Two Degrees Off: The Implications of Climate Change for Insurers

The 2020s modern-day enterprise is characterised by heightened operating uncertainty, coupled with the need to adapt to an ever-changing environment. Environmental, Social and Governance (ESG) captures a wide dashboard of goals that consider enterprise value beyond conventional financial considerations. Within these goals is the global ambition to limit the planet’s temperature rise to not more than 2 °C (and ideally 1.5 °C) to stave off the worst effects of climate change¹.

Given their role of facilitating risk pooling and transfer, it is in insurers’ interest to minimise the overall financial uncertainty of their policyholders. Increasingly, financial uncertainty is underpinned by environmental considerations, including climate change.

Climate change poses an imminent threat to both the short-term and long-term stability and sustainability of insurance operations. The Bank of England² identifies three broad classes of climate risks, which may expose an entity to financial losses:

• Physical risks: This class captures the direct financial losses and claims experience resulting from greater claim frequency and / or severity due to weather events (Natural Catastrophe [NAT CAT] perils) such as flooding, windstorms and hail. This is coupled with related losses such as diminished crop yields and business interruption. Examples include disrupted supply chains due to NAT CAT activity, or lower occupancy levels of a hospitality establishment (such as a ski resort) due to altered climate patterns. This is already evident in the trend of increased frequency and intensity of extreme weather events such as Hurricane Dorian in 2019 and more recently the persistence of prolonged droughts and increased fire risk in the Mediterranean³ such as seen in the 2021 heatwave and wildfires in Greece.
  
  
• Transition risks: The focus here is on financial losses resulting from the transition away from a carbon-based economy as insurers and insureds adapt to climate change. Examples include the redundancy cost and financial losses resulting from scaling down operations related to fossil fuel usage. Some insurers for instance have ceased writing coal-related risks to keep to nationally determined contributions (NDC) commitments in line with the 1.5°C Glasgow Pact objective.⁴ Transition risks also capture the cost of complying with climate change-related legislation such as climate change financial risk disclosures. Such disclosures may include those recommended by the ‘Task Force on Climate-related Financial Disclosures’ (TCFD), reporting under which is mandatory for the UK’s largest entities.
  
  
• Liability risks: Climate change could also expose insured entities to litigation and resulting damages from failing to comply with relevant climate change-related legislation or even failure to act. As a result, insurance undertakings may also be exposed to the resulting adverse liability losses, which may be latent for a while until the facts and circumstances leading to legal action materialise. An example of such, is the successful pursuit of Royal Dutch Shell by Friends of the Earth Netherlands (‘Milieudefensie’).

Focusing specifically on Non-Life Insurers, climate change can have far-reaching effects on the following impact areas, amongst others:

• Increased premiums and/or inability to find affordable reinsurance capacity, due to greater exposure to NAT CAT events. Increased NAT CAT exposure could also lead to increased risk capital requirements, to be able to absorb financial losses that are more frequent and more severe than previously envisaged. Reduced reinsurance capacity could also lead to lower risk-mitigation benefits in capital planning. Insurers that do not factor climate change into their pricing may risk bearing the cost of anti-selection resulting from market players that do select based on climate-change risk exposures (e.g., catastrophic risk zone / postcode rating in home or motor insurance).
  
  
• Potential financial exclusion of certain policyholders: for instance, premiums levied on NAT-CAT prone policyholders may reach unaffordable levels, or cover may not be within the insurer’s risk appetite at all.
  
  
• Increased burden on health insurers from greater heat stress, poorer air quality (possibly resulting in greater incidence of respiratory illnesses such as asthma), increased vector-borne illnesses such as dengue fever and malaria (outside of their normal geographical distribution), together with increased direct casualties from NAT CAT events.
  
  
• Secondary impacts on investments resulting from greater financial market volatility brought about by greater resource scarcity, and the resulting inflationary pressures, socio-economic tension and stressed diplomatic ties. 

For Life Insurers climate change may manifest in the following amongst others: 

• Increased seasonal mortality (e.g., due to heat waves) possibly net of less severe extreme cold-related deaths in winter.
  
  
• Changes in population demographics and their mortality / morbidity characteristics. This occurs as migration patterns shift to adapt to altered climates and environments.
  
  
• Greater investment uncertainty and potential insufficiency to meet guaranteed returns.
  
  
• Greater accumulation of risk resulting in events of mass loss of life (subject to policy exclusions), inherent to increased NAT CAT activity.

EIOPA therefore recommends that the entity amongst other things:

• Conducts a sufficiently detailed assessment of material climate change risks.
  
  
• Conducts, where appropriate, subject to the materiality of identified risks, “a sufficiently wide” range of stress or scenario analyses, taking into account both short- and long-term outlooks. This is to include at a minimum, two long-term oriented scenarios:
  • A climate change risk scenario where the global temperature increase remains below 2°C, preferably no more than 1.5°C, in line with the EU commitments; and
  • A climate change risk scenario where the global temperature increase exceeds 2°C.
     
• Considers the relevant methods and main assumptions used in its assessment and the necessary data requirements to conduct such analyses.
  

In July 2021 EIOPA issued its “Report on non-life underwriting and pricing in light of climate change” (EIOPA-BoS-21/259) (EIOPA, 2021) concerning the implications of climate change on general insurance premium setting and underwriting risk acceptance.

It acknowledges the potential implications on rate-setting and reinsurance availability, and the sustainability of cover of NAT-CAT exposed business, including potential rate increases and ‘crowding-out’ of certain cover, in view of persistent adverse climate-change related experience.

Emphasis is placed on the importance of impact underwriting practices. Simply put, these constitute initiatives taken by insurers to incentivise policyholders to take on preventative measures to reduce their carbon footprint and exposure to climate risk.

EIOPA recommends that the entity takes account of the implications on climate change in its pricing and underwriting strategy. This could entail:

• Assessing the acceptability of current underwriting and exposure limits in view of the increased potential for adverse underwriting experience.
  
  
• Assessing the tenability of current reinsurance and retrocession arrangements in view of the same.
  
  
• Underwriting action and risk mitigation activities that could help reduce adverse climate-change experience and NAT CAT loss exposure.

The industry has responded to the increased prevalence of NAT CAT events through Government-backed / industry-tariff supported Natural Catastrophe Pools such as Flood Re in the UK and the French ‘Caisse Centrale de Réassurace’ (CCR).

• Performing gap analyses as to how climate change may be considered as part of the entity’s pricing, reserving and capital modelling considerations, together with its reinsurance programme selection.

• Synthesising and parameterising suitable ORSA-climate change related scenarios.

• Performing model impact assessment.

• Helping model representative risk scenarios to model asset portfolio returns⁵.

¹The 2021 Conference of Parties ‘COP26’ and the resulting Glasgow Pact build upon the 2015 Paris Agreement, which resulted in signatories committing to a strategic target of maintaining global temperature increases to under 2°C. As of 2021 the Glasgow Pact revises this target to at least not more than 1.5°C. To achieve this, individual members have committed to actions known as nationally determined contributions (NDCs).

²BoE (2019) https://www.bankofengland.co.uk/knowledgebank/climate-change-what-are-the-risks-to-financial-stability [accessed on 25/04/2022].

³The Greek wildfires in 2021 were one particular instance highlighted by the IPCC (Intergovernmental Panel on Climate Change)’s Sixth Assessment report in August 2021 (IPCC,2021).

⁴Adapted from the IFoA Climate Change Working Party (2020) Climate Change for Actuaries: An Introduction.

⁵International Actuarial Association (2022) Application of Climate-Related Risk Scenarios to Asset Portfolios.