Scholarship runner up Michaela Dolk explores re/insurance transformation

IAG Flood Analyst Michaela Dolk was one of two runners up in the 2021 Aon Scholarship. The topic of her essay below is 'A Transformation of Re/Insurance: Responding to the Climate Emergency'.

As an investor with a capital pool exceeding $30 trillion [1] (almost a third of the estimated $100 trillion global assets under management [2]), and an underwriter with premiums exceeding $5 trillion [3], the re/insurance industry has a crucial role to play in responding to what has been declared a 'climate emergency' [4].

Where the industry will be in 2050 is yet to be determined — it could be looking back with pride on a transformation that facilitated climate change mitigation, or it may be facing existential concerns stemming from a deterioration of insurability and a broader economic breakdown.

Several pathways have been mapped out, ranging from early action scenarios where warming is limited to well-below 2°C, through to 'business-as-usual' scenarios where warming far exceeds 3°C [5, 6, 7].

The actions (or inactions) of the re/insurance industry will be highly influential in determining which pathway is ultimately followed.

Although both investment and underwriting actions will be important, the focus of this paper is mainly the ‘underwriting side’ (Section 1), since it is currently lagging behind the ‘investment side’ in its response to the climate emergency.

As part of an underwriting transformation, re/insurers will need to consider: i commercial implications and enterprise-wide realignments (Section 2); ii the technical expertise required to facilitate the transformation of underwriting (Section 3); and iii how underwriting can shape the industry’s contribution to broader societal adjustments to the challenges of climate risk (Section 4).

While the transformation ahead may seem daunting, the disruptions of 2020 provide important learnings and encouragement (Section 5).

1. Underwriting: realigning the 'forked tongue'

Amanda Blanc, Group CEO of Aviva, has warned the insurance industry not to 'speak with forked tongue' [8] on climate change by having an inconsistent approach to climate change action between its investment portfolios and the products it sells.

According to Blanc, 'the underwriting needs to catch up with the investments'. This entails shifting to a net-zero underwriting model, alongside efforts to better reflect climate risks in underwriting and to develop sustainable products. 

1.1 Net zero underwriting

The shift to a net zero underwriting model is still in its early phases. Some recent progress has been made, with an underwriting carbon footprinting methodology published in April 2020 [9].

However, the industry needs to make progress towards implementing such methods and using insights derived therefrom to steer underwriting portfolios.

According to ShareAction’s May 2021 report, less than 5 per cent of surveyed insurers have set net-zero targets for underwriting, and only a third refer to underwriting in their climate policy [10].

Initiatives such as the Net-Zero Insurance Alliance launched in July 2021 [11], will support the shift towards more widespread adoption of net-zero targets.

A move towards net-zero underwriting will involve a shift away from clients with high carbon footprints.

In Australia, several insurers have already moved to restrict underwriting of fossil fuels, yet targets vary substantially between insurers.

IAG committed to cease underwriting entities with fossil fuel extraction contributing more than 30 per cent of the entity’s activities and entities using thermal coal for more than 30 per cent of electricity generation by 2023, with this commitment not applying to supporting businesses that supply, transport, or distribute services to these entities [12].

Suncorp set a target to phase out underwriting thermal coal, oil and gas by 2025 [13] and QBE has moved to phase out insurance for companies with more than 30 per cent of revenue or 30 per cent of power generation from thermal coal, and, from January 2030, companies with more than 60 per cent of revenue from oil and gas extraction that are not on a pathway consistent with achieving the Paris Agreement [14].

These targets have received substantial criticism from investor activist group Market Forces, who argues that they have 'glaring gaps' [15].

Indeed, a comparison with the underwriting policies of other re/insurers around the world highlights room for improvement in targets of Australian insurers, though political dimensions need to be considered, given recent public inquiries [16].

For example, Aviva is targeting net-zero by 2040 and uses a 5 per cent revenue threshold criteria for coal and unconventional fossil fuels business [17], and Generali includes a combination of absolute, relative and expansion criteria consistent with the Global Coal Exit List [18, 19].

Yet with the exit of major re/insurers from fossil fuel insurance, the fossil fuel industry is likely to seek alternative risk management options, for example the mutual planned by Australian coal mining companies [20].

Thus, it is essential to also consider other approaches, in addition to underwriting restrictions, to encourage the transition away from carbon-intensive industries.

Swiss Re has adopted a hybrid model of exclusion and engagement, restricting coverage for the 10 per cent most carbon-intensive oil and gas producers, while working with the remaining 90 per cent to support their transition [21].

Such approaches could also be useful for other high-emissions industries, including agriculture and transport, which are currently receiving less attention in re/insurers’ climate policies [10].

Underwriters can also support decommissioning of emissions-intensive assets, for example through surety insurance covering reclamation [22].

The shift towards net-zero underwriting will be aided by growth in low-carbon and net-negative industries, with re/insurers playing a crucial role in supporting this growth.

For example, Swiss Re’s solar irradiation index-based insurance supports scaling of solar generation [23], carbon capture.

