Climate Change: Insurance Issues
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THE TOPIC
NOVEMBER 2008
There is now a consensus among the scientific community that the climate is changing, with potential risk to the global economy, ecology, and human health and well being. But how much of this is due to natural phenomena and how much to the effects of human activity is a matter of debate. Also unknown is the extent to which weather patterns have already been affected.
As assumers of risk, insurers seek to mitigate potential losses every day through a process known as risk management. Since climate change could lead to losses on a scale never before experienced, insurers are not waiting for researchers to produce all the answers. A 2007 report by Ceres, a network of companies concerned about global warming, identified some 190 insurance-related organizations in 26 countries that were working to find solutions to the threat posed by greenhouse gases emissions. Insurers are also redoubling their efforts in the more traditional areas of risk management, including alerting policyholders to the potential for lawsuits for failure to protect against or disclose possible harm to the environment.
Meanwhile, society’s concern about climate change offers insurers new avenues for leadership and new opportunities for innovative products.
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RECENT DEVELOPMENTS
- Pay-As-You-Drive (PAYD) Auto Insurance: Pay-As-You-Drive is a type of auto insurance where the actual miles driven has a greater impact on the cost of insurance than a traditional policy. In California the insurance commissioner has proposed amending the Insurance Code to enable insurers to offer a PAYD option based on verification of actual mileage. Currently, mileage is estimated by the policyholder before the policy is issued. With PAYD, the policyholder agrees in advance to have the miles driven verified at the end of the policy period and the premium adjusted retroactively if justified under the terms of the policy. Under California’s auto insurance law the number of miles driven annually is the second most important factor in setting auto insurance rates—the policyholder’s driving record is the first. A 2006 California Insurance Department study found that 56 percent of policyholders underreported mileage. Insurers generally favor the PAYD concept.
- The measure would accomplish two goals. The first is fairness—people who drive fewer miles and are thus exposed to fewer accidents will pay less for their insurance. The second is a reduction in traffic congestion and greenhouse gas emissions because there is an incentive to drive less. The proposed regulation was drafted following passage of PAYD legislation in the California Assembly and in the Senate Appropriations Committee. The amendments will take effect after a period of public comment, no later than the fall of 2009. Insurers are suggesting that they be allowed to verify mileage by a greater variety of methods and that the insurance department adopt new regulations that expand the PAYD program to take into account when miles are driven, how miles are driven (speed etc.) and the road conditions drivers encounter.
- A report by the Brooking Institution’s Hamilton Project estimated that if auto insurance premiums in California were based on miles driven (as well as other factors such as driving record) PAYD would bring the state 7 to 9 percent closer to the reduction in CO2 target for 2020, reduce driving in light duty vehicles by 8 percent and produce annual social benefits of $10.8 billion currently and of $21.1 billion, based on 2020 projections. Under the PAYD rules proposed by the Insurance Commissioner, miles driven will be verified by one of three methods: odometer readings by the insurer; service records from an automotive repair dealer; or through the use of a technological device.
- An insurer in Massachusetts will now reward policyholders for “going green.” It will offer a discount to customers who drive fewer miles than the average for the geographic area, based on vehicle mileage records collected by the state’s Registry of Motor Vehicles during annual inspections. Rates could decrease by as much as 15 percent according to the company.
- In Texas, where a mileage-based law was passed in 2001, a new insurer is offering auto insurance by the mile directly to consumers online. Policies are valid for the amount of miles purchased, from 1,000 to 6,000 miles, or a six-month period, whichever occurs first, and premiums are calculated based on the vehicle driven, its location and the age of the driver.
- State Regulatory Initiatives: In Maryland the governor has established the Maryland Commission on Climate Change to discuss the causes and possible impact of climate change, the future preparations for what is expected to occur, and benchmarks and timetables for implementation. One component of the plan is the establishment of a Climate Change Insurance Committee to advise the Insurance Commissioner on how the availability and affordability of insurance in the state may be affected by climate change and ways to expand loss mitigation efforts. The committee’s initial report is due July 2009.
