Governments Struggle with Financial Crisis as the Planet Warms up

January 11, 2013 by Charles E. Boyle

The global economy has been through economic recessions before, and has eventually recovered from them. This time around, however, it must do so while coping with the ever increasing menace of climate change – that makes it a whole new ballgame.

The general consensus, shared in large part by the re/insurance industry, now accepts that temperatures around the world are increasing. The argument continues as to whether mankind’s over-consumption of fossil fuels, which produce greenhouse gasses like carbon dioxide, is responsible. But this really no longer matters. Arguing over it is like arguing over who started the fire, instead of trying to put it out. What matters now is how to deal with it.

One of the prime purposes of the upcoming World Economic Forum’s (WEF) annual meeting in the Swiss ski resort of Davos from January 23 to 27, is to examine what the overall risks are, and what solutions, if any, are available to address them. At a press conference in London, where a preliminary copy of “Global Risks 2013 Eighth Edition” was unveiled, Lee Howell, the editor of the report and WEF Managing Director, described the global risks it enumerates as “essentially a health warning regarding our most critical systems.”

The report is comprehensive, examining five critical risk areas: economic, environmental, geopolitical, societal and technological. They are all interlinked and united in one overarching consideration – a great deal of money will be needed in the coming years to address them. According to the EU Climate group, as cited in the preliminary report, “the costs of climate change impacts, increasing in magnitude with the rises of global temperature, may amount to 5 to 20 percent of [global] GDP (or higher) in the long term.”

While “kicking the can down the road” (or ‘dithering’) may be a popular option with U.S. and European politicians when it comes to making financial decisions, it’s no longer an option when it comes to dealing with climate change, as tomorrow may be too late. Zurich’s Chief Risk Officer Axel P. Lehmann put it this way: “With the growing cost of events, like Superstorm Sandy, huge threats to island nations and coastal communities, and no resolution to greenhouse gas emissions, the writing is on the wall. It is time to act.”

Undertaking those acts is hampered by the fact that possible solutions frequently address only one part of the equation – economics or climate change – not both together. Swiss Re’s Chief Risk Officer David Cole described the situation, and urged people to “go beyond this thinking-in-boxes approach.” He pointed out that “smart risk management is about taking a holistic stance on situations,” adding that “we should do the same when it comes to the economic and climate-change challenges we’re facing.”

John Drzik, CEO and President of the Oliver Wyman Group, a division of Marsh &McLennan, put it even more forcefully. “Two storms – environmental and economic – are on a collision course,” he said. “If we don’t allocate the resources needed to mitigate the risk from severe weather events, global prosperity for future generations could be threatened. Political leaders, business leaders and scientists need to come together to manage these complex risks.”

After the press conference, we asked Drzik to expand on the problem and what may be a partial solution – a greater role for governments in dealing with the threats and costs of natural disasters. “Government has been bearing an increasing role in disaster relief over the last fifty years,” he said. In the 1950’s the government took about six percent of the overall losses from Hurricane Diane. More recently, after hurricanes such as Ike and other more recent storms “the government was taking something like 60 to 70 percent of the total loss.”

As a result, “what we see happening are rising expectations from people that the government is going to step in and provide relief; politically it becomes harder and harder once you’ve set a precedent to turn that clock back, and so we think there needs to be more private sector engagement in terms of creating risk management strategies that enable the government to transfer some of the risks to the private sector.”

There are also, he continued, “front end strategies to steer people out of flood prone or disaster prone zones, or at least require them to have more insurance coverage so that it isn’t entirely the backstop of coming back to the government, as people are currently expecting, for disaster relief.”

Addressing the problem of convincing the insurers and reinsurers to provide that type of coverage in areas where natural disasters – hurricanes, floods, fires, etc. – frequently occur, Drzik said: “It comes down to the pricing of the insurance. I think insurers are rational actors, they’re going to look for taking risks that they can earn an appropriate return from, and steering away from those [risks] that they can’t.” So, if you “cap the price of the insurance, you might not get a lot of insurers interested in certain zones.

