Abstract
In recent years, the private insurance sector has started to incorporate climate change issues into its standard business practices and even begun to lobby governments to regulate and reduce global greenhouse gas (GHG) emissions. The establishment of the ClimateWise Principles (ClimateWise) in 2007 embodies this effort. ClimateWise is an example of what scholars studying corporate strategy identify as a self-regulatory institution. To date, however, academic scholarship has failed to explain the emergence and function of ClimateWise, a unique initiative designed to leverage the insurance industry’s technical and political authority in governing climate change risks. This article will make the case that ClimateWise emerged in response to strategic incentives to reduce exposure to climate change risks, but that the form of this unusual self-regulatory institution was driven by institutional conditions.
In recent years, the private insurance sector has shifted its position and strategy toward climate change politics. The establishment of the ClimateWise Principles (ClimateWise) in 2007 embodies this effort. ClimateWise commits 39 (see Table 1) of the world’s largest insurers to mobilizing support not only within but also outside of the insurance sector to govern exposure to climate change risks. ClimateWise is an example of what scholars identify as a private self-regulatory institution governing environmental issues (Clapp, 1998; Falkner, 2003; Prakash & Potoski, 2006; Stripple, 2006). Despite research on self-regulatory institutions in the utilities (Delmas & Montes-Sancho, 2010), chemicals (King, Lenox, & Barnett, 2002; King, Lenox, & Terlaak, 2005), nuclear power (Rees, 1994), and hospitality and recreation sectors (Rivera & De Leon, 2004), scholars have yet to conceptualize the emergence of self-regulation around environmental issues within private insurance markets.
ClimateWise Participants
Scholars have examined the emergence of climate change self-regulatory institutions within the financial sector, specifically among institutional investors. Michael MacLeod and Jacob Park explained the emergence of the Carbon Disclosure Project (CDP) and Investor Network on Climate Risk (INCR) as an example of “private governance” (Macleod & Park, 2011, p. 58). These initiatives leverage the market power of institutional investors over the firms they invest to encourage the disclosure of climate change risks through a comparable framework. Once these risks are disclosed, investors are assumed to be incentivized by a “business case” to shift their investments away from economic activity exposed to these risks, such as green house gas (GHG) intensive industry.
Although these financial actors are using self-regulation to promote global climate governance, this “investor environmentalism” has been criticized. Investors will not respond to disclosure without first pricing the externalities contributing to these risks within the global economy through government regulation (Harmes, 2011, p. 111). These externalities are primarily associated with economic behavior that contributes to climate change risks that remain discounted within a firm’s corporate accounts and market decision making more broadly. This behavior includes green house gas (GHG) intensive production and any economic activity exposed to losses through physical changes in the environment.
ClimateWise addresses Harmes’ criticism by attempting to not only mobilize insurers in pricing climate change risks within insurance markets but also through the implementation of international mitigation and adaptation policy. From this perspective, ClimateWise represents an important development within global climate governance, specifically climate change self-regulation in financial markets. To facilitate its objectives, ClimateWise encourages insurers to adopt best practice standards designed to leverage the industry’s technical and political authority in pricing risk throughout the economy. These unique characteristics justify an explanation of the emergence of ClimateWise as a self-regulatory institution.
The author will begin by reviewing existing theories that explain when preferences among firms align to support the formation of self-regulatory institutions. These theories explain the emergence of existing examples of climate change self-regulation among institutional investors. The author will build on them to develop a framework that can explain the emergence of ClimateWise. The second section will introduce this article’s design and method. The third section will apply these existing theories to explain why insurer preferences aligned in support of a self-regulatory institution designed to govern climate change risks throughout the economy. The fourth section will then explain ClimateWise’s unique approach to facilitating this objective.
Before explaining the case study on ClimateWise, it is necessary to highlight two key limitations within the article. First, this article is not designed to evaluate the effectiveness of ClimateWise in generating the policies necessary for insurers to defend their markets from climate change risks. Second, the article is not empirically testing the accuracy of theory explaining the formation of self-regulatory institutions but using these theories to conceptualize and understand the motivations for an overlooked and potentially powerful strategic shift in private insurance markets toward climate change.
Explaining Self-Regulation
ClimateWise represents an example of a “private decentralized institution” because participation is voluntary and “private actors” design and govern the institution’s central regulatory objectives (Haufler, 2001, p. 8; King et al., 2005, p. 1091). There are two primary schools of thought explaining the formation of self-regulatory institutions. Scholars working in the tradition of collective action theory contend that “strategic incentives” are necessary before firms will voluntary participate in a self-regulatory institution that provides a public good (King et al., 2005; Olsen, 1965). Institutionalist literature builds on these assumptions within collection action theory by attempting to understand “how the social context shapes organizations’ behavior and the dynamics of collective relationships” (Delmas & Montes-Sancho, 2010, p. 578).
Michael Barnett and Andrew King’s work explaining how firms use self-regulatory institutions to defend their “industry commons” represents a broad approach capable of identifying strategic incentives for firms to support a self-regulatory institution (Barnett & King, 2008). Their theory follows from Elinor Ostrom’s work arguing that self-regulatory institutions emerge to protect a “physical commons” such as fish or water that a sector depends on for commercial viability (Ostrom, 1990). Barnett and King extended this notion to modern industry by discussing how firms share an “industry commons” that when damaged “can pose a serious threat to the success of individual firms that share it” (Barnett & King, 2008, p. 1151). When the outputs from different firms are “closely substitutable,” such as insurance policies, an error made by one firm can “spillover” to affect firms within the entire industry (Barnett & King, 2008, p. 1152). When an industry’s “commons” is threatened by “spillover,” firms have strategic incentives to develop a self-regulatory institution to generate strategies capable of protecting the commons.
