A Global Review of Insurance Industry Responses to Climate Change

A healthy and sustainable environment is a precursor to the long-term well-being of society, the strength of the economy and the continuing success of our business. We recognise that climate change is one of the most significant risks facing the world today.

Climate change is a fact. Countering it is a must. We are convinced that climate protection makes economic sense, as it would be more expensive in the long term to pay for the damage it causes. It offers companies and national economies that react quickly great opportunities.

Taking the temperature of the insurance industry

The insurance sector finds itself on the front lines of climate change and its response to the challenge has varied enormously. Insurers are, by definition, selective and cannot be expected to insure all risks.

At a minimum, insurers can be messengers of climate risks through their pricing, terms and conditions and help society diversify the costs of losses. Insurers are intrinsically vulnerable and, in some cases, hampered by insufficient data.

They are also increasingly challenged to make a greater effort to safeguard customers from natural hazards, before limiting coverage or exiting markets. Mainstream insurers have increasingly come to see climate change as a material risk to their business.

The worldwide economic losses from weather-related natural disasters were about $130 billion in 2008 ($44 billion insured),3 and the losses have been rising more quickly than population or inflation.

A 2007 PricewaterhouseCoopers survey of 100 insurance industry representatives from 21 countries indicates climate change is the number-four issue (out of 33); natural disasters ranks number two.5 The majority of the other issues are arguably compounded by climate change.

The following year, Ernst & Young surveyed more than 70 insurance industry analysts around the world to determine the top-10 risks facing the industry.

Climate change was rated number one and most of the remaining 10 topics (e.g. catastrophe events and regulatory intervention) are also compounded by climate change.

The investigators note that ‘‘it was surprising that this risk, which is typically viewed as a long-term issue, would be identified as the greatest strategic threat for the insurance industry’’. Progress in scientific understanding is no doubt driving the growing engagement of insurers.

The scientific debate is over, with the Intergovernmental Panel on Climate Change (IPCC) – representing the definitive scientific consensus and receiving the Nobel Peace Prize in 2007 for its work – now using the considered term ‘‘unequivocal’’ in describing its certainty that climate change is here.

IPCC has also pinpointed human activity as the main driver of observed and projected warming. It has been steadily eliminating sources of uncertainty and reinforcing the conclusion that further delaying action would be highly ill-advised. Indeed, many indicators of climate change are evolving more quickly than projected by IPCC.

The economic analysis has shifted as well, as reports (such as the U.K. government’s ‘‘Stern Review’’)7 turn on its head the conventional wisdom that taking action on climate change will harm the economy.

Companies and investors now increasingly realise that, in fact, it is the lack of action to combat climate change that is the true threat to the economy, while engaging with the problem and mounting solutions represents not only a duty to shareholders but also a boon for economic growth.

Many in the insurance world share the concern. In the words of an associate editor at National Underwriter: ‘‘Given the stakes for insurers covering catastrophic losses, waiting for proof instead of taking action now would amount to just plain foolish behaviour’’.

The insurance community has become increasingly accepting of the science and macroeconomic modelling. Some still prefer to dismiss the science or take remaining uncertainties as a reason to wait on the sidelines, while others take it as precisely the reason for insurers not to be complacent.

Most agree that reducing vulnerability to weather extremes should be a higher priority, but some dispute the need for insurers to engage in addressing the core drivers of climate change or the need to discern the relative roles of human influence and natural factors.

Insurers’ own analyses have provided a sobering outlook for insured economic risks and one that is increasingly consistent with what scientists predict for the physical world.

Modelling studies conducted by the Association of British Insurers find that losses in typical and extreme future years will exceed today’s by a factor of two or three. Even those insurers who did not partake in earlier waves of insurer engagement on climate change are now publicly recognising its potential threats.

State Farm is ‘‘concerned about the prospect of global climate change, its possible impact on severe weather patterns and the challenges this presents to the business of insurance’’. Allstate – insurer of one in nine vehicles and one in eight homes in the United States – recognises the onset of climate change and the presence of human fingerprints:

Allstate recognises the emerging scientific consensus that the world is getting warmer and that this trend is influenced to some extent by emissions of greenhouse gases. Climate change, to the extent it produces rising temperatures and changes in weather patterns, could impact the frequency or severity of extreme weather events and wildfires. Such changes could also impact the affordability and availability of homeowners insurance.

The chairman of Lloyd’s of London has said that climate change is the number-one issue for the massive insurance market. Europe’s largest insurer, Allianz, stated that climate change stands to increase insured losses from extreme events in an average year by 37 per cent within just a decade, while losses in a bad year could top $400 billion.12 UNEP has put the value at $1 trillion by the year 2040.

The initial reaction of many insurers – particularly in the United States – has been to focus on financial means for limiting their exposure to losses, e.g. by limiting availability, tightening terms and raising prices.

The availability-affordability issue places a bright light on the respective roles of the public sector and insurers, and the likelihood that government will have to assume more climate risks if the private sector recedes.

This comes as the existing subsidy-based model for public flood insurance in the United States – the FEMA-managed National Flood Insurance Program17 – was rendered insolvent in 2005 by Hurricane Katrina and again in 2008 by Hurricane Ike, with a combined deficit approaching $30 billion.

