Home Economy, Policy & Business How is the insurance industry responding to climate change?

How is the insurance industry responding to climate change?

Arup Chatterjee
The insurance expert at the ADB speaks about the insurance industry coping with the growing number of extreme weather events
An interview with
Principal Financial Sector Specialist, Sustainable Development and Climate Change Department at Asian Development Bank
Arup Chatterjee speaks with Unravel

In this second part of the interview, Arup Chatterjee, Principal Financial Sector Specialist, Sustainable Development and Climate Change Department at Asian Development Bank, speaks about how the insurance industry is coping and innovating to respond to the growing number of extreme weather events. He also speaks of strategies being used by insurance companies to better manage extreme weather events.

Unravel: In the first part of this interview, you talked about responses financial market stakeholders and governments are considering to mitigate climate risks. Is it practically possible to implement these measures in emerging and developing economies transitioning to a low carbon economy?

Arup Chatterjee: Overall, financial authorities in emerging markets note significant teething problems in capabilities, data and tools. Today’s reality is that the taxonomy, necessary rules, regulations, standards and best practices remain nascent, weakly defined and not harmonised. As a result, immense challenges confront financial institutions, particularly around quantification and scenario analysis.

Due to weak policies and conventions in the financial industry and a lack of climate risk disclosure besides adequate support and incentives to act, very few financial institutions actively incorporate climate risks into their financial decision-making. Moreover, because of the immaturity of business models and the risk management practices still evolving, there is a perceived lack of private benefits to scale up climate finance.

A few financial institutions have incorporated their exposure to climate risks in their investment, lending, and underwriting decisions and integrated them into their broader risk management processes. As a result, environmental, social and governance (ESG) issues are gaining in with institutional investors exerting their influence and channelling investments into projects that deliver measurable non-financial benefits while improving long-term financial returns.

Even major credit rating agencies now factor ESG elements, including climate risks, in their ratings, to varying degrees. 

Any successful response will need to involve a mix of compulsory and voluntary measures backed by a robust framework for assessment, implementation and monitoring. Such a framework should leverage the innovations happening in big data, data analytics, automation, artificial intelligence and machine learning to help meet the sustainability ambitions.

Unravel: With the number and frequency of these events multiplying at such speed, can the insurance industry cope even if awareness increases and buy-in for insurance increases?

Mr Chatterjee: One cannot precisely comment on the level of preparedness of the Asian insurance industry to deal with rising climate change-related losses and the extent it will threaten their underwriting and investment portfolios. 

In the absence of adequate disclosure and climate-specific stress-testing, beyond traditional catastrophe models, it may not be easy to assess the effectiveness of insurers’ actions to withstand extreme weather events and defend their underwriting and pricing decisions.

Insurance of some risks can either become unaffordable for customers or unfeasible for insurers. And, this could lead to underinsurance, higher rates of self-insurance and increased demand for disaster relief from the public sector. 

However, compared to other financial market participants, insurance companies still fare much better in understanding the impact of climate risk on their balance sheets. 

Insurers need to shift business models away from transactional risk transfers and indemnity payments towards mitigating physical climate risks such as rebates for using resilient construction materials or working with the government to improve land use planning and building standards and policies.

The insurance industry can seize the opportunity to offer innovative solutions – parametric insurance, pooling mechanisms by collaborating with governments to provide affordable coverage and alternative risk transfer solutions using capital markets for specific risks. 

Insurance companies should also consider re-evaluating their investment-allocation strategies. They should restructure their portfolios towards supporting a sustainable decarbonised economy.

Unravel: With the vast amount of data now available to quantify climate change risks, how do you think the growth of insurance markets will be impacted in the medium- to long-term in Asia?

Mr Chatterjee: Granular mapping of financial exposures to different climate change drivers will help better assess vulnerability across Asia’s sub-regions at the sectoral and institutional levels. For example, it can help quantify exposures to physical climate hazards and emission-intensive firms concentrated across economic sectors at a sub-national level. Additionally, it can quantify exposures to climate risk drivers concentrated in financial institutions.

The massively increasing volume, velocity and granularity of data sets will allow consumers and insurers to see and understand risks clearly. Moreover, it can transform how insurers see large pools of consumers and price risks. 

