Inclusive Green Insurance for Climate Change in the Global South: Thoughts for Colombia
This article is based on a keynote presentation by the author to the International Insurance Convention, Colombian Federation of Insurance Companies (FASECOLDA) in Cartagena, Colombia, September 16, 2022 entitled “How can the insurance sector be part of the solution to climate change?”
According to the World Economic Forum (WEF), not only environmentalists, but also the global business community have determined that climate change is the ultimate risk facing society. For the past 17 years, WEF has benchmarked the input of business leaders and other stakeholders on dozens of global risks (economic, environmental, geopolitical, social, and technological). They have found that environmental risks have increasingly dominated the highest likelihood and severity regions of the risk map, particularly those involving extreme weather, natural disasters, and failure to address climate risks. Moreover, many other risks deemed significant (e.g., water shortages and involuntary migration) are also compounded by climate change. Noted insurance industry players Zurich Insurance Group and Marsh McLennan help coordinate this eye-opening effort.
Insurance in a Climate of Change
As the world’s largest industry — at $6.8 trillion in revenues and $30 trillion in assets — insurers have for decades experienced the escalating costs of weather and climate extremes. Business risks facing insurers include traditional insurance losses (property/casualty as well as life/health), liability exposures, regulatory restraints, reputational damage, asset devaluation resulting in stranded assets associated with greenhouse-gas emissions, and internal challenges from inadequate environmental, social, and governance practices. The bottom-line consequences can range from eroded profitability to insolvency. Along with these comes market contraction, resulting in a crisis of availability and affordability for policyholders and increased pressures on governments to bridge the gap.
In the core business, virtually every insurance line has exposure to weather and climate extremes, there is risk of compound events (e.g., fire leading to mudslide), and with increasing frequency of extremes, annual accumulations of losses are rising. These risks are sometimes correlated in unexpected ways within underwriting and between underwriting and asset management.
Such concerns are not hypothetical. According to Swiss Re, aggregate inflation-corrected global losses rose from about $10 billion per year in the 1970s to about $100 billion per year today ($180 billion in the highest year on record). The vast majority of these losses (~90%) are unrelated to weather and climate. These insured losses represent about 40% of the total economic losses (the worst years reaching $500 billion). In low- and middle-income countries, the share that is insured is far lower (e.g., 16% in Latin America), shifting a particularly large share of the burden to individuals, businesses, and governments. In Colombia, for example, only 2 to 4% of flooding losses and 1.25 to 5% of agricultural land are insured.
This differential between total and insured losses is often referred to as the “protection gap,” although in fact, governments often bear a significant portion of the uninsured cost. These mask various nuances of this rapidly evolving risk landscape. For example, smaller-scale (e.g., local storms) and diffuse or slow-moving events (e.g., droughts) are not included in the time series. In aggregate, the costs of such events represent a significant increment above the aforementioned numbers. Insured and uninsured health impacts and loss of life are also not included in these data. Meanwhile, lower-income demographic groups are often excluded from insurance markets altogether, a reality that is also not apparent from the averaged national statistics.
Colombia provides a useful case study for the Latin American context. Over the past half century about 64% of loss events in that country have been weather- and climate-related, along with 73% of associated fatalities. These events are dominated by floods and landslides, sometimes exacerbated by deforestation and resulting in extensive damages. Going forward new categories of losses will emerge, such as wildfire, as “development” moves assets further into harm’s way.
In an example of emerging climate risks, while today Colombia experiences only about 20 days per year in which temperatures of 35 degrees C (95 degrees F) are exceeded, the most concerning (highest emissions) climate change scenario shows this number growing as high as 250 days per year. Temperature extremes are not only correlated with adverse public health outcomes. They also underpin risks from wildfire, crop/livestock losses, fishery degradation, power outages and business interruptions, and crime rates. Warming oceans also correlated with increased hurricane risk and longer hurricane season.
Globally — and particularly in low- and middle-income economies — the specter of insurability looms large. Without widespread risk-spreading, detailed and accurate data and models, and pricing that makes insurance affordable, insurance markets cannot function. Factors outside insurers’ control (e.g., building codes and land-use planning) further complicate the situation. The compounded uncertainties created by climate change, continue to erode insurability.
While it is tempting to conclude that economic development reduces vulnerability and enhances insurability, this is not necessarily the case. Insurance industry exposure skyrockets as values increase and a larger fraction of homes and businesses purchase insurance. In tandem with increased wealth, human settlements tend to extend into harm’s way — e.g. to scenic forested areas (the “wildland-urban interface”), river valleys, and coastlines. Meanwhile, government policies and programs that stand to improve resilience often fail to keep pace with the rising risks, even in “advanced” economies.
