The climate disasters that have been occurring around the world have generated numerous concerns in terms of public health and socioeconomic impacts. Given the importance of talking about this issue, we invited Dr. Franziska Arnold-Dwyer,* a researcher at Queen Mary University of London and an associate of Fundação Getulio Vargas’ Institute for Innovation in Insurance and Reinsurance (FGV IISR), for an exclusive interview on insurance applied to climate catastrophes, which you can check out below.

On the specific topic of forests, what new insurance models are needed?

Dr. Franziska Arnold-Dwyer: The first point to note is that deliberate deforestation caused or instigated by policyholders themselves – whether for the use of agricultural land, logging or mining – cannot be insured. This is because insurance provides protection against specific risks that may or may not occur, and not the deliberate actions of insurance customers. Therefore, when we talk about insurance against deforestation, we are referring to insurance coverage for losses or damage to forests caused by natural hazards or by third parties. The most common risks to forests are forest fires and arson, but a forest may also be damaged or destroyed by windstorms, heavy rains leading to flooding and landslides, or frost.

Traditionally, insurance works on the basis of a compensation model: in exchange for premiums paid by policyholders, the insurer promises them that if they experience a loss caused by an insured risk, it will pay them an indemnity that, in monetary terms, will compensate them for their loss. The insurer charges premiums reflecting the probability and severity of the loss. Claims can sometimes take a long time to be paid, exacerbating the financial difficulties of companies and individuals, pending the establishment of liability and the magnitude of the loss. Major forest fires around the world, such as in Chile, Canada, the United States and Greece in 2023, have increased premiums and restricted the insurance industry’s capacity to cover forest fire risks. Inaccessibility and restricted insurance capacity may lead to protection gaps.

That’s why we need to rethink traditional insurance and create new models and structures that pay claims quickly, avoid protection gaps and help policyholders and local communities build resilience.

How has the sector been working in light of increasingly frequent climate risks, which affect investments?

Dr. Franziska Arnold-Dwyer: Parametric insurance can help with the speed with which payouts are made after a loss event. Parametric insurance payouts are triggered according to a pre-agreed formula, a model, which acts as a proxy for the actual loss. The model calculates an estimated loss based on meteorological data (e.g., wind speed or precipitation), geophysical data, and economic and population data. If the modeled loss reaches a pre-agreed threshold, the mechanism makes a payment to the affected participant, regardless of whether the modeled loss was higher or lower than the actual financial loss. This has the advantage that payments can be made quickly, right after the loss event, as there is no need to assess and verify actual losses. It also saves administrative costs, which can be reflected in lower premiums. However, the possible disadvantages of parametric insurance are that the actual costs of losses and damage suffered may exceed the modeled loss, so there is a shortfall in the amounts paid out, and parametric structures are expensive to set up and are therefore mainly implemented at sovereign or sub-sovereign level.

In its report “Climate Change 2021: The Physical Science Basis,” the Intergovernmental Panel on Climate Change noted a rapid and widespread increase in extreme weather events as a result of climate change, such as droughts and extreme heat, leading to greater risks of forest fires, windstorms and floods. This is already, and will increasingly be, a challenge for the insurability of such risks.

It is therefore becoming a strategic necessity for the insurance industry to support its policyholders and the local communities in which they operate in adapting to the harmful impacts of climate change that already exist, in order to build resilience. Building resilience means avoiding, minimizing and dealing with losses and damage associated with the adverse effects of climate change. In relation to forest fires, this means that insurers must provide support, including preventive measures that avoid or minimize the outbreak of forest fires, while ensuring an effective firefighting response that can limit the spread of forest fires.

How can insurance companies do this?

Dr. Franziska Arnold-Dwyer: The insurance industry can engage with the public sector to shape policies and regulations that improve forest fire management, safety and resilience. They can use their distribution network and points of contact with existing and potential policyholders to raise awareness of wildfire management and suppression measures that can be implemented at an individual level.

When claims are paid, they can ask their policyholders to use the payouts to “build back better,” making their properties more resilient to future weather and wildfire risks. They can work together with local communities and governments through public-private partnerships to implement resilience measures. They can also be instrumental in providing ex ante financing: funding for infrastructure projects and measures to prevent forest fires before they occur.

