A serious problem for people and state

This is a problem for two reasons. Firstly, a lot of property owners underestimate the risk. They develop a false sense of security and can then be surprised by a sudden extreme weather event. In the worst case, they not only lose their property – and therefore their home – but also do not receive compensation for the loss if they are inadequately insured. Secondly, the protection gap is also a major problem for the state. After all, if a major loss occurs and numerous property owners are uninsured, then there is immense pressure on the state to provide financial support to those affected. This strains the national budget and leads to ever greater financial risks for the taxpayer in the face of advancing climate change.

The mechanisms at work in the event of major losses are demonstrated by the example of the devastating Ahr Valley flood disaster in western Germany in the summer of 2021, in which more than 180 people lost their lives and large parts of the infrastructure and buildings in many towns and villages were damaged or destroyed. In this case too, many property owners were not insured against natural hazards. However, the majority of German federal states had decided back in 2017 to no longer pay for uninsured losses in the event of natural disasters. Nevertheless, when the terrible images from the flooded area circulated in the media, a €30 billion state reconstruction fund was established. “From a human perspective, robust state intervention is completely understandable,” says Markus Wehrmann, Political Affairs Specialist at the Association of German Public Insurers (VöV). “But it burdens the national budget. And it creates a moral hazard, discouraging property owners from getting insurance.”

EU Initiatives to develop possible solutions

Against this backdrop, there are now several initiatives aimed at reducing the protection gap. The state has an interest in this, as does the insurance industry. At the EU level, for example, the European Insurance and Occupational Pensions Authority (EIOPA) and the European Central Bank (ECB) are dealing with the question of how the protection gap could disappear in the long term. They have published a joint discussion paper entitled ‘Policy options to reduce the climate insurance protection gap,’ in which they outline possible approaches. Another initiative is the Climate Resilience Dialogue, a platform for exchanging views at EU level. Participants include representatives from the European insurance and reinsurance industries, other companies, authorities and regions as well as consumer advocates. Together, they discuss the causes of the problem and potential solutions. A final report with concrete proposals from the initiative is expected in summer 2024.

However, it is already apparent which solutions could work. One starting point is better education of property owners. Anyone who comprehends how high the risk of a natural disasters is and how climate change is causing it to rise will feel highly motivated to insure their property accordingly. Furthermore, it is important that insurance customers are aware of exactly what is covered by their policies – and what is not. “Although the vast majority have homeowners’ insurance, many of these property owners do not realise that they are not insured against the consequences of flooding and heavy rainfall,” remarks VöV expert Wehrmann. Many insurance companies are already combating such knowledge gaps with information campaigns.

The Swiss Concept: mandatory insurance as a solution?

Another option to significantly narrow the protection gap could be compulsory insurance against natural hazards. Such a system exists in Switzerland, for example. There’s one clear advantage to this solution (if it gains widespread acceptance): hardly any uninsured properties would remain and there would be no need for the state to come to the rescue in the event of major losses. Other countries could soon follow the Swiss example. In Germany, for example, the federal states of Baden-Württemberg and North Rhine-Westphalia are advocating for mandatory insurance. In fact, this used to exist in Baden-Württemberg at one time. It was subsequently abolished there in the 1990s, but the proportion of private property owners with natural hazard insurance still stands at over 90 percent there, far exceeding the German average of just 52 percent. However, VöV expert Wehrmann is well aware that mandatory insurance has a critical disadvantage. “With nearly 20 million residential properties in Germany, monitoring compliance alone would entail a significant administrative burden, especially for the financial authorities.”

Consequently, another solution is being discussed as an addition or alternative to compulsory insurance: the so-called opt-out principle. In this scenario, insurers must actively offer natural hazard coverage to anyone looking to take out homeowners’ insurance. Customers can only take out a policy without natural hazard insurance if they expressly decide against it. Such customers could be obliged to sign a declaration that they are aware of the consequences and that they are knowingly forgoing the possible coverage. “You could even go a step further and include a waiver of state aid in the declaration,” suggests Wehrmann.

France favours mandatory component

In France, home insurers have been obligated to include natural hazard coverage in building insurance since 1982. Of course, every French citizen is free to not insure their own building. However, when a property owner does take out homeowners’ insurance, then natural hazard coverage is a mandatory component. In this case, customers are only uninsured against natural hazards if they knowingly and actively decide against homeowners’ insurance altogether. 

