Background on: Climate change and insurance issues

The topic

There is now a consensus among the scientific community that the climate is changing, with potential risk to the global economy, ecology, and human health and well-being. But how much of this is due to natural phenomena and how much to the effects of human activity is a matter of debate. Also unknown is the extent to which weather patterns have already been affected. Any increase in damage and litigation over damage is likely to raise insurance company losses. What, then, are insurance companies doing to lessen the impact of global warming?

As assumers of risk, both property and liability risk, insurers seek to mitigate potential losses every day through a process known as risk management. Since climate change could lead to losses on a scale never before experienced, insurers are not waiting for researchers to produce all the answers.

On the property side, they are redoubling their efforts to raise awareness of climate change and pointing out how potential damage can be limited through more prudent land use, stronger building codes and better planning. Some large companies have launched innovative projects to help developing countries adapt to climate change or have invested in renewable energy.

On the liability side, insurers are helping clients focus on risk management related to climate change, including avoiding harm to the environment. Failure to protect against or disclose such harm may lead to lawsuits.

Insurance industry groups are studying the effects of climate change on the industry. The Geneva Association, whose members represent the world’s largest insurers and reinsurers, agreed in May 2009 to continue its CC+I research project on climate change and its economic impact on insurance. In a comprehensive report, “The Insurance Industry and Climate Change–Contribution to the Global Debate,” the association sets out the issues and the role insurance can play in the process of adapting to the negative effects of change, particularly in developing countries.

Recent developments

  • In September 2014 more than 120 world leaders were scheduled to meet at a one-day summit on climate at the United Nations. The summit was organized by U.N. Secretary General Ban Ki-Moon to gain support for a new international treaty on climate change, with hopes a new deal could be made in Paris near the end of 2015. Negotiations in 2009 failed to produce a binding agreement. Anticipating the U.N. event, tens of thousands of people marched in New York City on September 21 to draw attention to the issue. Similar, smaller marches occurred worldwide.
  • In May 2014 subsidiaries of Farmers Insurance filed class-action lawsuits against a number of communities in the Chicago area, arguing that they had not done enough to prepare for last year’s heavy rains and widespread flooding, which could have been anticipated due to global warming. The severe weather caused extensive property damage. The insurers sought to make the municipalities reimburse it for the claims it had paid for flood damage. Some two weeks later, Farmers withdrew the suits, suggesting they had had the desired effect. The lawsuits had drawn the defendants’ attention to “important issues,” it said, and it expected its policyholders’ interests would be protected by the local governments going forward. The company also said that it “hopes to continue the constructive conversations with the cities and counties to build stronger, safer communities.”
  • In a June 2013 report, “The Warming of the Oceans and the Implications for the (Re) Insurance Industry,” the Geneva Association said there is strong evidence that the world’s oceans have warmed significantly and that temperatures will continue to rise. In such an environment, the report noted, the old approach of analyzing historic data to predict future risk is inadequate. A more effective approach is to include the use of models based on various likely scenarios. The report concluded that in some high-risk areas, ocean warming and climate change threaten the insurability of catastrophic risk more generally.
  • As of February 2014, California, Connecticut, Minnesota, New York and Washington State had agreed to participate in a National Association of Insurance Commissioners climate risk disclosure survey adopted in 2009. California requires all insurance companies writing more than $100 million in direct premiums to respond to the eight-question survey, while the other four require companies writing more than $300 million in premium to respond. For smaller insurers, providing information on climate change risk is voluntary. Responses are available to the public.


When fossil fuels—coal, oil and natural gas—are burned to produce energy, so-called greenhouse gases, largely carbon dioxide, are emitted into the atmosphere where they trap heat. The result is global warming.

Forests and oceans can absorb some of the carbon. But to avoid the most catastrophic effects of what is predicted to occur, researchers say, carbon emissions must be greatly reduced, hence the push to reduce overall energy use, boost the use of energy from renewable sources such as solar heat and curb the use of paper and other products made from trees, which absorb carbon dioxide in the process of photosynthesis.

Global warming has the potential to affect most segments of the insurance business, including life insurance if rising temperatures lead to an up-tick in death rates. Property losses of all kinds are most likely to increase, and there is the potential for much higher commercial liability losses if shareholders and consumers try to hold businesses responsible for changes to the environment.

Insurers’ contribution to lowering greenhouse gases: Insurers, like companies in other industries, are promoting strategies to lower greenhouse gas emissions in the hope that if every person takes the threats related to global warming seriously, some of society’s worst fears will ultimately prove unfounded. Some insurers have been warning public policy leaders and the general public about the threat of climate change for years and others were among the first to adopt public statements on the environment and climate change and to join business coalitions calling on the federal government to enact legislation to reduce greenhouse gases. Increasingly, companies are establishing specific units to address concerns and coordinate initiatives on climate change and the environment. Some, particularly reinsurers, are sponsoring research and working with others interested in the same kind of problems, such as finding ways for individuals and society to adapt to extreme weather, particularly in developing countries.

