Reparation for Climate Change: The Successes and Limits of Litigation

Alberto Monti

Chapter 2: Insurance,

Reinsurance and Financial

Sectors’ Perspectives on

Quantifying Climate Change-

related Harms

1.Reparation for Climate Change: Damage, Risk and Insurance

a.Setting the Scene

From a legal perspective, there are some fundamental questions that must be addressed in order to ensure a comprehensive and adequate approach to the issue of reparation for climate change.

Firstly, it is necessary to ascertain what harm is recoverable at law. That is to say, it is necessary to determine which type of harm or damage will trigger the legal obligation to restore the status quo ante or to pay monetary compensation. To answer this question, reference should be made, among others, to the following legal concepts: (i) interests protected by the law; (ii) causation; and (iii) absence of causes of exemption from liability (eg legitimate exercise of a right).¹

Within the domain of legal discourse, the concepts of harm and damage require precise qualification, since not all negative impacts are suitable for triggering remedies. The scientific consensus on climate change is unambiguous: it is an established fact.² Furthermore, it is widely acknowledged that this fact — S. 40 —is not perceived positively. However, the question remains as to whether the phenomenon of climate change per se constitutes damage or harm for remedial purposes, or whether the impacts of climate change on interests protected by law can be considered as such.

Assuming that the relevance of climate change for the purposes of reparation is determined by its impact on individual and collective rights, it is evident that a significant portion of such harm is projected to occur in the future. To elaborate, the adverse effects of climate change manifest not only in the present but also, and most significantly, in the potential for future harm. Plaintiffs in climate change litigation scenarios very often base their claims on both current harms and future potential losses.³ This is reflected in the model scenarios used throughout this volume.

—In scenario 1, the plaintiffs argue that the respondent state is liable for vio-

lations of their rights under the European Convention of Human Rights (ECHR) arising from adverse events linked with climate change. This is due to the fact that they face an increased risk of mortality that cannot be fully averted even if the respondent state takes the most ambitious mitigation measures possible. From a remedial perspective, they seek, inter alia, a monetary award as reparation for the damage that they have suffered and will inevitably suffer in the future.

—In scenario 2, the claimants are seeking monetary remedies for current

and future harms, including the costs of adaptation and the value of climate-related loss and damage already suffered.

—In scenario 3, the claim made by the Sicilian farmers is based on the allega-

tion that the ongoing water crisis, which is purportedly linked to climate change, has had a detrimental effect on their harvests, and has also increased the risk of desertification of their land in the near future. The remedies sought by the farmers include a combination of mitigation measures, adaptation measures, and compensation for lost future profits and loss in value of the land.

—In scenario 4, the claim is based on the alleged violation of the plaintiffs’

right, under the International Covenant on Economic, Social and Cultural Rights (ICESCR), to the “continuous improvement of living conditions” (alongside the right to an adequate standard of living for the individual — S. 41 —and their family) due to the adverse effects of climate change. The plaintiffs are requesting an evaluation of the aforementioned climate-related damage to these present and future conditions and the establishment of a loss and damage fund accessible to affected individuals.

—In scenario 5, the case is brought also on behalf of future generations, seek-

ing both individualized economic reparations and collective, communitywide ones, alleging that the respondent state’s high greenhouse gas (GHG) emissions are violating and will continue to violate their human right to a healthy environment, along with their right to life, to food, to water, to cultural identity and to property.

—In scenario 7, Peru asserts its standing to sue on the basis of its high sus-

ceptibility to climate-related natural disasters, claiming compensation for present and future climate related loss and damage.

—In scenario 10, the claimants assert that the respondents have breached

their obligations under international human rights law and the no-harm principle. This breach of duty is alleged to have occurred due to the respondents’ awareness of the links between fossil fuel extraction and global warming. The claimants are seeking remedies, amongst other things, for the potential consequences of climate change that are yet to materialize.

As is evident from the characterization of the claims in the aforementioned scenarios, the negative impacts of climate change can be conceptualized for reparation purposes as an increased risk of damage. The notion is vividly exemplified by the growing frequency and severity of extreme weather events attributable to climate change. These events have the potential to result in fatalities, bodily injury, property damage, business interruption, and other substantial economic and non-economic losses.

From this standpoint, climate change engenders a “risk difference” or an increased risk of loss and damage that is contingent on several variables. Consequently, the evaluation of climate change-related harms necessitates the capacity to assess and quantify risk and risk differences in monetary terms.

