Insurance – bullish on new products but realistic on risks

Severe storms, wildfires, drought – these are all causing the private insurance markets to refuse cover or raise premiums. The announcement last year by multiple companies that they were pulling out of the California market due to wildfire risks is a prime example.

In many instances, insurance is no longer affordable in specific locations, which is impacting the desirability of those locations for both residential and commercial uses. We saw this post-Katrina in New Orleans and, increasingly, we are seeing that Gulf Coast insurance costs may cause business relocations or closures.

But boards are increasingly aware of the rising costs of insurance – there is plenty of evidence that premiums are up – even if they are not as knowledgeable about the impacts of climate change. What is concerning is that the insurance market is itself likely behind the curve when it comes to fully pricing in and accounting for the extent of climate risks many places will face.

What could insurance look like going forward?

In many higher risk locations, we are seeing one of the inherent problems with insurance play out before us. That is the problem of ‘adverse selection’. Economically, adverse selection in the insurance market means that as insurance gets pricier, only the riskiest assets are insured, making the overall pool riskier, driving the price of insurance higher, and again driving less risky participants from the market.

Consequently, you are seeing in the market, self-insurance, limited insurance, higher deductibles, whole new ways of compensating for loss, the possibility of a protection gap and the potential for a structural shift in a traditional industry.

But insurance innovations have the potential to improve the situation somewhat. Parametric insurance can allow for hedges against specific climate disasters. As risk data improves, more bespoke coverage becomes easier to do, helping to reduce costs and risks simultaneously.

These changes are – in my view – the insurance market’s ‘adaptation response’ to the effects of climate change.

What should boards do?

Given these tangible structural shifts in the markets’ approaches to worsening risks, the most important thing a board can do on climate is to stop seeing it as merely a compliance issue. Climate impacts ought to be reflected in reporting documents at a minimum. Board members can add real value by helping a company navigate this emerging time of unprecedented change and uncertainty.

Boards should take a systemic approach to risks, including those in their value chains. It’s easy to view risks in isolation or to draw a narrow perimeter from where everything looks safe. This is a bit like looking at only one mirror while driving. Doing so means you won’t get the full picture; nor will you be able to contextualise what you are seeing.

With global changes like climate or the transition, effects will often correlate and amplify each other. Financial and climate impacts rarely occur in isolation. This can mean that the solutions are more challenging.

Smart boards are educated boards. That is not to say everyone needs to be a climate expert, but board members are intelligent people who are likely to be in those roles because of good decisions made under periods of past uncertainty. The most effective board members look at climate and the transition as massive change management problems.

How can we ensure that we are looking at the right risks, what opportunities do these changes present us, what may we be missing today that we should keep an eye on tomorrow? These kinds of questions create a culture of curiosity from the top that can be reflected throughout the organisation.

And you cannot underestimate the impact of incentives. Boards should ensure the incentives towards good climate risk management are in place. People won’t manage risks if they are incentivised not to do so.

But I am bullish on the evolution of new and innovative insurance products. However, these must be accompanied by effective climate action at both policy and company level. That said, the risks of climate change will continue to rise at least until we hit net zero. That means we are working on managing a problem rather than solving it.

Just like a hole in a dam, our patches will only work in the longer term if we are not continuing to make the hole bigger.