A Sustainable Future: Margherita Giuzio, European Central Bank, on the Climate Insurance Protection Gap

Does Europe face a climate insurance protection gap? Listen to Jason Mitchell discuss with Margherita Giuzio, European Central Bank, about what’s at stake from a financial stability and macroeconomic perspective.


Margherita Giuizo from the European Central Bank joins the podcast to talk about what’s at stake from a financial stability and macroeconomic perspective; how the ECB is proposing a ladder of approaches; and why public-private sector solutions like impact underwriting are vital to reducing moral hazard risks.

Recording date: 15 June 2023

Margherita Giuzio

Margherita is a Team Lead in the Market-Based Finance division of the Macroprudential Policy and Financial Stability Directorate at the European Central Bank. Her research interests include non-bank financial intermediation, climate-related risks to financial stability and sustainable finance. She has co-authored a number of papers examining the intersection of sustainability and financial markets including “What to Do About Europe’s Climate Insurance Gap”, “The Low-Carbon Transition, Climate Commitments and Firm Credit Risk”, and “Are Ethical and Green Investment Funds More Resilient?”


Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Jason Mitchell:

I'm Jason Mitchell, head of Responsible Investment Research at Man Group. You're listening to A Sustainable Future, a podcast about what we're doing today to build a more sustainable world tomorrow.

Hi, everyone, welcome back to the podcast and I hope everyone is staying well. The past month has been a pretty sobering one for a couple of reasons. First, friends back in the US are describing the Canadian wildfire induced miasma overhanging the East Coast as nothing short of a dystopian landscape. And second, in California, where I'm originally from, insurers continue to pull out of the insurance market with State Farm's exit following departures last year from AIG and Allstate.

Which is interesting because, for all the politicization around climate and ESG, it's a pretty powerful reminder that insurers are going to manage risk in ways that increasingly bear consequences. In fact, we often talk about climate risk in the future tense about how climate effects rising like sea levels are going to reshape property and in insurance markets in the future. But frankly, it's already happening in climate vulnerable regions. It's why this episode is so relevant.

When I first read the ECB paper on the climate insurance protection gap, I was struck by the title itself. After all, a gap represents a space or an interval which sounds relatively benign. But with only a quarter of climate related catastrophe losses insured falling to as little as 5%. In some countries, the paper describes something much more alarming. Which is why it's great to have Margherita Giuzio from the European Central Bank on the podcast. We discuss what's at stake from a financial stability and macroeconomic perspective, how the ECB is proposing a ladder of approaches and why public-private sector solutions like impact underwriting are vital to reducing moral hazard risks.

Margherita is a team lead in the market-based finance division of the Macroprudential Policy and Financial Stability Directorate at the European Central Bank. Her research interests include non-bank financial intermediation, climate-related risks to financial stability and sustainable finance. She's co-authored a number of papers examining the intersection of sustainability and financial markets including what to do about Europe's climate insurance gap. The low carbon transition, climate commitments and firm credit risk and are ethical and green investment funds more resilient.

Welcome to the podcast, Margherita Giuzio. It's great to have you here and thank you for taking the time today.

Margherita Giuzio:

Thanks a lot, Jason. It's great to be here and I really look forward to our chat. Let me just add a usual disclaimer that the views I will express here are mine and not the official position of the ECB, the Euro System or EIOPA.

Jason Mitchell:

Understand. No, thank you very much. So, Margherita, I've really been looking forward to this conversation especially in light of some of the recent events in the insurance industry which we'll talk about a little bit later. But let's start out with some scene setting. First, what is the climate protection insurance gap? And second, what does the ECB EIOPA paper you co-authored set out to accomplish? What are its key messages?

Margherita Giuzio:

Yeah. So, in general, the term insurance protection gap refers to the difference between the amount of economic losses related to a certain event and the amount of insurance coverage actually purchased and eventually paid out. So, in the context of climate related risks, this protection gap indicates then the amount of uninsured losses from climate related catastrophes. And according to the available data, this protection gap has increased steadily over the past decades and is expected to widen further making natural disaster more costly for society.

