Addressing Extreme Weather Events Through Captives

This article was originally published in Captive Review and is reprinted here with permission.

An unprecedented hurricane struck Southern California. A wildfire in Canada burned 20 million acres and blanketed U.S. cities in a layer of dangerous smoke. Catastrophic storms and flooding left a city in Libya completely cut off. Severe heat impacted millions across the United States, Europe and Asia. Monsoons struck India, claiming lives and disrupting everyday life and businesses.

The United States has seen a record number of weather disasters this year, according to the National Oceanic and Atmospheric Administration, and according to the European Union-funded Copernicus Climate Change Services (C3s), Earth just had its hottest three months on record.

Insurers Are Feeling the Heat

Extreme temperatures, wildfires, hurricanes, floods and other natural disasters leave insurance carriers and reinsurers scrambling to cover the catastrophic losses, straining financial resources and profitability. The surge in claims has insurance carriers concerned: Environmental risks are being deemed too high with losses too great.

And there’s more for insurance carriers to consider than the cost of the claims. More states are implementing strict regulations or requirements to cover the risks of environmental events. Remaining compliant with these ever-changing regulations is becoming more costly, leaving many carriers to decide whether it’s financially viable to continue operating within those states. Rising reinsurance costs add to the financial burden.

As more natural disasters occur, the long-term sustainability of these companies is put at risk. So, it’s no surprise to see insurance carriers withdrawing from markets with high risks of weather disasters. Farmers Insurance was the fourth carrier to pull out of the Florida market. More than 20 insurance companies have left Louisiana in the past two years. The increasing wildfire risks and soaring construction costs in California have caused two major insurers to withdraw from the insurance market in the state.

Yet businesses need a solution to continue operating. Fortunately, captive insurance programs can fill the gaps left by the traditional insurance market. With a captive, organizations can address the environmental impact liability by developing an insurance program to address specific risks that may go uninsured otherwise.

The strength of a captive solution lies in its flexibility. Whether covering a high-severity, low-frequency risk or filling a gap in traditional insurance, a captive can provide the protection needed to continue operations.

Quantify the Risks of Environmental Disasters

Environmental disasters lead to two types of exposures: Direct exposure, which includes the damage done by wildfires, floods and extreme temperatures, and indirect exposure—the disruption to normal operations caused by natural disasters, such as increased costs of working and supply chain issues.

As the global economy becomes increasingly interdependent, the consequences of an environmental disaster are far-reaching. Though not considered a natural disaster, COVID-19 illustrated the extreme economic impact that can occur as factory shutdowns impacted the supply chain.

As with any captive, the risks must first be quantified. Start by identifying potential environmental risks and considering key exposures. This should include more than just the consequences of a natural disaster itself, such as the loss of a building because of a hurricane, but any supply chain dependencies that can disrupt business. What types and amounts of risk do those exposures cause? Gathering this data is the first step in building an effective captive strategy. Carriers and reinsurers typically rely on a set of big data models to inform underwriting. However, this data is becoming increasingly unreliable as the changing climate compounds the effects.

Loss incubation can help, in which a risk is identified but has not yet developed into an actual loss. The risks are identified throughout the loss incubation period, and measures are taken to prevent or mitigate them before the loss is realized. A captive can be established in such a way that you gather data on the risks of weather events on your business as you transition risk coverage. For example, your business may fund 100 percent of the risk in the first year. In the second year, you can fund 80 percent through the captive and obtain market coverage for the remaining 20 percent based on your learnings. Each subsequent year, you can transfer more risk to the captive as you gather more data, learn more and establish strategies to mitigate new risks, allowing you to pinpoint coverage.

Captives are particularly effective strategies for tracking changing risk profiles when it comes to environmental risks. Start by thinking broadly, as some events truly are unexpected.

Insure Against Specific Weather Events

A captive is an ideal vehicle for insuring against specific weather events, especially by devising and incorporating alternative risk management solutions, such as parametric coverage. Parametric coverage, which pays out a predetermined, fixed amount, can be tied to specific, measurable weather events. For example, the amount of rainfall in certain areas or wind speed. Because these payouts are based on objective data as opposed to the extent of a loss, parametric insurance offers transparency, customization and financial control.

Access Different Markets

A captive inherently offers access to different markets, including traditional reinsurance markets, alternative risk transfer, fronting companies, excess and surplus lines markets, and global insurance markets. This access allows for tailored coverage, which can include catastrophic weather; competitive pricing; and more risk transfer mechanisms, such as bonds, insurance-linked securities (ILS), and parametric insurance.

These additional markets can provide specialized coverage for large-scale events, including hurricanes, earthquakes and wildfires. Reinsurance market access, especially, is a valuable tool, as reinsurance helps spread the financial burden of large claims to ensure the financial stability of a captive.

Bolster ESG Initiatives

Additionally, more companies are adding Environmental, Social and Governance (ESG) initiatives to their long-term strategies. While many are added voluntarily to become better corporate citizens, others add them in response to regulations, such as the EU ESG Regulatory Regime. When appropriately structured, a captive can address the gaps in coverage as traditional carriers withdraw from markets while covering ESG initiatives.

Establish Financial Stability

Even if your organization isn’t impacted by insurers withdrawing from markets, the large losses due to weather events are leading to increased pricing. Not only will a captive help alleviate the risk of major weather catastrophes and cover gaps, but it will smooth pricing fluctuations.

Traditional insurance relies on market conditions. Captives, on the other hand, are wholly reliant upon your business’s own loss history. The direct control and customization owners have over coverage limits, deductibles and policy design create continuity and stability for captive members.

As climate change continues to impact how everyday businesses run and traditional insurers withdraw from articles, leaders need solutions for catastrophic weather events. A captive strategy can address the risks that are quickly becoming uninsurable.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.