Insurance Reform: Weathering the Risk of Climate Change

Record-breaking global temperatures driven by greenhouse gas emissions, rising water levels, and atmospheric vapour have led to an increase in both the frequency and magnitude of adverse climate events. Extreme global weather conditions such as droughts, forest fires, and severe storms have doubled since 1980. Carbon Brief, a U.K.-based climate change publication, shows that 68 per cent of all extreme weather events were either caused or amplified by greenhouse gas emissions and anthropogenic environmental degradation of key ecosystems.

Ecological infrastructure refers to naturally occurring ecosystems that provide invaluable benefits to surrounding communities, including disaster risk reduction. Coral reefs in coastal ecosystems, for example, function as a barrier against hurricanes, storm surges, and flooding. Wetlands are similarly effective in mitigating the risk of flooding in coastal areas and inland river basins by acting as natural drainage systems. Mountain forests on hillsides protect against soil erosion and the threat of avalanches and landslides by increasing slope stability. The degradation and erosion of these ecosystems have a substantial impact on the severity of these climate events.

While it is possible to respond to environmental disasters with reactive measures like building levees, these efforts often damage ecological infrastructure and limit the long-term potential of environments to protect against natural disasters. In the case of Hurricane Katrina, the levees built during the disaster contributed to the degradation of nearly 1,900 square miles of wetlands. Yet according to the University of Florida Soil and Water Sciences Department, every 2.7 miles of wetlands reduce storm surges by a foot. Hence, it is essential to prioritize the conservation of ecological infrastructure for its long-term benefits.

Deficit Disaster
Extreme weather conditions come with a hefty price tag. In 2018 alone, natural disasters generated global economic losses close to $225 billion. Of this figure, uninsured losses were estimated to be around $135 billion. This global protection gap, defined as the difference between total economic losses and insured losses, places undue strain on the governments of affected countries to provide aid, thereby exacerbating the economic shock of natural disasters. Hurricane Katrina increased the federal budget deficit by an unanticipated $100 billion in 2005, highlighting the reality that natural disasters have severe, fiscal impacts that are difficult to plan for.

When quantifying economic losses, macroeconomic models account for the direct costs associated with climate events such as physical damage, restoration costs, and loss of productivity. These models fail to consider indirect losses which account for the long-run economic impacts of climate events, including loss of economic production and consumption, subsequent healthcare costs, and loss of life. While Hurricane Katrina triggered $125 billion in property damage, its true economic cost was closer to $250 billion when accounting for indirect costs.

In 2018, insured losses of $90 billion accounted for the remaining global cost of natural disasters. This was recorded as the fourth costliest year on record for the industry, outlining an emerging trend in insurance of increasing annual costs. This trend is particularly concerning for property and casualty (P&C) insurance companies who are responsible for property protection coverage in the case of an injury or accident. In 2009, StateFarm terminated all homeowner policies in Florida after a proposed 47-per-cent rate increase was rejected by regulators. The proposal was brought forward in an effort to mitigate the risk of high payout costs within the hurricane-prone state. Increasingly, P&C insurers have responded to a changing climate by raising premiums and terminating policies in volatile regions. With the increased occurrence of catastrophic climate events, P&C insurers must deal with unprecedented levels of risk when underwriting high risk geographies which demand more frequent payouts.

Both government institutions and private organizations have fallen victim to the repercussions of climate change. The environmental and economic costs of climate change are too high for one stakeholder to bear, challenging the status quo and practicality of current reactive solutions to catastrophic events.

The Power of Partnership
Governments and insurance companies are facing parallel challenges resulting from the heightened costs associated with natural disasters and climate change. Combining business objectives with public goals presents a unique opportunity to create public-private partnerships (PPP) that could leverage the political power of public institutions in conjunction with the increased access to capital available within the private sector. Proposed partnerships would involve insurance companies working with the federal government in a two-pronged approach to mitigate financial and environmental risk.

Breaking the Ice with Backstops
First, insurers would provide coverage up to a predetermined threshold with the governments providing a financial backstop for any excess amounts. Governments would partake in financial backstopping in the context of P&C coverage for private property owners. This practice of financial backstopping, common in the reinsurance industry, limits the amount of risk that P&C insurers would undertake in areas like New Orleans or Southwestern Ontario, both of which are highly susceptible to flooding. Research conducted by the Property and Casualty Insurance Compensation Corporation in Canada suggests that insured losses in excess of C$30 billion begin to threaten the solvency of otherwise healthy insurers. While this threshold is unique to the Canadian insurance landscape, similar considerations should be made when determining a backstop threshold for countries around the world.

