The role of U.S. insurance regulators in responding to climate change.

Author:Mills, Evan


This article addresses three key issues set forth in the National Association of Insurance Commissioners' (NAIC) Climate Change & Global Warming Task Force charter:

  1. Implications of climate change on the insurance sector

  2. Insurers' knowledge of potential climate change impacts

  3. Recommendations on steps that regulators could take to assure that they are adequately monitoring insurers' activities with regard to managing the financial condition and performance of insurance markets

    The physical and economic aspects of the first question are dealt with in a previous article in the journal Science, and are summarized here. (3) The closely related issue of insurance availability and affordability is handled in depth elsewhere. (4)

    The balance of this article treats the second two questions, and offers twelve specific recommendations for activities in which the NAIC can play a leadership role.

    I. INTRODUCTION: IMPLICATIONS OF CLIMATE CHANGE FOR INSURERS AND THEIR CUSTOMERS A. Property and Business Interruption 1. Liability Risks B. Health and Healthcare Infrastructure II. THE STATE OF INSURERS' KNOWLEDGE AND ACTIVITIES ON CLIMATE CHANGE III. THE ROLE OF INSURANCE REGULATORS A. Stay current on the science B. Require that insurers collect and analyze more comprehensive data on weather-related losses and their insurance implications C. Raise the standards of practice for catastrophe modeling and create a non-propriety modeling and data-collection entity D. Support risk-based pricing based on improved understanding of climate-related risks in combination with insurer accountability and attention to availability and affordability issues E. Promote the development of climate friendly insurance products and premium incentives through model laws and/or regulations F. Take the lead on a coordinated national effort to improve disaster-resilience through the adoption, enforcement, and implementation of improved building codes G. Promote "Rebuilding Right" following losses H. Promote partnerships with policyholders for loss mitigation I. Safeguard reserves and surplus based on an understanding of climate change, and encourage prudent investments in technologies and industries that will be part of the solution J. Communicate industry needs and priorities to federal and local governments with lead responsibility for implementation K. Encourage or require public disclosure of insurer risk analysis of climate change L. Encourage or require insurers to minimize their own carbon footprint IV. CONCLUSION I. INTRODUCTION: IMPLICATIONS OF CLIMATE CHANGE FOR INSURERS AND THEIR CUSTOMERS

    The insurance sector serves as a national and, increasingly, global integrator of catastrophe costs across all sectors of the economy as well as a messenger of these impacts through the terms and price signals it projects to its customers. The insurance sector provides a critical function within the global economy by contributing to peace of mind for homeowners and the levels of certainty and risk spreading that businesses need in order to invest and grow.

    At various points in history, including the Great Dust Bowl of the 1930s, the urban riots of the 1960s, and terrorism today, watershed events or trends ushered in profound structural changes within the insurance industry. While entirely different in their specifics, each of these watersheds had in common an element of acute surprise followed by the subsequent realization that the future would be different from the past. Global warming is the next watershed of this type. The growing destructive power of extreme weather events coupled with increasing insured exposures poses a material financial challenge to insurers. A survey of 139 insurance executives from 21 countries found that natural catastrophes were the number-two top concern and climate change ranked number four (out of a total of 33), while the majority of other concerns (e.g. actuarial assumptions) are arguably also linked to climate change. (5)

    The scientific debate is over, with the Nobel-Prize-winning Intergovernmental Panel on Climate Change, representing the definitive scientific consensus, now using the considered term "unequivocal" in describing its certainty that climate change is here. The economic context has shifted as well; reports like the UK government's "Stern Review" (6) turn on its head the conventional wisdom that taking action on climate change will harm the economy. Companies and investors now increasingly realize that, in fact, it is the lack of action to combat climate change that is the true threat to the economy, while engaging with the problem and mounting solutions represents not only a duty to shareholders but also a boon for economic growth.