So, in the discussion paper that the ECB and EIOPA have recently published jointly, we outlined some policy actions to increase the uptake and the efficiency of catastrophe insurance while, at the same time, creating incentives for policyholders to adopt and reduce climate risks. So, the aim of this measure is to help provide prompt liquidity and funding for reconstruction after natural disasters complementing existing insurance mechanisms that are currently, though, not sufficient.

And an important element of this policy work is that it requires the sharing of costs and responsibilities across different sectors and economic agents to reduce the moral hazard that is often embedded in insurance contracts or in the lack of insurance and this overall would help to reduce the share of economic losses borne by the public sector over the long term.

So, I would say that the key messages of the paper can be summarized as three. The first is a factual message and it's that the level of private insurance is currently very low in Europe but also globally. Although insurance is a key factor to mitigate the effect of catastrophes on the economy, on public finances and also financial stability as it can speed up reconstruction. So, it is important to increase this uptake of catastrophe insurance as this is our first line of defense against catastrophe losses.

Second, the increase in frequency and severity of disasters due to climate change may lead to higher insurance premiums or lower insurance supply as diversification becomes more difficult for insurers and reinsurers. So, what we say is that additional risk sharing solutions are needed, for example, to transfer part of the risk to capital markets or to set up public-private partnerships and announce the disaster risk management strategies of governments to avoid always acting exposed without providing incentives for reducing risks.

And then the third key message is that we should think of climate related catastrophe risk as a global challenge that goes beyond national borders and try to find solutions that can enhance resilience to large scale catastrophes, for example, exploiting risk pulling benefits across countries in terms of cost efficiency and predictability of funding. And for this reason, we also thought of a multinational insurance scheme for natural disaster relief that can help close the climate protection gap further while, at the same time, providing incentives for the member states to announce national insurance coverage and pursue risk mitigation strategies. And we thought of an EU wide scheme but, of course, this could be extended to other countries, too.

Jason Mitchell:

That's super helpful. Can you animate the paper a little bit? Can you give a picture of just how vulnerable the EU and individual member states are to uninsured losses? Frankly, I was pretty struck by the number of European countries who share insured economic losses against weather related events is less than 20%. And particularly those in Southern and Eastern Europe like Italy and Greece who are even under 5% and already experiencing the effects of climate stress.

Margherita Giuzio:

Yeah, that's a very good question that I think we should all should ask ourself. So, how vulnerable are we to weather related events? The impact of catastrophe is ultimately determined by how exposed and how vulnerable people and economic activities are to natural peril. But in a way, we can say that, while the underlying events are certainly natural because they're related to temperatures and precipitation, catastrophes are definitely manmade in the sense that their impact is ultimately determined by our exposure and vulnerability to the peril that we can control to some extent. And indeed, insurance is a key tool to reduce and mitigate exactly these vulnerabilities and losses from weather related events.

Now, unfortunately, as you rightly pointed out, only about a quarter of climate related catastrophe losses are currently insured in Europe and, in several countries, this share is well below 5%. There are some structural reasons for these insurance protection gap related, for example, to the tendency of people to underestimate the likelihood and the impact of catastrophes but also because they expect some compensation from the governments in case of severe disaster which gives rise to a well-known problem of moral hazard.

But apart from these structural reasons, some areas also present a high protection gap because they're more subject to these weather-related events and this affects insurance premiums because catastrophe insurance contracts are typically repriced every year and get more expensive after disasters occur. So, in these high risk areas, this may lead to insurance become unaffordable or unavailable and we have examples of both cases.

As we have seen already, the premiums of property catastrophe insurance increasing in the last decades and we have also seen insurers announce that they will stop providing coverage for specific events. And this obviously has implications for the economy in general because households and firms will have to bear higher losses from catastrophes and also for financial stability as credit provision, in some countries where banking sector exposures are very high, the credit provision may reduce without insurance.

And ultimately, this would increase the burden on governments in terms of fiscal spending to cover uninsured losses potentially in an asymmetric way as economies differ significantly both in their climate risk exposure but also in their resilience. In some countries suffering high historical losses from disaster relative to GDP also have this protection gap. Some have high debt to GDP ratio which can reduce their fiscal space to respond to disasters in the absence of well-designed risk management tools.