This underlines the critical importance of understanding the perspectives of insurance, reinsurance and financial sector players — who operate in the risk transfer and financing market — on the modeling, valuation and quantification of climate change-related harms.

b.Risk, Uncertainty and Insurance

In view of the aforementioned discussion, it is apparent that climate change issues and associated harms pertain to both the present and the future, encompassing risk and uncertainty.

Historically and from a societal perspective, the business of insurance developed in response to risk aversion and the need for protection, with a view to managing risks efficiently by minimizing the amount of unproductive resources set aside to cover future potential losses. At the core of insurance lies the concept of risk-transfer. In exchange for the payment of a premium, the insurer accepts the transfer of risk from the insured, undertaking the legal obligation to indemnify the loss or to render another performance in case of occurrence of the insured event. The insurance premium, therefore, represents the price of risk from an ex ante perspective.

The aggregation of a substantial number of independent and homogeneous risks within a portfolio enables the insurer to estimate future expected losses with greater precision than any individual insured party. The riskspreading and loss-distribution functions of insurance are further enhanced by global reinsurance markets, which facilitate worldwide geographic diversification, thereby minimizing the negative economic impacts of future potential harmful events on each participant.

To this end, a crucial distinction is made in the (re)insurance field between the notion of “risk” and the notion of “uncertainty.” Based on a seminal study by Knight,⁴ it is now widely acknowledged in the insurance domain that “risk” is about predictable and quantifiable probabilities, while “uncertainty” refers to unpredictable probabilities of outcomes. In other words, as opposed to risk, uncertainty is characterized by situations in which the ex ante probability distribution of a random outcome is unknown: Knightian uncertainty, in essence, is about the unknown unknowns.

To be more precise, in this domain a distinction can be made between three different types of uncertainty:

(i) aleatoric uncertainty (inherent to risk, due to the variability of possible

outcomes). Aleatoric uncertainty arises because of the unpredictable, random nature of the physical system under study: coin flipping is the prototypical example of aleatoric uncertainty. In this type of experiment, the data-generating process has a stochastic component that cannot be reduced by any additional source of information.

(ii) epistemic uncertainty (due to imperfect knowledge or ambiguity). Epis-

temic uncertainty arises due to a lack of information or knowledge about the model. For example, our knowledge of how climate change will affect regional climates and relevant factors is imperfect.

(iii) Knightian uncertainty (the complete unknown). An illustration of

Knightian uncertainty is constituted by the potential repercussions of a wholly novel and uncharted technology or market disruption. It is impossible to predict the probability or impact of such a risk using conventional models, since there is no precedent or historical data from which to draw.

Insurance and reinsurance markets reduce aleatoric uncertainty, but their functioning is impaired by the other two types of uncertainty.

In the field of climate decision-making, Smith and Stern⁵ offer a slightly different conceptualization of the notion of uncertainty, which they subdivide into the four categories of imprecision, ambiguity, intractability, and indeterminism.⁶ They further posit that scientists ought to explicitly articulate the policy relevance of these different uncertainty types through dialogue with policymakers.

Over the past decades, improvements in the scientific knowledge and understanding of climate change, its drivers and its impacts — including, for instance, the increase in the frequency and intensity of extreme weather events — by reducing epistemic uncertainty expanded the role of insurance and reinsurance in this field.⁷ However, climate variability, global warming and changing weather patterns make statistical analysis based on historic data less reliable and require the adoption of a forward-looking approach to climate risk assessment.⁸

Against this backdrop, insurance and reinsurance market players have been investing significant resources in the research, study, modeling, assessment and quantification of climate change-related risks and their harmful consequences, with the aim of developing sophisticated climate-risk transfer tools that cater to the needs of households, corporations and governments.⁹

c.Different Types of Insurance

The content of insurance contracts is subject to variation depending on the specific risks transferred and the nature of the assets or interests that are the subject of the insurance coverage. From a product perspective, a common distinction in the international insurance market is made between first-party and third-party insurance policies.¹⁰

In first-party insurance contracts, the risk transferred is a risk of loss threatening the person or the assets of the insured (eg fire insurance, theft insurance, business interruption insurance, personal accident insurance) and, as a general rule, the insurance proceeds — ie the pay-out of the insurance contract that becomes due upon occurrence of the insured event — are paid to the insured to compensate for the loss directly sustained.

On the other hand, third-party insurance — often referred to as liability or casualty insurance — covers the insured against the risk of liability for damages to a third party. Depending on the specific terms and conditions of coverage and the applicable law, insurance proceeds can be paid by the insurance company directly to the injured third party who, in certain jurisdictions, also has a direct action against the liability insurer of the tortfeasor.