Storage insurance products being developed by Zurich Insurance will cover physical and legal risks [24], and Munich Re’s tailored warranty insolvency protection products lower the cost of capital for solar by including a double trigger that enables the insurance to effectively be passed on to the registered buyer in the event of a solar manufacturer’s insolvency [25].

For newly emerging industries, a lack of historical data for risk assessment may present underwriting challenges, and engineers will need to be engaged to develop necessary expertise.

Re/insurers that develop on-the- ground experience early are likely to reap benefits as markets mature [26].

In supporting the shift towards a greener underwriting portfolio, some re/insurers are setting underwriting targets for low emissions industries, for example RSA’s 50 per cent minimum threshold for renewable energy within its energy underwriting portfolio [27].

1.2 Capturing climate change risks in underwriting

The physical, transition and liability risks associated with climate change pose significant challenges to underwriting.

The relative weighting between these is likely to differ depending on the extent of global warming, with physical risks becoming more severe under a 'business-as-usual' scenario.

Physical risks are first-order risks which arise from weather-related events [28].

Climate change is resulting in unprecedented extremes in the frequency, severity, timing, geographical distribution and clustering of events [29].

Property underwriters need to be aware of these changes, and consider the degree to which physical climate change risk is captured within catastrophe model calibration.

Models calibrated using long historical records (e.g. tropical cyclone models) may not represent present-day risk due to climate change trends during or following the calibration period (30).

Due to potential changes in teleconnections and clustering of events, there is a need to develop new modelling approaches that better represent risk interconnectedness, since traditional methods that consider individual perils/regions in isolation are likely to underestimate portfolio risk [31].

A new generation of global climate-connected catastrophe models are emerging, such as Reask’s global tropical cyclone model [32], but models that accurately capture the inter-dependencies between the full suite of climate-related perils are yet to be developed [33].

Physical climate change risks may also impact life and health re/insurers, with climate change driving shifts in the geographical distribution of vector- borne diseases, more severe heatwaves that impact mortality, and increased bushfire risk affecting respiratory health [34].

Transition risks arise from the transition to a lower-carbon economy [28].

Most transition risks affect a re/insurer’s balance sheet on the asset side, but some may impact the liability side too [30].

Increased adoption of green technologies creates new risks, such as fire and explosion risks from electric car batteries [35], and can compound physical risks, as illustrated by elevated hailstorm claims sizes in regions with widespread use of solar panels [36].

Liability risks stem from climate change-related litigation, which may be brought due to failures to mitigate or adapt to climate change, or to comply with climate change-related regulations or legislation [28].

Re/insurers’ exposure to such risk may be through litigation brought against them, as well through both their investments and policies they underwrite.

Underwriters need to keep abreast of the shifting litigation risk environment, with a recent escalation in climate-related litigation targeting a wider variety of entities and using a more diverse range of arguments, including fiduciary duty [37].

In an environment of changing physical, transition and litigation risks, underwriters need to respond by leveraging underwriting rules, pricing, and policy wordings.

With the annual insurance renewal cycle, pricing needs to be dynamically adjusted to reflect the present-day risk over the coverage period.

In cases where climate change uncertainties impede underwriters’ ability to properly model and price risk, they may consider adding a large margin to the premium to allow for the uncertainty or withdrawing capacity (38).

Withdrawal of capacity may also occur in cases where risks are considered too high to be profitable to insure at affordable prices.

Examples of this are already occurring, with California regulators deciding to impose a one-year moratorium against non-renewal of residential property insurance policies after a large increase in insurers refusing to renew policies in response to increased wildfire risk [39].

Underwriters may also respond through changes to policy terms and conditions. For example, pollution exclusionary language may be used to restrict coverage for climate change litigation risks under D&O policies [40].

1.3 Underwriting a new suite of sustainable products

The transition to a greener economy is creating opportunities for re/insurers to develop innovative products to meet evolving demands.

These products include not only risk transfer solutions for low- carbon technologies (see Section 1.1), but also other products aimed at encouraging sustainability and resilience [22].

For example, several US insurers have introduced premium discounts for hybrid and electric vehicles [41, 42], and Suncorp has introduced Build it Back Better property resilience funding for customers with eligible claims [43].

2. Commercial transformation: the ship of Theseus

According to the UK’s Prudential Regulation Authority, 'there is potential for climate change to present a substantial challenge to the business model of insurers' [28].

Climate change-induced changes to loss frequency and severity will impact premiums, loss ratios, reserves, capital requirements, and reinsurance needs, and necessitate strategic responses to shifts in demand, insurability and risk appetite [7].

It will be important for insurers’ climate strategy to be well-aligned with their commercial strategy and integrated into all aspects of the business.

The Task Force on Climate-related Financial Disclosures recommendations provide useful guidance in this respect, covering not just metrics and targets, but governance, strategy, and risk management too [44].

Just as old planks of the ship of Theseus needed to be replaced with new ones to keep the boat afloat, all enterprise functions need to undergo transformation to ensure alignment with climate and commercial strategies that will enable ongoing commercially viability in a future governed by climate change.