Jason Mitchell:

That's really helpful in terms of describing some of the challenges around these markets. But maybe a big picture question, how do we incentivize more people to buy insurance? What are the policy levers to raise it to... You tell me what the appropriate level you think from an EU perspective is. What do we need to do in terms of premiums and those eligibility requirements to raise coverage?

Margherita Giuzio:

Yeah. Definitely we need to increase the uptake of climate catastrophe insurance to limit this growing impact of natural disasters on the economy and the financial system. To do that, we can act on the factors that constrain both the demand and the supply of insurance. So, regarding the demand side, which is the focus of your question, the factors that affect the individual's choice to purchase insurance may be related, for example, to the tendency of people to underestimate the likelihood but also the potential impact of an event which leads to a misevaluation of their actual risk. But also, people may expect public support from the government in the event of severe disasters.

And then there may be constraints related to the process of purchasing insurance which can act as an extra cost. For example, there is a limited use of digital channels in some markets which can be more user-friendly, less effort demanding and this may hindering a higher uptake currently, at least in Europe. And to address these demand side issues, I think more and better information is needed to increase the risk awareness, especially in more exposed areas. For example, consumers could be informed about CAT risk when they buy a new property or when they registered.

And the industry and regulators could also work on some labels or minimum standards for CAT policies that could help clarify further what is the exact coverage of this policy and what are the exclusions because many times specific catastrophic events are not included in property insurance and this could facilitate the consumer's understanding. Finally, we can also think of linking insurance to other financial products, for example, to mortgages especially in high risk areas.

Jason Mitchell:

Can you put this paper in the context of the ECB's efforts to understand that relationship between climate risk and financial stability more widely? And also, to what degree does this all run parallel with the EU wide stress tests that the EBA, EIOPA and, obviously, the ECB will be conducting this year across the financial sector, including the insurance industry?

Margherita Giuzio:

Yeah. So, the protection gap is clearly part of our climate risk monitoring framework as it affects key sectors of the financial system and the economy overall in many ways. First, risk associated with a lack of insurance may trigger higher capital needs on the banking sector and reduce credit supply as a result because of direct damages to properties but also because of the physical collateral that banks take in response to loans is less valuable.

And to provide an example of this interconnectedness, we can consider flood risk, which is one of the rising risks in many European countries, and we've measured that around three quarters of the exposures of Euro area banks to firms subject to high or increasing flood risk is either uncollateralized or secured by physical collateral which is exposed itself to physical risk and the potential losses in case of large scale events can be substantial.

But in addition, lack of insurance may also slow down the reconstruction activity after catastrophes and this may negatively affect supply chain increasing credit risk throughout the financial system. And one of the things we briefly touch upon in the discussion paper is that there may be potential role for targeted prudential or macroprudential regulation in relation to enhancing the actual resilience of the banking sector to the implication of a persistent or even widening of the insurance protection gap.

These interactions between the bank and insurance sectors are also included in the economy-wide climate stress test that the ECB conducts, although there are clear data limitations related to insurance data at borrower level. And more broadly, what we also highlight in the paper is that the efforts to reduce the protection gap should be complimentary to ambitious mitigation policies to tackle climate change and reduce catastrophe risk and should not be seen as a substitute for such policies.

And to understand the relationship between transition physical risk and their impacts on the economy and the financial sector, the stress test that the ECB runs together with the other European institutions are very useful to understand what could be the related policy action and the effects on the financial system.

Jason Mitchell:

What's at stake from an ECB perspective, particularly in your role as an ECB economist? In other words, can you walk through the macroeconomic implications, not just of potential climate related losses, but I guess also the indirect impact on GDP growth and inflation? For instance, I've been struck by the fact that the rate of growth for natural catastrophes runs between five to 7% per annum which, frankly, is a frightening multiplier of, call it, steady state GDP growth assumptions of two and a half percent.

