What the IPCC report means for insurers: The Oxbow Partners View

August 19, 2021

The most recent Intergovernmental Panel on Climate Change (IPCC) report published on 9 August has made it clear that the impact of climate change can no longer be ignored. The report asserts that some changes to the earth’s climate are already “irreversible” and the global warming limit of 1.5°C will be hit in the next 20 years without “immediate, rapid and large-scale reductions in greenhouse gas emissions”. Whilst the dire picture painted by the report may come as no surprise, it has added fresh impetus for governments, NGOs and corporations to take immediate action to cut emissions and reduce the already evident consequences of climate change.

The insurance industry is uniquely positioned to support these efforts. Global warming is a particularly pertinent issue for the industry as it threatens insurers on the underwriting side through more extreme weather events, and on the asset side through the financial uncertainty of the transition to a decarbonised economy. However, insurers can leverage their investment and underwriting processes to drive forward efforts to reduce emissions.

Physical risks will change how insurance companies currently operate

The physical risks of climate change pose a significant challenge for the future of the industry in terms of insurability and affordability. The spate of extreme weather events in recent years has been a discomforting reminder that floods, wildfires, droughts and storms are only going to increase in the future as the planet continues to warm. Severe droughts are currently occurring 1.7 times as often as in the past century, and the IPCC report has found that extreme weather events will increase in their regularity and intensity even if global warming is limited to 1.5°C. The implication of this from an underwriting perspective is already clear: the amount that insurers are forecast to pay out globally in the next six months due to 2021’s extreme weather events is as high as £31 billion.

However, the changing nature of weather-related risks will also alter the coverage and premiums offered by insurers. For example, the unavoidable sea level rise of 2 to 3 metres in the next century predicted in the IPCC report will result in increasing premiums in coastal areas as the risk of flooding grows, making insurance increasingly unaffordable for customers. In extreme cases, insurers may refuse to cover areas where the risk is seen as too high or will be forced to seek a greater amount of reinsurance to protect against losses caused by large scale floods.

Insurance risk modelling will also need to rapidly adapt to the changing climate to formulate accurate forecasts and prices. Most recently, speciality insurer and reinsurer Chaucer has stated that wildfires should now be considered a primary rather than secondary peril in the United States. The Lloyd’s syndicate has found that the number of wildfires has risen by 30% in the last 15 years to a current average of 41 a year due to climate change, requiring the methodologies and assumptions in the industry’s risk modelling to be updated. Draper Esprit, a VC firm, recently predicted that “climate intelligence” was going to be a $40bn market category.

Transitional risks threaten insurance companies on the asset-side

A key component in preventing the planet’s ‘carbon budget’ from running out will be the transition to a low-carbon economy. Decarbonising the economy will be economically beneficial in the long-term, as evidenced by a RethinkX report which predicted that at least $2tn in recent investments made over the last decade in coal, natural gas and nuclear power assets will be stranded by the solar, wind and batteries (SWB) disruption of the energy sector.

For insurers still invested in these “sunset industries”, this shift will likely cause significant changes in asset values which could impact their investment portfolios. Other short-term risks include the financial impact of a carbon tax or a sudden technology disruption which reduces the economy’s reliance on fossil fuels, as well as the reputational risk of companies not being perceived to be taking adequate steps to address the climate crisis.

What to do about this

We believe that there are four main ways in which insurers can make a tangible impact in response to the IPCC’s findings.

Firstly, insurers can encourage and facilitate the economy’s transition by accelerating their wind-down of investments in carbon-intensive industries. As discussed in previous blog posts, many large (re)insurers such as Aviva and Swiss Re have made pledges to become net-zero on the investment and underwriting sides of their operations. Companies that make more than 5% of their revenue from coal will be removed from their investment portfolios and will not be provided insurance unless they have signed up to the Science Based Targets Initiative.

However, there is scope for industry initiatives to be more robust on the underwriting side. For example, the Net-Zero Insurance Alliance, a group of eight leading (re)insurers committed to reaching net-zero greenhouse gas emissions by 2050, does not have an underwriting policy on fossil fuels for its members despite all individual members having their own policies on insuring coal companies. This highlights the need for industry initiatives to encourage insurers to restrict underwriting not just for the coal industry, but for companies involved in oil and gas exploration in order to make a bigger positive impact on global emissions.

Secondly, there is an opportunity for insurers to help mitigate both the environmental and financial impact of global warming by offering new policies to encourage change. The recent ABI Climate Change Roadmap focuses on how insurers can support the growing e-vehicle market to facilitate efforts to reduce emissions. The ABI suggests that insurers should consider replacing written-off or stolen petrol cars with electric vehicles and encourages insurers to develop a consistent practice for re-using and recycling charging equipment. This is a promising area for insurers to focus on, demonstrated by the 84% increase in searches for electric car insurance reported by GoCompare over the past year.

Third, insurers can mitigate the financial impact of climate change by offering new insurance products that protect companies and individuals from losses incurred from extreme weather events. For example, parametric insurance pays out a pre-agreed amount when a pre-determined event occurs, such as a magnitude 7.0 earthquake or a river reaching a certain water level, regardless of whether damage to property has occurred. Companies that provide parametric insurance such as Impact 25 Members FloodFlash and Hailios install digital devices on premises, allowing claims to be paid automatically. This is a critical way for reducing protection gaps in traditional insurance policies and ensuring resilience in vulnerable communities.

Finally, insurers can use their deep understanding of risk modelling to guide efforts to build socio-economic resilience. Partnerships between the insurance sector and the public sector have demonstrated the potential of insurers to create innovative solutions. For example, the Insurance Development Forum launched a project in September 2020 to design an insurance program for Peruvian public schools involving AXA XL, Munich Re, the Peruvian Association of Insurance Companies, risk modellers GEM Foundation and JBA Risk Management and InsurTech Picsure.

Ultimately, the insurance industry is the best-placed and most well-incentivised sector within financial services to address climate change. The IPCC report is a clear sign that insurers need to begin accelerating their efforts to tackle carbon emissions, or face the consequences of a worst-case future climate scenario.