Climate change, insurability of large-scale disasters, and the emerging liability challenge.

• Author: Kunreuther, Howard C.

This Article focuses on the interaction between uncertainty and insurability in the context of some of the risks associated with climate change. It discusses the evolution of insured losses due to weather-related disasters over the past decade and the key drivers of the sharp increases in both economic and insured catastrophe losses over the past twenty years. In particular, the authors examine the impact of development in hazard-prone areas and of global warming on the potential for catastrophic losses in the future. In this context, the authors discuss the implications for insurance risk capital and the capacity of the insurance industry to handle large-scale events. A key question that needs to be addressed is which factors determine the insurability of a risk and the extent of coverage offered by the private sector to provide protection against extreme events when there is significant uncertainty surrounding the probability and consequences of a catastrophic loss. The authors further discuss the concepts of insurability by focusing on coverage for natural hazards, such as earthquakes, hurricanes, and floods. The Article also focuses on the liability issues associated with global climate change and possible implications for insurers, including issuers of Directors' and Officers' policies, given the difficulty in identifying potential defendants, tracing harm to their actions, and apportioning damages among them. The Article concludes by suggesting ways that insurers can help mitigate future damages from global climate change by providing premium reductions and rate credits to companies investing in risk-reducing measures.

INTRODUCTION

The World Economic Forum recently stated that climate change is one of the most important global risks that key decision makers will face in the years to come. (1) In the same vein, a report commissioned by the Chancellor of the Exchequer in the United Kingdom echoes this perspective and notes that "climate change presents very serious global risks, and it demands an urgent global response." (2) The Stern Review notes that global climate change "presents a unique challenge for economics" due to the long time horizons involved, the uncertainty associated with the risk, and the unprecedented scale on which one needs to envision such a problem. (3) These points reinforce the common sentiment that we need to address the role of different industrial sectors in reducing the impacts of global warming.

This Article focuses on the role that the insurance sector can play in this regard and the challenges insurers and reinsurers face in dealing with the impact of climate change on their risk management strategies. Indeed, the direct and indirect impact of firms' activities to limit future emissions of greenhouse gases (GHGs) and to adapt in other ways to climate change is likely to have major implications on the insurance sector. In a recent interview, John Coomber, former CEO of the Swiss Reinsurance Co. (Swiss Re), a world reinsurance leader, stated that climate change "is the number one risk in the world ahead of terrorism, demographic change and other global risk scenarios...." (4) In May 2006, American International Group (AIG), the largest insurer in the United States, issued a statement that "©limate change is increasingly recognized as an ongoing, significant global environmental problem with potential risks to the global economy and ecology, and to human health and wellbeing." (5)

Extreme-weather-related events (such as hurricanes, floods, and ice storms) will impact the premiums and available coverage for property damage and business interruption losses. They may affect health and life insurance as well. Because insurance policies are usually renewed annually, insurers are faced with the problem of how to set premiums and what coverage to offer in the coming year. This can be a difficult challenge, given the inability to distinguish between random weather patterns and systematic changes in climate in the short run.

Insurers have also begun paying attention to the liability issues associated with climate change because shareholders could accuse some companies of failing to prepare for climate-related financial exposures. To the extent that shareholders take such cases to court, insurers have to defend those firms who have purchased Directors' and Officers' (D&O) liability coverage from them.

The Article is organized as follows. Part I discusses the evolution of catastrophic losses over the past twenty years. In particular, we examine the impact of climate change, coupled with the development of hazard-prone areas, on the potential for large losses to insurers in the near future. In this context we discuss the capacity of the insurance industry to handle large-scale disasters without assistance from the public sector. Part II addresses the issue of attribution by examining the main drivers of this new dimension of catastrophic losses. While climate change may impact the intensity and frequency of future hurricanes, the growing concentration of population and industry in high-risk areas is largely responsible for the billions of dollars in losses that will result from such events.