“On the other hand there are zones where the price would be right. So, if you can’t find a private insurer who will step in to provide that type of coverage in a certain area, you have to wonder whether the government should be doing that as well, or whether they should be steering people out of that zone because basically putting that exposure on the taxpayer isn’t necessarily the right thing to do.”

Asked whether this would lead governments to become more involved in trying to prevent people from building in dangerous zones, Drzik indicated that up to now they haven’t been doing so, “but,” he said, “I think that they should.” For example, zoning restrictions could be imposed on certain high risk areas, “or in other areas stronger building codes to help mitigate the risk in the event of a catastrophe.”

In other areas “more insurance requirements” might be appropriate. “I think”, Drzik continued, “that some mix that takes away this moral hazard that exists today, where you have people anticipating disaster relief from the government, and therefore not necessarily buying insurance, and still moving into the coastal zones, because they expect that the government is there. In a sense it’s a free insurer. And I think that through one method or another – some type of restriction or some type of insurance requirement or through some other type of incentive, we need to get to a different balance.”

Drzik sees the chances of this happening as more likely at present, because of the “fiscal pressures that the governments are facing, and with some of the recent events. I think it’s clear that when you have ‘Sandy,’ and it costs $60 billion, or anticipating that you have another ‘Katrina’ at another $100 billion, these start to add up pretty quickly.”

As a result, when the government already has budget deficit problems, “to know that you have an exposure through the precedent setting of disaster relief that could add tens or hundreds of billions to an already high deficit*, I think that puts some pressure on policy makers to think ‘well, maybe now is the time to think about different solutions here;’ where this [type of] risk at least gets transferred.”

Even though the government would still be at least partially responsible for taking on some of the loss, Drzik said: “Maybe it doesn’t need to take the proportion that it has, and I think the time is actually good to consider new solutions because of the fiscal pressure on the government.”

It’s therefore evident that actions by government should go beyond automatically indemnifying people for their losses. It should also be more proactive in trying to prevent those losses in the first place.

*A number of commentators have remarked that the amount of additional taxes raised from high income individuals in 2013 will just about cover the U.S. government’s costs in providing relief and reconstruction funds from Hurricane Sandy.

While “kicking the can down the road”(otherwise known as ‘dithering’) may be a popular option with U.S. and European politicians when it comes to making financial decisions, it’s no longer an option when it comes to dealing with climate change, as tomorrow may be too late. Zurich’s Chief Risk Officer Axel P. Lehmann put it this way: “With the growing cost of events like Superstorm Sandy, huge threats to island nations and coastal communities, and no resolution to greenhouse gas emissions, the writing is on the wall. It is time to act.”

After the press conference concluded, we asked Drzik what he sees as the problem and a possible solution – a greater role for governments in dealing with the threats and costs of natural disasters. “Government has been bearing an increasing role in disaster relief over the last fifty years,” he said. In the 1950’s the government took about six percent of the overall losses from Hurricane Diane. More recently, after hurricanes such as Ike and other more recent storms “the government was taking something like 60 to 70 percent of the total loss.”

There are also, he continued, “front end strategies to steer people out of flood prone/disaster prone zones, or at least require them to have more insurance coverage so that it isn’t entirely the backstop of coming back to the government, as people are currently expecting, for disaster relief.”

Drzik sees the chances of this happening as more likely now, because of the “fiscal pressures that the governments are facing, and with some of the recent events. I think it’s clear that when you have “Sandy,” and it costs $60 billion, or anticipating that you have another “Katrina” at another $100 billion, these start to add up pretty quickly.”

As a result, where the government already has budget deficit problems, “to know that you have an exposure through the precedent setting of disaster relief that could add tens or hundreds of billions to an already high deficit*, I think that puts some pressure on policy makers to think ‘well, maybe now is the time to think about different solutions here;’ where this [type of] risk at least gets transferred.”

It’s therefore evident that actions by government should go beyond indemnifying people for their losses. It should also be more proactive in trying to prevent those losses in the first place.

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