25 February 2009

Published in: Insurance risk, Cat risk - ILS

Maintaining insurability in a changing climate

Higher and more volatile weather risks could make increasing numbers of people and properties uninsurable. But there are ways to address this, says Celine Herweijer

Managing climate change risks requires urgent action, both to mitigate the buildup of atmospheric greenhouse levels through reducing global emissions and to adapt to the changes in climate locally to minimize harm and maximize potential opportunities. The insurance industry can play an important role in both of these responses. Adaptation, or lack thereof, is particularly critical to the insurance industry as it directly affects the very core of property and casualty businesses - the risk landscape that is insured.

Climate change could potentially threaten the widespread availability and affordability of insurance for people and their property in many regions. Insurability depends on a number of criteria, including actuarial, market-based and societal factors, many of which may be affected by climate change, as the table below shows.

Table 1

Criteria for insurability and impacts of climate change (Adapted after Swiss Re (2005))

Category	Criterion	Characteristic	Impacted by Climate Change?
Actuarial	Risk/Uncertainty	Measurable	Yes
	Loss Occurrences	Independent	Possible Impact
	Maximum Loss	Manageable	Likely Impact
	Average Loss	Moderate	Yes
	Loss Frequency	High	Yes
	Moral Hazard, Adverse Selection	Not Excessive	Unlikely
Market-Determined	Insurance Premium	Adequate, Affordable	Yes
	Insurance Cover Limits	Acceptable	Possible Impact
	Industry Capacity	Sufficient	Yes
Societal	Public Policy	Consistent with Cover	Likely
	Public Policy	Consistent with Cover	Likely
	Legal System	Permits the Cover	Unlikely

In particular, it is currently difficult to estimate exactly how climate change will affect future weather hazards locally, leading to additional uncertainty about the frequency and magnitude of potential losses. Any increase in the frequency and/or intensity of weather hazards would mean that the consequent average and maximum losses would increase. For example, a recent RMS and Lloyd's of London study indicated that sea level rise by the 2030s could lead to a doubling of average annual losses from storm surge for properties in the most exposed coastal areas, and around a 10-20% increase in losses that occur, on average, once in every 200 years.

Research by the Association of British Insurers (ABI) in 2005 concluded that with a 6% increase in wind speeds, annual losses from hurricane damage to current US properties would rise from around $5.5bn to $9.5bn, and 1-in-250 year losses from $85bn to $150bn. Additionally, more large "super catastrophes" could result in correlated losses across business lines, coverages and perils and increased correlation between climate events across geographically diverse locations arising from correlation with a latent variable, such as sea level rise or warmer tropical oceans.

Such increases in uncertainty, expected losses, and interdependencies between climate risks because of climate change would have profound consequences for the future affordability and availability of cover. Recent evidence from the US suggests that such major changes in policies offered by private insurers to cover homeowners' properties, particularly if introduced relatively rapidly, can create negative public and political reactions. Insurers may find that other parts of their businesses are affected by public and political dissatisfaction. In Florida, for instance, regulators have attempted to prevent private insurers from withdrawing wind damage coverage by making licences to write automobile policies contingent on maintaining adequate provision of homeowners property insurance. This suggests that the insurance industry is likely to face increased reputational risks, as well as regulatory scrutiny and action if it does not respond appropriately to the threat of rising uninsurability.

Moreover, an increase in the proportion of uninsurable properties potentially threatens the viability of private insurers, as it could lead to a reduction in the overall number of policies that are sold. Such a contraction might initially have a relatively small effect on insurance companies if they can find new customers to replace those considered to be uninsurable. However, this may be limited in relatively mature markets with high insurance penetration.

The role of adaptation

Future losses can be limited by investing in hard defences, adapting existing and planned properties to withstand hazards better, and by improving land-use policies to discourage growth in the highest risk areas. Successful adaptation will be fundamental to maintaining and extending insurability both in existing and emerging private insurance markets. For example, in the recent RMS and Lloyd's of London study, it was shown that adaptation could reduce average annual storm surge losses for individual properties in high-risk coastal communities in the 2030s to below present-day levels.

Figure 1

Losses with higher return periods can also be significantly reduced, lowering the risk. For example, the ABI (2005) demonstrated that investments to improve flood defences along the UK coast (on a par with those suggested in government plans), could reduce losses from a major storm surge in the 2080s from £8-£16bn to £4-£7bn. Such findings demonstrate the large benefits that the insurance industry can gain from adaptation.

