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Climate change and insurance

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Climate change and insurance: strategies to provide financial protection to the general public against catastrophic risks
Philippe Legault Michaud for OMA Insurance
4/3/2017
Multiple studies published in peer-reviewed scientific journals show that 97% or more of climate scientists agree: climate-warming trends over the past century are very likely due to human activities.¹

​The socio-economic impacts of climate change are countless: the droughts, hailstorms, floods, mudslides, heat waves and other types of catastrophes around the world claim thousands of lives and cost tens of billions of dollars every year. Nearly every industry must adapt to its direct or indirect consequences. This is especially true for the insurance industry: weather-related losses accounted for 88% of all property losses paid by insurers from 1980 through 2005, costing more than $320 billion.2

This article discusses the impact of climate change and the strategies that are available to provide financial protection to the general public against catastrophic risks.

The Outlook F​​or Climate​​ Change In Canada

Canada is more exposed to the effects of climate change than most countries due to its proximity to the North Pole (global warming is at its worst at the two poles of the planet). The average temperature in Canada has been rising faster than the global average, especially in the northern regions of the country. What impact does this have on our ecosystems and economy?

Imp​act On The Agriculture Industry

Canadian agriculture is a good example of how climate change does not necessarily only have adverse effects. For countries such as Canada, warmer temperatures will provide for longer frost-free seasons, allowing for longer growing seasons. This, along with other factors such as increased soil quality, will contribute to increase the productivity of the land and the variety and profitability of the crops that can be grown.​

Warmer temperatures are also beneficial for livestock production through lower energy costs, lower feed requirements and lower mortality. However, climate change will increase the intensity and frequency of droughts, violent storms and floods, all of which can have a devastating impact on crop yields (as much as 50% of the total Canadian output could be lost due to such events, according to Agriculture Canada).3 Therefore, a bigger slice of a bigger pie will be at risk due to climate change: Canada's production potential could increase, but so would the potential for production losses.

​ Climate change will increase the intensity and frequency of droughts, violent storms and floods, all of which can have a devastating impact on crop yields

Impact ​​On The Mining Sector

The Canadian mining industry employs approximately 50,000 people in primary mineral extraction (and several times that number in downstream activities related to transforming the minerals). The mining sector contributes about $10 billion a year to the Canadian economy. The industry is exposed to many risks caused or aggravated by climate change. Here are some real life examples:

  • Quebec Ice Storm, 1998: the ice destroyed hydro towers and power to multiple mines was lost for up to four weeks, resulting in multimillion dollar losses.

  • Northwest Territories, 2006: ice roads were closed due to an unusually warm winter and diamond mines were forced to transport supplies and equipment by air, costing millions of dollars.

  • Yukon, 2008: heavy rains flooded a large mine's access road and the company operating it had to release excess untreated water into the Yukon river system.

  • Saskatchewan, late 1980s and Ontario, 2005: reduced water levels at several mines due to a long drought forced production to a near standstill.

  • Southern Quebec, recent past: dust suppression regulation forced gravel quarries to slow production after the hot and dry climate reduced the availability of water.

  • Great Lakes, present day: maximum shipping loads are being reduced due to lower water levels, thus increasing the cost of transportation.

Impact ​On Our Forests

Changing climate in an area makes trees weaker (through maladaptation), more prone to sickness, and more prone to attacks by insects and pests. This strongly affects tree mortality and growth rate, to the severe detriment of the logging industry. The risks that trees face are compounded by the fact that dead/unhealthy/dry trees are wildfire fuel. For example, in the case of Alberta and British Columbia, the current infestation of mountain pine beetles is a cause for concern due to their impact on both tree health and wildfire risk.

The negative impact of climate change on tree health is such that Natural Resources Canada expects the annual area burned by wildfire each year to double by the end of the century.4

Natural Disasters In C​anada

The frequency and intensity of natural disasters has been increasing. Out of the top-five costliest natural disasters in Canadian history, four occurred in the past five years.

