Policy Options to Reduce the Climate Insurance Protection Gap

Catastrophe insurance is key to reducing abrupt macroeconomic losses caused by extreme weather events. Yet only a quarter of EU climate-related catastrophe losses are currently insured, says a new report. This number falls below 5% in seven EU countries, including Italy and Greece.

This “insurance protection gap” has significant implications for financial stability, and the report – produced by the European Central Bank and the European Insurance and Occupational Pensions Authority – calls for forward-looking policies to increase coverage and bolster financial system resilience.

The authors explore various channels through which uninsured natural catastrophes could disrupt banking stability. These include adverse impacts on growth, inflation, production and consumption, credit supply, collateral value, sovereign debt sustainability, and asset values.

The worsening climate is expected to widen the protection gap as the frequency of natural disasters increases and, according to the report, results in more unforeseen claims. This will increase underwriting and liquidity risks, and is likely to result in premium increases.

The authors stress the need for forward-looking policies which increase coverage and incentivise adaptation and mitigation at every level. Policies should also reduce the share of losses borne by the public sector by transparently spreading the costs before catastrophes occur through a precautionary approach, rather than distributing resources abruptly via emergency relief.

The report outlines a “ladder approach” that shares responsibilities between parties at various levels of impact:

1. private insurance should be the “first line of defence” for low impact/high frequency events
2. reinsurance and capital market instruments such as catastrophe bonds can diversify coverage and enable insurers to pass on losses for medium-impact/frequency events
3. national government measures, such as public-private partnerships and reserve funds, can spread responsibility for insuring higher impact/lower frequency events
4. an EU-wide fund could be established for the highest-impact events which is separate from the EU solidarity fund

To reduce moral hazards – the risk that increased coverage encourages risky behaviour – the authors recommend incorporating climate risk-based incentives and impact underwriting. For instance, they suggest discounts on premiums where policyholders have reduced their climate vulnerabilities. They also propose conditions on access to reserve funds, such as deductibles.

Finally, given the potentially substantial impact of the protection gap on the banking sector, the report advises banks to consider the use of macroprudential policies to enhance their resilience.