Using a Scenario-Based Risk Approach to Assess Climate Impacts

Even as climate modeling has improved, companies are finding scenario-based approaches are increasingly valuable for mapping out climate risk.

For the past 50 years, traditional climate models have helped simulate the changing effects of our oceans, land surface and sun. They’ve also helped make sense of the record-breaking levels of tsunamis, inland flooding and extreme heat that have hit in the past decade.

And while those models have proven particularly prescient in predicting rising global temperatures, the frequency and intensity of weather events has pushed organizations to look beyond such models to factor in an increasing number of variables. Changes in rainfall have altered the scope of 100-year floodplains; rising ocean temperatures have translated into stronger hurricanes; and extreme heat has aided wildfire intensity.

The scenario-based risk approach

An effective way to model potential climate impacts is to begin by identifying key risks and how likely they are to impact business strategy.

This exercise can quickly become tricky, however, because global firms with manufacturing and complex supply chains are vulnerable to events around the world. A business that relies on suppliers in New Orleans (flood risk) and San Francisco (wildfire risk), for instance, needs to consider weather events occurring concurrently or in rapid succession. And some industries, such as utilities and information technology, are more suspectable to chronic climate change risks than others. When Hurricane Sandy hit in 2012, for example, it knocked out a large part of Verizon’s power systems, which contributed to a $4.2 billion quarterly loss, despite the communications firm adding customers during that period.^[2]

Once climate risks are identified, companies can focus on understanding potential consequences and the financial impact they may have, and work to mitigate those risks. Climate risk analytics can also help companies understand their total cost of risk strategy, including balancing retention, mitigation and risk transfer. This analysis will help companies establish their risk appetite — essentially how much risk they’re willing to accept — and then determine what thresholds should be used to set risk limits and make business decisions.

In some instances, real estate companies have changed planned developments and investments because their analysis shows that climate events are likely to decrease the asset value by the time they look to sell.  For many companies managing property assets, this assessment can be calculated at the property level and aggregated to the portfolio level—which may also impact certain business decisions as they determine where to place, or withdraw, their footprint.

Evolving solutions for climate risk

While insurers cannot stop natural or weather events from happening, they can amend policies and coverages to better address the complex and evolving impact of climate risk. Some carriers, for instance, are expanding parametric insurance offerings, which enable businesses to get paid a pre-negotiated and formulaic amount should a triggering event (such as a hurricane reaching the category 4 threshold) occur.

This kind of policy can speed up the recovery-time difference for an organization with high climate-risk exposures, as the payout comes more quickly compared with traditional policies. It also enables businesses to get some coverage even in scenarios where climate risk is difficult to predict. Risk managers who understand their total cost of risk can use parametric insurance to make certain uninsurable risks insurable and complement their traditional indemnity programs. Parametric insurance can also help organizations match insurance capital to their specific risk profiles, providing more liquidity exactly when they may need it the most.

Public and private-sector stakeholders could also play a role in mitigating climate risk (and help close the protection gap) through expanded catastrophe bonds. Even if companies get smarter about assessing risk, a protection gap will likely still exist, especially if insurance becomes difficult to obtain for natural hazards that become more frequent. By improving risk mapping and scenario-modeling, for instance, global firms can lessen the burden on bond investors.  This would in turn allow those investors to be more willing to provide risk transfer capacity, since there will arguably be less uncertainty about how climate events would impact the firm.

***

Using a scenario-based approach to climate risk is not a perfect solution. However, it enables organizations to better plan for the increasingly complex and significant impacts of climate change on different areas of the business.

^{[1] Weather, Climate & Catastrophe Insight: 2020 Annual Report, Aon}

^{[2] Weather, Climate & Catastrophe Insight: 2019 Annual Report, Aon}