Environmental financial risk is a hot topic and insurers need to comply with regulations and guidelines. However, until this year the current regulation in Switzerland applied only to large insurers. With the upcoming regulation all insurers are now expected to act. Where should small and medium-sized insurers start?
Insurance companies can be materially impacted by environmental risk including climate change, both in terms of physical risk (due to insurance losses) and transition risk (mostly affecting asset portfolios). The drivers pushing companies to take action range from protecting their own balance sheet, to shareholder pressure, to pressure from clients and cedants, and critically from regulation.
As the focus increases, regulators and international bodies, including FINMA, have published a series of revised and updated guidelines around climate and environmental risk management for insurers.
Regulation on Environmental Risk for Swiss insurers
Swiss insurers in FINMA regulatory category 2 have been explicitly required to disclose climate related financial risks since 1 July 2021 as part of their financial disclosure requirements (See FINMA Circular 2016/2).
In January 2023, FINMA released a new guideline (the 01/2023 Guidance) reiterating its expectation that all insurers must establish an appropriate climate risk management framework based on recognized international practices. The guideline clarifies that all insurers are obliged to identify, manage and disclose climate risks as part of their risk management processes. It references guidance from various international standard setting bodies, specifically IAIS , for recommendations on how to address this topic.
The guidance paper sets the scene for the upcoming changes to the Swiss CO2 Act expected to enter into force in 2025 which, amongst other changes, will require FINMA to regularly review and report on the climate-related financial risks of all supervised entities. The goal of the revised CO2 Act is to reduce greenhouse gas emissions, adapt to the effects of climate change, direct capital to low-carbon and climate-resilient developments.
To enact the requirements of the CO2 Act, FINMA is planning an amendment of circular 17/2 regarding new requirements on governance, risk management and scenario analysis. The FINMA circular will refer to the concept of environmental related financial risk, which is a broader definition than climate risk as it also includes the risk of loss of biodiversity, pollution, deforestation etc.
- Governance: there will be new requirements regarding the roles and responsibilities of the Board of Directors and Executive Management, organizational policies and directives, internal control systems and Internal Audit
- Risk Management: companies will be need to identify, assess, monitor and manage environmental related risks. In addition, it will include requirements on the reporting of relevant risk indicators or metrics within internal reporting as well as collecting information from counterparties.
- Scenario analysis: the circular will require companies to use scenario analysis to inform their decision-making. Environmental risks will need to be considered over time horizons which are longer than traditional planning horizons.
Reporting requirements are not yet clear, but our expectation is that the circular will operate in the ORSA context, and therefore it is likely that the ORSA reports will need to be amended to include the reporting on environmental related financial risks. Whether or not institutions will be required to disclose environmental risks publicly is yet to be seen.
The new requirements apply to all insurers; however, the proportionality principle should be considered when putting them into practice. As such, small and medium-sized insurance companies, that were so far exempted from any obligations to manage and disclose on climate risk management, will also need to start assessing this highly complex topic. Large insurers will need to expand their existing climate risk processes to the broader environmental risk landscape.
In terms of timing, a draft of the amended FINMA circular 17/2 is expected later this year, with the final version likely to be published late in 2024 and to enter into force in January 2025. Reporting may therefore be affected as early as 2025.
Where is the starting point?
Insurers first need to better understand the environmental risks in their own insurance and asset portfolios and then quantify the relative risk.
We suggest the following three steps:
- Performing a Maturity Assessment to help companies get an overview of the current and future ESG requirements and identifying any gaps, also when compared to market best practice.
- Conducting an Exposure Assessment to identify risk drivers, exposure and concentration in the insurance and asset portfolios
- Performing a Scenario Analysis to quantify the company’s exposure to environmental risks, helping to identify vulnerabilities and supporting the development of its business strategy.