- The National Association of Insurance Commissioners (NAIC) is finalizing a Climate Risk Disclosure white paper that examines the possible impact of climate change on insurers, insurance consumers and insurance regulators. The report also recommends that state regulators develop standardized risk disclosure requirements to obtain information regulators need in order to determine how climate change will affect consumers. Some insurers are concerned that the proposal will require them to disclose proprietary and competitively sensitive information.
- Forecasts: A new study on climate change is being financed by the National Science Foundation with additional funding from the reinsurance broker Willis Group’s research unit, among others. The study will try to assess whether the number and intensity of hurricanes is likely to increase in the Gulf of Mexico due to global warming. The model will include data going back to 1950 to better determine the impact of natural processes on hurricane activity and man-made contributions. The goal of the project is to provide information to insurers, energy companies, coastal communities and others that could be affected by climate change. The first results should be available early in 2009.
- Adding to the uncertainty about the impact of global warming on hurricanes, researchers at Florida State University say that the 2007 and 2008 hurricane seasons produced the least activity in the Northern Hemisphere in 30 years. The Northern Hemisphere includes both the Atlantic and Pacific basins. While activity in the Atlantic basin was above normal in 2008, Western and Eastern Pacific basins produced fewer than normal typhoons and hurricanes, suggesting that hurricane activity is variable and not connected to global warming, the researchers say. When there is an active season in one basin, the other basin tends to be quiet.
- Global Warming Litigation: In February 2008 the Inupiat Eskimo community of Kivalina filed a lawsuit in the U.S. District Court in San Francisco alleging that greenhouse gas emissions from energy-related companies are leading to rising sea temperatures and, as a result, the Arctic sea ice that surrounds the village is melting, exposing it to winter storms and possible destruction. Kivalina is seeking “monetary damages for the defendants’ past and ongoing contributions to global warming, a public nuisance, and damages caused by certain defendants’ acts in furthering a conspiracy to suppress the awareness of a link between these emissions and global warming.” Government experts say the village must be relocated, and the cost of relocation could be as high as $400 million.
- Public nuisance is a common law tort that imposes liability on an individual or entity that interferes with a public right—to health and safety, for example. In the past, the concept has been used in tobacco and gun litigation. But in a lead paint ruling in July 2008 in a case seeking damages from several paint manufacturers and their trade association for potential lead paint poisoning, the Rhode Island Supreme Court refused to allow the expansion of the public nuisance law to environmental and product liability cases, saying “public nuisance law simply does not provide a remedy for this harm.” Similar rulings have been handed down in Ohio, Missouri, New Jersey and Wisconsin. According to Property Casualty Insurers Association of America, judicial rulings in these cases could affect global warming litigation such as the Kivalina lawsuit.
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BACKGROUND
When fossil fuels—coal, oil and natural gas—are burned to produce energy, so-called greenhouse gases, largely carbon dioxide, are emitted into the atmosphere where they trap heat. The result is global warming.
Forests and oceans can absorb some of the carbon. But to avoid the most catastrophic effects of what is predicted to occur, researchers say, carbon emissions must be greatly reduced, hence the push to reduce overall energy use, boost the use of energy from renewable sources such as solar heat and curb the use of paper and other products made from trees, which absorb carbon dioxide in the process of photosynthesis.
Global warming has the potential to affect most segments of the insurance business, including life insurance if rising temperatures lead to an up-tick in death rates. Property losses of all kinds are most likely to increase, and there is the potential for much higher commercial liability losses if shareholders and consumers try to hold businesses responsible for changes to the environment.
Insurers’ Contribution to Lowering Greenhouse Gases: Insurers, like companies in other industries, are promoting strategies to lower greenhouse gas emissions in the hope that if every person takes the threats related to global warming seriously, some of society’s worst fears will ultimately prove unfounded. Some insurers have been warning public policy leaders and the general public about the threat of climate change for years and others were among the first to adopt public statements on the environment and climate change and to join business coalitions calling on the federal government to enact legislation to reduce greenhouse gases. Increasingly, companies are establishing specific units to address concerns and coordinate initiatives on climate change and the environment. Some, particularly reinsurers, are sponsoring research and working with others interested in the same kind of problems, such as finding ways for individuals and society to adapt to extreme weather, particularly in developing countries.