Part III discusses the concept of insurability by focusing on coverage for natural hazards--such as earthquakes, hurricanes, and floods--and showing how these extreme events impact whether these hazards are insurable by the private sector alone (and, if so, under what market conditions). The seven major hurricanes that devastated Florida in 2004 and the Gulf Coast in 2005 served as a wake-up call not only to insurers and reinsurers, but to other stakeholders as well. Among these stakeholders are modeling firms that have developed and revised catastrophe models for quantifying insurers' and reinsurers' exposure, rating agencies that have modified their rating methodologies and imposed more stringent conditions of catastrophe exposure management by insurers and reinsurers, and investors who now require a higher return on equity to reflect the higher volatility of insurers' portfolios, due to the new scale of extreme events. Part IV then demonstrates how these stakeholders are modifying the frontier of the insurability of catastrophic risks.

Part V focuses on another challenge that will face the insurance sector in the coming years: the liability issues associated with global climate change given the difficulty in identifying potential defendants, tracing harm caused by their actions, and apportioning damages between them. We also suggest ways that insurers can help mitigate future damages from global climate change by providing premium reductions and rate credits to companies that have taken actions that produce short-run tangible benefits and have a long-run positive impact on global climate change. Part VI provides a brief summary of our findings and issues a call for a more systematic collection of data to allow well-informed strategies and policies.

1. CHANGES IN EXTREME-WEATHER-RELATED EVENTS

   Catastrophes have had a more devastating impact on insurers over the past fifteen years than in their entire history. Between 1970 and the mid-1980s, annual insured losses from natural disasters (including forest fires) were in the $3 to $4 billion range. The insured losses from Hurricane Hugo, which made landfall in Charleston, South Carolina on September 22, 1989, exceeded $4 billion (in 1989 values). It was the first natural disaster in the United States to inflict more than $1 billion of insured losses. In the 1990s, the scale of insured losses from major natural disasters changed radically: it grew to $17 billion in 1991, greater than $30 billion in 1992 (with $20 billion from Hurricane Andrew alone), more than $20 billion in 1994 (with $18 billion from the Northridge earthquake alone), and $25 billion in 1999 (mainly due to major storms and floods in Europe).

   Damages reached a new record in 2004 with total financial losses of $123 billion from natural disasters throughout the world. Insurance covered $49 billion of these losses. (6) This upward trend is continuing. In 2005, insured losses from Hurricane Katrina alone are estimated at $45 billion. (7) Worldwide major catastrophes in 2005 inflicted $230 billion in economic damage, $83 billion of which was covered by insurance. (8) Figure 1 depicts the upward trend in worldwide insured losses from catastrophes between 1970 and 2005 in 2005-indexed prices. (9)

   Table 1 shows the twenty most costly catastrophes for the insurance sector over the past thirty-five years in 2005 dollars. With the exception of the terrorist attacks of September 11, 2001, all of the most costly events were natural disasters. (11) Among these natural disasters, more than 80% were weather-related events: hurricanes and typhoons, storms, and floods constituted nearly three-quarters of the claims emanating from the United States. The era we have now entered is best illustrated by data showing that of the twenty most costly events over this thirty-five-year period, ten occurred during the past five years.

   The insured losses from Hurricane Andrew in 1992 and the Northridge earthquake in 1994 led insurers and reinsurers to pay much more attention to the catastrophic potential of natural disasters. These two events, considered the first two super-catastrophes (insurance losses above $10 billion), caused insurers to reflect on what constitutes an insurable risk. To assist them in making this determination, many firms began utilizing catastrophe models to estimate the likelihood and consequences of specific disasters in hazard-prone areas to their insured portfolios. (12)

   1. Insured Versus Economic Impact

      Insurance does not decrease the global losses from an untoward event, but rather spreads its financial impact by enabling those at risk to pay a relatively small premium so that they can be protected against a large loss that has a small chance of occurring. Hence, insured losses...