With regard to climate change-related risks, first-party insurance products can be designed to protect the insured’s property against physical loss caused by extreme climatic events, such as floods, storms, hurricanes, droughts, excessive rainfall and related hydrogeological hazards, including landslides and mudslides. First-party insurance products can also protect the insured against the risk of business interruption, the risk of loss of agricultural output and the risk of having to sustain additional costs and expenses due to the occurrence of the insured event. The policyholder is normally the person — S. 45 —or entity (private or public) whose property and/or economic interests are exposed to the risk of loss (ie the insured), but it can also be a collective entity that aggregates the interests of scattered individuals (eg a farmers’ association, a cooperative). Public entities, including central and local governments, can also insure against the risk of having to sustain costs and expenses to perform emergency management functions and rescue operations in the immediate aftermath of an insured event (eg a hurricane, a flood, a storm, a heat wave).¹¹

Third-party insurance policies, such as commercial general liability, environmental liability, and directors and officers liability policies may also provide coverage against climate change-related risks, insofar as the applicable terms and conditions do not contain specific exclusions or limitations.

In some jurisdictions, a further distinction is made between indemnity and non-indemnity insurance.¹² Indemnity insurance refers to transactions in which the insurance proceeds are aimed at providing compensation for a loss, cost or expense that is tied to a replacement, reimbursement, or fair-market value. The terms and conditions of certain indemnity insurance contracts contain partial derogations to this general rule: this is the case, for instance, of valued policies and new-for-old policies.

In valued policies, upon conclusion of the insurance contract the parties agree a value to be placed on the insured property — sometimes on the basis of an expert appraisal — and such value is then conclusive and binding between both parties, so the insured need not prove the actual value of the loss suffered to obtain payment of the full amount due from the insurer. Such first-party indemnity policies are used to protect works of art, vintage cars and other property characterized by idiosyncratic value.

In new-for-old policies, upon occurrence of the insured event the lost, damaged or stolen property shall be replaced with a brand new, like-for-like replacement or one of an equivalent specification, without accounting for depreciation.

Non-indemnity insurance, on the other hand, refers to transactions in which the insurance proceeds are not directly correlated with the loss (eg life insurance, disability insurance) and are freely determined by the parties.

d.Different Types of Climate Change-Related Risks

From the perspective of insurance, reinsurance and other financial sector players, and according to the terminology adopted by the Task Force on Climate-related Financial Disclosures (“TCFD”) established by the Financial Stability Board — an international body that monitors and makes recommendations about the global financial system¹³—, climate-related risks can be divided into two major categories:

(i) transition risks — related to the transition to a lower-carbon economy; and (ii) physical risks — related to the physical impacts of climate change.

Additional conceptual categories have been recently proposed,¹⁴ including that of:

(iii) litigation risks — related to the risk of being involved in a judicial dispute for

failure to mitigate impacts of climate change, to adapt to climate change or for insufficient or inadequate disclosure of material financial risks.¹⁵

Acute physical risks are event-driven, such as those arising from the increased frequency and intensity of extreme weather events (eg floods, cyclones, hurricanes, storms, heat or cold waves, drought), while chronic physical risks are those associated with longer-term shifts in climate patterns (eg sustained higher temperatures, rising sea levels, changing precipitation patterns).

For the purpose of the present analysis, it is important to note that acute physical risks can have a significant impact on the financial system and its stability. First, physical risks may have financial implications for corporations, such as direct damage to assets, business interruption and indirect impacts from supply chain disruption. Second, companies affected by extreme weather events might be unable to service their debts. Third, collateral, such as buildings or land, might suddenly lose value, with negative effects on price levels.

Insurers and reinsurers perform multiple functions and their relationship with climate change risks is manifold, insofar as they act as:

(i) risk carriers

(ii) risk managers

(iii) investors — S. 47 —In their capacity as risk carriers, from an underwriting perspective insurers and reinsurers are mostly concerned with acute physical risks (as regards first-party insurance contracts) and litigation risks (as regards third-party liability insurance contracts). Their underwriting choices may also expose them directly to litigation risks, insofar as their shareholders or even third parties might question such choices or the way in which they are disclosed to the market.¹⁶

As risk managers, insurers contribute to risk awareness and can design and implement solutions aimed at incentivizing risk prevention and reduction, in addition to risk transfer.

In their role as investors, insurance and reinsurance companies face all types of climate change-related risks, not only because the corporations in which they invest their assets are exposed to such risks and may lose value, but also in consideration of the fact that their own business conduct can be judged on the basis of their investment decisions.¹⁷

e.Risk Assessment and Loss Quantification

As stated above, a necessary precondition for the (re)insurance markets to operate is the possibility to perform accurate risk assessments able to generate quantitative outcomes and monetary evaluations that are required by insurers to determine the price of risk (ie the premium) and their overall exposure at portfolio level.

