CLIMATE RISKS: THE INSURANCE CHALLENGE
Katherine Spector, New York - Mar 28, 2022
The private insurance industry is not always at the fore of conversations about climate risk, but it should be: Short of government mandates, the inability to insure risky assets and business activities could become the single biggest constraint on behavior that contributes to climate change. The latest report from the UN’s Intergovernmental Panel on Climate Change (IPCC) minced no words in describing the state of play as a “damning indictment of failed climate leadership.” Can the private insurance industry fill the leadership gap?
When we think of insurance and climate risk, thoughts go first to physical risks like buildings or vehicles destroyed by wildfire, infrastructure damaged by hurricanes, or harvests lost to extreme weather. Shockingly — or perhaps not so shockingly — more than half of all natural disasters since 1900 have occurred since the year 2000. According to Swiss Re, average annual insurance losses from natural disasters have increased from about $12 billion in the 1980s to an inflation-adjusted $50 billion in in 2000-10, to some $85 billion in the past decade.
The primary purpose of the insurance industry, of course, is to price risk accurately and precisely, and to pool that risk across a wide enough population to make its mitigation affordable to individuals. But in addition to making risk palatable, insurance companies invest policyholder premiums in capital markets in expectation of future claims. In fact, the insurance industry is one of the biggest single segments of institutional investment and a particularly meaningful source of fixed income capital.
Some carbon-intensive companies suggest there will always be another investor to buy stocks or bonds that others divest. Insurance companies may be one of several categories of investors to test that theory. But even if there is always another investor, will there always be another insurer willing and able to step in where others step out? Will carbon-intensive industries continue to find insurers willing and able to underwrite their activities, and will owners of assets that are vulnerable to the effects of climate change be able to afford protection?
An Uninsurable World?
Former CEO of French insurer AXA, Henri de Castries, has been repeatedly quoted as saying that “a world that warms by 2º may be insurable but a world that gets warmer by 4º would certainly not.” This sentiment reflects the risks to insurers and the entities that they insure, but also the critical interest that insurance companies have in actually helping to slow and reverse climate change.
The “uninsurable world” scenario leads to broader questions about systemic economic risks from climate change. Insurance is not simply about prudence; without it the economic system simply can’t function. Beyond the direct impact on insurers and lenders and the entities that they insure and finance, unmitigated climate risk also has implications for budgets at all levels of government and poses macroeconomic risks to households as a result of displacement, interruption of employment, health costs, and loss of home and other equity wealth.
Actions Taken, Actions Needed
Much work has been done on identifying the ways in which climate change touches the insurance industry, and regulators are taking early steps to nudge the industry further in terms of defining and responding to this challenge. Smaller insurers lag behind their larger counterparts, but the insurance industry as a whole has made significant progress on climate disclosures and most have also adopted environmental, social and governance (ESG) policies or goals for their investment strategies and their own operations.
However, there is much more work to do in developing and stress testing climate risk scenarios. We tend to think of very large-scale, catastrophic disasters as the costliest, and generally they are. But because per-event payouts to individual clients are typically capped, multiple, closely-spaced smaller events could actually be more financially devastating to the private industry. As climate science continually improves these are the types of complex scenarios that need to be tested rigorously.
Beyond the steps that individual insurance companies can and should take, a few broad existential themes and questions apply to the industry as a group and beyond.
Beyond Exclusion Criteria
Importantly, changes in both investment and underwriting policy — similar to ESG strategies in other parts of the financial sector — have focused heavily on criteria for exclusion. There is some product innovation designed to encourage proactive behavior change, but more is needed. The insurance industry has an opportunity to shape how individuals, industries and governments price risk and therefore how they make rational decisions about adjusting to a warming world. This requires a carrot, not just a stick.
Who Fills the Gap?
The insurance industry is a fairly concentrated one. In addition, many smaller, more regional, or more sector-specialized insurers rely heavily on reinsurance markets which effectively funnel risk to larger insurers. Notably, only 10 companies account for about 70% of total underwriting in the oil and gas industry, for example. This begs the question of what happens if several of those large companies exit or significantly reduce service to certain sectors. Will the companies that do continue to insure carbon-intensive activities or climate-vulnerable assets have a risk concentration that effectively makes them “too big to fail”?
Alternatively, one pattern that has already been identified when companies or investors divest of carbon-intensive assets is that those assets are not always stranded but often simply transfer to other owners, operators and investors. That is not necessarily an improvement in terms of climate impact and can be a step backward in terms of transparency, governance or operational sophistication. If the insurance companies dominant in today’s market were to end coverage of carbon-intensive assets and activities, what alternative entities might step in? Self-insurance is one possibility, but only so many companies and individuals have the capacity to self-insure in the long term. Instead, perhaps insurance would move increasingly to the shadows the way that banking has — again, with implications for transparency and stability. Or could it be governments that are ultimately left holding the risk bag?
Insurer of Last Resort
In 2021, just 43% of global losses from natural disasters were insured (and far less in the developed world), so really government is already often the insurer of last resort. For government to assume even more of the insurance industry’s riskiest coverage — either wholesale or via public-private partnership — would inflate that burden. And who gets that public sector lifeboat, so to speak, in a world of rising sea levels? Which ocean-front homes are protected? Which industries are?
In addition to complicated calculations of the potential for systemic economic contagion and even threats to strategic national interest, there are major equity considerations at play when government decides who to bail out. Equity considerations are at play in developed economies where private insurance has a large footprint, and — as the latest IPCC report emphasized — even more so in less-developed countries where options for private insurance are severely limited.
Timing the Transition
Concentration in the insurance industry may make it an even richer target for climate activism than equity investment has been. That spotlights another challenge that many in the investment community have already identified: The transition to a low-carbon society must happen quickly to avoid devastating climate impacts, but a disorderly transition would create shocks with unintended and counterproductive consequences.
Fortunately, being on both the underwriting and investment side of the equation, insurance companies themselves have an interest in an orderly untangle. The insurance industry can have an outsized impact on climate policy and behavior by setting the price of climate risk, by mandating behavior change at the corporate and individual level in exchange for protection, and by redirecting investment money at a large scale in a way that reflects climate goals.
Setting the price of carbon and mandating carbon-reducing behavior change are two things that governments have not yet managed, at least in a comprehensive and cross-border way. Insurance companies — the largest of which make up a small and highly international group — have a unique opportunity and are properly incentivized to get climate risk management right.
Founder of ProSpector Energy Advisors, Katherine Spector is a longtime energy market analyst who spent 15 years producing thought-leading research on Wall Street on energy supply/demand fundamentals, price behavior, market structure and geopolitical risks.