Financial regulators worldwide are grappling with the impact of climate change and the increasing risk it presents for financial systems, while climate scientists call for rapid reductions in greenhouse gas emissions to prevent a climate disaster. At the same time, U.S. insurers remain highly exposed to fossil fuel-dependent industries like oil, gas, coal and utilities, and the pace of change in the industry is slow.

Globally, the insurance industry is in a unique position when it comes to climate risk as insurers are exposed on both sides of the balance sheet: Their investments face climate risk on the asset side of the balance sheet, and they face underwriting risk, particularly in the property and casualty line, on the liability side.

As companies and investors get to grips with the risks of rising global temperatures, climate stress testing is becoming more commonplace across many parts of the world — with eye-opening results for insurers. France’s central bank, for example, released the first results of its climate stress tests earlier in 2021: It found that natural disaster-related insurance claims could increase up to five-fold in the nation’s most affected regions. That would cause premiums to surge as much as 200% over 30 years.

In a world first, the French central bank conducted a climate stress test on its financial sector. Listen to this episode of ESG Insider, a podcast hosted by S&P Global Sustainable1, to hear an interview with Laurent Clerc, director for research and risk analysis at the supervisory arm of the French central bank, which conducted the world’s first climate stress tests.

In the U.K., regulators are working to analyze transition and physical risk through the Bank of England's climate change stress tests, which will ultimately help shape the strategic objectives of both insurers and banks.

And in the U.S., President Joe Biden issued an executive order at the beginning of 2021 that is expected to usher in sweeping climate-related disclosure requirements and standards. The order directs the U.S. government to more actively help financial institutions and other market participants understand and tackle growing sustainability risks. 

Momentum is also building in the U.S. for heightened scrutiny at the state level — and that matters because states play a unique role as the primary avenue for regulating the nation’s insurance industry. This differs significantly from other financial industries, where the U.S. federal government has more influence. 

Increasing frequency, severity of natural catastrophes impacts property and casualty insurance

"On the underwriting side, one has only to look at both regional and global losses that are driven by catastrophic weather events that in turn are being driven by climate change to understand the enormity of the exposure that insurers have." – Dave Jones, former California Insurance Commissioner, speaking at a June 16 webinar hosted by S&P Global Sustainable1.

Through the property and casualty business line, insurers extend coverage to structures, property and belongings that may become destroyed, damaged, or vandalized, among other things. Over the past two decades, climate change has intensified extreme weather events. For example, in 2020, the U.S. experienced 22 extreme weather and climate-exacerbated disasters that each had losses in excess of $1 billion, according to figures the National Oceanic and Atmospheric Administration released at the beginning of 2021. Those events collectively caused at least $95 billion in damages, killed at least 262 people and injured scores more, according to NOAA’s National Centers for Environmental Information.

According to research from S&P Global Sustainable1, 66% of major global companies have at least one asset at high risk of physical climate change impacts.

The increasing frequency and severity of certain natural catastrophes has caused insurers to rethink their approach to underwriting coverage. Often, this results in decreased affordability and availability of insurance in certain disaster-prone areas. 

When individuals cannot buy insurance in the U.S. private market, they are forced to seek coverage through a state-backed insurer of last resort, or remain uninsured, causing people to rely on funds from the Federal Emergency Management Agency or other government entities when there is a loss. 

California, for example, saw residential non-renewals by insurance companies grow statewide by 31% from the end of 2018 to the end of 2019. When residents are denied traditional coverage in the state, they must turn to other admitted carriers, surplus-lines insurance or California's FAIR Plan, an association of insurers that acts as a provider of last resort. FAIR Plan policies increased 36% statewide over the same period. 

Despite climate concerns, rising fossil fuel investment

"We can't be cognitively dissonant in a way that you may be investing in the best renewables out there, but then undermining it with underwriting practices … There is a big opportunity within insurance companies, within the insurance industry, to really have that total balance sheet approach [to] sustainability. I think there are more and more insurance companies who are doing that, but frankly, the vast majority have not yet come to that agenda." – Butch Bacani, Programme Leader UNEP Principles for Sustainable Insurance, speaking at a June 16 webinar hosted by S&P Global Sustainable1.

To better understand the climate-related risks and opportunities that insurers face, S&P Global Sustainable1 analyzed nearly 4,000 insurance investment portfolios across the U.S. insurance industry representing nearly $6.5 trillion in assets under management. As of year-end 2019, the U.S. insurance industry had $582 billion invested in some combination of oil, gas, coal, utilities and other fossil fuel related activities, a slight increase from $519 billion in 2018.

However, the percentage of fossil fuel-exposed assets held steady at 9% as total assets under management grew year over year. 

Levels of exposure to carbon intensive sectors among individual insurers' portfolios varied dramatically. For example, nearly 1,000 portfolios had no measured fossil fuel exposure, while a handful of insurers had fossil fuel exposure that exceeded 30% of total assets. This highlights the need for deeper analysis on climate-related risks and opportunities at the asset level.

Several influential state regulators, including the California Department of Insurance and the New York Department of Financial Services, have expressed concern about the amount of insurers' investments that are exposed to fossil fuels as they have potential to become stranded assets — those are assets that experience unexpected or premature write-downs or devaluation caused by innovation, changes in the market or other factors.

