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How insurable is climate change?


Published: 24 Jun 2022

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The awkward question for governments, insurers and consumers is rearing its head, writes Adam Leach for ICAEW Financial Services Faculty.

In November 2018, the state of California suffered its most destructive period of wildfires in more than a century. Flames ripped through more than 13,000 insured homes and businesses, and prompted 46,000 separate claims, totalling more than $11.4bn in losses.

Over the course of March and April of this year, much of the east coast of Australia was battered with extreme rainfall that caused some of the most severe flooding ever experienced in the country.  

In the first week of March, both northern New South Wales and southern Queensland received more rain than in an average year. Weeks later, a similar amount fell again in an equally brief timespan. On April 7, its most populous city of Sydney received a month’s worth of rain in a single night.

Overall, more than 20,000 homes and businesses were flooded in Queensland and a further 5,000 were damaged in New South Wales. Current estimates suggest that the total value of claims could reach more than AUD$2.5 bn.

A Climate Council report suggests that Australia is facing an “insurability crisis” with 1 in 25 homes uninsurable by 2030, with 1 in 11 houses under-insured by the same date.

The US and Australia are experiencing worse weather events and it is getting harder to cover the costs of the losses. The Insurance Council of Australia told the BBC that house insurers pay almost four times the premium that they did in 2004.

Even in the United Kingdom, where extreme weather events are far less dramatic and rarely generate international interest beyond the delay of sporting events, a decline in insurability is being increasingly discussed.

According to a recent climate change analysis by Dye & Durham, which provides services to property lawyers and surveyors, the drier, hotter summers being forecasted by the country’s Met Office are likely to increase the risk of soil shrinkage and place almost two million more homes at risk of subsidence by the 2080s. Those in the wealthier region of South East England are deemed particularly vulnerable due to the high levels of clay in the soil.

Liabilities to increase if action on climate change is not taken

To try and better account for the financial risk this poses, the Bank of England recently released the results of its Climate Biennial Exploratory Scenario (CBES), which tested the balance sheets of banks and insurers against three climate scenarios over the next 30 years.

Unsurprisingly, the consequences of the no additional action (NAA) scenario were found to be most severe, but the scale of the impact would be extreme. Under this course of inaction, life insurers could see the value of their assets decline by 15% of total market value by the end of the 30-year window.

But for general insurers, the increased risks of flood, wind, and other climate related damages, were assessed as having the potential to increase average annualised losses by up to 70% by the end of the NAA scenario.

But as much as the CBES illustrated the extremity of the downside of taking no action whatsoever, which is a deliberately unlikely scenario, it also served to highlight the value to the industry of acting to limit the risks.

“Insurers have a collective interest managing climate-related financial risks in a way that supports that transition over time,” said the report. “They will need to improve their management of climate risks in order to be able to do so.”

Getting it wrong will incur a huge capital risk. The BoE said in its inaugural climate stress test that insurers which failed to manage transition risk faced an annual 10%-15% hit to profits. Banks could incur up to £225bn of credit losses by 2050, while insurers’ asset value could fall by 15% under the worst-case scenario.

In this era of increasing climate risk and decreasing time to act, how can the insurance industry respond to help both mitigate its impact and try to ensure that coverage can still be provided as the risks rise?

Speaking to ICAEW, Peter Uhlenbruch, director of financial sector research standards at ShareAction, made clear that first the sector must account for the risks within its business models.

“It’s crucial that insurers focus on fit for purpose climate governance to ensure that climate risks are managed consistently across business lines,” he says. “This is even more important for insurance firms who made net-zero commitments, where internal alignment and coordinated action is key.”

One way in which several of the largest global insurers are acting on this principle is through the Net-Zero Insurance Alliance (NZIA) that has been convened by the UN Environment Programme’s Principles for Sustainable Insurance Initiative (PSI) which counts Allianz, Lloyd’s of London and Swiss Re among its members.

To join the initiative, which currently includes 27 insurers and reinsurers, each member must commit to “transitioning all operational and attributable greenhouse gas emissions from its insurance and reinsurance underwriting portfolios to net-zero by 2050”.

In addition to committing to transitioning to net-zero across all their lines of business, the NZIA signatories make several commitments that are designed to both disincentivise carbon-intensive activities and incentivise those that are key to decarbonisation.

These include a commitment to engage particularly with their ‘most GHG-intensive’ clients on their decarbonisation and net-zero transition strategies, while in contrast committing to developing and offering insurance products and solutions for low-emission and zero-emission technologies that are key to the net-zero transition.

Invest in assets that help to avert the crisis

The insurance industry can exercise its full influence regarding its sale of insurance products and the associated liabilities they bring. It can also exert influence through the assets it invests into to support the transition.  

Speaking to ICAEW, a spokesperson for Swiss Re explained that together with other long-term investors such as pension funds and sovereign wealth funds, the insurance industry manages around $80tn of assets, giving it significant power and influence to steer investment towards those areas required.

“Together with the public sector, reinsurers and insurers are well equipped to steer development away from high-risk areas and invest in protective measures such as green infrastructure,” she explained. “This keeps assets insurable while also improving the growth outlook.”

Insurers and regulators are in contention over the treatment of such assets by the current Solvency II regulations. According to the industry, the current capital treatment of long-term green infrastructure assets such as offshore wind projects fails to accurately account that they are critical to the success of the net-zero transition.

In the UK, where the Solvency II regulations are currently being reformed because of its departure from the European Union, it has been claimed that such changes could unlock an additional £95bn to be invested in infrastructure projects.

Working with governments to unlock investment and avoid un-insurability

Such reforms are something that Linda Hedqvist, senior manager within Deloitte’s EMEA centre for regulatory strategy, sees as key to enabling the insurance industry to maximise its positive impact on the transition.  

“Governments can play a role in enlisting the insurance industry to invest in solutions that reduce emissions or enhance resilience to physical climate impacts. A case in point are the reform proposals in relation to the review of Solvency II in both the EU and the UK which aim to free up insurers capital to enable long-term and sustainable investment.”

Turning specifically to the UK reform proposals, Hedqvist added that the changes would particularly free up funds from the life insurance sector. “Life insurers with Matching Adjustment portfolios will have more investment flexibility to match the long-term nature of their liabilities if the proposals made by the UK government are adopted.”

Should such changes be forthcoming, then the insurance industry will be able to back up its positive soundings on wishing to invest the additional capital to combat climate change, while initiatives such as the PSI enable them to decarbonise their liabilities.

However, no matter how successful the industry and more significantly the global efforts to achieve net-zero emissions by 2050, it remains the case that under current arrangements, uninsurability will continue to rise.

“Insured losses are increasing year-on-year and uninsured losses are also increasing,” explains Wynne Lawrence, legal director at Clyde & Co, who spoke to ICAEW. “With time, the protection gap between the two will continue to go as insurers and reinsurers will find it increasingly difficult to price and model certain risks.”

According to Lawrence, one way in which this might be mitigated, is by governments stepping in to reduce the liabilities placed on the sector by creating risk mechanisms such as Flood Re in the UK where the coverage of high-risk homes is subsidised by a levy on all property insurance policies.

“As financial gaps grow, the onus on governments will continue to rise, which is just one reason why climate action is so urgent internationally,” she explains. “Governments can support the creation of risk pooling mechanisms to better manage systemic climate risks on a national or regional basis and support a multi-stakeholder approach.”