Mind the “NatCat” gap – the natural catastrophe insurance protection gap

A series of devastating environmental catastrophes in Europe and across the globe in the summer of 2023 has further demonstrated the growing urgency to get on top of the climate crisis. European (re)insurers know that they have a role to play and are grappling with the need, on the one hand, to integrate climate change risk into their governance and risk management frameworks as they would other key risks, and on the other hand, to continue to offer products and solutions that meet their customers’ needs. This is no small undertaking.

In this short article, we:

• explore the European Insurance and Occupational Pensions Authority’s (EIOPA) growing concerns about the insurance implications of the climate crisis, particularly in relation to the “insurance protection gap” in respect of natural catastrophe (NatCat) insurance
• consider what practical next steps insurers and businesses might consider taking

What is the insurance protection gap?

The insurance protection gap relates to the concerningly small number of people and businesses that are sufficiently insured against natural disasters. As of February 2023, EIOPA estimated that only 23% of the total losses caused by catastrophic climate-related events were insured across Europe. A recent speech by Petra Hielkema, the Chairperson of EIOPA, to a conference of the Croatian Financial Services Supervisory Authority noted that Europe is the fastest-warming continent in the world and was warming at twice the speed of the global average since the 1980s. This would indicate that the insured volume of total losses resulting from climate change is likely to become even lower over time.

Policy exclusions

In January 2023, EIOPA released a supervisory statement in relation to exclusions in insurance products relating to risks arising from systemic events (including natural catastrophes). The statement noted that the increasing volume of natural catastrophes has the potential to make insurance products unaffordable. In addition, products which would have traditionally covered such events or which may have been silent tend now to explicitly exclude them to allow the insurance sector to limit its exposures. It was noted, in particular, by national competent authorities that insurers were creating new exclusions without a proper application of product oversight and governance requirements.

Product oversight and governance requirements oblige insurers (and other manufacturers of insurance products) to factor the objectives of customers into the product approval and product testing processes for each insurance product as well as target market identification processes and distribution channels. The supervisory statement noted that issues were arising in relation to insufficient disclosure of changes to insurance products and processes that did not fully take into account customer expectations and the target market’s needs, objectives and characteristics.

While the supervisory statement did not go so far as purport to restrict insurers’ ability to create exclusions, it did say that insurers should operate in accordance with product oversight and governance rules, in particular that product disclosures should be tested to ensure that customers were making well informed decisions while properly understanding any applicable exclusions.

Public perceptions

EIOPA has pointed out that as well as exclusions in insurance products, a significant part of the protection gap also results from customer perceptions.

In July 2023, EIOPA released research in relation to the reasons why European consumers and firms are reluctant to avail of existing insurance options and to set out potential solutions that might result in more Europeans purchasing NatCat insurance products. The findings identified a number of factors specific to NatCat insurance that are leading to a lack of customers willing to buy NatCat insurance products. These included the perceived unaffordability of coverage, a misperception of the risks of NatCat events occurring, and misguided expectations as to the level of state intervention in a NatCat event.

EIOPA’s proposed solutions to these problems included increasing the level of risk awareness, better standardisation of products, simplification of purchasing processes and reductions in premium where risk mitigation measures are put in place.

Closing the “gap”

Conscious of the severe risks that the NatCat insurance gap poses to economic and financial stability, EIOPA has collaborated with the ECB on proposals to begin addressing it. In a joint discussion paper published in April 2023, the two supervisory authorities proposed measures that would incentivise risk mitigation and adaptation, involve the sharing of costs across all relevant stakeholders and lower the share of economic losses arising from NatCat events borne by the public sector. They set out the following “ladder approach” to gradually build up insurance coverage as well as spreading the risk more widely:

• Layer 1 – Potential measures to enhance private insurance and impact underwriting: This involves insurers incentivising risk reduction and adaptation to support insurability e.g. by offering premium deductions for property insurance where premises are built using flood-proofing standards.
• Layer 2 – Potential measures relating to reinsurance and catastrophe bonds: The supervisory authorities state that reinsurance improves insurability in high-risk areas but that, ultimately, the cost may become uneconomical for reinsurers at the highest loss layers. In this context, insurance-linked securities such as catastrophe bonds are recommended. Such bonds allow NatCat risk to be transferred to a wide set of investors, who are increasingly turning to investments that general a social or environmental benefit as part of their ESG strategies.
• Layer 3 – National measures – the role of the public sector: In this respect, the supervisory authorities recommend public private partnerships such as schemes in France and Spain that provide reinsurance for natural disaster-related property risks. The supervisory authorities note that such public private partnerships should be more than just a financial backstop but should share the risk arising from NatCat events between the public and private sectors.
• Layer 4 – EU-level measures – The supervisory authorities note that the EU Solidarity Fund provides limited relief in the case of major disasters but that the amount paid out is small compared to the overall cost of those disasters. The supervisory authorities suggest widening the scope of support that is available at a European level.

Next steps

As the climate crisis becomes more pressing and the NatCat insurance protection gap widens, insurers can expect to see more action at both European level and by regulators in individual member states to address the growing problem.

Insurers will be expected to ensure that exclusions in policies are carefully considered and properly disclosed and that products are designed in such a way that businesses are incentivised (for example, through premium reductions) to adopt risk mitigation and climate adaptation steps. More broadly, despite the costs, businesses will have to consider purchasing NatCat insurance products as the frequency and intensity of extreme weather events increases but can avail of opportunities to reduce the costs of such insurance by adopting risk mitigation practices.

Insurers may wish to consider the following:

• whether disclosures to customers in relation to exclusions have been carefully considered in light of product oversight and governance requirements and whether the scope of such conclusions is easily understood by customers
• whether, for products that cover NatCat events, appropriate reductions in premium are provided where the customer engages in risk mitigation measures. Insurers may wish to consider what practical education and other supports they can offer in this regard
• whether any new and innovative insurance products or co-insurance arrangements could be developed to address NatCat risks in a prudent way
• engagement with regulators and other stakeholders on potential public and European solutions closing the protection gap

Businesses in general may wish to consider the following:

• whether their policies contain any exclusions for NatCat events
• engaging with their brokers and insurers to find out if any measures could be taken to reduce risk and whether any insurance policies currently held by the business or available on the market provide incentives such as a reduction in premium for the taking of those steps

For advice or for further information on this topic please contact Laura Mulleady, Partner, Niall Guinan, Associate, or any member of the Insurance & Reinsurance team at ALG.

Date published: 4 October 2023