Rethinking insurance to support a net-zero world

The idea that misunderstood climate risk leads to systemic asset mispricing throughout financial markets has long been a talking point among climate investors.

The think-tank Carbon Tracker warned that pension funds overly rely on economic research that ignores critical scientific evidence about the financial risks embedded within a warming climate. Climate scenario analysis is often “problematic”, “useless” and “not fit for purpose", Carbon Tracker has told investors. 

EU regulator EIOPA, the European Insurance and Occupational Pensions Authority recently acknowledged this in a report on the prudential treatment of sustainability risks under Solvency II. It recommends additional capital requirements for fossil fuel assets on European insurers’ balance sheets to accurately reflect the high risks of these assets.

More on this: Net Zero Investor's Insurance Investment Summit | 5 December 2024 | 1 Cornhill London

One source of mispricing is a widespread uncertainty around the year in which oil prices will peak, a key green transition date that may sound the death knoll for oil assets and therefore prove essential for risk calculations. Climate risk isn’t adequately priced in to oil and gas assets, effectively making them more expensive than they should be, according to Rory Sandilands, a portfolio manager for Aegon AM.

Speaking at COP29, Dr John Murton, senior sustainability advisor at Standard Charted Bank, summed up the risk calculation conundrum rather neatly. "It's often cheaper for us to finance a new fossil fuel project than a new renewable energy project," he said. "That makes absolutely no sense."

Can insurance play a corrective role?

Insurers may also face a similar reality to those of bankers and investors: price distortions caused by misplacing climate risk.

Anthony Hobley, deputy chair of climate risk and resilience at Howden Group, the world’s largest insurance and re-insurance broker outside the US, said that a combination of short-term thinking and a backwards-looking risk model often made new fossil fuel projects relatively cheap but renewable energy projects prohibitively expensive to insure.

The insurance industry, he said, needed to change the way it calculates its risk and even its business model to correct such distortions.

Hobley is an alumnus of Carbon Tracker, the same thinktank that sounded the alarm bells on pension funds underestimating climate risk.

He’d been hired because Howden was looking for an eclectic climate risk team, many members of which come from outside the insurance world, to evaluate and help transform how the industry tackles climate risk.

Under the current model, commercial insurers may insure and de-risk carbon intensive projects even as climate change negatively impacts other parts of the insurance industry, such as property and casualty insurance, which may suffer from rising costs of property damage and reconstruction due to more frequent extreme weather events.

Agricultural, health and life, liability, and re-insurance, as well as insurers’ own investment portfolios, are yet more examples of businesses that may face increasing stress due to climate change.

“We’re moving into a world of physical and economic transition, a world of unprecedented change,” Hobley said. “The problem is that insurers are stuck in the past, reliant on backward-looking historical data as a proxy for risk. But we can’t use a rear-view mirror to see the future. We need a forward-looking price curve to calculate risk.”

Other sectors, he continued, often use an eight-to-ten year forward looking model to assess business critical services and commodities. Insurance, however, is stuck in a “12-month renewal model” that “only makes sense” in a static world that’s in “economic and climate equilibrium”, a world in which insurers assume that “governments will automatically pick up anything that becomes un-insurable”.

“Those old assumptions are breaking down,” he said. “What insurance clients actually need is a longer term relationship with their insurer, together with a longer term assessment of risks.”

Such a dynamic would help insurers think not just about the next twelve months but also contingent liabilities, policies, and their overall role in the transition to a net zero world.

“Insurers have largely been missing in action from the demands of a transition to a net zero world,” he added. “But that needs to change.”

Climate finance goal supportive

In its recent report titled “The Great Enabler”, Howden Group argues that a transformed insurance industry could help the world meet 2030 climate finance goals by “de-risking” energy transition projects, which, under current risk models, may be considered too risky to be bankable or investable.

Insurance could provide a “second training wheel” alongside blended finance to help bolster green capital flows into emerging markets where climate investments are desperately needed, Hobley said.

Unlike blended finance, insurance has no hard structural limit in terms of donor capital.

Billed as the “Finance COP”, climate finance was top of the agenda at this year’s COP29 in Baku. Yet to date, the role of insurance has largely been “a blind spot” in strategic conversations about climate and nature finance, according to Howden.

By focusing on financial risk reduction and mobilisation of capital, optimisation of operational and project performance, and public policy implementation and market expansion, Howden calls on policymakers, corporates and investors to interact with the insurance industry to harness the power of insurance across the climate transition.

The firm estimates that insurance solutions could unlock $10trn of climate finance.

“Over the last thirty year, insurers have worked hard on climate change,” Hobley added. “They’ve got better at assessing certain extreme weather events and other factors that allow them to better price premiums, but that's essentially a defensive and reactive approach.”

“Now’s the time to be proactive, step up efforts, and de-risk the transition as a whole.”