Case — Impact of Fort McMurray Wildfire

Fort McMurray was the costliest disaster in Canadian history. What does that mean for home insurance premiums? Normally, home insurance premiums tend to increase after large losses (just like car insurance premiums). However, there are several factors that mitigate the possibility of a hike in premiums, even following the biggest disaster in our country's history:

  1. ​Insurance companies do have reinsurance for events like the Fort McMurray wildfire. A significant share (estimates go as high as 85%)5 of the total damages is expected to be paid by global reinsurers to the local insurers, who in turn will cover their policyholders. The Canadian insurance industry is likely to absorb limited amounts of losses and may not need drastic premium increases to recover.

  2. Competition on both the reinsurance and insurance markets will reduce the risk of large premium inc​reases, especially in regions that were not affected by the wildfire and/or are not exposed to that kind of risk. Reinsurers will look to spread their premium increases to various international insurance markets in order not to get priced out of the Canadian reinsurance market. The smaller reinsurance premium increases will provide for smaller insurance premium increases. Insurers will then look to pass on the increase to the areas that are at high risk, while maintaining the best prices for the best risks. This will "encourage" the bad risks to go shopping for insurance and perhaps change carriers. The company will therefore retain the good risks and "send" the bad risks to its competitors. This is why Albertans, who experienced seven of the 10 costliest weather events, are more likely to experience large premium increases than Ontarians. 

     
  3. A large share of the total losses caused by the wildfire is not for property damage. For example, lost production from the oil sands could top 30 million barrels, or $1.4 billion.6 Business interruption losses should not, in theory, impact property insurance rates. Out of the total property damage, 33% of the losses incurred were for commercial property that has distinct pricing from personal property.

Who Pays For Natural Disasters In Canad​a?​

Loss coverage for natural disasters depends on the kind of disaster, the amount of total losses, and the types of losses. The Fort McMurray wildfire was largely an insured event (i.e., most of the 2,400 homes that were destroyed were covered by insurance). On the other hand, the Alberta floods of 2013 really cost $7 billion in damages, but were only insured for $1.7 billion.7 This is because floods are typically not covered by insurance policies. Flooding is a risk that insurers are only beginning to understand, and were not historically willing to insure. Still today only a limited number of Canadian insurers cover overland floods but not in all areas and conditions.

​ Loss coverage for natural disasters depends on the kind of disaster, the amount of total losses, and the types of losses.

Below is a list of other types of perils that are typically excluded from homeowners' insurance policies (source):

  • Damage caused by gradual deterioration/wear and tear (including rust and corrosion).
  • Water damage caused by flood or seepage through cracks of the foundation.
  • Damage caused by the freezing of liquids in plumbing systems (however, in some cases where all the necessary precautions were taken to avoid this, the damage might be covered).
  • Damage caused by the melting or moving of snow or ice.
  • Damage caused by any kind of earth movement, including earthquakes, snowslides, landslides, etc.
  • Damage caused by insects and rodents.
  • Intentional or criminal acts (fraudulent claims).

When disasters occur, insurance companies are the first payers and pay only for what is covered under the policy. Then, the federal and provincial governments, as well as the individual homeowners, are responsible for the rest of the damages.

The provincial and federal governments share the costs of natural catastrophes through the Disaster Financial Assistance Arrangements (DFAA) program, which was created in 1970 and is run by Public Safety Canada. This federal program reimburses the provinces (not the individuals) for eligible expenses and damages resulting from disasters, if they exceed an established threshold. The following are examples of provincial/ territorial expenses that may be eligible for reimbursement under the DFAA, listed on Public Safety Canada's website​:​​​

  • Evacuation, transportation, emergency food, shelter and clothing.
  • Emergency provision of essential community services.
  • Security measures including the removal of valuable assets and hazardous materials from a threatened area.
  • Repairs to public buildings and related equipment.
  • Repairs to public infrastructure such as roads and bridges.
  • Removal of damaged structures constituting a threat to public safety.
  • Restoration, replacement or repairs to an individual's dwelling (principal residence only).
  • Restoration, replacement or repairs to essential personal furnishings, appliances and clothing.
  • Restoration of small businesses and farmsteads including buildings and equipment.
  • Costs of damage inspect ion, appraisal, and clean up.