For example, if a firm fails to eliminate an information asymmetry between “exchange partners,” such as its suppliers or customers, and these partners are not able to judge the firm independently of its rivals, a sector’s commons can come under threat (King et al., 2002, 2005). This threat emerges as either a broad reputational attack by concerned stakeholders on individual firms, which can spread to the sector involved, or regulatory intervention through the implementation of new legislation on the sector. To prevent these sanctions, firms can develop a self-regulatory institution that develops strategy for defending against these sanctions. In the case of ClimateWise, this strategy involves leveraging the industry’s political and technical authority to support measures that price climate change risks within insurance markets and throughout the economy.
From the perspective of scholars working in the institutional tradition, self-regulatory institutions do not emerge from strategic incentives alone. Rather, institutional conditions such as uncertainty in a sector’s organizational field also influence how firms respond to these incentives (Hoffman, 1999). This approach was famously described in Andrew Hoffman’s research on the rise of environmentalism in the U.S. chemical industry. Organizational fields represent a common arena where “multiple field constituents” interact with “situated institutions” and compete over the formation of preferences on any emerging issue.
Hoffman identified three types of “situated” institutions that can influence a firm’s incentives to support self-regulation. These types include (a) “regulative” or “legal” institutions, which “commonly take the form of regulations”; (b) normative institutions such as “standard operating procedures, occupational standards, and educational criteria”; and, (c) cognitive institutions such as “cultural rules and frameworks that guide understanding of the nature of reality and the frames through which that meaning developed” (Hoffman, 1999, p. 353).
Institutional change, according to Hoffman, occurs in response to “trigger” or “disruptive” events that create uncertainty in the ability of field constituents to use these institutions to inform decision making or interests. These events create obstacles in using existing institutional practices to govern market uncertainty in ways that are conducive to reward “unorthodox experiments that diverge from established practice” (Hoffman, 1999, p. 353). It is after these events that “institutional entrepreneurs” can challenge existing institutions and the actors that support them to facilitate change where new ideas and perspectives become entrenched (Kolk, Levy, & Pinkse, 2008, p. 724).
Within the financial market context, scholars have recognized the importance of both strategic incentives and institutional conditions as important explanations for the emergence of existing examples of “climate change self-regulation.” Institutional investors support the CDP and INCR based on strategic incentives in governing the exposure of their investments to climate change risks (Macleod & Park, 2011). Because institutional investors employ a similar strategy and provide “closely substitutable goods,” a mistake by one firm in undervaluing an asset based on its exposure to climate change risks is likely to be repeated by others. For this reason, the industry has strategic incentives to defend the commons through self-regulation. While this analysis does explain why institutional investors have incentives in governing climate change risks, it does not explain why self-regulation governing risk disclosure was the optimal approach for pursuing these incentives.
For this reason, it is necessary to examine whether institutional conditions influenced how institutional investors responded to these incentives. Although MacLeod and Park do not explicitly identify the institutional conditions described by Hoffman, they do provide evidence that obstacles in using these institutions to govern exposure to climate change risks informed the use of risk disclosure. In particular, institutional investors inform investment decisions based on their “fiduciary duty” to shareholders to avoid high-risk investments (Macleod & Park, 2011, p. 60). This professional obligation represents an important normative institution that shapes investment decisions. To fulfill this obligation investors require information on the exposure of their investments to climate change risks. But existing regulations do not require the mandatory disclosure of climate change risks. This gap in the regulative institution creates an obstacle for insurers in pursuing strategic incentives to govern climate change risks.
In the case of the CDP and INCR, institutional entrepreneurs recognized these obstacles and proposed self-regulated disclosure as a strategy to address this information asymmetry. For example, Tessa Tennant and Paul Dickenson, two entrepreneurs working in the U.K. investment industry, founded the CDP (MacLeod, 2010, p. 52). The INCR was founded by the Coalition for Environmentally Responsible Economies (Ceres) by approaching institutional investors with the idea of using self-regulation to promote climate change risk disclosure (MacLeod, 2010, p. 56).
Based on this analysis, a framework that combines both strategic incentives in defending an industry commons from “spillover” and institutional conditions conducive to self-regulation can be used to explain climate change self-regulation in financial markets. This framework helps identify the incentives in governing climate change risks, and explain how self-regulation represents an optimal strategy for pursuing these incentives. In this article, the author will adapt and augment these arguments to explain the emergence of ClimateWise’s more robust approach to governing climate change risks.
Design and Method
The author will focus on evidence from the property and casualty (P&C) insurance sector’s response to increasing weather-related losses during the 2000s, specifically historic losses in the aftermath of the 2004-2005 Atlantic hurricane season. The global insurance sector’s experience in responding to these losses can be seen as a “stress-test of what might be expected under climate change” (Mills & Lecomte, 2006, p. 4). These losses spread throughout the industry and demonstrated how increasing weather-related losses are not isolated to specific markets (The Geneva Association, 2009, pp. 62-63). The author reviewed a variety of primary documents authored by insurers and their industry associations; environmental nongovernmental organizations (ENGOs); ClimateWise; insurance industry trade journals; and secondary and academic accounts of the insurance industry’s response to climate change risks.
