Insurers' adaptation to climate risk

In 1973, Munich Re, one of the world’s largest reinsurers (key actors in the industry who assume some of the financial risk to which retail insurers are exposed), became the first in the industry to raise the possibility that climate change might present risks to insurers (Munich Re 1973). At the United Nations Conference on Environment and Development in June 1992, insurers were encouraged to support climate change mitigation efforts. For example, Greenpeace’s Jeremy Leggett, with a background in the oil industry, presented the argument that climate change challenged insurers’ capacity to manage risk (Paterson 1999), and that mitigation offered the only viable way for insurers to manage climate risk. Given that insurers maintain substantial financial investments to support their capacity to pay out claims as necessary, Leggett urged insurers to divest from fossil-fuel-intensive investments. Insurers, however, demurred.

Why insurers have not acted already—the views from international political economy and organisational studies

Paterson (1999, 2001) draws on international political economy (IPE) to explain why insurers did not respond favourably to Leggett and why they would in fact be unlikely to take strong action on climate change. Paterson (2001) argues that the industry has considered climate change a threat to itself that is manageable—in part because it considers itself as having at its disposal two apparent opportunities for limiting its own exposure to climate risk. The first strategy relates to system prediction and the potential for better prediction of extreme weather events over periods of 12—18 months, roughly congruent with standard reinsurance contract periods. This could allow reinsurers to increase premiums prospectively or limit exposures to large claims—by declining coverage in some years, for example. This approach is problematic, even where technically possible. First, market expectations limit insurers’ capacity to move in and out of markets at will—doing so undermines insurers’ reputations for dependable risk management. Second, regulatory frameworks are also constraining: transferring and pooling risk is a key function in modem economies, and commercial insurance markets are heavily regulated to ensure ongoing access to insurance.

The second strategy relates to insurers’ capacity to carry climate-implicated risks. For example, catastrophe bonds and other insurance-linked securities are financial instruments that allow climate risk to be shifted outside the insurance system and onto capital markets (Cabral 1999; Guy Carpenter & Company LLC 2007; Tynes 2000). In the case of catastrophe bonds, a ‘special purpose vehicle’ (SPV) is created, which enters into a standard reinsurance contract with the insurer (or other risk carrier). Investors may then purchase bonds from the SPV, which invests the principal amount in low-risk money market instruments.

Investors then earn premiums and interest on the investment. If no catastrophe occurs, the principal amount is repaid to investors. If a catastrophe occurs before the bond matures (usually after three years), however, the principal amount is used to cover the costs of the insurer and payments to investors may be reduced or even terminated (Entropies Asset Management AB, n.d.; Tynes 2000). This strategy’, in short, provides a way to spread financial risks that are traditionally managed within the industry to the substantially enlarged pool that capital markets provide.

Herbstein (2015) complements the IPE account of insurer inaction with a perspective that draws on organisational studies (e.g., March 1991). Herbstein (2015) argues, with reference to underwriting, that organisations can be expected to fully exploit strategies with which they are familiar before exploring alternative approaches. As an example, Herbstein (2015) identifies defensive underwriting, i.e., increasing premiums, tightening policy conditions and withdrawing cover, as a tried and tested approach that insurers will continue to employ’ prior to contemplating alternative approaches with which they have little or no prior experience (see also Herbstein et al. 2013). With reference to investment, Herbstein (2015) identifies a number of constraints on insurers’ capacity and willingness to divest from fossil-fuel-intensive investments, as Leggett had proposed in 1992. Constraints centre on the obligation of commercial insurers to continually’ maximise returns to shareholders and the intricacy of insurers’ relationships with businesses in the fossil fuel sector—as insurers, as investors and, in turn, as investees. As the size of the industry’ suggests, insurers have become located centrally and deeply in the fossil-fuel-dependent global economy, and have reaped financial reward accordingly.

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