The European Central Bank and the EU’s top insurance body have warned that businesses and households are not sufficiently insured against climate-related disasters, raising the risk of financial instability and economic crises.
A discussion paper issued on Monday argued that catastrophe bonds should play a bigger role in bridging the overall climate insurance gap, while national and European authorities need to encourage uptake of policies to prevent such crises from occurring.
Currently only a quarter of losses caused by extreme weather events are covered by insurance, but with global temperatures rising faster than expected this figure is likely to decrease further unless action is taken. The paper concluded that steps must be taken now to avoid an economic disaster in future years due to inadequately protected populations from natural catastrophes.
“We need to increase the uptake of climate catastrophe insurance to limit the growing impact of natural disasters on the economy and the financial system,” said ECB vice-president Luis de Guindos. “However, to reduce losses in the first place, we must ensure that a smooth and speedy green transition is complemented by effective measures to adapt to climate change.”
Insurance costs rising
Some also shy away from insurance, preferring to rely on government support, said the paper. As natural disasters become both more frequent and more severe, insurance costs are expected to rise. What’s more, some insurers may reduce risk coverage or stop providing certain types of catastrophe insurance altogether, which would widen the insurance gap further, the ECB and Eiopa concluded.
“Insurance plays a major role in protecting businesses and people against climate-related catastrophe losses by swiftly providing the necessary funds for reconstruction,” said Eiopa chair Petra Hielkema. “In order to efficiently protect our society, we need to address the concern of the increasing insurance protection gap by proposing and finding appropriate solutions.”
If losses are not covered by insurance, the speed at which households and firms can resume their activities is reduced, slowing economic recovery. Lasting supply chain disruptions can also lead to spillovers from one firm to another and affect firms’ ability to pay back loans, thereby increasing banks’ exposures to credit risk. Additionally, the financial position of governments may be weakened if they need to provide relief to cover uninsured losses.
Cat bonds part of solution
To foster insurance coverage, the ECB and EIOPA suggest that insurers should design their policies to encourage households and firms to reduce risk, for example by granting discounts for implementing effective mitigation or adaptation measures. To support the overall supply of insurance, the use of catastrophe bonds, or ‘cat bonds’, could be increased to pass on part of the risk to capital market investors.
ECB and Eiopa laid out four levels of action to bridge the insurance gap. As a first line of defence, private sector firms need to take out better insurance policies. International use of public funds, such as for example provided by the EU, is seen as a final backstop. In between as national backstops, such as fiscal buffers and strong incentives to reduce risks. Public-private initiatives such as cat bonds and other reinsurance programmes can also play a role.
Capital market instruments such as cat bonds can complement insurance schemes and help provide prompt liquidity for reconstruction after disasters, it said. Cat bonds were first introduced during the mid 1990-s in the aftermath of Hurricane Andrew in 1992. The global cat bond market had 35.5 billion dollars outstanding at end-2022, compared to 467 billion in traditional reinsurance, and is mostly dominated by issuances covering US-based perils.
Catastrophe losses rising
Swiss Re has estimated global catastrophe losses for last year at 120 billion dollars, well above the past ten-year average of 81 billion. Six consecutive years of above-average losses have driven property reinsurance prices higher in recent years. Howden, an international broker, said European rates had increased 30 percent at the January 2023 renewals.
Finally, national-level insurance schemes could be complemented by an EU-wide public scheme that makes sure sufficient funds are made available to European countries for reconstruction following rare, large-scale climate-related catastrophes.
The joint discussion paper is part of the ECB’s climate agenda and, more broadly, its work to improve understanding of climate-related risk. The paper aims to foster debate on how to tackle the climate insurance protection gap. The ECB and EIOPA will collect feedback on the policy options and also discuss them in a workshop with regulators, policymakers, insurers and academics on 22 May 2023.