In addition to this documentary analysis, the author incorporates interviews with various insurance industry officials working on climate change issues, and officials involved with ClimateWise. These interviews adopted a semistructured approach by asking each respondent a series of standard questions. Respondents were encouraged to elaborate on the core problems and challenges involved in governing climate change risks within the insurance industry. For reasons of anonymity, the names and positions of the various respondents are not disclosed in the text. Rather, respondents are identified according to their profile or role in the initiative. (Official with the ClimateWise Secretariat, personal communication, January 22, 2010; Official with Lloyd’s of London, personal communication, March 10, 2010; Senior Official with RMS, personal communication, March 23, 2010).
Explaining the Emergence of ClimateWise
The section examines the emergence of ClimateWise. It explains that weather-related losses helped generate insurer preferences in support of governing climate change risks. Then the section addresses insurer obstacles in using situated institutions to govern these risks. Finally, the section explains the role of institutional entrepreneurs in assisting with the emergence of ClimateWise.
Defending the Commons and Institutional Obstacles
The insurance industry “commons” is defined by its risk management expertise: the ability to model the probability and magnitude that a risk will materialize into a cost, and price that risk accordingly using premiums to generate enough reserves to cover for this cost. Insurers use this expertise to determine the “market rate” that risk must be priced to cover for a potential claim, administrative costs, while still producing a profit. Market forces drive insurers to pursue new risk markets that increase their premium base, while diversifying the firm’s existing risk exposure (i.e., a larger premium base offsets claims). But this strategy is also exposed to market uncertainty if an insurer’s expertise cannot compensate for increased coverage and risk spread. Because insurers produce “closely substitutable” goods (i.e., insurance policies), a mistake by one firm in pricing uncertainty into its premiums can lead to “spillover” throughout the entire industry.
During the 2000s, weather-related losses reached historic highs for insurers around the world. In the United Kingdom, heavy rainfall doubled flooding losses to more than 6 billion pounds between 1998 and 2003 (Dlugodecki, 2004, p. 8). In 2005 weather-related losses from Hurricane Katrina, Wilma, and Rita totaled US$80 billion—the highest payout in the sector’s history (Mills & Lecomte, 2006, p. 1). But most significantly, this rise in losses signaled that weather-related losses were “rising faster then premiums, population or economic growth both globally and in the U.S.” (Mills & Lecomte, 2005, p. 2). The losses generated by the 2004-2005 hurricane season provide evidence for that what Barnett and King describe as “spillover” within the affected exchange partners throughout the P&C market (Barnett & King, 2008, p. 1153).
First, U.S. primary insurers suffered historic losses. Allstate, for example, faced more than US$1.55 billion in claims (Mills & Lecomte, 2006, p. 12). Second, these losses spread among the world’s largest reinsurers. Munich Re and Swiss Re calculated their losses at US$1.5 (Felsted, 2005) and $1.2 billion (Pilla, 2005) respectively. In 2005, Lloyd’s of London paid out US$1.12 for every US$1.00 in premiums as a result of more than US$2.55 billion in losses (Mills & Lecomte, 2006, p. 7). Among Bermuda’s reinsurers, Montpelier Re suffered losses equivalent to 60% of its shareholder’s equity (Felsted, Jenkins, & Simanion, 2005). Third, spillover emerged through a series of large class-action lawsuits launched against primary insurers and their brokers in Gulf Coast markets. These lawsuits are a particular concern for reinsurers who are forced to pay for these losses under their coverage for primary insurers. Fourth, the rise in losses also led to credit rating downgrades, which threatens a firm’s share price and increases the cost of capital. In the aftermath of Katrina, for example, AM Best, an insurance rating agency downgraded 13 U.S. insurers (AM Best, 2006). In addition, insurance giants Allstate, State Farm, ACE, Allmerica, Montpelier Re, and Swiss Re had their ratings categorized as “under review” by Moody’s or Standard & Poor’s (Hays & McDonald, 2005).
Analysis on the insurance industry’s losses in the aftermath of the 2004-2005 Atlantic hurricane season demonstrates how even isolated weather events can create global “spillover” throughout the industry. Some analysts have calculated that foreign insurers paid out as much as 60% of loss payments in response to this hurricane season” (Kading 2011). In London, which hosts the third largest insurance market in the world, insurers lost more than US$2.5 billion (Strachan, 2007). It is these losses that helped shape support among these London insurers for ClimateWise.
This rise in weather-related losses during the 2000s has also been widely interpreted by insurers as a significant physical risk emerging from the impact of climate change. According to Evan Mills and Eugene Lecomte, whose research for Coalition of Environmentally Responsible Economies (Ceres) has been tracking insurer strategies in response to climate change, the losses suffered during the 2000s constitute a “tipping point” in the insurance industry’s position toward climate change (Mills & Lecomte, 2006, p. 4). In 2006, for example, John Coomber the former CEO of Swiss Re, stated that “climate change is the number one risk in the world ahead of terrorism, demographic change and other global risk scenarios” (quoted from Kunreuther & Michel-Kerjan, 2007, p. 3).
Several surveys asking insurers to identify the strategic risks to their industry have revealed similar conclusions. A 2007 survey by PricewaterhouseCoopers of insurer executives and directors identified climate change as the fourth greatest risk facing the sector (PricewaterhouseCoopers, 2007). In 2008, a survey by Ernst & Young asked 70 insurance industry analysts to identify their top 10 trends and uncertainties facing the sector in the next 5 years. Climate change emerged as the number one uncertainty beating out regulatory intervention, emerging markets, and demographic shifts (Ernst & Young, 2008).
