We’re currently seeing more risk managers explore whether captives can play a bigger role 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, heatwaves, droughts, and wildfires – climate-related risks consistently rank among the top concerns for risk managers, according to recent research by AXA.
We believe to address these long-term and potentially catastrophic risks, you may need to shift risk management mindsets. This is about moving away from the traditional, short-term focus on annual insurance renewals and toward longer-term horizons and risk financing strategies.
So, below, we explore the role of captives to support this move to longer-term approaches. Captives can both work to stabilize your financials in the face of ongoing climate change and accelerate continued sustainability efforts.
If your 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 years, you’ll be in a better position to roll your 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.
To ensure business continuity in the face of an increasingly volatile climate, more businesses may 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, you can use captives 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.
Executing a climate hedging strategy effectively requires quantifying the financial exposures of your climate risks. With this insight, you can 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 identifying the locations of your exposed physical assets, as well as the locations of ‘sourcing regions’ in your supply chains that may be vulnerable to climate-related perils. Analytical geospatial tools can help you build this picture.
Once you’ve identified your climate-related exposures across your operations and supply chains, you need to stress-test them for hazards such as drought, flood and other climate-related events.
Using scenario testing and a wide variety of scientific data lets you simulate the potential effects of climate change on your business. Well-established actuarial simulations used by insurers can also give you a detailed understanding of the potential financial losses associated with different climate-related scenarios.
Having quantified the potential financial impact of climate-related risks, you’re now in a position to develop a risk financing strategy that responds to these multiple, complex and increasingly severe risks.
Companies’ sustainability reports often include details about how organizations use energy and water, as well as greenhouse gas emissions across business units. You can use your captive insurance program to actively encourage the right behaviors across business units in support of your organization’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, you can introduce sustainability metrics into your model. For example, if a business unit is making strong progress on sustainability by using less water and energy or reducing emissions, you can reward it with lower premium payments into the captive. Should a unit fall behind, you can apply higher payments.
By linking premiums paid into the captive to sustainability performance, you give every part of your business a clear financial reason to improve, making the captive a tool to drive positive change, not just a backstop for risk.
When you use a captive to manage climate-related risks, you may find the risks you retain, particularly catastrophic ones, can become significant over time. To protect your captive’s capital from being eroded by larger losses, you can turn to structured solutions, including parametric solutions, 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. Parametric policies pay out based on specific, measurable events (like a certain level of rainfall or wind speed), rather than on the actual losses you incur, meaning you get quick, predictable payouts when a defined event happens.
You can also use structured, multi-year, multi-line reinsurance to cover several years to create a safety net that helps smooth out the financial impact of major events.
By structuring your 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.
To discover how captives can support stronger long-term climate risk resilience, get in touch with our climate risk and captive specialists.
