
Across the globe, we are witnessing natural catastrophes increasing in frequency and severity, worsened by anthropogenic climate change. Too often the focus is on disaster recovery, with too little attention being given to loss prevention and preparedness for natural disasters. Can the insurance industry play a role in climate loss prevention?
Natural disasters and their impacts
Natural disasters destroy lives, physical and mental well-being, livelihoods, homes, commercial and communal property, and interrupt public services and business activities. Clean-up costs and lost economic activities during the reconstruction period generate additional costs. In 2023, natural catastrophes resulted in economic losses of USD 280 billion.1 Urban areas are particularly exposed because they are densely populated and contain a high concentration of housing, commercial property, infrastructure and public services.
According to the Intergovernmental Panel on Climate Change, there is increasing evidence that degradation and destruction of ecosystems increases vulnerability to natural disasters and weather extremes, and vulnerability also increases in countries with high levels of poverty, governance challenges and limited access to basic services and resources, violent conflict and high levels of climate-sensitive livelihoods.2 Where natural disasters interact with high vulnerability they can escalate into humanitarian crises, compounding food and water insecurity, the spread of infectious diseases, displacement, and the precarity of the livelihoods of local communities, as well as contributing to the growing debt burden of the least developed and developing countries.
Traditional role of insurance
The insurance sector plays a critical role in absorbing the financial risk of loss from natural catastrophes. Economies with high insurance penetration bounce back more quickly from natural disasters because claims payments provide a source of funding for recovery and reconstruction, allowing the real economy to resume business as usual more quickly.
However, this traditional model of insurance is challenged by the increasing frequency and severity of natural catastrophes, resulting in increasing losses and claims payments. In 2023, insurers paid USD 108 billion for natural catastrophe losses, which is above the previous 10-year average of USD 89 billion.3
In response to rising claims costs and limited reinsurance capacity, insurers are increasing premiums and reducing coverage, and in some regions are withdrawing coverage altogether, to maintain profitability. Rising premiums can make insurance increasingly unaffordable and give rise to protection gaps. Reducing coverage, exclusions for natural catastrophe losses, and withdrawal of coverage also create protection gaps. In 2023, over 60% of the global total economic losses from natural catastrophes were uninsured, leaving a protection gap of USD 172 billion.4
Protection gaps lead to financial hardship and can have cascading effects on the wider economy caused by the disruption to economic activities, supply chains, and the performance of loans and investments across the financial systems. Recently, the G7 Finance Ministers and G7 Central Bank recommended the establishment of public-private insurance programmes for addressing protection gaps, but they also noted the need for improving risk awareness and investing in loss prevention and reduction.5
Investing in loss prevention
Conventional property insurance indemnifies for actual loss proximately caused by an insured peril; it does not pay out in advance of a loss occurring and it does not usually cover the insured’s costs for pre-emptive loss prevention measures. Instead, some policies contain terms that seek to ensure that the insured risk does not increase after the contract of insurance has been established. Standard property policies do not tend to require policyholders to invest in and implement measures to prevent or reduce natural catastrophe losses.
But could insurers make advance payments for the purpose of reducing or preventing natural catastrophe losses, even before an insured event and its loss occurs? At first glance, this screams “insurance heresy,” being contrary to the indemnity principle, as well as potentially creating issues with reinsurance coverage, accounting and regulatory capital requirements.
And yet, the literal meaning of the “hold harmless” principle that underpins insurance is that the insurer promises to prevent the insured loss from happening.6 Economically, loss prevention makes sense. The proverb “prevention is better than cure” has been attributed to the Dutch Renaissance philosopher Erasmus van Rotterdam (1466–1536). It has become a fundamental principle in healthcare, where it means that proactive awareness and preventative interventions are more effective than later remedial action. As such, it is also reflected in health insurance where costs for health check-ups and diagnostic tests are often covered regardless of whether they reveal any medical conditions.
The US Chamber of Commerce, Allstate, and the US Chamber of Commerce Foundation recently published a report on the example of 25 disaster scenarios, which demonstrated that each USD 1 of investment in resilience and disaster preparedness reduces a community’s economic costs after an event by USD 7. Preparedness measures can reduce the number of lost jobs and lost homes, reduce the loss in population, and maintain labor force numbers and economic production, thereby ensuring income flows from continuing economic activities.7 Considering that insurers will pay for at least some of these losses, it is not unreasonable to suggest that they would benefit from contributing financially and with their risk management expertise to loss prevention and preparedness for natural catastrophes.
The idea that insurers pay for the costs of preventing loss is not new. For nearly 2 centuries, marine insurance contracts have contained sue and labour clauses, which require (1) the insured to take such measures as may be reasonable for the purpose of averting or minimising a loss, and (2) the insurer to pay to the insured any expenses properly incurred pursuant to the clause in addition to any indemnity payable.8 The insured’s duty to sue and labour comes into play when the peril has arisen or is imminent, a concept often expressed as “in the grip of a peril,” which is assessed by considering whether, based on the facts available at the relevant time, a reasonable person would regard the loss in question as sufficiently likely to happen sufficiently soon.
