In the past month, three leading economists and central bankers have turned their attention in a public address to the impacts of climate on human economic activity. In early April, the Governor of the Bank of England, Mark Carney, in his speech to insurance supervisors spoke of increased likelihoods of clustering of extreme events. He reminded the audience that unrelenting underwriting discipline of up-to the mark risk management practices has become a requirement for the very survival of the insurance business model. Full transcript of the address is available at this link - ...
A week earlier, at an Institut Louis Bachelier event, Professor Lars Peter Hansen from the university of Chicago, Nobel prize in economics recipient for 2013, raised the discussion to the need for portfolio managers to include in their asset pricing models the marginal impact of a climate change variable. Both of these analysis bring up the fundamental question of our understanding of the price of climate risk. Furthermore it matters evidently how this understanding is applied to practical questions of financial asset and insurance premium pricing.
This month as well, M. François Villeroy de Galhau, Governor of Banque de France defined climate stability as a 'determinant for financial stability' and further argued for more transparency on climate risk present or 'hiding' in the balance sheets of financial and insurance institutions. The concept could drive regulatory requirements. Climate risk on the balance sheet may have a long lifespan, but it can be estimated at present. Pondering over a rewrite of the textbook net present value [NPV] model is not too far fetched.
About 40 years ago another principal question in finance needed immediate solution – and that was on the price of derivatives’ risk. The derivative contract itself already hedged the volatility of futures’ prices. Futures in their own right were designed to hedge the volatility of spot prices. So the challenge of pricing the ‘volatility of volatility’ was brilliantly solved in 1973 by Black, Merton and Scholes - for which a Nobel prize in economics was given, as well, in 1997. It took about 10 to 15 years for the framework of their solution to be adopted by risk management practitioners and financial markets. Today the outputs of BMS models are the currency of derivatives’ risk trading and management – i.e. the price of volatility of volatility.
Now 40 years later another fundamental pricing question in insurance, finance and economics has emerged, and I feel the sophistication and challenge of understanding this new emergent risk are at least as high.
Category: Climate/natural disasters: Climate change, Disaster risk
Location: Paris, France