The emergence of these physical risks, and the “spillover” that can occur throughout the industry when insurers fail to price accurately weather-related risk constitutes an important threat to the industry commons, and a strategic incentive to support self-regulation. This spillover is, however, more robust for insurers than institutional investors. Whereas institutional investors are concerned about “indirect” spillover from an information asymmetry about climate change impacts, it is the “direct” physical impact that threatens insurance markets. This more material concern helps explain the industry’s support for a more robust approach to climate change self-regulation.
Although rising weather-related losses explain why preferences among insurers have emerged in support of governing climate change risks, it does not explain why self-regulation through ClimateWise emerged as an optimal approach to govern these risks. To explain the industry’s support for this approach, it is necessary to explain how insurers face obstacles in using “situated” institutions to govern climate change risks. These institutional obstacles constrain an insurer’s ability to respond to incentives in governing climate change risks and help explain why insurers support ClimateWise’s effort to expand the industry’s technical and political authority in global climate governance.
Climate Change Risks and Institutional Obstacles
There are three “situated institutions” that influence an insurer’s decision-making process in setting the price of risk. The regulative institution includes insurance regulators, which provide oversight to rate setting to not only ensure that these rates are not priced at unaffordable levels but also to protect against competitive “underpricing” so that insurers hold enough capital in their reserves to compensate for potential claims. Governments also influence the regulative institution by implementing “loss-prevention” policy, such as building codes, land-use planning, and prohibitive laws on risky behavior. These policies protect private insurance markets by making sure these risks do not become uninsurable.
The normative institution can be linked to the “standards of insurability.” Insurers use these standards to ensure they uphold their professional obligation to accurately price risk based on market rates. The first standard is that the insurer must be able to model, or quantify the chances of a weather-related event occurring, and the losses associated with this event. The second standard is that risk must be priced at a level that is affordable to the customer, while adequately compensating the insurer for potential claims (Kunreuther & Michel-Kerjan, 2009, p. 12). The cognitive institution can be described a belief in “actuarialism” or the ability to track the magnitude and frequency of past events to model future-oriented risk. Risk modeling is ultimately imprecise and can lead to losses, but insurers are predisposed to believe their models are accurate based on robust actuarial analysis (Ericson, Doyle, & Barry, 2003, p. 8).
These institutions actually create obstacles for insurers in pricing rising weather-related losses associated with climate change. In particular, an insurer’s ability to use the normative institution, specifically the standards of insurability, to guide decision making has led to obstacles linked to the regulative and cognitive institutions. Insurers have tried to use the standards of insurability to inform their response to rising weather-related losses in three ways. First, they have tried to raise premiums to cover for the costs associated with increased losses. Second, they have implemented market pullbacks where weather-related losses are rising too quickly. Third, they have tried to develop new modeling techniques that incorporate climate change conditions into their premium pricing.
First, in response to increasing weather-related losses, the standards dictate that insurers should raise their rates to compensate for these increased losses to incentivize risk-adverse behavior, such as strengthening property and infrastructure against worsening weather. In the aftermath of the historic losses in 2004 and 2005, reinsurers in Florida and the Gulf States responded to increased risks by raising their premiums between 30% and 100% (Pilla, 2006). These rate increases “spillover” and force primary insurers to raise their own rates as well. For example, State Farm threatened to raise rates by as much as 75% in response to increased costs for reinsurance. One insurer, RSUI group, could simply not afford to pay reinsurance rates and abandoned providing coverage to all coastal property between North Carolina and Texas (Mills & Lecomte, 2006, p. 10).
The drawback to raising rates is that consumers can complain to insurance regulators that their rates are unaffordable. In the aftermath of the 2005-2006 Hurricane season regulators intervened in several U.S. states. Florida insurance regulators suppressed rate increases by 16% for Allstate, 17.5% for Nationwide, and 23.7% for USAA. Further attempts by insurers to increase their rates were met with resistance from consumer advocacy groups, who pushed regulators to introduce legislation to reject new rate changes and roll back previous rate changes (Mills & Lecomte, 2006, pp. 11-12). For State Farm, the largest U.S. P&C insurer, these regulatory risks forced the firm to abandon Florida homeowner insurance in 2009 (Kunreuther & Michel-Kerjan, 2009, p. 36).
In addition to the threat of regulatory intervention in local markets, raising rates to accommodate increased physical risk will ultimately make insurance unaffordable for most developed economies. ABI estimates that premiums would have to rise 67% to generate an additional US$76 billion to cover for climate change related losses in Europe, Japan, and the United States (Dlugodecki & Lafeld, 2005). Such a premium increase would diminish existing insurance markets by making private insurance unaffordable to both individuals and firms. This analysis demonstrates how the normative institution creates obstacles associated with the regulative institution. In particular, insurers will not be able to price risk at an affordable level without government support in implementing mitigation and adaptation regulations.
Market pullbacks represent a second strategy that can be used to maintain the standards of insurability. If insurers cannot price risk at level that is affordable, while compensating the insurer for potential claims, the standards dictate that insurers should not enter the market. In Florida more than half a million policies were cancelled or not renewed in 2006. Along the Gulf Coast, Allstate, one of the largest insurers in the United States, suffered losses of US$3.68 billion, which convinced it to not renew more than 140,000 policies (Lehmann, 2006). In New York, Allstate refused to renew 30,000 policies because of hurricane risk, despite the fact that a hurricane has not hit the area in 70 years. In South Carolina, insurance brokers ran out of policies to sell as insurers refused to provide property insurance (Mills & Lecomte, 2006, p. 12).
