The Bank of England wants to be the first regulator to stress-test its financial system against climate risks. In... View Article...
How does climate change affect Insurance ?03/01/2021
Insurance companies invest insurance premiums in various asset portfolios in order to manage the insurance liabilities arising from their underwriting activities. When an Insurer has to indemnify clients, assets are used to cover client claims.
The solvability of an Insurer, which determines its ability to pay future indemnity claims, may thus be negatively impacted by an indemnity claims rate that is superior to calculated technical reserves, or by financial losses in asset portfolios.
Let us take the example of an Insurance company investing parts of its assets in a firm owning a production plant located in an area where there is a great natural disaster risk, covered by insurance contracts. If this risk materializes, the company will have to face two simultaneous negative consequences : an indemnity claim to be paid, and additionally a financial loss in its investments.
This risk – a correlation between assets and liabilities – already exists in insurance portfolios, but it is not always clearly identified.
Climate change impacts can be wrapped up in the following simple example.
1 – Climate change increases the risk of financial losses on assets
This risk on financial assets can be broken down in various categories :
- a behavioral risk – if most investors leave a given sector, e.g. coal mining, the financial value of this sector will plummet,
- a regulatory risk – for example if regulators or politicians impose a carbon tax, the financial value of the most impacted companies will go down,
- a physical risk – if production tools are located in a risky area, the risk of financial loss must be taken into account.
2 – Climate change may render uninsurable some assets
The basic principle of insurance relies on the ideas of uncertainty and risk-sharing. As an example, If climate change makes droughts very likely in some specific areas, then this type of risk will clearly become uninsurable.
In a nutshell, climate risk represents a double whammy for insurers,
- a solvency risk, not yet accounted for in regulatory models – hence the appearance of climate stress tests, still very basic at present, but probably meant to evolve deeply in the years to come,
- a business risk on the very existence of some of the insurance activities – insurers will have to try to mitigate this risk in their own financial investments.