In exchange, P&C insurers would make insurance policies more affordable and widely accessible due to reduced financial risk. Financial backstopping would close the global protection gap, decreasing the reliance on government programs and taxpayers for disaster relief funds. Historically, federal disaster relief spending in Canada averaged C$100 million in the 1990s and grew to C$600 million in the 2000s. This figure is expected to reach C$902 million annually in the coming decade. Governments have historically spent more on reactive solutions rather than investing in proactive, risk-reducing mechanisms. Financial backstopping creates an opportunity to engage in better budget management by improving financial predictability of unforeseeable events that have a severe impact on public finances.

A Plan for the Planet
There is also an opportunity to shift the way governments and insurers approach ecological infrastructure. Ecosystems like wetlands, forests, and coastal systems are invaluable assets in disaster risk reduction and investments into ecological infrastructure reduce the environmental risk by both insurance companies and the government.

Nature-Based Insurance Plans (NBIPs) would provide P&C coverage for ecosystems that reduce the risk of natural disasters, thus funneling capital investment into ecological infrastructure. The cost of such policies would be dispersed across public and private stakeholders in the municipalities benefiting from these ecosystems, thus reducing the overall cost of investing in ecological infrastructure for all stakeholders. In addition to purchasing an insurance policy, a portion of the premiums paid by stakeholders participating in NBIPs would be reinvested in development and maintenance initiatives to support and rehabilitate degraded ecosystems. Following an adverse environmental event, payouts from the insurance provider would cover the costs of repairing and rehabilitating the ecological infrastructure being underwritten. Reinsurance company Swiss Re piloted this proactive strategy in Quintana Roo, Mexico, by partnering with local environmental groups and underwriting the coral reef situated in the Yucatan Peninsula. A Business Insider report found that the success rate of restoring key ecosystems was higher for underwritten regions due to the fast mobilization of resources provided by insurers.

For example, with the introduction of NBIPs, wetland rehabilitation programs would reduce damage costs by 38 per cent in urban communities by improving the water drainage capabilities of surrounding land. As insurance companies are subject to lower payouts and work to gradually decrease disaster risk the firms would be able to pass-on saving to consumers. A lower protection gap ultimately improves the economic resilience of an economy when recovering from economic shocks such as natural disasters and better equips governments and insurance companies in navigating increased environmental and financial risks presented by climate change. Lloyd’s estimates that for every one per cent of costs covered by private insurance, the cost to taxpayers or governments in the aftermath of climate related disasters is reduced by 22 per cent.

A Conservation Conversation
The attitudes and political agendas of governments toward sustainability are a key element to the success of a PPP targeting climate change. Consequently, Europe offers the ideal political landscape to engage in such partnerships within the insurance industry. The reason for this is twofold. First, the political interests of European Union (EU) countries prioritize environmental concerns, creating a suitable environment to foster innovation in climate change initiatives through PPPs. Additionally, European countries collectively bear a very high stake in supporting and protecting one another from climate disasters. A report from Munich Re determined that flood risks in Europe often span over multiple countries. For example, a high flood risk in the UK also implies similar risk levels in Northern France, the Netherlands, and regions of Germany. While previous models analyzed the financial impact of disasters on a per country basis, damages are ultimately compounded in this area due to the high degree of financial codependence amongst countries in the EU.

On Cloud Nine
Given the high cost of addressing climate change, obtaining the financial support of insurance companies is key to support the economic and social wellbeing of a country. Rising numbers of insured citizens eases the demand for costly relief funds, allowing public institutions to redistribute resources towards other economic objectives. By introducing the financial backstop alongside insured ecosystems, this allows entire communities to rebuild infrastructure faster—a key element to maintaining long-term economic growth. Research has shown that economies with a higher proportion of private insurance coverage recover faster from natural disasters than do economies that rely on relief funds. NBIPs also provide a vast number of environmental benefits through the rehabilitation of degraded ecosystems, creation of natural carbon reservoirs, and nurturing of biodiversity. These environmental benefits further align with the current emphasis on sustainability prevalent among EU countries.