Captives smooth the transition to a low-carbon world

Climate change poses an unprecedented risk not only to society, but also to companies that must develop strategies to mitigate the physical and transition risks that will arise. Limiting global warming and avoiding a climate catastrophe requires the transition of economies to net-zero emissions, a shift that will require companies to adapt their strategies and navigate the risks around new regulations and technologies.

Captives have an important role to play in their parent companies’ efforts to meet these challenges, particularly in de-risking the necessary changes to their strategies and incubating those that could stem from the adoption of new and often untested technologies required to remain successful in the net-zero transition. There are specific actions both in the short-term and long-term that captives can take to help guide the management of climate-related risks.

All of this takes place against a backdrop of heightened risks and challenges, including the increasing magnitude of natural catastrophes, the impact of geopolitical tensions on supply chains, and managing a workforce in times of social advocacy for greater diversity, equity and inclusion.

A recent survey by Zurich Insurance Group, “Accelerating the Climate Transition1”, sheds light on the common challenges of the net-zero transition across sectors and regions, citing unprecedented reallocation of capital and lack of feasible and scalable technological solutions as key among the most pressing challenges.

From a risk management perspective, the lack of feasible technology is compounded by limited appetite in the traditional insurance markets to cover the related emerging exposures.

In their nascent stages of development, the loss experience of new technologies may be poor or the risks may not be understood well enough to enable modelling and pricing. This creates a mismatch between insurance demand and supply, leading to insufficient coverage or coverage that can be adequate but only at a very high costs.

Such circumstances are an opportunity for captives, which have always been crucial tools to provide capacity and a structured means of risk financing that can supplement traditional insurance solutions. A captive can provide a formal structure for setting aside resources through premiums to fund a risk that might be uninsurable in the traditional market.

Technology risks and rewards

As a risk management tool, a captive can incubate the emerging risks that may arise from new and sometimes untested technologies by providing coverage and collecting data on the risks until the traditional market is comfortable enough to supplement the captive’s capacity. This means captives can broaden their mandate beyond the traditional focus on cost efficiency and deliver foundational business protection that enhances resilience to evolving risks.

During the transition phase, measuring and monitoring the impact of emerging risks is required, and captives that provide coverage for emerging risks associated with transition investments and/or activities, are able to help collect data for tracking, target setting and informed decision-making.

Companies deploying the emerging and quickly developing technologies needed to decarbonise their business operations have a great need for insights and data that let them improve the safety and efficiency of those technologies as quickly as possible while allowing them to learn from any losses. Captives provide a major benefit: access to granular and aggregated data which can be mined to help refine and enhance risk management while providing transparency for regulatory or voluntary disclosures.

Filling the traditional market void

The net-zero transition will give rise to novel risk financing opportunities. As companies increasingly use carbon offset and removal certificates in their decarbonisation efforts, they will be able to retain the associated carbon credit risks, such as invalidation or shortfalls in produced credits, using self-insurance where traditional products are only slowly being brought to market. A more practical example is where a company may own land for biodiversity regeneration and opts to finance and retain the associated risks via self-insurance through the captive.

Captives aid in a just transition

While accelerating the decarbonisation of our economy is one of the defining issues of our time, it must not be pursued as an isolated objective. The transition needs to be executed in a diligent manner that provides value for communities across geographic boundaries, as well as for employees that will need to be equipped with the new skills required to execute a transformed business strategy. Such company transformations may be mentally stressful to many employees and may call for special requirements around the management of employee wellbeing.

Captives can help parent organizations strengthen and expand protection for employees, support social transformation and respond to changing employee preferences for different ways of working. The growing practice of funding employee benefits in captives illustrates how companies are harmonizing and taking greater control over their global employee offerings. Beyond supporting employees to protect their health and wellbeing, captive-enabled programs help create a values-aligned work environment where employer commitments are backed by adequate solutions that are well financed.

Large organizations are domiciled in diverse locations, each with their own insurance practices and laws, which can make it challenging to provide consistent benefits to employees around the world. A captive can make it possible for a multinational to provide the same benefits package to its global workforce, by, in essence, providing difference-in-conditions coverage.

The captive’s contribution to a diligent transition goes beyond employee matters.

Zurich has been asked by some of its captive customers to help explore micro-insurance index-based solutions that a captive could use to protect vulnerable small farmers who supply critical raw materials to their customers. Those farmers are particularly exposed to increased volatility in extreme weather events, impacting their ability to secure consistent harvests. Parametric index protections against excess rainfall and drought would ordinarily be either unaffordable or unavailable in domestic markets for these small farmers. But having such programs backed by a captive could protect the farmers against the [financial] consequences of climate change, help build resilience and sustainability of supply chains, and, more crucially, protect and sustain livelihoods of the small-scale farmers. With the long-term financial viability of its suppliers secured, the captive parent benefits from more stable supply-chains.

Collecting data and understanding exposures is one thing. Finding ways to drive relevant risk management, investment decisions and business model adaptations is another. Developing implementable, affordable and broadly available solutions is the ultimate aim. This calls for collaboration among the captive, its parent and, potentially, other stakeholders. Captive stakeholders must hold steadfast to their commitment, and engage actively and inclusively in the transition strategy in order to clarify issues and expand ways in which captives can catalyse the practices of their parent organizations and co-developers of insurance solutions.

By leveraging their knowledge of a parent’s decarbonisation strategy and its risks and insurance management activities, captives help develop a coordinated and consolidated approach to financing transition risks. By facilitating insurance solutions for their group companies and championing development of market solutions, captives provide more than protection of physical assets – they protect the balance sheets of the company and build resilience for societies.

Originally published in Captive Review on October 23, 2023.