Innovation in insurance services can help address the climate change dilemma

Out-Law Analysis | 24 Sep 2018 | 3:32 pm | 9 min. read

ANALYSIS: Climate change poses huge questions for the insurance industry, and the implications of major weather events, changing temperatures and shifting land use and availability will be felt by insurers for decades to come.

A Lloyd's City Risk Index report published in collaboration with Cambridge University this year said that $123 billion of the world's GDP is at risk every year in cities affected by climate change, and most analysts agree that the effects of climate change will increase over time.

Although the risks and challenges for insurers are significant, insurers are uniquely placed to bring about positive change through innovation.Some of that innovation is already happening.

The International Development Fund (IDF) said that 70% of economic losses from natural disasters remain uninsured. It said that a 1% increase in insurance penetration may reduce the cost to taxpayers of climate-related disasters by 22%. Insurers are being encouraged to harness new technology and information to close this protection gap in a commercially viable way and in the process greatly mitigate the wider damage caused by climate-related disasters.

First party property insurance policies covering weather-related risks are being extended and introduced to new sectors. Third party liability policies covering environmental liability, directors and officers' liability and other professional liabilities are being adjusted to cover liabilities linked to climate change losses.

Some insurers give companies adopting green or energy-saving policies lower premiums or other advantages. This could be if an insured building has been made less vulnerable to flood damage, or ‘pay-as-you-drive' policies for car insurance to incentivise drivers to drive less, or lower premiums for those using GPS on the assumption that this will reduce driving time. Other insurers are reducing premiums for people who have purchased a season rail ticket or for those insuring hybrid low emission cars.

Insurance policies covering windmills, solar panels, hydro power, geo-thermal energy, wave energy or bio fuels are increasingly available. Parametric, or index, insurance is gaining recognition. Using satellite data to monitor crop patterns, insurers can pick up early signs of drought, flooding or crop failure. This data then enables the insurer to gauge the risk for large numbers of small customers, making the insurance more affordable.

Carbon dioxide-related insurance coverage is another emerging product, for companies which take actions to reduce carbon emissions in order to be able to gain carbon credits to sell on the market. This activity creates risks that the business will fail to reach its objective and gain the credit, so carbon credit delivery insurance protects against this risk. Insurance is available for the risks associated with capturing carbon dioxide and storing it underground. Certain insurers are also offering to offset carbon emissions caused by some insured activities.

The scale of the dilemma

Anthropocentric or human-made climate change is a real and serious issue as the Lloyd's index report, and other recent reports, areshowing.

In financial terms, tropical windstorms present the costliest single risk to Asian cities in the index report. Both extreme heat and extreme cold were noted as risks to Paris and London, highlighting the complex and sometimes paradoxical nature of climate change risk to GDP. Loss from climate-related risks is set to grow as major weather events increase in frequency and severity. The costs of mitigating these and the re-structuring of the global economy towards a low-carbon future are set to mount.

Since the signing of the Paris Climate Change Agreement in 2015 several major insurers have put programmes in place to manage climate-related risks. They are developing risk models for changing weather conditions to set rates more effectively and developing resources to assist individual firms and wider insurance markets in managing climate-related risks. Bodies such as the International Association of Insurance Supervisors (IAIS) and Lloyd's are producing reports on research in the field.

Here are some of the recent developments:

  • 2015: Paris Climate Change Agreement signed by the Conference of the Parties of the UN Framework Convention on Climate Change.
  • 2015: Task Force on Climate-Related Financial Disclosures (TCFD) established by Financial Stability Board.
  • 2015: Bank of England produces 'The Impact of Climate Change on the UK insurance sector'.
  • 2016: Sustainable Insurance Forum (SIF) launched.
  • 2016: G20's Green Finance Study Group established to promote green investment.
  • 2017: Green Finance Study Group focuses on climate information development.
  • 2018: European Commission presents Action Plan on Sustainable Finance.
  • 2018: SIF and IAIS produce joint issues paper on Climate Change Risks to the Insurance Sector.

Categories of Financial Risk

The effects of climate change on risk are complex. The Bank of England's 2015 report on the impact of climate change on the UK insurance sector identified categories of financial risk.

Physical risks

Physical risks capture the tangible changes brought about by climate change, such as sea-level rise, global warming and the increase in the number of severe weather events. This also captures the shocks that these changes bring about – for example floods, droughts and hurricanes. According to the G20 Taskforce on climate-related financial disclosures (TCFD), companies engaged in agriculture, transportation and building infrastructure, insurance and tourism are more exposed to physical risks.

For insurers, these physical risks can dramatically alter the risk profile of portfolios in different geographical regions and market sectors, and often in an unpredictable manner as effects compound. A 2018 paper by the International Association of Insurance Supervisors (IAIS) highlighted knowledge gaps and uncertainties in the understanding of climate change and catastrophe models which may lead to events being effectively "unforeseen" in insurers' rate setting – and gave the example of marine insurance as a sector facing a particularly complex set of changing risks. Such unforeseen risks, of a sufficient scale, could overwhelm an individual insurer's ability to absorb the resulting loss and impact its solvency. In 2017, $144bn of insured losses were incurred globally from disaster events according to Swiss Re - the highest figure recorded by the organisation for 50 years - highlighting the scale of the risk of shocks from physical risks.

Systemic or transition risks

Systemic risks, also described as transition risks, capture rather the risks arising from the shift to low-carbon technologies, as well as changing social and political attitudes to the problem of climate change, and the potential for geographical repositioning of the global economy. According to TCFD, companies engaged in fossil-fuel based industries, energy-intensive manufacturing, and transportation activities are most exposed to transition risks.