With regard to climate-related risks, in consideration of climate variability and changing weather patterns, statistical analysis based on historic data becomes less reliable and risk assessment must be performed adopting a

forward-looking approach, which implies significant uncertainties. The predictability of long-term climate trends must be balanced with the uncertainty of climate projections and then translated into the real economic impacts of climate change. In this regard, from an insurance viewpoint climate change could impact all underwriting lines: for life and health insurance, for instance, this would concern mortality, longevity, and disability/morbidity risks;¹⁸ for non-life insurance, the main area of concern lies in the property catastrophe underwriting lines.¹⁹ Over the past decades, the (re)insurance industry has made significant investments in modeling and quantifying physical climate risks. Catastrophe risk models are aimed at providing the necessary guidance in this highly complex field.²⁰ Risk analysts in the insurance market use different types of models to perform their climate risk assessments, among which: (i) Scenario models — adopting a deterministic approach, such models are used to build and analyze “what if?” situations, with a view to assessing the impact of specific events on exposure. Scenario models, in other words, are not concerned with the probability of occurrence of the risk event under scrutiny (eg the worst-case scenario, an event with a certain return period), rather they are aimed at understanding what would happen should such event materiali ze;²¹ — S. 49 —(ii) Stochastic or probabilistic models — adopting a probabilistic approach,

such models are used to investigate the probability of occurrence of a series of risk events and outcomes which depend on a wide range of variables.

Probabilistic risk models are mathematical representations of a system whose purpose is to predict and analyze its potential future outcomes. Historic data and the insights of human experts are combined in risk models to assess the probability and severity of events to which a system is exposed. The output of these models converts risk into a metric of potential loss, which in turn allows for comparability of risks across categories, perils and geographic locations.

Physical climate risk models adopting a probabilistic approach assess future potential financial impacts of extreme weather events using a framework that combines (i) hazard, (ii) exposure, (iii) vulnerability and (iv) financial modeling.

The first three elements are based on the concept of “risk triangle”:

(i) Hazard refers to the probability of occurrence of a certain intensity of

hazard (eg hurricane, flood, storm) at a certain location.

(ii) Exposure refers to the people and assets exposed to hazard, and it may

include socioeconomic factors.

(iii) Vulnerability accounts for the susceptibility to damage of the people and

assets exposed to the hazard.

Risk is the combination of hazard, exposure and vulnerability.

To build a climate risk model, it is necessary to start by generating a stochastic event set, comprising a database of scenario events (eg hurricanes, cyclones, floods, storms) reflecting climate change trends and projected future potential climate states. Specific characteristics must be attributed to each event, including physical parameters of the hazard (eg wind speed, rainfall measurements, elevation of water level), location or path, and probability of occurrence. Thousands of plausible event scenarios are included in the catalogue to simulate and probabilistically model what could happen in the future. The hazard module then assesses the level of physical hazard across a geographical area at risk. For example, a hurricane model calculates the speed of the winds, considering the specific features of the terrain and the built environment at a given location.

The exposure module includes information about the people and assets exposed to hazard at any given location and, for insurance industry purposes, it also comprises insured values, as well other terms and conditions of coverage (eg coinsurance, deductibles, retentions, limits, attachment points).

The vulnerability module assesses the susceptibility of exposed people and assets, including buildings, structures and contents to be damaged by the hazard, based on construction types, building codes and other physical or technical characteristics. In the insurance industry, vulnerability modules mostly focus on buildings and infrastructure, but some also consider human vulnerability to extreme climate events when assessing mortality risk. This is based on factors such as age, disability, and health conditions.

Finally, the financial module translates the expected physical damage into a monetary value, based on a set of parameters derived from the specific terms and conditions of insurance coverage applicable to the exposed assets (eg sums insured, new-for-old clauses, retentions, deductibles).

In the perspective of first-party insurers, therefore, the quantification of the loss in monetary terms depends on the specific contractual terms and conditions agreed upon by the parties. The position of third-party liability insurers is different, insofar as the monetary evaluation of the loss depends on the underlying damages award granted by the court to the injured party and for which the insured party is liable, up to the limit of liability established in the insurance policy as the maximum exposure of the insurance company, and subject to any applicable deductible, retention or coinsurance provision.

