As the economic impact of climate change will move economies towards de-carbonization, and carbon-neutral investments, climate risk is going to alter insurance policies, portfolios, and assets. The insurance industry must prepare for the physical, and systemic effects of climate change by adapting new business models.
The effects of climate change are stronger and immediate, with increasing frequency of natural disasters, destruction of properties, and businesses now hitting record-breaking rates. According to McKinsey the value at stake from climate-induced hazards could increase from about 2 percent of global GDP to more than 4 percent of global GDP by 2050.
The changes in the global climate are locked in for at least the next ten years. And insurers can no longer wish them away as individual catastrophic events.
2020 was the fifth-costliest year for the insurance industry in 40 years. According to a report, global disasters exacerbated by climate change produced $210 billion in losses in 2020 as several countries, including the U.S. and China, battled hurricanes, floods, and wildfires. The worldwide monetary losses in 2020 were up 26.5% compared to 2019’s cost of $166 billion. And $82 billion worth of damage was insured last year, up from $57 billion in 2019.
At first glance, the effects of climate change may not seem harmful to property and casualty (P&C) insurers. Through sophisticated understanding of evolving risks, insurers can rely upon re-pricing and rearranging portfolios to manage exposure to climate events. And the growth in the value at risk, and volatility — should increase the demand for new and customized insurance solutions, which can expand insurance opportunities.
However, insurers are underestimating the long-term impact of climate change. Its effects are systemic, as climate risk stresses local economies. More frequent catastrophic events will lead to changing regulatory environment, which can threaten existing business models — and alter risks permanently.
Reshaping the P&C Business Model
A shift in business model is required, away from transactional risk transfers and indemnity payments, towards scaling existing incentives. Stakeholders — such as customers, shareholders, and regulators, are therefore likely to demand that insurance solutions go beyond traditional risk transfer to explicitly address risk mitigation.
Climate events need to be understood within the context of geographies. Insurers need to develop tools that can assess spatial insights, making parametric insurance important. Insurers are well placed to draw upon their expert understanding of risk to help organizations mitigate and adapt to climate risk. Hence, developing products that cover climate-related risk, and revisiting existing carbon-intensive investment strategies is imperative.
01 Asses climate risk through advanced data analytics
Insurers’ current models do not account for the growing number, types, and interconnectivity of risk. Concentration and aggregation of risk will likely increase, and spread across diverse coverage — flood, property, and business interruption.
Bank of England’s findings suggest that the industry is failing to capture the full spectrum of potential losses due to use of low-quality data.
Insurers need to adopt climate-specific stress testing, that go beyond traditional catastrophe models, to understand the impact on their portfolios. They can accomplish this by using advanced data analytics to project various acute and chronic hazards accurately.
02 Build resilience and rebalance portfolios
Although insurance companies fare better in understanding and measuring the impact of climate risk on their financial resilience, when compared with other sectors. Many institutions, from banks to asset managers, that have historically been less exposed, and therefore remained less sophisticated assessors of climate risk — have also begun to incorporate climate risk into their considerations of investment allocations, credit risk, and asset management.
With advanced risk analysis, insurers can build greater resilience by including low-probability catastrophic events, diversifying their portfolio, and planning to evolve exposure over time.
03 Help organizations mitigate climate risk
Insurers should now also focus on mitigating and even preventing physical climate risk. This commitment requires shifting business models away from transactional risk transfers and indemnity payments, towards scaling existing incentives — such as rebates for using resilient construction materials etc.
A major part of this shift will be focused on preventing customers from incurring damage and reducing claims. Customized insurance products that adjust premiums to individual behaviors will become more common.
04 Create innovative products to address climate risk
As partners, insurers might deploy new solutions to protect customers from new exposures, while leveraging market opportunities. Solutions could be as straightforward as parametric pricing, or insuring against events of a set magnitude, instead of the value of losses. Insurers can also play a role in matching risk-transfer solutions to alternative capital from investors with more risk appetite.
The consequences and knock-on effects of specific climate hazards need to be incorporated. Thus, long-standing actuarial approaches to risk modeling will have to evolve in tandem with climate science.
05 Revise investment strategies
Insurers must re-evaluate their investment allocations as economies transition towards long-term de-carbonization. This will cause rapid re-pricing of assets, and portfolio volatility for carbon-intensive investments.
A shift in significant portions of their portfolios toward supporting a sustainable, decarbonized economy is now necessary. Regulators are expected to alter policies and incentivize financial investments and services that focus on their environmental, social, and governance (ESG) footprint.
Time for Climate Readiness is Now
Climate risks present a significant challenge for the insurance industry, since they are likely to increase over time. The efforts to respond at scale will take time, but with the long-term viability of the industry at stake, insurers should start acting now
Finding a balance between affordability, availability, and financial stability is set to get tougher for insurers. Therefore, the focus should be on fortifying their assessment of climate-related risks while taking long-term actions to alleviate and mitigate such exposures.
Incentivizing the right behaviors among customers, facilitating the development of climate-resilient public policies, and developing a holistic approach toward managing climate risk should become part of business strategy.
Finally, insurers will have to better demonstrate their climate readiness to regulators, investors, analysts, and customers. This will help insurers, and regulators to create a more level playing field and a stable market for all stakeholders.