Known unknowns and the certainty of net zero

The insurance industry, historically adept at navigating the complexities of risk management, faces an unprecedented challenge in aligning with the global economy’s shift towards net zero emissions. 

This challenge is not just about adapting to new risks but fundamentally reevaluating the industry’s role in a rapidly changing world. 

Insuring fossil fuels projects earned the insurance industry over $20bn (£15.8bn) last year, with the London market recognised as the world’s biggest fossil fuel underwriter. 

Offshore wind, while beneficial for its substantial energy generation, poses risks related to maritime operations, turbine maintenance, and weather-related damages, requiring insurers to develop new methodologies for risk assessment and management.

But this revenue contrasts with the increasing pressure on insurers to meet ESG standards, and a growing reputational risk in insuring ‘brown’ sectors as financial services firms shift assets towards green investments.

It’s clear that the initial steps taken towards net zero have highlighted a capability gap across the industry when it comes to accurately projecting and underwriting the impact of climate change.

The management and accurate estimation of risk are the cornerstones of the insurance sector. 

Traditionally, the industry has excelled in quantifying the foreseeable, yet it now confronts a series of “known unknowns” that have left too many insurers across the sector unclear of how to move forward. The certainty of needing to comply with net-zero targets has introduced a paradox: while the goal is clear, the pathway is fraught with uncertainties. 

Climate change presents risks that are not only unprecedented but also highly complex, making them difficult to forecast and price accurately. 

This uncertainty complicates the industry’s ability to underwrite policies that are both economically viable, provide customer protection, and aligned with environmental objectives.

The problem is systemic. The transition to net zero has underscored a significant knowledge gap within the insurance industry, where many firms find themselves ill-equipped to accurately assess the risks associated with climate change, from the physical impacts of extreme weather events to the transition risks of shifting towards a low-carbon economy.

This is partly because the task of calculating risk in the context of climate change is fraught with complexity. 

There is a mixed consensus on the relative difficulty of assessing physical versus transition risks. Physical risks, stemming from direct climate impacts, present modelling challenges due to their variability and the intricate ways they interact with socioeconomic factors. 

Transition risks, associated with the shift away from fossil fuels, introduce uncertainties related to policy changes, technological advancements, and market dynamics.

Both types of risk require sophisticated analytical tools and a deep understanding of the interconnectedness of environmental, technological, energy, social, and economic systems.

New technologies are proving pivotal the transition but bring unique complexities that challenge traditional insurance models. 

Small modular reactors, for example, introduce novel nuclear technologies with different risk profiles. 

Hydrogen requires specialised safety and transport considerations, impacting insurance coverage for production facilities, storage units, and distribution networks. 

Offshore wind, while beneficial for its substantial energy generation, poses risks related to maritime operations, turbine maintenance, and weather-related damages, requiring insurers to develop new methodologies for risk assessment and management. 

The integration of these technologies into the existing energy grid and their interdependencies introduce systemic risks that are not fully understood. This complexity requires insurers to adopt more sophisticated risk modelling techniques, incorporating climate science, advanced engineering insights, and data analytics.

Fresh models

In addressing these challenges, the insurance industry must evolve. It needs to develop more sophisticated risk assessment models that account for the multifaceted nature of climate change. 

Furthermore, it must embrace its potential role as a catalyst for sustainable development, leveraging its influence to promote practices that align with net zero objectives. This involves not only refining underwriting standards and investment strategies but also advocating for policies that facilitate the transition to a low-carbon economy.

The insurance industry’s journey to net zero readiness is emblematic of the broader challenges facing the global economy. It requires a fundamental rethinking of risk, value, and the role of financial institutions in shaping a sustainable future. 

By confronting these challenges head-on, the industry will succeed in reshaping its contribution to the collective endeavour of mitigating climate change.