Climate change and the insurance industry

Many of us in the insurance industry do not regard climate change as a significant issue. However a certain amount of research and analysis has been performed by several progressive companies who now see it as a fundamental issue, which will affect not only the nature of insurance risk, but also public policy towards natural hazards.

In parallel, there is a broader move within the industry to understand and cope with the impact of insurance extreme events, because of the growing exposure to catastrophic losses and the increase in their actual impact in recent decades. Finally, there is a recognition that environmental issues will have to feature more prominently on the management agenda in future.How insurance can form a part of a broader programme for natural disaster reeducation, incorporating climate research, land use planning, and information strategies. Problems and opportunities might then arise for insurance and how best to capitalize on the common elements in the where the insurance industry stands on climate change now, and second to identify what opportunities and problems will flow from it to affect the insurance sector.

It is now generally accepted that the Earth’s temperature has risen about  0.6  C  since  1860,  with  a  corresponding  rise  in  sea  level. Man-made “greenhouse gases” like carbon dioxide, methane and which retain the sun’s energy, the human influence on climate was now discernible. Greenhouse gases have a long lifetime in the atmosphere and are increasing in volume due to global economic activity, so the changes will not cease by 2100, but will in fact accelerate. IPCC recommended that governments should jointly agree to limit greenhouse gas emissions to mitigate the long-term changes. It is easier to devise a plan than to implement it.

The insurance world runs the full gamut of opinion on climate change, from disbelief to disinterest to acknowledgement and then active involvement. While there are always exceptions to any rule, attitudes tend to be based on location (for property insurers) or function (for other arms of the insurance industry).

Looking first at property insurers, one should not subscribe to the idea of global warming. This is typical of the business climate in that county, which sees climate change almost as an environmentalist plot designed to undermine its competitive international position, which is heavily based on cheap energy. A factor which is specific to insurance is that weather loss experience is dominated by hurricanes, and those in turn are influenced by a number of factors, particularly el nino, which are apparently cyclical. This means that any underlying natural trend is camouflaged, apart from the widely recognized fact that there is a strong growth in exposure along the Atlantic seaboard anyway.

Some other functions in the insurance market are more aware of and more involved in global warming, because they are more specialized. Either they stand to benefit from an increase in weather related transactions, or they are even more exposed than insurers. The former category includes brokers, reinsurance brokers and loss adjusters who are generally remunerated in proportion to the premium or claims flows. The second comprises reinsurance companies, who are often the true carriers of catastrophic losses even when the original losses

are settled by a local insurer.The most active insurance body on the issue of climate change is the United Nations Environment Programme Insurance Industry Initiative (UNEP III) which was founded in 1995.

There are perhaps four significant reasons why the insurance industry is not currently more actively involved in climate change: the poor quality of information; the predominance of short-term thinking in business circles; peer group influence, and the nature of current institutions.

a) Poor quality information: The flow of information about climate change to insurers is deficient in several ways. In the first place, the state of knowledge about the future weather is embarrassingly poor, because the global weather system is so complicated that even three-day forecasts can be seriously inaccurate. General trends in temperature are not much help to insurers.

b) Short-team thinking in business: It is human nature to respond to recent or urgent stimuli, and insurers are no exception. In the early

1990s for example, reinsurance rates rocketed as a result of Hurricane Andrew, and that recent windstorms have been less costly in terms of insured damages, serious natural disasters do not impinge on the insurance world, because flood damage is often excluded, as is much of the agricultural sector. This means that insurers are considering only a partial picture as they look at weather loss trends, but not and not at consequences of climate change.

c) Peer group pressure: If powerful sectors like energy and motor vehicles take up determined positions on an issue like global warming, this is bound to influence others without a strong stake, or who are less well informed. In the case of one major reinsurer which reversed its proactive stance on climate change.

d) The institutional dimension: Climate change is a problem which needs  to  be  addressed  internationally,  many  industries  have

international associations which lobby effectively on trade and other global issues, including climate change. Unfortunately, the insurance industry is not one of these and until the creation of NEP III there was no channel at all for it to communicate with policymakers at the annual Conferences of parties which are attempting to initiate measures to deal with climate change.

At national level, insurance industry associations do exist, but they are traditionally concerned with local regulation, e.g. taxation, accounting, product design, and consumer affairs. To lobby on environmental issues is quite foreign to such bodies, particularly when there is such a large degree of uncertainty about the likely impacts on their member’s interests. On the other side, governments and scientists are not generally used to seeking the assistance of the business community on environmental issues, and have been slow to recognize that there may be allies in the insurance sector (and others, e.g. tourism) to counterbalance the antipathy from energy-intensive sectors.