Uncertainties about the amount of monetary compensation that courts and arbitral tribunals will award as damages in standard situations can hinder the development of third-party liability insurance markets or make insurance products covering climate change litigation risks extremely costly, due to the need to incorporate significant safety loadings in the pricing structure. The problem has emerged in the recent past with regard to environmental pollution liability insurance products in several jurisdictions.²²

For the purposes of the present analysis, it is worth noting that a variety of loss metrics can be derived from risk models, including:

—Exceedance Probability: It is the probability that a loss will exceed a certain

value in a year. It is presented as a curve, to illustrate the probability of exceeding a range of losses with different values.

—Return Period: Return periods of loss events, expressed in years, are the

inverse of the exceedance probability. For instance, a loss event that has a 1% probability of occurrence in any given year is characterized by a return period of 100 years, meaning that such a loss has a 1 in 100 chance of being exceeded on an annual basis.

—Average Annual Loss (“AAL”): AAL is the average loss of all modeled events

or periods, weighted by the probability of their occurrence. In simple — S. 51 —terms, the AAL is the expected loss per year, averaged over many years. It is often referred to as the “pure premium” or “technical cost of insurance,” insofar as it can be incorporated into pricing of insurance along with safety and fluctuation loadings, an allowance for expenses and return on capital.

In light of the above, it is evident that the AAL is powerful physical climate risk metric that can have a wide range of possible applications in climate risk management and the domain of reparation for climate change. To some extent, from an insurance point of view the AAL represents the monetary evaluation of acute physical risks from climate change affecting a certain portfolio. To be more precise, the AAL displays the quantification in currency units of the risk of loss arising from extreme weather events, not the portion specifically attributable to their increased frequency and severity due to climate change. Having said that, it must be acknowledged that the uncertainties associated with the estimation of the rate of recurrence and intensity of the extreme climatic events make it difficult to precisely gauge climate change impacts via risk models.²³ Chronic physical risks, associated with longer-term shifts in climate patterns, are also difficult to capture, model and assess.²⁴

2.The Costs of Climate Change: beyond Loss and Damage

a.Conceptual Framework

A survey of the literature and relevant policy documents reveals that there is no commonly agreed definition or conceptualization of “loss and damage.”²⁵ In general terms, loss and damage describes the negative impact associated with the adverse effects of climate change caused by extreme events and slow — S. 52 —onset events such as sea level rise, increasing temperatures, ocean acidification, glacial retreat and related impacts, salinization, land and forest degradation, loss of biodiversity and desertification.²⁶

From an economic perspective, it is a shared view that the total costs of climate change can be seen to consist of:

—mitigation costs, or the costs of reducing GHG emissions

—adaptation costs, or the cost of dealing with the consequences of unavoid-

able climate change,²⁷ and

—loss and damage — the residual costs that cannot be avoided through ad-

aptation and mitigation,²⁸ which can be further split into

—economic loss and

—non-economic loss.

These three dimensions of the total costs of climate change are linked to one another: higher investments in mitigation costs would reduce loss and damage and make adaptation less costly; higher investments in adaptation costs would also reduce loss and damage. The economic problem, therefore, is how to balance these elements in order to reduce the total costs.

Focusing on loss and damage, with respect to the economic loss component monetary quantification is feasible, even if not straightforward. From an accounting and insurance perspective, for instance, there are several ways to monetize a loss consisting in physical damage to or destruction of a building. Such methods can be based on acquisition cost, fair-market value, replacement (new-for-old) value, each of which would result in a different quantification in monetary terms. The same applies for the economic assessment of business interruption losses following a major weather event that can be quantified based on different criteria such as gross profit, gross earnings, extra expenses and contribution margin.

Disasters resulting from extreme weather events such as flood, storms and hurricanes generate a wide range of economic losses and costs to households, businesses and governments:

—Costs related to restoring access and basic services, such as debris re-

moval, emergency management and infrastructure repair;

—Costs related to meeting basic needs (including living expenses and tem-

porary housing) of those affected by the disaster;

—Losses and costs related to the rehabilitation or reconstruction of dam-

aged buildings and structures, as well as replacement of damaged contents, crops/livestock, machinery or inventory; and

—Lost production, income or revenues (including tax revenue for govern-

ments).

Governments, in particular, may face significant costs to support households and businesses that have insufficient financial capacity to absorb the costs that they face, including as a result of limited availability or acquisition of insurance coverage for those losses.²⁹

With regard to the evaluation in monetary terms, non-economic loss poses more serious challenges, insofar as non-economic items are not traded in markets and there are no prices or accounting data to refer to. The insurance industry has not specifically addressed the issue of monetary quantification of non-economic losses through risk models, but certain types of non-economic losses are implicitly contemplated in non-indemnity insurance, such as life and disability insurance, where payment by the insurance company of a predetermined amount is merely linked to the occurrence of the insured event and does not require an ex post monetary assessment of the underlying loss. In this contractual context, the evaluation of the loss of life is based on subjective preferences and willingness and ability to pay the corresponding risk cost, or the premium in insurance terms.