At the same time, two factors ensure that the natural hazard component of homeowners’ insurance in France is very affordable at an average of €26 per year for each property. Firstly, there is a state reinsurance system. Secondly, the principle of solidarity is applied – insurers do not assess the risk of each customer individually. The result: according to figures from the European Consumer Centres Network (ECC-Net), 98 percent of property owners in France are covered against natural hazards. Since 1982, the state has only had to step in once to pay for damage to a private property.

No solution without climate change adaptation

Besides raising awareness of the risks, mandatory insurance and the opt-out principle, there is another crucial factor to consider in narrowing the protection gap – or at least for not letting the gap widen further: climate change adaptation. If this does not happen, ultimately no insurance solution will be of help. For example, governments can impose bans on new construction and reconstruction in known flood areas, in order to prevent new risks from being built in the first place and to respond to known risks. Preventive measures, such as the construction of floodplains and dams, can also increase regional flood resilience. These precautionary structural measures would ensure natural hazard insurance remained affordable for property owners.

Ultimately, the insurance industry must come up with its own ideas and solutions for reducing the climate protection gap, believes Wehrmann. “The industry can make a substantial contribution in this regard, especially with its vast expertise in loss prevention.”

The digital transformation of the insurance industry has received a tremendous boost thanks to AI. Consultants and IT experts are warning that the disruptive potential of artificial intelligence in virtually all business areas of the industry – from risk assessment and the automation of business processes to communication with customers – is likely to overturn traditional business models and make way for new players.

That said, great hype is always followed by a phase of disillusionment. For all the discussion about AI and its revolutionary potential among the general public and in specialist media, the insurance industry has so far only taken small steps forward in terms of specific applications. Many insurers have launched tentative pilot projects. However, these have mostly involved limited internal applications, such as filtering customer enquiries or navigating the overwhelming variety of pricing options. This hardly amounts to a revolution – or the industry disruption that was predicted.

Regulatory guidelines for the use of AI

At the same time, policymakers are starting to introduce stricter regulation of AI in order to mitigate the risks of uncontrolled and potentially improper use of the technology. Because AI has such far-reaching potential to change so many industries and our society as a whole, and because it also affects highly sensitive and protected areas of life, the EU presented draft legislation to regulate the technology in spring 2024. As a result, guidelines for using AI are being set out for the first time. 

This provides some orientation for the insurance business in its adoption and use of AI. However, the “EU AI Act” classifies certain risk assessment and pricing systems in the insurance industry as high-risk applications – which will affect the life and health insurance segments. In future, the EU will place high demands on the risk management, governance, technical documentation, explainability, accuracy, robustness and cybersecurity of AI systems in these segments. Furthermore, it requires that a human must always oversee the systems as the final authority. The EU is also prohibiting the use of AI for “social scoring” in which information from social media is used to create a customer risk profile.

With its draft legislation, Europe is taking a leading role in dealing with AI and is setting the international standard for the development of AI in accordance with ethical standards and European values. The risks associated with uncontrolled usage and artificial intelligences that one day soon will be no longer comprehensible to humans are considered so great that European lawmakers felt compelled to intervene. 

Too much or too little regulation?

Amid the applause for regulating the rapid development of systems that have so far largely been driven by international IT companies, there is also criticism from the insurance industry. The planned requirements, especially in the area of personal insurance, mean that the great potential of the technology, such as for optimal risk assessment and accelerated underwriting, can only be exploited to a limited extent. The level of protection regarding the risk assessment of individuals or pricing is already very high as a result of existing regulations.

Consumer watchdogs are concerned that AI will primarily be used in the insurance industry to optimise customers’ willingness to take out coverage and pay. They also contend that underwriting – possibly by means of self-learning algorithms – could become a black box in future, which lawmakers must absolutely prevent. 

The focus is on the role of AI as a facilitator

Many business experts concur that the greatest benefit of AI for insurers is for the interpretation of complex documents and the conversion of unstructured documents into structured data. In other words, the focus is on the role of AI as a facilitator – not least when it comes to difficult business processes, such as underwriting industrial risks. Some insurers are already achieving tangible productivity gains from using AI, for example in customer communication and the collection of decision-relevant data. 

