Field of Action Finance and Insurance Sector

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Climate change affects the business risks of insurers and credit institutions.
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Impacts of Climate Change

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Global climate change

Banks and insurance companies operate on global markets. For this reason, these sectors are increasingly affected not only by regional but also global climate changes. As a result of climate change, the risk potential is expanded by extreme weather events, higher temperatures and rising sea levels. Thus, climate risks such as droughts, floods or unstable water availability influence the business risks insurance companies and banks have to face.

 

Insurance industry

Insurance companies are especially affected by the increase of extreme weather events. In 2005, such extreme weather caused global insurance losses of around 96 billion euros. Yet, climate change is not the sole cause of the steady increase in financial losses caused by natural disasters. Also the population growth - especially in large cities in risk areas - as well as the general increase of insured assets plays an important role.

Insurance payments incurred as a result of climate change are likely to be higher and more frequent. In 2011, for example, a single hailstorm in Germany caused damage to commercial buildings amounting to 21.2 million euros and residential property damage amounting to 260 million euros. There was another severe hailstorm in the same year, which also caused enormous material damage.

The increase of damage caused by natural hazards is a major challenge for insurance companies. An additional factor is that climate change increases the uncertainties in terms the occurrence of future events significantly. This makes the calculation of adequate insurance premiums more complicated. Reflections of the past and linear extrapolations of trends alone are no longer able to provide sufficiently reliable estimates for the future. Therefore, progress and innovations in the area of data availability, modelling and risk assessment are of crucial importance for the insurance industry.

Because of the additional climate risks, insurance premiums can rise under certain circumstances. Insurance companies should be able to counteract this effect by taking timely adaptation measures. Nonetheless, the overall insurability in particularly exposed risk areas has to be called into question due to the high damage potential.

So far, the degree of climate impacts in Germany is at a manageable level for insurance companies. If, however, the number of extreme weather events accumulates and insurance values rise simultaneously, insurance companies may have to deal with potential insolvency risks. The state’s final liability should be avoided through fixed maximum liability limits and reinsurances.

 

Banks and investors

In future, climate and weather risks will also play a larger role when it comes to investments. For instance, extreme weather events can cause damage and lead to long-term production losses in companies. Thus, in the case of prolonged flooding of premises, for example, payments to creditors can be delayed or may drop out altogether. In view of listed companies, investors will also face yield losses due to the falling corporate profits and the reduced total value of the company.

International companies face the additional risk of supply chain disruptions caused by climatic events in other regions of the world. This can also lead to production delays or failures entailing significant yield losses.

The increasing climate-related uncertainties also increase the requirements to the assessment of investments. These risks are difficult to estimate, particularly when it comes to long-term investments such as infrastructure projects. Thus, investment decisions are affected by climate risks and borrowers who can potentially be affected by future climate change may increasingly decide not to make such an investment.

Creditworthiness and costs of capital procurement will be critical issues for those companies that are particularly vulnerable to climate change. However, affected companies can adapt to the price, climate and regulatory changes at an early stage and thus stabilise their market opportunities or in some cases even expand them. In addition, investment priorities can shift from climate-sensitive sectors such as water management or tourism to sectors that are less prone to climate impacts. Such changes in investment rates in economic sectors affect the overall economy. Claims can also lead to the insolvency of companies with low equity ratios. In extreme cases, this can have macroeconomic implications.

 

Chances of climate change

However, climate change also offers opportunities for the financial sector. The demand for property insurances covering damage caused by natural hazards will increase. This especially applies to companies in industries whose added value will be particularly affected by climate change, such as the tourism, energy and water sector.  Already today, the insurance density of storm and hail insurances in Germany amounts to 75 to 80 percent. In view of natural hazards such as flooding or heavy rain, however, the insurance density so far only amounts to ten percent. The newly emerging market potential should be tapped.

In addition, climate change offers new sales opportunities and markets for insurances through consulting services focusing on climate change impacts. Also the market opportunities for other climate-related products such as insurance for damages in the renewable energy sector or risk transfer solutions that are used in case of yield losses of the respective facilities (power plants, infrastructure) will increase.

Investments in innovative environmental industries that contribute to climate protection or whose products increase the adaptability to climate change will be particularly profitable for banks.

If you are interested in obtaining information about possible adaptation measures in the field of action finance and insurance sector, please click here.

 

Sources

Adaptation to Climate Change

Insurance industry

An active management of the increasing climate-related uncertainty factors initially requires a valid database. On this basis, future risks and possible damages can be assessed and appropriate premiums can be determined. Risk analysis should take advantage of innovative procedures such as scenario techniques because a simple extrapolation of the statistics of past events cannot adequately display climate change and its consequences.

The German Insurance Association (GDV) has developed a geographic information system for floods, high water and backwater (ZÜRS) to calculate the insurance premiums for building insurances against natural hazards such as floods, hail or storm. Through the use of such information systems, the region-specific data availability can be increased significantly and the assessment of local risks is improved.

In addition, incentives for risk reduction can counteract the increasing damage incidents. For that purpose, it is first important to raise awareness of the changed risk situation amongst the population through information and education campaigns and targeted advice provided to policy owners. Geographic information systems can be used for this purpose, too, as the example ZÜRS public shows.

In addition to information campaigns, flexible premiums such as premium discounts for technical preventive measures against floods in vulnerable areas can motivate policy owners to adopt adaptation measures. Also a mandatory natural hazard insurance – possibly with a graded deductible – is recommended, as these could motivate property owners to implement damage prevention measures. In case of particularly high risk potentials, deductibles, fixed maximum amounts or limitations of the insurance coverage could provide additional incentives to reduce individual risks.

To secure the solvency of insurance companies in case of increasing damage incidents, an increase in equity could become necessary, too. The development of new financial products with which climate risks of policy owners such as companies or municipalities are scattered on the capital market constitutes another possibility for the insurance industry. Examples include weather derivatives or catastrophe bonds.

Insurance protection opens up further market opportunities for products or technologies that become increasingly important in the wake of climate change, for example wind turbines.

Furthermore, insurance companies can increase their adaptability through cooperation with other actors. Thus, insurers, reinsurers, environmental organisations and scientists have established the Munich Climate Insurance Initiative (MCII) to develop strategies to deal with the risks of climate change.

Banking industry

Investors should work to ensure that climate risks become an integral part of investment decisions. Potential investment objects should be subject to systematic climate risk assessments. Therefore, a reliable and comparable information base is necessary for the assessment of such risks.

In this context, it is worth mentioning the Carbon Disclosure Project (CDP) that combines approximately 300 institutional investors, including large German financial service providers. Apart from information on company-specific greenhouse gas emissions, it also provides information on how to deal with the physical risks of climate change. However, also beyond this project investors can assess whether the company in question performs effective adaptation measures to climate change before deciding to invest in companies.

Especially when it comes to companies that are influenced by their investors due to their bonds and investments it is possible to demand a risk-conscious corporate policy. In case of non-adapted companies, investors can thus demand higher risk premiums.

Climate change also provides banks with new business sectors. Examples are climate-friendly financial services and investments in innovative climate technologies.

If you are interested in obtaining information about concrete impacts of climate change in the field of action finance and insurance sector, please click here.

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