How can the captive industry adapt to the developing impact of climate change and adopt measures to mitigate impact to their shareholders, themselves, and the natural environment?
One can separate the green equation for captives into three distinct but overlapping areas: the underwriting portfolio; the investment portfolio and corporate governance.
There is an assumption that most captives are used for non-catastrophic and more predictable risks that are lower in severity and higher in frequency. This is not the case for all industries and sectors. During hard market cycles, captives are used to provide cover for just about every imaginable class of business, especially those that are not readily available in the commercial markets. Captives are important for risk-finance. Over time, the build-up of excess surplus on its balance sheet can fund potential catastrophic risk which will assist with liquidity and buffer the impact of funding uncertainty when it’s most useful, thus creating economic resilience to unforeseen catastrophes.
There is an argument that the essence of an insurance product: providing support at a time of heightened financial stress, thereby increasing resilience and sustainability, places insurance firmly in the positive realm of ESG. But does that follow regardless of the type of risk being covered? Does a product that provides an indemnity on say a ‘new for old’ basis truly support a drive for a greener ecosystem?
Captives can, of course, be very useful to industries with environmental risks. A captive’s activities can be beneficial related to environmental protection coverage and the provision of future funding requirements for the reclamation and rehabilitation of land post events that create pollutants that are either limited in cover or not covered at all. A captive funding mechanism can provide additional comfort in a challenging risk environment where there is supply-chain coverage limitations, decreasing risk coverage, and increased insurance pricing.
Some companies are increasing their climate plan’s visibility after acknowledging the physical threats accelerated by climate change. Insight into their estimates on the cost of impact and mitigation help build a picture of how seriously they are considering these potential threats, and captives can be at the heart of that process. The Carbon Disclosure Project (CDP) has issued voluntary questionnaires on the reporting of emissions and climate impacts for cities and companies around the world since the early 2000s. While the CDP disclosure framework has been around longer than others, there are other avenues for increasing visibility into climate plans, including the Task Force of Climate-Related Financial Disclosure (TCFD). These frameworks form part of the corporate social responsibility paradigm and we anticipate participation will grow over time and draw billions in investment to protect physical and financial assets.
Examples of catastrophic events impacted by climate change are the 2018 Kincade and Camp Fire wildfires in California and their financial impact to Pacific Gas and Electric Company (PG&E) which resulted in the first climate-change related bankruptcy. The Kincade fires resulted in an estimated $30 billion in wildfire liabilities and PG&E faced criminal proceedings, fines and penalties. The impact to industry losses for utilities companies exacerbated potential loss costs and increased insurance pricing across the board for certain lines of coverage. Captives can be used as efficient long term risk financing vehicles by corporates who are seeing the third party market shrink away from risks which are being exacerbated by climate change.
As pressure mounts on factoring in climate change in underwriting and risk models used to develop probable maximum loses, captives can facilitate funding mechanisms to assist as they transition from ‘non-green’ activity to more sustainable practices over time. In times of unprecedented change, we expect market participants to take a step back, look at feasibility studies, see how the landscape is changing, quantify the impact to volatility in the short and long term, and explore novel ESG-related risk management tools. One such way companies are developing their ESG framework is looking through a ‘green’ and/or sustainability lens influencing investment strategies and determining changes to their investment appetite.
From an investment perspective, adopting ESG principles can include structuring investment decisions directly or indirectly to consider the concept of responsible, ethical or sustainable investing which is often referred to as ESG investing. Certain lines of business and industries can expose captives to more ESG risk than others, but ESG investing, and socially responsible investing (SRI), are issues that all captives should become aware of and involve making changes to an investment portfolio, which can be done fairly simply.
There has been the misconception that adopting ESG investing will compromise overall investment returns. However, evidence is increasingly surfacing from analytical reports and data samplings from reputable sources that counters such argument. According to a recent meta-study by NYU Stern Center for Sustainable Business, aggregating evidence for 1,000 plus studies published between 2015 – 2020, the results showed the majority of ESG-focused investment funds do outperform the broader market. Another important investment factor to consider for captives is the concentration of risk from certain asset classes exposed to climate risk (and reputation risk) resulting from climate impact and the potential for volatility and investment losses impacting their portfolios.
With large European commercial insurers leading the way, we have seen commercial carriers incorporating ESG principles into their investment portfolios. Captives would benefit from taking a similar position in examining their investment portfolio and adapting investment guidelines that are more in line with not only their parent companies but could also be used as a platform for investing surplus capital into more highly rated ESG investments. This could also be through supporting a green fund, or investing directly in green assets like mangrove forests, biodiversity, and humanitarian efforts that provide resilience to emerging countries.
ESG risk is an area that many captives have historically not explicitly addressed when considering their own day-to-day operations but will become more significant as parent groups are required to document their own responses to climate change. Captives are increasingly being encouraged to explore what ESG means for the sector as part of the corporate governance framework to enhance reputation resilience which is permeating boards’ concerns around governance, compliance, investors’ equity risk and credit risk.
One area that’s received much attention since the onset of the COVID pandemic is global supply chain vulnerability and business interruption due to uncertain business environments and the critical importance to the impact to business disruption. Not only has there been a focus on global supply chains, but there is increasing focus of the greening of supply chains by doing business with vendors and service providers with green credentials. This includes insurance managers, banks, auditors, and any other vendor.
Strategic Risk Solutions, Guernsey, is the first Guernsey Insurance Services company to make the pledge to have net zero emissions before 2050. Recognizing that climate change poses a threat to all, SRS and other companies are committed to act. This aligns with the COP26 agenda to tackle climate change and the United Nations race to net zero.
As a global insurance manager dedicated to the continued development of ESG principles and integration within the firm, it is evident that different jurisdictions are farther along in the ESG journey than others with respect to adoption and implementation. There is a plethora of market commentary on the subject recognizing that common standards across jurisdictions are lacking and the insurance industry, along with others, would benefit from common reporting terminology and the consideration of group and third-party standards for the development of best practices in this area.
Increasingly, investors are choosing reinsurers who have pledged to help close the protection gap (the distance between total and insured losses), recognizing that stronger neighborhoods, communities, cities, and metropolitan areas allow countries, regions, continents, and the planet to recover from disasters and prosper. It will be important for the industry to build on strengths of the entire risk management chain in its pledge to address the protection gap more broadly and, as a result, build stronger, more resilient corporations and communities benefitting all stakeholders.
Author: Anna Pereira is a key member of our SRS ILS team in Bermuda. Her responsibilities include business development and the implementation and delivery of treasury and collateral management services. She advises on client and internal needs related to treasury, corporate banking, and collateral management processes.