It shall be noted, incidentally, that legal systems have adopted different quantification methods to attach a monetary value to the loss of life or physical integrity for the purpose of determining the amount of damages to be awarded in liability cases. While the analysis of this area would go beyond the scope of this paper, it is worthwhile noting, from a comparative viewpoint, that different legal approaches to the monetary quantification of non-economic losses for damage assessment purposes (loss of life, personal injury, pollution damage to — S. 54 —natural resources) offer a rich menu of options from which to select possible criteria to evaluate non-economic losses due to climate change.

Similarly, certain elements of climate change-related non-economic losses, such as loss of tangible cultural heritage (eg monuments, archive materials, books, works of art, artifacts) could in theory be considered for insurance coverage — and climate change reparation purposes — through valued indemnity policies, in which the amount of the indemnity to be paid by the insurer in case of loss, damage or destruction of the insured asset — in this case, tangible cultural heritage — is determined ex ante on the basis of an agreed upon appraisal.

b.The Loss and Damage Fund

After the establishment of the Warsaw International Mechanism for Loss and Damage (“WIM”) in 2013, loss and damage is now considered the third pillar — besides mitigation and adaptation — of climate action under the United Nations Framework Convention on Climate Change (UNFCCC).³⁰ Dating back to 1991, when the Alliance of Small Island States proposed an “insurance scheme” aimed at providing financial resources to countries impacted by rising sea level,³¹ the idea that loss and damage due to climate change should be addressed by some form of international financial mechanism continued to permeate climate negotiations.

In 2023, upon conclusion of the negotiations at the 28th meeting of the Conference of the Parties to the UNFCCC (COP28) in Dubai, a landmark decision was adopted to operationalize new funding arrangements, including a Loss and Damage Fund (“Fund”).³² The purpose of the Fund is to assist developing countries that are particularly vulnerable to the adverse effects of climate change in responding to economic and non-economic loss and damage associated with the adverse effects of climate change, including extreme weather events and slow onset events.

The Fund will provide financing in the form of grants and highly concessional loans, concessional resources and other financial instruments, modalities and facilities. Article 58 of the decision explicitly indicates that the Fund may deploy insurance mechanisms, risk-sharing mechanisms and pre-arranged finance that augments and complements national resources for addressing loss and damage. The Fund will provide finance for addressing a variety of challenges associated with the adverse effects of climate change, such as climate-related emergencies, sea level rise, displacement, relocation, migration, insufficient climate information and data, and the need for climate-resilient reconstruction and recovery.

The financial support of the Fund may include funding that is complementary to humanitarian actions taken immediately after an extreme weather event; funding for intermediate or long-term recovery, reconstruction or rehabilitation; and funding for actions that address slow onset events. It may also include developing national response plans; addressing insufficient climate information and data; and promoting equitable, safe and dignified human mobility in the form of displacement, relocation and migration in cases of temporary and permanent loss and damage. Developing countries that are particularly vulnerable to the adverse effects of climate change are eligible to receive resources from the Fund.

c.Reducing Vulnerabilities to Climate Change: Ex Ante v Ex Post Financial Management Tools

Whilst it would seem that the present structure and financial resources of the Loss and Damage Fund are inadequate in comparison to the financial requirements of developing countries, in order to enable them to effectively cope with climate change,³³ the operationalization of the Fund at COP28 provides new opportunities to develop and implement innovative risk transfer and risk financing tools, with the aim of reducing vulnerabilities to climate change.

The escalating cost of climate-related disasters imposes a major drain on governmental resources, as governments are not only expected to rescue populations in devastated areas, but also often called upon to cover a large proportion of the losses that are not insured. In times of economic crisis, the need to manage disaster risk efficiently becomes even more pressing in order to maintain economic growth and national budgetary positions: disaster risk financing, therefore, has become an essential and integral part of any — S. 56 —comprehensive disaster risk management strategy, with a view to optimizing the allocation of public financial resources needed to cover natural hazard risks and losses, and possibly at reducing risk over time.³⁴

The effort requires a partnership between public and private sectors, as witnessed by the experience of several jurisdictions in managing the financial impacts of extreme weather events and other climate change-related risks.³⁵