Challenges in implementing loss prevention
Could sue and labour clauses be a blueprint for insurers to contribute to loss prevention costs in relation to natural catastrophes? There are several considerations. First, the English courts have been skeptical toward any attempt to recover such costs from the insurer in the absence of express provisions.9 Such provisions are not as common in non-marine insurance contracts, but in principle an express sue and labour clause (or equivalent) that allows for the recovery of sue and labour costs could be included.
Second, the “imminence of loss” hurdle that applies in sue and labour clauses excludes from their scope measures taken in anticipation of future losses. While the occurrence of natural catastrophes is highly probable, they are not necessarily imminent in time. Property insurance wordings frequently use “reasonable precautions” clauses that require the insured to take steps to prevent or minimise future loss, but compliance is usually at the policyholder’s own expense, and courts have interpreted reasonable precaution clauses restrictively, so as not to undermine the intended insurance cover. A loss prevention provision could be drafted as a hybrid that draws on the structure of the sue and labour clause but extends its scope to anticipated losses.
Third, despite huge advances in attribution science, it is not (yet) possible to link causally climate change mitigation measures (i.e., reducing greenhouse gas emissions) to a (measurable) reduction in the risk of a natural catastrophe occurring in a specified region. In any event, any beneficial effect may not materialize until long after the expiry of the policy period. Therefore, loss prevention measures are likely to be focused on minimising exposure and vulnerability to natural catastrophes through climate change adaptation measures, as well as improving resilience and preparedness. If such provisions are too onerous on the insured in terms of costs and effort, they will render the insurance product uncompetitive and, in relation to consumer policyholders, are likely be regarded as unfair.
Fourth, loss prevention measures can be costly. While they benefit the insured and the wider community in the short and longer term, the insurer may only benefit fractionally for the time it is at risk for the property insured. Therefore, consideration must be given to the allocation of cost between the insured, the insurer and wider society (through taxpayers’ funds) that reflects the benefits that accrue to different stakeholders, on different timescales, and with different degrees of impact and probability. Under a sue and labour clause, the insured is reimbursed for expenses it has already incurred, rather than obtaining advance payment. Consumer policyholders and small businesses may not have the resources to pay for risk prevention measures up-front (or indeed for their own share of the costs). If advance payments are made by the insurer, there need to be control and accountability mechanisms to ensure that the funds are spent appropriately for pre-agreed loss prevention measures.
Fifth, consideration must be given to what extent advance payments for loss prevention made by an insurer are disclosable and recoverable under its reinsurance arrangements. It is for all of the above reasons that loss prevention measures for natural catastrophe risk require collaborative efforts between the insurance sector, policyholders, government, local communities and insurance regulators.
Looking forward
As natural catastrophes are increasing in frequency and severity, insurers’ capacity for absorbing losses is reaching its limits, while the value proposition of what insurance has to offer needs to keep pace. By enabling policyholders and communities in their loss prevention efforts, insurers can maintain insurability, counteract premium increases and address protection gaps, while supporting the sustainable growth of their businesses. With their risk management expertise, access to data and ability to leverage new technologies, insurers can expand their risk management services into loss prevention for climate change adaptation measures and preparedness for natural disasters. Prevention is better than uninsured losses and claims.
Footnotes
- Swiss Re Institute, ‘Sigma 01/2024: Natural catastrophes in 2023’ https://www.swissre.com/institute/research/sigma-research/sigma-2024-01.html
- IPCC, ‘Climate Change 2022: Impacts, Adaptation and Vulnerability’ (H.-O. Pörtner et al, Cambridge University Press 2021), Summary for Policymakers, B.2.1, 2.4 and 2.5 https://www.ipcc.ch/report/ar6/wg2/ Ibid.,
- Swiss Re Institute (n 1)
- Ibid.
- G7 Italia 2024 Finance Ministers and Central Bank Governors’ Meeting, ‘High-Level Framework for Public-Private Insurance Programmes against Natural Hazards’ (May 2024) https://www.g7italy.it/wp-content/uploads/Annex-II-Full-Document-High-Level-Framework-for-PPIPs-against-Natural-Hazards.pdf
- Sprung v Royal Insurance (UK) Ltd [1999] 1 Lloyd’s Rep IR 111
- U.S. Chamber of Commerce, Allstate, and the U.S. Chamber of Commerce Foundation, ‘The Preparedness Payoff: The Economic Benefits of Investing in Climate Resilience’ (June 2024) https://www.uschamber.com/security/the-preparedness-payoff-the-economic-benefits-of-investing-in-climate-resilience
- Marine Insurance Act 1906, s.78(4) and (1)
- Yorkshire Water Services Ltd v Sun Alliance and London Insurance Plc [1997] 2 Lloyd's Rep 21