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

Letter

Background

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.

Climate Change Is Expected to Alter the Frequency or Severity of Damaging Weather- Related Events

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.

Weather-Related Insured Losses Totaled More Than $320 Billion between 1980 and 2005 and Appear to Be Increasing

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.

Major Private and Public Insurers Differ in How They Manage Catastrophic Risks Associated with Climate Change

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.

Major Private Insurers Prospectively Manage Potential Increases in Catastrophic Risk Associated with Climate Change

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.

Major Federal Insurers Have Taken Little Action to Prospectively Assess and Disseminate Information on Potential Increases in Catastrophic Risk Associated with Climate Change

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.

Information on Federal Agencies’ Long-Term Exposure to Catastrophic Risk Could Better Inform Congressional Decision- Making

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.

Concluding Observations

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.

Key Contact and Staff Acknowledgments

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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