How do unconscious biases influence our ability to identify opportunities and risks arising from climate change?

In this article, we’ll highlight how an understanding of cognitive biases can support investment and underwriting decisions, facilitating the journey to net-zero for Property and Casualty (P&C) insurers. Additionally, we’ll delve into further reasons why a deeper focus on climate change can be beneficial in our day-to-day roles.

The impact of unconscious biases

Cognitive biases are systematic deviations from rationality in processes that require judgment or decision-making. Throughout our article, we’ll feature some of these biases to demonstrate how they can influence our decisions in the P&C industry.

A key challenge for many firms is reaching Net Zero by 2050, and tracking progress can be difficult due to the lack of data quality and coverage. For example, there are assets and products out there which are labelled as green or carbon-neutral, without having complete or accurate data to back up these claims. The limited regulation in this area further increases the risk of litigation.

‘Anchoring’ bias describes people’s tendency to overweight the first piece of information they receive, and this can be misleading if the assets and products are not as ‘green’ or ‘carbon-neutral’ as they are initially claimed to be.

To mitigate this, it’s important to be aware of the biases that may be affecting you and those around you. Having this awareness can facilitate more focused discussions and help you avoid biases in decision-making.

Another emerging risk in the insurance industry is climate change litigation. P&C insurers are not only exposed to litigation related to their contributions to climate change, but also to potential legal action against their policyholders which may be covered by the policy offered – e.g. Directors' and Officers' (D&O) insurance, where a claim payout could occur if company directors overstate their progress towards Net Zero, and shareholders take legal action against them for 'greenwashing’.

It is crucial for P&C insurers to understand their exposure to climate change litigation risk and establish robust provisions accordingly. It is essential to steer clear of ‘optimism’ bias when setting these provisions to ensure sufficient reserve adequacy.

Considering stakeholders

While insurers are heavily involved in assisting consumers, they generally focus on providing a range of options, leaving the ultimate decision to them. As a result, investment and insurance purchase decisions can often be influenced by individuals' emotions, such as affection, love, fear and anxiety, which lead to the creation of further biases.

Brokers need to collaborate with insurers to understand how they’re adapting insurance products to address the changing climate and how these adaptations will impact their consumers. They need to invest time and resources in designing insurance products that promote environmental sustainability and reduce the impact of climate change.

For example, electric vehicles appear to be revolutionary in the fight against climate change, as they move away from harmful fossil fuels. Continued enhancements are crucial for these vehicles to achieve sustainability, and this will lead to the introduction of new products in the market. P&C insurers can play a pivotal role in this advancement by providing insurance coverage for these innovative products. This involvement will not only enable insurers to gain a comprehensive understanding of the associated risks and opportunities, but it will also make them active contributors to the journey towards a more sustainable world.

Asset managers play a pivotal role in influencing their clients towards a Net Zero world. They must continue to identify, assess, and manage climate risks across different asset classes, markets, and industries. They should enhance engagement with their clients to be transparent about the risks and opportunities associated with more sustainable products. Moreover, they need to carry out detailed due diligence on products to minimise the risk of overstating the green credentials of an asset, which is crucial to reducing the risk of 'greenwashing.'

Simply divesting from problematic industries, such as coal, may not be an effective solution. Once divested, these shares are often reallocated to investors with less emphasis on sustainability. Alternatively, without any capital flowing into these less sustainable industries, they will lack the means to fund their journey to Net Zero, thus hindering a ‘just’ transition. Instead of divesting, proactively engaging in investment stewardship may prove to be more effective in achieving the Net Zero objective. However, it is crucial to establish clear investment tolerances where divestment becomes a potential choice, such as when engagement efforts are ineffective or the transition to Net Zero progresses too slowly.

Underwriting opportunities arising from climate change

Climate change is likely to create significant opportunities within the P&C space. Focusing on these opportunities can help resolve the conflict of interest between the short-term nature of insurance and the long-term commitments required to tackle climate change.

The goal of reducing carbon emissions has led to significant innovation and development. For instance, carbon capture and storage facilities that operate alongside industrial processes are becoming more widespread. Whilst aiming to protect the environment, these products come with their own set of risks, such as fire, explosions, and leakage from cracked pipes. Naturally, this presents an underwriting opportunity for the insurance market. Insuring these types of products at an early stage will not only contribute to a more sustainable environment but also enable insurers to gather essential data, guide on improved risk controls, and thereby reduce insurance costs in the future. This can provide a competitive advantage and potentially position insurers as market leaders in a growing industry.

Three main takeaways from this article

In conclusion, let's consider the three suggested actions from this article:

1. Integrate sustainability into solutions provided to encourage climate-friendly choices, whilst ensuring you are not over-marketing these benefits and hence potentially being at risk for ‘greenwashing’.
2. Consider and explore new underwriting opportunities that might arise from the risks associated with sustainable investment products.
3. Engage openly and honestly with your own psychology and biases; understanding how they influence your thinking and lead to irrational thought processes; acknowledgement of your biases will lead to better opportunities for effective collaboration across the industry.

How Hymans Robertson can support you?

If you are interested in a conversation about any of the topics discussed in this article, please get in touch.

This blog is based upon our understanding of events as at 31 October 2023. It is a general summary of topical matters and should not be regarded as financial advice. It should not be considered a substitute for professional advice on specific circumstances and objectives. Where this blog refers to legal matters please note that Hymans Robertson LLP is not qualified to provide legal opinion and therefore you may wish to obtain independent legal advice to consider any relevant law and/or regulation. Please read our Terms of Use - Hymans Robertson