Many insurance companies are committed to reducing their own total greenhouse gas emissions and offsetting the remainder through contributions to reforestation and renewable energy projects. They also encourage their employees to adopt “green” policies in their private lives. Some were involved in projects to reduce greenhouse gases even before such efforts gained widespread public attention, and many are now reinforcing their policyholders’ desire to reduce their carbon footprints by offering them paperless billing and documentation. Some have upgraded the quality of their Web sites to encourage policyholders to transact business electronically. (See Buying Insurance: Evolving Distribution Channels.) At least one auto insurer sells policies exclusively online.

Insurers are also working on another front: seeking to reduce the incidence and cost of property damage caused by those events that still occur, despite society’s best efforts to reduce greenhouse gases.

Property losses: Much remains unknown about the potential impact of climate change on property losses. Most scientists agree that precipitation is becoming more intense and more erratic, leading to hotter and drier environments that raise the risk of wildfires in some regions and damaging rainstorms that increase the risk of flooding in others. However, there is less agreement about how the rise in temperatures will affect the number and severity of hurricanes and when the effect of climate change on storms will be clearly felt.

According to Karen Clark, president of the Boston-based Karen Clark & Co. hurricane modeling consulting firm, global warming could lead to a 2 to 5 percent increase in hurricane peak wind speeds over the next 20 years, which in turn could result in a 30 to 40 percent increase in property insurance losses. Others believe the impact is less imminent. Property losses may include not only claims for structural damage such as broken windows, a hole in the roof and the resulting water damage to the inside of the structure and contents, but also for the extra expense of living elsewhere while the home is being repaired or rebuilt. On the commercial side of the business, in addition to direct property damage, losses may include the policyholder’s loss of income and extra expenses during the rebuilding or relocation process.

Catastrophes: Catastrophes appear to be growing more destructive, but insured losses are also rising because of inflation and increasing development in areas subject to natural disasters. In 2005, the year of hurricanes Katrina, Wilma and Rita, catastrophe losses totaled $64.3 billion. Hurricane Katrina caused losses of $41.1 billion, the highest on record, about twice as much as Hurricane Andrew would have cost had it occurred in 2005. If, as suggested, hurricane-related losses grow by as much 40 percent over the next 20 years, a Katrina-like storm could cause $60 billion in losses, or significantly more if it struck a densely populated metropolitan area like Miami or New York City.

It is not inconceivable that in any given year there could be more than one megadisaster. Indeed, after Hurricane Katrina in 2005, rating agencies that evaluate the financial health of property insurers raised the threshold for capital adequacy. They now look at capital adequacy relative to a company’s exposure to losses from a 250-year event, rather than 100-year event, and at potential losses from two megadisasters in quick succession. (A 100-year storm means that each year there is a one in 100, or one percent, chance of such a storm, not that such a storm is only likely to occur once every 100 years. Hurricane Katrina was considered a 400-year storm with a 0.25 percent chance of occurring each year.)

Managing catastrophe risk: If climate change results in more frequent and damaging windstorms, floods and droughts, developing countries that are poor and vulnerable to extreme weather events will be disproportionately affected. They generally have fewer resources to devote to mitigation in advance of a catastrophe, fewer resources to promote economic recovery after a catastrophe and lower insurance penetration rates–the proportion of individuals and businesses with insurance—than in the developed world. Traditionally, they have relied on emergency donations from wealthier countries and aid from international relief organizations. Now, the need to adapt to and mitigate the effects of climate change on a global scale—together with the development of new insurance products such as microinsurance policies, disaster recovery bonds and multination government insurance pools—see reports on Catastrophes and Microinsurance—is leading to new kinds of public/private initiatives to better manage risk.

One such proposal is the Munich Climate Insurance Initiative (MCII), which was launched in 2005 by insurers, climate research organizations, the World Bank and agencies associated with the United Nations, among others, in response to the growing realization that insurance related-solutions can play a role in adaptation to climate change. Experts come from the private sector, academia and nongovernment organizations. The basic idea behind the project is to create a balance between the emitters of greenhouse gases and the developing countries that are confronted with the consequences of climate change. This entails developing insurance programs that help low-income workers deal with disaster-related events, such a livelihood protection policy that covers the loss of income due to weather-related events, and at the same time helping them mitigate risks by, for example, reducing reliance on a single, disaster-vulnerable crop.

Liability losses: Most businesses purchase commercial liability policies to cover negligence that results in bodily injury, property damage, and personal and advertising injury. Companies may also purchase coverage to protect their directors and officers against charges that they failed to properly manage the company’s global warming liability exposures. Professionals who design the products or projects carried out by a company may be sued for the harm these projects cause. Lawsuits may be filed by shareholders or consumers against a business for actions or inactions that could harm the environment. In addition, shareholder lawsuits may target a company for failure to disclose important information that could materially affect its financial health and thus influence shareholder investment decisions.

