“exploring Climate Insurance: European Responses To Environmental Risks” – Casper Kristofferson Marguerite Jujo Team Leader – Financial Stability · Macroprudential Policy and Financial Stability, Market-Based Finance Hridesh Kumar Miles Parker, Senior Chief Economist · Economics, Supply Side, Labor and Surveillance Hanni Scholerman Team Leader, International Stability and the European Union

The EU has a problem with insurance against climate disasters: only a quarter of losses from climate disasters are covered. More attention can reduce the resulting financial losses. This joint EIOPA post for The Blog looks at ways to achieve this.

“exploring Climate Insurance: European Responses To Environmental Risks”

Agricultural production declined, river transport was disrupted and hydroelectricity production, exacerbating the energy crisis. Just over a year ago, severe flooding across the continent killed hundreds of people and caused significant damage. Climate change will make such disasters more frequent and more severe.

Blueprints To Advance Climate Change Mitigation And Resilience

Climate change must be contained by accelerating the green transition. But we also need strategies to mitigate the impact of disasters when they happen. Insurance plays a big role in this. By providing immediate funds for reconstruction, insurance allows economic activity to return more quickly to pre-disaster levels.

Thus, higher coverage rates and faster payments can significantly reduce financial losses. They can also reduce risks to financial stability and reduce the cost of government concessions to taxpayers to cover uninsured losses.

So are we protected when disaster strikes? No, in fact there are huge differences in climate insurance coverage across the EU. Only about a quarter of weather-related catastrophe losses are insured. In some countries, this figure is less than 5% (Figure 1). In addition, the increasing impact of climate change means that coverage is likely to decline as rising premiums reduce demand and insurers withdraw from high-risk areas.

There are various reasons for not buying insurance even when it is affordable. First, people tend to underestimate the likelihood and impact of disasters. For another, they believe the government will reimburse them and therefore don’t need their own insurance. This behavior is a well-known challenge for insurance and is called moral hazard. Generally speaking, moral hazard is when people do not try to reduce their risks because they expect to be compensated for their losses.

What To Do About Europe’s Climate Insurance Gap

The European Insurance and Occupational Pensions Authority (EIPO) is working together to find ways to solve this problem. Today they published a joint discussion paper outlining policy options to reduce the gap in climate insurance coverage in Europe. Insurance and catastrophe losses come at many levels. The discussion paper uses the concept of schools to visualize these levels and articulate policy options for them (Figure 2).

The first step on the ladder is private insurance, the initial line of defense against risks and losses. Carefully designed insurance policies can encourage households and businesses to better adapt to climate change and increase their resilience, for example by setting flood prevention standards for homes in flood-prone areas.

Source: A simplified version of the figure is included in the EAAPA Discussion Paper “Policy Options for Reducing the Climate Insurance Coverage Gap” (2023).

However, higher disaster risk requires a more complex system. The next step is reinsurance and greater use of capital market instruments such as catastrophe bonds (“cats”). Cat bonds can help insurers shift some of the losses from rarer but more devastating catastrophes to a wider range of investors, helping to diversify sources of capital and reduce overall premiums. A deepening of CAT bond markets, which could also be supported by further progress in the EU Capital Markets Union, could help close the climate insurance coverage gap.

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The third category includes the important roles of national governments. As already mentioned, low insurance coverage means that the public sector often has to help in an emergency. Public finances as a whole would benefit from more comprehensive disaster risk management strategies. This makes it easier to balance the costs of pre-disaster measures. Precautionary measures include spending on climate adaptation, such as sea walls or irrigation, as well as building fiscal buffers, such as national emergency reserves. Even with this preparedness, financial costs will continue to be an important part of disaster relief, especially for purposes such as public infrastructure. Governments can commit to public-private partnerships, such as those already in place in some European countries, through direct insurance or as a last resort as reinsurers. One of the main objectives of this level of policy is to reduce the amount of catastrophic losses of the public sector, while promoting and improving risk reduction and adaptation.

The final step on the ladder is a potential EU-wide public sector plan for rare but major climate-related disasters. By providing meaningful recovery assistance to Member States, it can complement and strengthen national efforts and help more effectively pool disaster risks that often affect individual EU countries at different times. Such a plan would complement the EU’s wider climate policy and existing instruments for disaster relief, such as the EU Solidarity Fund, which alone cannot meet growing climate change needs.

As the discussion paper notes, all of these policy options need to be carefully designed and implemented so that moral hazard behavior is not relegated to an isolated classroom in an isolated school. An EU-wide public sector plan would require safeguards, for example to ensure that member states also work to improve disaster resilience without relying entirely on EU aid. These safeguards may involve a partially linked contribution to the actual risk exposure and may be accessed only after Member States have implemented agreed adaptation strategies and achieved their emission reduction targets.

It will not be possible to fully insure against every future disaster risk, and it is not a good idea if we want to promote climate change adaptation. However, the measures outlined here should make Europe more resilient to future disasters and mitigate their wider economic, financial and fiscal consequences.

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The Authority and EIOPA welcome comments and feedback on all aspects of the discussion paper. Comments must be sent

On 22 May 2023, these policy options will be discussed with regulators, policy makers, academia and the private sector.

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