Climate Change: Financial Risks to Federal and Private Insurers in Coming Decades are Potentially Significant
Published: 2007-05-03T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Weather-related events in the United States have caused tens of billions of dollars in damages annually over the past decade. A major portion of these losses is borne by private insurers and by two federal insurance programs-- the Federal Emergency Management Agency's National Flood Insurance Program (NFIP), which insures properties against flooding, and the Department of Agriculture's Federal Crop Insurance Corporation (FCIC), which insures crops against drought or other weather disasters. In this testimony, GAO (1) describes how climate change may affect future weather-related losses, (2) provides information on past insured weather-related losses, and (3) determines what major private insurers and federal insurers are doing to prepare for potential increases in such losses. This testimony is based on a report entitled Climate Change: Financial Risks to Federal and Private Insurers in Coming Decades are Potentially Significant (GAO-07-285) released on April 19, 2007.
section_title: What GAO Found
paragraphs: Key scientific assessments report that the effects of climate change on weather-related events and, subsequently, insured and uninsured losses, could be significant. The global average surface temperature has increased over the past century and climate models predict even more substantial, perhaps accelerating, increases in temperature in the future. Assessments by key governmental bodies generally found that rising temperatures are expected to increase the frequency and severity of damaging weather-related events, such as flooding or drought, although the timing and magnitude are as yet undetermined. Additional research on the effect of increasing temperatures on weather events is expected in the near future. Taken together, private and federal insurers paid more than $320 billion in claims on weather-related losses from 1980 to 2005. Claims varied significantly from year to year--largely due to the effects of catastrophic weather events such as hurricanes and droughts--but have generally increased during this period. The growth in population in hazard-prone areas and resulting real estate development have generally increased liabilities for insurers, and have helped to explain the increase in losses. Due to these and other factors, federal insurers' exposure has grown substantially. Since 1980, NFIP's exposure nearly quadrupled to nearly $1 trillion in 2005, and program expansion increased FCIC's exposure 26-fold to $44 billion. Major private and federal insurers are both exposed to the effects of climate change over coming decades, but are responding differently. Many large private insurers are incorporating climate change into their annual risk management practices, and some are addressing it strategically by analyzing its potential long-term industry-wide impacts. In contrast, federal insurers have not developed and disseminated comparable information on long-term financial impacts. GAO acknowledges that the federal insurance programs are not profit-oriented, like private insurers. Nonetheless, a strategic assessment of the potential implications of climate change for the major federal insurance programs would help the Congress manage an emerging high-risk area with significant implications for the nation's growing long-term fiscal imbalance.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our findings on the potential  financial implications of climate change for federal and private insurers.  My testimony is based on our report entitled Climate Change: Financial  Risks to Federal and Private Insurers in Coming Decades are Potentially  Significant, released on April 19, 2007. I also presented the findings and  recommendations from that report at a hearing before the Senate  Homeland Security and Governmental Affairs Committee on the same day.  The uncertain and potentially large losses associated with weather-related  events are among the biggest risks that property insurers face. Virtually  anything that is insured is vulnerable to weather-related events.
The property and casualty segment of the insurance industry, spanning  both the private and public sector, bears a large portion of weather-related  losses—the dollar value of claims paid on damage attributable to weather- related events. The private sector includes primary insurers that insure  individuals and businesses directly, and reinsurers that insure the primary  insurers. The public sector includes federal and state programs that were  established as an alternative to disaster assistance in markets where  private insurance markets did not exist, such as for crop losses, and for  losses that private insurers had deemed uninsurable, such as flood  damage. The Federal Crop Insurance Corporation (FCIC) was established  in 1938 to temper the economic impact of the Great Depression, and was  significantly expanded in 1980 to protect farmers from the financial losses  brought about by drought, flood, or other natural disasters. The  Department of Agriculture’s Risk Management Agency (RMA) administers  the program in partnership with private insurance companies, which share  a percentage of the risk of loss and the opportunity for gain associated  with each insurance policy written. The National Flood Insurance Program  (NFIP) was established in 1968 to protect communities vulnerable to flood  damage. The Federal Emergency Management Agency (FEMA), within the  Department of Homeland Security, is responsible for oversight and  management of the NFIP. Private insurers administer the program in  partnership with the federal government, but the federal government  assumes the full liability for losses.
