Climate change is recognised as one of the most important issues in today’s society (Mills 2009) and is a significant source of risk and uncertainty for the insurance industry (Rothwell et al. 2020) Despite the significance of this issue, several insurance companies fail to recognise the harsh impacts the industry will have to endure as a result of the adverse effects of climate change (Dlugolecki 2000). Climate risks , stemming from climate change encompasses three main components; physical risks , transition risks and liability risks (Carney 2015). In this essay, the adverse impacts of climate change on the insurance industry be explored under these three broad frameworks, with an emphasis placed on the prevalence of climate change related litigation. The pricing of climate change related risks will also be considered with particular attention given to the importance of data in underwriting. Finally, the ability of technology to assist in the pricing of risk in connection with the emergence of InsurTech will be discussed and conclusions will then be drawn.
The increased frequency and severity of natural catastrophes is positively correlated with climate change and the physical risks the insurance industry is exposed to arising from these natural disasters can have a negative impact on the industry (CEA 2009). Insurers are likely to be subject to these risks through insurable events or from their asset portfolios (Rothwell et al. 2020) and this can have a direct consequence on different lines of business. The rise in insured property losses is one of the more apparent impacts, however numerous other lines will also be impacted (CEA 2009) for example, life and health insurers will be affected as the rise in the earth’s temperature facilitates the transmission of vector-borne diseases (Coomber 2006). As well as this, increased claims will cause operating profits to fall and insurance and reinsurance premiums to rise (Botzen 2013) which could potentially lead to a death spiral (Siegelman 2004). It is also possible for physical risks to be interconnected and this correlation between different business lines can impact an insurance companies’ diversification benefits and capital requirements (Prudential Regulation Authority 2015). In addition to this, as natural disaster losses increase, the ‘fat tail ’ of the natural disaster damage distribution is also likely to increase which leads to potential insolvency issues and insurability concerns (Botzen 2013).
Attempts to minimise the impact of climate change as we move to a lower carbon economy leads to transition risks (Rothwell et al. 2020) which in turn give rise to policy risks, technology risks, market risks and reputational risks. A major consequence arising from this transition is the potential for stranded assets , potentially leading to investment losses and lower asset values for insurers (Cleary et al. 2019). In relation to underwriting, potential under-pricing of new products covering green technologies may arise due to a lack of data surrounding the products. In addition to this, pressure on insurers from different stakeholders to invest in illiquid long-term green infrastructure may result in unprofitable investments (Cleary et al. 2019) which could, at an extreme, hinder an insurers ability to meet future claims (IAIS 2018). There is also a reputational risk at stake in relation to this for insurers who chose to underwrite carbon intensive projects or fail to appropriately manage climate risk (Dong et al. 2018). It is evident that both physical and transition risks can have negative impacts on the insurance industry however it should also be recognised that climate change can present opportunities for the industry which can be attained through resilience and adaptation. Insurers can utilise climate change opportunities by developing innovative new products such as loss prevention solutions, benefitting the industry, the government and consumers while simultaneously reducing emissions (Mills and Lecomte 2006).
Although physical and transition risks are of substantial importance, the impact that liability risks arising from climate change have on the insurance industry is an area of increased relevance, with the occurrence of climate change related litigation having risen by over 70 percent globally between 2017 and 2019 (Bosn et al. 2020). Liability risks can arise through climate change related claims under liability policies as well as through direct claims against insurers due to the inadequate management of climate risks (Carroll et al. 2014). Exposure is increasingly common under directors and officers, public liability and third-party environmental liability policies. The three principal arguments when establishing climate related litigation are; failure to mitigate, failure to adapt and failure to disclose/comply (Botzen 2013). Insurance companies failing to mitigate involves insured parties being held liable for the physical impacts of climate change. In order for these claims to be successful, a ‘duty of care ’ or a ‘causative link’ must be established which makes successful litigation quite difficult. Failure to adapt related claims arise when climate change risk factors are inadequately accounted for. Failure to disclose/comply claims on the other hand involve cases where the insurer or the insured fails to disclose relevant information, presents it in a misleading manner or fails to comply with climate change related legislation. Claims in this area are expected to materialise rapidly due to the increased ease in which they can be proven as companies evolve and become more transparent to keep in line with social expectations (Prudential Regulation Authority 2015).
