In this three-part series, we will explore possible solutions available to help corporations manage their climate-related physical, transition and liability risks.
'Climate Risk' refers to the financial risks arising from climate change including physical, transition and liability risks. It is critical that businesses accurately identify and protect themselves against these risks through comprehensive risk management processes and/or risk transfer solutions such as insurance.
Notably, the Australian Prudential Regulation Authority (APRA) is currently undertaking a voluntary climate risk self-assessment survey to improve both APRA's and the financial services industry's understanding of the approaches being taken by APRA-regulated entities to identify, assess and manage climate-related financial risks. In addition, over the next three years more than six thousand Australian corporate and asset-owning entities are required to begin preparing an annual sustainability report including a 'climate statement' identifying the climate-related risks and opportunities facing the entity. The relevant Australian accounting standard (ASRS S2) requires disclosure of information regarding the assets and business activities vulnerable to climate-related physical and transition risks as well as details of the entity's governance, strategy, and risk management of climate-related risks. That is part of so-called mandatory climate reporting.
What are Physical Climate Risks?
Physical risks are the most readily apparent form of climate risk. This type of risk refers to damages and losses to property that occur due to the physical consequences of climate change. This includes acute climatic events such as flooding, wildfires and extreme heat as well as chronic climatic events such as rising temperatures, droughts and coastal inundations.
Physical climate risks are unevenly distributed across countries and regions. In the past five years, Australia has experienced a number of unprecedented weather events including the Black Summer Bushfires in 2019-2020 and extensive flooding in 2022. These events are becoming increasingly costly. According to the Insurance Council of Australia, insurers have paid out more than $16.8 billion in natural disaster claims since the 2019-20 Black Summer Bushfires. It is predicted that this amount will continue to rise in the coming years with natural catastrophes occurring more frequently and being more extreme. So far this year, the world has witnessed the devastating wildfires in California in January 2025, which are expected to become one of the costliest disasters in US history.
Physical risks can have impacts across the business value chain. These risks can have direct impacts such as impairment costs and productivity loss as well as indirect disruptions to the supply chain.
As stated by APRA in CPG 229 Climate Change Financial Risks, physical climate risks can cause direct damage to assets or property, changes to income and costs and variation in the costs and availability of insurance. ASRS S2 – the accounting standard for mandatory annual climate reporting – similarly notes that physical climate risks:
…could carry financial implications for an entity, such as costs resulting from direct damage to assets or indirect effects of supply-chain disruption. The entity's financial performance could also be affected by changes in water availability, sourcing and quality; and extreme temperature changes affecting the entity's premises, operations, supply chains, transportation needs and employee health and safety
Relevant Insurance Products?
Property Insurance
Businesses are increasingly exposed to the physical risks of climate change if they own physical assets (including property, agriculture and infrastructure), rely on others who do or rely on the supply of physical resources.
Generally, businesses have protected themselves against physical risks to their physical assets by implementing a robust property insurance program. Property insurance typically provides cover for physical loss or damage to an asset as well as cover for business interruption losses associated with the loss or damage.
The increase in frequency and intensity of weather-related catastrophes has placed a strain on traditional insurance solutions. These incidents are causing issues in terms of the availability and affordability of insurance, particularly in some high-risk regions in Australia. Insurers are also excluding cover for certain physical risks, for example hail and pollution.
Given the worsening physical climate impacts and stress on traditional insurance solutions, there is a growing protection gap. Aon's 2024 Climate and Catastrophe Insights found that global economic losses from natural catastrophes in 2023 were estimated at $380 billion. Of concern, only 31% of this amount was covered by insurance. Of note, the California wildfires have exposed the disaster insurance protection gap which refers to the growing divide between insured and uninsured losses. One reason for this increasing gap is that many of the major insurers had retreated or completely exited the property insurance market in California prior to January 2025.
Given the increasing frequency of extreme climate-related weather events and the growing insurance gaps, there is a need for alternative insurance solutions to provide protection in respect of physical climate risks.
Parametric Insurance
Parametric (or index-based) insurance is a tool that may be able to help corporations and other institutions manage today's complex and fast-changing risk environment.