To remain financially solvent, the insurance industry must estimate and  prepare for the potential impact of future weather-related events. Any  unanticipated changes in the frequency or severity of weather-related  events can have financial consequences at the company level and industry- wide. Some infrequent weather-related events—drought or hurricanes, for  example—are so severe that they pose unique challenges for insurers and  reinsurers. Commonly referred to as extreme or catastrophic events, the  unpredictability and sheer size of these events—both in terms of  geography and number of insured parties affected—have the potential to  overwhelm insurers’ and reinsurers’ capacity to pay claims.
The earth’s climate and weather patterns are dynamic, varying on  seasonal, decadal, and longer time scales. Of particular concern, the global  average surface temperature has increased by 1.3 degrees Fahrenheit (0.74  degrees Celsius) over the past 100 years, and the National Academy of  Sciences (NAS) and other scientific organizations have concluded that  available evidence points to continued, perhaps accelerating, increases  over the next century. Much research and policy debate of late has  centered on the extent to which human activities have contributed to this  warming and accompanying changes in climate, and how much is due to  natural variability. But in any case, climate change, defined by the  Intergovernmental Panel on Climate Change (IPCC) as any change in the  climate over time due to either natural variability or as a result of human  activity, may affect social and economic activities in potentially profound  ways—by raising sea levels, changing precipitation patterns, and altering  the frequency or severity of weather-related events.
My testimony summarizes our report, focusing on (1) what is known about  how climate change might affect the frequency and severity of damaging  weather-related events, (2) the extent of the insured losses incurred by  private and federal insurers and reinsurers resulting from weather-related  events, and (3) what major federal agencies and private insurers and  reinsurers are doing to prepare for the potential risk of increased losses.
To describe how climate change might affect insured and uninsured  losses, we reviewed and summarized key scientific assessments by  reputable international and national research organizations, including the  IPCC, NAS, and the multi-federal agency Climate Change Science Program  (CCSP). To determine the extent of insured losses, we analyzed key data  from 1980 through 2005 from the insurance industry and federal agencies.  Comparable data on 2006 losses were not available at the time we  completed work on our report. To determine what federal and private  insurers are doing to prepare for potential increases in losses, we  interviewed agency officials and a subset of the largest insurers and  reinsurers operating within the United States. We also interviewed officials  from catastrophe modeling firms, insurance industry associations, the  National Association of Insurance Commissioners, and universities to  provide additional context for respondents’ statements. In addition, we  reviewed key reports and publications from federal agencies, insurance  experts, and selected insurance companies. We performed our work in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Insurance is a mechanism for spreading risk over time, across large  geographical areas, and among industries and individuals. While private  insurers assume some financial risk when they write policies, they employ  various strategies to manage risk so that they earn profits, limit potential  financial exposure, and build capital needed to pay claims. For example,  insurers charge premiums for coverage and establish underwriting  standards, such as refusing to insure customers who pose unacceptable  levels of risk or limiting coverage in particular geographic areas. Insurance  companies may also purchase reinsurance to cover specific portions of  their financial risk. Reinsurers use strategies similar to primary insurers to  limit their risks.
Under certain circumstances, the private sector may determine that a risk  is uninsurable. For example, homeowner policies typically do not cover  flood damage because private insurers are unwilling to accept the risk of  potentially catastrophic losses associated with flooding. In other  instances, the private sector may be willing to insure a risk, but at rates  that are not affordable to many property owners. Without insurance,  affected property owners must rely on their own resources or seek out  disaster assistance from local, state, and federal sources.
