By Anika Priyaranjan
Illustration by Keo Morakod Ung
Climate change is no longer a distant threat; it is a pressing reality that is reshaping industries worldwide. In 2023 alone, global economic losses from climate-related disasters surpassed $200 billion, marking one of the most expensive years on record. This has profound implications for the insurance industry, which relies heavily on predicting and managing risk. The increasing frequency and severity of extreme weather events translate into unprecedented claims and payouts, pushing traditional risk assessment models to their limits and necessitating a fundamental shift in how the industry operates.
Traditional risk assessment models have typically relied on actuarial science, using historical data to predict future losses. Based on long-term averages and patterns, they were effective in determining the likelihood of events such as floods or hurricanes. However, the introduction of new uncertainties and risks due to climate change is rendering these models at a high risk of becoming obsolete. This shift necessitates a fundamental overhaul of how risk is assessed and managed within the industry.
The rise in “black swan” events—rare, unpredictable occurrences with severe consequences—exemplifies this challenge. For instance, Hurricane Harvey in Texas in 2017 experienced rainfall as much as 60 inches in some locations, which was noted to have a return period of 2,000 years, or a 0.05% chance of happening in any given year. Such events are becoming more frequent, complicating the industry’s ability to accurately predict and price risk.
Moreover, climate change introduces systemic risks that affect entire regions or sectors simultaneously, such as widespread crop failures due to severe drought leading to significant insurance claims. Global interconnectedness exacerbates the concentration of risk as climate-related losses spread across various types of coverage, including flood, property damage, and business interruption. Aggregation risk, where multiple claims are filed in connection to a single event, is also becoming more prevalent. This is particularly concerning in regions with low insurance penetration, such as developing economies, where the models may not account for the growing number and types of interconnected risks. These risks are difficult to diversify and present substantial challenges to traditional risk management strategies.
As climate-related disasters increase, insurers face a tough choice: raise premiums to build reserves for future payouts, making insurance less affordable, or keep premiums low to attract customers, risking underpricing and significant losses. This delicate balance between affordability and financial stability is becoming increasingly difficult to maintain. In response, some insurers have begun withdrawing from high-risk markets, raising premiums, and reducing coverage, though these measures may not be sustainable long-term. For instance, insurers such as Aviva in the UK have raised premiums significantly, in areas prone to flooding.
To address these challenges, the insurance industry is adopting more sophisticated, climate-aware risk models. These models incorporate climate science, predictive analytics, and real-time data to provide a more accurate picture of future risks. Catastrophe modelling, which simulates the potential impact of extreme weather events under different climate scenarios, is becoming increasingly important. By considering variables like sea-level rise and changing precipitation patterns, these models help insurers understand the long-term impacts of climate change on their portfolios. The integration of machine learning and artificial intelligence (AI) into risk assessment processes is another innovation. AI can analyse vast amounts of data from various sources, including satellite imagery and climate models, to identify emerging risks and trends. This enables insurers to update their risk models more frequently and with greater precision, reflecting the rapidly changing climate landscape. Additionally, parametric insurance products, which pay out based on predefined triggers like specific levels of rainfall or wind speed, are gaining popularity as they offer faster and more efficient payouts in the face of climate-related events.
As the insurance industry grapples with such challenges, collaboration with governments and other stakeholders becomes crucial. Public-private partnerships can play a vital role in sharing the burden of risk and promoting resilience. Governments can invest in infrastructure to reduce the impact of climate-related disasters, while insurers can offer more affordable and comprehensive coverage, knowing that the risk of catastrophic losses has been mitigated. Further, insurers can work with government authorities to put measures in place for financial assistance in the case of an unexpected mass payout caused by an unforeseen crisis, similar to the Flood Re scheme in the U.K., where the government works with private insurers to provide reinsurance for areas with particularly high flood risks. Climate risk pools, where governments and insurers collectively share the risk of extreme weather events, are being explored as a way to stabilise the insurance market and protect vulnerable communities.
The insurance industry is at a critical juncture. There is a need for not only adopting new risk assessment models but also rethinking how insurance products are designed and delivered. Focusing on resilience and risk mitigation, rather than merely compensating for losses, will be key.. Insurers must act now to develop strategies that address the evolving risks posed by climate change, ensuring they continue to provide the vital protection that individuals and businesses need in an increasingly uncertain world.
Other Sources:
https://www.skadden.com/insights/publications/2023/12/2024-insights/corporate-trends/climate-change-and-its-undeniable-impact
https://www.mckinsey.com/industries/financial-services/our-insights/climate-change-and-p-and-c-insurance-the-threat-and-opportunity#/
https://www2.deloitte.com/us/en/pages/financial-services/articles/insurance-companies-climate-change-risk.html
UCL Rethinking Economics 