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Climate Change and the Insurance Industry

The insured portion of the world's total economic losses from weather-related catastrophes is rising, from a negligible fraction during the 1950s to 25 percent during the past decade, according to a scientist at Lawrence Berkeley National Laboratory's Environmental Energy Technologies Division (EETD). The ratio has climbed more quickly in the United States where more than 40 percent of total weather-related losses were insured during the 1990s.

In an invited "Viewpoint" article published in the August 12, 2005, issue of the journal Science, Evan Mills, an EETD scientist who has worked on the issue for a decade, reviews the evidence that the global insurance industry is paying out more in claims resulting from extreme-weather-related natural disasters. Because climate change could lead to an increase in both large-scale and localized extreme weather events, some insurance companies have called for a better understanding of the risks that climate change poses to their business and to society. Mills' article, entitled "Insurance in a Climate of Change," was part of a special issue of Science on disasters.

In response to industry concerns, Mills studied insurance claims costs from weather-related and other types of catastrophes. In his Science article, he notes that the weather-dependent share of global insured losses (about 90 percent) is even greater than the weather-related losses experienced by the world economy as a whole (about 75 percent).

Figure explaining the climate changes and it's economic impact

Figure 1. Global impacts of natural disasters from 1980 to 2004. Insured property losses are dominated by storm events due to risk selection preferences of insurers, coverage of flood and crop exposures by public entities, and low penetration of earthquake insurance. Economic values are inflation-adjusted to 2004 levels. Source: Munich Re, NatCatSERVICE

"Global weather-related losses in recent years have been trending upward much faster than population, inflation, or insurance penetration, and faster than non-weather-related events," Mills writes. "Specific event types have increased far more quickly than the averages. For example, damages from U.S. storms grew 60-fold to $6 billion a year between the 1950s and the 1990s. As the climate changes, populations are moving more into harm's way, but demographic factors do not appear to explain all of the increase" (See Figure 1).

According to Mills, insurance is the world's largest industry with yearly revenues of $3.2 trillion. If that number were a gross domestic product, insurance would be the third largest country in the world.

Climate Change a Strategic Factor for Insurers

Given the increase in the number, cost, and variability of catastrophic losses, some insurers, reinsurers, and their trade associations now view climate change as a "strategic factor" in charting their futures, Mills says. Particularly vulnerable are emerging insurance markets in the developing world. Insurers see these markets, which already represent $400 billion a year in premiums and are growing several times faster than mature markets, as the future of their industry. Yet these regions are also particularly unprepared for and vulnerable to climate change and its associated weather-related catastrophes.

Insurers from wealthy countries share the risks of weather-related damage to developing countries as these insurers take ownership of insurance companies domiciled in the developing world. Weather-related damage can come from disasters such as flood, droughts, mudslides, and wildfires. Storm surges cause coastal damage, and lightning strikes start fires and damage electronic equipment. Both gradual climate changes and abrupt weather disasters cause property, agricultural, and industrial losses as well as risks to life and health.

In his research, Mills found that 60 percent of total weather-related losses are attributable to small events rather than major catastrophes that make headlines. The insurance industry is vulnerable to weather catastrophes in many ways; property damage is only the most obvious source of claims, Mills says. Weather-related disasters also cause disruptions in business and supply chains, loss of utility service, equipment breakdown arising from extreme temperature events, and loss of data from power surges or outages. Extreme weather events can breach pollution containment, leaving industries open to liability, and power outages can disrupt manufacturing and services.

Mills found that from 1980 through 2004, the global economic costs of weather-related events totaled $1.4 trillion (inflation-corrected), of which $340 billion was insured. "To put the burden of these costs on insurers in perspective, recent average annual losses surpass those experienced in the aftermath of the 9/11 attacks in the United States," he notes.

According to Mills, these numbers are probably underestimates for a number of reasons. For one, damages from small events are rarely captured in global statistics. One claim service that aggregates statistics for U.S. insurers captures only events with costs greater than $25 million. In addition, observed losses would have grown even faster if disaster preparedness and recovery services did not exist.

Possible Threats to the Insurance Industry

The availability of insurance helps economies grow and develop by mitigating risk. But as the nature, scale, or location of hazards changes, the insurance system is threatened, particularly if insurers are unprepared for the scale of what can be perceived as "inconceivable" disasters, Mills says.

As the climate changes, there is the risk that weather-related claims will increase because storms could increase in frequency or intensity, several kinds of damage could result from a single event (for example, simultaneous wind, flood, and storm surge-related damage), and shifts in the spatial distribution of events could expose more property and populations to damaging events. In addition, the diversity and potential magnitude of health-related impacts of climate change are only now being appreciated. Of particular concern are a host of respiratory diseases arising from increased pollens, molds, and particulates mobilized by climate change. Actuarial uncertainty about these health issues can lead to rising insurance prices, reduced coverage, and, ultimately, to the uninsurability of certain hazards.

As a result, insurance premiums might, in some cases, not be enough to pay for claims. In a bad year, weather-related claims plus unrelated claims from earthquakes or terrorist incidents, together with uncorrelated declines in financial markets (where insurers hold their loss reserves), could form the kind of "perfect storm" that drives some insurance companies to the edge of insolvency. When insurers cannot pay, the burden shifts to governments and individuals, neither of which wish (or may be able) to assume the losses.

Historical Role: Prevention

"The good news is that the insurance industry has played a valuable historical role in loss prevention," says Mills. "Insurance companies were founders of the first fire departments, building codes, and auto safety-testing protocols. But the role they will play in climate change mitigation and adaptation remains to be seen."

Mills' Science article documents innovative steps being taken by some insurers to address climate-change concerns. Recognizing that insurance is a tool that helps society adjust to change, risk, and economic loss, Mills believes that insurers have a significant opportunity to become more engaged with the science of predicting the potential impacts of climate change, for example by coupling their existing "catastrophe models" with climate models.

"It's important that insurers, their regulators, and the policy community develop a better grasp of the physical and business risks from climate change," Mills says. "The most effective solutions will require public-private partnerships."

— Allan Chen

For more information, contact:

  • Evan Mills
  • (510) 486-6784; Fax (510) 486-6996

Insurance in a Climate of Change

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