Climate change as the ultimate ERM challenge

Climate change – and how to respond to it – is not ‘‘yet another’’ issue for insurers. It is, rather, bound up in the very fabric of the industry and its business environment, namely:

customer loyalty and retention;
corporate governance, investor relations and disclosure;
balance sheet strength, risk-based capital and solvency;
competitiveness;
emerging markets;
reputation and trust;
loss-model accuracy;
regulation

Moreover, in addition to existing risks, the very technological and behavioural responses to climate change will usher in new risks.

Examples include safety issues associated with a resurgence of nuclear power, or geo-engineering to cool the climate by heroic measures such as injecting man-made materials into the atmosphere, or the introduction of carbon capture and storage (CCS) technology.

Even some ‘‘green’’ strategies will bring with them new risks, while mitigating old ones. As such, climate change is a textbook example of ERM, a framework that has resonated very strongly with the insurance community in recent years by integrating an otherwise fragmented risk-management process.

ERM recognises the combined influence of internal and external pressures and how they interact across a broad portfolio of activities, including underwriting and asset management operations. The Casualty Actuarial Society notes that ERM ‘‘expresses risk not just as a threat, but as an opportunity’’.

The past year’s results for many companies put in sharp relief the potential for simultaneous spikes in uncorrelated natural catastrophe losses and adverse market conditions (Figure 1). The global industry saw huge insured catastrophe losses, superimposed on a financial meltdown and softening of insurance prices.

The recent volatility and spike in energy prices provides an excellent illustration of seemingly uncorrelated influences. For example, observers have suggested that opposition to credit scoring for personal auto underwriting could be amplified as the rising costs of gasoline create a cost crunch for consumers.

Meanwhile, both consumer organisations and the governor of New York have argued that the price-elasticity effect of rising gasoline prices has reduced the amount of driving and thus should translate into reduced premiums.

This argument has been used in support of the California insurance regulator’s recent effort to encourage pay-as-you-drive insurance. Some argue that the increased price of energy has driven up the cost of repair parts, offsetting gains resulting from reduced driving.

Meanwhile, shifts in vehicle transportation choices can accentuate other risks, for example, those associated with van pools or telecommuting. Observers have noted adverse implications for risk management in the airline industry, spanning financial and safety considerations.

Taking all of these factors into account, at least one major carrier (GEICO) withdrew a pre-existing rate increase request.

Global (business) climate change

Irrespective of how a given insurer interprets the science of climate change, insurers are increasingly aware that the business environment is changing around them.

In terms of risk perception, investors, rating companies, banks, customers, risk managers and regulators are each in their own way perceiving climate change as a threat and looking to those they interact with including insurers to support their response.

For example, in 2008 major investment banks issued statements of concern about financing coal-fired power plants. Meanwhile, many insurers perceive opportunities in responding to climate change.

Green building construction investment is expected to exceed $12 billion in 2008, while hybrid car sales grew by 38 per cent to 350,000 vehicles that year (almost 50 per cent year-over-year growth).

The electric power industry foresees large investments in renewable technologies and end-use energy efficiency.28 Another indicator of this changing business environment is shareholder resolutions regarding climate change.

The number of such resolutions hit an all-time record of 57 in 2008, as well as an all-time high of 25 per cent of shareholders voting for the resolutions. The number of subsequent withdrawals provides an indication that shareholders obtained their desired outcomes (Figure 2).

Such resolutions have been filed in various years with at least six U.S. insurance companies (ACE, AIG, Chubb, Cigna, Hartford, Marsh and Travelers).

Shareholders were subsequently encouraged when ACE joined the EPA Climate Leaders programme and the CEO spoke publicly about the importance of addressing climate change. ACE also developed a broader set of products and services related to climate change.

A resolution filed with Chubb Group was withdrawn after the company pledged to arrange a meeting with shareholders to discuss climate-risk issues.

The resolutions filed with Hartford Insurance and Prudential Financial were withdrawn after the companies agreed to improve their public reporting and disclosure regarding the potential financial risks they face from climate change and strategies for mitigating those risks.

The companies specifically agreed to respond to a climate-risk disclosure questionnaire sent to companies each year by the Carbon Disclosure Project (CDP).

To be sure, rising losses will create more demand for conventional forms of insurance, as well as new products such as weather derivatives and catastrophe bonds. This will be welcomed only if the changing risks can be understood and managed.

There will also be demand for new forms of insurance, as well as for conventional insurance for new assets (e.g. green buildings or renewable-energy technology installations). Innovative products such as micro-insurance and new public–private partnerships will allow markets to grow to serve the billions of people in the developing world who currently lack insurance.

Insurers seizing these opportunities will improve their market position. Note that micro-insurance products are not always designed or targeted with weather or climate factors in mind, although climate change will have consequences for most ‘‘lines’’ of micro-insurance.

With all of these factors in mind, insurance regulators under a National Association of Insurance Commissioners (NAIC) Task Force have met regularly in the U.S. to discuss climate change and issued a major white paper in 2008. The subject was among the top agenda items at the 2007 meeting of the International Association of Insurance Supervisors.

Location: Indonesia