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The Impact of Climate Change on Insurance

Posted on 5 October 2021

The Issues

In recent years, the impact of climate change has become increasingly apparent. An increase in global temperatures has resulted in significant droughts, and expansive forest fires in places such as California and Australia have become annual devastating events. Linked to this increase in temperatures, the rise in sea levels has also caused substantial flooding and coastal erosion in many parts of the world. The damage caused by hurricanes is also known to have cost the insurance industry many billions of dollars in recent years.

The insurance markets most widely impacted by these catastrophic events include the property and casualty sectors, and of course such losses also heavily impact on reinsurance programmes.

Insurers model risk based upon historic data, so common catastrophe models were, to a degree, insufficient for the purposes of projecting the increased risks associated with these events accurately, leading to increased insurer exposure. The fact that such events are now occurring far more frequently will, in our view, result in reduced capacity or willingness on the part of insurers to write such cover, which may lead to policyholders being unable to obtain adequate insurance and commercially affordable rates – either because insurers will no longer write the risk or because premiums become so high that purchasing the relevant insurance is no longer economically viable. This is akin to what has been experienced by many within the life science/product liability sectors; and, more recently, in connection with business interruption insurance which has seen insurers held legally liable to pay billions of dollars resulting from COVID-19 pandemic losses.

Potential Response

This potential gap in cover needs to be addressed proactively by the insurance industry.

In respect of the underlying issues causing climate change, many large insurance groups in Europe are making the fight against climate change a central part of their Environmental, Social and Governance ("ESG") strategies. For example, insurers already invest in sustainable initiatives such as windfarms and solar power, which are a good match with their long-term liabilities. The ABI is also a founding member of ClimateWise, a global insurance industry initiative established in 2007. Signatories to the initiative agree to annually report their progress in areas such as reducing the environmental impact of their business. ClimateWise also undertakes research and develops tools for use in climate change management.

Insurers are also working with policyholders in order to try to mitigate the impact of climate change and to reduce potential future losses. Such actions include assisting policyholders with increasing the resilience of their infrastructures, facilities, or supply chains, which could be rewarded with rebates. A more specific example is one North American insurer, which gives its homeowner's insurance customers access to wildfire-defence services such as relocating valuables and deploying certified fire professionals to homes if a wildfire is approaching. In the future, insurers could also assist with resilience in the climate-vulnerable countries, working with governments and local authorities. Insurers could provide input on topics such as where assets should and should not be developed, how dwellings should be designed and to what standards. Such collaborations would be effective at reducing the potential risk for the policyholder and exposure for the insurer.

In relation to underwriting itself, new products and solutions will be required to adapt to the changing environment. Policyholder portfolios will likely need to be managed differently and nonlinear effects will need to be taken into account, for example, assessing the correlation between more frequent flooding and the economic activity in a given area. Underwriters are becoming more strategic, using heat maps to assist with their modelling and risk tracking. Parametric insurance is also on the rise. In fact, a recent report produced by the United Nations in collaboration with 22 major insurance firms has also suggested that the insurance industry needs to adopt an integrated approach in order to manage future climate change risk. Reinsurance will also be a key factor in risk transfer and exposure sharing.

Additionally, a number of regulators, including the FCA and PRA, are unsurprisingly committed to the issue and are working on putting structures in place to avoid policyholders being left with no readily available cover. For example, on the west coast of America, a region heavily impacted by forest fires over the last few years, the California Department of Insurance (the "CDI") has made the relatively extreme decision to put into place Senate Bill 824 (2018). As explained on the CDI's website "[t]his important consumer protection law requires a mandatory one-year moratorium on insurance companies cancelling or non-renewing residential insurance policies in certain areas within or adjacent to a fire perimeter after a declared state of emergency is issued by the Governor". Insurers are also now not able to base their premiums on a forward-looking basis but just on a historical basis. Whilst this is positive for policyholders, this may impact insurers' future willingness to write cover in the State. A more balanced approach is therefore potentially needed on a larger scale.

Disclosures are an integral part of the risk management process. The Task Force on Climate-related Financial Disclosures ("TCFD") has provided the most comprehensive framework to date, which is widely accepted and endorsed by the UK government and regulators. As part of the government’s phased rollout, insurers will come under mandatory disclosure requirements in stages, depending on their size and scope. Such disclosures include governance arrangements, risk management processes, strategy, metrics and targets.

Another potential option to provide cover is through public-private initiatives/partnerships, which may provide more feasible risk-transfer solutions. For example, in the UK cover can be provided by Flood Re, the scheme designed to increase the availability of insurance to homes in flood risk areas, and the government in the US has been working for many years on Florida flood protection. Such partnerships could also be introduced more systematically across all countries exposed to the most severe and emerging climate change risks.

Conclusion

There are still so many unknowns about the impact climate change will have on all of us. It is clear, however, that risks are only going one way, and the number of catastrophic events is set to continue to rise.

Insurance is essential. The insurance industry and regulators must continue to take steps to ensure that policyholders remain properly protected and that they are still able to obtain meaningful cover, whilst still enabling insurers to operate profitably. Risk prevention and mitigation products being developed will be sharply in focus in connection with the integrity and availability of insurance cover which responds to climate-related risks.

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