    There is growing acknowledgement that the impact of climate change on future losses is likely to be profound. The chairman of Lloyd's of London said that climate change is the number-one issue for that massive insurance group. Europe's largest insurer, Allianz, stated that climate change stands to increase insured losses from extreme events in an average year by 37 percent within just a decade while losses in a bad year could top $400 billion. (7)

    The sky is not falling. The insurance industry can cope, especially if working in partnership with its regulators. While the challenges have been growing, insurance itself has been taking on a broader swath of risks as its appetite has broadened from a "fire-only" industry toward an "all-perils" one. Thus, there are two moving targets: the hazards and the exposure to those hazards.

    Rising weather-related losses are expected (see Exhibit 1), which will have adverse impacts on insurance affordability and availability. In Florida and Louisiana alone, more than 600,000 homeowners' property policies were cancelled or not renewed in 2006. In 2007, Allstate said that climate change prompted it to cancel or not renew policies in many Gulf Coast states, with recent hurricanes wiping out all of the profits it had garnered in 75 years of selling homeowners' insurance. (8) The company has cut the number of homeowners' policies in Florida from 1.2 million to 400,000 with an ultimate target of no more than 100,000, and has curtailed activity in nearly a dozen other states. More difficult to detect than formal withdrawals or price spikes is the "hollowing out" of coverage through increased deductibles, reduced limits, and new exclusions.

    A similar crisis in availability is occurring in many commercial insurance markets such as hotels and oil, (9,10) despite the absence of price regulation for non-household insurance. This suggests that there are factors at work beyond regulatory obstacles that limit price increases, such as the increased unpredictability that climate change has brought to the challenge of modeling and forecasting catastrophic losses. Bermuda-based ACE Limited has remarked that "[r]adical changes in natural catastrophe frequency and/or severity could eliminate certain of our markets through physical damage, price escalation, or regulatory activity ... unpredictability could negate the use of actuarial techniques and undermine our ability to price and risk-manage product offerings." (11)

    The U.S. residual markets (mandated insurance pools) contain about three million customers today, and the number is growing. Left unchecked, even more of the burden will shift to consumers and their governments, and growth of the industry itself could be slowed. As the crisis of insurance availability and affordability deepens, a new study from the U.S. Governmental Accountability Office brought into question the ability of government-backed insurance to provide a reliable alternative. (12) Restriction of insurance (be it publicly or privately underwritten) is often criticized, yet, in some cases, it can also be viewed as a recognition of previously hidden costs and as an indication of society's limited ability to pay its way around the effects of climate change.

    It is sobering to note that the average annual insured losses from weather-related catastrophes now exceed that of the September 11th attacks, and yet they receive only a fraction of the attention. According to Nebraska's late Insurance Director Wagner, loss-ratios in Nebraska due to hailstorms in a bad year are higher than those in New York following 9/11. If we are concerned about terrorism, shouldn't we be equally concerned about global warming and climate change? The U.S. Department of Homeland Security views the risks of hurricanes and terrorism as similar. (13)

    An international panel of insurers released a study in Nairobi stating that the global economic costs of extreme weather events are doubling every twelve years, and that a Probable Maximum Loss (PML) of $1 trillion can now be anticipated. Remarkably, their estimate of PML is up six-fold from just four years ago. (14)

    Climate change, of course, conspires with settlement and land-use planning practices that magnify exposures to catastrophes. What is particularly worrisome is that the trends in human activity and our changing climate are serving to compound one another. One of the U.S. insurance industry's leading catastrophe modelers is currently helping to unravel this attribution puzzle. (15)

    At the most conceptual level seven broad concerns characterize the implications of climate change for insurers and their customers:

  4. magnitude and declining predictability of extreme weather events The rising coupled with rising incidence of coupled losses previously believed to be uncorrelated (e.g. property and health/life), and the obvious conundrum this presents for actuaries and those who must determine the adequacy of loss reserves;

  5. While many who are sanguine about insurers' ability to adapt to climate change predicate their views on the assumption of gradual change, the reality is that abrupt climate change is a serious possibility and can lead to much more traumatic outcomes, as illustrated by the Great...

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