Defining the Tail Risk

When looking at risk, financial industry professionals will generally start at the tail; in other words, those unlikely but highly hazardous outcomes that reside at the ends of the distribution of all possible outcomes.  In simple terms, if you invest in stocks, bonds or derivatives, then what is the likelihood of a really bad market move taking place—one that will at best stop you sleeping at night or at worst get you fired.  To think about these things is a precondition for long-term survival in the financial industry, and it is certainly not alarmist.

Unfortunately, few people in the financial industry (who are trained to deal with the concept of risk), let alone the general public, take this method of thinking over to climate change—a lack of foresight that could be highly detrimental to their financial and even physical health.

But at what probability does an outcome, and associated consequence, become significant enough to act upon? The life insurance industry gives us some idea. The United States Centre for Disease Control (CDC) puts out a publication called the National Vital Statistics Reports in which it aggregates and analyses mortality data for the United States. In their latest report dated March 16, 2011 they analyse the 2009 data set (most up-to-date figures) and you can find mortality rates by age in Table 1. An extract is given here:

Critically, the life insurance industry is an industry of tail risk. The average American in their late 20s has only a 0.1% chance of dying in any given year and those in their late 50s 0.5%. Yet the latest figures from the life insurance industry’s think tank LIMRA show that 70% of US households have some type of life insurance (of which 44% are individual policies). For those households with children, the numbers are even high: 81% for Generation Y’ers rising to 91% for Baby Boomers.The industry has been in a bit of a panic recently because overall life insurance ownership has been on a gradually declining trend over the longer term, but the fact is that the majority of Americans understand the long-tailed risks of a major breadwinner in the family dying and actually do something about it. In sum, faced with the tail risk of death, adults buy life insurance to manage the risk, especially those people who have children.

Before we look at the tail risk of climate change, it is important to note that life insurance does not hedge against the risk of death: if you die, you are still dead regardless as to whether you own life insurance. What you are really insuring against is not your own death but the sustainability of your family’s prospects after your death. The realisation is that if you die without life insurance, your family will have a degraded life path. In the case of your children, this may, for example, mean reduced educational opportunities that will have negative consequences for their entire life. So actually the act of buying life insurance shows a high degree of concern for the quite distant future as not only are you thinking about a time horizon covering the insurance policy in question but also an even more distant time horizon that encompasses your family’s well being much further into the future after you have gone.

So let’s take a family with children and have a look at the tail risk of climate change. Well, if you have children, then their working lives will likely encompass the 2020s to 2060s, and their life expectancy will likely take them to the end of the century. What is the climate-related tail risk they face over that time period? The answer appears to be a far higher risk than that associated with the loss of a bread-winning parent during childhood. A paper by Richard Betts et al in the UK Royal Society’s flagship journal (that can be found here) spells it out:

The evidence available from new simulations with the HadCM3 GCM and the MAGICC SCM, along with existing results presented in the IPCC AR4, suggests that the A1FI emissions scenario would lead to a rise in global mean temperature of between approximately 3◦C and 7◦C by the 2090s relative to pre-industrial, with best estimates being around 5◦C. Our best estimate is that a temperature rise of 4◦C would be reached in the 2070s, and if carbon-cycle feedbacks are strong, then 4◦C could be reached in the early 2060s—this latter projection appears to be consistent with the upper end of the IPCC’s likely range of warming for the A1FI scenario.

A1FI is the high carbon emissions scenario prepared for the Intergovernmental Panel on Climate Change (IPCC) Fourth Assessment Report (AR4), which is also the emissions trajectory we are currently following owning to the general failure of carbon emission mitigation efforts made by governments around the globe to date. A description of the scenarios can be found here.

At the time of the Copenhagen Accord in 2009, the international community made a commitment to ‘hold the increase in global temperature below 2 degrees Celsius’ from pre-industrial revolution levels (we are up around 0.8 degrees Celsius now). Further, that two degree Celsius degree line is already deemed by mark the border between ‘dangerous climate change’ and ‘extremely dangerous climate change’ (see the Anderson and Bows paper at the Royal Society link above). The IPCC’s famous burning embers diagrams (updated chart below taken from the NYT here) adds some detail to the likely impacts. In short, we will rapidly progress up to the top of the bars shown below (click for larger image).

In sum, as the world temperature likely rises above the two degree Celsius level in most of our life times and probably moves to four degrees and beyond in our children’s life times based on the current emissions trajectories, we will all experience ‘extremely dangerous climate change’. The idea of ‘extremely dangerous climate change’ within the framework of risk is something I will leave to the next post. Suffice as to say, at a four degree global surface temperature mean warming, we will see the global land mean temperature rise by five to six degrees, a six to eight degrees rise in China, an eight to 10 degree rise in Central Europe and a 10 to 12 degree rise in New York (see here). With these kinds of changes, the planet our parents were born into will not be the same as the planet our children mature into.

Extremely dangerous climate change is, however, a risk that we cannot insure against, rather it is something that we can only respond to through mitigation, adaption or suffering. But first we have to recognise the reality for what it is.

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