Climate Change's Creeping Impact: Adjusting Short-Term Insurance Underwriting Practices

Climate change poses a significant risk to the insurance industry, with the potential to impact underwriting practices and short-term insurance. The increasing frequency and severity of extreme weather events, such as wildfires, heat waves, and floods, have brought greater regulatory scrutiny on the insurance sector. While the industry has been aware of climate change for decades, many insurers have been slow to incorporate these risks into their underwriting policies, focusing more on short-term rather than long-term risks. However, with mounting losses, insurers can no longer ignore the impact of climate change on their underwriting, pricing, and investment decisions.

Climate change can affect insurance companies in several ways, including physical risks from damage caused by extreme weather events, transition risks due to shifting consumer preferences and policies, and liability risks from litigation related to climate change mitigation and adaptation efforts. These risks can impact both sides of an insurance company's balance sheet, leading to higher claims payouts and losses in asset values. As a result, insurers may need to adapt their underwriting practices to address these evolving risks and ensure the long-term viability of their business.

Insurers' understanding of risk and climate science

Insurers play a crucial role in managing risk in the transition to a green economy. They must adapt their underwriting practices to incorporate climate change risks, ensuring that their models account for the increasing frequency and severity of climate-related events. This includes developing new products and solutions to address the unique challenges posed by climate change, such as incentives for risk reduction and proactive management of business interruption risks.

The insurance industry has been aware of climate change for decades, but integrating it into underwriting policies has been slow. Climate change models often differ from insurance risk models, making it challenging to apply climate science directly to insurance pricing. However, insurers must recognize that climate change impacts are no longer isolated events but interconnected with global human systems. As a result, they need to adopt a more strategic approach to underwriting, considering the complex and dynamic nature of climate risks.

Insurers should integrate climate risks into their governance structures and business decisions. This involves designating specific individuals to oversee climate risk management and considering both current and future climate factors. Scenario analyses are essential to testing an insurer's resilience to various climate change scenarios over different time horizons. Additionally, enhancing disclosures by incorporating climate risks into public filings can provide valuable information to stakeholders and the public.

Climate change poses physical, transition, and liability risks to insurers. Physical risks include increased losses due to climate-related events, such as wildfires and rising sea levels, which can lead to higher claims payouts. Transition risks arise from shifting consumer preferences and market forces, impacting the revenue from carbon-reliant businesses. Liability risks stem from litigation related to climate change mitigation and adaptation efforts, which can result in substantial payouts for liability insurance policies.

To address these risks effectively, insurers should collaborate with governments and local authorities to develop resilience and adapt to changing conditions. This includes investing in resilient infrastructure, supply chains, and facilities. By integrating climate science into their risk management procedures, insurers can make more informed decisions and contribute to a more sustainable future.

Insurers can also play a proactive role in promoting climate change adaptation. For example, by incentivizing policyholders to implement flood prevention measures, insurers can reduce potential flood impacts and lower premiums. Similarly, offering premium rebates for contingency planning can encourage businesses to remove their activities from high-hazard zones, reducing their exposure to climate-related risks.

Climate risk modelling and data collection

One of the main challenges in incorporating climate change into underwriting practices is the incompatibility between climate change models and insurance risk models. Climate change models often do not provide the level of detail and specificity required by insurance risk models to accurately price and assess risk. However, this is slowly changing as the insurance industry recognises the need to adapt to climate change.

To address this challenge, insurance companies can take several approaches:

• Integrate climate risks into risk management procedures: Insurance companies can develop procedures to identify, assess, and manage climate risks within their existing risk management frameworks. This includes incorporating climate risk into tools such as the Own Risk and Solvency Assessment.
• Enhance climate risk data and modelling: Insurance companies can invest in improving the quality and granularity of climate risk data and models. This includes collecting data on a wide range of climate variables and incorporating them into underwriting and pricing decisions. Advanced analytics techniques can be used to project how acute and chronic climate hazards will impact their business over time.
• Conduct climate risk stress testing: By stress testing their portfolios against various climate change scenarios, insurance companies can better understand their exposure to climate risks and make more informed decisions about risk management and portfolio diversification.
• Collaborate with public and private stakeholders: Insurance companies can partner with governments, academic institutions, and other private sector entities to improve climate risk modelling and data collection. This can include sharing data, developing new modelling techniques, and creating industry-wide standards for climate risk assessment.
• Engage in scenario analyses: Insurance companies can conduct scenario analyses to assess their resilience to a range of short-term and long-term climate change scenarios. This helps them identify potential risks and develop strategies to mitigate them.

By improving climate risk modelling and data collection, insurance companies can make more informed decisions about underwriting, pricing, and investment strategies. This enables them to better manage their exposure to climate risks and ensure the long-term sustainability and resilience of their business.

Insurers' investment strategies and portfolios

Insurers' portfolios are also vulnerable to transition risks. As the global economy transitions towards long-term decarbonisation, insurers' portfolios are exposed to rapid asset repricing and portfolio volatility, particularly for carbon-intensive investments. Insurers should therefore re-evaluate their investment-allocation strategies.

Insurers should also consider the environmental impact of their investments, as banks and asset managers are doing, and shift significant portions of their portfolios towards supporting a sustainable, decarbonised economy. This will help insurers demonstrate their proactive compliance as regulators may enact policies and incentives that affect the investments financial-services companies make towards their environmental, social, and governance (ESG) footprint.

