Clifford Chance

Traditionally, insurance is seen as a mechanism to absorb shocks and compensate unexpected events. However, insurance can have an important role in protecting natural assets and being proactive in the fight against climate change. Taking inspiration from nature itself, there has been a push over the last few years for companies to adopt Nature-Based Solutions ("NBS"). The insurance sector can have a significant role in promoting NBS, particularly through employing its expertise in risk management and transfer, providing capital and aiding growth of new markets through innovations and partnerships. Recent innovative insurance solutions have been an eye-opener as to what is possible.

Nature-based Solutions

Nature-Based Solutions involve working with nature to address societal challenges. Nature-based solutions to climate change range from green roofs and rain gardens to large projects, such as the construction of 8,000 hectares of terraces on hillsides in Burundi to control soil erosion and reduce runoff, and the Nature Conservancy's project to protect the Mesoamerican coral reef.

According to the United Nations Global Compact, NBS have the potential to provide more than a third of climate change mitigation to bring global warming below the requirement of 2°C. The market potential for NBS is also significant as it is forecasted to generate USD800 billion in annual revenues by 2050, creating a new insurance market estimated to be worth USD1.3 billion globally.

Innovative insurance solutions can help strengthen the investment case for the development and restoration of nature-based infrastructure. It can improve the financial resilience of communities by protecting governments and asset owners from potentially devastating financial impacts of natural catastrophes. For example, in 2017 Swiss Re alongside the Nature Conservancy, established a reef insurance policy to insure a stretch of the Mesoamerican reef and adjacent beaches along the Yucatan Peninsula in Mexico. The policy, purchased by the State Government of Quintana Roo's Coastal Zone Management Trust, was to ensure the health of the coral reef, and to reduce flooding damage in coastal communities. The policy was triggered in October 2020 when Hurricane Delta hit the coast of Mexico, and lead to the first ever coral reef insurance payment, which will be used to restore the reef. The project supported the quick release of funds to allow local communities to launch restoration actions and accelerate the recovery process following natural disasters.

Catastrophe Bonds and Parametric Solutions

Alongside traditional insurance, insurance linked securities ("ILS") have been around since the mid-1990s to absorb risk from weather-related catastrophes. Since most exposures to natural catastrophes emerge from climate-related risks, the potential impact of climate change has been a key consideration for the ILS market. Over recent years, there have been significant advances in climate modelling to incorporate climate change effects within catastrophe modelling, resulting in a better alignment between premium setting, disaster resilience and long-term profitability for investors.

In addition to advanced modelling, technological advances have also meant that pay-outs can be made faster, which is fundamental in mitigating the knock-on effects following a catastrophe. Parametric insurance offers pre-specified pay-outs based upon trigger events, such as an index-based trigger, or an event within a defined area (referred to as a "cat-in-a-box"). Since the pay-out is based on independently verifiable and unambiguous parameters, the predetermined payment is made quickly, simply and without lengthy adjustments

Whilst cat bonds and parametric solutions are receiving increased recognition for its ESG-positive characteristics in helping society develop long-term resilience against the effects of climate change, the ILS market can have a bigger role in preventing the acceleration of climate change.

Innovative Insurance

NBS and ILS have been used alongside one another in more complex structures to enable capital market investors to contribute to climate adaptation efforts. As an example, the Danish Red Cross has been working to create a Nature-Based Solution involving catastrophe bonds, the capital markets and carbon credits. The proposal anticipates that funding from the Danish Red Cross trust fund is used to plant mangroves in vulnerable communities. As mangroves store more carbon per unit area than any other ecosystem, it is expected that they would be able to sell carbon credits to corporate investors, which would be used to increase the funds in the trust. Trust funds are then used to pay for cat bond premiums. If the cat bond is triggered, a proportion of the funds will go to communities to support disaster relief, whilst the remainder will flow back into the trust fund to support future mangrove projects and future premiums. The pooled funds in the trust, whether from donors, sale of carbon credits or the triggering of a cat bond, are invested in the capital markets or other ILS products and earn an investment return, which are put back into the trust fund to be used for further projects and cat bond premiums.

This facility structure is an example of how the capital markets and insurance products can be used to support climate adaptation efforts, helping to change the approach to the effects of climate change from one that is reactive to one that is proactive.

Compensation to Prevention

With the advances in modelling and trigger-based pay-outs, there is clearly a market for insurance based NBS. The insurance industry has played a key part in combatting the effects of climate change by insuring against loss, but the industry can also have an important role to play in actively preventing the effects of climate change. In this sense, insurers are able to help communities mitigate climate risk through research, combining the vast amount of data insurers hold for modelling, speedy payments made possible by parametric solutions, access to the capital markets through ILS and working with nature itself.

International organisations recognise the future importance of NBS, demonstrated through the WWF's call for NBS to be given a substantive role at COP27, and the United Nations urge for NBS finance to triple by 2030. As the urgency to address the effects of climate change increases, NBS will only gain traction in influencing how the world responds to climate change and the insurance industry will play an important role in supporting and paving the way towards its implementation.