The automation of processes will accelerate dramatically thanks to the use of AI. But in Europe, we are unlikely to see the full automation of customer-relevant processes such as pricing and underwriting by the end of this development. The experts at the insurance companies can therefore rest assured that they will therefore not be replaced by AI – they will continue to be the final decision-makers. But the organisations and individuals who use AI in future and optimise work processes with it will surely replace those who do not.

Don’t lose your head over the AI Hype

The great potential of AI lies in this redesigning of complex, often unwieldy processes that have been established in the insurance business for decades – and it is putting pressure on companies to act. The digital transformation and the modernisation of IT systems already present huge challenges for the industry today. Right now it is a matter of designing systems so that AI can be used without hiccups and ensuring the data that most insurers already have in abundance can actually be utilised.

In the process, companies must clearly identify where meaningful applications of AI might exist within their specific business model. Euphorically chasing the hype and “simply doing something with AI” – because the Board says jump – would be a mistake. In the midst of an AI fever – when consultants and IT providers are prophesying revolution – there’s an even greater need for rationality and caution. 

Insuring all shared mobility models

For insurance companies, this means two things: Consumers must see a benefit in sharing their data, and then they need to trust their insurer's data expertise. “Many customers are reluctant to share their data,” says Larissa Klick, motor insurance specialist at Deutsche Rück. Consumers are particularly critical of insurers. According to a study by Deloitte, only a tiny minority of respondents worldwide believe that insurance companies handle mobility data responsibly (see chart). In some countries, the figure is as low as six percent. It is therefore good practice for insurers to be transparent with their customers about how their data is used. 

In general, it is important for car insurers to think about the design of their products. It's not just the car that’s changing, but mobility as an industry. “From a customer perspective, in the past it was mainly car ownership that was insured,” says Stephen Voss, co-founder and chief sales and marketing officer of digital insurance company Neodigital. That is changing. “There are more and more people who want to loan a vehicle rather than buy one.” In future, therefore, it will be less about insuring the physical ownership of a car and more about all aspects of shared mobility, in other words, car sharing, subscription models for rental cars – and, increasingly, electric vehicles. According to consulting firm Capgemini's World Property and Casualty Insurance Report 2023, 42 percent of policyholders worldwide want a single policy to cover this wide range of mobility solutions. Insurers who adapt to this trend will give themselves a competitive edge.

From motor insurance to mobility cover

With this in mind, traditional motor insurance could be transformed into a comprehensive mobility cover. To do this, however, insurers need greater quantities and variety of data than have previously been available – as well as flexible IT solutions. But most insurers are struggling with cumbersome, outdated systems. Deutsche Rück expert Klick therefore advises: “Motor insurers who want to be successful in the future must invest boldly in flexible IT that can process all available data, such as that relating to the individual portfolio, its claims experience, the current price situation on the market and their own flexible pricing model.” Providers would then also be able to tailor products and pricing to user groups that not all insurers have on their radar.

Agile IT combined with a database that allows competitive analysis also enable insurers to continuously adjust their prices throughout the year based on current market conditions. “The better companies can do this in future, the greater the competitive advantage they will gain over less agile insurers,” says Klick.

Combining historical and current data

For Neodigital founder Voss, much of this is already everyday routine: his team uses automated processes, digital contract management and individually collected driver data for risk categories instead of statistical models. “The motor insurance industry has relied on historical data, which is backward-looking,” says Voss. It is no longer up to date. “There is an opportunity to attract more new customers by combining historical and current data, resulting in fairer pricing.” Telematics data could play a crucial role here. “If a novice driver is in the least favourable damage class but drives very carefully, and the insurer knows this from the vehicle data transmitted, he or she could get a discount.”

In many countries, Voss points out, new, high-priced cars come with a telematics system as standard. This means that insurers will no longer have to install costly additional hardware. “If insurers can process this data quickly and automatically in future, telematics can also be implemented more cost-effectively and larger discounts can be offered,” says Voss. Surveys show that a premium discount is the biggest motivator for data sharing from the customer's point of view. 

To tap this potential in future, insurers are increasingly partnering with start-ups that offer data-based services. One example is the start-up Caruso, which is working with the Fraunhofer Institute to set up a data marketplace that will act as a link between car manufacturers and insurers to enable the secure and efficient exchange of telematics data. This is yet another example of how the focus in future will increasingly be on cooperation between customers and insurers, service providers and car manufacturers.