Insurance and Response to Climate Change Risks
Most insurers, particularly American ones, have been reluctant until recently to link their own business to the risks of climate change. Climate activists recognized in the early 1990s that the insurance sector would be significantly affected by natural disasters and should have an interest in preventing climate change. It has taken time, but insurers are finally recognizing the potential threat to their business posed by changing weather patterns. They have been prodded to act by a series of extreme weather events, increasing scientific evidence, targeting by climate change activists, changes in government policy, and by the early acceptance by major international reinsurers of the need to act.
Insurers can respond to "excessive" risk in a number of ways. The most common is simply to withdraw from a place or product line. After Hurricanes Dennis, Katrina, Rita, and Wilma, many insurers withdrew from coastal markets in the United States. They feared the financially disastrous combination of severe weather trends with increased population growth and economic development in urban areas. Insurers often withdraw, either temporarily or permanently, when losses are too high. This leaves the burden on individuals to cover their own losses, or turn to the government for aid. In coastal areas of the United States, state-backed insurance plans are being overwhelmed by new applications. When one person loses their house and has no insurance, they must dig into their own personal resources to rebuild. But when thousands of people lose their houses in a disaster, then government must step in to provide the resources to rebuild entire communities.
Insurers can raise prices after severe losses, to return to profitability and rebuild reserves to prepare for the next disaster. Raising prices drives people away from purchasing insurance. Again, the gap in coverage is filled by public spending. Many people can be left without affordable coverage. Or, insurers can shift or redistribute losses to others. Generally, they do this by buying insurance themselves, from reinsurers. Reinsurance typically covers a percentage of losses, or losses above a certain threshold. In some cases, governments may provide reinsurance, for instance, to cover the massive potential losses in case of nuclear disaster.
Finally, insurers can change the terms of contracts to limit their losses. They can do this by limiting the ability of customers to obtain payment for losses through stricter contract terms, and by denying claims. This common approach has led to extensive litigation. Or, insurers can provide incentives for customers to change their behavior in ways that reduce the risk of loss. For instance, insurers can charge less for customers who install smoke detectors. In some cases, insurers may even lobby government to change regulation to enforce less risky behavior. All of these responses, and more, are in play with regard to climate change risk, but only the last one provides a mechanism to reduce or prevent climate change.
Why should insurers worry? The predicted effects of climate change will cause sea levels to rise, modify ocean circulation. and change marine ecosystems. They will place increased stress on coastal resources and could threaten the existence of low-lying islands from the South Seas to Manhattan. There are areas of New Orleans that some experts believe should not be rebuilt because the land is too low and will flood again as global warming increases. Some agriculturally productive
regions in the plains regions of the United States and Canada may experience severe droughts, and the “breadbasket” of North America may become a parched wasteland. Coastal resort areas may be affected by rising waters as glaciers melt from warmer weather patterns. Pressure on habitats is increasing, and disease-carrying insects and animals are moving out of tropical regions farther north.
All of these consequences of global warming pose increased risk of loss to property and commerce, and in turn, to insurers. Just about every type of insurance may be affected: obviously property insurance, due to weather-related damage, but also health and life insurance, as diseases spread into new geographic areas. More specialized insurance also may be affected. For instance, companies selling directors’ and officers’ liability insurance may face shareholder lawsuits if company management does nothing to prepare for or prevent climate change. Insurers may also suffer investment losses, as they are some of the largest institutional investors in the world.
The impact of climate change need not be entirely negative, however. In fact, some have argued that climate change is a boon to insurers because more people will need insurance. They may also find new opportunities as entrepreneurial insurers devise new products for climate mitigation. such as policies to insure carbon credits in newly established exchange mechanisms.
Recognizing Climate Risks
Insurance, in its most fundamental form, is a mechanism for transferring financial risk. The insurance firm obtains payment in the form of premiums, and the customer receives in return a promise that the insurer will pay for losses when a specified risk occurs. Economic historians point to the development of institutions to manage risk as a key facilitator in the expansion and development of the modern economy. The insurance industry is composed of many different types, or “lines,” of insurance, including life, health, property and casualty, auto, and various specialized forms of insurance such as political risk or directors’ and officers’ liability. The industry includes the direct insurers (companies and agents) who sell to customers; brokers who bring customers and insurers together; adjusters who evaluate and administer claims; and reinsurers who provide insurance to the direct insurers. In addition, there are many different service providers, from rating agencies to specialist insurance providers.
The main hubs of insurance activity are in London and New York, with big reinsurers such as Swiss Re and Munich Re based in Europe, with one of the biggest direct insurers based in Tokyo. In the U.S. insurance is regulated at the state level, though the industry as a whole has experienced national consolidation and international mergers and acquisitions. The Canadian market is similar to that in the United States, though certain types of insurance are provided by provincial governments, and there is more extensive federal regulation. In addition, most insurance is sold through brokers, with local branches of international firms (e.g. Marsh Canada Ltd.). Most developing countries do not have big insurance markets. For instance, the Mexican insurance market is dominated by five companies that have all received significant foreign investment in recent years. As in many developing countries, the insurance market is underdeveloped, and most risks are not insured and simply become losses. Major reinsurance companies operate internationally; local markets and international ones are intertwined, so severe losses from storms in the Gulf can reduce the amount of insurance available in Europe.