Insurers can also contribute to climate change adaptation through their underwriting and pricing practices. For example, insurers can incentivise risk reduction through premium discounts to policyholders who protect their property against natural catastrophe damages. Insurers can also promote the proactive management of business interruption risks by improving the modelling of these risks and extending insurance coverage by including risk reduction measures.

Insurers can also improve creditworthiness through adaptation measures. Climate-related costs are a source of credit risk as they affect households' and firms' cash flows and wealth, which are key determinants of their creditworthiness.

Insurers' role in climate change mitigation

Insurers play a critical role in the transition to a green economy by helping stakeholders manage risk. They can develop innovative insurance products that incentivize climate-related risk prevention, for instance, by offering lower premiums to policyholders who implement climate-related adaptation measures. Insurers can also contribute to climate change adaptation through their underwriting and pricing practices. For example, insurers can incentivize risk reduction through premium discounts for policyholders who protect their property against natural catastrophe damages. Furthermore, insurers can promote the proactive management of business interruption risks by including risk reduction measures in insurance products, which will help businesses survive natural catastrophes.

Insurers can also improve creditworthiness through adaptation measures in property and non-damage business interruption insurance. By assessing the possible longer-term financial burden on a policyholder following a disaster, an insurer could adapt the terms and conditions of the credit insurance.

Insurers can also contribute to limiting the impact of catastrophic events through their knowledge and expertise in assessing, modelling, and pooling risks. They can also contribute to limiting the potentially systemic risks to society arising from climate change, such as economic consequences in terms of welfare, including damage to the capital stock, sectoral productivity, and changes in consumption.

Insurers can play a vital role in supporting the individuals and communities that are most vulnerable to the impacts of climate change. Well-designed policies can be beneficial for increasing communities' resilience, for example, if support payments are triggered by climate phenomena that challenge livelihoods.

Insurers can also use their understanding of risk to help organizations mitigate and adapt, thus protecting a greater share of the global economy. They can also contribute to improving building standards and policies by collaborating with governments.

Regulatory response to insurers' climate risk

Climate change poses a significant threat to the insurance industry, and regulators are increasingly recognising the need to address this issue. Here are some key aspects of the regulatory response to insurers' climate risk:

• Recognition of Climate Risk: Regulators, such as the US Federal Insurance Office and state insurance departments, are acknowledging the financial risks associated with climate change. They understand that insurers face physical risks from extreme weather events and transition risks as the economy moves towards decarbonisation.
• Enhanced Data Collection: Regulators are collecting more comprehensive data on insurers' exposure to climate risks. For example, the National Association of Insurance Commissioners (NAIC) in the US has updated its climate risk survey to align with international disclosure standards. This will provide regulators with a clearer picture of the climate-related risks faced by insurers.
• Supervisory Guidance: Regulators are issuing guidance to insurers on managing climate-related risks. For instance, the New York Department of Financial Services has published guidance on integrating climate risks into governance structures, business decisions, risk management procedures, and disclosures. Other states are encouraged to follow suit and provide similar guidance to insurers.
• Risk Assessment and Scenario Analysis: Regulators are emphasising the importance of climate risk assessment and scenario analysis. They expect insurers to conduct stress tests and analyse the resilience of their portfolios under various climate change scenarios. This helps insurers and regulators better understand the potential financial impacts of climate change.
• Addressing Underwriting and Pricing Practices: Regulators are encouraging insurers to incorporate climate risks into their underwriting and pricing strategies. This includes assessing the adequacy of current underwriting limits and reinsurance arrangements in light of increasing climate-related losses. Insurers are also advised to implement impact underwriting practices, which incentivise policyholders to take preventative measures to reduce their carbon footprint and climate risk exposure.
• Climate Risk Mitigation and Adaptation: Regulators are promoting the development of innovative insurance products that contribute to climate change adaptation and mitigation. For example, insurers can offer premium discounts to policyholders who implement flood prevention measures or adopt climate-resilient construction practices. These measures not only reduce potential losses but also help maintain the affordability and availability of insurance products.
• Collaboration and Public-Private Partnerships: Regulators are collaborating with international organisations and standard-setting bodies, such as the Financial Stability Board and the Network for Greening the Financial System, to address climate risks. Additionally, public-private partnerships are being explored to improve climate resilience and close the insurance protection gap, particularly in underserved communities.
• Disclosure Requirements and Transparency: Regulators are advocating for enhanced disclosure requirements to increase transparency around climate risks. They are encouraging insurers to integrate climate risks into their public filings and follow international frameworks for climate-related financial disclosures, such as those recommended by the Task Force on Climate-related Financial Disclosures (TCFD).
• Capital Requirements and Solvency: Regulators are considering the inclusion of climate risks in their assessment of risk-based capital requirements for insurers. They are also monitoring the potential impact of climate change on insurers' solvency and financial stability.
• Addressing Market Disruptions: Regulators are working to prevent disruptions in insurance markets due to climate-related events. They are developing strategies to deter practices such as "bluelining," where insurers deny coverage to neighbourhoods at high risk of climate-related disasters. Regulators are also exploring the feasibility of innovative insurance products, such as parametric insurance, to provide affordable coverage in high-risk areas.

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