Insurance, climate losses and solutions for enhancing resilience

May 24, 2024|Written by

An overwhelming majority of climate change-related losses are currently uninsured, representing a ticking time-bomb for the global financial system.

This “climate protection gap” is a mounting concern for supervisors as widespread uncovered losses can significantly impact growth, inflation, credit supply, and financial resilience and climate-related impacts are accelerating in unprecedented and unpredictable ways.

Research published by the Bank of International Settlements (BIS) has warned that this trend “may lead to an  insurance market failure forcing governments to become ‘insurers of last resort'”.

In 2023, only 38% of global economic losses from natural disasters were insured, and uninsured losses may double in 10 years, said research from reinsurer Swiss Re. The protection gap is particularly acute in developing countries, where the average insurance penetration rate is less than half that of global north.

Fortunately, there is a growing body of research on how to address the insurance sector’s resilience to climate-related impacts.

Improving existing solutions

Climate-related risks continue to be a significant concern” and expected increases in claims “may disrupt reinsurance markets”, according to the International Association of Insurance Supervisors’ (IAIS) 2023 annual global market review.

Catastrophe bonds are well-established alternatives to traditional reinsurance and can improve disaster resilience in regions without mature insurance markets such as Asia Pacific, according to the Organisation for Economic Co-operation and Development (OECD).

The OECD report recommends broadening investor participation, minimising basis risk, and developing local currency markets to improve bond uptake and coverage. National regulators will also need to establish reliable data and risk models for these markets to thrive.

Currently, however, insurers’ catastrophe models struggle to accurately forecast changing extreme weather patterns, exacerbating baseline uncertainty. This causes insurers to charge higher premiums and withdraw from underwriting high-risk areas. The models also fail to capture slower-moving climate vulnerabilities, such as heat stress and impacts on cash crops.

Insurers can utilise predictive analytics such as geospatial tools to make a more detailed assessment of where wider protection may be needed, said an article from a US multinational law firm. They can also use artificial intelligence to better price their policies and account for overlooked losses.

Despite physical risk exposures, many large insurers invest in and underwrite climate-damaging activities, exposing them to substantial transition risks that may undermine profitability, liquidity and capital. Insurers can use science-based transition plans and climate-specific stress testing-informed portfolio adjustments to reduce these exposures.

Lastly, many consumers lack access to appropriate catastrophe insurance. Enhancing consumer education and  collecting data on accessibility and affordability across regions and demographics can help target supervisory interventions, stated a report from the European Insurance and Occupational Pensions Authority (EIOPA).

Strengthening regulatory action for insurance

The IAIS has indicated that enhanced supervisory monitoring and risk assessment may be needed to address climate-related financial risks and promote a stable insurance market.

A BIS paper on “insurability tipping points” identifies a need for industry guidance on climate-informed pricing and underwriting to strengthen the sector’s resilience and avoid widespread withdrawal of insurers from climate risk.

While regulators have started taking action by establishing climate and resiliency taskforces and running climate-specific insurance stress testing, such efforts are still in early stages.

A Finance Watch report recommends integrating mandatory transition plans into the insurance supervisory framework to promote an entire-economy transition and more rigorous oversight. It calls for forward looking regulatory frameworks that encourage more accessible and affordable climate insurance products.

A joint report from EIOPA and the European Central Bank (ECB) states that regulators should promote policies that  transparently spread costs before catastrophes occur through a precautionary approach, rather than abruptly via emergency relief. The authors also recommend incentivising mitigation and adaptation, such as through premium discounts for policyholders who reduce their climate vulnerabilities.

International risk sharing solutions and government backstops

International risk-sharing systems pool shared capital from multiple nations or donors to create pre-arranged facilities for disaster relief. There are already several existing international catastrophe insurance pools, such as the Caribbean Catastrophe Risk Insurance Facility.

To build climate resilience in developing Asian economies, award-winning researchers Shaun Shuxun Wang and Andreas Bollmann have proposed a regional collaboration strategy centred around a new climate de-risk insurance (CDRI) product.

The proposed CDRI designates a portion of premiums for risk assessment and mitigation, rather than just loss coverage. The product is offered through commercial insurers and distributed via a network of dedicated risk management agencies. Development of the CDRI requires compatible insurance regulation and public-private partnership funding mechanisms to overcome affordability challenges.

Risk-pooling schemes should be evaluated based on the degree of risk mitigation achieved and adequacy of claim payments, say the authors.

The ECB / EIOPA paper also proposes a “ladder approach” that shares responsibilities between parties at various levels of impact, with an EU-wide risk-pooling fund reserved for the highest impact events.

The University of Cambridge has put forward a risk-sharing model for the global south that integrates a prearranged disaster finance mechanism into the UN’s loss and damage fund. This model leverages (re)insurance and capital markets to provide substantial contractual payouts to climate-vulnerable countries when disasters strike.

The report proposes an “umbrella stop-loss” system that would trigger the common risk-sharing framework once losses exceed 10% of a country’s GDP.

Elsewhere, researchers stress initiatives should complement, not replace, climate action funds such as those for loss and damage, adaptation, mitigation and resilience.

Parametric insurance and insurtech: a new paradigm?

Finally, insurtech companies – those using technology to enhance insurance services – propose combining technological innovations with parametric insurance, insurance that provides pre-determined payouts based on the occurrence of specific climate-related events, rather than actual losses, to help close the protection gap.

For instance, in 2023 an impact Insurtech firm partnered with an Indian trade union and the Adrienne Arsht-Rockefeller Foundation Resilience Center to launch the extreme heat income insurance, a parametric microinsurance product for women in India to automatically recover wages lost due to extreme heat.

Separately, researchers have documented instances in which parametric insurance technology has improved affordability and access for agricultural communities and reduced climate impacts.

However, insurtech faces challenges, particularly in the global south, where mismatches between payouts and actual damages and unaffordable premiums could threaten its efficacy. Careful design and implementation, as well as external premium subsidies, may be required to make this model effective for climate-vulnerable countries.

This page was last updated May 27, 2024

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