Mitigating climate change risks

Financial services companies are incorporating climate change into risk management practices, but natural peril risks remain insurable, according to Swiss Re.

Shaping mitigation policies

The financial sector is increasingly incorporating climate risk into prudential regulation, in part as a response to warnings such as from BIS in its Green Swan report [The Green Swan, BIS, January 2020]. There, the BIS says that “climate-related risks will remain largely uninsurable or unhedgeable as long as system-wide action is not taken”, and therefore “only a structural transformation of our global socioeconomic system can really shield the financial system against ’green swan’ events”.

Implications for, and the role of, insurance business

Importantly, weather-related risks remains insurable. This is due to the short-term nature of most property re/insurance business, which allows for continuous adjustment of risk views. The main effect of climate change on insurers is rising loss costs. The effects of rising temperatures are already feeding through to higher insured claims (eg, for property damage, crop shortfall, business interruption) from some secondary perils, including heat waves, wildfires, droughts and torrential rainfall. These are hazards for which confidence of a direct link with rising temperatures is medium/high. For other hazards like hurricanes (so-called “primary” perils), there is still much uncertainty around cause and effect with respect to climate change. This is in large part due to the relative infrequent occurrence of primary perils, and the complexity of their formation. Nevertheless, there are signals that climate change is impacting hurricane risk. For instance, there have been signs of increased scale of flooding as a result of the extreme precipitation and storm surges inflicted by major hurricane events (so-called secondary effects of primary perils) [sigma 2/2020, op. cit.]

There has been a rising trend of the economic cost of natural perils, both primary and secondary, over many years. This resulted from more people moving to high-risk areas including coastal regions and wildland-urban interface areas, and as economic assets in exposed areas accumulate. Given the rising loss potential, both from hazard intensification and rising exposure, and to ensure that natural peril risks remain insurable, the industry needs to consider increasing confidence through additional research, and by quantifying modelling uncertainties in areas where confidence remains low. In addition, insurers should actively track socio-economic developments and the status of local risk mitigation measures for continual assessment updates, so that risk models represent present-day climate and socio- economic circumstances.

Insurance is an important tool by which households and businesses can strengthen their resilience to better manage rising natural catastrophe risks. Based on sigma data, we estimate that today’s global protection gap for weather-related losses is at around 70%. At the macroeconomic level, uninsured losses from physical risks may affect resource availability and economic productivity across sectors with cascading impacts on the financial system. Re/insurers should use their understanding of risk to help households, private companies and societies mitigate and adapt, the aim being to protect a greater share of the global assets. Insurance is a central component of building resilience at the macro- and micro levels. This is acknowledged in the United Nations’ (UN) 17 Sustainable Development Goals (SDGs), which include insurance as a main tool to strengthen the resilience of societies. The 2030 Agenda for Sustainable Development makes explicit references to disaster risk reduction and includes numerous targets that capture various aspects of resilience [Transforming Our World: The 2030 Agenda for Sustainable Development, United Nations, 2015].

Insurers’ commitment to a “net zero” asset and underwriting portfolio and PPPs with sustainability criteria at their core would all support the climate transition. Insurers can also contribute to and capture opportunities from the transition to a low-carbon economy, in their function as institutional investors and risk capacity providers [Turning up the heat – climate risk assessment in the insurance sector, Bank for International].

For some industries, climate change will result in a decrease of insured asset values and/ or loss in the valuation of related securities (stranded assets) [assets that have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities which can be caused by a range of environment-related and/or policy risks].

Industries that focus on green technology, renewable energy, carbon capture and storage also provide new insurance and investment opportunities. Re/insurers have started to work with their clients supporting their transition to a low-carbon economy through underwriting activities and investment strategies. They can also encourage behavioural change by setting appropriate risk prices and work on new products and underwriting solutions as new hazards emerge.

Similar to developments in cyber and other emerging risk lines, insuring green technologies may initially be challenging due to limited loss history and/or inadequate understanding of environmental and policy feedback loops. Parametric solutions can provide alternatives where traditional indemnity products face limitations to insurability. To facilitate the transition to a net zero economy, Swiss Re’s underwriting will also tighten its coal policy by 2023 through coal-exposure thresholds. These will be lowered gradually and will lead to a complete phase out of underwriting of thermal coal exposures in OECD countries by 2030, and in the rest of the world by 2040.

This is an excerpt from Swiss Re’s report, The economics of climate change: no action not an option. To access the full report, click here.

The main effect of climate change on insurers is rising loss costs. The effects of rising temperatures are already feeding through to higher insured claims (eg, for property damage, crop shortfall, business interruption) from some secondary perils, including heat waves, wildfires, droughts and torrential rainfall.

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