In situations where the private sector will not insure a particular type of  risk, the public sector may create markets to ensure the availability of  insurance. The federal government operates two such programs—the  NFIP and the FCIC. NFIP provides insurance for flood damage to  homeowners and commercial property owners in more than 20,000  communities. Homeowners with mortgages from federally regulated  lenders on property in communities identified as being in high flood risk  areas are required to purchase flood insurance on their dwellings.  Optional, lower cost flood insurance is also available under the NFIP for  properties in areas of lower flood risk. NFIP offers coverage for both the  property and its contents, which may be purchased separately. FCIC  insures agricultural commodities on a crop-by-crop and county-by-county  basis based on farmer demand and the level of risk associated with the  crop in a given region. Major crops, such as grains, are covered in almost  every county where they are grown, while specialty crops such as fruit are  covered only in some areas. Participating farmers can purchase different  types of crop insurance and at different levels.
section_title: Climate Change Is Expected to Alter the Frequency or Severity of Damaging Weather- Related Events
paragraphs: Assessments by leading scientific bodies suggest that climate change  could significantly alter the frequency or severity of weather-related  events, such as drought and hurricanes. Leading scientific bodies report  that the Earth warmed during the twentieth century— 1.3 degrees  Fahrenheit (0.74 degrees Celsius) from 1906 to 2005 according to a recent  IPCC report—and is projected to continue to warm for the foreseeable  future. While temperatures have varied throughout history, triggered by  natural factors such as volcanic eruptions or changes in the earth’s orbit,  the key scientific assessments we reviewed have generally concluded that  the observed increase in temperature in the past 100 years cannot be  explained by natural variability alone. In recent years, major scientific  bodies such as the IPCC, NAS, and the United Kingdom’s Royal Academy  have concluded that human activities are significantly increasing the  concentrations of greenhouse gases and, in turn, global temperatures.  Assuming continued growth in atmospheric concentration of greenhouse  gases, the latest assessment of computer climate models projects that  average global temperatures will warm by an additional 3.2 to 7.2 degrees  Fahrenheit (1.8 to 4.0 degrees Celsius) during the next century.
Based on model projections and expert judgment, the IPCC reported that  future increases in the earth’s temperature are likely to increase the  frequency and severity of many damaging extreme weather-related events  (summarized in table 1). The IPCC recently published summaries of two of  the three components of its Fourth Assessment Report. The first, in which  IPCC summarized the state of the physical science, reports higher  confidence in projected patterns of warming and other regional-scale  features, including changes in wind patterns, precipitation, and some  aspects of extreme events such as drought, heavy precipitation events, and  hurricanes. The second, in which IPCC addresses climate impacts and  vulnerabilities, reported that the potential societal impacts from changes  in temperature and extreme events vary widely across sector and region.  For example, although the IPCC projects moderate climate change may  increase yields for some rain-fed crops, crops that are near their warm  temperature limit or depend on highly-used water resources face many  challenges. Additionally, local crop production in any affected area may be  negatively impacted by projected increases in the frequency of droughts or  floods. Furthermore, the IPCC stated that the economic and social costs of  extreme weather events will increase as these events become more  intense and/or more frequent. Rapidly-growing coastal areas are  particularly vulnerable, and the IPCC notes that readiness for increased  exposure in these areas is low. These reports have not been publicly  released in their entirety, but are expected sometime after May 2007.
In addition to the IPCC’s work, CCSP is assessing potential changes in the  frequency or intensity of weather-related events specific to North America  in a report scheduled for release in 2008. According to a National Oceanic  and Atmospheric Administration official and agency documents, the report  will focus on weather extremes that have a significant societal impact,  such as extreme cold or heat spells, tropical and extra-tropical storms, and  droughts. Importantly, officials have said the report will provide an  assessment of the observed changes in weather and climate extremes, as  well as future projections.
section_title: Weather-Related Insured Losses Totaled More Than $320 Billion between 1980 and 2005 and Appear to Be Increasing
paragraphs: Based on an examination of loss data from several different sources, we  found that insurers incurred about $321.2 billion in weather-related losses  from 1980 through 2005. In particular, as illustrated in Figure 1, our  analysis found that weather-related losses accounted for 88 percent of all  property losses paid by insurers during this period. All other property  losses, including those associated with earthquakes and terrorist events,  accounted for the remainder. Weather-related losses varied significantly  from year to year, ranging from just over $2 billion in 1987 to more than  $75 billion in 2005.
Private insurers paid $243.5 billion—over 75 percent of the total weather- related losses we reviewed. The two major federal insurance programs— NFIP and FCIC—paid the remaining $77.7 billion of the $321.2 billion in  weather-related loss payments we reviewed. NFIP paid about $34.1 billion,  or about 11 percent of the total weather-related loss payments we  reviewed during this period. As illustrated in Figure 2, claims averaged  about $1.3 billion per year, but ranged from $75.7 million in 1988 to $16.7  billion in 2005.
