Climate Change and Reinsurance

Climate change is a burning issue in 2022. There is not even an iota of doubt that climate change affects almost everyone in the world in one form or another. However, some industries are impacted more than others. The reinsurance industry is among the ones which are deeply impacted. Climate change has been identified as being among the biggest risk factors for the reinsurance industry. In this article, we will see how the reinsurance industry is affected by climate change.

1. Rising Claims: It is important to understand that reinsurance companies are the most affected when there is a natural calamity or catastrophe in any part of the world. Normal insurance companies underwrite the risks for their policyholders. However, these companies ultimately insure their risks with a reinsurance company. Hence, the reinsurance company is the one that actually has to pay out cash.

   Now, catastrophe modeling is done based on empirical data. This means that the data on catastrophes that have happened in the past is considered to be the basis for the catastrophes which are likely to happen in the future. The problem is that because of climate change, the correlation between past events and future events is reducing.

   For example, the reinsurance industry faced claims totaling to $600 billion between 1980 and 2014. However, the same industry has now paid out claims of over $200 billion in both 2020 and 2021. Hence, the pace at which catastrophes are leading to claim payouts is clearly increasing. Reinsurance companies are seeing a rapid increase in the frequency of raising claims and also the severity with which claims are raised.

   

2. Difficult to Price Climate Change Risk: The reinsurance industry is well aware that they are facing the negative impact of climate change risks. However, they are not able to increase their prices to offset these losses. This is because the reinsurance industry is largely commoditized. Hence, lower premiums are amongst the main ways in which reinsurers attract customers. Hence, if a company raises its premium too much, it will end up losing customers. However, if they do not raise their premium enough their probability will be impacted.

   The problem with climate change is that it is still a nascent phenomenon. Hence, there isn’t enough data available to accurately adjust the catastrophe models in order to include the risks. There are a couple of more factors that make pricing more challenging.

   Firstly, claims related to climate change are sporadic. This means that losses occur suddenly whereas the premiums have to be raised on an annual basis. Also, many steps are being taken to prevent the deterioration of climate worldwide. The degree to which these steps are followed will also have an impact on the actual losses incurred because of climate change. Since almost all the components are unpredictable, adjusting the premiums to deal with this situation becomes quite difficult.

3. Underestimation of Risks: Reinsurance companies pay out a large percentage of their claims when catastrophe hits. Scientific studies have shown that more than 70% of the catastrophes which took place within the past 30 years were impacted by climate change in one form or the other. However, the problem is that the catastrophe data models have not yet been fully adjusted to accurately take the impact of climate change into account.

   If the data for only the past 30 years is taken into account, the risks seem to be far greater than compared to when we take the total available data into account. Hence, there is almost an industrywide consensus that the reinsurance company is underestimating the risks that they have underwritten. The only disagreement is how much the underestimation has been. There are some experts who believe that the reinsurance companies have only accounted for half the risks that they actually face!

4. Volatility in Earnings and Capital: As mentioned earlier, the claims which have to be paid as a result of climate change are sporadic in nature. This means that it is possible that there will not be any claims for many years and then suddenly several claims might arise. The problem with this is that since reinsurance companies cannot further reinsure the risks, they are the ones that have to face this unpredictability.

   The end result is that there is increased volatility in the earnings that reinsurance companies are able to generate. Also, since losses can arise at almost any time, the reinsurers have to ensure that they keep a large percentage of their funds in assets which can be easily liquidated. This creates a situation in which the reinsurance company is not able to completely utilize the capital that they have on hand.

5. Increase in Premiums: Last but not the least, reinsurance companies cannot afford to lose money. Hence, they are likely to increase premiums at a slow rate. Some reinsurance companies have already started increasing their premiums by 3% to 5% every year on account of climate change. This could mean an approximate 100% increase in premiums over the next decade or so. The increasing premiums are causing the size of the reinsurance market to shrink because more and more insurance companies are finding it very expensive to opt for reinsurance.

The fact of the matter is that climate change is a huge factor for reinsurance companies. Also, since it is quite new and unpredictable, reinsurance companies are finding it difficult to tackle the same.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.