Property and Casualty (P&C) insurance companies and bond investors share common exposures to climate risks. While climate event effects and assessment timeframes may differ—insurers focus on possible monetary losses due to property damage or business interruption, while bond investors evaluate potential impairment of a bond issuer’s ability to meet obligations to investors—each is addressing how climate-driven extreme weather events may affect long term business sustainability.

Insurance and Investment Risks Increasing as Climate Changes

The trend in increasing losses due to catastrophic (CAT) storms is at least 20 years in the making (See Figure 1).

According to the “U.S. Life and P&C Insurance 2023 Mid-Year Primer” by CreditSights, a Fitch Ratings affiliated company, “Insured CAT (catastrophic storm) losses in 2022 totaled $132 billion, largely driven by Hurricane Ian and severe convective storm (SCS) activity. Average insured losses reached an all-time high of $86 billion in 2022. The year 2023 is already off to a rough start with leading P&C insurers reporting seasonally elevated CAT losses in the first quarter which were largely driven by severe storms and other non-hurricane events.”

Ceres, a nonprofit organization working with capital market leaders to solve sustainability challenges, recently published reports examining the insurance sector’s responses to climate change. The reports, Climate risk management in the U.S. insurance sector: An analysis of climate risk disclosures (July 2023) and Changing Climate for the Insurance Sector: Research and Insights (August 2023) are available on the Ceres website.

Considering Climate Risks in Insurance and Investing

When insuring against physical or financial loss, insurers primarily assess climate risks related to the potential for physical damage to insured assets over a period defined by an insurance policy term, usually one year. The damage can be caused by anomalous weather-related events including drought-driven wildfires in the western U.S., cold weather in southern states, Midwest flooding, coastal hurricanes, and sea-level rise. Insurers evaluate the probability and likely severity of future events and how they may affect the ratio of premiums charged to claims paid.¹

Investors consider both physical and transitional climate risks as related to the creditworthiness of issuers or projects over the full period until maturity of the bond, which can range as long as 30 years. Physical risks can present an immediate threat to property or human life. Transitional risks include how the bond issuer might mitigate future risks through near-term infrastructure investments, for example. Collectively, these risks may negatively affect an issuer’s ability or willingness to pay principal and interest until the bond matures.

Materiality Can Be an Essential Consideration for Insurers and Investors

The materiality represented by a risk helps define its significance or relevance to financial performance of an insurance contract or the value of an investment. P&C insurers and bond investors consider materiality when assessing climate risks.

For insurers, materiality of climate risk may help to determine whether coverage can be provided on a profitable basis and how it should be priced. For bond investors, climate risk materiality may help determine whether an investment is sustainable over the long term as well as the appropriate price and yield risk and reward relationship.

If climate change risks are deemed material, insurers may adjust underwriting criteria, increase premiums, or impose specific requirements to mitigate the risks. Similarly, bond investors may require a higher yield or a shorter maturity for a bond that is subject to a higher level of climate-related risk. Conversely, for issuers with climate adaptation plans or investments, a bond investor may accept a lower yield or longer maturity based on an issuer’s positive efforts to address climate risk.

Insurers and Investors Find Common Approaches To Integrate Climate Risk in Their Operations

P&C insurance companies and bond investors may employ similar strategies as they assess their climate risks. Among some strategies that have been discussed in company reports and news accounts, for example, are:

• Geographical Risk Assessment: Insurers and investors evaluate geographical exposure of insured properties or bond holdings to climate-related hazards by detailing proximity to coastlines, floodplains, wildfire-prone areas, or other high-risk zones across an underwriting book of business or investment portfolio.
• Risk Modeling: Sophisticated risk models can help insurers and investors assess climate change’s potential impact on specific regions, policyholders, and security issuers. These models consider historical data, climate projections, and other relevant variables to estimate the likelihood and potential losses associated with climate-related events.
• Collaboration and Partnerships: Both insurers and investors collaborate with climate scientists, research institutions, and governmental bodies to gain insights into climate change impacts and mitigation strategies. These partnerships help them refine their underwriting practices and stay informed about the latest developments in climate science.²
• Climate Scenario Analysis: Various tools are available to analyze the evolving changes in climate-related weather events and potential effects on insured assets or bond credit quality. These models project potential changes in temperature, precipitation patterns, sea levels, and other relevant factors.

Underwriting practices can vary between insurance companies, just as investment approaches can vary among bond investors. A commonality among both is an eye toward climate risks as evidenced in increasingly frequent and extreme weather events.

By assessing the significance of climate-driven weather risks in relation to financial performance, insurers and investors can shape underwriting and investment practices, respectively. In addition, they can develop risk management strategies that recognize material climate risks and integrate their consideration in their business and investment operations.

 
[1] To provide a basis for reviewing insurance and investment considerations, one can consider that the Task Force on Climate Related Financial Disclosures (TCFD) set two categories for climate risks: Physical and Transition. Transition risk is defined as the risks stemming from the looming shift to a low carbon economy. including 1) policy and legal risk, 2) technology risk, 3) market risk, and 4) reputation risk. Policy risk can relate to the effect of changing regulations on a business. Technology risks may relate to lagging competitors as adaptations to climate change emerge, such as electric vehicles. Market risk may occur during a shift in commodity demands, declining coal use, for example, that could erode the value of an asset, such as a coal mine Reputation risk may result if business suffers when customers grow concerned about management’s response to climate change. For more on the TCFD, visit https://www.fsb-tcfd.org/. The TCFD distinguishes two types of physical climate risks: acute and chronic. Acute physical risks arise from changes in event-driven hazards, such as an increased severity of cyclones, hurricanes, or floods. Chronic physical risks refer to longer-term, incremental shifts in climate patterns, such as changing annual average rainfall or temperature. Consideration of the TCFD’s approach to climate risk within the insurance context seems appropriate. In its report, “Next in Insurance ESG: A Growing Sense of Urgency,” the accounting and consulting organization PricewaterhouseCoopers International Limited (PwC) noted, “The National Association of Insurance Commissioners (NAIC) released an updated climate risk disclosure survey in April. Survey questions align almost entirely with the Task Force on Climate-Related Financial Disclosures framework. This will result in a significant shift towards TCFD-aligned disclosures for U.S. insurers, forcing carriers to think about climate change in multiple facets of their business and confront how they address it.”

[2] For more insight into our engagement meetings with insurance companies on the topic of climate change, please read Insurance and Climate Change Transition Risk, in our 2022 ESG Issuer Engagement Report. This article explores specific commonalities among insurance underwriting and bond investing regarding the effects of extreme weather that is being more frequently associated with the effects of climate change.

#BCAI-08242023-ojdh2nan (8/30/2023)

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