In 2016, Dave Jones, who was California's insurance commissioner at the time, asked that insurers doing business in California voluntarily divest from thermal coal. He said at the time that the request felt appropriate due to his "statutory responsibility" to ensure insurers address any potential financial risks in the reserves that they keep to pay out claims. Several insurers complied with the request. 

Jones was also among the first state regulators to require that insurance companies provide public disclosures of their investments in carbon intensive sectors. 

Unique challenges for U.S. insurance regulators

Insurance regulators have been paying attention to climate change and the impact this has on insurers as well as policyholders, whom they also have a sworn duty to protect. In the U.S., most aspects of the insurance industry are regulated at the state level, with state insurance commissioners having the final say on issues in many cases. Most insurance commissioners are appointed, while a small handful are elected.  

The unique way that insurance is regulated in the U.S. can make it difficult to reach a uniform approach across states for many different issues, including how to appropriately address climate change. 

For example, Connecticut's General Assembly just passed a mandate in its state budget that directs Connecticut's insurance commissioner to submit a report biennially until 2032 disclosing the department's progress toward addressing climate-related risks.

Meanwhile, North Dakota Gov. Doug Burgum signed a bill in March that asks the state insurance commissioner to study the availability, cost and risks of insurance coverage for the coal industry, and evaluate whether there is a need for a state-based insurance product for the sector that would insure against risk at an "appropriate cost." The directive comes amid waves of activist and investor pressure on insurers to distance themselves from coal and other emissions-intensive industries. This pressure appears to have yielded some results as some coal companies have reported difficulty in obtaining affordable insurance coverage over the past several years. 

This is part of the reason why the National Association of Insurance Commissioners, or NAIC, exists — to provide a forum where regulators from all 50 states, the District of Columbia and five U.S. territories can come together to hash out issues, and to provide data and expertise to help insurance commissioners effectively regulate the industry. 

Although the NAIC has its own staff, a handful of insurance commissioners are also elected yearly to serve as NAIC leadership. The NAIC President in 2021 is David Altmaier, who also serves as Florida's insurance commissioner. Altmaier chose to focus on climate and natural catastrophe risks and resiliency as one of the group's main priorities for 2021.

The NAIC has also been active in considering climate risks. It formed a Climate and Resiliency Task Force, which is an executive-level committee that brings together regulators and experts with the goal of evaluating the potential solvency impact of insurers' exposure to climate-related risks. The task force also works to develop climate risk-related disclosure, stress testing and scenario modeling. 

At the federal level in the U.S., Biden's recent executive order will also have a direct impact on insurance industry regulation. The order directs the Treasury Department’s Federal Insurance Office to assess the adequacy of state regulators' oversight of insurance sectors as it relates to climate risk.

The opportunities ahead

Financial regulators in many parts of the world are beginning to require greater disclosure of climate-related risks, as well as incorporating climate change into stress testing scenarios. 

Corporations in Australia and Europe, particularly banks and insurers, are increasingly excluding coal and other fossil fuels from their investment portfolios and client lists. However, activists have frequently criticized insurers in the U.S. for being slower to move away from fossil fuels than their international peers. 

Several insurers have already committed to exit coal financing or speed up efforts to do so. According to an activist report, the number of insurance companies withdrawing coverage for the coal sector doubled in 2019, with about 37% of the insurance industry's global assets earmarked under plans to exit involvement in the coal sector. Certain insurers have also pledged to drastically increase their green investments.   

And new regulations in some parts of the world could serve as a tool to help insurers assess climate exposure in their business. For example, the European Union introduced a “green taxonomy” as a common classification system for environmentally friendly investments. Simply put, it’s a dictionary that defines what is sustainable and what is not by assessing more than 100 economic activities, spanning manufacturing to transport to insurance. The taxonomy is designed to steer companies as they adapt their business strategies to climate change, as well as help investment funds judge sectors based on their environmental performance.

According to research from S&P Global Sustainable1, 22% of U.S. insurers’ total assets under management were eligible for alignment with the sustainable activities outlined in the EU taxonomy as of 2019. Green bond exposure grew to $12.62 billion in 2019 from $5.46 billion in 2018; it still represents a small fraction of all assets across U.S. insurance portfolios. 

"Unless we actually get that sort of adaptation, and really take ESG seriously and take climate change seriously, then we really haven't got much of a future as a business," said Yvonne Braun, Director of Policy, Long Term Savings and Protection at the Association of British Insurers, during a June 16 webinar hosted by S&P Global Sustainable1. 

Scientists project that as average global temperatures continue to rise due to human-caused greenhouse gas emissions the number and intensity of extreme weather events would rapidly increase. A 2020 report by S&P Global Ratings found that water scarcity will affect 38% of counties in 2050 under a high-stress climate scenario, presenting risks under this scenario for their municipal water utilities, public-owned power utilities, and local governments. Heat wave risk will continue to increase across all states and under all scenarios to midcentury, with Florida particularly exposed.

But the conventional wisdom is that the insurance industry has historically been slow to change in many aspects of its business. When it comes to assessing and addressing climate risk, that will need to change. 

"If I were an insurance company CEO, I wouldn't wait until my regulator told me that I need to seriously address these risks," former California Insurance Commissioner Dave Jones said at the June webinar. "I would start doing it now."