Margherita Giuzio:

Yeah, that's true. We clarified already what is at stake from a financial stability perspective but, obviously, catastrophe typically also have an adverse impact indirectly on GDP growth and inflation, both in the short and in the medium term, as they can affect economic production and consumption. And what we found is very interesting is that catastrophe insurance plays a very important role in mitigating these negative macroeconomic effects of disasters for different reasons.

First because it can enable the economy to recover faster by providing the necessary funds for reconstruction, reducing uncertainty and supporting aggregate demand and investment for reconstruction which helps to accelerate the recovery from disaster. And second, because catastrophe insurance can increase resilience by improving the understanding and pricing of climate change risk and this can promote, overall, the risk reduction and adaptation and allow for a better mutualization of risks.

To provide some numbers, we estimated that large scale disasters, which can cause, for example, over 0.1% of GDP direct losses can reduce GDP growth by around 0.5 percentage points in the quarter of the event if the share of insured losses is low, let's say, below 30%. And this adverse effect on GDP growth also persist over the subsequent quarters after the event. At the same time, if a share of damage is covered by insurance is high enough, the indirect impact of catastrophes on GDP growth may be significantly reduced and this is a very important mitigation mechanisms that we started including also in our macroeconomic models.

Jason Mitchell:

I guess, per that point, what's the risk that we see potentially increasing economic, call it, divergence among EU member states if the climate insurance protection gap isn't fully addressed? I guess I'm tempted to cross over into the political economy realm in that sense. Do you think is there a political will for the system to evolve from the current risk driven one to, ultimately, a solidarity driven system?

Margherita Giuzio:

Yeah. We see that countries where the climate insurance protection gap is very high are more vulnerable to rising fiscal risk as public finances and debt sustainability may be negatively affected by catastrophes mainly due to a higher fiscal cost, for example, higher social assistance expenditures or relief payments and lower tax revenues. Now, this fiscal pressures may also arise in a period where growth is lower following disasters as capital is typically absorbed by reconstruction activities rather than new investments. And the scale of contingent fiscal liabilities from growing climate related catastrophes can, therefore, increase the need for well-designed disaster risk management tools and risk sharing mechanisms that can enhance resilience.

But as you pointed out, physical risks are likely to have a asymmetric effect on the fiscal stability of European countries given the difference in climate risk exposures but also in the resilience of these countries. So, it's hard to say if there is a political will for the system to evolve to a solidarity driven system. But the cooperation and solidarity that we saw, for example, during and after the pandemic within the EU, including with the NextGeneration EU and the recovery and resilience facility gives us hope. But eventually, this is for the individual governments and the commission to explore. What we tried to do in the discussion paper is to provide the economic and financial reason for a higher and enhanced risk sharing among member states independently from the political will.

Jason Mitchell:

That's super interesting. Can we dive into that paper a little bit more? Can you walk through the ECB's ladder approach to catastrophe insurance as proposed in the paper through that section talking about private insurance, reinsurance/cap balance, public sector measures like PPPs and EU wide public sector efforts as well? Which rung of this ladder is the ECB most focused on from a financial stability perspective?

Margherita Giuzio:

Yeah. So, insurance and catastrophe losses come in several layers and, for this reason, we chose this concept of a ladder to help visualize them and also tailor the policy options to these layers. In particular, we consider options for announcing private insurance deepening CAT bond markets, developing shared resilience solution between public and private entities at national level but also at a European one.

And the first rung of the ladder is in the private insurance as it's a primary line of defense to pull risks and cover disaster losses. And there we see that a better underwriting strategy and pricing strategy could help, not only to cover more catastrophe losses, but also to incentivize policy holders to reduce their risk over time and adapt to an increasing climate risk.

But then, larger catastrophe risk, however, require a more elaborate framework. So, in the next rung we also involve a reinsurance and a greater use of capital market instruments such as CAT bonds that can help to pass on part of the losses from less frequent but highly severe catastrophes to a broader set of investors. And so, this may help diversify the sources of capital and lower the overall premiums. So, the deepening of CAT bond markets can, therefore, help to tackle the climate insurance protection gap and may be supported by further progress on the EU capital markets union.

