Insurance companies are born risk traders. How do these sophisticated risk managers integrate climate risk into their strategy and business model? With climate risk potentially materializing at an increasing rate, there is no room for denial considering the potential impact on financial performance and stability. It is a matter of corporate life or death for participants in the $6 trillion industry.
Non-life insurance companies’ exposure to climate risk is manifold. First, insurers are subject to rising physical risk (extreme weather, rising seas) through property and casualty (‘P&C’) activities. Second, as they invest the collected premia, insurers are exposed to an underappreciation of the underlying assets’ climate risk. Third, building a ‘green’ infrastructure provides new revenue opportunities that must be fairly priced (e.g., green capex construction protection, carbon credit protection, performance protection for solar fields). And fourth, they must minimize their own operational exposure.
There are many challenges ahead. Critically, there is no historical statistical data allowing the industry to price climate risk accurately. Furthermore, risk diversification in P&C activities is compromised since climate change has nonlinear systemic effects, meaning that ‘a small physical shift can change entire systems irreversibly.’ Finally, there is a circularity element: left unchecked, the collected premia might be invested in sectors (including real estate) and firms carrying an underestimated, correlated climate risk.
Swiss Re, the reinsurance company, tentatively estimates that P&C premia will increase by nearly $200 billion p.a. by 2040 to cover climate risk. This amount represents a c.20% increase in premia (above and beyond the anticipated increase ex climate risk).
Affordability is a growing concern as increasing premia create a rising financial burden for asset owners. Some assets may even become uninsurable, affecting both asset owners (uncovered risk exposure) and insurers (declining addressable market). To support their industry, insurers must engage with their clients to help them proactively address climate risk (so that they remain economically viable clients).
Meanwhile, insurance companies must invest collected premia with a long-term perspective. Since this investment pool amounts to $13 trillion globally, insurers’ investment preferences move the financial markets. Unsurprisingly, insurers have been pioneers in sustainable finance and are expected to remain committed to sustainable investments.
By nature, insurance companies’ challenges represent the concentrated mirror image of the climate risk with which the rest of the world is confronted. All firms are exposed to climate risk through their revenues (obsolescence, affordability), costs/investments (adaptation, mitigation, productivity), assets (properties, plants, and equipment), and working capital (customer credit risk, supply chain resilience). If that risk is purely hypothetical to some, it still has to be managed as a matter of fiduciary duty.
Given the many challenges faced by insurance companies, counting on this industry to fully underwrite climate risk in its many forms is a bold bet. The most effective and economical insurance against climate risk is likely to be the one provided by each firm for itself and its stakeholders. It is just a matter of corporate risk management.