Examples of expenses that would not be eligible for reimbursement:

  • Repairs to a non-primary dwelling (e.g., cottage or ski chalet).
  • Repairs that are eligible for reimbursement through insurance.
  • Costs that are covered in whole or in part by another government program (e.g., production/crop insurance).
  • Normal operating expenses of a government department or agency.
  • Assistance to large businesses and crown corporations.
  • Loss of income and economic recovery.
  • Forest fire fighting.​

Once the amount of eligible expenses and damages is known, the cost is shared between the province and the DFAA program according to a set formula.

The nominal annual appropriation for the program is $100 million dollars, but the DFAA expects to have total annual costs of $902 million for weather-related events (with $673 million from floods, since the population is largely uninsured) over the next five years. The provinces that have cost the DFAA the most money are Alberta, Saskatchewan and Manitoba, with 82% of the total spending. Almost all of it was caused by flooding.8

The Various Ways Climate​​​ Change Affects Insurance

Warmer climate has many indirect consequences but can generate losses on its own. Sustained heat waves can cause hundreds of deaths (in 1995, 700 people died during a five-day heat wave in Chicago), production losses and equipment breakdowns. In turn, a warmer climate over a piece of land can lead to severe droughts, causing crop failure and wildfire.

Warmer sea surface temperature has been linked to increased hurricane intensity, with the number of category 4 and 5 storms nearly doubling since the 1970s.9 Severe storms and changing precipitation patterns cause wind damage, floods, hail damage, mudslides, power cuts, and so on. Warmer temperature at the poles causes the ice caps to melt, the sea level to rise, and coastal communities around the world to be flooded irreversibly. All of these hazards can cause deaths, injuries, and destruction on a large scale. Insurers taking on these risks need to monitor and predict such events and adapt quickly in order to stay ahead of the curve.

How Insuran​​ce Companies Deal With Catastrophes

​​Reserves

Insurance companies provide for expected losses by taking a portion of each premium dollar and setting it aside to cover for future claims instead of declaring it as profit. These reserves are regulated by governments to ensure each company operates with enough funds to meet all its obligations toward each policyholder. When disasters occur, the reserves are used to pay claims. It is useful to note that in the vast majority of cases, insurance companies insure themselves by buying reinsurance.

​Reinsurance

Reinsurance is basically insurance for insurance companies. It is one of the most commonly used risk transfer mechanisms. Few people know that reinsurers exist and that they are the companies that truly take on the risk from catastrophic events. Climate change is, therefore, a big deal for reinsurers: more natural disasters mean more claims and less profit.

​ ​Few people know that reinsurers exist and that they are the companies that truly take on the risk from catastrophic events.

According to the Office of the Superintendent of Financial Institutions (OSFI) — the Canadian federal regulator of insurance companies and banks — approximately 22% of all premiums collected by Canadian property and casualty insurance companies are used to purchase reinsurance. Local insurers can spread the risk of house fires, floods, etc., over their many thousands of policyholders because most will not have such claims at the same time. The small premiums paid by the masses will cover the large claims of the few. However, if an earthquake levels every single house in a city, local insurers may not have enough reserves to cover such catastrophic claims unless many insurers across the world pay "small" premiums to a global reinsurer to cover for the severe claims of the few local insurers who incur them.

Munich Re, one of the world's largest reinsurers, first warned about global warming in 1973, when it noticed that damages from floods were rising sharply. Munich Re and other large reinsurers are among the leading experts in climate change research. They have access to quality data at the global scale and to the expertise needed to build sophisticated models to assess the importance of the risks, both short term and long term, posed by climate change.

Different reinsurers have different risk models and different opinions on the dollar value of certain risks. They can exchange risks and premiums among each other and even with insurers if they see opportunities caused by mispricing or other strategic errors.a In other words, reinsurers can and will purchase insurance if it is more advantageous than taking the risk themselves.

