The IPCC call to insurers: Building resilience

March 7, 2022

Building on our coverage of last year’s report, the latest Intergovernmental Panel on Climate Change (IPCC) report looks at the alarming impact of climate change on human societies, the associated vulnerabilities, and our capacity to adapt. With 3.5 billion people highly vulnerable to climate impacts, it highlights the necessity of building global resilience to mitigate the inevitable impacts of climate change.

The impact on financial institutions in general has been outlined by the UNEP-FI. This article focuses on the impact on insurance.

Through an insurance lens, the IPCC report focuses on tackling the protection gap for those most vulnerable to the impact of climate change and building equitable resilience against the impact of increasing climate risk.

This can be achieved across two main pillars:

1. Increasing protection to cover the growing risk due to climate change
2. Actively reducing climate risk, particularly for those who are most at risk

…with recognition that high-income countries are more easily able to build this resilience, despite it being lower-income countries and often those with lower socio-economic backgrounds who are most affected.

Increasing protection to cover the growing risk due to climate range

The IPCC proposes parametric insurance, also known as index insurance, as a potential viable solution. Parametric insurance uses technology, such as remote-sensing and climate analysis tools, to agree on a payment to the policyholder once a prearranged index is met. For example, rather than waiting for a specific claim following a flood, this insurance contract would pay out as soon as the sea level rises above a pre-agreed level.

The reason such products close the protection gap and are valuable for the most vulnerable, include:

1. Lower premiums: driven by lower uncertainty of pay-out and lower expenses
2. Ability to provide insurance in developing countries: the inability to assess claims, prevents insurance companies from engaging in certain countries
3. Rapid responses needed and possible: given no need for claims assessments

These have led to a rise in agriculture and livestock index insurance in many developing economies, reducing the global protection gap in those sectors. Parametric insurance has also promoted public-private partnerships that enhance the efficiency of overall program delivery.

Actively reducing climate risk, particularly for those who are most at risk

With worsening risk profiles due to global warming, the IPCC report recognises the importance of risk mitigation to reduce vulnerability and improve the capacity to adapt. Insurers must design insurance products to incentivise risk-reducing behaviours and encourage investments in climate change prevention (ex-ante investment). In doing so pressure on insurance premiums will decrease, vulnerability will reduce and our adaptive capacity will increase.

Private insurance companies are already active players in reducing risk. For example, Suncorp in Australia is offering the ‘Build it Back Better’ scheme which provides capital for policyholders to build stronger homes following a claim.

The IPCC also encourages public-private partnerships to increase resilience and reduce risk. Some local governments are already using risk transfer instruments to fund investment into resilience projects. Reducing risk with ex-ante investment should therefore be a priority to enable sustainable equitable resilience.

Drawbacks

The IPCC insurance-specific solutions to climate change need to be carefully designed and implemented together.

There are concerns about increasing insurance coverage in developing countries:

1. Shifts responsibility of paying the premiums to those least responsible for climate change,
2. Could still be excluding the most vulnerable due to unaffordability (or availability)
3. Basis risk, i.e. the difference between the risk they actually face and the risk covered by the insurance

Efforts to increase protection are therefore not a silver bullet and must be coupled with efforts to increase ex-ante investment for the long-term risk reduction. Public-private partnerships could aid this effort, but most are still in the early stages of development and need more governmental support.

For reducing risk, potential maladaptation needs to be avoided as strategies to reduce risk could unintentionally direct investment to ‘short-sighted’ unsustainable projects. For example, providing extra funding for those impacted in flood-prone areas to build more resilient homes could lead to rebuilding in these risky areas, undermining the aim of reducing risk.

The IPCC calls for government and private sector initiatives to update building design guidelines and engineering standards, as well as insurance modelling tools, that reflect the damages from climate change. Such responses will help increase resilience without the undesired consequences.

Conclusion

The insurance sector has a key role in shaping and implementing adaptations to climate change and must act now. By increasing protection coverage and reducing risk alongside disclosing climate-related information, insurers will massively aid in building equitable long-term climate resilience.

If you would like to discuss any of the issues raised in this email, such as how to push forward your ESG agenda or navigate emerging ESG trends, please get in touch.

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