From a theoretical viewpoint, governments have the option of financing climate-related disaster losses ex post through budget cuts and reallocations, post-event debt financing and taxation, thereby spreading disaster costs across present and future generations. Many countries, however, have complemented their investment in physical risk reduction with ex ante disaster risk financing tools. These instruments can address short-term (emergency response), midterm (recovery) or long-term (reconstruction) financial needs and can be used in combination to cover different risk layers, based on the relative frequency and severity of the expected events. Policy options in this field include

—government reserves, such as dedicated contingency reserves for disasters

(with allocated funds lapsing at year end), or multi-year disaster reserve funds (with allocated funds building up over time);

—insurance, which enables the transfer of risks and indemnifies against

damage (eg to cover damage to government assets such as buildings and infrastructure);

—contingent credit arrangements with a financial institution or interna-

tional organization; and

—catastrophe bonds or other types of catastrophe-linked securities or de-

rivatives, which provide an alternative means for risk transfer.

Risk financing involves the retention of risks combined with the adoption of an explicit financing strategy to ensure that adequate funds are available to meet financial needs should a disaster occur. Such financing can be established internally through the accumulation of funds set aside for future use or obtained externally through pre-arranged credit facilities. The banking sector, capital markets and international lending institutions are sources of risk financing.

Risk transfer involves the shifting of risks to others who, in exchange for a premium, provide compensation when a disaster occurs, ensuring that any financing gap that might emerge is partially or fully bridged. Risk transfer may be obtained through insurance policies or capital market instruments such as — S. 57 —catastrophe bonds.³⁶ The insurance and reinsurance sectors are the main sources of risk transfer, although capital markets provide an alternative source.

In response to the peculiar insurability problems posed by catastrophic risks — such as the geographical and inter-temporal risk spreading issues and the high cost of capital to cover low-probability/high consequence risks — and in the context of country-specific disaster risks and other possible national factors, governments have entered into partnerships with the private insurance sector with the policy objective of making disaster insurance available to the general public at affordable rates and/or ensuring that private assets exposed to risk are duly covered by insurance.

To this end, special institutional arrangements aimed at the explicit coordination of public and private actions have been set up to deal with losses caused by different catastrophic perils, including extreme weather phenomena.³⁷ The opportunity to develop an ex ante strategy for the financial management of large-scale catastrophes is generally suggested by the observation that purely ex post approaches to the compensation of disaster losses may have several limitations.³⁸ From a legal perspective, the implementation of ad hoc ex post compensation is likely to result in inequalities in treatment and lead to discontent.

Possible ex ante solutions include the establishment of dedicated catastrophe funds, market-based or state-sponsored disaster insurance and reinsurance programs, alternative risk transfer and alternative risk financing tools — such as risk securitization and contingent capital arrangements — allowing broader risk spreading through capital markets.

Insurance and reinsurance companies are already actively engaged in several climate initiatives at local levels, through public-private partnerships and via transnational platforms, such as the Net-Zero Insurance Alliance, the Global Shield against Climate Risk, the Insurance Development Forum and the InsuResilience Global Partnership, which supports implementing programs and projects related to Climate and Disaster Risk Finance and Insurance.³⁹

d.Indemnity-Based v Parametric Risk Transfer and Financing Tools

As explained in section 1.c above, the pay-outs of risk transfer instruments, such as insurance, may be quantified on the basis of actual losses sustained by the protection buyer (indemnity based), or the value of the payment may be agreed upon by the parties irrespective of actual losses and triggered by a physical parameter measuring the intensity of the hazard at given locations (parametric) or by an index comprising multiple measurements of such parameters for each event (parametric index).

Parametric policies provide for a fixed sum to be paid on the occurrence of the event without the policyholder having to demonstrate the extent of its own loss. These instruments make payments based on measures of a parametric index that is assumed to proxy actual losses. Basing pay-outs on such an objective index allows for timely payments, without relying on potentially lengthy and subjective loss assessments or evidence of incurred costs, which is especially important to fulfill emergency management financing need.

Parametric approaches require reliable data and technology to monitor hazard levels, which may be costly to acquire, manage and maintain, presenting significant implementation challenges, but in principle they can be used with all risk transfer instruments and contingency financing approaches. With reference to both economic and non-economic losses due to climate change, innovative parametric risk transfer solutions⁴⁰ could be tested with the support of the financial resources made available via the Fund operationalized at COP28.

e.Linking Risk Transfer with Risk Reduction

While risk financing and transfer mechanisms can reduce financial vulnerabilities and optimize cost allocation, in the long term they are not a solution per se: with a view to strengthening financial resilience, a key challenge, therefore, is linking risk financing and transfer tools with risk prevention, reduction, mitigation and adaptation objectives, so as to improve the overall risk profile.