Since 1980, FCIC claims totaled $43.6 billion, or about 14 percent of all  weather-related claims during this period. As illustrated in Figure 3, FCIC  losses averaged about $1.7 billion per year, ranging from $531.8 million in  1987 to $4.2 billion in 2002.
The largest insured losses in the data we reviewed were associated with  catastrophic weather events. Notably, crop insurers and other property  insurers both face catastrophic weather-related risks, although the nature  of the events for each is very different. In the case of crop insurance,  drought accounted for more than 40 percent of weather-related loss  payments from 1980 to 2005, and the years with the largest losses were  associated with drought. Taken together, though, hurricanes were the  most costly event in the data we reviewed. Although the United States  experienced an average of only two hurricanes per year from 1980 through  2005, weather-related claims attributable to hurricanes totaled more than  45 percent of all weather-related losses—more than $146 billion.  Moreover, as illustrated in Table 2, these losses appear to have increased  during the past three decades.
Several recent studies have commented on the apparent increases in  hurricane losses during this time period, and weather-related disaster  losses generally, with markedly different interpretations. Some argue that  loss trends are largely explained by changes in societal and economic  factors, such as population density, cost of building materials, and the  structure of insurance policies. Others argue that increases in losses have  been driven by changes in climate. To address the issue, Munich Re—one  of the world’s largest reinsurance companies—and the University of  Colorado’s Center for Science and Technology Policy Research jointly  convened a workshop in Germany in May 2006 to assess factors leading to  increasing weather-related losses. The workshop brought together a  diverse group of international experts in the fields of climatology and  disaster research. Workshop participants agreed that long-term records of  disaster losses indicate that societal change and economic development  are the principal factors explaining weather-related losses. However,  participants also agreed that changing patterns of extreme events are  drivers for recent increases in losses, and that additional increases in  losses are likely, given IPCC’s projections.
The close relationship between the value of the resource exposed to  weather-related losses and the amount of damage incurred may have  ominous implications for a nation experiencing rapid growth in some of its  most disaster-prone areas. AIR Worldwide, a leading catastrophe modeling  firm, recently reported that insured losses should be expected to double  roughly every 10 years because of increases in construction costs,  increases in the number of structures, and changes in their characteristics.  AIR’s research estimates that, because of exposure growth, probable  maximum catastrophe loss—an estimate of the largest possible loss that  may occur, given the worst combination of circumstances—grew in  constant 2005 dollars from $60 billion in 1995 to $110 billion in 2005, and it  will likely grow to over $200 billion during the next 10 years.
section_title: Major Private and Public Insurers Differ in How They Manage Catastrophic Risks Associated with Climate Change
paragraphs: Major private and federal insurers are responding differently to the  prospect of increasing weather-related losses associated with climate  change. Many large private insurers are incorporating both near and  longer-term elements of climatic change into their risk management  practices. On the other hand, for a variety of reasons, the federal insurance  programs have done little to develop the kind of information needed to  understand the programs’ long-term exposure to climate change.
subsections: section_title: Major Private Insurers Prospectively Manage Potential Increases in Catastrophic Risk Associated with Climate Change
paragraphs: Catastrophic weather events pose a unique financial threat to private  insurers’ financial success because a single event can cause insolvency or  a precipitous drop in earnings, liquidation of assets to meet cash needs, or  a downgrade in the market ratings used to evaluate the soundness of  companies in the industry. To prevent these disruptions, the American  Academy of Actuaries (AAA)—the professional society that establishes,  maintains, and enforces standards of qualification, practice, and conduct  for actuaries in the United States—recommends, among other steps, that  insurers measure their exposure to catastrophic weather-related risk. In  particular, AAA emphasizes the shortcomings of estimating future  catastrophic risk by extrapolating solely from historical losses, and  endorses a more rigorous approach that incorporates underlying trends  and factors in weather phenomena and current demographic, financial,  and scientific data to estimate losses associated with various weather- related events.
