Risk Management Tools from the Insurance Perspectives
The response of the insurance and reinsurance industries to the challenge of providing their clients with solutions to enable compliance with emissions trading requirements has been gathering pace over the last few years. A number of the solutions provided are adaptations of classic risk transfer solutions whilst others break new ground, in some cases blending insurance and financial products.
Directors and Officers
Directors & Officers (D&O) insurance products offer cover to senior executives for their professional liability as company leaders. As soon as there is a legal obligation to reduce GHG emissions, new liabilities are likely to be faced by companies and their top executives. Whilst fines or penalties resulting from a breach of law would not be covered under a D&O policy, inappropriate or inadequate management of climate risks, resulting in a failure to protect a company”™s interests, could potentially lead to proceedings being taken against senior decision makers.
A possible cause for action could arise if shareholder value was perceived as being
damaged due to such a failure of management.
As part of the process of creating emission certificates, a pivotal contribution will be made by those who verify that certificates meet the required standards. Those conducting validation, verification and certification work, such as auditing organisations, will carry additional responsibilities. These roles will require professional indemnity policies to cover the new areas of practice.
The focus of many emission reduction activities will most likely be project-based. Therefore, project finance, whether offered by the banking, insurance or reinsurance industries, offers new opportunities when applied to projects aimed at reducing emissions (and clean energy in general).
By reducing the risks associated with emission reduction schemes through such tools as carbon delivery guarantees, contingent guarantees and traditional insurance products (e.g. fire, engineering and construction coverage for the projects themselves), a number of benefits should logically follow, including increased project investment ratings, reduced financing costs and improved return on equity.
Delivery guarantees are products offered by the insurance industry where the re/insurer acts as guarantor and financial compensation is paid if a product is not delivered according to agreed terms and conditions. This system can be used as a facilitator leading up to, and in the early years of, an emissions trading scheme. It is likely that instead of a monetary amount, the re/insurer of a project failing to deliver CERs would pay compensation in the form of CERs.
An example of this could be as follows: to ensure future compliance with its emissions ceiling, a buyer has the option to buy CERs in advance directly from a seller. After locating a seller, the buyer agrees to purchase a specified number of CERs. In the early stages of any new market system, there is a higher degree of uncertainty, especially if the “˜production time”™ (order to delivery) is extended over several years. It is therefore likely that, due to a potential risk of non-delivery, the
seller is required to reserve a larger quantity of CERs for the buyer than the buyer requires. This gives the buyer a buffer to increase the probability that the quantity of CERs it requires will indeed be delivered.
Alternatively, the re/insurer with contacts to CER sellers agrees to purchase a large quantity of credits from various sellers. Having done this, the re/insurer would then guarantee delivery to various buyers. This reduces the risk of failure of delivery and removes the need for the buyer to locate suitable sellers. Through this process, both buyer and seller benefit as the risk associated with the transaction is reduced and the important element of confidence is added to the system.
In addition to delivery guarantees, the risk of non-delivery can also be covered by other risk management tools such as extension of trade and investment insurance.