that needs to be urgently discussed and debated within the industry and with businesses. In Australia, we are already seeing a number of clients with property portfolios finding they either cannot obtain adequate insurance or are being asked for prohibitively high premiums.

While COVID-19 modeling was excluded from the analysis presented in this article, the COVID-19 impacts and flow on to toll road operators is another good example of why planning and modeling for extreme scenarios should be undertaken.

No one could ask insurers to make uneconomic decisions of course. The simple fact is that, collectively, viable solutions need to be found that work both for insurers and their clients.

This article is featured in Frontiers in Finance – Purpose or profit? Why not both.

Explore other articles. Download the full publication. (PDF 4.8 MB)

Systemic questions

There are systemic economic issues that arise as well. In a country such as Australia, economic activity and wealth generation is highly concentrated in a handful of major cities. If these cities are at high risk of suffering from climate change effects, what impact could that have on the national economy? Could a redistribution of some of the economic activity in the country be needed?

In conclusion

KPMG member firms' work is helping corporates and government agencies gain better understanding of their exposure to climate risk at a granular level and test the impact of different management responses that they could take. This may lead to a rethink of their approach to how they manage this risk.

For example, it could lead to new insurance and broader financial products emerging to help corporates transfer some of the risk, in particular, if other mitigation strategies are not viable. If they choose to mitigate the risk by implementing specific strategies, this could create a need for funding and financial advice.

Climate risk is posing new questions to all players in the corporate and financial services ecosystem. It is only by undertaking detailed assessments of the data available and modelling the impacts that we will be able to arrive at new solutions for the future.

Ripples across Financial Services

As we have seen through this project, climate impacts could have wide-ranging implications for a number of our clients and by extension for the insurance industry itself.

But, in the same way, climate shifts have implications for the insurance sector, they also pose significant questions for other parts of the financial services ecosystem too.

Banks need to analyze their mortgage portfolios and assess which properties they have lent against may be susceptible to climate impacts. Identifying geographical locations at risk, do those customers have the insurance needed to rebuild in the event of a catastrophic incident? Which customers, from their profiles and available data, are more likely to be financially resilient in the event of a disaster — and which ones may not be able to meet their commitments?

Then they need to consider: is there anything we can do to help them? What are our responsibilities in terms of making customers aware of the risks and helping them plan for the future?

This applies equally to commercial lending of course. Not only with lending against commercial property portfolios, but across all classes. Which business customers could be impacted by climate events, and to what extent? Banks need to build climate related metrics into their ratings systems. This is something that the big ratings agencies themselves are working on, although this is somewhat in the early stages.

The Bank of England’s publication in December last year of a discussion paper on stress testing banks for their resilience to climate risks — potentially starting from 2021 — only underlines the relevance of this. Banks have to get a firm handle on their exposures, quickly.

These issues are huge for pension funds, asset managers and institutional investors too. How exposed are their investments to climate risks, and how could these risks change if climate change accelerates? Do they need to rebalance their portfolios or exit certain stocks?