Number 15

The Earth’s climate is shaped by a complex interplay of natural cycles operating over various timescales. From the perspective of the insurance business, the primary concern is in short- and medium-term cycles, particularly those observed over the past few centuries or even recent decades. These cycles affect the intensity and frequency of extreme weather events such as hurricanes, typhoons, cyclones, hailstorms, wildfires, droughts, heatwaves, severe thunderstorms, cold snaps, snowstorms, ice storms, frost, bomb cyclones, extratropical cyclones, atmospheric rivers, gales, convective gusts, extreme cold, storm surges, snow avalanches, and upper-level cut-off lows.

The intensification of these phenomena is largely driven by global warming, which is disrupting climate patterns and increasing both the frequency and severity of extreme weather events. Since 1850, anomalies have been observed in global land and ocean surface temperatures, with averages rising significantly above long-term historical norms. Numerous studies link this trend to the industrial revolutions, identifying greenhouse gas emissions as a key driver of the planet’s accelerating temperature rise (see Chart 1). Climate prediction models, including weather forecasting systems, climate change simulations, and artificial intelligence, are essential tools for estimating risk levels and potential economic losses associated with extreme weather events.

The insurance protection gap for natural disasters refers to the difference between the total economic losses caused by such events and the portion covered by insurance policies. Certain catastrophic events are so large and systemic that neither the private sector nor public authorities can manage them independently, resulting in significant shortfalls in insurance coverage—often referred to as the “CatNat Gap.” This gap is especially pronounced in regions such as Asia and Latin America, where only a small share of losses is covered by insurance. Tropical cyclones and flooding account for the highest accumulated losses, underscoring the need to improve insurance coverage in these areas.

Between 2013 and 2022, hurricanes caused an estimated 899 billion dollars in economic losses, of which only 360 billion dollars were insured, representing an insurance coverage rate of 40%. Flooding alone caused approximately 496 billion dollars in damages, with an insurance coverage gap of 80.6%. These figures highlight the urgent need to close the insurance protection gap in order to mitigate the economic impact of natural disasters. Global losses from such events show substantial year-to-year variability but exhibit a clear upward trend, driven not only by the effects of climate change but also by economic and population growth, along with urban sprawl in high-risk areas (see Chart 2).

Disaster protection mechanisms include public-private partnerships, government-backed insurance funds, and subsidized coinsurance programs with varying structures across countries. Although still underdeveloped, there are also some regional mechanisms, such as those operating in the Caribbean and Africa.

In the United States, for example, there are programs such as the National Flood Insurance Program (NFIP) and the California Earthquake Authority (CEA), which provide coverage for flooding and earthquakes, respectively. In the United Kingdom, Flood Re applies a premium to home insurance policies in which flood risk is transferred to the fund, alongside a mandatory annual contribution from all insurers offering such coverage, calculated based on market share. In France, the Nat Cat system is financed through a compulsory surcharge on property insurance policies. In Spain, the Insurance Compensation Consortium (Consorcio de Compensación de Seguros) covers extraordinary natural disaster risks by collecting a mandatory surcharge on nearly all insurance policies, with only a few limited exceptions. In Mexico, the Natural Disaster Fund (FONDEN) and the Program for the Natural Disaster Fund are key mechanisms for managing catastrophic risk. In Brazil, the Rural Insurance Stability Fund (FESR) protects rural producers against the adverse effects of extreme weather events.

Extraordinary risk coverage in agriculture is essential for shielding producers from adverse climatic events such as flooding, droughts, frosts, hailstorms, and other natural disasters. These events can cause significant losses in agricultural production, threatening food security and the economic stability of rural communities.

To address these risks, various agricultural insurance models have been developed, combining instruments such as specialized insurance funds and multiple types of agricultural insurance. These may include individual, group, or state-sponsored policies, covering both non-correlated and catastrophic events. Additionally, both traditional and parametric insurance products exist, with the latter determining payouts based on climatic or yield indexes.

In many countries, agricultural insurance is supported by premium subsidies to make coverage more accessible to farmers. Risk zoning tools are also used to identify areas with heightened climate risk, helping to guide crop planning and the development of insurance products.

Reinsurance plays a critical role in managing catastrophic risks by enabling insurers to transfer part of their exposure to other companies. Reinsurance contracts can be proportional, where the reinsurer assumes a proportion of premiums and claims, or non-proportional, where the reinsurer covers claims exceeding a certain threshold. The global reinsurance market has experienced significant growth, reaching nearly 900 billion dollars in gross premiums and over 630 billion dollars in net premiums by the end of 2023—representing year-over-year increases of 12% and 13%, respectively.

