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The impact of climate change on the insurance sector

Posted on 7 February 2023

In today's world, businesses face no greater risk than those arising from the climate crisis. From flooding in Eastern Australia, to Europe's worst drought in 500 years, Hurricane Ian to Storm Eunice, 2022 bore witness to increasingly severe natural disasters which claimed lives, displaced millions and cost billions. With recent research indicating that the world's oceans are now at their hottest for 1,000 years, that trend is unlikely to change. One result is an increase in insurance claims, in both value and number.

However, as the Bank of England has noted, increased risk is likely to lead to repricing, potentially putting cover out of reach for many businesses, and rendering it entirely unavailable for some. Even where cover does remain available, lower margins and pressure on insurers to contribute to net zero targets may lead to reduced liability limits and the introduction of exclusions such as the LMA Model Climate Change Exclusion or the Chancery Lane Project's Climate Harm Exclusion clause.

In this article we consider the effect of the climate crisis on insurance claims, how insurers are likely to respond as claims increase, and what businesses can do to best protect themselves.

Enhanced risks arising out of the climate change crisis

Insurers have been concerned about the impacts of climate change for many years, with major re-insurers leading industry thinking on climate change from the mid-1990s onwards. That early work has proliferated across the entire value chain and backwards to retrocessionaires on a more accelerated basis since 2012.

In 2022, the Bank of England published its Climate Biennial Exploratory Scenario, which analysed the financial risks climate change has created for the UK's largest banks and insurers. The report identified three enhanced risks for insurers:

  1. physical risks attributed to climate change (e.g. more adverse weather conditions), mainly impacting property damage insurance policies and business interruption insurance;
  2. transitional risks associated with moving towards a lower-carbon or net zero economy, such as new climate change regulations, policies and technologies; and
  3. liability risks involving various policies such as directors and officers (D&O) liability insurance, and professional indemnity insurance.

Physical risks

According to Swiss Re, losses arising from natural disasters in 2022 caused an estimated US$115 billion in insured losses, significantly higher than the 10-year average of US$81 billion for 2012 to 2021. This has been attributed to more frequent adverse weather conditions.

The most expensive climate-related disaster for insurers last year was Hurricane Ian, a category 4 hurricane which mainly hit the southeast of the USA in September 2022. Swiss Re predicted that insured losses will range between US$50 billion and US$65 billion. Meanwhile, in February 2022, winter storms across Europe caused estimated losses of more than US$3.7 billion. The UK was particularly hard hit. According to the ABI, storms Dudley, Eunice and Franklin resulted in 177,000 claims for damaged businesses, homes and vehicles, with an expected cost to insurers of £497 million. Of these, 96% were related to property damage. Storm Eunice was one of the most catastrophic storms, with PwC estimating insurance losses between £200 million to £350 million, attributed to commercial and residential property damage, and travel disruptions.

Transitional risks

The transition to a lower-carbon economy also poses challenges to insurers, not least as a result of fluctuating carbon prices, which can impact pricing, lending and investment decisions. Meanwhile, the imposition of increasingly stringent climate change regulations, such as the UK's mandatory climate-related financial disclosure requirements for publicly quoted companies, large private companies and LLPs, are leading to increased costs.

Initiatives designed to encourage insurers to address Environmental, Social and Governance (ESG) risks and opportunities, including the UN’s Principles for Sustainable Insurance (which now has 140 signatories, representing 33% of global premiums) and its Net-Zero Insurance Alliance, are also placing greater pressure on insurers, whilst leaving some insureds at peril of losing cover entirely.  For example, in 2021 Aviva set itself a target to become net zero by 2040 and as part of that plan, last year it stopped underwriting insurance for companies making more than 5% of their revenue from coal or unconventional fossil fuels unless they have signed up to the Science Based Targets initiative.

Liability risks

The climate crisis has also fuelled a global rise in climate litigation (claims arising out of a failure to mitigate climate change). Last year the LSE reported that the cumulative number of climate litigation cases has more than doubled since 2015, totalling 2,000, of which approximately a quarter were brought between 2020 to 2022. As well as being used as a tool by claimants to influence government action, climate litigation is increasingly used by parties to seek compensation for losses arising out of climate change from those they deem responsible, such as company directors. Such loss will often fall on insurers, mainly under D&O insurance, if cover is not excluded.

For example, in May 2022, an English High Court claim was brought by members of a pension fund against the directors of the fund's trustees for not having a plan to divest from fossil fuel investments (McGaughey v Universities Superannuation Scheme [2022] EWHC 1233 (Ch)). Although permission to continue the claims was refused at first instance, that decision is being appealed to the Court of Appeal.

How insurers are responding to increased climate-related claims

For some insurers, this has led to higher rates, making renewals more difficult. For example, Carlisle United Football Club reported that its flood insurance is now £50,000 more expensive than it was in 2015. Other insurers are taking a similar approach to Aviva, refusing to provide cover to fossil fuel projects.

A less drastic approach has been the development of climate-related exclusion clauses. The Lloyd's Market Association (LMA) has, for example, produced a model climate change exclusion clause (LMA5570) for use in liability policies. The clause excludes cover where the insured/reinsured has caused or contributed to climate change or its consequences, meaning that a claim against a company director for breach of fiduciary duties which contributed to climate change, would be excluded under a policy containing the LMA5570 clause.

Meanwhile, the Chancery Lane Project has drafted an exclusion for climate harms (referred to as Connor's clause). The clause excludes cover for climate liability, costs and losses where the insured party has failed to meet greenhouse gas emissions reduction targets.

These clauses shift climate-related risk from insurers to the policyholder and, in doing so, go some way towards incentivising behavioural change. However, it remains to be seen how far these clauses will be taken up.

Policyholders should also be aware that even without these bespoke exclusion clauses, insurers might still be able to avoid cover for climate-related claims. A failure to disclose key information when obtaining a policy, such as any heightened vulnerability to certain climate-related physical risks, could result in cover being denied. Policyholders should also be aware of other conditions precedent to liability, such as any obligation to give notice of a loss or an event likely to give rise to a claim. Again, a failure to comply could lead to a loss of cover.

How businesses can protect themselves

The potentially devasting impacts of the climate crisis, both in terms of physical loss and potential third-party liabilities, mean it is imperative that businesses adequately assess their exposure, ensuring that they can present climate-change-related risks to brokers and put in place effective cover at the best price available.

It is also vital for businesses to prioritise a purpose-led approach to understanding and addressing ESG risks in order to mitigate risk. For example, businesses should be ready to implement sustainable practices and ensure that they are fully engaged with legislative requirements by putting in place a carbon reduction or net zero strategy, or accelerating the adoption of green technologies. Indeed, such steps will be crucial if taking out cover that includes exclusion clauses such as the LMA5570 clause or Connor's clause.

The Mishcon Purpose Framework, a global "standard" for ESG considerations focussing on governance and management for international businesses and combining strategic and legal aspects, can assist here.  The Framework is designed to enable firms to understand market expectations, mitigate business and legal risk, as well as capture new business opportunities.

The cost of coverage resulting from the climate crisis might be high. However, the risks of failing to insure are potentially significant.

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