In addition to limiting the availability of viable markets, market pullbacks have also led to regulatory risk. When insurers attempt to pull out of a market, insurance regulators can either impose moratoriums on a nonrenewal of contracts, which forces the insurers to maintain its existing policies, or abandon private insurance and establish a government-operated insurance “pool”. Often insurers are forced to cover the losses suffered by these pools as a condition on providing any form of coverage in the state (Sutter, 2009, p. 14). Because these pools charge below the market price for risk, they continually lose money. For example, in 2004, Florida’s public insurance pool lost US$2.5 billion due to an increase in hurricanes (Mills & Lecomte, 2006, p. 10). In Mississippi, insurers were forced to pay US$545 million in the aftermath of Hurricane Katrina to recover losses as part of their obligations to the pool (Mills & Lecomte, 2006, p. 14).
For insurers competing in the international market, the strategy of shifting the burden to government-backed pools is not sustainable. Most of the world’s developed economies are currently saturated markets for insurers, who are now looking for market opportunities in developing countries. These countries are asymmetrically exposed to climate change impacts, which, when combined with increasing market pullbacks in already established markets, represents a significant threat to the insurance sector’s future growth (Mills, 2007, p. 13). The use of market pullbacks to maintain the standards of insurability creates a similar obstacle related to the regulative institution as premiums increase. To govern effectively spillover from rising weather-related losses, insurers require the assistance of international mitigation and adaptation regulations that price climate change risks within the global economy to avoid the use of market pullbacks.
A third strategy that insurers can use to maintain the standards of insurability is to improve the accuracy of their modeling to capture the link between climate change conditions and changes in weather patterns. In response to the 2004-2005 losses, all three of the world’s largest risk modelers, including AIR WorldWide, Risk Management Solutions (RMS), and Eqecat, introduced what is known as a “near-term” or “short-term” model that predicted the intensity and probability of Hurricanes based on climate conditions in the last 5 years, instead of the last 100. The model produced by RMS predicted that landfall for Category 3, 4, and 5 hurricanes would increase by 30%, generating an increase in insured losses of around 40% (Eeuwens, 2009). Consequently, insurance rates for areas exposed to these weather-related losses would increase to accommodate the increased risk.
These models face two important obstacles. First, regulators have demonstrated a willingness to intervene when insurers use models that lead to significant premium increases. For example, the RMS model was rejected by Florida insurance regulators based on complaints from consumers who already pay some of the highest rates in the industry (Kern, 2007). According to a senior official with RMS, the politicization of these models in Florida demonstrates the obstacles insurers are likely to face as they try to legitimize the use of models that price climate change risks.
The second obstacle is that actuarial models, even the near-term approach, are not robust enough to capture the long-term influence of climate change on weather risk markets. As a consequence, insurers are concerned that their reserves will be insufficient to cover risk that cannot be modeled into present day premiums. According to Mills, “a major obstacle to insurers taking action on climate change has been that the models the industry uses to manage and price risk have been backward looking and thus, by definition, unable to take climate change into account” (Mills & Lecomte, 2006, p. 17). Because their models are “blind” in determining whether climate change risks are increasing or decreasing, the insurance industry’s belief in “actuarialism” and the ability to rely on the past as a predictor for the future is no longer valid.
This uncertainty has fuelled concern among insurers that the risk modeling process must be reformed to incorporate future oriented risks. Celine Herweijer, the Director of Climate Change Practice for the risk-modeler RMS, confirms this point by arguing that “climate change as an issue has shifted modeling from using purely historic data to having to forecast for a different world” (May, 2008). The emergence of these obstacles related to the development of new modeling approaches reveals that the cognitive institution is also exposed to a great deal of uncertainty in governing increasing weather-related losses.
Thus, “situated” institutions within insurance markets create obstacles for insurers in maintaining the viability of their markets as weather-related losses associated with climate change increase. The industry’s dependence on the standards of insurability to govern uncertainty in pricing risk has led to the emergence of obstacles in relying on regulative and cognitive institutions to guide weather risk pricing decisions. In particular, the industry faces technical obstacles in reforming the modeling process so that climate change risks can be priced. Also, the industry must overcome political obstacles in convincing governments to implement mitigation and adaptation regulation to preserve the insurability of existing markets from rising weather-related losses (Mills, Lecomte, & Peara, 2001, p. 117). These institutional obstacles represent a key distinction that explains why insurers support a more robust effort to govern climate change risks than the institutional investors involved in the CDP and INCR.
To govern climate change risks, institutional investors support risk disclosure to overcome obstacles related to maintaining their fiduciary duty (normative institution) and a gap in existing disclosure regulations (regulative institution). Risk disclosure is insufficient for overcoming the technical and political obstacles that insurers face in governing climate change risks. Indentifying these institutional obstacles complements analysis on strategic incentives for governing climate change risks by explaining why insurers support ClimateWise’s objective of pricing climate change risks within their markets, in addition to the global economy. Although this analysis explains why insurers would support the ClimateWise strategy, it does not explain the emergence of this strategy. The next section will explore how institutional entrepreneurs identified the obstacles insurers face in governing climate change risks, and promoted self-regulation as a strategy to overcome these obstacles.
Institutional Entrepreneurs and Self-Regulation Through ClimateWise
During the 2000s, several institutional entrepreneurs recognized that the insurance industry needed to rethink the existing strategy for pricing weather-related risks associated with climate change. In 2001, Evan Mills authored a paper with Eugene Lecomte, a former CEO and President of the Insurance Institute for Property Loss Reduction, and Andrew Peara, a Fellow of the Society of Actuaries and a climatologist for the U.S. Department of Energy, which outlined the case for proactive engagement on climate change risks.
