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29 November 2022ArticleLife

New era: insurers for decarbonisation

Ahead of the 27th United Nations climate change conference convening in Egypt, the latest count was that only 29 of the 196 countries that adopted the Paris Agreement in 2015 have raised their nationally determined contributions. The goal of that treaty is to limit global warming to well below 2 degrees—and preferably to 1.5 degrees—Celsius, compared to pre-industrial levels. According to the latest evidence from the Intergovernmental Panel on Climate Change, carbon dioxide emissions need to be reduced by 43 percent by 2030, compared to 2010 levels, but current national climate plans show instead a 10.6 percent increase.

There is no denying that the socioeconomic impacts of physical climate risk are escalating. In 2022, we have again witnessed some of the most devastating climate extremes: from excess heat, forest fires and droughts in Europe, Asia and Africa, to the most devastating floods in Pakistan, and some of the costliest hurricanes in North America. These, combined with a growing concentration of people and assets in high-risk regions, poor development choices, ageing infrastructure, vulnerabilities of supply chains, are all affecting lives, livelihoods and economic output all around the world, drawing more people into poverty.

The compounding effects of extreme events and other risks are also challenging future energy security and economic development. Just this summer, in Europe, the impact of extreme heat and drought on energy infrastructure, together with rising inflation, interest rates, and the Ukraine war, have significantly impacted energy supply and demand, sending an early warning to all nations of the need to expedite a resilient clean energy transition.

We are looking at a transforming landscape with many uncertainties. The industry needs to stay abreast of important developments on the climate science, policy, technology, litigation and regulatory fronts. These will have implications for companies’ efforts in not only assessing the financial impacts of climate change-related risks and opportunities on their business model, but importantly for how they can best serve their insureds and make sound investment decisions to support the transitioning to a more resilient carbon-neutral and nature-positive economy.

The World Economic Forum estimates that we will need approximately $4 trillion annually until 2050 to transition the global economy, but this cannot be provided entirely via public funding, and will necessitate the mobilisation of international development funding, as well as private capital, to enable a just transition. However, new technologies, industrial processes and infrastructure systems come with myriad risks that need to be assessed and managed to improve risk-adjusted returns to attract large scale capital.

Risk management also should be delivered with a forward-looking, full lifecycle view to avoid potentially large scale environmental risks of new technologies, and for managing the critical natural resources needed to develop them.

Expediting the decarbonisation of the global economy is fundamental to controlling the cost of climate adaptation measures. We need risk management solutions to reduce existing risks through retrofits, prevent new risks by building more resilient systems, and adapt to the residual risks of climate change.

As we look ahead, we need to navigate through many uncertainties associated with public policy, legal and regulatory frameworks, markets and consumer behaviour. We need to align priorities and work together to expedite this transition with a system-based approach to risk management to incentivise and enable the way forward.

Managing risks is at the heart of the insurance industry, and as the second-largest institutional investor, this industry is part of the solution. The industry is already engaging with a complex ecosystem of stakeholders, public and private, to leverage its capacity to find meaningful solutions on the ground. There is a need to innovate risk management approaches in this new era of economic decarbonisation, requiring engagement with a complex ecosystem of key stakeholders, governments, technologists, banks, corporations and project developers, accordingly.

“The industry is already engaging with a complex ecosystem of stakeholders, public and private.”

Task force

Steering the industry and companies through this highly complex landscape requires decision-relevant forward-looking risk information. In January 2020, The Geneva Association Board launched a task force on climate change risk assessment, for which we mobilised experts from 18 of the world’s largest P&C and life insurers, to develop and hone forward-looking climate risk assessment methodologies to enable access to decision-relevant climate change risk information for the insurance industry. The task force has since produced three reports: “ Climate Risk Assessment for the Insurance Industry”, “Insurance Industry Perspectives on Regulatory Approaches to Climate Risk Assessment”, and “Anchoring Climate Change Risk Assessment in Core Business Decisions in Insurance”.

We have clearly distinguished between the terms ‘climate risk’ and ‘climate change risk’ for the insurance industry. Climate risk refers to the (extreme) weather-related risks that P&C re/insurers underwrite at any given time with annual contracts. Our focus is on the latter and includes physical, transition and litigation risks, how they evolve and interact with a view to the future—for example, ‘the next five years’, ‘by 2030’, ‘by 2050’.

The work of The Geneva Association Task Force has brought significant clarity and offered practical guidance on how companies can develop their capacities using an exploratory, iterative and adaptive process to develop a more holistic approach to climate change risk assessment. This considers physical, transition and litigation risks and their interactions at different time horizons across business functions and decision feedback loops to assess the materiality of risks and develop potential actions to address them, using a combination of qualitative and quantitative scenario analysis. It also emphasises the benefits of cross-company engagement and deliberations, which lead to increased climate change risk awareness, out-of-the-box thinking and the leveraging of expertise, data and tools.

“The world simply cannot aim towards a net-zero, resilient economy without factoring in nature.”

