Insurers should brace for rising tide of coverage issues related to climate change

According to the UN’s World Meteorological Organisation, economic losses are soaring because of the more frequent occurrence of climate change-related events.

What will be the effect on the pricing of policies and the premiums charged by insurers; and will this be affordable for policyholders?

The European Insurance and Occupational Pensions Authority observed climate-related risks are often excluded from pricing methodologies because short-term contracts permit annual repricing so the price can be adjusted according to risk variations over time.

This would implicitly take into account (based on historical loss data) the higher likelihood of damage associated with increases in climate risk.

Insurers may steadily raise their premiums to reflect a greater risk, which could discourage policyholders from purchasing or renewing insurance, posing a risk to the viability of the insurance market for climate-related events and leading to a widening of the insurance protection gap.

Swiss Re estimates annual property insurance premiums will increase $183bn by 2040 and risks associated with climate change would account for more than 20% of the overall rise in property premiums in the next 20 years.

Insurers face significant pressure from environmentalists and investors to align their underwriting portfolios with decarbonisation targets and other climate goals.

Lloyd’s has voiced concerns about opposition from climate change activists should it not remove its support for activities that are detrimental to the climate and said, from January 2022, its managing agents should not provide new insurance coverages for certain activities that should be phased out by January 2030.

Closely associated are stricter obligations on insurers to identify, assess, report and disclose climate change-related risks and opportunities in their underwriting portfolios.

For example, the UK’s Financial Conduct Authority requires UK premium listed companies to state whether they have made disclosures about their exposure to climate change risks and opportunities. In accordance with the EU’s Sustainable Financial Disclosure Regulation, insurers that provide insurance-based investment products or advise on such products must make certain environmental, social and corporate governance disclosures. 

Similarly, the UK’s Prudential Regulation Authority expected insurers to have fully implemented and embedded their approaches to climate-related risk management, disclosure and governance by the end of 2021.

Liability exclusions

Insurers may seek to exclude climate change liability from cover explicitly to ensure policyholders bear the financial burden of their own climate impact.

Also, many claims have focused on fiduciary duty breaches by company directors in relation to, for example, failure to disclose sufficient or relevant climate-related information. Directors’ and officers’ (D&O) liability insurance will be important in this context, yet insurers may build in exclusionary language in respect of costs and losses because of pollution.

Policyholders could experience more collaborative efforts from insurers to manage climate-related risks, illustrated by the integration of clauses into D&O policies that provide a reduction in premiums for improved reporting and disclosure standards in relation to climate-related financial risks. 

Better-quality information on climate-related risk would provide insurers with more information to price policyholder’s climate risks.

The response of insurers… has demonstrated the resilience of the market and has produced opportunities for policyholders, with novel and innovative insurance products, as well as incentives to reduce their own carbon footprint

Policyholders may see variations in insurance policy clauses such as those stipulating that buildings that have sustained damage because of climate events must be repaired to a higher standard than previously accepted under the policy, such as better flood defence where that was the issue. However, it may not be clear who foots the bill for this work. 

The risk of the same level of damage and the cost of claims in the future is likely reduced so may correspond to premium reduction.

Demand is increasing for new insurance products and solutions, which perhaps go beyond the typical transfer of risk to reinsurers and explicitly address climate adaptation and/or climate mitigation. For example, Zurich’s pollution liability insurance provides cover in respect of pollution caused by construction work on or on behalf of the policyholder at project sites.

Additionally, in July 2020 Lloyd’s advised innovative electric vehicle insurance products should be designed to manage new risks and address protection gaps arising from the evolution of vehicle business models and research should be conducted into the risks involved in the hydrogen sector to develop specialist insurance coverage, such as in relation to the transportation of hydrogen.

Parametric cover

Parametric insurance products are also emerging. They are triggered by specific events that are measured according to a pre-agreed index or set of parameters (such as a hurricane with a certain wind speed) of which the payable amount is predetermined, irrespective of the actual loss suffered by the policy­holder. As such, claims under parametric policies can often be paid faster.

Another potential solution is sourcing alternative capital from investors with a greater risk appetite than the typical insurer. For example, in 2013 the World Bank completed a $450m weather and oil price insurance transaction for a hydro-electric power company owned by Uruguay.

The company was insured for an 18-month period against drought (which would clearly hinder hydro-electric production) and high oil prices (which make thermal power generation expensive). The World Bank offset its risk with two reinsurance companies.

Increasing claims linked to extreme weather events have required the insurance market to examine the insurability of related events. Questions have been raised as to whether the insurance market has both the capacity and expertise to manage the associated risks. However, the response of insurers (including their efforts to contribute to climate mitigation and adaptation) has demonstrated the resilience of the market and has produced opportunities for policyholders, with novel and innovative insurance products, as well as incentives to reduce their own carbon footprint.

Nonetheless, insurers may well create challenges that may leave policyholders uninsured and vulnerable to the threat of climate change. For example, premiums may become prohibitively expensive and insurers could divert their capital away from potential policy­holders whose activities may be deemed too “risky” for an insurers’ portfolio from a climate perspective. 

Insurers should be advising policyholders to give due consideration to the terms of their existing (and any future) policies to ensure they are adequately protected against the risk of extreme weather events related to climate change. 

Peter Sharp is a partner and Paul Mesquitta and Charlotte Warke are associates at Morgan, Lewis & Bockius