Functions undergoing transformation include:

• underwriting and pricing (see Section 1)
• capital management (incorporating climate risk into capital decisions, with a regulatory shift underway to include climate change in calculation of solvency capital requirements [45]
• investment (integrating climate risk into investment decisions, with several insurers committing to making their investment portfolios carbon neutral, through coalitions such as the Net-Zero Asset Owners Alliance [10])
• claims (adapting to increased claims from more frequent and/or severe events, and shifting towards environmentally sustainable claims servicing models, for example Aviva’s approach to restoring rather than replacing carpets, which reduces carbon emissions by an average of 35 per cent per claim [46])
• reinsurance (restructuring vertical and horizontal programs due to changed severity and frequency of loss events)
• risk management (adopting forward-looking stress and scenario tests to manage physical, transition and liability risks)
• Human resources (recognising the importance of climate change reputation for attracting and retaining talent, and aligning employee incentives with climate objectives, for example AXA’s integration of performance on the Dow Jones Sustainability Index into executive compensation [47]).

3. Technical imperatives: Scientia potentia est

In an industry that prides itself on its technical understanding of risk, knowledge will be a source of power in the climate change transformation.

Technical progress in modelling will be necessary to support efforts to understand the impacts of climate-related risk on re/insurers, with 'expertise in modelling climate-related risks in its infancy' [5].

There is a need for incorporation of forward-looking information in catastrophe modelling; improved methods for modelling climate change-affected secondary perils such as bushfire that leverage advances in data science, computing and remote sensing; and further development of open-source loss modelling frameworks such as Oasis that support smoother collaboration between industry and academia [33, 48].

Technical advances will also be critical for product innovation.

New sensor technologies will enable the development of parametric products that enhance climate resilience, for example index-based hail insurance products developed using Hailios’ new hailstone sensing technology [49].

4. Societal implications: insurance as a 'fulcrum'

The insurance industry is a 'fulcrum institution', with the power to influence how society mitigates and adapts to climate change [50].

To help mitigate climate change, re/insurers can steer their investment and underwriting portfolios towards a net-zero model (see Section 1.1).

It is important that this is done in a way that ensures a ‘just transition’ across society. However, most insurers are not yet addressing social dimensions and the need for a ‘just transition’ in their investment policies [10].

Product innovations may also support a ‘just transition’, such as insurance products for workers from carbon-intensive sectors adversely impacted by the transition [22].

Facilitating adaptation Insurers also have an important role in facilitating climate change adaptation, by providing financial protection to customers from the impact of climate risks.

Maintaining insurability will be crucial to ensure that the industry can continue to serve this function.

As insurers reprice or restrict coverage to limit their own climate risk exposures, societal challenges may arise if people are no longer able to affordably obtain insurance.

In this context, it is imperative for insurers to work with governments and communities to help mitigate risk by drawing upon their risk expertise, for example by informing land zoning regulation and building codes [51].

The democratisation of risk knowledge (for example, through initiatives such as those of First Street Foundation in the US [52]), is important for improving society’s understanding of risk.

Information shared should incorporate a forward-looking approach, with transparency today potentially also helping to protect the industry should difficult questions around insurability arise in the future.

Insurers may need to collaborate with governments on the development of risk pools for perils and regions that face insurability challenges.

The industry can also have a role in developing innovative risk transfer programs, such as the 'climate proofing' catastrophe bond for the Philippines [53], and more novel ideas including climate change attribution-based pricing models [54] and parametric structures that use wellbeing-based metrics [55].

5. Learnings from 2020

The resilience of the re/insurance industry and the global economy have been 'put to the pandemic test' by COVID-19 [56].

There are some key learnings that can been taken from the outcomes of this test as the insurance industry considers its approach to other systemic risks, including climate change.

One learning will be the importance of disciplined risk management. Use of exclusionary wordings by several Australian insurers based on reference to the repealed Quarantine Act rather than the Biosecurity Act that replaced it, represent an example of a 'costly and unacceptable' failing [57].

The insurance industry needs to learn from this incident, for example when reviewing its approach to exclusionary language for climate risk in liability policies.

A more positive learning is that the industry has an ability to respond quickly and with agility to changes in the risk landscape and industry and societal needs.

There has been an acceleration of digitisation, and the development of innovative risk transfer solutions, including Sompo’s parametric pandemic insurance product triggered by civil authority restrictions [58] and a Live Events Reinsurance Scheme supported by Lloyd’s [59].

Although climate change is regarded as a slower onset risk, the potential for fast transformation witnessed in response to COVID-19 provides hope for the re/insurance industry’s ability to respond at pace to the climate emergency.

The path ahead With COP26 in November, the world is at a critical junction.

Actions of the re/insurance have the power to significantly influence the future of the globe’s climate.

To ensure that the industry finds itself in a commercially sustainable risk environment in 2050, it is imperative that it achieves net-zero across both investment and underwriting portfolios as soon as possible.

This requires a transformation of underwriting, supported by enterprise-wide changes in commercial practices, technical advances, and an evolution of the societal role of re/insurers.

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