As extreme climate events continue to increase in frequency and severity, industry professionals discuss the role of the insurance industry in developing adaptation and mitigation measures, as well as the implementation of captives for climate-related risks
Climate action failure is the most significant long-term threat to the world and has the potential to cause the most severe impact over the next decade. This warning is according to the results of the World Economic Forum’s (WEF) 2022 Global Risks Perceptions Survey, in which respondents overwhelmingly marked environmental and climate change-related risks as an area of serious concern.
Although the survey identifies societal risks as the most troubling over the next five years, from a long-term perspective, concern over the health of the planet undoubtedly dominates the 10-year horizon.
Of the top five most critical long-term threats to people and the planet identified by respondents, three are explicit environmental risks: climate action failure (42.1 per cent), extreme weather (32.4 per cent) and biodiversity loss (27.0 per cent).
Ray Monteith, senior vice president of HUB International’s risk services division, practice leader for organisational resilience, and Canadian risk control services leader, notes that risks associated with climate change are no longer theoretical.
He cites the 2022 assessment report by the Intergovernmental Panel on Climate Change, which “draws very clear conclusions that recent changes in the climate are widespread, rapidly intensifying, and are currently at levels outside of the experience of anyone’s living memory.”
Amy Barnes, head of sustainability and climate change strategy at Marsh, adds that the past few years have seen a shift in how people engage with climate issues. She explains: “We are becoming increasingly aware of climate and weather-related perils affecting our lives and livelihood, whether in the global north or south.
“As citizens, we are seeing images on the news of the very real impact and harm that changes in extreme weather can cause, whether the loss of homes, damage to property, people being injured, or loss of livelihood. The consequences feel increasingly personal.”
Governments, businesses and societies alike face increasing pressure to address and mitigate these consequences. However, the complexities of technological, economic and societal change at this scale are enormous. In the report, WEF warns that a “disorderly climate transition” (characterised by divergent trajectories and urgency across regions and sectors) will likely create international barriers to cooperation to address climate risks, as well as exacerbate inequalities.
For example, countries with a reliance on carbon-intensive sectors, such as energy production, manufacturing and shipping, will risk losing their competitive advantage through the higher cost of carbon, reduced resilience, limited leverage in trade agreements, and overall failure to keep pace with technological innovation.
On the other hand, the report notes that shifting away from carbon-intensive industries is highly likely to trigger economic volatility and higher unemployment, as well as exacerbate societal and geopolitical tensions.
The WEF report notes that the post-pandemic financial and economic landscape is increasingly shaped by the rise in stakeholder capitalism and shareholder activism, as well as evolving ESG agendas, targets and metrics.
Antoine Bavandi, global head of public sector, parametric and climate resilience solutions at Gallagher Re, states that global ESG assets exceed US$40 trillion in 2022, with a projection of US$50 trillion by 2025 to make up one-third of total assets under management globally. He notes that this demonstrates the extent to which ESG issues are becoming a core priority for the insurance industry, from both a risk and opportunity perspective.
As banks, insurers and institutional investors divert capital towards net zero, financial systems are rapidly emerging as important enablers of this transition.
The role of the insurance industry
The insurance industry has an important role to play in adaptation and mitigation measures to address the impacts of climate change.
Adaptation refers to the risk modelling of events, responses to natural catastrophes, and development of sustainable solutions, while mitigation refers to efforts to support the transition to a net zero economy, developing low-carbon solutions, and addressing insurable transition risks.
The insurance industry has embraced mitigation measures on both sides of the balance sheet. For example, Barnes notes that last year, under sponsorship of the United Nations, the Net-Zero Insurance Alliance was formed to promote principles for sustainable insurance and risk management from developing climate impacts.
Barnes states: “We now know that mitigation is not enough. Assets and infrastructure systems need to adapt to the changing climate. The insurance industry has an ability to influence how the global economy considers climate and carbon intensity.”
However, she adds that adaptation brings some challenges for the insurance industry. For example, in a flood loss event, the basis of an insurance policy is to place the insured back into the same situation they were in before the loss. The current wording of policies may not allow for the insured to build back a more resilient asset or an asset that has adaptation measures.
“The insurance industry has an opportunity when a loss has occurred to ensure that whatever is built back is adapted for climate change and more resilient to future losses,” Barnes explains. Therefore, insuring the climate transition also encompasses risk reduction and loss prevention.