Events in California provide a startling example of these dynamics in the case of perils such as mudslides and wildfire. In the 2017/2018 period, wildfires caused 53,000 insurance claims across the state resulting in insured losses of $12.6 billion. One burned area was soon hit by a massive atmospheric river storm, abruptly causing 3,000 mudslide claims among adjacent high-value homes in the town of Montecito, resulting in $660 million in insured losses. These losses were quite material to California insurers, exceeding 2.5-times the entire state-wide homeowners’ insurance annual premium volume. These events also illustrate the increasingly common causal relationships among natural hazards and thus correlated losses. As a result of increasing wildfire frequency and severity (attributed in large part to climate change), California is today facing an acute insurance availability and affordability crisis, with widespread premium increases (2- to 4-fold), tighter terms, exclusions, and many non-renewals. As private insurers have exited the market, the public insurance mechanism known as the “California Fair Access to Insurance Requirements (FAIR) Plan” has become the dominant fire insurer in many parts of the state.
Colombia is also a land of coastal mountains prone to flood and fire. Both territories have a history of land management that has compounded these hazards. The aforementioned losses in California are nearly twice the annual revenues of Colombia’s non-life insurance market. For perspective, Columbia has 2.5-times the land area of California and 125% of the population.
The Vanishing Insurer Culture of Loss-prevention
Dating from the middle 1600s, the foundations of insurance were formed with a technical and philosophical focus on loss prevention. Insurers protected ships from pirates, cleaned chimneys, and tested products for fire safety.
Today, however, a culture of “cash-flow underwriting” has largely displaced such practices, in which losses are largely allowed to occur and insurance is priced to ensure solvency. For market segments and customer types for which this model is not profitable, limits and exclusions are imposed, or insurers retreat altogether.
Isolated examples of improved practices have begun to re-emerge, extending the industry’s founders’ vision of preventing conventional losses at the discrete customer level to ambitiously preventing and otherwise adapting to climate change at a global scale.
In modern times, a very limited number of insurers and their regulators have sought to help enhance resilience to weather and climate extremes at the customer or community level. In the U.S., the Institute for Business and Home Safety (IBHS) created a residential and commercial property hazard-resilience rating system. Now, at least 55 insurers in 14 states offer premium credits to compliant properties, with some also offering endorsements to upgrade following losses or waiving deductibles for improved properties. In some cases local governments offer tax incentives for highly-rated properties, and even property-tax-based financing for improvements. In 2022, the insurance regulator in California became the first in that country to require insurers to recognize and give insurance premium credits to consumers that “harden” their properties against wildfire risk.
Other initiatives are proving far more ambitious and innovative. In an example of what has come to be known as “nature-based solutions”, Willis Tower Perrins and the Nature Conservancy (assisted with a government grant) modeled ecological forestry (thinning plus prescribed fire), which resulted in a predicted 40% loss reduction. Their proposal is to capture these savings and redirect them towards financing bonds to perform the indicated forest management.
A few insurers have actually implemented programs to utilize such ecosystem services as a means for reducing climate risks. The longest-standing example is Tokio Marine Nichido’s planting of 11,618 ha (28,700 acres) of mangroves across nine Pacific nations. The company notes carbon storage and reduced storm-surge risks as benefits. That program began in 1999 and is ongoing. The analogous practice of wetlands restoration has been cited as potential similar benefits for Colombia, but insurers have yet to be engaged.
The Greening of Insurance
While not widely publicized, many insurers and insurance-related firms and organizations around the world have engaged in efforts to avoid the risks of climate change. These initiatives, dating back to the mid-1990s, are far more proactive than simple adaptation. Per the Green Insurance Data Service, nearly 1500 activities have been undertaken by 350 companies from 56 countries. These efforts are spread broadly between the core business (green products and services), asset management (investment in climate-change solutions such as renewable energy and energy efficiency), and in-house corporate practices and policy engagement.
Innovative green products include premium discounts for energy-efficient buildings, replacing infrastructure following losses with greener alternatives, auto insurance based on distance driven (an incentive to drive less), and many others. One of the more innovative categories of products — insurance of energy savings estimated from energy efficiency projects — has been experimented within Colombia.
Insurance asset managers have also engaged, investing at least $60 billion in clean energy markets as of 2017. Meanwhile, many insurers around the world have begun de-investing in fossil fuels. In 2018, the California insurance regulator asked insurers to examine the particular transition risks related to investments in the coal industry. In response, 67 companies divested some or all holdings and 325 halted further investment.
