‘Uninsurable’ transition risks leave companies exposed to protection gaps

Lack of insurance to support companies’ decarbonisation plans and diverging views on the insurability of transition risk are widening protection gaps and making risk transfer more complex.

An increase in so-called risk protection gaps – a calculation of the difference between insured losses versus total losses – is raising concerns about the affordability and insurability of the transition risks that companies encounter on the path to net zero.

The Federation of European Risk Management Associations rang alarm bells in a recent white paper, in which it urged the insurance and reinsurance industries to improve their product offering to facilitate companies’ transition to net zero. Ferma president Dirk Wegener warned that “[a] lack of sufficient risk transfer will slow investments in innovative technologies as more risk must be carried by the enterprise.”

He is not alone. Cheng Li Yow, corporate insurance partner at law firm Clifford Chance, also notes the need for an increase in insurance protection and insurance firms’ capacity to provide this. More broadly, many risks related to climate change as well as to the transition to a lower-carbon economy are uninsured. Simply looking at total losses caused by extreme weather events in Europe, only a quarter of these between 1980 and 2020 were insured, according to a study by the European Environment Agency.

And transition risks have been well documented and defined as being an aspect of companies’ decarbonisation efforts. The Task Force on Climate-related Financial Disclosures, for example, distinguishes four types of transition risks: policy and legal risk, technological risk, market risk and reputational risk. These constitute risks that affect businesses from a societal and economic point of view in the context of transitioning to a lower-carbon future.

Others, however, have a different view. At leading reinsurer Swiss Re, head of sustainability corporate solutions Lasse Wallquist acknowledges the problem but says transition risks are “entrepreneurial risks” and, as such, are generally not insurable. Better risk data and analytics are needed to better understand the risks relating to new technologies deriving from the net zero transition, and to improve the development of risk transfer solutions, he adds, because at present the industry lacks meaningful loss histories.

Regulatory pressure

Increasingly, companies will come under pressure to demonstrate their green credentials, which is also reflected in upcoming regulatory obligations, says Ferma’s Wegener. He highlights the EU Corporate Sustainability Reporting Directive, which will be implemented from 2024.

CSRD amends the current Non-Financial Reporting Directive and requires companies to publicly disclose information about their sustainability risks and opportunities. The regulation is based on the principle of double materiality, meaning it considers both financial implications and the impacts on people and the environment, as well as the interactions between them. It will also apply to insurance companies and credit institutions, which will need to navigate their own exposure to transition and physical risks.

Yow at Clifford Chance says insurers would be considering transition risks as both asset owners – particularly in life insurance – and assumers of transition risks on the non-life insurance side.

Though physical risks are, to some extent, insurable through policies targeting environmental liability and catastrophe scenarios, the same is not true for transition risks.

However, insurers and reinsurers can support companies by providing risk analytics that would help companies make decisions related to the transition, says Wallquist at Swiss Re. He notes that when managing risks, reinsurers monitor the development of individual sectors, taking into account premium volume shifts between sectors, changes in accumulation, increased litigation activity and changes in risk quality.

Still, lack of direct cover may push companies on an alternative path. Yow says that this may lead to the introduction of transition risk in capital markets products, such as insurance-linked securities – resulting in the need to educate potential investors on the relevant insurance risks they are indirectly assuming. She considers other solutions too: “If there is a protection gap then a variety of alternative risk transfer solutions, such as captives for corporates and parametric insurance, would be helpful.”

Innovative solutions

Captives are a specific form of self-insurance whereby a company creates its own insurance subsidiary to provide coverage for well-estimated claim payouts. They could be used to address transition risks with the only difference that the risks are kept within the corporate group, adds a Munich Re spokesperson.

Parametric is a type of insurance whereby a policyholder is paid a set amount based on a trigger event, rather than the magnitude of the losses in a traditional indemnity policy. Under which circumstances a trigger event occurs is key to the contract and the payout.

Munich Re says that these triggers are usually based on physical risks but that they could be used for transition risks too on the condition that measurable triggers can be defined. Wallquist at Swiss Re considers captives and parametric insurance to be less practicable to address transition risks, but says they may be helpful in structuring risk transfer for new technologies that are relevant for the transition.

Ferma is concerned about this lack of risk transfers. In its white paper, it notes that more than four in 10 corporate risk managers it surveyed for its 2022 European Risk Manager Report said they “believe that some of their locations or business activities will become uninsurable in the future”. It also noted the lack of coverage for specific new technologies or materials such as offshore solar panels, offshore wind farms, hydrogen fuel or storage, and new construction techniques that support decarbonisation efforts.

Industry experts agree on the need for new insurance solutions to attract greater investment towards wind, solar, hydro and energy storage technology. Weather insurance solutions in particular may become ever more relevant due to the growth of wind and solar energy, which are dependent on weather conditions, says Wallquist. He also expects risk data and services to feature more prominently in Swiss Re’s offering, given the lack of historical claims data in the area of these new technologies.

The transition to a lower economy is creating risks as well as opportunities for companies adapting their activities to reduce carbon emissions. It is presenting equal challenges and new growth paths to their insurers.