The third rung considers, instead, the important role played by national governments. As already noted earlier, low insurance coverage means that the public sector often has to provide disaster relief. So, public finances would generally benefit for a more comprehensive disaster risk management strategy, including precautionary measures. So, spending on climate adaptations or creating fiscal buffers such as national reserve funds for emergencies. But even without such preparations, fiscal spending will remain an important part of catastrophe relief, especially for cases such as public infrastructure.

And for these reasons, governments could also enter into public-private partnerships that already exist in some European countries, either that direct insurance or as an insurer of last resort. And a key objective of this policy should be to lower the share of loss as borne by the public sector while, at the same time, incentivize and improve risk mitigation and adaptation. In the final rung of the latter, we imagine a possible European wide public sector scheme covering rarer but larger climate related catastrophes. And this scheme could complement and reinforce the national measures and help to more efficiently pull catastrophe risk which typically hit individual countries at different times.

So, such a scheme would complement European weather climate policies and existing tools for disaster relief such as the Solidarity Fund that are currently not sufficient to cover an increasing need for climate related catastrophe funds. And I would say that the first three rung of the latter are more closely related to financial stability as they address risks within the private insurance sector, also in relation to banks and governments, and suggest a role for financial markets in covering part of the losses.

While the policies related to the public sector at national and EU level address also the fiscal concerns related to disaster risk management. But obviously, the announcement of insurance coverage throughout the ladder will eventually provide benefit for financial stability overall.

Jason Mitchell:

I want to dig into reinsurance which, as you mentioned, represents one of the rungs in this ladder approach and obviously plays a vital role in terms of risk transfer, risk sharing and diversification. So, there's a natural assumption that reinsurers provide a private sector backstop in a certain sense to natural catastrophes. I feel compelled to ask, with reinsurance prices going higher, there have been as much as 30% increases to European rates following six consecutive years of above average losses.

What's the risk that insurers or reinsurers react by also limiting the types of coverage that they provide or even exiting some markets? It's obviously not Europe but I've seen that reinsurers like Swiss Re and Munich Re have cut their risk exposure to insurance dependent markets like Florida in the United States by as much as 80%. Is there a read across you can make?

Margherita Giuzio:

That is a very good point, Jason, and I think, more than a risk, this is a reality already in some areas where physical risk is very high or it's expected to increase significantly in the near future. As catastrophes become more frequent and more severe, reinsurance becomes more valuable. But some reinsurers recently indeed announced their plans to cut coverage and the incidence of natural events exceeds what their model have been anticipating.

So, at such very high loss layers, the traditional model of reinsurance may reach its limit causing reinsurance to either charge very high premiums or stop underwriting catastrophe risk altogether. And this obviously has a knock on effect on primary insurers and on policy holders as they must either pay a very high premium or bear the risk themselves. So, as such, climate related risk may not be sufficiently insured by the private sector and the use of financial markets, for example, to transfer risks may support the reinsurance of these risks.

However, as catastrophe risks are expected to grow, policymakers, we think, need to consider putting in place more sophisticated frameworks to deal with extreme weather events and reinsurer's retreats and these include particularly public private partnerships and ex-ante public.

Jason Mitchell:

I do want to come back to some of these examples in a little bit. But, generally speaking, I've always thought of insurance cover as representing compensation for a given event or damage. But insurance hasn't, at least in my mind, traditionally been designed to prevent certain perils, think drought or the reduction of heat root induced death tolls, for instance. So, what kind of measures, and I guess I'm thinking around impact underwriting, can ensure that insurers play a more active role in climate adaptation and mitigation specifically?

Margherita Giuzio:

Yeah, it's true that the main role of catastrophe insurance has been to provide liquidity and support the reconstruction after catastrophic events. But it's also true that insurance can have a preventive role, not much in reducing cut risk per se, but in limiting the risk of high losses. And this is the key concept behind impact underwriting which uses risk-based premiums to incentivize policy holders to implement ex-ante structural measures to reduce exposures to climate related hazards.

