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Adaptation option

Insurance as risk management tool

Disaster risks and losses are of great concern for society, since they have increased over the last years. Such events are expected to further increase as a result of several factors such as projected demographic development, land use change, expansion of residential and economic activities in disaster-prone areas and projected climate change. There is evidence that climate change has increased the frequency and severity of certain extreme weather- and climate-related events, such as droughts, heat waves and heavy precipitation events in several European regions, and these trends are projected to continue, without climate change mitigation and adaptation (EEA Report 15/2017). Therefore the implementation of compressive risk management mechanism (such as insurances) gains more and more importance.

Insurance transfers risk from an insured person, object or organisation to an insurer. Compensation depends on the assessment of losses caused by the specified hazard events, e.g. crop loss in agriculture, losses in houses from flooding, forest losses due to storm or forest fires. For extreme weather, this is a valuable tool because the financial damage does not turn into long term economic damage if a house or a business can be rebuilt or compensated for. Before an extreme weather event can be insured, an insurer should be able to identify the risk and to quantify it. Of course, an insurer should be able to bear the costs if the extreme event actually occurs. One last important element of insurability is that it cannot be known to anyone how, where and where exactly the extreme event will take place; it needs to be random.

The European Commission’s Green Paper on the insurance of natural and man-made disasters was published in 2013 as part of the Adaptation Strategy package. It aims to encourage improvement in the ways insurers help to manage climate change risks, to increase the market access of natural disaster insurance and to release the full potential of insurance pricing and other financial products.

A European Commission report on insurance of weather and climate-related disaster risk analyses different insurance schemes established in several Member States. Based on their assessment the insurance markets (across countries and sectors) can be divided into three broad groups:

  • Voluntary insurance market; a potential policyholder decides if he will buy insurance coverage and the insurer decides if he will provide the coverage.
  • Semi-voluntary insurance market; in principle it is similar to the voluntary one; both the insurer and the policyholder can choose whether they will engage in the extreme weather insurance market or not. However, in practice this freedom can be curtailed in the sense that there is an unofficial compulsion from, for example, mortgage providers or an implicit contract between stakeholders that require the individual to take part in the insurance market.
  • Mandatory markets; an insurer or a policyholder has a legal compulsion to take part in the market. For example, an insurer may be legally unable to refuse coverage against extreme weather events, while a policyholder may be compelled to buy fire insurance which has extreme weather insurance included.

Some countries (e.g. France, Switzerland) have state or quasi-state monopoly insurance while other countries (e.g. Germany, Italy, United Kingdom) have commercially structured “free market solutions“, which are systematically coupled with state-funded ad-hoc relief. Other countries (e.g. Austria, Denmark) have public disaster funds financed by tax-payers' money and still others have various mixed solutions of private insurance providers supplemented by public disaster funds (e.g. Belgium, the Netherlands, Norway) (Schwarze et al., 2009). Spain has a public-private partnership scheme where the public entity (Consorcio de Compensación de Seguros - CSS) covers extraordinary climate risks (and others) and collects its premiums through a proportional surcharge included in the invoices of the private companies (EEA, 2017).

Additional Details
Reference information

Adaptation Details

Category

Soft

IPCC categories

Institutional: Economic options, Institutional: Law and regulations

Stakeholder participation

Stakeholders (e.g. owners of public assets, stakeholders from the agricultural sector, private property owners, conductors of commercial activities, etc.) involved in the insurance sector can generate incentives or requirements for risk management, which in turn can limit the potential impacts of an extreme weather event. This could happen through price signalling: for example home-owners who fortify their roofs to be ready for hail storms, could be charged with a lower premium, or a lower deductible. Another option would be to include requirements that relate to resilience in the insurance policy: if an insurance-taker does not take any measures against the risk to which he/she is exposed, the pay-out will be lower.

In various countries a “state guarantee” system is in place. A “disaster fund”, or similar budget line, reimburses some of the damage above a certain threshold to make sure the private partners cannot go bankrupt and offer insurance premiums that are affordable to the majority of the interested. In that case the incentive to be insured is low and limited to the highest risk zones. In such cases the market mechanism cannot function properly and premiums for remaining interested parties are becoming too high to be affordable.

Success and Limiting Factors

What makes an insurance scheme perform well? Long term cost and benefits of insurance remain the main indicator. For climate change, these costs and benefits should be seen together with a broad range of risk management tools (prevention, protection, early warning). The risk management objectives depend on the expectations that governments, insured parties or insurers may have. An insurance scheme based on solidarity will achieve maximum coverage in order to evenly distribute risk. Climate risk management insurance will increase risk awareness and provide incentives to increase resilience through adaptation measures.

However there are also voices that state that insurance is maladaptive, as insurance regimes reinforce exposure and vulnerability as they might favour actions which preserve the ‘status-quo’ rather than enabling adaptive behaviour such as transformative adaptation (e.g. O’Hare et al., 2015). In this perspective, insurance shall be seen as part of a broader approach to risk management and adaptation.

Costs and Benefits

Insurance companies distribute financial risk amongst policyholders, and risk-based premiums can incentivise individual policyholders to reduce risk which reduces the cost in the case of damage. However, insurance becomes less attractive for high-risk households or farmers when premiums reflect the underlying risk. Although lower risk policyholders have a weaker incentive to reduce risk, they are more likely to buy insurance since premiums are more affordable.

This trade-off between premium affordability and risk-reduction incentives is important but difficult to balance, and is often influenced by the differing risk management objectives of individual countries and/or stakeholder groups.

The EU Solvency II Directive (2009/138/EC) codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. “Commission Regulation (EU) No 267/2010 of 24 March 2010 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to certain categories of agreements, decisions and concerted practices in the insurance sector” grants an exemption to the application of competition rules to certain types of agreements in the insurance sector (for more detailed information see here).

Life Time

Insurance schemes last normally as long as a contract is agreed between the insurer and the insured item. Most contracts have an annual duration and are yearly renewed, including the revision of contract, such as the insurance premium.

Reference information

References:

EU, (2018). Using insurance in adaptation to climate change. Publications Office of the European Union,

Ramboll Environment and IVM, (2017). Insurance of weather and climate‑related disaster risk: An inventory and analysis of mechanisms to support damage prevent in the EU. Final report. European Commission.

Published in Climate-ADAPT Mar 25 2020   -   Last Modified in Climate-ADAPT Nov 28 2022

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