Opportunities for the insurance industry

Adaptation (or risk mitigation) can significantly help sustain existing private insurance markets. With such a clear stake, the private insurance industry has an opportunity not only to contribute to the formulation of public policy on adaptation, but to directly influence adaptation through its business practices. Both can be achieved through a combination of strategies, examples of which are outlined below. As well as incentivising and enabling adaptation, such strategies are themselves a necessity for ensuring the sustainability of weather-related insurance.

1. Promote risk awareness and risk-reducing behaviour by risk-based pricing. In principle, risk-based pricing is the practice of charging individual insurance policy-holders premiums that directly reflect the risk of losses to which they are exposed (i.e. the technical risk price). Risk-based pricing provides an incentive to businesses and homeowners to limit or reduce their risks to take advantage of lower premiums, in line with the experience of other insurance markets, such as automobile coverage.
2. Develop insurance products and/or terms and conditions that incentivise risk reduction. In certain circumstances it may make financial sense for insurers to offer incentives, in addition to lower premiums, to policy-holders to invest in risk mitigation measures. Some insurers are already doing this, sometimes indirectly via discount and credit schemes. For example, a number of US insurers are offering premium discounts for homes that follow the Institute for Business and Home Safety (IBHS) "Fortified... for safer living" program. Such premium discounts should not be arbitrary and should be informed by a quantification of the impact of the measures, for instance through the use of catastrophe risk models that can be employed with a specific building code standard or risk mitigation measure built-in.
3. Finance risk reduction /adaptation measures. Larger insurers are in a position to directly finance customer-side adaptation measures that improve the resilience of properties to damage by climate hazards and therefore reduce the risk of losses. For example, an insurer associated with banking operations may offer preferential lending terms to policy-holders who have invested in increasing their home's resilience against the impacts of weather and climate change. Alternatively, given a demonstrable financial benefit, a larger insurer could make a cost-benefit decision to invest in improving climate resilience as part of a service for higher premium clients, or banks with insurance operations may become involved in financing adaptation projects, in a similar manner to the increase in commercial funding for climate change mitigation.
4. Risk education. Insurers can play a significant role in informing and educating customers about the risks of climate change that they face, and, importantly, about how best to reduce them.
5. Fostering disaster resilience practices and technologies. The insurance industry has a history of fostering practices and technologies to reduce risk, through, for instance, innovations in building codes, vehicle safety and fire prevention. The industry likewise can enable and incentivise practices and technologies that help increase policy-holders' resilience to the impacts of climate change. Examples include: providing funding for independent research on climate risk mitigation and adaptation; lobbying for adoption of improved building codes; advocating improved land-use planning; formulating multi-stakeholder adaptation principles; and undertaking and disseminating research that highlights the cost-benefits of risk mitigation /adaptation.
6. Public-private partnerships. The private insurance industry can play a leading role in guiding society's adaptation to the impacts of climate change, but this will require constructive relationships with policy-makers, regulators, public sector organisations and other stakeholders in the private sector. An important example of a public-private partnership on adaptation is a voluntary agreement between the UK government and the ABI on UK flood insurance. Private flood insurance has been sustained through a voluntary agreement known as the statement of principles, under which ABI members have committed to continue making flood insurance available for domestic properties and small businesses where flood has an annual occurrence probability of lower than 1.3 % (1 in 75 years) and/or where the Environment Agency commits to reduce risk to below that level within five years. Alongside the statement of principles is an agreement with the government to put in place a long-term flood management investment plan and to ensure that that planning regulations prevent inappropriate building in high-risk areas.

As we have seen, climate change does not necessarily have to translate into rising risk. Risk can be maintained, or even reduced, through adaptation, i.e. by limiting vulnerability and exposure to weather-related hazards. Adaptation, therefore, is crucial to maintaining insurability in a changing climate.

While opportunities for investment and underwriting related to climate change mitigation (e.g. coverage for, or investment in low-carbon technologies) have so far received the most attention, there is clearly a fundamental business and societal role for the industry to play by leading on adaptation. Insurer and reinsurer activities that incentivise and enable adaptation not only generate opportunities but are increasingly necessary for the sustainability of the industry.

Celine Herweijer is Director of Climate Change, Risk Management Solutions Ltd. E-mail: celine.herweijer@rms.com

A longer version of this article has been submitted for "the 2009 special issue on Climate Change" of the Geneva Papers on Risk and Insurance, due for publication in July 2009.

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