Using your captive to manage the budget impact of ESG risks

By Ed Koral, director, Strategic Risk Consulting, WTW

 

Organisations grappling with the challenge of developing a long-term strategy for managing their ESG strategy are being confronted with an ongoing problem. The evolving nature of ESG risk, and insufficient agreement on the quantification of the risk, means there is no standard coverage available to comprehensively cover all a corporation’s potential ESG-related losses.

Insurance policies often fall short because first party losses such as property damage, business interruption, extra expense, recall/replacement, weather-related losses, and others are difficult to estimate in advance, and equally difficult to measure afterwards.

What is especially limiting is that property policies respond only if there is physical damage to owned assets, even as substantial losses may occur without any such damage. ESG commitments can compound that issue, since a corporation’s ESG-related expenses are often voluntary; that is, they are not the result of a third-party legal settlement or a fortuitous loss that is incurred directly by the corporation itself.

Frequently ESG expenses are paid as a matter of goodwill and duty to the larger community. In the more conventional insurance framework of first-party proof of loss statements and principles of indemnification, those ideals do not trigger payment under insurance policies.

Evaluate the organisation’s total risk portfolio

So, what’s a responsible corporation to do?  How can a corporation maintain social and environmental commitments without wreaking havoc on the stability of its operating budget?

A recent trend is for firms to use sophisticated econometric and actuarial tools to model a truly corporate-wide view of risks – over multiple time frames, across all geographies and operations, and risk types.

This initiative can produce a deeper understanding of the true risks to a company’s operations and financial health and expressed in terms aligned with financial priorities set by the company’s senior management.

By broadening management’s perspective on risk drivers and viewing them collectively rather than in isolation, modeling the company risks can help uncover and exploit offsetting benefits that exist within the portfolio of risks, while also revealing dependencies and compounding effects of severely adverse events.

And here is where captives fit in. Often at the vanguard of insurance product innovation, captives write risks that are not well-understood by commercial insurance companies, where historical loss data is usually scarce, and in a coverage format that is not in widespread use in the insurance industry.

Most captives write their coverages on manuscript forms customized to the needs of the insured parent, instead of standardized commercial insurance policy forms.

As the organizations that run into the fire, captives play a key strategic role for organizations investigating their entire risk picture because the net retained risk across all areas may be sequestered and centralized in a captive dedicated to serving as a platform for risk-taking, and to allocating capital to that risk.

Parent organizations that are deeply engaged in “de-risking” their operations cannot afford to overlook ESG commitments and the risks surrounding them because they may either mitigate or compound other related risks that are better understood by financial professionals.

Including ESG risks in the captive provides a fuller picture and more complete governance in understanding the risks of the organization.

Consider Parametric Contracts

Along with this knowledge comes the realization that external protection is likely needed when ESG expenses drastically exceed expectations. But how can the captive deal with the situations and events where “loss payments” are difficult to define in advance?  What market support is available for organizations looking to budget and plan for ESG commitments?  This dilemma may be addressed, at least in part, by instruments known as “parametric” insurance contracts.

Derrick Easton, managing director of Alternative Risk Transfer solutions at Willis Towers Watson, comments: “We have seen a dramatic expansion in interest in parametric structures from both buyers and risk-takers, because they offer broader coverage than traditional equivalents, respond within days or weeks, and place no constraints on the use of proceeds. This creates a previously unavailable level of flexibility that is critical in allocating funds to ESG initiatives.”

Briefly, a parametric insurance contract is triggered by the severity of a pre-agreed event (e.g., extreme weather, an earthquake, or even a pandemic) or movements in an index (e.g., excessive or inadequate rainfall, temperature swings).

The policy is rated based on the probability of the event, using objective and observable measurements and indexes, and not the value or vulnerability of the insured’s assets.  Claim proceeds are released according to a pre-agreed scale of payment and released through a “loss certification” process that enforces the concept of indemnity; losses are not “adjusted” in the conventional sense, so claims are paid quickly after the occurrence of the policy trigger.

And importantly, there is usually no restriction on the use of claims payments. In the ESG arena, that can be huge because it enables the organisation to be creative and nimble in dispensing funds in a crisis, making decisions that fit the immediate situation rather than the requirements of an insurance policy issued many months ago.

Leigh Hall, Senior Originator at Munich Re Markets, adds that parametric contracts’ “fast, simple and efficient features make them attractive to an insurance buyer. A corollary of this development is that it has made participation by the Capital Markets in the insurance sector more attractive.”

Get started on reducing basis risk

An important concern in parametric transactions is basis risk – that is, the chance that the actual loss sustained by the insured will not match the payout available under the contract. Example: a parametric earthquake contract that specifies the location and minimum strength of the earthquake event, but which is not triggered by a given event even though the insured suffered property damage.

But what are the available objective indexes for actuaries or other analysts to correlate with likely required cash outflows on the wide array of ESG risks?

This is a great challenge with evaluating ESG risks, and the task can seem gargantuan and even paralyzing – making perfection the enemy of the good and creating the temptation to do nothing at all.  This need not be the case.

It is worth noting that with each passing year, data becomes more plentiful, more accessible, and less expensive, while the resources for analyzing it become more powerful. The technology has finally caught up with the concept.  For certain industries a more universal index may be useful, e.g., passenger flow through an airport could be correlated to a variety of risks that affect their business.

As businesses consider non-direct events that may cause significant disruptions of their operations, there are multiple coverages that are evolving rapidly — e.g., reputational risk, pandemic, environmental, supply-chain disruption, cyber risk.

These in turn depend on unusual and innovative indexes – pronouncements from global health organisations, actions of civil authorities, reduction in foot traffic, credit card transactions, reduction in passenger volume, etc.

While the elusive “complete protection package” may still be in the future, a good ESG strategy should involve the captive subsidiary in planning the balance between risk assumption and risk transfer. It is a flexible and useful vehicle for formalising risk-taking, with access to the best and most current financial tools for designing a realistic plan to cope with the risks that accompany ESG commitments, giving those commitments more weight.

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