Climate Change Impacts Insurers

Published on March 18, 2009

The National Association of Insurance Commissioners voted to require insurance companies to disclose the impact of climate change on their businesses.  This action taken on March 17, 2009 will compel insurance companies to fully disclose the impact of forecasted climate change along with their actions to manage the risks.  The move by the insurance commissioners was reported this morning in The Wall Street Journal and elsewhere. 

Higher Risk of Natural Disasters

If the predictions related to climate change are accurate, more cases of extreme weather are likely to occur in future years.  Berkshire Hathaway and other insurers are obviously exposed to such events through hurricane and storm coverage and both the frequency and severity of claims could increase.  Much will depend on how gradually changes to the climate emerge over time.  Gradual changes to the climate would be far easier to manage and insurers would have the benefit of being able to adjust their models over time.  Disruptive and sudden changes, in contrast, could catch insurers off guard and cause large scale losses.

Risk is the name of the game in the industry and underwriting discipline is the major factor that determines long term results.  If climate change risks are not explicitly taken into account by the majority of industry players, it is possible that rates could be artificially depressed.  If this occurs, prudent insurers will need to walk away from business rather than take on risk without adequate payment. 

Risks of Cap and Trade Regulation

In an effort to combat climate change, the United States is very likely to adopt some form of a cap and trade system in which overall carbon emissions are limited by law at a certain level that is set to decline over time.  The idea is to ensure that overall emissions decline over time while allowing industry to gradually adopt new and cleaner technologies.  Most forms of cap and trade involve the government auctioning “pollution credits” to business that can then be traded.  A business that finds it uneconomical to install pollution limiting technologies could instead purchase a pollution credit from another business that has installed such technology and therefore has “spare” credits to sell on the open market.

Leaving aside the question of whether this is desirable public policy, it is quite clear that the regulation would impose a government imposed scarcity on the ability to pollute.  Since power plants are one of the largest sources of industrial pollution, utilities will be heavily impacted.  Berkshire Hathaway’s Mid American Energy subsidiary is no exception. 

Most regulated public utilities operate under a regime where commissioners permit the utility to earn a regulated return on capital by setting rates to consumers accordingly.  A major question is whether the higher costs of cap and trade (either through the purchase of cleaner technology or the purchase of pollution credits) will be passed on to the consumer or absorbed by the utilities through a lower regulated return on capital.  If utility regulators attempt to limit rates charged to consumers, the economics of the utility business could be adversely affected.

Putting aside the question of whether cap and trade regulation is desirable or necessary, it seems prudent to take this risk into account when evaluating the overall investment climate in general, and the outlook for companies such as Berkshire Hathaway in particular.  In today’s political climate, it would seem very naive to think that politicians would permit the entire impact of cap and trade to fall on utility consumers without also demanding that large regulated utilities “sacrifice” some profits for the common good.

Climate Change Impacts Insurers