What’s next for the insurance sector in 2022 | Article

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Climate change and sustainability are key themes

Climate change is at the heart of the insurance sector for many reasons, and it has a profound impact on both the liability side and the asset side of insurance companies’ balance sheets.

The number of natural disasters, such as floods, wildfires, droughts, storms and earthquakes has been increasing steadily over the past decades. Climate change has exposed the vulnerabilities of insurance and reinsurance companies in the wake of rising catastrophe claims through the impact of natural disasters on businesses (business interruption) and homes (property damage and destruction).

We note systemic and aggregation risks

One of the challenges of climate change is the systemic nature of the risks. For example, rising global temperatures increase the number of wildfires, affect crops, can kill livestock, etc. The interconnected nature of the world means that the consequences of natural disasters are spread widely, and multiple claims can be made regarding a single event, called aggregation risk.

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Extreme weather conditions caused by climate change are common. It is no longer just about drought in Africa, but recent floods in Germany, Belgium and the Netherlands have shown us the local nature of climate change here in Europe. The insurance policy of insurers is always based on the experience of past claims, so it is important for them to proactively reassess the risk to be reflected in their premiums. New products can emerge to reflect the complex nature of new risks, and insurers must remain flexible in introducing new underwriting solutions to maintain coverage capacity. Insurance companies are also taking active, climate-conscious action by offering new innovative products to their customers. Whether it’s discounting auto insurance for electric vehicles or providing protection on wind and solar power, insurance companies are taking part in actions aimed at combating climate change. The systemic nature of climate risk makes the need for global cooperation among insurers indispensable. Insurance companies need to study climate risks together to understand them better and provide customers with the best solutions. In September 2021, it was announced that the EIOPA was scheduled to conduct climate stress tests. The European Commission also revealed that the Revision of the Solvency Framework 2 will include a new requirement for long-term climate change analysis as well as possible changes to the standard formula for the DRU.

Another way in which climate change is becoming increasingly important for insurers is the environmental impact of their investments. More and more financial institutions, including insurance companies, are looking to align growing portions of their asset portfolio with ESG’s goals through responsible investments. Across Europe, insurers have invested more than 10 trillion euros in assets, and changes in their investment behavior could have a significant impact on the market. As discussed above, insurance companies are looking to re-risk their portfolio, which is an ideal opportunity to take environmental considerations into account. The opportunities in sustainable investments are endless and any insurance company can find one that suits them. Investing in ESG-related infrastructure debt would be a better choice for insurers’ growing appetite for risk, as it provides portfolio diversification, attractive return on capital, much needed tenure, and at the same time a positive environmental impact. Another good alternative is real estate investing, whether it be directly or through mortgages, specifically social housing and student housing. EIOPA has been mandated by the European Commission to prepare a report by 2023 on potentially environmentally and socially harmful investments for insurance companies with a view to reviewing the standard formula.

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Climate change could ultimately have a negative impact on the catastrophic bond market. CAT bonds offer investors attractive returns and the opportunity to diversify their portfolios with instruments that are generally unrelated to economic and market conditions, and CAT bonds allow insurance companies to transfer some of the risk to investors, reducing their expenses in the event of a natural disaster. If the number of natural disasters continues to rise, the perceived risk of CAT bond investments will also increase, resulting in more difficult conditions for raising funding via CAT bonds and driving up spreads on insurance-related securities more broadly.

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