Insurance strategies in an age of climate change
Commercial insurance premiums are on the march worldwide, but particularly in the Pacific region. Climate risk is part of the reason. How should corporations be responding?
- The Pacific area’s upward trend began in 2015
- Climate change is forecast to drive an increase in the frequency and severity of extreme weather events
- In the US, there’s a shift from risk transfer to prevention or mitigation of climate-related risk
By Prue Moodie
Insurance broker Marsh’s Global Insurance Market Index for the first quarter of 2021 shows increases in Pacific region commercial insurance premiums of 29% compared with the first quarter of 2020.
Property insurance premiums were up 20% year-on-year and casualty insurance premiums were 17% higher over the same period.
Marsh’s research shows the Pacific area’s upward trend began in 2015. Back then, much of the concern was about the impact of weather catastrophes on commercial insurance premiums. Today, insurers are seeking to return to solid profitability after years of high claims and low returns from the fixed-interest portions of their portfolios.
But the impact of climate change on insurers and the insured is never far from the agenda.
In March 2021, the Australian Prudential Regulation Authority’s Executive Director, Cross Industry Insights and Data, Sean Carmody, discussed APRA’s concerns about the systemic risk to the financial system from climate change.
“Looking ahead, climate change is forecast to drive an increase in the frequency and severity of extreme weather events,” Carmody told a Senate inquiry into the 2019-20 bushfire season.
He noted that without mitigation efforts, the increased severity of the events, combined with urbanisation, would translate to higher insurance premiums and uninsurability.
“From our point of view, in terms of thinking of the financial system as a whole, it's not enough if insurers have the capacity to pay every claim but there's a shrinking number of people who can actually secure insurance,” he said.
“How long before the climate stabilises?” asks Rade Musulin, principal at Finity Consulting and the lead actuary on the Australian Actuaries Climate Index. “Assuming we constrain emissions and assuming that eventually temperatures stabilise, we’re still talking decades before the climate stabilises. Probably not centuries, but not years.”
The role of insurance
Insurance is usually seen as a simple cost to companies. The positive, although painful, flip side is that in an era of climate change, unaffordable premiums may spur a faster uptake of what Carmody calls mitigation: measures taken to reduce physical climate risk.
The extended storms NSW experienced in March 2021 were a reminder that in Australia, despite the fear evoked by fire, flood is the main risk for insurers.
Across vast stretches of low-lying Queensland, from Bundaberg near the coast, to inland towns as far afield as Roma and Emerald, insurers are putting pressure on local and state governments to build levees. They’re holding out the promise of relief from sky-high premiums in return for action by governments.
In New Zealand, hail and storms are responsible for the highest levels of insurance claims, but fire has emerged as a high-profile insurability issue: insurers have started withdrawing from the forest fire market.
Mark Jones, chief broking officer for New Zealand’s Crombie Lockwood, says the recent withdrawal of three of the main insurers who were writing forestry business in NZ, in response to forest fires and increased claims, led to turmoil in the sector.
“A few of our clients decided that the increased cost of reduced coverage from limited markets meant that self-insurance was a better option. But this isn’t usually an option where the client is insuring plantations on behalf of investors. What we have seen in that area is the existing insurance being continued but with restricted cover, higher excesses and increased premiums.”
How should cost controllers and managers respond?
Understanding and reducing risk
One of the problems for corporations, when it comes to weighing up self-insurance versus paying rising premiums, is that it’s hard to understand what level of risk insurers attach to different hazards.
Karl Mallon is a director of consultancy XDI Cross Dependency Initiative, which helps companies do that.
“We look at their physical risks and assign a risk percentage to them. A risk translates to a dollar figure. We can define risks over five or even 10 years. We tell clients, ‘When you look at all the hazards, your insurance will look something like this’.
“But they can’t take that to an insurer and ask them for a quote – that’s just not the way insurers operate. They operate one year at a time.”
Still, armed with this kind of information, there seems to be an obvious way for an individual company to negotiate with insurers. Namely, analysing its operations and reducing its risk.
Yes, mitigating risk should translate to lower premiums, says Rick Shaw, actuary, Deloitte. “But premiums for individual insureds are impacted by more than their own risk profile. There may be worldwide trends for premiums to increase across the board in response to actual or anticipated increases generally in claims payouts.”
A senior partner specialising in insurance at McKinsey, Kia Javanmardian, agrees that this is a more complex issue than it appears on the surface.
“The question is, will the underwriting process evolve to account for mitigation of risk by individual companies?
“I hesitate to answer,” he says. “Not because it’s not important, but because this is a tipping point. If risk mitigation is voluntary, it’s not as effective. I think the reinsurers will drive the action here.”
Javanmardian says that in the US there’s already a shift from risk transfer to prevention or mitigation of climate-related risk.
“Insurance companies in the US are thinking about how to go upstream. Some of that is on the engineering side – they go into the physical location and engineer the building. Or, in another example, they’re working with authorities to find ways to clear debris in forests.”
Collective action, then, may be the most powerful tool available to corporations.
As well as taking on more of their own risk, they should be bringing pressure to bear on their industry organisations and governments to improve building standards and find ways to embed climate resilience into the economy.
And there are other options available. One is so-called captives. Another is a new approach to insurance called parametric insurance.
Insurers in the United States are considering whether parametric insurance could be useful for climate risk, says Javanmardian.
Parametric insurance pays out in the event of a catastrophe – a storm over a certain category of intensity, for example. In the US, it’s sold to local authorities or companies to cover earthquakes.
“If there’s an earthquake above a certain scale you get paid independent of loss,” says Javanmardian. “If you have a big catastrophe, it’s important to get money into the community quickly.”
The advantages of parametric insurance are efficiency of assessment and the fact that it allows communities to demonstrate wide scale catastrophe readiness.
In September 2019, Hurricane Dorian in the Caribbean provided evidence of the practicality of parametric insurance. The Bahamas government was insured with the Caribbean Catastrophe Risk Insurance Facility, a regional risk-pooling fund based in Grand Cayman.
Hurricane Dorian’s intensity triggered a parametric payout of about US$13 million to the Bahamas government within two weeks of the disaster occurring. The payout was a small amount compared with the actual cost of reconstruction, but a useful contribution in the immediate aftermath of the disaster.