“Driven by climate change, the property and casualty market is transforming,” comments John Meder, head of risk consulting and claims advocacy at Risk Strategies. “Brokers, insurers and insureds must all pay close attention to the changing landscape and do everything in their control to manage risks, mitigate losses and prepare for the worst.”
Gallagher Re’s Bavandi outlines that as risk managers, risk carriers and investors, the insurance and reinsurance industry has a significant interest in fostering sustainable economic and social development.
“Through holistic risk management, comprehensive data, and innovative analytics, insurers and reinsurers are ideally placed to drive positive cultural change across the risk and finance industry, and strengthen their contribution to building a resilient, inclusive and sustainable society,” Bavandi says.
HUB’s Monteith points to catastrophe risk modelling as a key adaptation tool for the industry to employ, to encourage activities from client to help them understand their loss potential:
- A specific event is modelled based on historical data and likely event parameters
- From this model, hazard potential can be identified to form the basis of a vulnerability assessment
- The assessment highlights potential physical damage and financial loss estimates
- This helps organisations understand the extent of their exposure
- This informs strategic decision making around risk management
He adds: “There is no question that the insurance industry will continue to play an important role in creating awareness of the physical risks associated with climate change. It is increasingly important that insurance carriers drive awareness of risks arising from societal changes as the world transitions with increasing speed towards a low-carbon economy.”
Captives
Captives are well-positioned to aid the insurance industry in developing adaptation measures against climate change because the inherent flexibility of captive structures facilitates and provides coverage for evolving climate-related risks.
“Captives offer agility and adaptability that is often not found in, or even possible for, traditional insurance structures,” Monteith says. “Captives can create an effective means of managing and financing all, or portions of, an organisation’s specific risks associated with climate change.”
This is affirmed by Meder, who notes that captives play an important role particularly when risks are more difficult to place or require higher retentions, as this allows companies to tailor coverage and allocate costs over a longer period of time.
He adds: “With increased catastrophe losses due to climate risks, businesses are having to take on larger deductibles and self-insured retentions. In this environment, captives can become an important part of risk financing, offering flexibility in managing the risk, developing creative property loss control solutions and a mechanism by which businesses can fund their losses.”
In terms of mitigation measures, captives are able to consider sustainability as a framework to improve risk management, rather than simply as an investment topic. As subsidiary companies, captives can also be used to support the parent corporation’s net zero targets.
Lorraine Stack, international sales and advisory leader at Marsh Captive Solutions, notes that “it stands to reason that captives will be used, as ever, to house risks that insurers cannot or will not.” Specifically for climate-related risks, she anticipates that captives will be used to cover risks where risk appetite among commercial insurers declines.
Stack adds: “Alternative structures like protected cell companies may be used for certain risks, and we anticipate other transformative vehicles, such as insurance-linked securities, being used to access alternative capital. Since captives tend to be a lot more nimble and flexible, they can adapt quickly. This means captives will be an intrinsic risk management tool throughout the climate crisis.”
Furthermore, the accelerating pace of change in the current global operating environment means insurers that fail to embrace innovation may find it difficult to sustain long-term success.
Brace yourself
So how can an organisation best position itself to manage its climate risk? Barnes highlights that the starting point is to understand the risk and the company’s exposure; considerations around climate risk encompass both transition risk (the impact of a business on the climate) and physical risk (the potential for the climate to impact a business).
“Often, risk managers are responsible for managing the physical risks of the organisation, so it is important that the risk management community is part of the conversation,” Barnes notes.
For example, she highlights that if the company has a sustainability officer, the risk management function should collaborate to provide knowledge and skill sets to the task, ensuring that they are engaging with the output, as they may be involved in the implementation.
Monteith affirms that awareness is crucial across an entire organisation, not just within specific aspects of operations. He says: “It is important to create a culture of preparedness and adaptability, as the ever-evolving nature of climate change means implications are not static. An organisation needs to develop a framework to which it can constantly assess, identify, and manage climate-related risks because the process is cyclical.”
Stack adds that within a risk governance framework, there is an expectation that firms will understand the impact of climate change, and will implement a form of scenario analysis and stress testing to evaluate the impact of future climate events.
As part of a comprehensive enterprise risk management strategy or framework, it is therefore paramount to understand the areas where a captive can be used to help mitigate some of the climate-related risks, as Barnes notes captives are well-placed to build financial resilience beyond property damage once the nature and consequences of the risks are recognised.
