Forecasting the future: insurance solutions for the climate risk landscape in 2026 and beyond

Climate risks are not new. Neither are the insurance market's attempts to grapple with those risks. Insurers, particularly reinsurers, were among the earliest corporate entities to identify and study climate change. Reinsurers in the 1970s noticed an undeniable trend in rising claims relating to weather-related disasters.

However the climate risk landscape is far from static. It continues to evolve at pace. And the protection gap between the insurance cover that has historically been available for weather events and what traditional insurance is now willing to cover continues to widen. For some asset classes and geographical areas, insurance for certain climate-related risks is either unavailable or uneconomical. In Australia, the poles and wires necessary to bring the renewable energy that will be generated back into the grid are largely uninsurable. Cyclone cover in certain areas of the Pacific is also often unavailable. Exclusions for floods are now standard in many property insurance policies. Sub-limits often apply. Policyholders can no longer assume their policies will provide cover for natural disasters.

New insurance protection gaps will continue to emerge in response to the evolving risk landscape. The Australian government recently released its first National Climate Risk Assessment which concluded that Australia "is likely to experience more intense and extreme climate hazards, and in some cases in areas where people and places haven't experienced these hazards before." The challenge for insurability of these areas is self-evident.

Regulatory and legal risks associated with climate change are similarly increasing. Changes to continuous disclosure regimes, heightened focus on climate-related reporting, and increasing societal and investor pressure around environmental, social, and governance considerations are all placing pressure on boards and senior management. Annual sustainability reports containing climate-related financial disclosures are now mandatory for many large Australian businesses and financial institutions.

Climate litigation also continues to increase across the world, with just under 3,000 cases filed against corporations and governments globally. Corporations, including their directors and officers, are increasingly exposed to the "inaction risk" of failing to respond adequately to climate-related issues. Australia's regulators have repeatedly demonstrated their commitment to enforcing climate-related obligations, for example ASIC recently succeeded in its third greenwashing enforcement case.

Meeting the climate risk challenge

While traditional liability insurance policies may cover some of these risks, they may not always be fit for purpose.

So how do we address this emerging insurance challenge?

The insurance market is cyclical and, for a number of classes of business, is currently in a relatively soft phase. This means that there is competitive pricing and broad capacity across various lines of business. Now is the time for corporate policyholders to review their insurance programs and consider whether they address adequately the climate related risks faced by the organisation and, if not, to negotiate broader terms of cover or look at other options in the market. Policyholders should also look out for structural shifts in the market before they get baked in. For example, exclusions that impact climate related risks are already emerging in certain risk areas. It is advisable to guard against such developments.

The lack of availability or limitations of traditional indemnity-based insurance may also drive the use of alternative risk transfer solutions. Captive insurance, parametric insurance products and catastrophe bonds are becoming more widely considered and increasingly relied upon to address climate risks, particularly extreme weather events. These instruments have existed for some time, but the increasing limitations of traditional coverage are accelerating their adoption. For corporate policyholders, understanding these alternatives is becoming a cornerstone of prudent risk management.

Captive insurance can enable companies to transfer high volume, low severity losses from its balance sheet and to access the reinsurance market. However it comes at a cost. Significant capital is necessary to set up and maintain a captive and there are resulting constraints on the insured group's capital. Then there are the ongoing operational costs. The benefits of captives are typically only realised in the long-term. A captive set up now may generate value in the future, particularly if the traditional market capacity for climate-related risks continues to contract.

Parametric insurance is also used for natural catastrophes (NatCats) and short circuits the claim assessment required before a claim is paid out under traditional insurance. Instead, payouts are distributed once pre-agreed and pre-defined events occur – such as an earthquake or cyclone of a particular magnitude or intensity. Parametric insurance products therefore provide obvious benefits when NatCats occur.

Catastrophe bonds sit at the intersection of the insurance and capital investment markets. Investors are issued bonds typically by a Special Purpose Vehicle (SPV) acting on the instructions of a corporate client. The SPV holds the proceeds as collateral. The client pays premiums to the SPV in return for coverage against a defined NatCat. If that event occurs, the client gets the benefit of the principal to cover its losses. If the bond expires and no triggering event occurs, the principal and interest is released to the investor. Catastrophe bonds allow corporate policyholders to access the broader capital markets. This could be particularly valuable if traditional insurers and reinsurers withdraw from high-risk zones.

Key takeaways

The boundaries of what can be insured, on what terms, and at what price are all being pressure-tested. Now, more than ever, it is imperative for policyholders to understand their climate-related exposures and to take a long-term view on how to manage these risks. Most importantly, policyholders must ensure that the insurance or alternative risk transfer solution chosen is fit for purpose and will operate as intended.

_Disclaimer

_{Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.}