Parametric insurance is a type of indemnity that triggers and/or pays out a pre-agreed amount when a pre-defined event occurs using a pre-defined index or parameter. In other words, parametric insurance is not attached to the loss but to the happening of an event which falls within a certain index or timeframe. This insurable trigger must be fortuitous, independently verifiable and able to be modelled by the insurer.
The key differences between traditional insurance and parametric insurance are summarised as follows:
Traditional insurance:
- Nature of the Risk covered: Occurrence of loss or damage caused by insured event to covered risk/asset
- Recovery: Reimbursement of adjusted loss;
- Basis Risk: Policy conditions, deductibles and exclusions;
- Term: Usually annual;
- Claims Assessment: Based on loss adjuster's assessment of actual loss suffered on happening of an insured event;
- Claims Payment: Can take weeks, months, years;
- Structure: Standard products and contract wordings with some customisation;
- Form: Insurance contract
Parametric Insurance
- Nature of the Risk covered: Occurrence of pre-determined event (usually established by a third-party agent such as the national earthquake body or weather agency)
- Recovery: Pre-agreed payment structure based on parameter or index value
- Basis Risk: Modelling accuracy; correlation of index with loss exposure
- Term: Single or multi-year
- Claims Assessment: Automatically triggered on occurrence of insured event with the payout determined according to the pre-arranged parameter
- Claims Payment: Within days
- Structure: Customised product uniquely tailored to individual needs with high structuring flexibility (single trigger, multi-trigger etc.)
- Form: Insurance contract or derivative
Parametric insurance is often used to address coverage gaps in existing traditional insurance programs, not replace them. In this respect, parametric insurance is increasingly recognised as a way to bridge the protection gap relating to physical climate risks.
With technological developments in satellite data, remote sensing and real-time monitoring, insurers are able to provide more precise and reliable parametric policies.
Parametric insurance is already being used in the agricultural sector to cover the physical risks of climate change. It can provide cover for several perils including cyclone (e.g. based on Bureau of Meteorology (BOM) Categorised Cyclone Path), fire (e.g. based on NDVI Burn Ratio Index), temperature (e.g. based on BOM Rainfall at nearest station or SILO Grid) and production shortfall (e.g. based on Area Yield based on shire or grid).
By way of example, Liberty Mutual Re has collaborated with Sprout and Britam to introduce a parametric solution to protect Kenyan coffee farmers from climate risks. This partnership uses satellite data to monitor rainfall, and when trigger levels are met, farmers receive payouts to compensate for reduced coffee yields. This approach addresses the specific challenges that smallholder farmers face, providing them with immediate financial relief.
It is predicted that the role of parametric insurance in managing physical climate risks will become more prominent as the effects of climate change continue to intensify. Regulators and law makers are expected to support and encourage the responsible roll-out of parametric insurance.
In addition to covering natural catastrophe risks, the insurance industry is now developing parametric solutions to cover non-physical damage such as business interruption losses.
Supply chain insurance
Given the impact physical climate risks can have on supply chains, it is vital that policyholders understand how to manage the unique risks associated with supply chain-related claims in order to maximise their coverage options in the event of a loss.
The industry has developed specialty 'supply chain insurance' or 'trade disruption insurance' which covers disruptions caused by property damage to a supplier or a dependent property. This type of insurance can cover the financial impact of the supply chain disruption including extra costs and expenses incurred and/or loss or net profit. The product can also be tailored to cover specific losses relevant to the policyholder and can be added as a business interruption endorsement.
Key takeaways
As the physical impacts of climate change intensify, it is important for businesses to accurately identify and protect themselves against these risks through comprehensive risk management processes and/or risk transfer solutions such as insurance.
At MinterEllison, we can assist you and your business with:
- identifying how you (or your suppliers) may be exposed to the physical risks associated with climate change, noting your particular vulnerabilities to extreme weather events;
- assessing whether there are any coverage gaps in your insurance or alternative risk management solutions; and
- advising you in relation to obtaining relevant risk transfer solutions to fill any gaps such as parametric insurance and supply chain insurance.
Get in touch with our MinterEllison experts today to identify and mitigate the physical impacts of climate risks for your business.