Many insurance companies are committed to reducing their own total greenhouse gas emissions and offsetting the remainder through contributions to reforestation and renewable energy projects. They also encourage their employees to adopt “green” policies in their private lives. Some were involved in projects to reduce greenhouse gases even before such efforts gained widespread public attention, and many are now reinforcing their policyholders’ desire to reduce their carbon footprints by offering them paperless billing and documentation. Some have upgraded the quality of their Web sites to encourage policyholders to transact business electronically, see buying Insurance: Evolving Distribution Channels. At least one auto insurer sells policies exclusively online.
Insurers are also working on another front: seeking to reduce the incidence and cost of property damage caused by those events that still occur, despite society’s best efforts to reduce greenhouse gases.
Property Losses: Much remains unknown about the potential impact of climate change on property losses. Most scientists agree that precipitation is becoming more intense and more erratic, leading to hotter and drier environments that raise the risk of wildfires in some regions and damaging rainstorms that increase the risk of flooding in others. However, there is less agreement about how the rise in temperatures will affect the number and severity of hurricanes and when the effect of climate change on storms will be clearly felt.
According to Karen Clark, president of the Boston-based Karen Clark & Co. hurricane modeling consulting firm, global warming could lead to a 2 to 5 percent increase in hurricane peak wind speeds over the next 20 years, which in turn could result in a 30 to 40 percent increase in property insurance losses. Others believe the impact is less imminent. Property losses may include not only claims for structural damage such as broken windows, a hole in the roof and the resulting water damage to the inside of the structure and contents, but also for the extra expense of living elsewhere while the home is being repaired or rebuilt. On the commercial side of the business, in addition to direct property damage, losses may include the policyholder’s loss of income and extra expenses during the rebuilding or relocation process.
Catastrophes: Insurers talk about disasters in terms of catastrophes. A catastrophe denotes a natural or man-made disaster that is unusually severe. An event is designated a catastrophe by the insurance industry when claims are expected to reach a certain dollar threshold, currently set at $25 million, and more than a certain number of insurers and policyholders are affected. The insurance industry tracks catastrophes to monitor claims costs, assigning a number to each catastrophe. A catastrophe can be a hurricane or tropical storm, which over the past decade have accounted for the largest portion of catastrophe losses, a tornado or winter storm, or any other type of disaster such as terrorism and earthquakes, which are unlikely to be affected by global warming.
Catastrophes appear to be growing more destructive, but insured losses are also rising because of inflation and increasing development in areas subject to natural disasters. In 2005, the year of hurricanes Katrina, Wilma and Rita, catastrophe losses totaled $64.3 billion. Hurricane Katrina caused losses of $41.1 billion, the highest on record, about twice as much as Hurricane Andrew would have cost had it occurred in 2005. Seven of the 10 most expensive hurricanes in U.S. history occurred in the 14 months from August 2004 to October 2005. If, as suggested, hurricane-related losses grow by as much 40 percent over the next 20 years, a Katrina-like storm could cause $60 billion in losses, or significantly more if it struck a densely populated metropolitan area like Miami or New York City.
It is not inconceivable that in any given year there could be more than one megadisaster. Indeed, after Hurricane Katrina in 2005, rating agencies that evaluate the financial health of property insurers raised the threshold for capital adequacy. They now look at capital adequacy relative to a company’s exposure to losses from a 250-year event, rather than 100-year event, and at potential losses from two megadisasters in quick succession. (A 100-year storm means that each year there is a one in 100, or one percent, chance of such a storm, not that such a storm is only likely to occur once every 100 years. Hurricane Katrina was considered a 400-year storm with a 0.25 percent chance of occurring each year.)
Managing Catastrophe Risk: Not surprisingly, since Hurricane Katrina many insurers have adopted more conservative approaches to dealing with their exposure to catastrophic losses. Where they are not permitted by state officials to raise rates to actuarially sound levels, they have been forced to reduce the number of high-risk policyholders they insure. Those that do not take appropriate actions may face rating downgrades, which in turn affects their cost of raising capital and, if downgrades are severe enough, their ability to attract new business. Applicants for insurance generally seek out companies with the highest financial ratings.