Liability risks

Climate change is real and companies have to quantify, report and mitigate it as a genuine risk.  A recent report from the Commonwealth Climate and Law Initiative, Directors' Liability and Climate Risk: United Kingdom - Country Paper, highlights that liability risks exist in the potential exposure of companies and directors to legal liability for all of the following factors:

A company's contribution to anthropogenic climate change: in recent years, several oil companies have seen actions brought against them attempting to find them liable directly for climate change brought about by their promotion of fossil fuels, or underplaying the risks of their use. The chances of success of such actions appear relatively slim, however the same may not be said of actions brought against directors of these companies.

Failure to adequately manage the physical and transition risks: as institutional investors, insurers are increasingly being scrutinised for the climate-sensitive investment choices they make. Large investments in fossil fuel producing entities, which might see revenues fall as the world economy rebalances away from fossil fuels, or as they are prevented by governments from extracting reserves, may result in substantial damage to insurers' balance sheets - and in turn returns for investors.

Barclays Energy Analyst estimates that the revenues of upstream energy companies may fall by $33 trillion by 2040, representing a significant decline in what frequently forms a segment of institutional portfolios. Losses to infrastructure and real estate caused by severe weather events may also impact previously relatively stable investments. Insurers may be required to seek stable revenue from alternative investments, again introducing the problem of limited information in new fields upon which to base substantial programmes of investment.

Inaccurate, misleading or fraudulent reporting: disclosure and quantification of climate change risks is a relatively new exercise for insurers as well as other companies, however the risks of failing to do so adequately are already becoming apparent. Regulatory action and/or litigation could result. For example, in 2016 a class action law suit was brought against ExxonMobil by shareholders alleging it failed to price its climate-related risk appropriately. More recently, ClientEarth, a charity which uses legal action to promote positive change to environmental practices, reported three insurers to the FCA for failure to properly report upon climate-related risks.

Cases brought against senior managers at Volkswagen for their role in the doctoring of emissions tests show that actions can be brought against senior managers in this context and are potentially damaging.

Directors must not mislead shareholders, investors or customers about the environmental impact of the company or its products. Breach of these duties may result in significant D&O liability claims.

ESG, regulation and social change

Many investors and consumers increasingly demand that companies operate in an environmentally conscious manner. Companies are increasingly adhering to an environment, social and governance (ESG) assessment of potential investments, to limit the damage that a potential investment might have to the environment or wider society. More broadly, ‘conscious consumers’ may shift purchasing decisions to companies who demonstrate environmental awareness in their business activities.

This shifting social attitude is also reflected in changing political and regulatory focus. Recent years have seen the formation of the Paris Agreement on climate change, as well as local climate-related laws and taxation regimes. Again, not only might this directly impact insurers, for example by making mandatory insurance for high-risk climate areas, but it might have a significant impact upon the companies to which insurers are exposed. One of the most direct examples on this is the potential restriction of access to oil reserves placed on fossil-fuel companies.

Underwriting considerations

From an underwriting perspective, several types of existing property insurances may be affected by the impact of physical risks. Examples include: agricultural insurances for damages to crops, forestry and livestock; home and building insurances; machinery and equipment; transport and marine insurances; export credit insurance, and business interruption insurance.

In many cases underwriters are not considering new risks but rather the aggravation of existing ones. Insurers may want to protect themselves without necessarily withdrawing from normal coverage of insured risks like fire, flooding and other natural catastrophes. Any restrictions or exclusions would therefore be limited to the additional part of the risk caused by climate change. This concern could be met with careful drafting of the relevant provisions of the policy. The challenge for insurers is to find language that will identify the part specifically attributable to climate change. What is meant by 'climate change' and its effects on the insurance coverage has to be precisely defined. Quantitative criteria can sometimes be used, for example, various natural catastrophes are covered however caps are applied amounting to exclusions of events of a certain magnitude e.g. where winds blew above a certain speed.

The policy terms of life insurance products like term assurance and critical illness insurance cover may have to be reviewed for issues like the increase of death rate due to excessive heat; natural catastrophes; climate change-related diseases like malaria, meningitis, skin cancer, allergies, stress due to excessive heat or malnutrition due to drought.

Climate change may also affect the liability position of professions and sectors whose activities can have an influence on climate change. For example, oil and gas companies, large corporations and their senior management, architects, engineers, manufacturers, bankers, insurers and public authorities.

Types of liability insurance cover that may be sought include liability for excessive gas emissions, violation of regulatory requirements, failure to disclose information, lack of preventative measures, and inadequate handling of accidents. If a liability insurance policy covers the consequences of losses caused by climate change factors, significant difficulties will arise where losses are due to a combination of different factors, climate change being only one of them.

Insurers and supervisory bodies are beginning to respond to these risks and attempt to secure coverage and solvency. In 2017 for example, following a spike in weather-related claims the Canadian supervisory body asked Canadian insurers to assess their exposure to weather-related risk and the availability of reinsurance in order to review the Canadian reinsurance framework. Several large international insurers have launched dedicated programmes to assess the impact of climate-related risk on their businesses and the sectors they are exposed to.

Climate change around the world is creating a shifting risk landscape for insurers. As well as squarely facing the challenges, insurers should focus on the many opportunities available. They are in a unique position to effect positive change.

Nicholas BradleyElaine Quinn and Conor Langan and  are insurance experts at Pinsent Masons, the law firm behind