The Effect of Climate Change on Insurance

Climate risks were projected to increase annual property insurance premiums by up to $183 billion by 2040.

6 mins read
Saarbrücken, Germany [Photo: Kevin Mueller/Unsplash]

Risk comes from not knowing what you’re doing. ~ Warren Buffett

So far, we have been obsessed with (and rightfully so) the portentous calamity we are facing with a rapidly heating globe. In addition to this existential threat, there is seemingly an economic threat looming on the horizon: insurability of our assets.

 In 2021, an article in The Financial Times (FT) reported that climate risks were projected to increase annual property insurance premiums by up to $183 billion by 2040. The rising frequency and severity of extreme weather events were causing insurers to hike prices. The Swiss Re Institute, the research arm of the reinsurance group, had forecasted that climate-related risks would constitute just over 20% of the total increase in property premiums over the next 20 years.

According to the FT, factors categorized under “economic development,” which include inflation and the growth of insured assets, were expected to account for three-quarters of the increase, adding as much as $616 billion to the premiums in what the institute predicted will be a $1.3 trillion market. Wildfires, winter storms, and floods had made 2021 an expensive year for the sector. It had experienced the worst start of the year for natural catastrophe insurance in a decade, even before the July floods in Europe and the destruction caused by Hurricane Ida in the US.

Fast forward to 2024, the BBC World Business Report of 10 July had Swiss Re saying that disasters such as  widespread wildfires, floods, landslides and adverse weather phenomena which are increasing exponentially due to climate change would make otherwise insurable interests uninsurable.

The Background

It is recorded that 2023 was the hottest year on record.  From the likes of it, 2024 may even surpass that feat. The Intergovernmental Panel on Climate Change (IPCC) in its 2023 Synthesis Report (SYR) of the IPCC Sixth Assessment Report (AR6) summarizes the current understanding of climate change, its extensive impacts and risks, as well as measures for mitigation and adaptation. The SYR highlights the crisis, stating that human activities, mainly through greenhouse gas emissions, have undoubtedly caused global warming, with global surface temperatures rising to 1.1°C above the 1850-1900 levels during 2011-2020. Global greenhouse gas emissions have continued to rise, with uneven contributions historically and currently, stemming from unsustainable energy use, land use and changes in land use, lifestyles, and patterns of consumption and production across different regions, countries, and individuals.

The SYR further states that there have been widespread and rapid changes in the atmosphere, ocean, cryosphere, and biosphere. Human-induced climate change is already influencing many weather and climate extremes in every region worldwide. This has resulted in widespread negative impacts and related losses and damages to nature and people. Vulnerable communities, which have historically contributed the least to current climate change, are disproportionately affected.

How So?

The rising frequency and intensity of climate-related catastrophes present formidable obstacles for the insurance sector, causing numerous insurers to decline coverage for properties damaged by such occurrences. This pattern is driven by several key factors: surging financial risks, unpredictable future damages, and the increasing complexity of evaluating and managing climate-associated risks.

A principal reason why insurers are hesitant to insure properties ravaged by climate-induced disasters is the mounting financial risk. The cost of natural calamities has soared significantly in recent years, with incidents like hurricanes, wildfires, and floods inflicting billions of dollars in damages. For instance, the 2017 Atlantic hurricane season alone caused over $282 billion in losses. As the financial burden on insurers intensifies, covering properties in high-risk zones becomes progressively impractical. The threat of catastrophic losses can jeopardize an insurer’s financial stability, necessitating a limitation on exposure to such high-risk policies.

Additionally, the unpredictability of future losses plays a critical role. Climate change introduces a level of uncertainty that complicates the conventional models used by insurers to evaluate risk. As climate change accelerates, historical data on weather patterns and disaster frequency becomes less reliable. This makes it difficult for insurers to set accurate premiums and ensure they have adequate reserves to cover potential claims. The inability to confidently forecast future losses leads insurers to either hike premiums to unsustainable levels or entirely withdraw coverage from high-risk areas.

The increasing complexity of assessing and managing climate-related risks also contributes to insurers’ reluctance to cover certain properties. Insurers must consider a myriad of factors, including the physical vulnerability of properties, the efficacy of local mitigation efforts, and the potential for cascading effects from multiple concurrent disasters. For example, a coastal property might face risks not only from hurricanes but also from rising sea levels and storm surges. The interconnection of these risks complicates underwriting decisions and heightens the likelihood of significant losses.

