Impacts of Climate Change
The increase in extreme weather events is particularly relevant for insurance companies. According to the reinsurer Munich Re, weather-related natural catastrophes have caused losses of around USD 4.2 trillion worldwide since 1980. Indirect losses such as the interruption of supply chains, credit defaults at banks or the curtailment of power plant production during heat waves are not included in this figure.
The amount of damage caused by extreme weather events fluctuates from year to year. The insurance industry's Natural Hazards Report 2020 puts the property damage caused by storms, hail, floods and heavy rain in Germany in 2019 at three billion euros. The long-term average is 3.7 billion euros.
Climate change is not the sole cause of the increase in financial losses due to extreme natural events. The general increase in insured values also plays an important role. Accordingly, insurance payments will probably not only be higher, but also claimed more frequently.
However, there are also gaps in insurance coverage in Germany. The insurance density for storm and hail insurance is 94 percent. For natural hazards such as flooding or heavy rain, however, it is only 43 percent for building insurance and only 24 percent for household insurance. Yet the demand for natural hazard insurance has risen significantly in recent years. In 2002, the share of residential buildings with such policies was only 19 percent.
Surveys show, however, that risk awareness among the German population is not yet sufficiently pronounced. This can become a problem for the insurance industry. Only if awareness of climate risks is broadly anchored and, as a result, many people take out insurance can sufficiently large risk communities be formed for insurance to ensure that insurance premiums are affordable.
For insurance companies, the increase in losses from natural hazards is a major challenge, especially due to the uncertainties associated with climate change regarding the occurrence of extreme weather events. A linear projection of extreme weather trends does not provide sufficiently reliable estimates for the future. This makes it difficult to calculate insurance premiums. Advances and innovations in data availability, modelling and risk assessment are therefore of central importance for the insurance industry.
Due to the additional climate risks, this may lead to an increase in insurance premiums under certain circumstances. Insurers and policyholders should be able to counteract this by taking timely adaptation measures. Nevertheless, the general insurability in particularly exposed locations may increasingly be called into question due to excessively high loss potentials. This in turn has implications for the public sector as the "insurer of last resort", which would have to step in - in addition to damage to public infrastructure, the costs of disaster management and, for example, the reconstruction of flood protection.
So far, the extent of climate impacts in Germany is considered to be largely manageable for insurance companies. Thanks to a well-functioning reinsurance market, the insurance industry can cope well with the impacts of extreme climatic events. If insurance companies increasingly operate on global markets, there is a higher risk that they could also be affected by the impacts of global climate change.
Indicators from the monitoring on the DAS: Claims ratio, combined ratio in homeowners’ comprehensive insurance, Incidence of storms and floods
Climate-related risks have become increasingly important for the banking industry as a lender, investor and advisor to investors in recent years. These risks manifest themselves in different ways. For example, extreme weather events can cause damage and longer-term production losses in companies to which banks have lent or in which they hold shares. This can lead to loan defaults and higher refinancing costs. Investors will also experience yield losses due to declining corporate profits and the reduced overall value of the company.
For internationally active companies, there is also an increased risk of disruptions in the supply chain due to climatic events in other regions of the world. This can also lead to production delays or failures with a corresponding loss of return.
Lenders can protect themselves against possible climate risks by taking out appropriate insurance. The review of relevant insurance policies is thus gaining in importance.
The so-called transition risks are becoming increasingly relevant. Regulatory interventions in the course of ambitious climate protection efforts as well as changes in the economic structure, such as a switch to renewable energies and more sustainability, increase the danger of "stranded assets", i.e. the loss of value of assets on the balance sheets of the banking industry. This increases the requirements for the valuation of investments, especially for long-term investments, for example infrastructure projects, as climate risks will have to be taken into account to a greater extent in the future. Investments in projects or companies severely affected by climate change could therefore decrease in the future.
Reputational risks associated with investments in climate-damaging projects also play an increasing role for the financial sector.
Adaptation to Climate Change
A valid data basis is necessary for active management of the increasing climate-related uncertainty factors. This enables future risks and potential losses to be assessed and appropriate premiums to be set. Various climate change information systems provide region-specific data. These can help to improve the assessment of local risks.
In addition, incentives for risk reduction can counteract the increasing incidence of damage. To this end, it is important to increase the population's awareness of the changed hazard situation, for example through information and education campaigns as well as targeted advice to policyholders.
In addition to information campaigns, flexible premiums can motivate policyholders to take adaptive measures, such as premium discounts for precautionary measures. In the case of particularly high risk potential, deductibles, fixed maximum amounts or restrictions on insurance cover can also create additional incentives to reduce the individual risk.
In addition, an increase in equity capital may be necessary to ensure the solvency of insurance companies in the event of increasing claims.
Another possibility for the insurance industry is the development of new financial market products that spread climate risks of policyholders such as companies or municipalities on the capital market. Examples of this are weather derivatives or catastrophe bonds.
Further market opportunities are opened up by insurance cover for products or technologies that are becoming increasingly important in the wake of climate change, for example wind power plants.
Insurance companies can also increase their adaptability by cooperating with other players. For example, insurers, reinsurers, environmental associations and scientists have joined forces in the Munich Climate Insurance Initiative (MCII) to jointly develop strategies for dealing with the risks of climate change.
Capital providers should work to ensure that climate risks become an integral part of investment decisions. Potential investment objects should be subjected to a systematic climate risk assessment. A reliable information base and comparable methods are therefore necessary for the assessment of such risks.
The non-profit organisation Carbon Disclosure Project (CDP) can be mentioned as an example in this context. It is supported by numerous institutional investors and advocates the disclosure of climate risks and environmental data in order to improve risk management. The number of companies participating and reporting their non-financial climate risks now exceeds 8,400.
The G20 Financial Stability Board also established the Task Force on Climate-related Financial Disclosures (TCFD) following the 2015 Paris Climate Change Conference to develop voluntary, standardised disclosures on climate-related financial risks that companies can use to provide information to lenders, insurers, investors and other stakeholders. In 2017, it presented its recommendations.
The EU has since taken steps to transform the Task Force's proposals into national law and thus build sustainable financial systems. In addition to a uniform EU classification system for green activities ("taxonomy"), this also includes, among other things, an EU standard for green bonds.
The German government has set up a Sustainable Finance Advisory Council in 2019 to advise it on the development and implementation of its Sustainable Finance Strategy. This strategy aims to support the financial sector in aligning its activities with the achievement of the UN Sustainable Development Goals and the targets of the Paris Climate Agreement, in order to mitigate climate-related risks to the economic and financial system.
Regulators such as Bafin and Bundesbank will conduct climate stress tests in the future to provide guidance to companies on how to deal with the increasingly important climate and sustainability risks.
With a "Climate Self-Commitment", the German financial sector committed in mid-2020 to aligning its monetary transactions with the goals of the Paris Climate Agreement. In future, the institutions want to measure and reduce the emissions associated with their loans and securities transactions. This is intended to make a contribution to climate protection and support sustainable and future-oriented further development of the economy.
In addition, it is possible for investors, who can exert influence on companies through bonds and shareholdings, to actively demand a risk-conscious corporate policy.
Climate change also opens up new business areas for the banking industry. Climate-friendly financial services and investments in innovative climate technologies can be mentioned here as examples.