As previously mentioned, climate change related litigation has experienced a considerable increase in occurrence worldwide (IAIS 2018) and this increase can somewhat be attributed to today’s highly litigious society (Cao 2003). It can be argued that a ‘compensation culture ’ largely exists within society (Lewis 2014) and this, combined with the notion of deep pocket hypothesis is likely to further increase the prevalence of climate change related litigation. Despite this prevalence, successful claims can be difficult to achieve, and this emerging area will take time to gain traction in the courts (Prudential Regulation Authority 2015), however substantial costs are nevertheless incurred by the insurance industry as court cases have significant costs attached to them (Botzen 2013). Insurers may also experience negative reputational impacts and a loss of investor support even when claims are unsuccessful (Dong et al. 2018) and it is often the case that insurers will choose to settle claims rather than go to court however, this is also costly (Guthrie and Rachlinski 2006). Despite the increased relevance of climate change related liability claims, this type of litigation is an area of ambiguity for insurers. As a result, the impact of liability risk is difficult to determine and is deemed to be more disruptive to the insurance industry than catastrophe claims. Moreover, although many insurers regard climate change related litigation as a low probability risk, it is a long tail risk and the case of asbestos illustrates that although the risk may currently appear to be of a low probability, it has the potential to transform into a significant and unanticipated liability for insurers (Prudential Regulation Authority 2015). The ambiguity regarding the scope and extent of potential liability in this area means it can be extremely challenging for insurers to price climate change related risks (Hecht 2008).
Climate change requires a significant amount of modelling (Renn 2015) and pricing uncertainty can be induced from climate change (Barnett et al. 2020). Although it can be argued that catastrophe risk modelling, portfolio diversification and alternative risk transfer illustrate that the insurance industry is fully capable of managing the risks induced by climate change (Prudential Regulation Authority 2015), availing of new innovative adaption and mitigation techniques is imperative to allow the insurance industry to excel while also influencing the behaviour of others, persuading them to act in more responsible ways to both combat climate change and reduce moral hazard (Hecht 2008). The capability of climate data and computer models to deliver accurate estimations about future changes in the climate will determine the success of these strategies (CEA 2009). Many risk pricing strategies implemented by insurers rely on the projection of past data which is inadequate when it comes to pricing climate risk due to the uncertainty and unpredictability associated with this type of risk (Rothwell et al. 2020). As a result, insurers have had to adapt and innovate, availing of new technologies to more accurately price their risks and this is illustrated through the emergence of InsurTech which highlights the relevance of data and supports the view that data is the ‘lifeblood’ of the insurance industry (Lin and Chen 2019).
Insurers often lack sufficient data when underwriting risks and this inability to obtain precise, comprehensive data can act as a potential barrier for insurers however, insurers can avail of emerging technology to overcome this as InsurTech generates ever-increasing quantities of data which can assist in the pricing of risk (Catlin and Lorenz 2017). In addition to this, artificial intelligence algorithms can be exploited to allow for more precise underwriting predictive assessments which aid insurers in determining more accurate premiums and decreasing their loss ratios (Lynn et al. 2019). The use of artificial intelligence in underwriting can also reduce the probability of the misdiagnosis of a risk resulting from human error or bias (Lewis 2017). Insurers can also avail of virtual reality technologies to model risk scenarios which will allow them to more efficiently deal with disasters and emerging risks such as climate change (VanderLinden et al. 2018). Furthermore, technology and data can be utilised detect fraud. A claimant’s speech patterns can be analysed through natural language processing programmes to identify potential lying. Improving fraud detection could prove vital in relation to climate change related litigation due to the abundance of frivolous claims the court has seen in recent years. Fraud must be accounted for when pricing risk and using technology to reduce the prevalence of fraud within the industry would result in more accurate, equitable premiums (Lewis 2017). Other technologies such as Telematics are being made use of in insurance lines such as motor, life and health (KPMG 2019) and blockchain is also being utilised to improve pricing accuracy (Colaco et al. n.d). It is evident that technology can be utilised in different ways to more accurately and efficiently price risk however it should be noted that the potential implications of using technology can be significant (Neale et al. 2020). For example, prejudice and discrimination are often a consequence of applying data and the increased prevalence of InsurTech may lead to concerns regarding cybersecurity and data privacy. The possibility also exists that fraudsters may abuse InsurTech and discover new technology-enabled ways to execute insurance fraud (Lin and Chen 2019). Although InsurTech reaps many benefits for the insurance industry in terms of allow for better, more accurate pricing of risks which enables more informed decision making, it does not come without its perils.
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