The report identified the obstacles that insurers face in governing climate change risks that have since been targeted by ClimateWise. First, insurers cannot act on climate change risks until their models can measure and detect these longer term risks. Although near-term models can be used to inform exposure to short-terms risks on an annual basis, models that inform rates based on longer term risks associated with climate change represent a significant technical challenge. Second, insurers will not act without significant government and regulatory support in allowing rate increases and adopting mitigation, loss prevention, or adaptation strategies.
In 2004, Ceres commissioned Lecomte and Mills to research the impacts of climate change on the insurance sector. Their first report revealed that insurers were highly exposed to increasing risks from weather-related losses associated with climate change. But the report also outlined that insurers will need to develop a proactive strategy along with regulators, governments, and consumers “to build the structure for policy implementation, as well as good actuarial analysis and catastrophe modeling” (Mills & Lecomte, 2005, p. 26).
In the second report, released in 2006, Mills and Lecomte refined their proposed strategy by suggesting that insurers adopt a “ten point strategy” based on a set of voluntary best practices. This list of best practices represented what Mills and Lecomte described as the “Risk to Opportunity” strategy, where insurers collectively work to establish and overcome the technical and political obstacles that stand in the way of pricing climate change risks throughout the economy. Indeed, according to the Lloyd’s of London representative who attended the initial meetings that established ClimateWise, the “Risk to Opportunity” strategy provided an important blueprint on how to proceed.
In the United Kingdom, the Association of British Insurers (ABI) had reached a similar conclusion to Mills and Lecomte. ABI recognized that insurers needed to engage their “exchange partners” including stakeholders, regulators, and customers in a conversation not only on the vulnerability of the insurance sector to climate change but also the potential benefit from the role of the sector as a risk-expert in mitigating climate change risks. In their 2004 report, ABI argued that
[A]s experts in managing risk and its financial and economic consequences, the insurance industry is uniquely placed to contribute to the climate change debate. Insurers understand risk and understand their customers. Insurance as a business also needs to manage its own risks arising from climate change, and to engage with Government and others who affect those risks. (Dlugodecki, 2004, p. 4)
Although Ceres and ABI identified the challenges that insurers faced in governing climate change risks, the Prince of Wales and his ENGO the Cambridge Programme for Sustainability Leadership (CPSL) initiated ClimateWise. In early 2006, the Prince of Wales contacted ABI to organize a meeting between London-based insurance CEOs. According to an official with the ClimateWise Secretariat, The Prince’s goal was to “put the challenge” to insurer CEOs to become “more pro-active” as a sector in managing the risks associated with climate change.
The Prince provided more clarity on his strategy in a speech to ABI where he argued that “if insurance companies could take a strategic view across all aspects of what they do and look at [climate change] as part of the whole business it might just make a difference” (Purdey, 2007, p. 1). Several CEOs, including the head of Lloyd’s of London, Aviva, Allianz, Axa, and Swiss Re were receptive to the Prince’s idea and formed a working group facilitated by ABI to develop a more proactive and coordinated strategy between the insurers.
After 9 months of negotiation, the working group established a list of best practice principles for coordinating a response to climate change risk (Insurance Newslink, 2007). According to an official with ClimateWise, the working group designed the principles, which they named the ClimateWise Principles or ClimateWise, to aggregate knowledge on new strategies to manage climate change risks that other insurers would be encouraged to join, and coordinate lobbying on regulations required to defend the industry from rising weather-related losses. They also organized a secretariat to govern the implementation of the Principles by administering an annual audit on each insurer’s compliance. By the time of the ClimateWise’s official announcement in September 2007, 39 insurers had signed up.
By signing up to ClimateWise, insurance firms make commitments to work toward achieving 40 detailed standards of best practice that are organized in six broad principles. These principles include (a) leading in risk analysis; (b) informing public policy making; (c) supporting climate awareness among their customers; (d) incorporating climate change into investment strategies; (e) reducing the environmental impact of their operations; and (f) accountable reporting on their progress toward these goals. This principle outlines the annual third party audit that the ClimateWise Secretariat administers to improve compliance (ClimateWise, 2009b). The principles roughly parallel the list of best practices in the Lecomte and Mills (2006) Ceres report.
This analysis demonstrates the role institutional entrepreneurs played in mobilizing support for the use of self-regulation. In particular, these entrepreneurs were able to promote self-regulation as a strategy to overcome obstacles in pursuing strategic incentives to govern climate change risks. While entrepreneurs were also involved in the formation of the CDP and INCR, the Prince of Wales and the CPSL were able to take advantage of more robust incentives and institutional obstacles in convincing insurers to establish ClimateWise. The next section will explain how ClimateWise is designed to overcome the obstacles insurers face in pursuing incentives to govern climate change risks by leveraging the industry’s technical and political authority.
Governing Climate Change Risks Through ClimateWise
The ClimateWise Principles can be grouped into two categories. The first category includes Principles 1 and 4, leading in risk analysis and including climate change in investment strategies, which are designed to leverage the insurance industry’s technical authority in implementing a price on climate change risks vis-à-vis its markets. The second category includes Principles 2, 3, and 5, which are designed to leverage the industry’s political authority in lobbying for national and international regulations that price economic behavior exposed or contributing to climate change risks. Principle 6 is designed as a “reflexive mechanism” that is administered by the ClimateWise Secretariat to identify weaknesses in implementing the other principles and focus insurer expertise and capacity to resolve these weaknesses. This strategy reflects the obstacles insurers must overcome in advancing their interests in governing climate change risks.