Nobody underestimates how difficult it is for many people who live in the path of hurricanes to pay higher homeowners insurance premiums. Many moved to coastal communities during a period when premiums were low because storms were less frequent and costly. However, insurers have a fiduciary responsibility to their policyholders. Because property owners purchase insurance in the expectation that their insurer will be able to pay their claims when a storm hits, insurers must have the financial resources to pay for the damage global warming may inflict.
Insurance rates are based on past claim costs in a given state adjusted to take into account future trends -- profits in one state cannot be used to subsidize rates in another. Since many meteorologists predict that there will be a rise in hurricane activity along the eastern seaboard and in the Gulf of Mexico, both in the near-term, due to cyclical changes in storm patterns, and possibly into the future, as a result of global warming, this projected increase must be built into rates in those states. Rates must be high enough to produce a good profit in years of average hurricane activity so that insurers have sufficient reserves to cover the billions of dollars in claims payments in very active years. In states like Florida, Texas and Louisiana, a single hurricane or string of large losses can wipe out profits from previous years or even decades.
There are several ways to reduce potential property losses. First, insurers support proper land use planning that takes account of the risk of natural disasters when new applications for commercial and residential development are considered. Already in California, officials are struggling to fund the growing cost of fighting wildfires as local governments continue to allow building in remote hillside areas that are difficult for fire fighters to reach. In coastal areas vulnerable to hurricanes, development in wetlands exposes more high-value property to damage and reduces the natural ability of such areas to act as buffers against storm surge.
Another way is to mitigate the severity of losses. Mitigation is a term used in the insurance industry to denote a process or activity that reduces the severity of a negative event. Research into the extent of damage caused by prior hurricanes has found that structures erected after the enactment of stronger building codes fared better in storms than those built earlier. As a result, insurers have been working to strengthen building codes and beef up enforcement of those codes. In addition, they have been strong supporters of programs that help homeowners to retrofit their homes to better withstand high winds or to reduce the likelihood of damage due to wildfires, see Background section of Catastrophes, Insurance Issues. They also support the concept of offering premium discounts to encourage retrofitting as long as the percentage offered is in line with the potential reduction in insurers’ losses.
In addition, the insurance industry is funding scientific research into stronger, more disaster resistant building materials and construction techniques. After Hurricane Andrew and the rise in hurricane activity starting in the late 1990s, the industry expanded its efforts to mitigate the social and economic impact of natural disasters. Building on the success of the Insurance Institute for Highway Safety, which for some 30 years has been working to reduce deaths, injuries and property damage from auto accidents, the insurance industry created the Institute for Business and Home Safety (IBHS), an institution devoted to disaster-related engineering and disaster-safety communications. IBHS is now constructing a state-of-the-art applied research facility to test buildings and building components.
Liability Losses: Most businesses purchase commercial liability policies to cover negligence that results in bodily injury, property damage, and personal and advertising injury. Companies may also purchase coverage to protect their directors and officers against charges that they failed to properly manage the company’s global warming liability exposures. Professionals who design the products or projects carried out by a company may be sued for the harm these projects cause. Lawsuits may be filed by shareholders or consumers against a business for actions or inactions that could harm the environment. In addition, shareholder lawsuits may target a company for failure to disclose important information that could materially affect its financial health and thus influence shareholder investment decisions.
The potential increase in property losses may be relatively small in comparison to what could happen on the liability side. Liability suits could be filed based on legal concepts yet untested as well as existing ones tailored to “sustainability” cases. Sustainability is broadly defined by the U.S. Green Building Council as “meeting the needs of the present generation without compromising the ability of future generations to meet their own needs.” Awards could be substantial because, by their very nature, activities that result in harm to the environment and future generations can impact large numbers of people. Even where lawsuits are not successful, and there is no court award against the defendants, insurers can incur substantial legal costs.
To minimize the likelihood of lawsuits, insurers analyze their policyholders’ liability risks and provide guidance as to the best approach, based on their extensive experience insuring businesses in more than a thousand categories. Among the activities reviewed to reduce the risk of global warming lawsuits would be the company’s efforts to adapt to global warming to help ensure that they did not cause harm, along with their emissions reduction program and their energy conservation projects.
New Products and Business Opportunities
Without insurance the economy could not function. Insurers essentially enable new products and services to be created by assuming the risk of loss. Just as they quickly adapted existing liability insurance policies for horse-drawn carriages, or teams of horses, to automobiles towards the end of the nineteenth century, so they are responding to climate change initiatives at the beginning of the twenty-first century.