The price of insurance is indeed a strong signal of the level of risk. Then, risk-based incentives linked to premiums can help increase awareness and, as a result, provide incentives to implement simple adaptation and mitigation measures that can minimize the physical risk exposures. For example, premium reductions could be associated with homes meeting certain standards, for example, with respect to flood proofing in flood prone areas or protection against storms and with the use of real-time weather data and alert systems in relation, for example, to crop insurance.

The cost of implementing these risk reduction measures could be compensated by a lower premium. And I think we can think of a more familiar parallel maybe in a different line of business which is health insurance where you can get premium discounts, for example, if you carry out regular checks and medical examinations that lower losses in the medium term.

Jason Mitchell:

I want to come back to the issue around moral hazard. Moral hazard risks seem to be a big obvious concern here as you've voiced already. What are ways to control for moral hazard problems in terms of implementing ex-ante measures, as you mentioned earlier, against climate hazards? Is it, for instance, impact underwriting and how can we better reduce specifically the informational asymmetries between insurer and the insured so that compensation expectations create less risky behavior?

Margherita Giuzio:

Yeah, broadly speaking, avoiding moral hazard is a core issue in the design of insurance. This behavior may rise when people do not make the effort to reduce risks themself because they expect to be compensated for their loss anyway. So, in the case of private insurance, moral hazard can result in higher claims for the insurer. And the greater the information asymmetry between the insurer and the policyholder, the higher is the risk of moral hazard.

So, what can insurance do to mitigate this issue? They have traditionally increased the deductible, so the portion of the loss that is paid by policyholder before the coverage kicks in, and they have also limited coverage. But what insurance can do is to improve their pricing and underwriting strategy engaging with and incentivizing policy holders, for example, by offering risk-based premiums or premium discount whenever policy holders take actions to reduce their exposure and vulnerability to a certain peril.

But moral hazard can also be an issue between private insurance companies and the public sector or between different levels of the public sector. For example, when private insurance relies on a public backstop, it may reduce coverage or adaptation efforts or local governments may apply more complacent regulations when the potential losses are covered by central government. And to face these challenges, we think that, first, the responsibility for providing disaster relief should be merged with the responsibility for enforcing the relevant regulation to the extent possible.

And second, public insurance schemes should include incentives for risk mitigation adaptation, for example, through subsidies for investments in adaptation. In the presence of a European-wide insurance scheme, the moral hazard can also be an issue among member states in case one of them doesn't make sufficient effort to reduce climate risks or the insurance protection gap as the coverage is provided by the EU wide fund.

So, to address these concerns, we think it is important to design such a scheme including conditionalities that push the member states to implement specific adaptation strategies or common regulation and standards that can help reduce the protection gap in their jurisdictions. And in addition, as for private insurance, there could be deductibles to be paid by other layers of protection before the European scheme covers any losses. And this will mean that the common funds would only be available for the very tail risks associated with major events.

But an important consideration to make and I think it is related to the status quo. Because, given the high protection gap, the public sector is currently, in any case, liable for large climate related catastrophe losses. Most of the time, in an implicit way, giving rise to a very large moral hazard that can even disincentivize the uptake of insurance. So, the policies we outlined in the discussion paper make this public sector support clearer ex-ante, if anything, limiting the moral hazard and conditional to risk reduction and adaptation measures.

Jason Mitchell:

It's a really good point that you made. I tend to think of moral hazard problems as being specific to the private sector but, obviously, they can exist at the public sector, EU member state level as well. What are potential policy solutions to avoid specifically adverse selection costs in insurance markets? Reinsurers seen particularly vulnerable to this problem because of, again, to go back to that asymmetric information problem and the likelihood that it's only the high risk insurers that end up charging reinsurers.

Margherita Giuzio:

Yeah, this is a very important issue and indeed reinsurers are particularly exposed to adverse selection but they definitely have the technical expertise to assess the risk that insurers are transferring them. More broadly, the problem of asymmetric information and adverse selection can be addressed in part by enhancing risk pooling, risk materialization and diversification and a potential solution to consider would be to require insurance coverage against catastrophes. So, in a mandatory or quasi mandatory insurance.