There has been a general rise in insured losses in recent decades, largely reflecting changes in exposure, rather than a fundamental trend in the natural hazards themselves. The most significant drivers are: property has become more susceptible to damage, through the use of flimsy structures like trailers and the water-sensitive nature of modern business and personal equipment; populations have grown, have become wealthier, and are increasingly located in maritime regions or megacities (or both); and business are more vulnerable to interruptions following extreme events. Scientific knowledge will continue to accumulate at an accelerating rate, which will lead to advances in materials technology and medical techniques. In turn these are likely to give rise to larger exposures for insures.

The most proactive initiative in the insurance sector is the United Nations Environment Programme Insurance Industry Initiative, founded in 1995, and closely associated with the issue of climate change. It has always advocated early action, because of the uncertain

nature of the impact on weather patterns, and the enormous potential for property damage. Scientific research has conclusively shown that at the time of the last delectation, the climate oscillated wildly even on a decadal timescale, which confirms that the Earth’s climate system is sensitive to disruption. One of the most notable outputs from the initiative is their Global Warming Potential indicator, which estimates the emissions of carbon dioxide for which a company has been responsible. However, the initiative recognizes that a wide range of environmental issues are relevant to insurers, including responsible investment. Currently the membership is largely European and Japanese, but it is hoped that this membership will extend to other continents, and to develop closer co-operation with the banking industry, which has a separate UNEP initiative.

Another epochal change in the industry is the convergence of financial services, with banking and insurance increasingly blending, either through mergers, acquisitions and Greenfield subsidiaries, or through joint venture partnership arrangements. This will obviously reinforce the trend towards scale, but will also lead to more innovation in the provision of financial services. For example, while insurers and banks are not under common ownership, it has been easy for an insurer to avoid risks like flood or growing crops which may constitute a major financial problem for a bank’s customers and therefore the bank. When the interests are united, it is more likely that a new service will evolve to protect them. Alternative Risk Transfer (ART), although only a fraction of the global reinsurance demand has been diverted to them. However, this innovation could prove decisive if a major increase in insurance for natural hazards were to be required. The mounting toll of human casualties and property losses motivated the United Nations to declare the 1990s the International Decade for Natural Disaster Relief (IDNDR). The two basic planks in a disaster policy are mitigation.

Traditionally insurers have had four strategies to manage their exposure to natural hazards; limit the risk; control the damage; transfer the risk; and adjust the product price. Limiting the risk by not writing

it, or restricting the quantum through upper and lower limits of liability or narrowing the circumstances of loss which are covered, are common tactics, but  they often give rise to disputes over coverage, and are not welcomed by regulatory bodies, intermediaries or the public. In some cases, they may be essential to safeguard insurers own interests, but it is helpful to link them with other strategies, e.g. prancing incentives. Insurers do often assist their business customers with advice on how to manage specific risks, but it is not generally possible to provide on-site advice for the personal market.

Controlling the damage after has happened has always been a valuable strategy, and as disasters have become more frequent, and insurance companies have growing in size, so it has become possible to apply a more professional approach. Thus 24 hour telephone helplines are common features of service, linked to the nomination of approved repairers/suppliers with a guarantee of quality delivery. This is immensely helpful in reducing the claim costs and improving customer satisfaction.

It used to be easy to transfer risk through reinsurance. Little attention reinsurers   paid   to   catastrophic   risk,   and   ultimately   proved catastrophic for the reinsurers themselves. Now, reinsurers are the heaviest users of exposure management techniques, although this does not always flow through to their prancing. The other way in which risk might be transferred would be to demonstrate that human agency had materially caused or worsened a particular catastrophe, and so seek compensation.

The final instrument is price. Here the underwriter faces major problems, because of public and sometimes regulatory resistance. This is particularly so with extreme weather, since incidents are relatively localized and infrequent, yet a small shift in return periods can producea insurer huge increase in the risk premium. If competitors do not share the same view, the insurer stands to lose a significant proportion of his market share, but the underlying uncertainty and the ease of entry for new competitors makes it difficult to reach a consensus.

A shift to a more co-operative stance would be more effective, and it would be in the public interest to avoid a poor response to disasters when they do come. Insurers can contribute greatly to a societal approach, because they have acquired skill and knowledge of use in preparing for, coping with and recovering form, disasters through their normal activities. Before the event, they have to assess and possibly improve risks, and price them to reflect the degree of hazard, as well as marketing a “grudge” intangible service, which is notoriously difficult. During the incident, they provide emergency advice, and then afterwards they are accustomed to controlling the recovery process because they provide funds from their reserves. This involves appointing a whole range of specialists, suppliers and contractors,  as  well  as  looking  after  the  financial  and  physical well-being of customers. Their ability to mobilize resource internationally, and their possession of an efficient administration release public resources for more vital tasks, and they are instrumental in resisting dishonesty which often abounds after disasters.

