Captive insurance: a strategic asset for long-term climate resilience
Peter Carter and Torolf Hamm, from WTW, look at the potential for captives to enable more efficient climate risk management and the longer-term risk financing view demanded by climate change.
Risk managers are increasingly exploring the role captives can play in delivering more efficient climate risk management. As climate change amplifies the impact of multiple hazards – from more intense cyclones and snowfall to severe floods, heatwave, droughts and wildfires – climate-related risks consistently rank among risk managers’ top concerns.
To address these long-term and potentially catastrophic risks, organisations might need to shift their risk management mindsets. This is about moving away from the traditional, short-term focus on annual insurance renewals towards longer-term horizons and risk financing strategies.
To what extent can captives support this move? How well suited are captives in working both to stabilise a company’s financials in the face of ongoing climate change and accelerate continued sustainability efforts?
Why adopt a longer-term view of climate risks?
If an organisation’s risk finance strategy is still tied to the short-term focus of annual insurance renewals, it’s time to think beyond this. By adopting a longer-term time horizon, such as three to five years or up to ten, the business will be in a better position to roll its risk management strategy forward and smooth out the volatility of climate-related losses over time.
Any business impacted by a warming world and transitioning to a lower-carbon economy needs to do this to maintain stable financial foundations for enduring resilience.
Also, to ensure business continuity in the face of an increasingly volatile climate, more businesses might turn to ‘climate hedging’ strategies that incorporate captives and bring captive management into their core business strategy. Just as companies hedge against foreign currency risks, captives can be used to hedge against the continuing financial impacts of climate-related losses.
Captives can provide a financial safety net and a way to enable more proactive approaches to climate risk management by funding risk mitigation efforts, such as investing in climate-resilient infrastructure or implementing adaptation measures.
Managing climate exposures with captives
Executing a climate hedging strategy effectively requires quantifying the financial exposures of a business’s climate risks. With this insight, it becomes easier to aim for the most efficient blend of self-insuring through your captive, funding adaptation and mitigation measures and looking to traditional insurance markets to transfer certain climate exposures.
The first step in quantifying climate exposures is to identify the locations of an organisation’s exposed physical assets, as well as those of ‘sourcing regions’ in its supply chains that might be vulnerable to climate-related perils. Analytical geospatial tools can help build this picture.
Once the climate-related exposures have been identified across a company’s operations and supply chains, these will need to be stress-tested for hazards such as drought, flood and other climate-related events.
Using scenario testing and a wide variety of scientific data allows the simulation of the potential effects of climate change on the business. Well-established actuarial simulations used by insurers can also give a detailed understanding of the potential financial losses associated with different climate-related scenarios.
Having quantified the potential financial impact of climate-related risks, the business is now in a position to develop a risk financing strategy that responds to these multiple, complex and increasingly severe risks.
Supporting corporate goals on climate and sustainability
Companies’ sustainability reports often include details about how organisations use energy and water, as well as greenhouse gas emissions, across business units. Captive insurance programmes can be used actively to encourage the right behaviours across business units in support of an organisation’s sustainability goals and reporting.
This entails establishing a premium allocation model as part of your captive, which adjusts what each business unit pays into the captive for its insurance. You can base these models on claims history, as well as how each business unit is managing risk currently and plans to in the future.
To make this even more effective, a business can introduce sustainability metrics into its model. For example, if a business unit is making strong progress on sustainability by using less water and energy or reducing emissions, this can be rewarded with lower premium payments into the captive. Should a unit fall behind, higher payments can be applied.
By linking premiums paid into the captive to sustainability performance, every part of a business is effectively being given a clear financial reason to improve, making the captive a tool to drive positive change, not just a backstop for risk.
Shielding captives from major climate losses
When using a captive to manage climate-related risks, companies might find the risks they retain, particularly catastrophic ones, become significant over time. To protect their captives’ capital from being eroded by larger losses, businesses can turn to structured solutions, including parametrics, combined with structured multi-year, multi-line reinsurance.
Parametric solutions can help the business ring-fence the financial impact of specific weather or natural catastrophe threats. Such policies pay out based on specific, measurable events (such as a certain level of rainfall or wind speed), rather than on actual losses incurred, meaning a quick, predictable payout when a defined event happens.
Structured, multi-year, multi-line reinsurance can also be used to cover several years to create a safety net that helps smooth out the financial impact of major events. By structuring a captive’s protection in this way, you give yourself time, typically three to five years, to absorb and manage losses, rather than facing sudden capital depletion.
Peter Carter is head of climate practice and head of captive & insurance management solutions; and Torolf Hamm is senior director, physical climate risk, climate practice at WTW.
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