July 2023 was Earth’s hottest month on record.

Last month, scientists announced that the average global temperature will pass the 1.5C threshold for the first time in the next five years.

Wildfires are raging in Canada, which has never seen so much land burn so early in the year.

The RBI, which annually releases a report on the state of currency and finance in India, took us by surprise this time. The theme for 2022-23 is – ‘Towards a Greener Cleaner India.’  No guesses then that Climate Change is a burning topic in everyone’s mind!

We sat down with Sidhant Pai, Co-founder & CSO of StepChange, a Corporate Sustainability Platform, to understand the role and impact of Insurance in tackling Climate Change.

Why it makes business sense for insurers to go net zero?

While net zero can mean different things in different contexts, it typically refers to driving a company’s baseline emissions down to zero (or close to it). This involves a detailed accounting of emissions hotspots within an organization. In the context of an insurance company, an outsized portion of its emissions will be categorized as Scope 3 emissions resulting from the companies and projects it insures.

For instance, let’s consider a company that operates a coal power plant and is looking to insure the plant against extreme weather. While such insurance is distinct from a loan or equity investment that might directly contribute capital, the risk mitigation provided by the insurance product is still crucial to the operation of the power plant. It is thus clear that the insurance company that underwrites its operations should have to account for a portion of its emissions. These are called Insurance-Associated Emissions or IAEs. While IAEs are quite difficult to estimate, there is emerging guidance around best-practices. Despite the difficulty, it is critical for insurance companies to start measuring IAEs, for a few key reasons.

As regulations tighten and insurers are held accountable for their IAEs, there will be significant downsides to maintaining insurance portfolios with high emissions intensities.

There are also meaningful market implications to not being seen as sustainable from a brand-equity perspective. Insured companies with high carbon-intensity legacy business models are at the risk of having stranded assets that are no longer productive in a low-carbon economy. These risks are called Transition Climate Risks and they will be passed on to insurers that are not proactively managing their portfolios. Secondly, climate change will drive sea level rise, droughts and other extreme weather conditions, which will result in unpredictable damage to infrastructure and business operations that are key to the insured business, resulting in more claims and higher costs for insurers. These risks are called Physical Climate Risks. Insurance companies that are looking to future-proof their business models, and stay competitive over the next decade, will need to ensure that they account for and mitigate both these types of risk.

On Regulatory Trends:

We’re in a fast-changing regulatory landscape where regulators are increasingly requiring companies in different sectors to account for and report their CO2 emissions, with the goal of incentivising them to reduce emissions significantly, if not to net-zero. Financial institutions are already taking major steps to account for their portfolio emissions. Insurance companies will be similarly impacted in the coming years.

Let me also briefly explain scope 1, 2, and 3 emissions. Scope 1 emissions result from operations and activities that are owned or controlled by a company. Scope 2 refers to emissions resulting from the generation of purchased electricity, heat, or steam consumed by the company. Scope 3 emissions are the indirect emissions that occur as a consequence of the company’s activities but originate from sources not owned or controlled by the company. For insurance companies, the most salient type of emissions are those that occur from Insurance-Associated Emissions in their portfolio, which are classified under Scope 3.

On the role of Indian Insurance companies:

While climate change poses serious risks, Indian companies have an opportunity to leverage the changing market and regulatory landscape and build future-proof business models that are both sustainable and lucrative. I’m cautiously optimistic that large companies in India are starting to take positive steps in this direction, based on the interest we’ve seen in the accounting and decarbonization tools we’re developing at StepChange.

Insurance companies are similarly not immune from the changing market landscape. For instance, consider an insurance company that offers residential homes flood insurance. The estimated premiums are directly related to the probability of a qualifying flood event over the insurance term. Such a company might not realize it, but it has de facto become a climate insurance company. This is because, if it’s insuring a residence over a 30 year period, climate change will very likely impact the probability of a qualifying flood event, and should thus be factored in when estimating the premiums. Savvy insurers should immediately start thinking about these considerations and leverage models that incorporate such climate risks.

India is a large and climatically heterogeneous country with a dense population and thriving economy that is at meaningful risk from climate change over the coming decades. Any company or individual that wants to plan on a timescale longer than 5 years should start considering climate risk immediately. Similarly, instead of continuing to underwrite legacy business models that pollute our atmosphere, insurance companies can develop bespoke climate insurance offerings that future-proof their portfolios and facilitate our transition to a greener Indian economy.