Nature-positive activities

On November 23, The Geneva Association published my latest report about addressing large-scale nature-related risks as part of insurers’ core business: “ Nature and the Insurance Industry: Taking action towards a nature-positive economy”. The world simply cannot aim towards a net-zero, resilient economy without factoring in nature. First, nature has systematically been considered an externality—undervalued and mispriced by the public and private sectors. Second, there is clear and concrete evidence of the large scale impacts of the pollution and depletion of natural capital due to human activity, and subsequent implications for people and businesses. Third, addressing climate change and large scale nature loss are profoundly interlinked in both risks and solutions.

Assessing and valuing biodiversity and ecosystem services is complex and still under development. However, the most comprehensive estimates suggest that nature provides a value of $125 to $140 trillion per year. It is important to note that more than half of global gross domestic product (GDP) is dependent on natural capital and ecosystem services, but many of those ecosystems are close to tipping points, beyond which they may be unrecoverable. This will have significant implication on nature-dependent industries. For example, in China, the EU and the US, nearly 18.9 percent, 15.9 percent and 9.8 percent of GDP, respectively, depends on natural commodities (based on 2019 values). Industries that are highly dependent on nature generate 50 percent of global GDP, the three largest sectors being construction, agriculture and livestock, and food and beverages. These impacts, along with a few other developments, are driving considerations for large scale nature loss into core business decision-making.

Over the last few years, a number of insurance companies have taken important steps in supporting research and innovation in this area. For example, AXA has been funding academic research on how healthy nature translates into more resilient and less cost of damage to properties in coastal areas. Swiss Re is working with The Nature Conservancy and Conservation International to develop innovative insurance solutions that would incentivise that kind of activity. Zurich has been underwriting sustainable business models, such as mass timber as a new class of building materials. The Muséum National d’Histoire Naturelle in Paris, in partnership with the SCOR Foundation, has provided a systemic view of the risks associated with large scale biodiversity and nature loss. Munich Re is providing innovative solutions to incentivise a circular economy. Intact Financial, together with a number of other insurers, is investing in preservation of wetlands in Canada to build community resilience to floods. And Manulife has developed an integrated sustainable investment strategy for agriculture and timber.

As we consider new climate technologies for decarbonising the economy, these come with potentially serious environmental footprints, from the mining of rare earth and metals, to manufacturing and production and, ultimately, to the recycling and disposal of the waste. If we don’t anticipate and address these environmental risks with a circular economy perspective, while we may address our decarbonisation goal to tackle climate change, we may find ourselves in a much larger global environmental crisis.

Fortunately a number of leading universities, the EU and regional circular economy hubs are looking into the environmental implications of the entire value chain of new technologies. These will have major implications for developing relevant public policy, environmental regulation, and liability frameworks as we look ahead. These are issues that need to start being thought about now. We are already starting to consider these emerging risks in our industry dialogues. For example, I organised a major conference “Environmental Risks and the Insurance Industry” last year, to raise awareness among insurers that addressing nature is not just an environmental and a corporate social responsibility idea, but a core business issue.

In my report, I have identified the reasons why it is challenging for insurers to create a market from nature-based products. The main reason is that nature is not properly priced. That’s because people make the mistake of seeing nature as free for all. That erroneous assumption will change as the Taskforce on Nature-related Financial Disclosures further develops its beta framework for nature-related risk management and disclosures. And so, in my report, I describe how nature-related risks could hit the insurers’ bottom line and balance sheet. This is a real risk for insurers, their customers and investees.

The question is, what can you do from an opportunity perspective on your underwriting and investment sides to mobilise and motivate your customers on a trend towards a healthy nature. The big challenge there is for insurers to find clients willing to pay for a nature-based insurance product. In addition, the availability of and accessibility to data and tools, to quantify the risks and benefits associated with nature-based systems, remain a challenge. Finally, governments need to step up by investing in nature-based solutions and develop clear policy and regulatory frameworks around protection and preservation of nature. The point though is not that there are challenges, but that the conversation around finding solutions is starting. Why? Because no company can achieve a net-zero target without investing in protecting and conserving nature. I explain that, from the resilience side, from the carbon sequestration side, and from the deployment of new technological solutions side.

“Governments need to step up by investing in nature-based solutions and develop clear policy and regulatory frameworks.”

What’s next for research?

During the second quarter of 2023, we will publish a major report on how insurers can engage in de-risking and investing in large scale deployment of new climate technologies for industrial decarbonisation.

I see a major movement towards expediting commercialisation of a number of promising technologies that are going to be crucial for industrial decarbonisation and the energy transition. But many of these technologies are at pre-commercialisation stages. Insurers are a critical part of the solution, given the trillions of dollars that will be needed every year to bring these technologies into commercial operation. At the moment, we are seeing concessionary money, from governments, from philanthropy, from venture capital, but to really scale up, we need to bring in debt financing and to tap into capital markets. To do that, you need to have a very good risk management strategy in order to make these projects investable grade with risk adjusted returns that appeal to institutional investors.