Principle 1 commits members of ClimateWise to “lead in risk analysis” by researching how climate change risks will affect future business, develop accurate climate change forecasts, generate models that inform premium levels and capital reserves, generate risk profiles for new green technologies, and most importantly, share research with others (ClimateWise, 2009b). Principle 4 asks ClimateWise members to evaluate how climate change risks can be implemented into their investment strategies (Forum for the Future, 2009).
Both of these principles are designed to harness the insurance industry’s technical authority in modeling and pricing risks to establish a link between climate change and increasing weather-related losses. This ability to model and impose a price on behavior that contributes to risk constitutes an important source “technical authority” in the global economy. International Political Economy scholars (IPE) defined “technical authority” to explain the implicit power of financial knowledge in governing outcomes in the global economy (see Porter, 2005; Sinclair, 2007; Tsingou, 2010). Insurers, specifically underwriters and actuaries, are trained in the “actuarial sciences” to assign probability and values to certain risks. This expertise is widely perceived to be legitimate among market actors because it involves a “normative dimension” in which compliance to this expertise is “elicited as a result of a belief in the inherent superiority of a technical or scientific way of doing things” (Porter, 2005, p. 4).
ClimateWise is designed to leverage this authority in modeling and pricing climate change risks throughout the economy. To accomplish this goal, Principle 1 is designed to facilitate the development of an insurer “epistemic community” (Haas, 1992), including reinsurers, primary insurers (both property and casualty and health and life insurers), brokers, and risk-modelers in building knowledge partnerships that ultimately reduce research transaction costs for developing more effective actuarial models. For example, the 2010 audit outlines a project recently initiated by ABI to combine actuarial and climate models as an example of best practice. ABI commissioned the U.K. Met Office to partner with the risk-modeling firm AIR in an effort to link the two types of models. Based on climate models produced through the Met Office, AIR created “climate conditioned catalogues of potential future events and compared the resulting insured losses with losses associated with today’s climate, which is the representative of the baseline risk” (Daily, Huddleston, & Fasking, 2009, p. 15).
These models are also important for facilitating compliance with Principle 4. If insurers are to govern the exposure of their investments to climate change risks, new models could educate insurers on areas of the economy that are disproportionately exposed to these risks. Providing this information to the fund managers charged with making investment decisions can help improve investment decision making as climate change risks increase.
These efforts to overcome technical obstacles through ClimateWise help insurers defend the commons and maintain the standards of insurability in two ways. First, it is necessary for the industry to support a consensus that legitimizes a higher price on P&C coverage in areas exposed to increased weather-related losses associated with climate change. Without this consensus, regulators and consumers are likely to challenge these models and expose the industry to reputational and regulatory risk. Second, it is also necessary for insurers to determine markets that are exposed to higher losses to inform governments and international policy makers about the necessity of implementing mitigation and adaptation policy.
Indeed, the second category of principles adopted by ClimateWise is designed to leverage the industry’s political authority in supporting such policies. Principle 2 asks insurers to not only collectively engage in public policy making by lobbying for regulations that mitigate climate change risks but also encourage adaptation to these risks in the global economy. Principle 3 asks members to work within their customer and stakeholder base to “inform customers of climate risk” (ClimateWise, 2009b). This principle helps insurers defend their commons by building a constituency of support among market participants that recognize and understand why insurers have to raise rates in response to climate change. Without effective communication, ABI contends insurers “run a reputational risk,” “since they may be seen as the bearers of unpopular messages and blamed for factors which they alone cannot control” (Dlugodecki, 2004, p. 19).
Principle 5 asks ClimateWise members to reduce the overall environmental impact of their business by mitigating GHGs across their supply chain and publicly disclosing their emissions (ClimateWise, 2009b). By agreeing to work toward reducing their emissions, ClimateWise attempts to send a reputational signal to the sector’s stakeholders that climate change risks are issues of strategic importance for insurers, requiring both regulatory and societal adjustments in behavior to mitigate these risks. According to an official with ClimateWise, signing up to ClimateWise without a principle that demonstrates the signatories’ own efforts to mitigate GHGs would create a significant legitimacy problem when pricing climate change risks, lobbying policy makers or working to reduce climate change risks among customers and stakeholders.
These three principles are designed to leverage the insurance industry’s political authority in governing outcomes in the global economy. Insurers have two sources of political authority in dictating outcomes in the global economy. First, the industry has access to instrumental authority through its ability to leverage its resources in lobbying policy makers to support policy favorable to the industry (Fuchs, 2005, p. 3). The P&C insurance market is worth approximately US$2 trillion in terms of global revenue, and 5 of the top 10 global insurers are members of ClimateWise, including Allianz (1), Axa (2), Zurich (3), Aviva (8), and Prudential (10) in addition to the Lloyd’s of London insurance market (see Forbes, 2010; Mills & Lecomte, 2006, p. 1).
Second, the insurance industry also has access to “structural power” through its ability to regulate economic behavior by pricing risks (Strange, 1996, p. 124). Virginia Haufler’s analysis on the industry confirms this influence. When insurers collectively decide that a risk is uninsurable they can force states into implementing regulations that reduce these risks to maintain the efficiency of insurance markets (Haufler, 1997). Indeed, coordinating collective lobbying efforts to secure policy that defends the industry from climate change risk is one of the central planks in ClimateWise.
The ClimateWise audits reveal several examples of best practice according to Principles 2, 3, and 4. To fulfill the commitment to Principle 2, insurers have supported ClimateWise’s efforts to lobby policy makers on their behalf. According to a ClimateWise official, these policies are identified based on the industry’s expertise in identifying regulations that can offset potential losses the industry is likely to face as climate change impacts increase. ClimateWise has lobbied policy makers at the last two Conference of the Parties (COP) in Copenhagen and Cancun, advocating for a robust 40% GHG emissions reduction by 2020, which is 20% more than the EU’s current position (Torrance, 2010).
