In order to understand how climate change risks are affecting the insurance industry, we should probably start from the balance sheet of a typical insurance company. On the left side of the balance sheet, what we find is typically investments in different asset classes, can be bonds, equities, real estate. On the right side of the balance sheet, we find something that is a very specific of insurance company. These are something that is called usually insurance technical reserves. Then you have equities that represent the capital of the insurance company. The peculiar structure of the insurance company balance sheet depends on the business of insurance companies. They receive money from policy holders from their clients against a future possible claim or likely claim in relation to maybe a damage or maybe just a saving plan. In the case of a life insurance, can be just that the clients are going to receive a certain amount of money at a certain date in the future when for example, they retire or their children go to school, to university. This is also reflected in the peculiar income statement of a insurance company. The first line of the revenues for the insurance companies are the premiums, so is the money that clients pay to the insurance company in order to get an insurance product. The second line is typically the claim, so is the cost that the insurance company incurs when a certain event happens to their clients. Then there is an investments income. Because remember, on the left side of the balance sheet, there are the investments that insurance company is making. Those investments awfully generate a positive income. Then there are the operating expenses to run the insurance company and that there are also the taxes and eventually the net income. The bottom line of the income statement. A profit or a loss if the business is not running in a health way. There is a specific climate risk that is especially important for insurers. These the liability risk. Differently from for example, commercial banks or other financial and non-financial companies, because of the peculiar business of insurance, there is these specific climate-related risk that insurance company have to have in their business. These liability risk refers to the risks that could arise for insurance companies, from clients who have suffered losses from climate change. For example, insured clients who have suffered the consequence of a physical risk because of a storm or because of a flood, and they are seeking to recover those losses. The insurance company has to cover those losses. Over last few years, incidence of a climate-related weather events have tended to become more common and more severe. Insurers who have their job of protecting societies, and businesses, and households from these kind of risks or in the case, these risks become manifest themselves are therefore on the front line of protecting societies from climate-related risks. In the short-term, physical risks that arise for weather-related events such as floods, wildfires, and storms, and the longer-term climate-related risks that are related, for example, to the rise in the sea level, or heat waves need to be factored by insurance companies. If we think of the business of insurance company, the exposure to climate risks is therefore on both the investment side and the liability side. For the liability side, in the short term, there are physical risks that are arising from increased weather-related events such as floods, wildfires, and storms. Then there are longer-term physical risks that are due to elements such as the sea level rise or chronic heat waves. All these physical risks related to climate can impact the liabilities side of the balance sheet of an insurance company. But there is also an impact on the investment side, on the asset side of the balance sheet of an insurance company. The value of the investments is not only at risk from a physical damage to properties, for example, to real estate assets that are in the balance sheet of the insurance company, but also true the disruption of normal working in the economy. Those disruptions that are due to climate change can affect corporate profits and therefore can affect the value of the assets that are in the balance sheet of the insurance company. Potentially in extreme circumstances, also, the bonds and the securities issued by governments, the sovereign debt or municipalities debt can be affected by climate change. Therefore, these are all possible sources of risk for insurance companies. For property and casualty, P&C insurers, climate risk translate into its so-called tail risk that is arising because of natural catastrophes. Insurers must be careful not to underestimate the true threat of climate change that can generate these climate catastrophes. Because its effects are systemic, climate risk is likely to stress local economies and cause failures that affect both insured and insurers. More frequent catastrophic events in combination with the need to meet evolving regulatory requirements can threaten insurance company business model, and make insuring some risk unaffordable for customer, or actually unfeasible for insurers. On the other end, life insurers will need to consider the longer-term implications of climate change on the health and longevity of our societies. Traditional insurance companies are not the only financial possibility to ensure and manage climate risks. An alternative is the so-called catastrophe bonds possibility. Catastrophe bonds, also known as CAT bonds, have emerged recently as an alternative insurance device to handle and manage catastrophic risks such as hurricanes, which the insurance industry had partly avoided before. Those kind of bonds bring natural disasters to the financial market. Issuers of cat bond use them to fund payments if a specific catastrophic event occurs, in which case, the buyers of cat bonds can lose the entire investment they made. In return, investors receive a regular interest payments, the so-called coupon, reflecting the probability for the catastrophic event to occur and thus of losing the capital invested. There is also another possible insurance device in order to protect the income of households and companies. I'm referring to so-called weather derivatives. Weather derivatives can be useful whenever a certain household or a business is exposed to weather risks. The revenues or profits for that household or business can be sensitive to weather conditions. If this is the case, it's possible to design and to use weather derivatives. These are financial products that allow companies to manage and hedge their weather-related risk exposure. They are like the traditional financial derivatives. But of course, the focus of these financial instruments is just on weather risks. For financial derivatives, the value of the financial instrument depends on the value of an underlying assets or an index or a commodity. The value of a weather derivative depends on the value of underlying weather statistics, weather metrics. The idea is that weather derivatives can protect the buyer from certain abnormal weather situations. The buyers that can benefit from weather derivatives are utilities and energy companies, where the sales and the costs are related to climate conditions, or they can be agricultural companies because the quality of the productivity of these companies is heavily affected by weather conditions, or they can be just municipalities, where business and ability to generate revenues for the community depends on weather conditions. There can be other kinds of businesses in different industries where revenues or costs are at risk because of changing weather conditions. Typically, the weather derivatives is addressing a specific underlying weather statistics. Those statistics, those metrics can refer to the average temperature to abnormal level of temperature to the level of precipitation or snowfall to the degree of humidity or to the wind speed. There are other possibilities to design a weather derivative that is convenient for both the client, the insured, and the counterpart. Most temperature contracts in the weather derivatives markets are actually based on heating degree days for winter protection and the cooling degree days for summer protection. This is a growing area of finance and because of the intensification of climate change consequences on the economy, we are likely to see more innovation in this specific segment that allows the hedging and protection from climate change risks.