But this solution would avoid only the high risk insurers and individuals end up charging reinsurers. In a way, though, this can disincentivize risk reduction if there are no proper safeguards and end up subsidizing developments in high risk areas. So, we have to consider this trade off when designing the insurance and reinsurance policies.

Jason Mitchell:

It's interesting, we've talked a lot about potential policy solutions in the abstract in a sense. But it feels like, since you and I have been talking about this over the last one to two months, we've seen it become more and more realized or animated. And I guess what I'm wondering is how relevant a parallel in your mind are the recent announcements in the United States of insurers pulling out of important markets like California and Florida?

Most recently, State Farm, one of the largest insurers in California, pulled out of the market only two weeks ago which follows the exits of AIG and Allstate as well effectively saying that they would cease accepting new applications in California citing weather inflationary pressures on rebuild costs and a challenging reinsurance market.

Margherita Giuzio:

Yeah, these examples of insurance retreats are very important developments that show the limitations of private insurance markets and models when risks become very high. And this isn't a trend that's limited to the US as similar developments can be seen in many parts of the world, including Southern Europe or parts of Australia and this problem is expected to worsen given global warming and increasing catastrophes.

Now, of course, the implications for the real economy in the financial sector may be particularly severe in densely populated areas or where the economic activity is very relevant. And in this case is, we think, the public sector intervention may become necessary, not just to supplement the insurance that is not provided anymore by the private sector, but also to set up effective adaptation strategies that can reduce losses overall in the medium to long term.

Jason Mitchell:

Where do you identify risk sharing opportunities given the private sector's propensity effectively to not fully insure against climate risks in this moral hazard issue? I guess I'm wondering specifically around PPPs or public-private partnerships as a solution to stabilize premiums. And as an add-on to this, because I find this super interesting, what are some useful examples in your mind that can be applied in the EU context? I'm from California so I'm thinking back to the creation of the California Earthquake Authority following the Northridge earthquake in California in 1994 where insurers left the market and took a PPP structure to stabilize earthquake insurance.

Margherita Giuzio:

Yeah, yeah. So, we see definitely that climate related risks are unlikely to be sufficiently insured by the private sector going forward and the design of insurance and reinsurance policies can address only in part the related market failures. So, for high risk areas, additional risk sharing solutions such as public-private partnerships might be needed to provide a backstop to private insurance, either directly with insurance coverage or by indemnifying private insurance against specific events. And this backstop would help making insurance more affordable by lowering premiums.

In the discussion paper, we outlined some key principles for these public-private partnerships to be effective such as a clear sharing of cost and responsibilities across public and private components and the inclusion of prevention and adaptation measures. But public-private partnerships are useful, not only to transfer and share risks across the private and the public sector, but also to improve the risk assessment, the preventions and insurance product design. And we have seen that in some cases of public-private partnerships in Europe, for example, in Spain, France and the United Kingdom, for different types of physical risk because countries have different exposures to natural events and also face different challenges depending also on the development of their insurance sector.

So, depending on the design of these schemes, both insurers and reinsurers hold some of the risk alongside government while policy holders are incentivized to reduce risk, therefore, reducing moral hazard. Now, unfortunately, these remain exceptional examples and, in most countries, while physical risk is very high, still, fiscal spending remains an important part of catastrophe relief. But a low public-private insurance share poses substantial risk for governments and taxpayers and high moral hazard concern as they are expected to cover the cost of catastrophes after they have occurred.

Jason Mitchell:

Catastrophe bonds or CAT bonds are one of the key measures considered by the ECB and EIOPA to spread out catastrophe risk among a broader set of investors as well as lower the overall cost of coverage. What are the opportunities from a public-private perspective to really reframe the merits of CAT bonds given, let's be honest, the historical and sometimes controversial perception around particularly the mechanics of that underlying parametric trigger that the assumption is underneath that. How do we cure that historical controversial association with CAT bonds?

