Insurance is about the transfer of risk, in which the policyholder pays a premium to an insurer to take on a specific risk. The industry consists of three main sectors: (1) personal and commercial property (P&C) insurance (market cap of $96.6 billion), (2) life and health insurance (market cap of $43.7 billion), and (3) the reinsurance sector which covers insurance companies themselves (New York Times 2011).

Physical Exposure Risk. The industry has already begun to grapple with the physical impacts of climate change. The year 2010 saw 950 natural catastrophes, totaling $37 billion in insured losses, marking the year as among the worst in insurance losses since 1980 according to Munich Re, a global reinsurance company that has been tracking such information for decades (Kirkland 2011).This is consistent with a growing trend of major weather-related catastrophes since 1950 (see fig.). Notably, eight of the top ten costliest natural catastrophes worldwide for the insurance industry since 1980 (not considering the March 2011 earthquake in Japan)have affected the United States. Hurricanes dominate the list with seven catastrophes. Hurricane Katrina is responsible for the most expensive insured loss of $62.2 billion; more than triple that for Hurricane Ike, the next most expensive natural catastrophe (Munich Re. 2011).

Source: Munich Re, 2009.

Climate change is predicted to increase the risk of such extreme weather events, as well as a gradual change in the climate and sea level. The industry relies heavily on risk modeling to evaluate new risks for coverage, inform the underwriting process, and manage risks across a company’s entire portfolio (Macdonald 2010). However, the industry is struggling with incorporating climate change into its models, particularly with the uncertainty surrounding the frequency and severity of direct and indirect (UNEP/SBI 2011); for example, the rising sea level impacts on coastal properties or health care costs associated with the spread of vector-borne diseases. A 2011 United Nations Environment Programme and Sustainable Business Initiative survey (hereafter referred to as “UNEP/SBI survey”) of insurance and financial companies found that less than half of respondents feel they are sufficiently well-informed on climate change. In North America, 68% of respondents reported themselves as “badly informed and/or would like to be better informed” about climate risks (UNEP/SBI 2011).

Policy & Regulatory Risk. To hedge against climate uncertainty, regulators and ratings agencies may increase the capital that insurance companies are required to have on hand so that they may be available to pay for claims, as was the case after Hurricane Katrina in 2005 (Llewellyn 2007).By extension, insurance premiums may increase in the short term for particular areas and demographics, while certain risks may become uninsurable. As a consequence, local and federal governments may find themselves shouldering the risks of the newly uninsured (Llewellyn 2007).

In March 2009, the National Association of Insurance Commissioners (NAIC), a voluntary organization of all the state chief insurance regulatory officials in the U.S., adopted a mandatory requirement that all insurance companies with annual premiums that exceed $500 million be required to disclose their financial risks due to climate change and actions taken to mitigate such risk (NAIC 2009). A year later, a backlash from state commissions uncomfortable with the perception of being engaged in the climate debate, succeeded in scaling back the requirement so that companies can choose to disclose survey results anonymously (Lehmann 2010).

The National Flood Insurance Program

Since 1968, the federal government has been providing flood insurance through the National Flood Insurance Program (NFIP), which is run by FEMA. Private insurers currently provide very limited flood insurance because they are unwilling to insure against floods, which are high-risk and high-cost. Floods are involved in 90%of all natural disasters in the United States(GAO 2008).The series of disastrous hurricanes from 2004-2005, particularly Hurricane Katrina, forced the program to borrow heavily from the U.S. Treasury, leaving the program today struggling with almost $18 billion of debt and near insolvency (Williams Brown 2011).

The program provides subsidized flood insurance, which critics argue fails to reflect the actual risk-based market price of living in a flood zone, and as a result, creates more risk by attracting more construction and people to these areas. NFIP is enormous and expensive: FEMA manages 5.5 million flood policies, about 22% of which are priced at less than half of their true risk price, at an annual cost of $1.8 billion (Lehmann 2011).

Congress is currently considering legislation to reform NFIP. In April 2011, the House Finance Services Subcommittee passed a bill sponsored by Representative Judy Biggert (R-Ill) that takes steps towards privatizing flood insurance and would raise premiums as much as 20% annually for some currently subsidized properties and properties newly zoned within a floodplain due to ongoing floodplain remapping efforts (Quinlan 2011).

The Government Accountability Office has also reported on FEMA’s serious operational and management issues and recommends that the agency improve its strategic planning, human capital planning, intra-agency collaboration, records management, acquisition management, and information technology (GAO 2008; Williams Brown 2011).

Given the need for reform, there will likely be continuing pressure for policies requiring the insurance industry to provide more flood insurance, which would be a very expensive risk for the industry.

Reputational Risk. The industry has been under scrutiny by the public and investors alike for how it addresses climate change. Ceres—a network of investors and environment and public interest NGOs working with investors and companies on sustainability issues—has an active campaign pressing the insurance industry to take on a leadership role on climate change (Ceres 2011). Ceres argues that the insurance industry has the clout to motivate policy change as lobbyists and via its ability to essentially dictate the underwriting criteria that are needed to support effective climate change mitigation and adaptation measures (Ceres 2011).For instance, the industry could require that building code standards require existing structures be retrofitted for protections against storm damage and incorporate energy efficiency features as conditions for more affordable coverage (Ceres 2010).Acknowledging the importance of the insurance industry to the solution, some have suggested that the insurance industry receive carbon credits as an incentive for encouraging emissions reductions and adaptation (Lehmann 2010).

Investors are also increasingly paying attention to climate risk. Life insurers manage vast portfolios with investments in equity and bond markets. These investments have some level of embedded climate risk, and depending on their portfolio mix, some industries, such as the coal, may be considered or perceived as risky. To compensate for this risk, investors may raise the cost of capital (Llewellyn 2007).Ultimately, however, the brand value of the industry is relatively low because insurance coverage is a fairly inelastic product.

Competitive Risk. In the short run, insurers may benefit from higher rates and a new market for new products, but in the long run, this may draw increased competitors into the market (Llewellyn 2007). The UNEP/SBI survey report concludes that companies that can successfully manage its climate risk profile will have an advantage: “…insurers that get ahead of the curve in understanding and managing the risks linked with the physical impacts of climate change will build a strong competitive advantage relative to lagging competitors.” Hence, information is crucial. The survey revealed industry demand for more applied climate research and information products, with top votes for sectoral analyses, regional scenarios, and project databases (e.g. for renewables). Insurers and reinsurers were especially willing to cooperate with data providers, research institutes, and other partners towards meeting this need. Insurance companies also identified a need for market potential studies for new and/or modified insurance products.

 
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