How insurers can promote resilience in the face of climate change

Climate risk presents particular challenges for insurers. It affects both sides of the balance sheet; it’s difficult to measure and model; and it unfolds over an extended time horizon. In addition, insurers must navigate the tension between physical risk (the direct impact of a warming climate) and transition risk — effects associated with the transition to a low-carbon economy. 

Assessing risks of climate change

The effects of climate change and an uptick in weather-related events are already apparent. The years 2017 to 2018 represented the worst two-year period for global natural disasters on record, with insurers’ losses totalling US$225b.¹ The California wildfires alone cost insurers US$24b in claims,² erasing three decades of profits for homeowners’ insurers in that state. The increased dollar value of losses partly reflects economic growth and urbanization in disaster-prone areas; however, it is clear that weather-related disasters are increasing due to climate change.

While property and casualty (P&C) insurers are more exposed to the immediate impacts of climate change on underwriting losses, life insurers are not immune to claims arising from climate effects. One IGLN participant noted that the World Health Organization projects that climate change will result in 250,000 deaths annually from 2030 to 2050. Another participant pointed out that climate change is expanding the geographic areas at risk for tropical diseases, with significant implications for mortality patterns.

The risks associated with transition to a low-carbon economy are also significant. Key sectors, such as energy, transportation and agriculture, will need to dramatically reduce emissions. Lockdowns for COVID-19 across the globe led to a substantial reduction in greenhouse gas emissions. But as one director said, even these shutdowns “did not change the cumulative effect.”

The International Energy Agency estimates carbon emissions will fall by 8% in 2020. To meet targets set by the 2015 Paris Agreement, emissions need to fall by nearly as much or 7.6 every year until 2030.³ Studies have shown that the devaluation losses associated with achieving the Paris Agreement’s “net zero” target could be as high as US$20t.⁴

Integrating climate risk into risk management frameworks

Faced with the reality of climate risk, insurers are beginning to integrate both physical and transition risk into their risk management frameworks. According to one IGLN participant, “Insurers are asking which sectors and geographies create the most material exposures across their balance sheets. Once they have a good view of the exposures, the key is to think about what will happen to those exposures in any given climate scenario." This can be difficult. Data is often lacking and insurers vary in their ability to assess and integrate sustainability factors into a unified risk management framework. 

Pricing – on both the asset and liability side – is the key mechanism by which insurers incorporate climate into their risk management frameworks. P&C insurers generally believe that “if we have annual renewals, then the price can be adjusted for the risk on an annual basis,” said one participant. “The challenge is obviously to think beyond the renewal cycle and assess the impact over a longer time frame.”

To ensure that there are no gaps in exposures, insurers are building risk models to better understand and predict the impact of climate change on weather-related disasters. Yet, many realize that there are limitations to the most sophisticated forward-looking models – adding that the impact of climate change remains unpredictable. Climate change also makes historical weather data less useful for insurers and limits their ability to estimate future losses.

Climate change is further stressing markets for disaster insurance, “which is already expensive and hard to write because of fat tail losses,” as one participant pointed out. The danger is that prices can only escalate so far, and some areas may become so prone to risk that they become uninsurable. The Chief Risk Officer Forum reported in 2019 that some coastal and forest-fringe areas in the US are "already at the edge of insurability.”

As insurers limit their own exposures to climate risk by repricing or withdrawing coverage, difficult social questions arise.  One director said, “I think we are in pretty good shape to protect the company. The question is, who is going to protect society?”

In some cases, policymakers may require insurers to extend coverage where it may not be economically feasible to do so. But, IGLN participants worried that such interventions in markets would exacerbate programs in the long run.

Committing to sustainable underwriting and investing

To maintain financial stability in the face of long-tail climate risks, insurers need to integrate climate effects into investments, as well as underwriting. One approach calls for excluding certain carbon-intensive sectors or activities. But some participants cautioned against this, suggesting a more nuanced approach where portfolio managers make investment decisions for the long run. “We want companies to be just as creditworthy in 20 years as they are today,” said one executive.

Participants acknowledge the difficulties in assessing how investment portfolios will be affected by climate change. One executive said, “Only one-third of assets you can invest in have environmental, social and governance (ESG) ratings. We need to increase that.” Firms have been looking at sectors as a whole rather than individual investments. Even where ESG ratings and metrics exist, lack of standardization limits their usefulness. A lot of work needs to be done to standardize measurement across the industry.

Driven by pressure to act in a socially responsible manner, some insurers are reducing their exposure to carbon-intensive industries. While they generally support sustainable investment efforts, IGLN participants identified several challenges. These include:

• Balancing obligations to shareholders: whether insurers refuse to serve particular clients or how deeply investors will commit to “green investments.”
• Limited influence or leverage on climate change: a position that will not make a difference in the final outcome.
• Lack of consistency in approach: integrating ESG into asset portfolios without considering the underwriting framework on the liability side.
• Unintended consequences associated with energy transition: short-term economic dislocations might fall on those able to bear them.

As one executive said. “Climate change has to be managed well. The transition should not be a disruption.”

Even as insurers work to assess and manage their own exposure to climate risk, IGLN participants agree that the sector has an important role in promoting climate resilience and furthering the transition to a low-carbon economy. As one director said, “Unless there is a systemic, collective response by policyholders and politicians, there cannot be any effective planning for this transition.”

Implementing collective solutions to climate change

Participants discussed two policy and regulatory tools that could foster effective action to address climate change:

• Carbon tax:  Several participants agree that a global mechanism for pricing carbon is a requirement for achieving meaningful action in mitigating climate change.
• Capital charges: Standardizing charges would subject investments that are more affected by climate risks to higher capital requirements.

With resilience, insurers can overcome challenges

Despite the challenges facing the insurance industry, including its response to the COVID-19 pandemic, participants agreed that the industry can promote resilience in the face of climate change. One director said, “There is a wonderful opportunity for insurers to play a role coming out of COVID-19 by devoting substantial investment into better climate resiliency and green infrastructure. That will contribute to greater environmental resiliency and potential job creation.” Participants noted that life insurers, in particular, should be well-positioned as long-term investors in sustainable infrastructure that can contribute to the energy transition.

A growing protection gap provides opportunities for insurers to think creatively about extending protection to potentially uninsurable populations, especially lower-income consumers who need insurance for recovery but are least able to afford it. New solutions include parametric insurance, and models that incentivize consumers to protect their assets against climate change.      

One director suggested that the insurance industry would play its traditional role of helping customers mitigate and lay off risk: “We will continue to help our clients understand what their risks are and how they affect them, and to mitigate what they can and get coverage for what they cannot.”