Opportunities exist on several fronts. First, there are new risks to insure, including new industries such as wind farms and other alternative fuel facilities, and emerging financial risks such as those involved in carbon trading. Insurance policies related to carbon trading protect those that invest in clean technology projects against failure of the project to deliver the agreed-upon emission rights. A number of companies are also offering their clients carbon project risk management consulting services. A carbon credit permits the holder to emit one ton of carbon. The Kyoto Protocol and other cap and trade systems now under discussion set ceilings for carbon output and allow those that produce less than the limit to sell credits to those that exceed it. Investors in clean technology projects such as reforestation and renewable energy buy the rights to credits and sell them in the international carbon trading market. Among the risks associated with purchasing carbon trading rights is that the technology/project designed to reduce carbon emissions will not meet expectations or that the company will become insolvent before it is able to fulfill its contract, leaving the investor without the necessary carbon offsets.
Second, the need to curb global warming has spurred the creation of insurance policies that provide incentives to policyholders to contribute to these efforts. These include discounts on auto insurance policies for owning a hybrid car and for driving fewer miles, see Recent Developments, and policies for green building construction.
Auto Insurance: Motor vehicles account for more than 25 percent of all U.S. greenhouse gas emissions. Insurance policies such as pay-as-you-drive, which factors mileage driven into the price of insurance, and hybrid car discounts could reduce that amount by more than 10 percent if broadly implemented according to Ceres, a network of companies concerned about global warming. A study by the Brookings Institution suggests that if drivers paid by the mile, driving would drop by about 8 percent.
There are two ways to reduce the greenhouse gas emissions associated with driving. One is to encourage people to purchase vehicles that emit less carbon dioxide into the environment and get more miles per gallon of gasoline. A number of companies offer discounts to people who drive hybrid vehicles—some believe that people who are socially responsible are also more responsible behind the wheel. The other way is to reward people for driving fewer miles, known as pay-as-you-drive (PAYD) auto insurance. Several insurers have developed technology-based discount programs that provide financial incentives to drive fewer miles. Mileage information comes from a special device. In some, it is linked to the car’s odometer and in others it is a wireless sensor that can monitor speed as well as mileage. These programs are offered in a growing number of states. In addition, California and several other states are encouraging the development of PAYD programs.
Insurers are helping to promote sustainable building practices by offering green homeowners and commercial property policies. In addition, they are responding to the growing demand for assistance with energy and emissions-reduction projects with risk management services that address global warming.
“Green” Building Insurance Coverage: Increasingly, homeowners at the leading edge of the environmental sustainability movement are generating their own geothermal, solar or wind power and selling any surplus energy back to the local power grid. Several insurers are supporting this trend by offering a homeowners policy that covers both the income lost when there is a power outage from a covered peril and the extra expense to the homeowner of buying electricity from another source. Policies generally cover the cost of getting back online, such as utility charges for inspection and reconnection.
Some insurers offer homeowners insurance policies that, in the event of a fire or other disaster, allow policyholders to rebuild to environmentally responsible “green” standards, even if they had not purchased such a policy originally. Green standards, part of the sustainability movement, include energy conservation benchmarks and the use of renewable construction materials. The Green Building Council introduced its Leadership in Energy and Environmental Design (LEED) certification program in 2001. According to Ceres, buildings account for more than one-third of greenhouse gas emissions and green building practices can reduce energy use and emissions by more than 50 percent.
With green commercial building construction expected to rise significantly over the next few years, a growing number of insurers are offering green commercial property insurance policies and endorsements, some of which are directed at specific segments of the business community such as manufacturers. The first green commercial policy was introduced in 2006.
In general, the policies allow building owners to replace damaged buildings, whether or not they are already certified green, with green alternatives including energy efficient electrical equipment and interior lighting, water conserving plumbing, and nontoxic and low odor paints and carpeting. They also may also pay for engineering inspections of heating, ventilation, air conditioning systems, building recertification fees, the replacement of vegetative or plant covered roofs and debris recycling. Some cover the income lost and costs incurred when alternative energy generating equipment is damaged.
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