Why Home and Vehicle Insurers are Between a Rock and a Hard Place

When it comes to insurance risk assessments, climate change is no longer that far-off, rumbling storm cloud. In fact, it’s already started raining. Traditional actuarial methods based on historical data are becoming obsolete as extreme weather events increase in frequency and severity, and insurers grapple with the challenge of covering houses and cars increasingly at risk of environmental damage.

Impact on Insurers’ Profitability

Insurers have long relied on the law of large numbers and the principle of indemnity to calculate premiums and manage risk pools. However, climate change has already disrupted these fundamental principles. The result? A significant decline in profitability and an increasing number of policy non-renewals, particularly in high-risk areas.

In the US, non-renewals of home and fire insurance policies jumped from 11% in 2018 to 13% in 2021.  ⁱThis is a modest increase, but given that, in the UK home insurance market, 90% of policyholders are existing customers, even a small swing in non-renewals will make a big splash on year-end profit margins.  ⁱⁱThis change is likely driven by the soaring costs of insuring homes, particularly in areas prone to natural disasters - often the same areas where the most socioeconomically vulnerable segments of the population live.

Extreme Weather, Extreme Costs

In a typical autumn/winter storm season, the UK experiences six or seven storms, usually reaching the letters F or G in the alphabetical naming system.  ⁱⁱⁱHowever, the 2023/24 season saw 11 storms, resulting in us reaching the letter K with Storm Kathleen. A study by Imperial College London revealed that rainfall during autumn and winter storms in the UK and Ireland in 2023/24 was about 20% more intense due to manmade climate change - and it’s expected to get worse.^iv

However, the threat of climate change isn’t limited to flood-prone areas - urban residents are feeling the effects as well, with record-breaking temperatures in large cities causing subsidence to become increasingly likely. In 2022, Halifax Home Insurance reported that the number of subsidence cases it received in August and September was three times that of the typical monthly average.  ^vOverall, it saw a 45% increase in claims compared to the previous year.

So, how can insurers (and reinsurers) manage increasingly volatile risk profiles while keeping costs at a manageable level?

Predicting Future Risk Environments

The industry has only been tracking advanced data about certain climate phenomena, like storms, for a limited number of years. Therefore, traditional actuarial models based on the principle of stationarity are becoming increasingly unreliable. We know storms are becoming more frequent, but firms often don't have the technology or data to accurately predict where they will hit hardest and who will be most at risk. There are simply too many unaccounted variables to make informed decisions on pricing.

In addition, the industry is having to confront the concept of "silent climate risk" – climate-related exposures that are neither explicitly included nor excluded in policies. This parallels the challenges faced with "silent cyber" risks. For firms to reassure policyholders and eliminate potential legal ambiguity, they may want to consider reviewing policy wordings across various lines of business.

Factoring in Government Action

Risk profiles are tied to both natural phenomena and human action—or inaction, in many cases. Government policies and investments in infrastructure should also factor into firms’ decision-making, as they play a crucial role in mitigating climate catastrophes. For example, the effectiveness of flood defences and improved water drainage systems can significantly impact the severity of future floods and will certainly change how houses are assessed for risk when pricing insurance.

However, the pace and extent to which governments take action to mitigate the impact of climate disasters can vary and timelines are often ripped up and changed, adding another layer of complexity to risk assessments. Accounting for different policy outcomes through scenario analysis will be crucial here. For instance, the Task Force on Climate-related Financial Disclosures (TCFD) recommends that companies consider scenarios where global temperature increases are limited to 2°C or lower, as well as higher temperature scenarios.^vi

AI as a Path Forward for Insurers

Assessing and managing risk is a complex, frustrating task even at the best of times. When it comes to planet-altering phenomena that affect our environment and our weather—it only makes it harder. In the light of these challenges, it is more important than ever to have strong AI models which can work from what we know, while acknowledging a wider range of outcomes and tolerance for error. Indeed, when losses do occur, technologies such as generative AI and computer vision lend themselves to quicker assessment of exposure calculations and of claims.

If you would like to hear more about how NTT DATA can support your organisation’s digital transformation journey, book a free 45-minute consultation today.