Ex ante financing is a well-known approach in humanitarian aid, but it has not yet been conceptually incorporated into the private insurance sector. The United Nations Capital Development Fund (UNCDF) and the United Nations Office for Disaster Risk Reduction (UNDRR) are currently testing an innovative project in Fiji, in which community-based insurance for cyclone risk includes an ex ante payment component to help local residents buy food supplies and equipment to protect their property when a cyclone is imminent. Together with Guy Carpenter, I developed a Climate Resilient Development Bond structure that combines risk transfer with a blended finance solution that provides ex ante financing for infrastructure, which can increase resilience to the relevant climate risk.

This implemented insurance mechanism would be a community-based parametric catastrophe policy that incentivizes local businesses and residents to implement resilience measures identified at the household level. The insurance policy, in turn, is reinsured in a capital market vehicle that can attract a stack of combined financial instruments, each with different return expectations. For example, philanthropic investors can take the first layer of loss, with ESG impact investors taking the second layer and standard investors taking the third layer.

In addition, a portion of the funds raised by the capital market vehicle will also go toward financing a project or infrastructure measures to improve local resilience. The risk reduction attributable to infrastructure and resilience measures will materialize during the life of the program. FGV and FGV IISR, under the leadership of Professor Gesner Oliveira, are working on plans for a pilot project.

What are your recommendations for the sector in the post-COP28 context?

Dr. Franziska Arnold-Dwyer: I attended COP28 as an observer and my focus was on the development of the insurance sector. What I noticed at COP28, compared to previous COPs, is that insurance is now becoming an established part of the toolkit for responding to the threat of climate change. Most notably, the agreement on how to operate the new Loss and Damage Fund, reached at the beginning of COP28, makes explicit reference to “insurance” as one of the financial instruments through which the funds may be applied.

Several COP28 events discussed the role of the insurance sector in adapting to climate change and building resilience. The Insurance Development Forum – a public-private partnership led by the insurance industry and supported by international organizations – is actively working to improve global resilience and address insurance protection gaps, supporting various projects in the Global South. The InsuResilience Global Partnership for Climate and Disaster Risk Finance and Insurance is a collaboration led by the most climate-vulnerable countries and the G20+ countries, with more than 100 members, encompassing governments, civil society, international organizations, the private sector and academia. The aim of InsuResilience is to promote and enable the adoption of climate and disaster risk insurance and financing approaches as part of comprehensive disaster risk management strategies that integrate preparedness, response and recovery plans into national systems.

A more controversial topic is the extent to which insurers should become more actively involved in mitigating climate change, and particularly in reducing greenhouse gas emissions, in order to meet the Paris Agreement’s 1.5-degree temperature target. The UAE Consensus resulting from COP28 makes it clear that we must accelerate efforts to phase out uninterrupted coal power and transition away from fossil fuels in the energy system. Should insurance companies still insure and invest in fossil fuel industries? Climate activists say that this facilitates the continued operation of fossil fuel companies. However, science must be balanced with equity and fairness: a rapid and disorderly withdrawal of insurance from fossil fuel assets and activities could jeopardize energy security and disrupt supply chains in important sectors such as transportation, manufacturing and construction. This, in turn, could destabilize national economies and exacerbate poverty and inequality.

Should insurance companies still insure and invest in fossil fuel industries? Climate activists say that this facilitates the continued operation of fossil fuel companies. However, an abrupt and non-consultative withdrawal of insurance and investment in fossil fuel companies is likely to be counterproductive and could have detrimental effects on employees, communities and other stakeholders, as well as supply chains.

Some insurance regulators have started asking insurers to prepare transition plans that set out their climate commitments in line with national net zero targets and the measures that need to be taken to meet these commitments. Emerging disclosure standards (such as the TCFD Recommendations and the IFRS Sustainability Disclosure Standards) and regulatory disclosure requirements (for example, the UK FCA’s ESG Sourcebook and EU Regulation 2019/2088 on sustainability-related disclosures in the financial services sector) require the disclosure of greenhouse gas emissions in scope and transition plans. However, emissions related to underwriting, i.e., emissions caused by policyholders, are not yet recognized as emissions in the scope of the Greenhouse Gas Protocol.

How do you view the insurance market’s trends, opportunities and challenges in the context of climate change?

Dr. Franziska Arnold-Dwyer: The insurance industry itself is exposed to financial risks related to climate change, which could affect an insurer’s business model and financial stability. These fall into three broad categories: (1) physical risks; (2) transition risks; and (3) liability risk. Insurance regulators around the world are currently requiring the insurers they oversee to identify and assess the financial risk of climate change on their balance sheets. The concept of “dual materiality” – the impact of an entity’s business on the environment – has been recognized by the EU and it is gaining traction with the UK’s FCA and the Net-Zero Insurance Alliance. Disclosure frameworks related to sustainability and climate are consolidating into mandatory national regimes.

