Climate and insurance regulatory capital

November 2024 

In its recent report on the prudential treatment of sustainability risks within Solvency II, EIOPA recommended that insurers holding equities and bonds in the fossil fuel sector should face additional capital charges. This is a significant milestone in the debate on how to reflect climate change in capital requirements for financial institutions.

The proposals

For equities, EIOPA recommends the introduction of a supplementary capital requirement of up to 17% in additive terms. EIOPA's impact assessment showed that this measure would only have a limited impact on insurers due to their low exposures to directly held fossil-fuel related stocks (comprising, on average, one per cent of insurers' total investments). 

For bonds, EIOPA recommends a supplementary capital charge of up to 40% in multiplicative terms. This would maintain the Standard Formula's duration-rating-based mapping of capital charges, again with limited impact due to insurers' low exposures to bonds held directly in the fossil fuel sector. 

EIOPA has begun to consider how climate-adaptation measures could reduce capital held for premium risk, and the appropriate prudential treatment for social risks. However, there is insufficient data in either area to draw conclusions, and therefore EIOPA will conduct further analysis.

Implications: balance sheets, spillover and divergence

Additional capital charges on fossil fuel assets will likely be interpreted by insurers as a 'brown penalising' measure, forcing firms to consider divesting their holdings and reconsider their investment strategies. If adopted, insurers will need to assess how the additional capital charges affect their solvency ratios. Although EIOPA asserts that the impact will be limited, insurers' own assessments may be different.  Additionally, those firms with internal models will want to understand how any Standard Formula changes could affect how they design, calibrate and change their models in future. 

Firms will also be keen to see if there is any jurisdiction spillover. Currently, EIOPA's proposals represent divergence between the UK and EU. Where EIOPA has recommended capital charges for climate-related market risks, the PRA does not mandate any specific climate capital charges for insurers or banks. Instead, it expects firms to make their own assessments on their climate-related exposures and evidence how their capital levels are sufficient to manage these risks. This may change as the UK regulator consults on updates to Supervisory Statement (SS) 3/19 in Q1 2025 and as part of any future review of the Standard Formula within Solvency UK, but all messaging to date suggests that this is unlikely and that the PRA will probably continue to follow a principles-based approach. At a global level, the International Association of Insurance Supervisors (IAIS) has identified climate change as one of its three strategic themes for the next four years, and insurers will be keen to see how it approaches the subject of capital requirements.  

Other non-insurance FS-firms will also be monitoring how the European Commission responds to EIOPA's recommendations. If adopted, there will be questions around whether the other European Supervisory Authorities, the EBA and ESMA, could take a similar approach in due course for banks and investment firms. There will also be concerns around how EIOPA's proposals might impact economic growth. This is currently a major political drive in the European Union and will likely be a factor in the Commission's assessment of the proposals. 

EIOPA's recommendations are not final policy. The Commission will need to consider the proposals and then decide whether to adopt them. There are currently no indications of when this could happen.