Meanwhile, at least 41 global insurers have developed policies to decline insurance to climate polluters, beginning with the coal industry. As of late 2022, 62% of the reinsurance market and 39% of the primary insurance market now have coal exclusions, with Allianz, Axa and Axis Capital identified as having the most effective policies. Participants in the U.S. include the leading names AIG and Travelers.
Toward Best Practices
Insurers can and should play a much more substantial role in climate change mitigation (emissions reductions) as well as adaptation and improved resilience. Leading companies have demonstrated innovative approaches, but most of the industry lags behind.
At the highest level, best practices must begin by aligning corporate culture with climate-change goals. The concepts of enterprise risk management (ERM) and Environment, Social, and Governance risk reduction (ESG) are good guiding principles. This requires coordination across insurance lines and business areas; management of insurers’ own carbon footprint; proactive risk assessment, mapping, and modeling; implementation of stress-testing to understand loss potential under climate change, and increased transparency toward consumers, policymakers, and investors.
There is much talk in development-finance circles about “inclusive green growth”. It is time to now discuss inclusive green insurance, examples of which include microinsurance for unserved lower-income segments of the market. Colombia has already begun developing parametric microinsurance products for small farmers.
Far more green products, services, and finance must be developed. Care must be taken to avoid greenwashing and taking credit for activities that are standard practice or required by law. Success requires not just “launching” innovations but also educating and incentivizing policyholders to adopt. This requires thoughtful market research, little of which appears to have been done.
Investment and asset management must also be aligned with core business risks and objectives. This can include supporting nature-based solutions (aka “green infrastructure”) to help prevent losses at wide scales and creating performance expectations for customers (e.g., energy, logging, or mining interests) that contribute to climate risk, including potentially deinsuring those that create excessive risk for insurers and their other customers.
The Green Insurance Data Service provides many examples of engagements on the part of diverse stakeholders within the insurance marketplace. Intermediaries such as brokers understand and can cultivate demand for green products, adjusters can identify the potential for green upgrades as part of the claims-handling process and help properly value damaged green assets, insurance regulators can conduct valuable stress-testing and identify and remove barriers to market innovation, modelers can help better define the risk landscape, and actuaries can help quantify climate risk while developing the pricing rationale for green products and services. Notably, actuaries in North America have already developed a detailed climate risk index for insurers in the region.
Much more rigor and precision can be brought to tracking, analyzing, and projecting weather- and climate-related losses. More focus must be placed on accelerating return periods, undetected solvency risks, and aggregate annual accumulations as distinct from probable maximum losses (PML) from isolated individual events. On the customer side, availability and affordability issues must be more explicitly tracked, and associated equity issues identified and addressed.
Insurance loss modeling has enormous room for improvement and innovation. Traditional predictive exercises have value, but the use of broader scenario analysis is fundamentally different and complementary. For example, new modeling approaches can help define the insurance value of improved forest management or proactive adaptation investments.
Insurers are not omnipotent. Public-private partnerships are essential. These can include improved building codes, land-use planning, forest management, and other activities that enhance resilience. The least desirable outcome is for governments to become catastrophe insurers of last resort and then find themselves as the only entities offering insurance (this has already occurred in many parts of the U.S.). Non-governmental organizations can also play catalytic roles.
Insurers are also essential stakeholders in broader discussion about the energy transition. The research is clear that absolute priority must be given to improving energy efficiency at the point of use in homes, businesses, industry, and transportation, as it is highly cost-effective and all energy supply options have vulnerability and risks. Renewable energy — including storage and a smart grid — is then the priority for providing energy that is needed. An efficient and renewable powered energy system can also be far more disaster-resilient than today’s systems. Among renewables, biofuels are the most problematic, especially those derived from forests, competing with lands needed for food production, and requiring energy-intensive production processes.
It must be kept in mind that not all adaptation and resilience strategies are necessarily green. A classic example is increased use of air-conditioning to address rising temperatures, which, of course, results in more energy use, potentially increased greenhouse-gas emissions. Other strategies may create new and unacceptable risks. For example, nuclear energy is not only the most expensive form of energy (about 5-times the cost of wind and solar), but its many intractable technical problems such as high water requirements, poor fit with the smart grid, weapons proliferation, vulnerability to terrorism and natural disasters, and unwillingness by insurance to shoulder the risks have not been resolved.
* * *
More about my work on the nexus of insurance, risk management, and climate change can be found at https://evanmills.lbl.gov/projects/insurance-and-climate-change