Premium pricing will more accurately reflect risk behaviour. With a better understanding of customers’ risk profiles, insurers will be able to provide closely tailored and more accurately priced products. In addition, the use of data to provide early client warnings can give an incentive to undertake risk mitigation. Thus, in practice, price signalling can drive better behaviour and reduce risk. As a result, it offers enormous insurance benefits for society, such as improved risk management and fairer premiums.

Of course, this will have implications on the cost and availability of insurance for all consumers. A small group of consumers may have to pay more for insurance because they may belong to a higher risk category, although they may not control the risk they seek to insure. 

The regulators will need to tackle privacy and discrimination-related concerns. Additionally, governments must develop plans to finance uncontrollable risks to protect society, particularly the vulnerable, in collaboration with commercial insurers.

Unravel: How can the insurance industry prepare consumers for adapting to climate change and prioritising financial protection?

Mr Chatterjee: Despite ample evidence that insurance is a climate change adaptation tool, significant challenges remain that impede the ability of the industry to deliver on its full potential.

In emerging markets, there is a need for risk and insurance literacy. The insurance industry can improve the capacity to identify and assess risk by using modelling techniques and approaches developed over the years. Risk assessments can help drive climate-sensitive public policies, investments and risk management solutions. 

They can invest in generating capability and expand awareness of the pros and cons of the different risk financing instruments available to reduce risk, manage residual risk and considerations around tradeoffs.

However, building risk capacity and insurance literacy is not an easy task and is time-consuming.

Unravel: What business strategies are insurance companies adopting to help better manage extreme weather events? What innovations do we see in insurance products that will be relevant for emerging markets?

Mr Chatterjee: Building resilience to extreme weather rests on three pillars: resistance – the ability to lower impacts; recovery – the ability to bounce back; and adaptive capacity – the ability to learn and improve. These pillars of resilience can be influenced depending on how specific insurance mechanisms are structured to respond to extreme weather. 

Insurers are pursuing business strategies that include combining multiple extreme weather events in a single policy and linking the purchase of extreme weather event insurance to a more commonly required and enforced product. In addition, policies covering weather-related risks are being extended and introduced to new sectors. 

Some insurers incentivise adopting green or energy-saving policies by offering lower premiums like premium discounts for hybrid low emission cars.

Insurance policies covering solar panels, hydropower, geothermal energy, or bio-fuels are increasingly available. 

Carbon dioxide-related insurance coverage is another emerging product for companies interested in reducing carbon emissions to gain carbon credits to sell on the market. This activity creates risks for businesses that fail to reach their target and earn credit. So carbon credit delivery insurance can protect them against such risk. In addition, 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.

Adjustments to third-party liability policies covering environmental liability, directors’ and officers’ liability, and other professional liabilities are taking place to cover liabilities linked to climate change losses.

One also observes collaboration between the public and private sectors for setting up insurance pools and public reinsurance or backstopping support for catastrophic losses in addition to private reinsurance coverage. Also, we see insurers bundling extreme weather event insurance with conventional general insurance coverages and risk financing mechanisms to fund losses through public-private partnerships. 

For the agricultural sector, there is a shift towards comprehensive crop yield insurance by linking with agricultural subsidies. The use of multi-risk or yield insurance is being pursued actively by ensuring that the entire cultivated land is insured. And subsidies are being directed as a premium contribution to multi-risk policies. Additionally, pool-like structures or public reinsurance for systemic risks such as droughts in collaboration with the public sector and insurers are also on the anvil.

Parametric or index insurance is gaining recognition. Using remote-sensing data to monitor crop patterns, insurers can pick up early signs of crop failure due to climate changes. This data further enables the insurer to gauge the risk for large numbers of small farmers, making insurance more affordable.

All these innovative approaches offer important cues to insurers in emerging economies. They are crucial for designing appropriate insurance products for reducing the protection gap.

* The views expressed are personal.

The first part of the interview can be read here.

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Principal Financial Sector Specialist, Sustainable Development and Climate Change Department at Asian Development Bank

Arup Chatterjee is Principal Financial Sector Specialist, Sustainable Development and Climate Change Department, Asian Development Bank. His current work involves financial, governance, risk management, and regulatory reforms across different industries. He has held stints with the Bank for International Settlements in Switzerland, and Insurance Regulatory and Development Authority of India.

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