Margherita Giuzio:

Yeah, that's a very important point. So, we start recognizing that CAT bonds can complement traditional reinsurance to provide liquidity for reconstruction after disaster and to lower the overall cost of coverage. They can, in fact, provide higher diversification by transferring part of the tail risk assumed by their insurers to capital markets, so to a wider set of investors. They can also stabilize the cost of insurance and, likely, traditional CAT insurance policies, they are typically structured to provide cover over multiple years which may be particularly convenient for public-private partnerships.

At the same time, CAT loans issuance by the public sector is still very limited, partly because most of these instruments are parametric, meaning that the payouts are triggered on the basis of a parameter reaching a threshold value irrespective of the actual damage caused by the event. So, this mechanism may be beneficial for the speed at which funds are provided but can also be controversial if a substantial loss event occurs while, at the same time, the parameter thresholds for triggering the payouts are marginally missed. But apart from this, there are some measures that can foster a greater and more effective use of catastrophe bonds. For example, the reduction of issuance cost, the simplification of the issuance process and further progress on the capital markets union to promote the depth, the liquidity but also the cross-border integration of EU capital markets.

And let me also mention that CAT bonds may be beneficial also from the point of view of investors which can gain some exposures to assets or risks that are normally low correlated with equity and credit markets.

Jason Mitchell:

That's helpful. Last question, maybe. What are some of the existing facilities and initiatives currently in place in the EU? The EU Solidarity Fund, I'm thinking of, was set up to respond to major natural disasters. What have been the limitations and the constraints of this Solidarity Fund? If I recall, since it was created in 2002, it's been used more than a hundred times in disasters which include floods, forest fires, earthquakes, storms and drought. How can other initiatives contribute to this effort?

Margherita Giuzio:

Yeah. Currently, EU member states can get financial assistance for emergency relief and reconstructions for non-insured damages following major disaster through the EU Solidarity Fund. At the same time, this provides only limited disaster relief and, as the name suggests, is definitely not specific nor targeted to climate related events which are on the rise in the EU. So, the payouts tend to be very small compared to the overall cost of such events. Between 2002 and 2021, the Solidarity Fund has, on average, covered only 3% of the total direct damages across all covered disasters.

In addition, although the scope of the Solidarity Fund has been broadened to cover also public health emergencies, the budget has been decreased which makes it difficult for this fund to meet current and future demands. Finally, the Solidarity Fund is designed purely as a solidarity tool so it doesn't provide any incentive to take preventive measures which we explain are very important for this type of insurance. So, they do not request adaptation or disaster risk measures from national governments. And as we said earlier, these incentives tend to be very important in reducing future losses from disaster.

So, for this reason, a European public component for climate change related disaster insurance would ideally help reduce the insurance protection gap more effectively and efficiently while also minimizing the overall cost from these disasters and the share of costs borne by the public sector overall. So, in the discussion paper, we outline a set of key principles for such a scheme, many of which actually draw lessons from the designs of other European instruments beyond the Solidarity Fund such as the European Stability Mechanism, the Single Resolution Fund and the EU Recovery Fund.

These instruments have very different objectives and functions but they tend, for example, to provide a degree of risk sharing or solidarity that we will find very useful in the case of CAT risk to provide funding for agreed purposes and to make access to financing conditional on specific measures to be taken by member states which is a key component of insurance schemes in general.

Jason Mitchell:

That's good to hear. So, it's been fascinating to discuss what's at stake when we talk about the climate insurance protection gap, how a ladder of approaches can begin to address it at the EU level and why public-private sector solutions are vital to reducing moral hazard risks. So, I'd really like to thank you for your time and insights. I'm Jason Mitchell, head of Responsible Investment Research at Man Group here today with Margherita Giuzio, a team lead in the market-based finance division of the Macroprudential Policy and Financial Stability Directorate at the European Central Bank.

Many thanks for joining us on a sustainable future and I hope you'll join us on our next podcast episode. Thank you so much, Margherita.

Margherita Giuzio:

Thank you, Jason, for having me and for the very interesting discussion.

Jason Mitchell:

I'm Jason Mitchell, thanks for joining us. Special thanks to our guests and, of course, everyone that helped produce this show. To check out more episodes of this podcast, please visit us at man.com/ri-podcast.

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