Insurability becoming uncertain beyond 2°C

Re/insurers should see adaptation and resilience as crucial components of safeguarding communities, economies and the environment against the impacts of climate change. They should also see them as critical to the survival of their own industry, according to the head of WTW’s ecosystem resilience practice.

“That might sound alarmist, but climate change is increasing the frequency and/or intensity of a range of climate-related perils, which could limit the affordability of insurance in the future,” Sarah Conway says in an interview with Insurance Day.

“Beyond 2°C warming, insurability becomes increasingly uncertain,” she continues, “leading to possible and serious economic and societal disruptions as future losses may be carried by individuals, firms and governments, which are often the ‘insurer of last resort’.”

Risk reduction through adaptation may be the only sustainable means to limit the increase in future climate losses and damages, and potential disruptions to insurance markets. Therefore, risk transfer and risk reduction increasingly need to go hand-in-hand, Conway says, and the insurance industry is uniquely positioned to support this.

"Beyond 2°C warming, insurability becomes increasingly uncertain, leading to possible and serious economic and societal disruptions as future losses may be carried by individuals, firms and governments, which are often the ‘insurer of last resort’"

^{Sarah Conway
WTW}

In risk transfer, insurance coverage provides households, businesses and communities with the funding they need to recover rapidly from climate events. Insurers also have the data and expertise to encourage risk-reducing activities, enable more resilient communities and directly invest in resilience.

Alongside mitigation, adaptation is one of the major responses to addressing climate change under the UN Framework Convention on Climate Change.

Broadly speaking, adaptation refers to adjustments in natural or human systems to address the impacts of climate change, with the intention of moderating harm or exploiting beneficial opportunities. Building resilience, similarly, is preventing, anticipating and absorbing the impacts of climate shock and slow-onset events.

Business imperative

Insurers are exposed to both transition and physical risks from climate change through their underwriting and investment activities. Understanding climate risk therefore is “not only important but a business imperative”, Conway says.

There is an increasing recognition that natural catastrophe models developed using historical loss data may be limited when it comes to assessing future impacts, she says, because climate change is modifying the baseline processes that drive risk. There is also awareness of the need to accurately represent changes to exposure because of the rising concentration of people in often higher-risk urban areas.

Conway says: “We’re seeing a lot more money and time spent on modelling that makes use of new technologies like artificial intelligence and satellites, and lots of new companies forming that provide real-time data for globally consistent coverage. As such, we can understand climate risk a lot better than we could 30-plus years ago when catastrophe modelling began.”

This trend is likely to persist, thanks to advanced analytics, augmenting climate change models with big data and predictive analytics which have “huge potential” to significantly broaden risk assessment considerations.

Furthermore, over the past few years, climate risk is increasingly discussed alongside biodiversity and ecosystem-related risk. Conway says this represents an increasing recognition of the need to bring “natural capital” within risk assessment and management frameworks.

In its latest Natural Catastrophe Review, WTW highlights global insured losses from natural catastrophe events surpassed $100bn for the fourth year in a row in 2023. Conway says these losses are “becoming the norm, not the exception”.

Wildfire in British Columbia, Canada Xinhua/Alamy Stock Photo

“What’s driving this? Well, interestingly, the so-called secondary perils are a key contributor,” she says.

Primary perils, such as earthquakes and tropical cyclones, are historically defined as having the highest loss potentials. They are well-monitored and usually covered by catastrophe models. Secondary perils, like hail, flood, landslide, storm surge and bushfire, are those that generate small to mid-sized losses.

The economic and societal impacts of secondary perils have become a focal point for risk managers following a year dominated by severe convective storms, wildfire, drought and flood. It is the aggregation of these perils that poses a threat to re/insurers, Conway says.

The distinction between perils is thus “increasingly blurred”, and secondary perils have acquired an alternative label – earnings perils – to acknowledge that they can, in aggregate, have a primary effect on re/insurance profitability.

Cat model pros and cons

The availability of climate-conditioned hazard data means re/insurers can better understand the range in frequency and severity of potential events under a number of greenhouse gas concentration trajectories, known as "shared socioeconomic pathways". This is a huge improvement, Conway says, from the early days of natural catastrophe modelling.

Modelling is, however, a “simplification of reality” and ultimately only as good as the data it receives.

“There will always be model ‘misses’, where an event is not picked up adequately, but this highlights the importance of validation – post-event analysis – after an impactful event has occurred, especially in the context of climate change,” Conway says.

Another issue to flag, Conway continues, is that, typically, natural catastrophe models do not “capture” the risk reduction or protective value of ecosystems, such as the way coral reefs and mangroves mitigate storm surge and flood.

Ultimately, catastrophe models are a good first step in quantifying risk to transfer and price it, and they support an understanding of range, in terms of the frequency and severity of hazard events that could “plausibly occur” at a given geographic location, Conway says.

This is achieved through the stochastic event set, which can also be altered to incorporate climate change. As such, catastrophe models can help with stress testing and allow the user to understand the best- and worst-case scenario in terms of hazard for a given exposure, and the associated modelled losses.

Model resolution is important to ensure processes are not overly simplified or too generalised in their assumptions – otherwise the value of the model output would “deteriorate”, Conway says. This is particularly the case for flood, as its impact can change rapidly over small spaces depending on topography and land cover. Fine resolution models are thus needed for this peril, she adds.

