Climate change poses a systemic risk to the insurance sector. Sonia Shah looks at the key risks and explains what insurance firms need to do to stay ahead.
As businesses and individuals around the world work to reduce climate change, firms are also taking action to manage the financial risk it presents. For insurers, it will specifically affect underwriting, reserving, coverage and pricing, and insurance firms are currently under scrutiny for responsible targets for their underwriting and investment activity. Safeguarding clients and the wider financial system is paramount, with insurance premiums totaling USD 6.3 trillion, and assets under management sitting at around USD 13 trillion across the globe.
Regulatory and legislative change has put pressure on firms to act on climate risk. The PRA has given insurers until the end of 2021 to meet regulatory expectations on climate risk management covering governance, risk management, scenario analysis and disclosures. Similarly, the FCA requires UK premium listing firms to make disclosures in their annual financial reporting in line with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations. The EU regulations on Sustainable Financial Disclosure Regulation (SFDR) also impact insurers as they need to provide a harmonised set of Environmental, Social and Governance disclosures.
We take a look at the top challenges for the insurance sector.
Climate change risks to the insurance sector
There are two distinct types of climate risk: physical and transitional. Physical risk refers to elements such as temperature changes, drought or extreme weather events. Transitional risks refer to government and regulatory efforts to reduce physical changes - these may include laws on carbon emissions among others. Early government action to reduce climate change will put the onus on physical risks, while late action may lead to a flurry of changes in a short timeframe and increased transitional risk for all market participants.
Both will shape the risk landscape for general insurers, but underwriting risk is perhaps the most immediate in the form of:
Acute physical risks due to a greater volume of extreme weather events
Chronic physical risks due to ongoing climate change or a rise in sea levels, among others
It’s also important to recognise emerging legal risks. If policyholders suffer losses due to climate change there is a liability risk which is magnified by the systemic nature of climate change, giving rise to a large volume of claims in a short timeframe. Embedding an appropriate risk management approach is essential to maintain financial stability, provide effective coverage and meet policyholder expectations.
While we’ve specifically talked about general insurers above, it’s important to note that these challenges are not unique to them. Climate and environmental change will also have a societal impact, with a knock-on effect on health, life expectancy and claims.
Emerging best practice
Climate risk is a fairly new area of research and best practice is slowly emerging from cross-sector working groups, such as the Climate Financial Risk Forum (CFRF). The group is co-chaired by the FCA and PRA, and broadly aligns with their collective regulatory expectations. It forms a comprehensive, best practice approach for addressing climate risk, and key elements are outlined below.
Climate risk is a board level concern and a firm's climate strategy must align with its business strategy and be integrated across all operational processes. Insurers need to assess the needs of all stakeholders, including clients, brokers, regulators, employees and investors.
A Senior Manager Function (SMF) must be allocated, with ultimate responsibility for climate risk management. In turn they will determine and oversee roles and responsibilities across all three lines of defence. Boards need to monitor the development of a climate risk strategy and ensure it is implemented robustly, through regular updates and management information.
Risk assessments for the physical and transitional impact of climate change can be a challenge as the time horizons are so much longer than the traditional time frame of five years or so. Long term climate risks are expected to crystallise at around the 30 year mark, while medium term risks sit around 10-15 years. Getting a firm to buy into these extended risk management horizons demands a cultural shift, training programmes and effective delegation of responsibility across the business. Putting strategy into action requires accountability at every level, with measurable goals, reporting and monitoring processes. The risk frameworks will need to be reviewed and updated periodically as these risks will evolve and materialise.
Underwriting risk is the key concern for insurers and re-insurers. The first step is to map transition and physical elements against common risk factors, to identify how they will impact underwriting exposures and to assess materiality. Heatmaps will help gauge the potential impact and identify risk concentrations for key business lines. When it comes to measuring and tracking risks, this will depend on developing appropriate metrics, which may cover carbon intensity metrics or other indicators, such as those defined in the EU Taxonomy
Key considerations for insurance firms include:
Benchmarking climate strategy against peers in terms of commitments and performance
Reshaping portfolios to consider climate risk from counterparties, the volume of green activities, and changing the products offered in line with the risk appetite
Pricing, exposure management, reserve adequacy and uninsurable risks
Impact on underwriting to factor climate risk into product design
Reinsurance to transfer the risk of natural catastrophes
Working closely with the public sector to understand natural catastrophe planning and expectations
Use of probabilistic models to analyse scenarios and embed climate risk management processes
Scenario analysis is an integral tool to help insurers assess risk management processes and identify improvements to the control framework. If using a pre-existing scenario, the CFRF suggests three key steps to get started:
Set clear objectives, identifying resources and setting the budget
Choose the scenario, decide on the relevant risk metrics and impact assessment tools
Convert the data into a financial metric or other meaningful type of reporting
If developing a bespoke scenario, or building on an existing one, it's important to consider the socioeconomic context, technical evolution (such as technological changes to reduce carbon emissions over time), the changing policy landscape and emissions pathways. The last point on the list applies to a range of potential temperature changes representing adherence to the Paris Agreement goals. Emission pathways are particularly important as they will inform the three scenarios for early, late and no policy action in the upcoming Climate Biennial Exploratory Scenario 2021 (CBES), which takes place this summer.
CBES applies to the UK’s biggest insurers and builds on the 2019 General Insurance Stress Test, which found gaps in capabilities, data and use of tools to assess and mitigate climate risk. A concern for insurers, as with all modelling, is to ensure the data is forward-looking and sufficiently robust. Similar concerns are likely to emerge from CBES, especially around data and metrics, although climate risk programmes are picking up pace.
Key learnings from scenario and stress testing will include:
An indication of instances where insurance is unavailable
Insurers resilience to climate change
Improved modelling drawing on a wider range of inputs over longer time frames
Greater understanding of how climate risk impacts claims and premiums, impacts on profit and loss, and affects portfolio valuations
Disclosures are perhaps the best-known element of climate risk and are an integral part of the risk management process. The Task Force on Climate-related Financial Disclosures (TCFD) has provided the most comprehensive framework to date, which is widely accepted as the gold standard and endorsed by the UK government and regulators. As part of the government’s phased rollout, insurers will come under mandatory disclosure requirements in stages, depending on their size and scope.
TCFD-aligned disclosures cover governance arrangements, risk management processes, strategy, metrics and targets. When deciding what to include, insurers must consider both underwriting and asset management elements of their business at a firm-wide or product-specific level. This includes:
Firms should include scenario analyses and resilience, risks and opportunities for portfolios, sectors and geography and integrating opportunities into underwriting processes. On a product-specific level firms may consider opportunities to develop new products to support low carbon transition.
Asset management risks
Including firm-wide investment strategies and product-specific factors such as risk assessments (including details of products and tools used). It may also include information on scenario modelling and analysis, how the findings are used and how often scenarios are updated.
On a broader level, insurers will also be expected to report on identification, assessment and management of financial risks, operational risk management processes and KRIs, among others. This will depend on developing appropriate metrics and data to track progress.
Regulators are increasing the pressure on climate risk for insurance and there’s a good deal of work to do by the end of 2021 to meet PRA and FCA expectations. Climate risk may have a significant impact on insurers and taking early action will promote financial stability, help firms develop appropriate products for clients and curb underwriting risk. Over time, new products lead to new opportunities and it may lead to long term innovation. Getting started now will help insurance firms turn regulatory compliance into a competitive edge.
Contact us for further information on climate risk for insurers.