As mentioned, extreme climate events can have severe financial and economic implications for governments, businesses and households through the direct damage they cause to buildings, equipment and infrastructure, as well as through indirect consequences such as business interruption, loss of employment and output, and decreased fiscal revenues. These impacts are — S. 59 —particularly severe for emerging economies, and especially for the poorest households within those countries, due to their more limited capacity to manage climate risks. Developing countries, in fact, are generally viewed as the most vulnerable to climate change due to their lower levels of physical and financial resilience, lower financial coverage through private insurance markets and more limited fiscal flexibility.⁴¹

Insurance plays a key role in reducing vulnerability by protecting households, businesses and governments from the financial impacts of climate change-related harms. Moreover, insurance has been identified as a useful tool in climate risk management: in addition to financial compensation for losses caused by an extreme weather event, insurance can provide incentives for adaptation, risk mitigation and preparedness before a disaster. In addition to providing the resources necessary to fund post-disaster needs, risk financing and transfer markets can convey signals regarding disaster risks and incentivize cost-effective disaster risk reduction measures.

Risk reduction is key, insofar as the expected impacts of climate change could potentially limit the availability of affordable insurance in the future, given the significant expected increase in risk cost.

Market-based risk financing and transfer mechanisms can play an important role in reducing vulnerability and building resilience to the impacts of extreme climatic events.⁴² Working in this direction, the private insurance market becomes a strategic tool for prevention and not just a loss compensation mechanism.

With specific reference to floods and storms, it is also especially important to leverage opportunities to rebuild damaged assets in a more resilient way in the aftermath of major events. A full recognition of the central importance of what was once known as the “building back better” principle (now labelled “building forward more resilient”) — which appears to be missing in most systems — would require a radical change of mindset and a completely new approach to the design and implementation of financial management tools — including insurance —, insofar as the amount of financial resources to be made available in case of occurrence of a disaster should not be measured against the status quo ante, rather it should be calculated with a view to cover the cost of re-configuring the risk profile and improve resilience going forward.⁴³

3.Conclusions

Assuming that the relevance of climate change for the purposes of reparation is determined by its impact on individual and collective rights, it follows that a significant portion of such harm is projected to occur in the future. The adverse impacts of climate change, therefore, can be conceptualized for reparation purposes as an increased risk of damage since climate change produces a “risk difference” that is contingent on several variables. Consequently, the evaluation of climate change-related harms necessitates the capacity to assess and quantify risk and risk differences in monetary terms, which underlines the critical importance of understanding the perspectives of insurance, reinsurance and financial sector players on the modeling, valuation and quantification of climate change-related harms.

Over the past decades, insurance and reinsurance market players worldwide have been investing significant resources in the research, study, modelling, assessment and quantification of climate change-related risks and their potential harmful consequences, with the aim of developing sophisticated climate-risk transfer tools that cater to the needs of households, corporations and policy makers.

Improvements in the scientific knowledge and understanding of climate change, its drivers and its impacts — including the increase in the frequency and severity of extreme weather events — by reducing uncertainty expanded the role of insurance and reinsurance in this field.

In consideration of climate variability and changing weather patterns, statistical analysis based on historic data becomes less reliable and climate risk assessment must be performed adopting a forward-looking approach, which implies significant uncertainties. The predictability of long-term climate trends must be balanced with the uncertainty of climate projections and then translated into the real economic impacts of climate change.

Probabilistic risk models have been developed by the insurance industry (alongside scenario models) to predict and analyze the potential future impacts of climate change. The output of these models converts risk into a metric of potential loss, which in turn allows for comparability of risks across categories, perils and geographic locations. The AAL, in particular, is a powerful — S. 61 —physical climate risk metric that can have a wide range of possible applications in climate risk management and the domain of reparation for climate change, contributing to the determination of a price for risk and risk differences.

In 2023, upon conclusion of the negotiations at COP28 in Dubai, a decision was adopted to operationalize new funding arrangements, including a Loss and Damage Fund. The purpose of the Fund is to assist developing countries that are particularly vulnerable to the adverse effects of climate change in responding to economic and non-economic loss and damage associated with the adverse effects of climate change, including extreme weather events and slow onset events. The Fund may deploy insurance mechanisms, risk-sharing mechanisms and pre-arranged finance that augments and complements national resources for addressing loss and damage.

Insurance and reinsurance market players are now called upon to provide support in the design and implementation of innovative risk transfer and risk financing solutions aimed at reducing the total costs of climate change and at improving financial resilience of the exposed populations, making the most efficient and effective use of limited available financial resources.