APPROPRIATE REGULATORY ENVIRONMENT AND OVERSIGHT

Many developing countries with low non-life insurance penetration lack well-functioning supervisory systems and effective regulatory frameworks according to international stand¬ards. This can hamper the development of sustainable insurance solutions which can function as climate risk transfer instruments. Therefore, an adequate regulatory and supervisory framework needs to be in place to ensure that insurance undertakings are financially viable and that products are designed and sold in a way that ensures value to the customer. The International Association of Insurance Supervisors (IAIS) established a set of essential principles, called Insurance Core Principles (ICPs), to be adhered to for an insurance supervisory system to be effective and which gives guidance on how these principles can be applied in low-income countries.

Pro-active management of climate risks requires long-term commitment from public champions, e.g., relevant ministries and public climate and disaster risk management initiatives. This includes a sustained public engagement with relevant stakehold¬ers like the private sector and civil society on building resilience and reducing exposure to climate-related risks. Public-private-partnership approaches, also with international support, are particularly important for  low-income  countries  where  pure  market-based  solutions  are often not feasible due to high start-up costs, unavailability of data and limited access or low demand for standard insurance products from the low-income part of the society. Thus, a joint effort from the public and private sector with support from inter¬national development partners, or through international climate financing sources such as the Green Climate Fund, is needed to approach climate-risk management more effectively.

The ICPs established by the IAIS, comprise essential principles that need to be adhered to for an insurance supervisory system to be effective. In 2012, the IAIS published the Application Paper on Regulation and Supervision Supporting Inclusive Insurance Markets. Recognizing the intent that the ICPs are universally applicable, the paper provides practical guidance for regulators and supervisors on how to apply an approach proportionate to the nature, scale and complexity of the risk in the specific market context. It shows that some approaches to implementa¬tion may be more conducive to enhancing inclusive insurance markets, particularly for those that are underserved. The Paper provides background material and discusses solutions relevant for supervisors, for example how supervisors can deal with innovation and pilot projects. It covers topics such as formaliza¬tion of informal insurance and supervisory review and reporting that are high on the agenda of developing country supervisors, as well as the issue of how to define microinsurance and what the requirements are that have to be met at a minimum when following a proportionate approach.

While public-private partnerships involving insurance companies and governments are common in developed countries, they are more recent in developing countries. However, low-income countries are beginning to experiment with schemes that extend beyond the traditional form of public-private partnerships and include international development partners.

Governments can provide financial support to climate-related insurance in different forms, such as direct premium subsidies, financial support for reinsurance facilities or operational cost subsidies. Subsidies can benefit the customer and target the initial motivation of insurance companies to enter and serve the mar¬ket. They prove to be especially important for the catastrophic risk layer where private reinsurance market costs could be prohibitive. However, there is a controversial discussion on whether sustainable climate-related insurance solutions in developing countries can work without governments financing part of the costs to share catastrophe losses in order to keep insurance affordable and support a large market penetration.

A World Bank study of government support to agricultural insurance

– an insurance type which is often offering protection from adverse weather events – showed that premium subsidies were the most common form of public intervention provided in almost two thirds of all the 65 surveyed countries. However, the introduction of subsidies to a market needs to be handled carefully: once a market is subsidized, it will be politically very difficult for the government to reduce its intervention. Furthermore, providing subsidies puts a fiscal burden on national budgets and thus, they should only be used very selectively for those target groups that are in real need of it. It also needs to be carefully considered that subsidies have a potential to distort the market and provide adverse incentives:

CONCLUDING REMARKS

Investment in risk management education and responsible management of clients is necessary to increase insurance literacy of both consumers and providers. This includes training on insur¬ance approaches and risk reduction, financial risk management, as well as on the use of early warning systems. Along with this, it is necessary to make clients understand the benefits and costs of the coverage they are about to purchase before potential clients sign up. Clear rules and regulations on responsible finance are needed to ensure that providers of risk transfer solutions have a sound understanding of the tools, the underlying technical issues and how to educate and protect consumers at the local level.

This article is excerpt of the main article published in the Insurance Journal Vol. 64 (Dec 2019) of the Bangladesh Insurance Academy.

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