Floods in Italy in 2023 ZUMA Press Inc/Alamy Stock Photo

Formulaic approaches to risk quantification can lead to the exclusion of important factors that cannot be easily quantified, she continues. For instance, the differential impact that disasters have on vulnerable segments of society, or how risk perception plays into risk management. “Holistic risk assessment should seek to capture these other aspects alongside robust quantitative risk assessment,” she adds.

The outputs of catastrophe models can be used for planning in a range of areas, she continues. They can provide indications of the required budget for potential losses, help design adaptation plans and implementation of precautionary measures, and help to rationally price premiums.

Catastrophe modelling “simplifies the science” behind risk assessment and allows technical experts to effectively communicate potential scenarios to interested stakeholders, she adds. The outputs of the models can also be used in capacity building activities and to raise awareness amongst those managing the financial impacts of disasters, such as finance ministries.

A disadvantage is the lack of a universal skillset among conventional catastrophe modelling vendors globally, with risk better understood in areas where there is more data availability. Vendor catastrophe models are often “black box”, moreover, which means there are many “hidden assumptions that are not visible to users”, Conway says.

Parametric insurance

When WTW works to design parametric insurance solutions it prefers to use open-source data and modelling platforms rather than “black box” models, as a method can “easily be replicated and the assumptions are visible”. This is also helpful when placing parametric products in re/insurance markets, as these “defensible” sources help gain the trust of underwriters.

Parametric insurance, a risk transfer solution that enables innovative coverage to address impacts beyond direct, quantified loss, are designed to pay – trigger – a pre-agreed amount to the policyholder when specific and measurable event conditions, or parameters, occur – such as peak wind speed above a certain threshold – in a defined geographic location and timeframe.   

Conway says parametric solutions can address both the direct and indirect impacts of climate risk. For example, they can be developed to capture the direct damage caused by wind and tailored to cover indirect losses, such as heat stress on power grids.

"Ultimately, parametric insurance has allowed for a widening of what is insurable. Any economic exposure arising from an event – whether a climate shock event or a cyber attack or a pandemic, to name a few – can be insured. As a result, uninsurable exposures become insurable, with the parametric trigger providing the ‘missing link’ to unlock contingent capital"

^{Sarah Conway
WTW}

Parametric insurance traces its roots back to the 1990s, to the weather derivatives market and the birth of the catastrophe bond market. In recent years, its growth has been fuelled by three factors, Conway says. They are the increasing frequency and severity of natural catastrophes and the hard market resulting from this; an increased awareness that climate change risks are pervasive and far-reaching; and an increased need for alternative risk transfer solutions.

“Ultimately, parametric insurance has allowed for a widening of what is insurable,” Conway explains. “Any economic exposure arising from an event – whether a climate shock event or a cyber attack or a pandemic, to name a few – can be insured. As a result, uninsurable exposures become insurable, with the parametric trigger providing the ‘missing link’ to unlock contingent capital.”

Another notable feature is that, unlike indemnity products which necessitate a potentially lengthy loss adjustment and claims process, parametric insurance pays out a pre-determined amount when specific, pre-defined parameters or triggers are met.

“Relying on objective and measurable data to determine pay-outs allows for money to flow within weeks of an event – when immediate liquidity can be critical,” Conway says.

WTW’s approach

WTW’s interdisciplinary global team of specialists in alternative risk transfer and disaster risk finance has offerings that contribute to adaptation and resilience – including insurance solutions, but also broader consulting services focused on disaster risk finance.

For example, the broker is working with the governments of the Bahamas and Pakistan on comprehensive disaster risk management and financing strategies, and with the Asian Development Bank on demonstrating how investments in tropical cyclone wind and flood adaptation measures in the city of Hue, in Vietnam, could lead to a reduction in insurance premiums.

On parametric insurance, WTW serves a range of public and private entities with solutions customised by geography, risk exposure, risk management objectives and the client’s budget.

Building on its work with the MAR Insurance Programme, which is underwritten by Axa Climate, WTW recently helped to design and launch a coral reef insurance programme in the Lau Seascape of Fiji, working with Vatuvara Foundation as policyholder and with financial support from BHP.

“This programme not only recognises the value of immediate liquidity to support reef restoration, but also the need for community assistance in the aftermath of a cyclone event – provision of water and food – and has built this into the post-cyclone response plan,” Conway says.

On livelihood protection, WTW is working with conservation non-governmental organisation Rare, and with support from the government of Canada via the Ocean Risk and Resilience Action Alliance, looking to design a parametric insurance product that helps small-scale fishers in the Philippines to adapt to climate change. This aims to provide protection from lost income incurred because of bad weather days that prevent safe fishing.

WTW is kicking off a project funded by the US Agency for International Development to develop a climate-resilient insurance solution that aims to unlock climate adaptation investment from the private sector. Specifically, WTW will design a pilot facility to offer a parametric insurance solution – a “resilience wrapper” – that protects direct loans to private enterprises from climate-related shocks.

After having supported Unicef – the United Nations Children's Fund – in developing the first child-sensitive cyclone insurance mechanism, WTW is looking forward to turning the Today & Tomorrow Initiative, launched at COP27 in 2022, from a pilot into a platform over the coming years, Conway says. The initiative includes response measures that promote climate-resilient, sustainable recovery and build-back-better interventions, such as the rehabilitation and reconstruction of health, education and nutrition infrastructure.

Conway concludes: “Without really doubling down on risk reduction – and recognising and rewarding the risk reduction value of intact ecosystems, for example, the insurability of certain perils and geographies will become increasingly questionable. Thankfully, the industry is well-placed to inform and encourage risk reducing adaptation activities and other investments that build resilience.”