Barnes adds: “An organisation should also find ways to bring the risk management tools to capital decisions. Whenever capital expenditure is spent on building upgrades, consider your understanding of the climate risks and whether the planned capex contemplates the changing climate. If you are building it for today’s weather patterns, risk managers can advise on more resilient construction strategies.”
Climate reporting acts as a useful driver for the understanding and quantification of climate risks. Many companies in the UK have compulsory climate reporting, while the U.S. Securities and Exchange Commission is currently in the process of introducing regulation — although Barnes notes that many companies are voluntarily reporting in the interim.
In terms of captive domiciles, Stack notes that, although not very many captive regulators have published guidance, those that have, have provided a sense of direction. For example, she outlines how the Central Bank of Ireland sent a “dear CEO” to regulated entities in November 2021 summarising its expectations, which were largely based around the EU’s sustainability framework.
“Given that, it is likely that other European regulators will go the same way,” Stack says. “With a focus on governance, the captive board is expected to take ownership of all ESG-related areas and risks.”
Guernsey recently changed the corporate governance code to require captive boards to assess the impact of climate change, on both strategy and risk profile, leading Stack to say: “Captive owners can expect to see climate regulation crystallise over the next few years, initially on board meeting agendas. Captive boards will have to take ownership of this and address it, as well as adapting to new reporting requirements and regulatory disclosures.”
Marsh’s Barnes adds: “Once reporting is compulsory, that information is then in the public domain, which allows stakeholders to interrogate the data and challenge companies to proactively manage their exposures.”
HUB’s Monteith elaborates that as consumer activism continues to gain prominence, this will likely impact organisations’ ability to meet changing demands from current and prospective clients to reduce their environmental impact.
Barnes affirms that this conversation will increase as long as more companies continue to fulfil climate reporting requirements, which make it easier for stakeholders to have a lens into what companies are doing around climate and sustainability. Therefore, it will be crucial for companies to not only be able to understand, assess and manage climate-related risks, but also to develop adaptation strategies and policies, and prioritise climate resilience planning and decision making by coalescing expertise in risk management and sustainability.
“Managing climate risk certainly requires a long-term vision that addresses both risks and opportunities, and a willingness to go beyond traditional risk transfer offerings,” adds Bavandi.
“It is also essential to continue to invest in innovation and technology, while focusing on value creation in the long-term.”
“For the insurance industry, climate is unlocking new growth perspectives and driving more efficient ways to leverage data analytics and better monitor exposures.”
Looking ahead
It is not an outrageous statement to say that extreme climate events will continue to increase in frequency and severity, and that organisations will need to continue to be more strategic in their approach to risk management.
Risk Strategies’ Meder notes that as at-risk catastrophe zones continue to expand, corporations and communities alike will require more advanced planning and resilience programmes, to adapt to changes in the climate and to assist in disaster recovery efforts.
Concerning the future role of the insurance industry in addressing climate risks, Monteith summarises: “As climate continues to change and the impact is increasingly felt, the need for the insurance industry to be responsive is certainly now evident, and will continue to evolve.”
Meder notes that the insurance industry’s ability to underwrite the impact of the low-carbon transition will be both interesting to observe and challenging to execute, as companies’ will need to be able to identify and articulate the impact of the transition on its operations.
“Insurance carriers must provide guidance and support to clients to help them understand the need to fully assess their risk and exposure. It is a very interesting dynamic at play now, especially as change accelerates,” he says.
For captives specifically, Barnes notes that the small percentage of rated captives, many of which are in carbon-intensive sectors, will need to understand how rating agencies will regard the carbon-intensive book they are writing and how this may potentially impact the rating.
“As well as the liability side, many captives obviously have significant assets under management,” she explains. “We are seeing clients changing their captive’s asset portfolio to be aligned with their sustainability goals. On the asset side, captive managers need to ensure that they are executing the same strategy as the parent company when it comes to sustainability.”
Marsh Captive Solutions’ Stack adds, that even though captive regulation is slow in becoming global, captive owners must be proactive in adding climate conversations to the agenda: “Most large companies now have sustainability officers and it is increasingly entrenched in strategy, so it needs to start permeating to captive board levels.”
Monteith continues that it is important to remember that the impacts of climate change are exacerbating an already hard insurance market, which brings with it stringent underwriting criteria and reduced capacity.
“There should be no question that insurance companies will increasingly require evidence of stringent climate risk mitigation activities from existing and prospective clients, and those requirements will continue to get more intense over the coming months and years,” Monteith concludes.