​Catastrophe (CAT) Bonds

In the past, insurers and reinsurers funded the reserves needed to cover claims (including catastrophes) through collection of policyholder premiums and investment returns. Individuals would pay a premium to an insurance company and, to the extent needed, the insurance company would turn around and pay a premium to the reinsurance company to get protection from r​isks that are too big to take on (such as hurricanes, earthquakes, etc.). After Hurricane Andrew struck in 1992 — devastating parts of Florida and costing an estimated USD $25 billion in property damage in today's dollars10 — the insurance industry came up with a new way of financing the payment of losses due to catastrophes: catastrophe (CAT) bonds.​​

Instead of buying reinsurance for specific natural disasters, insurers issue bonds which pay a high yield to their investors if the natural disaster in question does not occur within a specific period of time (say three to five years). If the disaster does occur, investors lose all or part of their capital, which is used to pay out the claims arising from the disaster. Independent expert firms evaluate the risk of a specific event occurring (and its expected severity) to set the level of returns these bond should pay, and the issuers then go on the road to promote these bonds to potential investors. The result is that the insurance company obtains its coverage from the bond markets instead of the reinsurance market.

From 1992 to 2007, CAT bonds were a rather unknown and obscure method of financing catastrophe risks. However, following the financial crisis and the drop in interest rates, CAT bonds started attracting investors who were looking to increase their returns. CAT bonds, which could pay 6% to 12% annual yield, succeeded in attracting vast amounts of capital that the insurers could use to self-reinsure. This was more cost-efficient than reinsurance. In other words, CAT bonds allow the bond market to act as one giant insurance company, reducing the need for reinsurance.

There are now CAT bonds tied to earthquakes, floods, hurricanes, pandemics, foreclosures and even longevity risk (for pension funds that want to reinsure against the risk of people living too long!). They are issued by insurance companies, reinsurance companies, governments, large corporations and so on. For example, the state of Florida, through an insurance company it runs, used a mix of CAT bonds and reinsurance to buy enormous amounts of coverage (almost $4 billion) at a discounted price, and passed on the savings to individual policyholders. Individuals have reported savings of hundreds of dollars on their homeowners insurance.10

​ ​The state of Florida... used a mix of CAT bonds and reinsurance to buy enormous amounts of coverage... at a discounted price, and passed on the savings to individual policyholders.

Conclusio​​n

Insurance and reinsurance companies, as well as governments and corporations, have adopted creative and innovative strategies to mitigate the impact of climate change and the catastrophes that come with it. Their expert knowledge and their ability to forecast and diversify risks play a significant role in reducing the direct impacts of natural disasters on the general public and our economy. However, with Canada being one of the countries where climate change impact could be the worst, we can expect the frequency and severity of natural catastrophes to rise, especially for floods, heavy storms and wildfires.

Although insurers and governments can withstand the impact of almost any one single disaster without significant impact on property insurance premiums or taxes, withstanding their gradually increasing intensity and frequency will eventually require that individuals share in their cost. The extent to which the general public will have to pay for climate change depends on the type and severity of the disasters, competitive pressures on the insurance and reinsurance markets (including the CAT bond market), and on the measures adopted by governments to protect against the adverse effects of floods, fires, storms, etc.

Such measures are already being developed by both governments and insurers, and include construction standards that are purposely devised to prevent flood damage, reduce the onset of fires and resist severe weather events such as hail storms.


