INDIA (DOMESTIC FIRMS): An Introduction to Insurance

Climate Risk and the Future of Insurance

In recent years, natural disasters have become more frequent and unpredictable globally, including in India. Climate change has the foremost impact on human life and livelihood and has wide-ranging implications for the economy. Businesses continue to face immense challenges due to climate risk, and economically weaker sectors and socially vulnerable groups are the hardest hit by the effects of climate change.

Challenges faced by insurers and policyholders

As a result of climate change, insurers are facing increasing risks and challenges in underwriting and pricing suitable insurance products. Unpredictable risks on account of climate change result in massive insured losses, which have an adverse effect on the balance sheet of insurers. At the same time, there is a lack of innovative insurance products to adequately protect policyholders, given the ever-evolving landscape and the highly unpredictable nature of such losses.

In many cases, insurers are unable to price climate-related risks accurately given the challenges involved in modelling such risks.

It is therefore imperative for insurers to factor in climate-risk considerations while developing insurance products, and appropriate metrics need to be considered while underwriting such risks. Innovative insurance products aimed at specific risks such as floods, droughts and other extreme weather events, need to be tailored to provide sufficient coverage while at the same time ensuring that such products are affordable.

The need for greater use of technology

There is also a need for greater use of technology and leveraging of artificial intelligence to better understand climate patterns and financial modelling of climate risk. Insurers are increasingly using AI to process big data sets in order to assess risk better and price products appropriately. Technology could prove to be a critical tool and could greatly benefit insurers in managing their exposure to climate risk, and also in managing the large volume of claims which arise from extreme weather events.

Parametric insurance

Parametric insurance could be widely offered for climate-risk mitigation. Under a parametric insurance policy, the policyholder is insured against certain pre-defined parameters. Once the parameters are met, this triggers a payout which is pre-determined, unlike a typical insurance policy, where the payout is linked to the magnitude of the loss. Parametric insurance cover ensures certainty, faster payouts, simplifies the underwriting process and caps the liability of the insurer, thereby making it effective for high-severity, low-frequency events where uncertainties are high. In the Indian insurance market, weather index-based insurances are offered by certain Indian insurers and are very attractive for farmers, given that their crop yield is heavily dependent on the annual monsoon. For example, some states in India have launched a weather-based crop insurance scheme. In the case of an adverse weather event, all the insured farmers in the relevant area will be deemed to have suffered the same level of crop loss, making all of them eligible for the same level of insurance payout.

ESG and investment

ESG factors are also increasingly becoming important parameters for any investment-making process. A large number of investors today carry out an ESG due diligence to understand the impact that the investee company has on the surrounding ecosystem. ESG metrics are also monitored after the investment.

The role insurers can play

Insurers can play a role in mitigating environmental risks and creating a more resilient society by nudging businesses and individuals to adopt sustainable practices, thereby promoting sustainable development. Insurers can also promote sustainable practices by offering insurance products that specifically address climate risks by offering adequate cover and by being affordable. They can also incentivise policyholders to adopt environmentally friendly practices by offering lower premiums or discounts. For example, insurers could provide premium discounts to individuals or businesses purchasing eco-friendly or more energy-efficient equipment and appliances, rewarding them for green behaviour.

Insurers can also help mitigate climate risk by taking initiatives so that customers do not suffer losses. There are instances in the United States where insurers have given policyholders access to certain services as a prevention and mitigation measure. Insurers could also independently take ESG factors into consideration while making investments, and increase their investment in eco-friendly sectors.

Increased regulatory influence

Insurance regulators worldwide have been agile and quick to act on the changing demands of businesses. A nimble-footed approach was adopted by insurance regulators globally while tackling various issues during COVID-19.

In recent times, there has been an increased regulatory influence on insurers to promote sustainable insurance practices while tackling climate risk. In this context, the Indian regulator, the Insurance Regulatory and Development Authority of India (IRDAI), has introduced certain noteworthy measures, such as insurers being required to have in place a board-approved ESG framework and for the ESG activities of the insurer to be monitored by this board. Also, foreign reinsurers’ branch offices in India are required to have an ESG framework approved by the board of their parent entity. Boards of insurers have been additionally mandated to establish a comprehensive climate-risk management framework to facilitate climate-risk management, keeping in mind their size, and the nature and complexity of their operations.

The IRDAI has permitted discounts on insurance premiums for electric and hybrid-electric vehicles. Separately, the IRDAI has encouraged insurers to invest in sovereign green bonds with the objective of de-concentration and diversification of their infrastructure investment portfolio, and for proactive participation in sustainable development. Insurers are now also required to monitor ESG risks in their investee companies.

The above steps show keen regulatory intent in India to address climate risk and promote sustainable development. The impact of climate change poses various challenges in the insurance sector and requires insurers to integrate various factors while underwriting risks and making investments. There is a need for more collaboration between the regulator and insurers to promote sustainable development and a robust climate insurance market in India. Increased insurance penetration will result in better insurance coverage to deal with climate risk, which can be achieved by increasing awareness and developing affordable and effective insurance products, and state-sponsored or state-subsidised insurance cover, for economically weaker sectors.