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Climate impacts loom large on the horizon for the insurance industry

Climate risk inaction from the policymakers portrays a future of economic disorder, unaffordable coverage for ordinary people and cascading impacts on the insurance industry. To avoid it, there must be a massive rethink of the service and sector.

As the recent COP27 failed again to land on an agreement to phase out fossil fuels, capitals across Europe reported record breaking temperatures in an unseasonably warm autumn.

Extreme weather events – once deemed a rare occurrence – are to evolve into another ‘new normal’.

According to the IPCC’s Sixth Assessment Report, extreme weather events have become more frequent since 1950 across most land regions, as a direct result of human influence on climate change.[1]

As the effects of climate change become increasingly more tangible, so does its rapidly growing impact on the insurance sector. Last year, natural catastrophes resulted in a total of $111bn USD of insured losses, in addition to another $270bn USD in total economic losses, according to Swiss Re.[2]

The NatCat in the Hat – An industry facing the stresses of climate change

In a report published in May 2022, EIOPA highlighted European insurers’ exposure to the physical risks of climate change on their property, content and business interruption policy portfolios.[3] The report clearly outlines an increasing exposure to climate risk on multiple levels, the most obvious of which is the direct impact of extreme weather events – most notably floods, wildfires and windstorms on insured properties and businesses.

Less immediate impacts are also beginning to present themselves, such as the long term effect of droughts on agricultural businesses, as well as subsidence risks due to a possible extreme loss of groundwater reserves.

As the frequency of natural catastrophes and extreme weather events rises, (re)insurers are confronted with an unprecedented number of claims. On top of the substantial physical impact of these events on insured property, it is important to keep additional ‘secondary’ impacts in mind.

‘NatCat events’ (national catastrophe events) have a serious general impact on domestic and international societies and economies, which will certainly result in a growing amount of non-physical damage claims.

As company policyholders’ operations come to a standstill, business interruption insurances will see (re)insurers footing the bill of operational continuity, such as temporal relocation of the affected policyholders.

In addition, rising unemployment in the wake of severe events could very well impact homeowners’ capacity to make mortgage payments, further triggering claims in mortgage insurance contracts.

All Risk, No Reward – An unprepared insurance industry has many losers, most of them ordinary people

Traditionally insurers have tried to diversify their risks, both geographically as well as sectorally, through reinsurance contracts in order to distribute risk over a large group of (re)insurance companies.

However, this approach to managing the risk may prove to be insufficient when confronted with the exponentially increasing frequency of severe climate change-related events. The unpredictability of future developments in combination with insurers’ use of risk-management models based on historical data, will certainly lead to underestimations of future losses and claims, which in the worst case scenario may result in insolvency if too many major events take place.

When questioned by EIOPA for insights on this matter, insurance companies reported several actions either taken or under consideration. The most tangible of these actions were the raising of premiums as a reflection of risk for the insured property, modifications in risk selection processes and the increase of deductibles, effectively shifting the burden of risk-mitigation to the policyholder.

The unpredictability of climate change-related events makes it difficult, if not impossible, to accurately forecast the necessary levels of repricing to account for the changing probabilities and severities of insured events and/or properties. All of these open the door to possibly severe negative effects on societies.

First and perhaps foremost, repricing insurance policies is not a limitless solution, as policyholders – confronted with unaffordably high premiums – might end up being left uninsured.

Secondly, increasing restrictions in risk selection processes will only exacerbate already existing protection gaps and negatively impact economies, as businesses need insurance in order to properly operate. Furthermore, widening protection gaps will translate into higher costs for national governments through emergency funding in case of extreme events, as well as adding pressure to already strained communities.

On the part of policyholders, the most vulnerable segments of society will be impacted the most. Increases in policy premiums – possibly combined with other economic factors such as inflation – will wreak havoc in low income families, whose inability to pay for insurance might see them ineligible for renting any form of residence.

The Way Out – Preventing catastrophe in the sector spilling over to the wider economy and society

As we paint this bleak picture of climate change’s impact on the insurance sector, one must not forget that insurers are not only victims of climate change, but also accomplice to its rapidly growing severity.

Finance Watch’s earlier report ‘Insuring the Uninsurable’, explains how the insurance sector enables climate change-accelerating economic activities (via the fossil fuel sector), by not only providing the insurance necessary to run their businesses, but also by financing their activities through their investment portfolios.

By not drastically rethinking business strategies, insurers and reinsurers are adding to what we have dubbed the climate-finance doom loop, effectively sponsoring their own demise and further endangering global financial stability.

The (re)insurance sector must ensure further risk-managing actions do more than simply shift the added pressure to policyholders, businesses, communities and the public budgets.

While the sound management of physical climate change risk by insurers plays an important part in guaranteeing solvency and stability of the sector, it will not be sufficient and increasingly impossible given the radical uncertainty of climate events.

Insurers must credibly align their operations with the net-zero transition objective, in order to not only save their own business, but to keep providing their indispensable service to families and businesses.

Nikolas Geirnaert

Footnotes:

[1] IPPC, Sixth Assessment Report (2021).

[2] Extreme flood events once again drive high losses in 2021, yet 75% of flood risks remain uninsured, Swiss Re Institute reveals

[3] EIOPA, Discussion paper on physical climate change risks (2022).

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