Catastrophe bonds, also known as cat bonds, which emerged in the 1990s following major disasters like Hurricane Andrew and the Northridge earthquake, allow insurers to transfer extreme risks off their balance sheets through securitization. These risks are pooled into insurance-linked securities (ILS) and sold to investors. These bonds are triggered under specific loss conditions, offering attractive returns and repaying 100% of the investment in the event of a catastrophe, with different bond classes according to risk levels. Cat bonds are financial instruments that provide an additional source of funding for post-disaster recovery. They are issued on the condition that a specific catastrophic event—such as a major hurricane or earthquake—occurs, and are activated when certain loss thresholds are met. Cat bonds offer investors competitive returns while providing immediate liquidity for disaster recovery (see Chart 3).

Insurance companies are exposed to physical, transition, and liability risks related to climate change. Physical risks refer to direct damages caused by extreme weather events, while transition risks stem from policy and technological changes needed to reduce greenhouse gas emissions. Liability risks involve potential legal actions linked to damages caused by business activities that contribute to climate change.

Global initiatives on sustainability, such as the Principles for Responsible Investment and the Principles for Sustainable Insurance, aim to mobilize private capital toward projects with positive environmental impacts. Green bonds and sustainable bonds are vital instruments in this transition, financing low-carbon activities and supporting climate change adaptation. These bonds allow insurers to invest in projects that contribute to climate change mitigation while also diversifying their investment portfolios and reducing exposure to climate risks. In addition to UN-led initiatives, the European Union (EU) has taken an active role in establishing a robust and comprehensive regulatory framework to integrate climate change considerations into investment decisions. This framework promotes sustainability through a range of regulations, including disclosure requirements that must be met by investors in financial markets, as well as substantive rules covering due diligence, civil liability standards, and sanctions that go beyond basic reporting obligations.

The carbon emissions trading market is a vital mechanism for reducing greenhouse gas emissions. This system enables companies to buy and sell emission allowances, creating financial incentives to cut emissions by assigning a cost to each ton of CO2 released. There are two main types of trading systems: regulated systems, which impose mandatory emission limits and allow companies to trade allowances; and voluntary systems, where companies purchase carbon credits to offset their emissions without being legally required to do so. Regulated systems, such as the EU Emissions Trading System (EU ETS) in the European Union, are the most developed and cover a wide range of sectors, including power generation, heavy industry, and aviation. These markets aim to promote sustainability and support the transition toward a low-carbon economy.

Closing the insurance protection gap for catastrophic risks is a significant public policy challenge that requires coordinated action between insurance companies and governments. Public-private partnerships (PPPs) play a fundamental role in managing disaster risks by creating collaborative frameworks to share risk and ensure affordable coverage. Public policies should integrate insurance considerations into broader climate adaptation efforts, such as investments in infrastructure, land-use planning, and early warning systems.

PPPs between government authorities and the insurance sector can be a key component in disaster risk management. These partnerships can take various forms, such as government-backed insurance pools, subsidised co-insurance schemes, state reinsurance for private insurers, or jointly funded programmes designed to ensure affordable coverage. Many countries have successfully implemented PPPs to address failures in the disaster insurance market, particularly when private insurers charge unaffordable premiums or exclude high-risk areas.

To ensure the success of PPP schemes, broad participation is essential: given the nature of the risks involved, the larger and more diverse the pool, the more stable and affordable the coverage will be. An analysis of existing PPPs currently in operation reveals a wide variety of partnerships, reflecting differences in the specific catastrophic risks covered and the insurance lines of business on which surcharges are imposed to fund their operations.

Public policies should integrate insurance considerations into broader climate adaptation efforts, such as investments in infrastructure, land-use planning, and early warning systems. Furthermore, enhancing the collection and management of catastrophic claims data is crucial, as it supports advanced dynamic modeling and encourages data sharing between insurers and public agencies. Parametric insurance solutions, which pay a predetermined amount based on specific trigger events, can play a key role in expanding coverage by providing immediate liquidity after extreme events. Insurance can also serve as an incentive for risk reduction and be integrated into broader climate adaptation efforts by improving claims data management and combining parametric solutions with traditional insurance products.

Finally, it is worth noting that in April 2023, the European Central Bank (ECB) and the European Insurance and Occupational Pensions Authority (EIOPA) published a discussion paper addressing the growing protection gap in climate insurance. Between 1981 and 2023, natural disasters caused approximately 900 billion euros in direct economic losses in the EU, of which only one-quarter was insured. The paper proposes an EU-level solution composed of two pillars: a public-private reinsurance system to increase insurance coverage in low-coverage areas, and a public financing fund to improve disaster risk management across member states. Both pillars seek to strengthen resilience against natural disaster risks, encourage risk mitigation, and capitalize on the benefits of risk diversification at regional and national levels (see Chart 4).

The following link provides access to the study Climate change: extraordinary risks and public policies (spanish), prepared by MAPFRE Economics. The report offers a detailed analysis of how climate change is intensifying extreme weather events and widening the insurance protection gap for natural disasters, increasing extraordinary risks for the insurance industry.