In our interviews with eleven of the largest private insurers operating in  the U.S. property casualty insurance market, we sought to determine what  key private insurers are doing to estimate and prepare for risks associated  with potential climatic changes arising from natural or human factors.  Representatives from each of the 11 major insurers we interviewed told us  they incorporate near-term increases in the frequency and intensity of  hurricanes into their risk estimates. Six specifically attributed the higher  frequency and intensity of hurricanes to a 20- to 40-year climatic cycle of  fluctuating temperatures in the north Atlantic Ocean, while the remaining  five insurers did not elaborate on the elements of climatic change driving  the differences in hurricane characteristics.
In addition to managing their aggregate exposure on a near-term basis,  some of the world’s largest insurers have also taken a longer-term  strategic approach to changes in catastrophic risk. Six of the eleven  private insurers we interviewed reported taking one or more additional  actions when asked if their company addresses climatic change in their  weather-related risk management processes. These activities include  monitoring scientific research (4 insurers), simulating the impact of a large  loss event on their portfolios (3 insurers), and educating others in the  industry about the risks of climatic change (3 insurers), among others.  Moreover, major insurance and reinsurance companies, such as Allianz,  Swiss Re, Munich Re, and Lloyds of London, have published reports that  advocate increased industry awareness of the potential risks of climate  change, and outline strategies to address the issue proactively.
section_title: Major Federal Insurers Have Taken Little Action to Prospectively Assess and Disseminate Information on Potential Increases in Catastrophic Risk Associated with Climate Change
paragraphs: NFIP and FCIC have not developed information on the programs’ longer- term exposure to the potential risk of increased extreme weather events  associated with climate change as part of their risk management practices.  The goals of the key federal insurance programs are fundamentally  different from those of private insurers. Whereas private insurers stress  the financial success of their business operations, the statutes governing  the NFIP and FCIC promote affordable coverage and broad participation  by individuals at risk over the programs’ financial self-sufficiency by  offering discounted or subsidized premiums. Also unlike the private  sector, the NFIP and the FCIC have access to additional federal funds  during high-loss years. Thus, neither program is required to assess and  limit its catastrophic risk strictly within its ability to pay claims on an  annual basis. Instead, to the extent possible, each program manages its  risk within the context of its broader purposes in accordance with  authorizing statutes and implementing regulations.
Nonetheless, an improved understanding of the programs’ financial  exposure is becoming increasingly important. Notably, the federal  insurance programs’ liabilities have grown significantly, which leaves the  federal government increasingly vulnerable to the financial impacts of  catastrophic events. Data obtained from both the NFIP and FCIC  programs indicate the federal government has grown markedly more  exposed to weather-related losses. Figure 4 illustrates the growth of both  program’s exposure from 1980 to 2005. For NFIP, the program’s total  coverage increased fourfold in constant dollars during this time from  about $207 billion to $875 billion in 2005 due to increasing property values  and a doubling of the number of policies from 1.9 million to more than 4.6  million. The FCIC has effectively increased its exposure base 26-fold  during this period. In particular, the program has significantly expanded  the scope of crops covered and increased participation. The main  implication of the exposure growth for both the programs is that the  magnitude of potential claims, in absolute terms, is much greater today  than in the past.
Neither program has assessed the implications of a potential increase in  the frequency or severity of weather-related events on program operations,  although both programs have occasionally attempted to estimate their  aggregate losses from potential catastrophic events. For example, FCIC  officials stated that they had modeled past events, such as the 1993  Midwest Floods, using current participation levels to inform negotiations  with private crop insurers over reinsurance terms. However, NFIP and  FCIC officials explained that these efforts were informal exercises, and  were not performed on a regular basis. Furthermore, according to NFIP  and FCIC officials, both programs’ estimates of weather-related risk rely  heavily on historical weather patterns. As one NFIP official explained, the  flood insurance program is designed to assess and insure against current— not future—risks. Over time, agency officials stated, this process has  allowed their programs to operate as intended. However, unlike private  sector insurers, neither program has conducted an analysis of the potential  impacts of an increase in the frequency or severity of weather-related  events on continued program operations in the long-term.
