Incorporating disaster risk in regulations proceeds as climate concerns mount.
The push to have companies include disaster risks in their financial statements is gaining momentum. The United Nations is sponsoring the effort as evidence mounts that climate change will begin impacting businesses’ bottom lines sooner rather than later.
Leading up to that goal, the UN is working with a range of companies to stress test that risk and design a methodology to disclose it as well as mitigation efforts to strengthen disaster resilience and appease investor concerns.
The initiative aim to work with regulators worldwide to incorporate disaster-risk disclosures into financial statements just like any other risk, displaying both the potential costs stemming from disasters as well as any offsetting measures companies have put in place. The Integrating Risks into the Financial System: The 1-in-100 Initiative was announced at UN Climate Summit in New York last September (see related story here), and it is anticipated to gain support in a series of disaster-risk and climate change-related events this year.
In the meantime, the UN has been pulling together a broad coalition to design a way for a company to disclose risk posed by natural disasters without jeopardizing the capital market’s perception of it.
“What we’re trying to do with this initiative, by working with the scientific, analytics, accounting and regulatory communities, is to come up with a common quantifiable metric that can be consistently applied to stress tests, to understand the solvency risk associated with one-in-100 year probability risk from natural hazards,” said Scott Williams, a director at PriceWaterhouseCoopers. Williams is also the lead director of the R!SE Initiative, launched by the UN Office for Disaster Risk Reduction (UNISDR), PwC and other private sector leaders last May to incorporate risk into investment decisions.
That concept of such probability risk, measuring the strength of a disaster likely to occur only once every hundred years, was put to use by the insurance industry following a series of major natural disasters in the late1980s that crippled several insurers. Regulators then required insurers globally to have sufficient capital to cover claims resulting from events occurring over a 12-month period whose severity happens only once every 200 years.
Despite continuing skepticism about climate change in the political realm, projections about the likely consequences have already by publicly issued by institutions including insurers, the credit rating agencies and the US military. In late January, the Risky Business Project, a collection of business and political leaders headlined by likes of Michael Bloomberg and Henry Paulson, released a report projecting how agriculture and manufacturing in the Midwest would be impacted by likely extreme levels of summer heat and warmer winters.
“Given the importance of the Midwestern United States to the world’s agricultural production, it would be irresponsible to dismiss these projections lightly,” said Greg Page, Cargill executive chairman and Risky Business Project risk committee member, in a statement.
The UN initiative’s goal is to gradually extend the practice of measuring disaster risk exposure beyond the insurance industry, without putting at risk early corporate adopters whose stocks, for example, could be pummeled in the short term if competitors do not disclose similar information. The intent is to find corporate volunteers willing to stress test their businesses in a sort of laboratory; a “research mode” to incent improved understanding of risk that is designed to avoid information about their disaster resilience or lack thereof from becoming public until the implications for the market can be more broadly understood. When sufficient evidence is gathered and analyzed, and an accurate methodology is developed for non-insurance organizations, the next step will be persuading the financial industry and its regulators to incorporate disaster risk in public companies’ financial statements as well bank regulator reporting.
Assuming progress on this stage, the formal process to develop regulatory and accounting rules, working through international organizations such as International Organization of Securities Commissions (IOSCO), the Bank for International Settlements (BIS), and the International Association of Insurance Supervisors (IAIS) is anticipated to begin in 2016.
“If this research mode can produce comparable, reliable, robust, investment-grade results, then over time we should be able to build a strong case for the interpretation and modification of existing regulations and standards to incorporate disclosures about disaster risk,” Williams said.
Along with reporting disaster risk, companies will be able to disclose steps they’ve taken to mitigate it, such as long-term, strategic changes including safer geographic and topographic locations or adopting more resilient power sources or robust supply chains. Insurance policies to cover damage from disasters could be another mitigating factor, as well as more recent capital-markets products such as catastrophe (cat) bonds or collateralized reinsurance, collectively referred to as insurance-linked securities (ILS)
The insurance and reinsurance industries are well versed in such capital market products, and nonfinancial issuers were anticipated over the last year to tap the market to diversify their disaster coverage. In addition, ILS provides two or more years of coverage compared to one for most insurance policies, and the cost tends to be lower, although insurers have become more competitive.
Non-insurance issuers, however, have yet to tap the ILS market, with the only exception being New York’s Metropolitan Transit Authority. It turned to the capital markets in July 2013, after being unable to meet its needs from traditional insurers, and completed a $200 million cat bond offering.
“If companies have to report contingent risk, then they should also report contingent sources of capital to offset that risk,” said Rowan Douglas, chairman of the Willis Research Network, a part of insurance and reinsurance broker and advisor Willis Group, which has been intimately involved with the UN initiative.
Douglas, who published a “concept note” last summer providing the rationale and approach for integrating disaster risk into the financial system, said 2015 is slated for much of the “investigative” work involving a “spectrum of stakeholders,” including issuers, investors, accounting firms, and credit rating and modeling firms. Insurers are the main aggregators of disaster-related risk and likely will be among the first companies to test the disaster reporting methodology, along with asset managers and other companies with material exposure to disaster risk, such as manufacturers with long supply chains.
Alongside the technical track, the 1-in-100 Initiative will seek to leverage a series of high-profile international events this year year. Elements of the initiative are anticipated to be included in the March renewal of the UN Hyogo Framework for Action that was initiated in 2005 in Kobe, Japan, to build global resilience to natural disasters. That’s also expected to be the case at the UN’s Conference on Sustainable Development in Rio this June, and the UN Climate Change Conference scheduled for December 2015 in Paris.