Our research, first of all, explores the role the P&C insurance industry could play in de-risking pre-commercial climate technologies to help expedite their commercialisation. For example, carbon capture storage, or hydrogen in all its different ‘colours’, as well as its transportation, storage and distribution. These are new risks for which we don’t have any data. This presents a major challenge for the actuarial approach of insurers, whereby they use historical data to price risk. Now, insurers will need to follow the development of new technologies from their early stages and acquire engineering expertise to develop and test innovative ways to underwrite risk.

The second part of our research is about the role of insurers as institutional investors. We need to make sure that the world understands the requirements of institutional investors, such as insurance companies, given that they are regulated entities with fiduciary responsibility. For insurers, the matter will not simply be about the cost of capital of risky projects, but also about access to a pipeline of investable-grade projects of a size that allows for efficiency in due diligence. We also need to make investment in green technologies an asset class. Part of that process will be aligning taxonomies and regulations of sustainable finance frameworks across jurisdictions to enable development of standard financing products and simplification of reporting in their respective jurisdictions.

The report will also include a survey of insurance in the current state of play and the challenges and opportunities looking ahead from the perspectives of CEOs, CIOs and commercial CUOs. On a technology-by-technology basis, it is going to need a very different approach to risk management, and insurers will need to prepare themselves with the required expertise. We will demonstrate this through several concrete technologies. The goal of all of this is to mobilise the insurance industry to identify how it can get involved, at scale, in the pre-commercialisation stages of new technologies.

And by early 2024, we will have a report on the long-term insurability of the physical risks from climate change. We still need to define this further, but more and more insurers, banks, real-estate and infrastructure investors, policyholders and governments are doing forward-looking, physical climate risk analysis. They’re seeing physical risks on their balance sheet associated with their portfolios, assets and operations over long-term horizons. This is opening up a whole new dialogue among insurers, policyholders, banks, governments and regulators because, with the rising frequency and severity of extreme events, and with the physical risks of climate events increasing, we need to ensure that insurance is not going to be priced out of the market, as it is foundational to the financial resilience of society.

Clearly, we need to manage these risks to ensure the affordability of and accessibility to insurance over time. If we take a system-wide approach, can we incentivise different stakeholders to reduce their risks and prevent new risks. For example, if the valuation, mortgage and insurance rates of a home are risk-based, then new homes may not be built in very high risk zones. On the other hand, home retrofits, combined with government investments in risk mitigation measures, such as building flood walls or preservation of nature-based systems, could improve their risk rating over time, and subsequently lead to better valuation, mortgage and insurance rates. Another idea is that if a home is damaged by a disaster, the terms for post-disaster aid from the government could require building forward more resiliently.

“Action on the ground is not waiting for COP discussions.”

Expectations from COP27

For nearly 10 years, from September 2004 until June 2014, I was the head of disaster risk reduction at the World Meteorological Organisation. During this time, I was actively engaged in the international framework negotiations in disaster risk reduction (Hyogo and Sendai Framework for Action) and climate change COP negotiations. For example, together with the United Nations Office of Disaster Risk Reduction, we worked to bring these framework agreements together through the loss and damage programme. So I am deeply familiar with these processes.

Beyond official government delegations, this annual UN climate change event traditionally brought together representatives from multi-lateral organisations, non-profit organisations and academia as observers. However, over the last few years, and particularly since Glasgow COP26, these meetings have become the largest convener of representatives from the industry, financial institutions, insurance companies, technologists.

My biggest expectations from COP27 are the important discussions and partnerships that will be forged on the periphery of the event itself, for example about the role of innovation and finance in expediting climate mitigation on the ground. There will also be discussions around new technologies for decarbonisation, with entities such as Breakthrough Energy, First Mover Coalition, and the Mission Possible Partnership that are trying to encourage early market adoption and leverage private sector and government funding to expedite large scale deployment. Also, the Insurance Development Forum, a multi-lateral partnership engaging the insurance industry, UN agencies, the World Bank Group and international development partners are working to avail insurance in the most vulnerable economies.

As for the formal segment of the negotiations during the second week, I can’t give up hope! I think a major discussion at this COP will be around the loss and damage programme, essentially, how high-income economies will support the development of risk management tools, such as multi-hazard early warning systems or the expansion of insurance in emerging and low-income economies to help build resilience to rising physical climate risk. I hope governments will achieve higher ambitions and practical solutions during their negotiations for expediting the global decarbonisation, and there will be some progress with the development of voluntary carbon credit markets.

Nevertheless, although proactive global negotiations among policymakers are crucial, action on the ground is not waiting for COP discussions. For example, with the bipartisan Infrastructure Act and Inflation Reduction Act, we are already witnessing how clear and aligned national public policy, complemented with legislative action to direct government spending, is sending a clear signal to private sector participants to scale up, expedite and galvanise industry participation and private investments domestically and internationally, in the US.