The insurance industry needs to think about sustainability through both an underwriting and an investment lens, says ESG analyst Xuan Sheng Ou Yong.
Sustainability issues such as climate change have been gaining more attention among insurance companies since they face a unique set of challenges. Natural catastrophes arguably affect their performance more than that of other financial institutions given their roles as underwriters of property risks and investors in real assets.
Yet, a recent survey found that one-third of regulators did not know how prepared insurers were to respond to the impact of climate change on their financial stability.
On the underwriting side, insurers have to deal with some major issues, including the growing difficulty in modelling the risks from climate-related extreme events. This is partly because the historical probabilities of natural disasters, droughts and crop failures are less and less representative of future probabilities due to climate change.
Common catastrophe models, largely based on historical data, are unlikely to accurately measure risk in a world where the climate behaves increasingly different from the past. These models could conceal the true extent of risk faced by insurers and insureds.
Research by Stanford University recently found that rising temperature trends across the US have contributed to 19% of national crop insurance losses between 1991 and 2017.
To absorb larger losses, or less predictable losses, insurers would naturally have to charge higher premiums. For instance, entering the 2021 wildfire season, the California FAIR Plan, the state’s insurer of last resort, raised its rates for California homeowners on average by 15.6% due largely to greater wildfire exposure. This came on top of a 20% increase 18 months earlier.
This suggests that risk-modelling methods used by insurers will need to evolve and consider emerging climate science to price risk transfer effectively. Failing to do so can cause the insurer’s balance sheet to deteriorate if the company has to pay out more than provisioned.
Climate-inadequate risk modelling may send the wrong price signals. Buyers of insurance could continue activities that are actually facing higher climate-related risks than thought, e.g., buying a house that will soon be flood-prone, or living in an area with higher heat stress. In other words, such an inadequate model may lead to inefficient market behaviour by insurers and insureds.
Besides climate-related issues, another problem insurers face is how to create valuable products for priced-out groups to reduce inequality. Lower income households are less likely to be able to afford health insurance. Rising climate risk could make home insurance less affordable for poorer communities, many of which suffer disproportionately from disasters.
The industry could look at solutions that go beyond traditional risk transfer and risk mitigation to help disadvantaged groups. Solutions could be as simple as offering parametric insurance. These policies pay out after the occurrence of predefined events rather than insuring the full value of losses. This reduces the burden of sometimes lengthy claims processes for these disadvantaged groups and can make coverage more affordable.
Other ideas include offering discounted premiums for flood insurance when low-cost preventive measures are taken or community-based catastrophe insurance programmes.
A third sustainability-related issue concerns the reputational risks that can come from insuring socially harmful (e.g., fossil fuel-intensive) activities.
Climate campaigners have used naming-and-shaming, physical protest and other forms of advocacy to pressure insurers to stop covering polluting industries. In some cases, the campaigners have won – this May 33 underwriters declined to provide insurance to a contractor of a thermal coalmine.
The reputation risk is such that some reinsurers are now going through the tiresome process of examining their treaties for coal exposure.
Insurers are influential investors – US insurers alone controlled USD 7.5 trillion of cash and invested assets in 2020. They can have an outsized impact on the transition to a low carbon economy if they channel their investments accordingly.
Insurance companies employ different strategies when investing their premium dollars. They include liability-driven investing and growth investing.
LDI involves creating a liability-matching portfolio, which combines assets with similar sensitivities to inflation, interest rates and other variables as the liabilities (e.g. life insurance policies). A typical LDI portfolio would include government bonds or high-credit quality bonds to ensure that cash flows and their durations match the requirements of the liabilities.
As investors, insurers could deploy a sustainability lens to their LDI strategies to avoid locking in sovereign or corporate bond issuers whose actions have negative sustainability outcomes. They could also look to buy green bonds, sustainability-linked bonds or other sustainable bonds where they are available with the desired duration and credit quality.
Growth strategies usually involve equities, higher-yield debt and even non-liquid alternative assets such as private equity, infrastructure and real estate. The aim is to grow the value of invested assets over the long term to fund future liability needs.
These strategies can benefit from a sustainable investor lens too. Investments in green buildings, sustainable infrastructure or affordable housing, for example, can have attractive risk/return profiles, while improving environmental or social outcomes at the same time.
Other investments could provide insurers with the ultimate win-win. Insurers can invest directly in real infrastructure improvements that reduce catastrophe risk (e.g., sea walls, levees or, better yet, nature-based solutions such as coral reef restoration, wildfire buffering, forest thinning, etc.). Such investments lower risk and allow for insurance premium savings which can be used to help pay for the cost of the resilience enhancement (see resilience bonds) or enjoyed by the local community.
In summary, insurers must consider both their roles – as underwriters and as investors – in addressing sustainability issues. The challenges can be unique to each insurer, but the key is to understand the issues, identify the risks and opportunities, and work to implement innovative solutions.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.