The Bank of Canada made history earlier this year by identifying the impact of climate change on the country’s financial stability. In the central bank’s annual financial system review (FSR), climate change is described as a risk “to both the economy and the financial system” via disruptive weather events and “transition risks from adapting to a lower-carbon global economy.” The review states how “economic activity and the environment are intertwined,” especially in Canada where natural resources play such a vital role in the economy.
Critics have been urging the Bank of Canada to analyze the resilience of Canada’s financial system against climate change for some time. Events like the Calgary floods in 2013, which cause around $5 billion in damages, and the Fort McMurray wildfire in 2016, which caused an estimated $3.7 billion in damages, only made them push harder. In the central bank’s 2019 FSR, it’s estimated that climate change will cost $21 billion-$43 billion by 2050. Regardless of where the final figure falls within that range, climate-related financial risk is something that all Canadian businesses need to take into account.
One solution that commercial entities might consider when transferring their climate risk is parametric insurance. According to Sean Hurley, managing partner at BFL Canada, parametric insurance is “an innovative way to complement traditional insurance”. With a parametric solution, pre-agreed payment for a claim is guaranteed upon the occurrence of a triggering event, which needs to be a pre-defined parameter or metric related to the insured’s particular exposure.
“One of the first projects that I worked on in [the parametrics] space involved a global steel manufacturer, located in Ontario,” said Hurley. “Their plant and operations are on the shores of one of the Great Lakes, and their main method of bringing in raw materials for making steel is through the Great Lakes waterways system, which freezes every year. They plan for that, and based on historical experience, they will stockpile coal and iron ore to get them through that winter period. In the winter of 2014 through the spring of 2015, there was a polar vortex that impacted Ontario and into Quebec to the point where those normal shipping routes didn’t open up until several weeks after the historical norm.
“And so, you’ve got a manufacturer who has depleted raw materials, in a low margin business where additional cost to bring those materials in through other methods (which would principally mean rail) would put them almost to the brink of bankruptcy. If you look at how a traditional property insurance policy would have responded, there was no physical damage to any of the process equipment and no physical damage to any of their stock, meaning they could not claim a business interruption loss. However, there was some significant economic hardship on the part of this manufacturer. So, we structured a parametric solution based on historical data, which triggered if there was a correlation of the number of days during a winter season below a certain minimum or low temperature. [If that parametric solution was] in place at the time, it would have paid out and covered that economic loss.”
Speaking on a panel at the RIMS Canada conference in Edmonton, Hurley argued the case for parametric solutions as complementing traditional insurance rather than replacing it. Likewise, fellow panellist Jonathan Ashall, vice president, AXA XL, described parametric solutions as an attractive addition to a risk management portfolio.
He said: “When you think about your risk management practice and how insurance claims are normally adjusted and paid out, one of the most interesting uses of parametric insurance is actually liquidity-based. Even though you have insurance that’s going to respond, if you need a liquid transaction within 48- to 72-hours, you can look at parametric products as a cash infusion that allows you to continue doing business while the claim is being adjusted. It’s transparent, because the insured has chosen an index, so it’s not subjective at all. It’s an index that’s developed, which has been modelled and statistically correlated with [an insured’s] financial loss. So, it’s not just insuring climate; it’s insuring our exposure to that climate.”
One of the key climate, weather, or CAT-related risks yet to fully materialize in Canada is earthquake. There’s significant earthquake exposure on the west coast, and in Quebec, which could eventually put parametric solutions to the test. Hurley commented: “If you take earthquake risk, for example, and you’re an organization that has significant values in the west coast of Canada or the United States, you’re very likely still faced with a deductible through traditional insurance that could be upwards of 10% of the total values of risk in that region. For a lot of organizations, that could be tens of millions of dollars, so if an event were to occur, it would still result in a significant financial burden to finance because of the size of that deductible. Parametric insurance can really act in complimenting that as a deductible buy-down effectively in three or four years.”