Furthermore, regulatory and market pressures influence insurers’ choices. In some areas, regulators may impose limitations on premium increases or mandate coverage for high-risk regions, adding financial strain on insurers. Concurrently, market competition and the imperative to maintain profitability push insurers to prioritize lower-risk policies. These pressures can prompt insurers to withdraw from markets or deny coverage for properties with high climate-related risks.

The refusal to insure properties impacted by climate change has broader societal implications. Homeowners and businesses in high-risk areas may find themselves without affordable insurance options, leading to financial instability and decreased resilience to future disasters. This situation can exacerbate social inequalities, as those with fewer resources are disproportionately affected by the lack of insurance coverage. Governments might be compelled to intervene with disaster relief programs, further straining public finances.

In response to these challenges, some insurers are adopting innovative strategies to manage climate-related risks. These include investing in advanced modeling techniques, advocating for climate-resilient building practices, and partnering with governments and other stakeholders on mitigation and adaptation efforts. However, these measures alone may not suffice to address the systemic risks posed by climate change.

Ultimately, the growing reluctance of insurers to cover properties destroyed by climate-related disasters highlights the urgent need for comprehensive climate action. Reducing greenhouse gas emissions, enhancing infrastructure resilience, and implementing effective adaptation strategies are crucial to mitigating the long-term impacts of climate change. Without such efforts, the insurance industry’s capacity to provide coverage for high-risk properties will continue to decline, leaving vulnerable communities increasingly exposed to risk.

My Take

The stance taken by Swiss Re seems entirely justifiable.

Insurers may justifiably decline to offer insurance to property owners if the potential for extensive damage due to climate change appears likely. This decision is based on foundational principles and practical considerations inherent to the insurance sector.

Insurance firms operate primarily by evaluating and managing risk. Their business model revolves around pooling risks from numerous policyholders and setting premiums commensurate with the likelihood and potential costs of claims. However, when climate change substantially heightens the risk of widespread damage, this equilibrium can be disrupted, rendering it economically unfeasible for insurers to provide coverage without incurring significant losses.

Insurers rely on historical and actuarial data to forecast future losses and establish appropriate premiums. Climate change introduces new variables and escalates the frequency and severity of weather-related incidents like hurricanes, floods, wildfires, and storms. These changes can diminish the reliability of historical data, complicating the accurate pricing of policies and the maintenance of adequate reserves. Consequently, heightened uncertainty often prompts insurers to decline coverage in regions deemed high-risk.

Maintaining financial stability and solvency is critical for insurers to fulfill their commitments to policyholders. Insuring properties at high risk of climate-related damage can jeopardize an insurer’s financial well-being. Major natural disasters can result in substantial claims that exceed the insurer’s ability to cover. To safeguard their financial health, insurers may opt to deny coverage to properties situated in areas prone to such risks.

Moreover, insurers face pressures from regulations and market dynamics. Regulatory bodies may impose requirements related to solvency and capital adequacy that insurers must meet. Providing coverage for properties at high risk of climate-related damage may conflict with these regulations, compelling insurers to limit their exposure. Additionally, competitive pressures and the imperative to maintain profitability further justify insurers’ decisions to avoid covering properties susceptible to climate-related risks.

Climate change-related risks also exacerbate concerns about moral hazard and adverse selection. Moral hazard arises when policyholders engage in riskier behavior because they are insured, while adverse selection occurs when those most likely to file claims are also the most inclined to purchase insurance. In regions increasingly impacted by climate change, these factors can strain insurance pools and escalate costs, validating insurers’ decisions to decline coverage as a means to effectively manage these risks.

By refusing to insure properties at high risk of climate-related damage, insurers can incentivize property owners and governments to implement measures for risk mitigation and adaptation. Such measures may involve investments in resilient infrastructure, enhancements to building codes, and promotion of sustainable land-use practices. Encouraging proactive risk reduction measures helps build long-term resilience to climate change.

Although denying insurance coverage to property owners due to climate change risks may seem stringent, it reflects a pragmatic approach rooted in risk assessment, financial stability, adherence to regulations, and response to market conditions. Insurers must balance their duty to policyholders with the imperative of maintaining solvency and profitability. In areas where climate change markedly increases the likelihood of widespread damage, insurers are justified in declining coverage to manage their risk exposure and promote broader initiatives aimed at mitigating and adapting to these evolving challenges.

Ruwantissa Abeyratne

Dr. Abeyratne teaches aerospace law at McGill University. Among the numerous books he has published are Air Navigation Law (2012) and Aviation Safety Law and Regulation (to be published in 2023). He is a former Senior Legal Counsel at the International Civil Aviation Organization.

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