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​​References
1 National Aeronautics and Space Administration. Global Climate Change: Vital​ Signs of the Planet. [Internet]. Washington, DC: National Aeronautics and Space Administration; Last updated: 2017 Feb 16. Scientific consensus: earth's climate is warming. [unknown date]; [about 14 screens]. Available at: https://climate.nasa.gov/scientific-consensus/. Accessed: 2017 Feb 22.
2 Tuft D. Climate facts: global warming heats up the insurance industry. New York, NY: Natural Resources Defense Council; 2007. Available at: https://nrdc.org/sites/default/files/insurance.pdf. Accessed: 2017 Feb 21.
3 Canada. Agriculture and Agri-Food Canada. Impact of climate change on Canadian agriculture. [Internet]. Ottawa, ON: Canada. Agriculture and Agri-Food Canada; Last modified : 2015 Jul 30. [about 3 screens]. Available at: http://www.agr.gc.ca/eng/science-and-innovation/agricultural-practices/agriculture-andclimate/future-outlook/impact-of-climatechange-on-canadian-agriculture/?id=1329321987305. Accessed: 2017 Feb 21.
4 Canada. Natural Resources Canada. Impacts. [Internet]. Ottawa, ON: Natural Resources Canada; Last modified: 2016 Jul 18. [about 4 screens]. Available at: http://www.nrcan.gc.ca/forests/climatechange/impacts/13095. Accessed: 2017 Feb 21.
5 Kading B. Who pays for Fort McMurray? The world, in reinsurance. [Internet]. The Globe and Mail; 2016 Sep 13. [about 4 screens]. Available at: http://www.the globeandmail.com/report-on-business/rob-commentary/who-pays-for-fortmcmurray-the-world-in-reinsurance/article31855545/. Accessed: 2017 Feb 21.
6 Canadian Press. Wildfire loss to oilsands at least 30 million barrels worth $1.4 billion: damage to oilsands projects minimal but analysts say restarting operations is taking longer than expected. [Internet]. Toronto, ON: Canadian Press; 2016 Jun 15. [about 3 screens]. Available at: http://www.cbc.ca/news/canada/edmonton/wildfire-lossto-oilsands-at-least-30-million-barrelsworth-1-4-billion-1.3636716. Accessed: 2017 Feb 21.
7 Kading B. Who pays for Fort McMurray? The world, in reinsurance. [Internet]. The Globe and Mail; 2016 Sep 13. [about 4 screens]. Available at: http://www.theglobeandmail.com/report-on-business/rob-commentary/who-pays-for-fortmcmurray-the-world-in-reinsurance/article31855545/. Accessed: 2017 Feb 21.
8 Story R ; Canada. Office of the Parliamentary Budget Officer. Estimate of the average annual cost for Disaster Financial Assistance Arrangements due to weather events. Ottawa, ON: Office of the Parliamentary Budget Officer; 2016 Feb 25. Available at: http://www.pbo-dpb.gc.ca/web/default/files/Documents/Reports/2016/DFAA/DFAA_EN.pdf. Accessed: 2017 Feb 27.
9 Tuft D. Climate facts: global warming heats up the insurance industry. New York, NY: Natural Resources Defense Council; 2007. Available at: https://nrdc.org/sites/default/files/insurance.pdf. Accessed: 2017 Feb 21.
10 Scism L, Das A. The insurance industry has been turned upside down by catastrophe bonds: investors are flocking to securities that shield risks of hurricanes, pandemics and hackers; reinsurers are suffering. Wall Street Journal; 2016 Aug 8.

 
Footnote
a Strategic error: for example, if an insurance or reinsurance company wants to exit a line of business because it is not profitable at the moment, but another company sees opportunities in the near future (e.g., car insurance and self-driving cars, or mortality/morbidity improvements, etc.), the latter company may want to invest in this line of business, even if at a loss at first, to be in a position to gain expertise, data, market position and hence a strategic advantage to reap future profits.

 
Additional Sources
i Insurance Information Institute. Catastrophes: global. [Internet]. New York, NY: Insurance Information Institute;c2017. [about 19 screens]. Available at: http://www.iii.org/fact-statistic/catastrophesglobal. Accessed: 2017 Feb 22.
ii Catastrophe Indices and Quantification Inc (CatIQ). CatIQ's Blog [Internet]. Toronto, ON: Catastrophe Indices and Quantification Inc. (CATIQ); c2016. Available at: http://catiqblog.blogspot.ca/. Accessed: 2017 Feb 22.