At a more specific level, ClimateWise has supported the implementation of “mandatory risk reduction” policy to strengthen adaptation at the national level (Torrance, 2010). These plans included implementing a national database on climate change risks and implementing land-use and loss prevention policies (or adaptation policy) based on exposure to these risks. The former policies are necessary because insurers lack the data necessary to inform new modeling techniques, whereas the latter is needed if markets are to remain insurable as climate change impacts increase (ClimateWise, 2009a).
The audits also outline several examples of best practice according to Principle 3. For example, Zurich has launched a web site to communicate to customers how they can identify climate change risks, and how to minimize the costs associated with these risks (PricewaterhouseCoopers, 2010, p. 14). Insurers have also demonstrated important progress toward Principle 5. According to the 2010 audit, most ClimateWise members have undertaken efforts to both measure and establish emissions reduction benchmarks (PricewaterhouseCoopers, 2010, p. 30).
Principle 6 plays a vital function in terms of expanding the insurance sector’s technical and political authority in global climate governance. Each year members must submit a report that outlines their progress in implementing the best practice standards. This audit evaluates compliance based on a “comply or explain” model, where members must either provide evidence of their efforts in working toward the standard, or explain why they are not complying. These responses are then assessed, assigned a “score” based on these efforts, reported back to the participant, and disclosed anonymously in a public report (i.e., scores are disclosed but member names are removed; PricewaterhouseCoopers, 2010, p. 37).
These audits incorporate reflexivity into facilitating ClimateWise’s objectives to help insurers overcome the technical and political obstacles involved in governing climate change risks. By incorporating this reflexivity, ClimateWise is designed to continually improve compliance to its core objectives in expanding the industry’s technical and political authority in global climate governance. For example, the audits have identified that insurers should devote more resources to linking new modeling approaches to higher premium rates (PricewaterhouseCoopers, 2010, p. 14).
Analysis on the ClimateWise Principles demonstrates how it is designed to pursue a unique form of self-regulation to overcome obstacles in defending the industry from climate change risks. Principles 1 and 4 are designed to leverage the industry’s technical authority in developing the models necessary to price climate change risks in insurance premiums. Principles 2, 3, and 5 are designed to leverage the industry’s political authority in mobilizing support for the implementation of international mitigation and adaptation regulations.
Conclusion
This article explored the emergence of ClimateWise as a case study in the formation of a self-regulatory institution in the insurance sector designed to expand the industry’s authority in global climate governance. The emergence of ClimateWise constitutes an important development from the perspective of global climate governance. Existing analysis on “climate change self-regulation” in the financial industry has so far only explored efforts by institutional investors to promote climate change risk disclosure. While these developments are significant, ClimateWise represents a much more robust effort to price the behavior contributing to climate change. Indeed, the insurance industry has access to both technical and political authority in pricing risk throughout the global economy.
A review of existing theories explaining the formation of self-regulatory institutions revealed that strategic incentives and institutional conditions represent a framework that can be used to explain the emergence of ClimateWise. The application of this framework reveals that throughout the 2000s weather-related losses reached historic levels for the industry. These losses spread throughout the industry and created strategic incentives in governing the industry’s exposure to weather-related losses associated with climate change. Although this analysis was able to identify that insurers have incentives in governing climate change risks, it could not explain why self-regulation through ClimateWise represented an optimal strategy.
Analysis on the industry’s use of “situated” institutions to inform decision making on pricing weather-related risk revealed that pursuing incentives in governing climate change risks faces a number of institutional obstacles. In particular, insurer efforts to price climate change risks using the standards of insurability, or the normative institution, created obstacles associated with the regulative and cognitive institutions. Price increases, market pullbacks, and new modeling techniques led to regulatory risks and uncertainty in using actuarial models to price the future-oriented risks associated with climate change. These obstacles explain why risk disclosure as a strategy for governing climate change risk in insurance markets is inadequate. In addition, these obstacles also explain the emergence of preferences in support of international regulations and new modeling techniques that price the behavior contributing to climate change risks throughout the economy, and within insurance markets, respectively.
While this analysis explains why insurers support international regulations on mitigation and adaptation and new modeling techniques, it does not explain the origins of the ClimateWise strategy. To address this weakness, the article explored the role of institutional entrepreneurs who recognized obstacles within the industry in governing climate change risks as an opportunity to promote self-regulation. The Prince of Wales took on the role of an “institutional entrepreneur” by proposing the formation of a self-regulation institution. After 9 months of negotiation, the ClimateWise Principles were announced. Analysis of these principles revealed that they are designed to leverage the technical and political authority of the insurance industry in facilitating the pricing of climate change risks throughout the global economy. This design incorporates the use of voluntary best-practice standards that harness the collective expertise and resources of the industry in developing new modeling techniques and lobbying regulators to implement international regulations governing mitigation and adaptation.
The creation of any self-regulatory institution within the insurance sector has the potential to steer “social systems” outside the insurance sector among states, firms, and individuals (Haufler, 1997; Jagers & Stripple, 2003). Indeed, ClimateWise’s objectives are an important development within global climate governance. By leveraging the industry’s technical and political authority in pricing risk throughout the economy, ClimateWise has the potential to preserve the viability of global markets in ways that strengthen global climate governance.
Footnotes
The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article from the Social Sciences and Humanities Research Council (SSHRC) Doctoral Fellowship.