section_title: Information on Federal Agencies’ Long-Term Exposure to Catastrophic Risk Could Better Inform Congressional Decision- Making
paragraphs: While comprehensive information on federal insurers’ long-term exposure  to catastrophic risk associated with climate change may not inform the  NFIP’s or FCIC’s day-to-day operations, it could nonetheless provide  valuable information for the Congress and other policy-makers who need  to understand and prepare for fiscal challenges that extend well beyond  the two programs’ near-term operational horizons. We have highlighted  the need for this kind of strategic information in recent reports that have  expressed concern about the looming fiscal imbalances facing the nation.  In particular, we observed that, “Our policy process will be challenged to  act with more foresight to take early action on problems that may not  constitute an urgent crisis but pose important long-term threats to the  nation’s fiscal, economic, security, and societal future.” The prospect of  increasing program liabilities, coupled with expected increases in  frequency and severity of weather events associated with climate change,  would appear to fit into this category.
Agency officials identified several challenges that could complicate their  efforts to assess these impacts at the program level. Both NFIP and FCIC  officials stated there was insufficient scientific information on projected  impacts at the regional and local level to accurately assess their impact on  the flood and crop insurance programs. However, members of the  insurance industry have analyzed and identified the potential risks climatic  change poses to their business, despite similar challenges. Moreover, as  previously discussed, both the IPCC and CCSP are expected to release  significant assessments of the likely effect of increasing temperatures on  weather events in coming months.
The experience of many private insurers, who must proactively respond to  longer-term changes in weather-related risk to remain solvent, suggests  the kind of information that needs to be developed to make sound  strategic decisions. Specifically, to help ensure their future viability, a  growing number of private insurers are actively incorporating the potential  for climate change into their strategic level analyses. In particular, some  private insurers have run a variety of simulation exercises to determine  the potential business impact of an increase in the frequency and severity  of weather events. For example, one insurer simulated the impact of  multiple large weather events occurring simultaneously. We believe a  similar analysis could provide Congress with valuable information about  the potential scale of losses facing the NFIP and FCIC in coming decades,  particularly in light of the programs’ expansion over the past 25 years.
section_title: Concluding Observations
paragraphs: We believe that the FCIC and NFIP are uniquely positioned to provide  strategic information on the potential impacts of climate change on their  programs—information that would be of value to key decision makers  charged with a long-term focus on the nation’s fiscal health. Most notably,  in exercising its oversight responsibilities, the Congress could use such  information to examine whether the current structure and incentives of  the federal insurance programs adequately address the challenges posed  by potential increases in the frequency and severity of catastrophic  weather events. While the precise content of these analyses can be  debated, the activities of many private insurers already suggest a number  of strong possibilities that may be applicable to assessing the potential  implications of climate change on the federal insurance programs.
Accordingly, our report recommended that the Secretary of Agriculture  and the Secretary of Homeland Security direct the Administrator of the  Risk Management Agency and the Under Secretary of Homeland Security  for Emergency Preparedness assess the potential long-term implications of  climate change for the FCIC and the NFIP, respectively, and report their  findings to the Congress. This analysis should use forthcoming  assessments from the Climate Change Science Program and the  Intergovernmental Panel on Climate Change to establish sound estimates  of expected future conditions. Both agencies expressed agreement with  this recommendation. In addition, at an April 19, 2007, hearing on our  report convened by the Senate Homeland Security and Governmental  Affairs Committee, Chairman Joseph Lieberman and Ranking Member  Susan Collins directed the agencies to provide the Committee a deadline  by which they plan to transmit this assessment to the Congress in  fulfillment of this recommendation. Chairman Lieberman also asked the  agencies to prepare and disseminate this assessment independent of any  annual reports to the Congress.
Mr. Chairman, this concludes my prepared statement. I would be happy to  respond to any questions that you or other Members of the Committee  may have.
section_title: Key Contact and Staff Acknowledgments
paragraphs: For further information about this testimony, please contact me, John  Stephenson, at 202-512-3841 or stephensonj@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found on  the last page of this statement. Contributors to this testimony include  Steve Elstein, Assistant Director; Chase Huntley; Micah McMillan; Alison  O’Neill; Kate Robertson; and Lisa Van Arsdale.
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