A Climate-Challenged Insurance Industry
At a Glance
The insurance industry for centuries has relied on historic risk assessment tools and high predictability. The increased incidence of climate change-related disasters, however, is driving the industry into unknown territory. Its traditional models have not been able to adapt to pricing-in unforeseen events into premiums, resulting in exponential losses, increased systemic financial risk, and alarm bells among regulators. To curtail losses, some insurance companies have retreated from particularly disaster-prone markets, with assets becoming uninsurable. While insurance companies’ balance sheets are climate risk-stressed—and even potentially saddled with stranded assets—the insurance cover to be deployed to develop net-zero aligned infrastructure requires considerable amounts of capital. Improved modelling that aligns with climate science is required, along with stricter regulatory supervision, government signals to avoid moral hazard, and stepping up adaptation investments.
Climate Change Multiplies Risks
Climate change leads to a multiplication of risks. Record-breaking heatwaves, wildfires, and floods are destroying valuable assets, taking an increasing toll on economies around the globe. Some sectors are particularly vulnerable to the already existing effects of climate change. Increased pressure on natural resources will affect agricultural yields, for example. The impact on crops will directly threaten food security in many developing countries—and rising food prices drives inflation, in turn reducing disposable income across the globe. More generally, businesses and their supply chains are likely to be disrupted by physical damage to buildings and equipment. Finally, private households in particularly disaster-prone areas are affected by increased risk of asset loss.
Losses Are Already Ballooning
Insurance companies’ business model is based on risk assessment and predictability. One thing all the above-mentioned sectors have in common is that they have been hitherto insurable. This was traditionally based on actuaries’ ability to predictably quantify risks for specific events and to collect premiums in line with expected future claims patterns. This classic risk modelling approach, however, is now being threatened as the natural events we’re now experiencing as a result of climate change are inherently unpredictable—insufficient historical data exists for accurate risk modelling. UNFCCC Executive Secretary Simon Stiell, in the wake of hurricane Beryl which struck most of the Caribbean in early July 2024, said: “Climate change was already pushing disasters to record-breaking levels of destruction.”
New probability modelling is therefore required. Synergies are needed between localized insurance industry risk models and the “general circulation models” prepared by the UN Intergovernmental Panel on Climate Change (IPCC), which map broader and longer-term global trends. It would allow taking into account events occurring on one side of the planet and how these could drive up the incidence of catastrophes on another.
Growing losses already lead to increased pressures on insurance premiums. Over the past 30 years, natural catastrophe insured losses grew by 3% points more annually than the global economy (inflation adjusted), and over the last five years insurers incurred more than USD 100 billion in losses each year—90% of these attributable to weather events. Net losses to economies are in fact much higher, as it is estimated that only half of damaged assets were insured in the first place. In the US alone, underwriters suffered a USD 15.3 billion loss in 2023. As a result, by 2023 insurance premiums for the protection from catastrophic natural events are set to increase by 50% to reach USD 200-250 billion globally.
Some assets have already become uninsurable. Already in 2015, then-CEO of insurer AXA Henri de Castries warned, “A 2°C world might be insurable, a 4°C world certainly would not be.” Insurance companies have recently taken unprecedented steps to retreat from particularly disaster affected areas. In Australia, one in seven properties are already considered uninsurable, while in the US, State Farm—the biggest US home insurance company—decided to stop selling homeowner insurance in California in order to stem growing losses. Higher premiums—if they were commensurate with risk exposure—would provide a strong incentive for customers to reduce risks, discouraging building in risky areas or remaining in areas prone to wildfires or floods. Premiums can also be modulated to account for property owners’ investments into protecting their assets against damage.
Potential systemic risks call for regulator interventions. Insurance companies typically move their risks off-balance sheet to re-insurance companies. But with increasing challenges to assessing probabilities, a potential systemic risk could emerge, calling for regulator interventions. In 2023, the Bank of England highlighted that “historic data sets are not likely to be a good predictor of how climate risks may affect firms’ future losses.” To illustrate, consider the 39 million US properties which are believed to be overvalued as a result of high climate risk exposure, contributing to a growing climate-insurance bubble. A conservative approach would lead regulators to request increased capital requirements for both insurance and re-insurance companies.
Governments ought to focus on the long term. Subsidizing insurance premiums in high-risk areas constitute a moral hazard as it prevents behavioural changes to adapt and encourages reckless building. Governments, however, have an important role to play in providing the signals and conditions to reduce risks. They can adapt building codes, redefine zoning, make agriculture more resilient to flooding, and prevent non-climate-proof investments while maintaining resilient public infrastructure. Governments can also lower barriers to investing in adaptation measures such as the deployment of nature-based solutions like improved forestry management or natural flood risk defences.
Stranded Assets Weigh on Balance Sheets
The Net Zero Insurance Alliance (NZIA), convened by the UN Environment Programme (UNEP), was launched in 2021 at COP26 in Glasgow as part of the Glasgow Financial Alliance for Net Zero (GFANZ). Its aim was to reduce the carbon footprint of the industry’s underwriting—pricing climate risks whenever possible and developing transition plans, which potentially affect the oil and gas industry. Amid a mainly US-focused anti-ESG campaign, the NZIA was discontinued in April 2024 amid allegations of anti-competitive behaviors and government concerns over potentially rising energy prices if insurance companies were to stop underwriting oil and gas related risks.
Insurance is also Key to Net-Zero Infrastructure Deployment
While the insurance sector’s balance sheet might already be stressed by increasing climate-related losses (and potentially stranded assets), the net-zero transition requires vast amounts of capital to be rapidly deployed in order to insure new infrastructure. Over half of the USD 19 trillion already committed to financing the climate transition through to 2030 will require additional insurance coverage. These USD 10 trillion include coverage for engineering, procurement, construction, operations, and maintenance of climate-related infrastructure in energy, road transport, and buildings. For the industry to support the deployment of a Paris Agreement aligned infrastructure, it will be critical to stem losses through improved modelling—including aligning premiums with risks—integrating government frameworks that disincentivize investment in risky areas and advancing adaptation efforts.
For additional information, reach out to Nikolaus.Schultze@EdelmanEGA.com