The potential increase in property losses may be relatively small in comparison to what could happen on the liability side. Liability suits could be filed based on legal concepts yet untested as well as existing ones tailored to “sustainability” cases. Sustainability is broadly defined by the U.S. Green Building Council as “meeting the needs of the present generation without compromising the ability of future generations to meet their own needs.” Awards could be substantial because, by their very nature, activities that result in harm to the environment and future generations can impact large numbers of people. Even where lawsuits are not successful, and there is no court award against the defendants, insurers can incur substantial legal costs.

To minimize the likelihood of lawsuits, insurers analyze their policyholders’ liability risks and provide guidance as to the best approach, based on their extensive experience insuring businesses in more than a thousand categories. Among the activities reviewed to reduce the risk of global warming lawsuits would be the company’s efforts to adapt to global warming to help ensure that they did not cause harm, along with their emissions reduction program and their energy conservation projects.

New products and business opportunities

Without insurance the economy could not function. Insurers essentially enable new products and services to be created by assuming the risk of loss. Just as they quickly adapted existing liability insurance policies for horse-drawn carriages, or teams of horses, to automobiles towards the end of the nineteenth century, so they are responding to climate change initiatives at the beginning of the 21st Century.

Opportunities exist on several fronts

First, there are new risks to insure, including new industries such as wind farms and other alternative fuel facilities, and emerging financial risks such as those involved in carbon trading. Insurance policies related to carbon trading protect those that invest in clean technology projects against failure of the project to deliver the agreed-upon emission rights. A number of companies are also offering their clients carbon project risk management consulting services. A carbon credit permits the holder to emit one ton of carbon. Investors in clean technology projects such as reforestation and renewable energy buy the rights to credits and sell them in the international carbon trading market. Among the risks associated with purchasing carbon trading rights is that the technology/project designed to reduce carbon emissions will not meet expectations or that the company will become insolvent before it is able to fulfill its contract, leaving the investor without the necessary carbon offsets.

Second, the need to curb global warming has spurred the creation of insurance policies that provide incentives to policyholders to contribute to these efforts. These include discounts on auto insurance policies for driving fewer miles and policies for green building construction.

Auto insurance: Pay-As-You-Drive (PAYD), also known as usage-based insurance, among other things, gives drivers the option of driving less in return for a lower premium. Driving less is expected to reduce pollution. Since motor vehicles are responsible for about 25 percent of all U.S. greenhouse gas emissions, anything that reduces driving reduces the amount of carbon released into the atmosphere. The number of auto insurers offering PAYD options is growing as are the number of states and cities investigating whether and how to promote their development.

Drivers that participate in PAYD programs are required to either get their odometer checked at the end of the policy period to verify the number of miles driven or to install a special device that transmits mileage to the insurance company. This device may be linked to the odometer or be a wireless sensor that can monitor mileage. Some insurers offer usage-based programs with sensors that also provide information on driving behavior such as speeding and sudden braking.

The attraction of PAYD programs is that they offer drivers more direct control of what they pay for insurance coverage. Initially, there was some concern that drivers would reject them because of privacy issues. However, with personal information increasingly available on the Internet and through social media, privacy may be less of a concern, some observers say.

Property insurance: “Green” building insurance coverage: Homeowners at the leading edge of the environmental sustainability movement are generating their own geothermal, solar or wind power and selling any surplus energy back to the local power grid. Several insurers are supporting this trend by offering a homeowners policy that covers both the income lost when there is a power outage from a covered peril and the extra expense to the homeowner of buying electricity from another source. Policies generally cover the cost of getting back online, such as utility charges for inspection and reconnection.

Some insurers offer homeowners insurance policies that, in the event of a fire or other disaster, allow policyholders to rebuild to environmentally responsible “green” standards, even if they had not purchased such a policy originally. Green standards, part of the sustainability movement, include energy conservation benchmarks and the use of renewable construction materials. The Green Building Council introduced its Leadership in Energy and Environmental Design (LEED) certification program in 2001. According to Ceres, a climate change research organization, buildings account for more than one-third of greenhouse gas emissions and green building practices can reduce energy use and emissions by more than 50 percent.

With green commercial building construction expected to rise significantly over the next few years, a growing number of insurers are offering green commercial property insurance policies and endorsements, some of which are directed at specific segments of the business community such as manufacturers. The first green commercial policy was introduced in 2006.

In general, the policies allow building owners to replace damaged buildings, whether or not they are already certified green, with green alternatives including energy efficient electrical equipment and interior lighting, water conserving plumbing, and nontoxic and low odor paints and carpeting. They also may also pay for engineering inspections of heating, ventilation, air conditioning systems, building recertification fees, the replacement of vegetative or plant covered roofs and debris recycling. Some cover the income lost and costs incurred when alternative energy generating equipment is damaged.

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