Brazil’s Finance Ministry and the Brazilian Securities and Exchange Commission (CVM) have announced that the IFRS Sustainability Disclosure Standards will be incorporated into the Brazilian regulatory framework, initially on a voluntary basis, but becoming mandatory on January 1, 2026. Regulators are also introducing rules and regulations to protect clients and investors against greenwashing. One hotly debated regulatory issue is whether the regulatory capital structures applicable to banking and insurance ought to encourage green investments and underwriting and penalize “brown” (fossil fuel-related) activities. Non-harmonized regulatory approaches across jurisdictions may give rise to regulatory arbitrage and create a complex compliance burden for insurers operating internationally.

What challenges does climate change pose for insurers?

Dr. Franziska Arnold-Dwyer: As average annual losses increase due to the accumulation of climate risks, insurers may pass on the cost of higher claims to premiums, exclude specific climate-related risks from coverage or refuse to renew insurance contracts for some high-risk policyholders. If insurers do not respond effectively, climate risks could cause a persistent and significant drag on their profitability and erode insurers’ market shares.

To remain relevant, insurers must play their part in tackling the global climate emergency, supporting their policyholders (whether individuals or companies) in their transition to a net zero economy and helping them improve their resilience to climate risks. Insurers also need to find innovative solutions in collaboration with the public sector and the private financial sector to empower the most climate-vulnerable communities to increase their levels of financial and physical resilience.

Effective and sustainable insurance solutions require data and modeling capabilities that support the quantification of risks, probable maximum losses and premiums, but this data is not always available or historical data no longer reflects the increase in climate risk. To date, modelers have found it challenging to quantify the “resilience effects” that compensate for risk. When we can quantify “resilience,” I think there will be an even more compelling argument for combining insurance solutions with ex ante payments to policyholders to pay for loss prevention measures before a loss occurs.

There are plenty of growth opportunities for insurers: according to a Swiss Re Sigma Report (March 2023), fewer than half of global weather-related events are insured. There are still many markets with low insurance penetration and consequent protection gaps. Insurance can also play an important role in reducing the risk of the transition to a net-zero global economy by supporting green infrastructure projects with operational and project construction insurance coverage, thereby reducing the cost of capital for these projects. Renewable energy sources and carbon capture technologies have already given rise to new insurance products that provide coverage for operational deficiencies and problems.

Returning to our initial theme of deforestation caused by forest fires, an insurance solution could include mechanisms for site-specific preparation, loss prevention, fire suppression and recovery that are based on local nature-based solutions and, in addition to technical knowledge, utilize the local knowledge of various stakeholders, including indigenous knowledge where applicable (M. Essen et al., “Improving wildfire management outcomes: Shifting the paradigm of wildfire from simple to complex risk,” Journal of Environmental Planning and Management, 66:5, 909-927).

Local communities could also contribute more detailed data on exposure to risk at plot level, access to water supplies, firefighting equipment and existing prevention measures. Insurers can be a crucial part of a collaborative resilience-building process, raising awareness of risks and contributing their expertise in risk management. A climate resilient development bond structure insuring properties and businesses in specific forest areas could provide ex ante financing for key loss prevention measures at individual and community level.

By engaging at the local level and offering solutions that focus on local needs, insurers can build trust, paving the way for greater market penetration. Increased insurance take-up and strengthened resilience mean that protection gaps are reduced and, when a loss event occurs, the affected insured people and businesses can recover economically more quickly.

Let’s adopt the motto of COP28 – Unite. Act. Deliver – to work together on climate risk mitigation, adaptation and resilience with innovative insurance solutions. I’d love to hear about insurance as a facilitator of climate action at COP30 in Belem!

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* Franziska Arnold-Dwyer is Insurance Law and Sustainability Associate Professor at Queen Mary University of London. Her research focuses on sustainable insurance and insurance solutions to the global threat of climate change. She works closely with colleagues at Fundação Getulio Vargas’ Institute for Innovation in Insurance and Reinsurance (FGV IISR), a research institute dedicated to studying innovations in insurance against extreme weather events in Brazil. Her forthcoming book, “Insurance, Climate Change and the Law” (Routledge), will be published in March 2024.